Definition and Explanation of Activity Based Costing System:
Learning Objectives:
1.
Understand activity based costing system.
2.
How it differs from a traditional costing system?
Activity based costing
(ABC) is a costing method that is designed to provide managers with cost
information for strategic and other decisions that potentially affect capacity
and therefore "fixed cost".
Activity based costing
system is used to determine product costs for special management reports. This
system is ordinarily used as a supplement to the company's usual costing
system. Most organizations that use ABC system have two costing systems--the
official costing system that is used for preparing external financial reports
and the activity based costing system that is used for internal decision making
and for managing activities.
In traditional cost
accounting systems, the objective is to value inventories and cost of goods sold for external financial reports in accordance
with the generally accepted accounting principles (GAAP). In
activity based costing (ABC) system the objective is to understand overhead and
the profitability of products and customers and to manage overhead. As a
consequence of these differences in objectives, "best practice"
activity based costing system differs in a number of ways from traditional cost
accounting.
In activity based
costing:
1.
Non-manufacturing as well as manufacturing costs may
be assigned to products.
2.
Some manufacturing costs may be excluded from product
costs.
3.
A number of overhead cost pools are used, each of
which is allocated to products and other costing objects using its own unique
measure of activity.
4.
The allocation bases often differ from those used in
traditional costing system.
5.
The overhead rates or activity rates may be based on
the level of activity at capacity rather than on the budgeted level of
activity.
Treatment of Costs Under Activity Based Costing (ABC) System:
Learning Objectives:
1.
How manufacturing, non-manufacturing
and idol capacity costs are treated under activity based costing system?
Contents:
In traditional cost accounting system, only
manufacturing costs are assigned to products. Selling, general, and
administrative expenses are treated as period costs and are not assigned to
products. However, many of these non-manufacturing costs are also part
of the costs of producing, selling, distributing, and servicing products.
For example commissions paid to salespersons, shipping costs, and warranty repair costs can be
easily traced to individual products. The term overhead is usually used to
refer non-manufacturing costs as well as indirect manufacturing costs under an
ABC system. In activity based costing, products are assigned all of the
costs-manufacturing as well as non-manufacturing-that they can reasonably be
supposed to have caused. The entire cost of the product is determined
rather than just its manufacturing cost.
In traditional cost accounting, all
manufacturing costs are assigned to products-even manufacturing costs that are
not caused by the products.
For example, a portion of the factory security guard's wages would be allocated
to each product even though the guards wages are totally unaffected by which
products are made or not made during a period. In activity based costing, cost
is assigned to a product only if there is a good reason to believe that the
cost would be affected by decisions concerning the product.
Plant wide Overhead Rate:
Normally overhead rate, called plant wide overhead rate or predetermined overhead rate,
is used throughout an entire factory and that the allocation base is direct
labor hours or machine hours.
This simple approach to overhead assignment can result in distorted unit
product costs when it is used for decision making purposes.
When cost systems were collected in 1800s, cost and activity data
had to be collected by hand and all calculations were done with paper and pen.
Consequently, the emphasis was on simplicity. Companies
often established a single overhead cost pool for an entire facility or
department. Direct labor was the obvious choice as an allocation base for
overhead costs. Direct labor hours were already being recorded for the purposes
of determining wages and direct labor time spent on tasks was often closely
monitored. In the labor-intensive production processes of that time, direct
labor was a large component of product costs--larger than it is today.
Moreover, managers believed direct labor and overhead costs were highly
correlated. (Two variables, such as direct labor and overhead costs, are highly
correlated if they tend to move together.) And finally most companies produced
a very limited variety of products that required similar resources to produce,
so in fact there was probably little difference in the overhead costs
attributable to different products. Under these conditions, it was not cost
effective to use a more elaborate costing system.
Conditions have changed. Many companies now sell a large variety
of products and services that consume significantly different overhead
resources. Consequently, a costing system that assigns essentially the same
overhead cost to every product may no longer be adequate. Additionally, many
managers now believe that overhead overhead costs and direct labor are no
longer highly correlated and that other factors drive overhead costs.
On an economy wide basis, direct labor and overhead
costs have been moving in opposite directions for a long time. As a percentage
of total cost, direct labor has been declining, whereas overhead has been
increasing. Many tasks that used to be done by hand are now done with largely
automated equipment--a component of overhead. Companies are creating new
products and services at an ever-accelerating rate that differ in volume, batch
size and complexity. Managing and sustaining this product diversity requires
many more overhead resources such as production schedulers and production
design engineers, and may of these overhead resources have no obvious
connection with direct labor. Finally, computers, bar code readers, and other technology have
dramatically reduced the cost of collecting and manipulating data--making more
complex (and accurate) costing systems such as activity based costing much less
expensive to build and maintain.
