SCM-ABC

Activity Based Costing

Conventional Allocation of Common Costs Service and Production Overheads
Product Lines

Production Department

Assigning Costs using Measures of service usage

Allocating Costs using a measure of Volume U S I N G A B C

P R O D U C T C O S T I N G

Prime Costs Direct Material Direct Labour Direct Expenses Overheads Production Administrative Marketing Sales Distribution R &D
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Product Cost

Non Product Costs

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SCM-ABC

Main Activities and its Cost Drivers Main Activities Customer order processing Material planning/ acquisition Inspection Main Cost Drivers Order value Oder source(old/ new customer) Order Source(location) No. of Material transactions Volume of Material receipts Volume of material order Gauge Usage Inspection Plans No. of problem Suppliers Lack of good quality Engineering Changes Supplies performance No. of Parts operational Make versus buy policy Over board changes No. to be supervised Shift patterns Industrial relations issue Flow of product from assembly Volume of service part/ kit Packing No. of Machine breakdowns Maintenance schedule Capital expenditure Activity Levels No. of system operational No. of systems devices Adequacy of existing system Inspection Plan No. of accounting Transactions No. of times accounts produced Volume of activity Coordinated shipping process Accuracy of feeder system Management Requirements Corporate requirements Activity levels Recruitment Activity Industrial relations climate Training requirements

Production Control

Production

Maintenance

Systems Control Quality Financial Accounting

Management Accounting

Personnel

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SCM-ABC

Allocation of Overhead cost under ABC

Service department and factory overheads

Activity Cost Pools

Product Lines

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SCM-ABC

Assigning costs of individual activities

Application of cost driver rates

Characteristic Of ABC a. Simple traditional distinction made between fixed and variable cost is not enough guide to provide quality of information to design a cost system.
b. The more appropriate distinction between cost behavior patterns are volume(scale)

related diversity(scope) related, events (decisions) related and time related c. Cost drivers need to be identified. A cost driver is a structural determinant, of cost related activities. The logic behind is that the cost behavior pattern must be understood so that behavior patterns is dictated by cost drivers. In tracing overhead cost to product, a cost behavior patterns must be understood so that appropriate cost driver could be identified. How to develop an ABC system?

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SCM-ABC

Three Key areas a. Product Cost Differentiation b. Activities and their cost driver c. Identification of non value added cost In ABC system a cost centre is established for each cost driver and identification, measurement and control of cost drivers is essential in ABC. ABC is planned and systematic study and determination of cost of each of the branches of business activities that add to the value of product and services. The matrix of activities showing the short term and long term cost strategy is presented as follows:

Short Term Product Value Pricing

Long Term Value addition Corporate growth

Steps to develop ABC system a. Identify the main activities performed in the organization, such as manufacturing, assembly etc., as well as support activities including purchasing, packing, and dispatching. b. Identify the factory which influence the cost of each activity-the cost drivers c. Collect accurate data on direct labour, material and overhead costs.
d. Establish the demands made by particular products on activities using cost drivers

as a measure of demand. e. Trace the cost of activities to products according to a products demand for each activity THE rules developed by Kaplan and Cooper for this process are: a. Focus on expensive resources, thus directing attention to resource categories where the new costing process has the potential to make big differences on product cost. b. Emphasise resources whose consumption varies significantly by product and product type- look for diversity, and
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SCM-ABC c. Focus on resources whose demand patterns are un- correlated with traditional

allocation measures.

How to implement ABC system?

In ABC the hidden weaknesses and high cost segments are identified for maximum effectiveness of cost accounting system. The process of designing and implementing an ABC system for support departments usually by way of interviewing the concerned departmental heads to have an insight into the departmental operations and into the factors that trigger departmental activities. Subsequent analyses trace the activities to specific products. Suppose the inventory control department is responsible for raw material and purchased components. The relevant questions that could be asked are:

How many people work in the department? What do they do? What determines the time required to process an incoming shipment? Does it matter if the shipment is large and small? Do you usually disburse the total amount of material required for a production run all at once or does it go out in smaller quantities?

After the interview the system designer can use the number of people involved in each activity to allocate the departments cost. ABC calls for high level costing policy, cost technology and modules for activities effectiveness in a competitive economy for survival and prosperity.

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SCM-ABC

GAINING COMPETITIVE ADVANTAGE THROUGH ABC

Which Products should we promote? Analyse the profit contribution and impact of inter-relationship of product/service

What prices should we set? Identity the true cost/ profitability of products and services

Which customers are profitability and why? Identity the true cost/ profitability of customers or type of customers

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Gaining Competitive Advantage

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SCM-ABC

How should we measure performance? Identity accountability/respo nsibility the cost behavior services

Which distribution channel should we set? Analyse the cost and performance of alternative distribution channels

How ABC system supports Corporate Strategy?

