Asfandyar

Asfandyar Jahangir
Jahangir
Azib
Azib Hamid
Hamid
Hassan
Hassan Mohi-ud-Din.
Mohi-ud-Din.
Activity-Based
Costing Systems

TRADITIONAL COSTING SYSTEMS

Traditional
Traditionalcost
cost systems
systemswere
werecreated
created when
when
manufacturing
manufacturingprocesses
processeswere
werelabor
laborintensive
intensiveor
ormachine
machine
intensive
intensive

A
Asingle
single company-wide
company-wide overhead
overhead rate
rate
based
based on
on direct
direct labor
labor hours
hours may
may be
be
used
used to
to allocate
allocate overhead
overhead to
to products
products
in
in these
these labor
labor intensive
intensive processes.
processes.

TRADITIONAL COSTING SYSTEMS

Labor Hours

Job 1

Job 2

In
Inthis
thisexample,
example,overhead
overheadwill
willbe
beallocated
allocatedto
tojobs
jobs
using
usingdirect
directlabor
laborhours.
hours. IfIftotal
totaloverhead
overheadis
is$120,
$120,
how
howmuch
muchwill
willbe
beallocated
allocatedto
toeach
eachjob?
job?

TRADITIONAL COSTING SYSTEMS

Job 1
Labor Hours
Overhead
$
Allocation

Job 2

2
30

6
$

90

Overhead Rate = $120 8 direct labor hours

Overhead Rate = $15 per direct labor hour
Job 1 = 2 hours $15 per hour = $30
Job 2 = 6 hours $15 per hour = $90

TRADITIONAL COSTING SYSTEMS

The company introduces
automated machinery. Total
overhead rises from $120 to
$420, while the labor time
needed for Job 2 falls from
6 hours to 1 hour. Now
allocate the $420 overhead
to the two jobs.

TRADITIONAL COSTING SYSTEMS

Job 1

Job 2

Labor Hours
2
Overhead
$ 280
Allocation

1
$ 140

Overhead Rate = $420 3 direct labor hours

Overhead Rate = $140 per direct labor hour
Job 1 = 2 hours $140 per hour = $280
Job 2 = 1 hour $140 per hour = $140

TRADITIONAL COSTING SYSTEMS

Job 1

Job 2

Labor Hours
2
Overhead
$ 280
Allocation

1
$ 140

Is this a reasonable costing method?

Automation benefited only Job 2, but most of the
additional overhead cost was allocated to Job 1.
Clearly, we need to look for another cost driver.

UNDERCOSTING AND OVERCOSTING

Product
Product Undercosting:
Undercosting: AA product
product consume
consume aa

high
high level
level of
of resources
resources but
but is
is reported
reported to
to be
be aa low
low
cost
cost per
per unit.
unit.
Product
Product Overcosting:
Overcosting: AA product
product consumes
consumes aa
low
low level
level of
of resources
resources but
but is
is reported
reported to
to be
be aa high
high
cost
cost per
per unit.
unit.

PRODUCT-COST CROSS-SUBSIDISATION

IfIf aa company
company undercosts
undercosts one
one of
of its
its products,
products, itit will
will
overcost
overcost at
at least
least one
one of
of its
its other
other products
products and
and vice
vice
versa.
versa.
Emma
Emma James
James Jessica
Jessica Matthew
Matthew
Entre
$60
Entre $11
$11 $20
$20 $15
$15 $14
$14
$60 $15
$15
Dessert
16
Dessert 00 88 44 44
16 44
Drinks
32
Drinks 44 14
14 88 66
32 88
Total
$15
$108
Total
$15 $42
$42 $27
$27 $24
$24
$108

Total
Total

$27
$27

Average
Average

ACTIVITY-BASED COSTING (ABC)

AA costing
costing method
method that
that identifies
identifies the
the activities
activities
performed
performed within
within the
the organization
organization as
as itit delivers
delivers
its
its goods
goods and
and services.
services.
Products
Require
Activities

Activities
Consume
Resources

People
Manage
Activities

ACTIVITY-BASED COSTING (ABC)

AA costing
costing method
method that
that assigns
assigns costs
costs to
to
products,
products, based
based on
on the
the number
number of
of activities
activities the
the
organization
organization used
used in
in producing
producing them.
them.
Lot size

Design
time

Direct
labor
hours

Process
setups

Machine
hours

Customer
contact

AN ILLUSTRATION
Usage of Cost
Drivers by
Customer Contract

Departmen
t

Cost Driver

Variable
Manufacturi
ng
Unite Holde
n
Overhead in d
Motor Motor
2011
s

Lelan
d
Vehicl
e

Design

CAD-Design
hours

$ 39000

110

200

80

Production

Engineeringhours

29600

70

60

240

Engineering

Machine-hours

240000

120

2800

1080

Total

308600

AN ILLUSTRATION
Usage of Cost
Drivers by
Customer Contract

Departmen
t

Cost Driver

Variable
Manufacturi
ng
Unite Holde
n
Overhead in d
Motor Motor
2011
s

Lelan
d
Vehicl
e

Design

CAD-Design
hours

$ 39000

110

200

80

Production

Engineeringhours

29600

70

60

240

Engineering

Machine-hours

240000

120

2800

1080

Total

308600

CONTD.
Actual plant-wide variable
MOH rate based on
machine hours,
$308,600/4,000