Nevertheless, direct labor remains a viable
base for applying overhead to products in some companies--particularly for
external reports. Direct labor is an appropriate allocation base for overhead
when overhead costs and direct labor are highly
correlated. And indeed, most companies throughout the world continue to base
overhead allocations on the direct labor or machine hours. However if factory
wide costs do not move in tandem with factory wide direct labor or machine
hours, some other means of assigning overhead costs must be found or product
costs will be distorted.
Departmental Overhead Rates:
Rather than use a plant wide overhead rate (predetermined overhead rate),
many companies have a system in which each department has its own overhead rate
(multiple predetermined overhead rates).
The nature of the work performed in each department will determine the
department's allocation base. For example, overhead costs in machining department may be allocated on the basis of
the machine-hours incurred in that department. In contrast, the overhead costs
in an assembly department may be allocated on the basis of direct labor-hours
incurred in that department.
Unfortunately, even departmental overhead rates will not correctly
assign overhead costs in situations where a company has a range of products
that differ in volume, batch size, or complexity of production. The reason is
that the departmental approach usually relies on volume as the factor in
allocating overhead cost to products. For example, if the machining
department's overhead is applied to products on the basis of machine-hours, it
is assumed that the department's overhead costs are caused by, and are directly
proportional to, machine-hours. However, the department's overhead costs are
probably more complex than this and are caused by a variety of factors,
including the range of products processed in the department, the number of
batch setups that are required, the complexity of the products, and so on.
Activity based costing is a technique that is designed to reflect these diverse
factors more accurately when costing products. It attempts to accomplish this
goal by identifying the major activities such as batch setups, purchase order
processing, and so on, that consume overhead resources and thus cause costs. An
activity is any event that causes the consumption of overhead resources. The
costs of carrying out these activities are assigned to the products that cause
the activities.
In traditional cost accounting,
predetermined overhead rates are computed by dividing budgeted overhead costs by a measure of budgeted
activity such as budgeted direct labor hours. This results in applying the
costs of unused, or idle capacity to products, and it results in
unstable unit product cost. In contrast to traditional cost accounting,
in activity based costing system, products are charged for the costs of
capacity they use and not for the costs of capacity they do not use. The costs
of idle capacity is not charged to products in activity based costing system.
This results in more stable unit costs and is consistent with the objective of
assigning only those costs to products that are actually caused by the
products. Instead of assigning the costs if idle capacity to products, in
activity based costing system these costs are considered to be period costs that flow through
to the income statement as an expense
of the current period. This treatment highlights the cost of idle capacity
rather than burying it in inventory
and cost of goods sold.
Real Business Example:
In Business
| Activity Based Costing (ABC) Changes the Focus
Euclid Engineering makes parts and components for the big automobile manufacturers. As a result of its ABC
study, Euclid's managers "discovered that the company was spending more
in launching new products than on direct labor expenses to produce existing
products. Product development and launch expenses were 10% of expenses, where
as direct labor costs were only 9%. Of course, in the previous direct labor
cost system, all attention had been focused on reducing direct labor costs. .
. Product development and launch costs were blended into the factory overhead
rate applied to products based on direct labor costs. Now Euclid's manager
realized that they had a major cost reduction opportunity by attacking the
production launch cost directly."
The new information produced by the ABC study also helped Euclid
in its relations with customers. The detailed breakdown of the costs of
design and engineering activities helped customers to make trade-offs, with
the result that they would often ask that certain activities whose costs
exceeded their benefits be skipped.
Source: Robert S. Kaplan and Robin Cooper, Cost & Effect:
Using Integrated Cost Systems to Drive Profitability and Performance (Boston:
Harvard Business School Press, 1998), pp. 219-222. |
Activity Based Costing (ABC) System and Top Management:
Learning Objectives:
1.
Understand the importance of the support of top
management in the implementation of activity based costing system.
Experts agree on
several essential characteristics of any successful implementation of activity based costing. First, the initiative to implement
activity based costing must be strongly supported by top level managers. Second, the design and
implementation of an ABC system should be the responsibility of cross functional
team rather than of the accounting department. The team should include
representatives from each area that will use the date provided by the ABC
system. Ordinarily, this would include representatives from marketing,
production, engineering and top management as well as technically trained
accounting staff. An outside consultant who specializes in activity based
costing may serve as and advisor to the team.
