Activity Based Costing

1. Activity Based Costing By Jan Van Deusen Larry Inguagiato

2. Outline • Overhead Cost Discussion • History behind Activity Based Costing • Activity Based Costing • What is it? • Who does it? • How is it done? • What do you do with it? • Why activities – management uses • Target Costing • Conclusion • Questions

3. Traditional Accounting • This is how manufacturing has traditionally tracked costs.

4. Shifting Trends in Accounting • Traditionally overhead costs have been allocated based on labor costs of a product. • As technology increases labor costs constitute a lesser portion of product costs. • Also modern companies manage highly diversified product lines, which makes random assignment of overhead a… PROBLEM

5. Overhead Example Product A consists of 20 components costing $180 and has an assembly time of 2 hrs at a labor cost of $20. Overhead is applied based on a direct labor factor of 120% which results in a cost of $44. The total cost of Product A is $244. Product B consists of 5 components costing $180 and has an assembly time of 2 hrs at a labor cost of $20. Overhead is applied based on a direct labor factor of 120% which results in a cost of $44. The total cost of Product B is $244. Does this sound right????

6. Overhead example • The key to the example is the difference in the number of components • Logically assembling 20 components must have more cost associated with it than assembling 5 components • The indirect overhead costs of ordering, receiving, stocking and issuing the difference in components are not accounted for • This is the problem with traditional accounting

7. History behind ABC • ABC became practiced in the early 1980’s but it has really become a force in industry in the mid to late 1990’s • Most current approaches to ABC are based on concepts developed by the Computer Aided Manufacturing-International (CAM-I) Project • Since then ABC plans have been further developed and diversified down to mid and small size companies

8. ABC – What is it? • ABC is the Activity Based Cost accounting method. • ABC focuses on identifying all activities associated with making a product or doing a process.

9. ABC – What is it? (cont) • Activity = Cost • Identifying activities will yield a total cost system.

10. ABC – What is it? (cont) • ABC has 3 strategic objectives: • Report accurate costs • Identify costs of activities • Identify future need for resources

11. Who is involved in it? • Engineers • Accountants • Management • Factory workers • Shipping personnel • Sales ……………….EVERYONE!

12. ABC Terms • Activity = work performed within an organization. • Resource = financial input consumed by activities. • Resource Driver = any measure of the quantity of resources consumed by activities. • Activity Driver = any measure of the frequency and intensity imposed by a cost object. • Cost object = any customer, service, process that a separate cost measurement is desired.

13. ABC Costs Business Process Resource Driver

14. How is ABC done? • Identify activities. • Determine how resources are linked to activities. (traced, assigned, allocated costs) • Calculate activity costs. • Identify cost objects. • Determine how activities are related to cost objects. • Calculate cost of object costs.

15. ABC Cost Example

16. Degrees of Implementation • Tier 1 – Direct Costs • Tier 2 – Incremental Costs • Tier 3 – Full Costs

17. Tier 1 – Direct Costs • Direct costs obviously associated with product including managerial costs. • Ex: personnel payroll, supplies, rental equipment. • Overhead and support costs not included. • Oriented for small projects or improving a process vs focus on price of production or where infrastructure is too large to determine overhead and support costs accurately.

18. Tier 2 – Incremental Costs • Tier 1 costs + support costs of organization. • Incremental costs typically include over 95% of the organizational costs. • More difficult than Tier 1 due to subjective distribution of expenses across multiple elements.

19. Tier 3 – Full Costs • Tier 3 includes all organizational, managerial, direct, support and overhead costs. This is the most comprehensive, difficult. • Least used method.

20. What do you do with it? • Use the collected data to make smarter business decisions.

21. Why activities – management uses • Activities are actions • Improve product cost accuracy • Activities drive cost • Facilitates evaluation of alternatives • Encourages continuous improvement • Activities are easily understood by user level • Improve decision support

22. Target costing • Key Japanese design technique • In Japan, cost is responsibility of design engineer – same as US in the 1920’s • The Japanese treat cost as a symptom, not a cause or solution • Begins with market-based pricing independent of cost – what the customer can pay

23. Target costing • Japan: • Target cost = Market-priced sales – Target profit • Other countries: • Actual cost + Planned profit = Price • Conclusion: Costs are best managed during concept and design phase

24. Conclusion • ABC is an excellent tool for identifying areas of concern in your company as well as being useful to integrate into management • It is however just a tool and must be set-up and used properly in order to be beneficial

25. Questions?

26. Bibliography • Electronic College of Process Innovation, Department of Defense at http://www.c3i.osd.mil/bpr/bprcd/ • Brimson, James. “Activity Accounting”. John Wiley & Sons, Inc., 1991. • Cokins, Gary. “Activity Based Cost Management”. McGraw-Hill, 1996. • Cooper, Robin and Slagmulder, Regine. “Activity Based Budgeting, Part 1.” Strategic Finance. Montvale, September 2000.

27. Bibliography • Deo, Baldinger S. and Strong, Doug. “Cost: The Ultimate Measure of Productivity.” Industrial Management. Norcross, May/June 2000. • Grieco, Peter & Pilachowski, Mel. “Activity Based Costing: The Key to World Class Performance”. PT Publications, Inc, 1995. • Marcino, George R. “Obliterate Traditional Budgeting.” Financial Executive. November/December 2000. • Yennie, Henry. “ABC: The New Cost – Cutting Tool.” Behavioral Health Management. Cleveland, September/October 1999.