ABC supports corporate strategy in many ways such as:

1. ABC system can effectively support the management by furnishing data, at the

operational level and strategic level. Accurate product costing will help the management to compare the profits that various customers, product lines brands or regions generate and to decide on pricing strategies dropping unprofitable product, lines etc.,
2. Information generated by ABC costing can also encourage management to redesign

the product 3. ABC system can change the method of evaluation of new process technologies, to reduce setup times, rationalization of plant lay out in order to reduce or lower material handling cost and improve quality etc.,

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SCM-ABC

4. ABC system will report on the resources spending vis--vis resources consumption and reduced demand in organizational resources lead to increase profits.
5. ABC analysis helps managers focus their attention and energy on improving activities

and the actions allow insights from ABC to be translated into increased profits. 6. The cost driver rates established by the system can be used to measure activity performance and efficiency and provide a more suitable basis for budgeting. 7. The accurate feedback can be provided to cost centre managers on their managers on their performance based their consumption of resources during a period rather than the allocation of cost over which they have no control, and 8. The provision of accurate information on product costs enables better decisions to be made on pricing, marketing, product design and product mix.

When to use ABC? Ways of achieving cost reduction 1. Reducing the set up time 2. Eliminating material handling activities Conventional Cost centers Ignore or reduce Direct labour Ignore or reduce Direct labour Activity Based cost centres Reduce set up time to achieve cost Eliminating activities to reduce cost of handling

3. Choosing an insertion Pick alternative with lowest Pick lowest cost process unit level activities alternatives 4. Using common components Using common components Use common components achieves the cost saving wherever possible. Using non-common components creates no cost penalty

Class Assignment on ABC

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SCM-ABC

1. The budgeted overheads and the cost driver volume of XYZ ltd. are as follows Cost pool Material procurement Material handling Set up Maintenance Quality control Machinery Budgeted Overheads(Rs.) 580000 250000 415000 970000 176000 720000 Cost driver No. of orders No. of movements NO OF SET UPS Maintenance hrs No. of inspections No. of Machine hrs Budgeted volume 1100 680 520 8400 900 24000

The company has produced a batch of 2600 components of AX-15, its material cost was Rs.130000 and labour cost was Rs.245000. the usage activities of the said batch are as follows. Material orders Material Movements Setups Required: i. ii. Calculate cost drivers rate that are used for tracing appropriate amount of overheads to the said batch Ascertain the cost of batch component using ABC. 26 18 25 Maintenance hrs Inspections Machine hrs 690 28 1800

2. A company manufacturing two products furnishes the following data for the year Product A B Annual Output (units) 5000 6000 Total Machine hrs 20000 120000 Total no. of purchase orders 160 384 Total no. of setups 20 44

The annual overheads were as under: Volume related activity based cost Set up costs
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Rs.550000 Rs.820000
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SCM-ABC

Purchase related cost

Rs.618000

You are required to calculate the cost per unit of each product A and Product B based on i.
ii.

Traditional method of charging Overheads Activity based costing method.

3. A company manufactures two products X and Y. the product X is low volum and its sales are only 5000 units p.a. Product Y is high volume and labour intensive, its sales are 25000 units p.a. Product X tales 6hrs to make one unit and product Y takes 8 hrs /unit. Details of cost for material and labour for each product are: Product A Direct Material Direct Labour (@Rs.10/hr) Rs.200 60 Product B 100 80

The company works 100000 direct labour hrs p.a. The total manufacturing OHs are Rs.1750000 p.a. Other information Activity Machine Set up Quality inspection Production Ohs Machine Hrs Material receipts Total Ohs(Rs.) 450000 300000 180000 625000 195000 Frequency of activity 10000 15000 600 50000 1500 Ratio X:Y 3:2 2:1 1:2 12:38 1:4

You are required to compute per unit of each product using i. ii. Direct labour rate method ABC method.

4. Family store wants information about the profitability of individual product line: soft drinks, fresh produce, and packaged food. The Family store provides the following data for the year for each product line:

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SCM-ABC

Particulars Revenue COGS Cost of bottles returned No. of purchase orders No. of deliveries recd. Hrs of shelf stock timing Items sold

Soft Drinks Rs.793500 Rs.600000 Rs.12000 360 300 540 126000

Fresh produce Rs.2100000 Rs1500000

Packaged Food Rs.1209900 Rs.900000

840 2190 5400 1104000

360 660 2700 306000

The family store also provides you with following information Activity Bottles returned Ordering Delivery Shelf stocking Description of activity Returning empty bottles Placing orders for purchase Physical delivery and receipt of goods Stocking goods on stores shelves and on going restocking Assistance provided to customers Total Cost(rs.) 12000 156000 252000 172800 Cost allocation base Direct tracing to the soft drinkline 1560 puchase orders 3150 deleveries 8640hrs

Customer support Required:

i.