The reason for
insisting on strong top management support and a multifunction team approach is
rooted in the fact that it is difficult to implement changes in organizations
unless those changes have the full support of those who are affected. activity based costing changes the "rules of the
game" since it changes some of the key measures that managers use for
their decision making and for evaluating individuals' performance. Unless the
managers who are directly affected by the changes in the rules have a say, resistance
will be inevitable. In addition, designing a good ABC system requires intimate
knowledge of many parts of the organization's overall operations. Top
management must support the initiative for two reasons. First, without
leadership from top management, some managers may not see any reason to change.
Second, if top managers do not support the ABC system and continue to play the
game by the old rules, their subordinates will quickly get the message that ABC
is not important and they they will abandon the ABC initiative. Time after
time, when accountants have attempted to implement an ABC system on their own
without top-management support and active cooperation from other managers, the
results have been ignored.
Activity Based Costing - GAAP and External Reports:
Some companies do
use activity based costing in their external reports, but most do not.
There are a number of reasons for this. First, external reports are less detailed than internal reports
prepared for decision making. On the external reports, Individual product costs
are not reported. Cost of goods sold and inventory valuations are disclosed,
but their is no breakdown of these accounts by product. If some products are
under-costed and some are over-costed, the errors tend to cancel each other
when the product costs are added
together.
Second, it is often very difficult to make changes in a company's
accounting system. The official cost accounting system in most large companies
are usually embedded in
complex computer programs that have been modified in-house over the course of
many years. It is extremely difficult to make changes in such computer programs
without causing numerous bugs.
Third, an ABC costing system does not conform to generally accepted accounting principles
(GAAP). Product cost computed for external reports purposes must
include all of the manufacturing costs and only manufacturing costs; but in ABC
system products costs exclude some manufacturing costs and include some
non-manufacturing costs. It is possible to adjust the ABC data at the end of
the period to conform to GAAP, but it requires more
work.
Fourth, the auditors are likely to be uncomfortable with
allocation that are based on interviews with the company's personnel. Such
objective data can be easily manipulated by management to make earnings and
other key variables look more favorable.
For all of these reasons, most companies confine their ABC efforts
to special studies for management, and they do not attempt to integrate
activity based costing into their formal cost accounting system.
Designing and Implementing Activity Based Costing (ABC) System:
Experts agree on
several essential characteristics of any successful implementation of
activity based costing system.
First, the initiative
to implement activity based costing must be strongly supported by top
management. Second, the design and implementation of activity based costing system
should be the responsibility of a cross functional team rather than of the accounting
department. The team should include representatives from each area that will
use the data provided by the activity based costing system. Ordinarily, this
would include representatives from marketing, production, engineering and top
management as well as technically trained accounting staff. An out side consultant
who specializes in activity based costing system serve as an advisor to the
team.
The reason for
insisting on strong top management support and a multifunction team approach is
rooted in the fact that implementing activity based costing system is difficult
in organizations unless those changes have the full support of those who are
affected. Activity based costing changes " the rules of the game"
since it changes some of the key measures that managers use for their decision
making and for evaluating individuals' performance. Unless the managers who are
directly affected by the changes in the rules have a say, resistance will be
inevitable. In addition, designing a good activity based costing system
requires intimate knowledge of many parts of the organization's overall
operations. This knowledge can only come from the people who are familiar with
those operations.
Implementation of
activity based costing system must be initiated by top management due to two
reasons. First, without leadership from top management, some managers may not
see any reason to change. Second, if top managers do not support the ABC system
and continue to play the game by the old rules, their subordinates will quickly
get the message that ABC is not important and they will abandon the ABC
initiative. Time after time, when accountants have attempted to implement an
ABC system on their own with top-management support and active cooperation from
other managers, the results have been ignored.
For designing and
implementing activity based costing system, management should carefully study
the existing cost accounting system and review the articles in professionals
and trade journals. In most of the organizations, the new activity based
costing system supplement, rather than replace, the existing cost accounting
system, which continues to be used for external financial reports.
The following chart
explains the general structure of activity based (ABC) costing model.
The Activity
Based Costing Model
Cost Objects
(e.g., products and customers)
|
¯
|
Activities
|
¯
|
Consumption of
Resources
|
¯
|
Cost
|
Usually, company's
traditional cost accounting system adequately measures the direct material and
direct labor costs of products since these costs are directly traced to
products. In most of the organizations activity based costing study is usually
concerned solely with the other costs of the company - manufacturing overhead
and selling, general, and administrative costs.
