activity based costing
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Better Costing for Better Decisions
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��Not easily and conveniently traceable to cost objects
� Cost element is shared among cost objects
� Physically impossible to trace
� Not cost effective to trace
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Indirect Costs
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��Need for allocation
� Estimate product or activity cost
� What does it really cost?
� Increase awareness of indirect costs
� Activities are not free
� Plan more cost efficient operations
� Now that we know what it costs, what should we do?
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Indirect Costs
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�� Typical allocation methods
� Ability to bear
� Fairness or equity
� Benefits received
� Cause and effect
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Allocation of Indirect Costs
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�� Indirect costs allocated to cost object based on the cost object’s consumption of some measure of activity, usually labor hours
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Traditional Allocation Method
$10,000,000 total indirect cost400,000 total labor hours
= $25 per hour rate
A product consuming 6 labor hours would be charged $150 of indirect costs
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��Assumes all overhead is volume-related
� Factory-wide or departmental rates
� All related to single activity measure
�Departmental focus, not process focus
� Focus on costs incurred, not cause of costs
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Criticisms of Traditional Overhead Allocation
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�� Purpose
� Allocation of indirect costs based on causal activities
� Attempts to identify “direct” link between cost and cost object
� Results in better allocation
� Does not provide “true” cost
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Activity-Based Costing
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�� Traditional allocation method
�Activity-based allocation method
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Activity-Based Costing
Costs Products
Costs ProductsActivities
First stage Second stage
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�� Identifies activities required to produce the product or service
�Determines the cost of the activities
�Allocates costs to the cost object based on the object’s consumption of activities
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Overview of ABC
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��Not all costs are volume-related
� Unit level
� Batch level
� Product level
� Facility level
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Levels of Cost Incurrence
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�
�Assign costs to activity pools
� First stage allocation
� Identify the costs incurred to perform various activities
�Determine the measure of activity best related to each cost pool
� Cost drivers
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Operation of an ABC System
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��Determine rate per unit of activity
�Assign costs to products/services based on consumption of activities
� Second stage allocation
� Indirect costs are converted to direct costs
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Operation of an ABC System
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�� Step 1 – Plan the system
� What are the goals?
� Inventory valuation
� Process improvement
� Foster active involvement
� Assemble cross-functional team
� Functional specialists
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Implementing ABC
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�� Step 2 – Define, analyze activities and resources
� Decompose organization into elemental activities� Who does what, and why?
� Interview employees
�Determine resources
�Determine inputs and outputs
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Implementing ABC
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�� Gather statistics on activities
� Inputs and outputs
� Transaction, duration, intensity
� For possible use as second-stage cost drivers
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Implementing ABC
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�
� Step 3 – Establish activity cost pools and determine first stage allocation
� First stage allocations assign costs to cost pools
� Requires costs to be re-categorized according to why they are incurred, not by type
� Drivers may be employee time, square footage, etc.
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Implementing ABC
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�� Step 4 – Determine second stage drivers and assign costs to cost objects
� Outputs of activity analysis may be second stage drivers
� Distance moved, times handled, machine hours, units, etc.
� Amount assigned to the cost object is the amount of activity consumed times the rate per unit of the activity
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Implementing ABC
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��High amounts of overhead cost
�Multiple products
�Complex products
�Complex production system
� Significant variation in volume between high and low volume products
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When is ABC Most Useful?
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��Different products place different demands on resources
� Problems with current cost allocations due to changes in products or processes
� Better cost information is needed
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When is ABC Most Useful?
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��Natural extension of ABC
� Why are activities performed?� Are they necessary?
� Are they consistent with organizational goals?
� How are they performed?� Are they performed efficiently?
� Can they be redesigned or eliminated?
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Activity-Based Management
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�� Focus on problems, opportunities
� Prioritize opportunities for improvement
� Most critical
� Greatest potential for cost savings
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ABM for Process Improvement
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��Determine and explain causes for problems and opportunities
� Cannot improve the system without first understanding it
� Select specific improvement projects
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ABM for Process Improvement
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��Use ABC/ABM data to test potential impact of changes
�Make changes
� Iterate
� Process of continual improvement
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ABM for Process Improvement
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�
� Shifts focus from managing costs to managing activities
�Aids in recognizing, measuring and controlling complexity
� Promotes understanding of why costs are incurred
� Provides better cost allocation information
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Implications of ABC/ABM
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�
�Useful for planning future operations
� Fosters continuous improvement
� Likely to meet with substantial resistance
� Analysis of why and how activities are performed
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Implications of ABC/ABM
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