307200

1536000 items sold

Family store currently allocates support cost (all costs other than goods sold to product lines o basis of COGS of each product line. Calculate the operating income and operating income as % of revenues for each product line

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SCM-ABC

ii.

If family store allocates cost(all costs other than COGS) to product lines using ABC, calculate the operating income and operating income as% of revenues for each product line Comment on your answers in requirement of (i) and (ii).

iii.

5. Bombay Steel Ltd. Manufactures four products, namely A, B, C and D, using the same plant and processes. The following information relates to a production period: Product Material cost Direct Machine Labour Cost Per Unit Labour Per time Per unit per unit unit A 500 5 hr hr 3 B 5000 5 hr hr 3 C 600 16 2 hr 1 hr 12 D 7000 17 1 hr 1 hr 9 Total production overhead recovered by the cost accounting system is analysed under following headings: Factory overheads applicable to machine oriented activity Rs.37424 Set costs Cost of ordering Handling material Administration for spare parts Rs.4355 Rs.1920 Rs.7580 Rs.8600 Volume

The overheads cost are absorbed by products on machine hour rate of Rs4.80 per hour giving an overhead cost per product of A: Rs.1.20, B: Rs.1.20, C: Rs.4.80, D: Rs.7.20 However, investigation into the production overhead activities for period reveals the following totals: Product A B C D You are required: No. of Set ups 1 6 2 8 No. of Material Order 1 4 1 4 No. of Times material was handled 2 10 3 12 No. of Spare parts 2 5 1 4

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SCM-ABC

i. ii.

To compute an overhead cost per unit Activity Based Costing, tracing overheads to production units by means of cost driver To comment briefly on the differences disclosed between overheads traced by the present system and those traced by Activity Based Costing.

6. Having attended a SCM courses on Activity Based Costing you decide to experiment by applying the principles of ABC to four products currently made sold by your company. Details of the four products and relevant information are given below for one period: Product A B C D Output in units 120 100 80 120 Cost per unit Direct Material Rs.40 Rs.50 Rs.30 Rs.60 Direct labour Rs.28 Rs.21 Rs.14 Rs.21 Machine Hours 4 3 2 3 per unit The four products are similar and are usually produced in production runs of 20 units and sold in batches of 10 units. The production overhead is currently absorbed by using a machine hour rate and the total of the production overhead for the period has been analysed as follows: Machine department cost (rent, business, rates, depreciation and supervision)Rs.10430 Set up costs Stores receiving Inspection/Quality Control Materials Handling and dispatch Rs.5250. Rs.3600 Rs.2100 Rs.4620

You have ascertained that the cost driver: to be used are as listed below for the overhead costs shown: Set up Costs =No. of production runs Stores receiving=Requisition raised Inspection and Quality control=No. of production run Material handling and Dispatch = orders executed

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SCM-ABC

The No. of requisition raised on the stores was 20 for each product and No. of orders executed was 42, each order being for batch of 10 of a product. You are required: a. To calculate the total costs for each product if all overhead costs are absorbed on a machine hour basic; b. To calculate the total costs for each product, using activity based costing; c. To calculate and list the unit product costs from your figures in (a) and (b) above, to show the difference and to comment briefly on any conclusion which may be drawn which could have pricing and profit implications. 7. Relevant data relating to a company are: Particulars P Total Production/Sales(units) 60000 Raw Material usage in units 10 Raw material costs Rs.50 2476000 Direct Labour Hours 2,5 342000 Machine hours 2.5 294000 Direct Labour Cost Rs.16 No. production costs 6 60 No. of Deliveries 18 64 No of receipts 60 1080 No of production orders 30 100 Set up Rs.60000 Machines Rs1520000 Receiving Rs.870000 Packing Rs.500000 Engineering Rs.746000 The company operates a JIT inventory policy and receives each component once per production run. Required: i. ii. Compute the product cost based on on direct labour hour recovery rate of overheads Compute the product cost using ABC Product Q R 40000 16000 10 22 Rs.40 Rs.22 4 2 2 4 Rs.24 Rs.12 14 40 6 40 140 880 20 50