The activity based
costing implementation team should carefully plan about implementing activity
based costing. Implementation process may be broken down into the following six
basic steps.
Targeting Process Improvements
Activity Based Costing + Activity Based Management
Activity based costing can be used
to identify areas that would benefit from process improvements. Indeed,
managers often cite this as the major benefit of activity based costing.
Benchmarking provides a systematic approach to identify the
activities with the greatest room for improvement. For example, the marketing
resource group of US WEST, the telephone company
performed an ABC analysis of the activities carried out in the accounting
department. Managers computed the activity rates for the activities of
the accounting department and then compared these rates to the costs of
carrying out the same activities in other companies. Two benchmarks were used:
1.
A sample of fortune 100 companies, which are the
largest 100 companies in the united states.
2.
A sample of world class companies that had been
identified by a consultant as having the best accounting practices in the
world. These comparisons are as as follows:
Activity
|
Activity Measure
|
US WEST
Cost
|
Fortune 100
Benchmark
|
World-Class
Benchmark
|
Processing accounts
receivables
|
Number of invoices
process
|
$3.80 per
invoice
|
$15.00 per invoice
|
$4.60 per invoice
|
Processing accounts
payables
|
Number of invoices
processed
|
$8.90 per
invoice
|
$7.00 per invoice
|
$1.80 per invoice
|
Processing payroll
checks
|
Number of checks
processed
|
$7.30 per
check
|
$5.00 per check
|
$1.72 per check
|
Managing customer
credits
|
Number of customer
accounts
|
$12.00 per
account
|
$16 per account
|
$5.60 per account
|
It is clear from this
analysis that US WEST does a good job of processing accounts receivable. Its
average cost per invoice is $3.80, where the cost in other companies that are
considered world class is even higher - $4.60 per invoice. On the other hand,
the cost of processing payroll checks is significantly higher at US WEST that
at benchmark companies. The cost per payroll check at US WEST is $7.30 versus
$5.00 at Fortune 100 companies and $1.72 at world class companies. This
suggests that it may be possible to wring some waste out of this activity using
total quality management, process reengineering, or some other method.
Real Business Example:
Disciplining the Software Development Process
Tata Consultancy Services (TCS) of India is the
largest consulting organization in India, serving both Indian and international
clients. The company used activity based management to identify problem areas
in its software development business. An early finding was that "quality
assurance, testing and error correction activities made up a significant
chunk of the overall effort required to build a system, and this cost had to
be kept under control to improve productivity and profitability." The
company already had in place a quality management system that helped identify
the types of errors that were occurring and the corrective action that would
be required, but no costs were attached these errors and actions. The
activity based management system provided this cost information system, which
allowed managers to set better priorities and to monitor the costs of
error-correction activities.
As another example of the usefulness of the system,
54 person-days in one software development project at TCS were charged to the
activity "waiting for client feedback" - a non-value-added activity. Investigation revealed that the
client was taking a long time to review the graphical user interface (GUI)
designed by TCS. The client was showing the GUI to various end users - often
resulting in contradictory suggestions The solution was to draw up guideline
for the GUI with client, which were enforced. "As a result of this
corrective action, subsequent client feedback was well within the time
schedule. Most of our screens were accepted because they conformed to
standards . . . . ."
Source: Maha S. Mahalingam, Bala V.
Balachandran, and Farooq C. Kohli, "Activity based management for
systems consulting industry," Journal of cost management, May/June 1999,
pp. 4 - 15.
|
Advantages, Disadvantages and Limitations of Activity Based
Costing (ABC) System:
Learning Objectives:
1.
What are the advantages and disadvantages of activity based
costing system?
Contents:
Activity based costing system has
the following main advantages / benefits:
1.
More accurate costing of products/services, customers, SKUs, distribution channels.
2.
Better understanding overhead.
3.
Easier to understand for everyone.
4.
Utilizes unit cost rather than just
total cost.
7.
Supports
performance management and scorecards
8.
Enables costing of processes, supply
chains, and value streams
9.
Activity Based Costing mirrors way
work is done
Activity based costing system
help managers manage overhead and understand profitability of products and
customers and therefore is a powerful tool for decision making. However
activity based costing has a number of limitations or disadvantages.
These limitations or disadvantages
are briefly discussed below:
1. Implementing
an ABC system is a major project that requires substantial resources.
Once implemented an activity based costing system is costly to maintain.
Data concerning numerous activity measures must be collected , checked, and
entered into the system.