$77.15 per
machine hour

United
Motors
Variable manufacturing overhead,
allocated based on machine hours
($77.15 120; $77.15 2,800; $77.15
1,080)

$9,25
8

Holden
Motors

Leland
Vehicle

Total

$216,02
0

$83,32
2

$308,60
0


Department
Design
Production
Engineering

Variable MOH
in 2011
$39,000

Total
Driver Units
390

Rate
$100

370

$ 80

4,000

$ 60

29,600
240,000

Design-related overhead, allocated on

CAD-design hours
(110 $100; 200 $100; 80 $100)
Production-related overhead, allocated
on engineering hours
(70 $80; 60 $80; 240 $80)
Engineering-related overhead,
allocated on machine hours
(120 $60; 2,800 $60; 1,080 $60)
Total

per CAD
design hour
per engineering
hour
per
machine
hour

United
Motors

Holden
Motors

Leland
Vehicle

Total

$11,00
0

$
20,000

$
8,000

$
39,000

5,600

4,800 19,200

29,600

7,200 168,000 64,800 240,000

$23,80 $192,80 $92,00 $308,60
0
0
0
0

a. Department rates
(Requirement 2)

United

Holden

Leland

Motors

$23,800

Motors

$192,800

Vehicle

$92,000

b. Plant wide rate

$ 9,258
$216,020
$83,322
The
The variable
variable manufacturing
manufacturing overhead
overhead allocated
allocated to
to United
United Motors
Motors
(Requirement
1)
increases
by
under
increases
by 157%
157%
under the
the department
department rates,
rates, the
the overhead
overhead
allocated
allocated to
to Holden
Holden decreases
decreases by
by about
about 11%
11% and
and the
the overhead
overhead
Ratio
of
(a)

(b)
2.57
0.89
1.10
allocated
allocated to
to Leland
Leland increases
increases by
by about
about 10%.
10%.

Department

Cost

United

Holden

Leland

Driver

Motors

Motors

Vehicle

Design

CAD-design hours

28%

51%

21%

Engineering

Engineering hours

19

16

65

COST HIERARCHIES
UNIT-LEVEL COST
Cost of activities performed on each individual unit of a product or service e.g.,
machine operation costs

BATCH-LEVEL COST
Cost of activities related to group of units of a product or service rather
than each individual unit of product or service e.g., set up cost

PRODUCT-SUSTAINING COST
Cost of activities under taken to support individual products or services regardless
of the number of units or batches e.g., design cost

FACILITY-SUSTAINING COST
Cost of activities that cannot be traced to individual products or services but that
support the organization as a whole e.g., general admin cost

ABC BENEFITS AND LIMITATIONS

More
More accurate
accurate and
and informative
informative

product
product costs
costs lead
lead to
to better
better
pricing
pricing decisions.
decisions.

The
The activities
activities driving
driving costs
costs are
are
more
more accurately
accurately measured.
measured.
Managers
Managers gain
gain easier
easier access
access to
to
the
the relevant
relevant costs.
costs.

Ma
Lim jor
itat
ion

s
t
i
f
e
n
e
B

An
An ABC
ABC system
system is
is very
very expensive
expensive
to
to develop
develop and
and implement,
implement, and
and
very
very time-consuming
time-consuming to
to maintain.
maintain.

WHERE TO APPLY ABC-YO!!!

1.
1. The
TheAsif
AsifZardari
ZardariRule:
Rule:
Go where the money is!
Go where the money is!
Look for the areas of large indirect cost/support activities
Look for the areas of large indirect cost/support activities
2.
2.
..

High
HighComplexity
ComplexityRule:
Rule:
Look
Lookfor
forhow
how different
differentproducts,
products,processes,
processes,customers
customersare!
are!
New
New Vs
VsMature
Matureproducts
products
Custom
CustomVs
VsStandard
Standardproducts
products
Infrequent
InfrequentVs
VsFrequent
Frequentproducts
products
Small
SmallVs
VsIrregular
Irregularproducts
products
Low
Lowvolume
volumeVs
VsHigh
Highvolume
volume

WHALE CURVE

ABC IN SERVICE AND MERCHANDISING COMPANIES

The process is exactly the same as for manufacturing!

Identify and classify the activities

related to the companys products

or services.
Estimate the cost of each activity
identified in .
Calculate a cost-driver rate for each
activity.
Assign activity costs to products
using the relevant cost-driver rates.

Thanks for the Patience

Now its your turn!!