2. ABC
produces numbers such as product margins, that are odds with the numbers
produced by traditional costing systems. But managers are accustomed to using
traditional costing systems to run theirs operations and traditional costing
systems are often used in performance evaluations.
3. Activity
based costing data can be easily misinterpreted and must be used with
care when used in making decisions. Costs assigned to products, customers and
other cost objects are only potentially relevant. Before making any significant
decision using activity based costing data, managers must identify which costs are
really relevant for the decisions at hand.
4. Reports
generated by this systems do not conform to generally accepted accounting principles (GAAP).
Consequently, an organization involved in activity based costing should have
two cost systems - one for internal use and one for preparing external reports.
Activity Based Costing Example / Problem:
Learning Objectives:
3.
Construct a table showing the overhead costs of units
and four orders.
Ferris Corporation
makes a single product - a fire resistant commercial filing cabinet - that it
sells to office furniture distributors. The company has a simple ABC system
that it uses for internal decision making. The company has two overhead
departments whose costs are listed below:
Manufacturing overhead
|
$5,00,000
|
Selling and administrative overhead
|
$300,000
|
|
|
Total overhead costs
|
$8,00,000
|
The company's
activity based costing system has the following activity cost pools and
activity measures:
Activity Cost Pool
|
Activity Measures
|
Assembling units
|
Number of units
|
Processing orders
|
Number of orders
|
Supporting customers
|
Number of customers
|
Other
|
Not applicable
|
Costs assigned to the
"other" activity cost pool have no activity measure; they consist of
the costs of unused capacity and organization-sustaining costs - neither of
which are assigned to products, orders or customers.
Ferris Corporation
distributes the costs of manufacturing overhead and of selling and
administrative overhead to the activity cost pools based on employee
interviews, the results of which are reported below:
Distribution of
Resource Consumption Across Activity Cost Pools
|
|
Assembling Units
|
Processing Orders
|
Supporting Customers
|
Other
|
Total
|
Manufacturing overhead
|
50%
|
35%
|
5%
|
10%
|
100%
|
Selling and administrative overhead
|
10%
|
45%
|
25%
|
20%
|
100%
|
Total activity
|
1,000 units
|
250 orders
|
100 customers
|
--
|
--
|
Required:
3.
OfficeMart is one of the Ferris Corporation's
customers. Last year OfficeMart ordered filing cabinets four different times.
OfficeMart ordered a total of 80 cabinets during the year. Construct a table
showing the overhead costs of these 80 units and four orders.
Solution:
Activity Cost Pools
|
|
|
Assembling Units
|
Processing Orders
|
Supporting Customers
|
Other
|
Total
|
Manufacturing overhead
|
$250,000
|
$175,000
|
$25,000
|
$50,000
|
$500,000
|
Selling and administrative overhead
|
30,000
|
135,000
|
75,000
|
60,000
|
300,000
|
|
|
|
|
|
|
Total activity
|
$280,000
|
$310,000
|
$100,000
|
$110,000
|
$800,000
|
|
|
Activity Cost Pools
|
Total Cost
|
Total Activity
|
Activity Rate
|
Assembling units
|
$280,000
|
1,000 units
|
$280 per unit
|
Processing orders
|
$310,000
|
250 units
|
$1,240 per order
|
Supporting customers
|
$100,000
|
100 customers
|
$1,000 per customer
|
3. The overhead cost
for the four orders of a total of 80 filing cabinets would be computed as
follows:
Activity Cost Pools
|
Total Cost
|
Total Activity
|
Activity Rate
|
Assembling units
|
$280 per unit
|
80 units
|
$22,400
|
Processing orders
|
$1,240 per order
|
4 units
|
$4,960
|
Supporting customers
|
$1000 per customer
|
Not applicable
|
|
4. The product and
customer margin can be computed as follows:
Filing Cabinet Product Margin:
|
|
|
Sales ($595 per unit × 80 units)
|
|
$47,600
|
Cost:
|
|
|
Direct materials ($180 per unit × 80 units)
|
$14,400
|
|
Direct materials ($50 per unit × 80 units)
|
4,000
|
|
Volume related overhead (above)
|
22,400
|
|
Order related overhead (above)
|
4,960
|
45,760
|
|
|
|
|
|
$1,840
|
|
|
==========
|
Customer Profitability Analysis - OfficeMart
|
|
|
Product margin (above)
|
$1,840
|
|
Less: Customer support overhead (above)
|
1,000
|
|
|
|
|
|
$840
|
|
|
===========
|
|