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SCM-ABC

8. ABC electronics makes audio player model AB100. It has 80 components. ABC sells 10000units each month at Rs.3000 per unit. The cost of manufacturing is Rs.2000 per unit or Rs.200lakhs per month for the production of 10000units. Monthly manufacturing costs incurred are as follows: Rs. lakhs 100.00 20.00 20.00 25.00 15.00 0.20 19.80 200.00 Labour is paid on piece rate basis. Therefore, ABC considers direct manufacturing labour cost as variable cost. The following additional information is available for AB100 Direct Material Costs Direct Mannufacturing labour Cost Machine Costs Testing Costs Rework Costs Ordering Costs Engineering Costs i. ii. iii. iv. Testing and inspection time per unit is 2 hrs 10% of AB100 manufactured are reworked It currently takes 1 hr to manufactures each unit of AB100 ABC places two orders per month for each month component. Each component is supplied by a different supplier

ABC has identified activity cost pools and cost drivers for each activity. The cost per unt of cost driver for each activity cost pool is as follows: Manufacturing Activity 1.Machining Costs 2. Testing costs Description of activity Machining Component Testing component and finished goods(each unot of AB100 is tested individually) Correcting and fixing errors and defects Ordering of components Designing and managing of products Cost driver Machine hours of capacity Testing Hrs Cost per unit of cost driver Rs.200 Rs.125

3.Rework cost Ordering costs Engineering costs

Units of AB100 reworked No. of orders Engineering hours

Rs.1500 per unit Rs125 per order Rs1980 per engineering hour
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SCM-ABC

Over a long run horizon, each of the overhead costs described above vary with chosen cost drivers In response to competitive pressure ABC must reduce the price of its product to Rs.2600 and to reduce the cost by atleast Rs.400 per unit. ABC does not anticipate increase in sales due to price reduction. However, if it does not reduce price it will not be able to maintain the current sales level. Cost reduction on the exciting model is almost impossible. Therefore, ABC has decided to replace AB100 by new AB200. The expected effect of design modifications are as follows: i. ii. iii. iv. v. vi. vii. The No. of components will be reduced to 50 Direct material costs to be lower by Rs.200 per unit Direct Manufacturing Labour costs to be lower by the Rs.20 per unit Machining time required to be lower by 20% Rework to Decline to 5% Machining capacity and engineering Hours capacity remain the same Testing time required to be lower by 20%

ABC currently outsources the network on defective unit Required: a. Compare the manufacturing cost per unit of AB100 and AB200. b. Determine the immediate effect of design change and pricing decision on operating income of ABC Ignore income Tax. Assume that cost per unit of each cost driver for AB100 continues to apply to AB200. 9. XYZ ltd. manufactures three different products for an industrial market. The cost accounting system used by XYZ is a traditional one in the sense that is very much like the systems literally thousands of firms have used for many years. The exhibit 1 data is regard to sales prices and sales volume for three product are shown along with basic production and standard cost statistics. There is only one production department machines and it takes a little more than 1 labour hour for each machine

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SCM-ABC

(11250/10000) at current production mix. Labour is paid at Rs.20/hr including fringe benefit and machine cost is Rs.71/hr.

Exhibit 1 Three products A Production Shipments Selling prices Target prices Selling Prices Rs.162.61 Rs.162.61 5 components@ rs.4/ component =Rs.20 Rs.134.09 Rs.125.96 6 components@ rs.5/ component =Rs.30 Rs.81.31 Rs.105.70 10components@ rs.1/ component =Rs.10 10000 units in 1 run 10000 units in 1 shipments B 15000 units in 3 runs 15000 units in 5 runs C 5000 units in 10 runs 5000 units in 20 shipments Total

Raw Material

Labour usage Set up labour Run labour Machine usage 10 hrs per production run hr per part 1/4hr per part Other overheads Receiving dept Engineering dept Packing dept 30000 500000 200000 10 hrs per production run 1/3 hr per part 1/3 hr per part 11 hrs per production run hr per part 1/2hr per part 150 hrs 11250hrs 10000hrs

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SCM-ABC

The total overheads distribution to the driver to the three products produced in the machine department(as is present done) shown in exhibit 2. Overhead is assigned to products on direct labour costs. Exhibit 2: Calculation of unit costs A Raw Material Direct labour Overheads(labour Rs.basis) Set up Machines Receiving Engineering Packing Total RS.3000 Rs.700000 Rs.300000 Rs.500000 Rs.200000 Rs.1703000 105.70 87.16 52.85 20.00 10.00 B 30.00 6.67 C 10.00 5.00

Overhead rate = Total OHs/Total Direct Labor cost=Rs.1703000/225000=757% 1. Do you think that there is anything wrong with present costing system? 2. IF XYZ ltd. was aware of ABC, do you think that would have given dramatic different assessment of the opinion under consideration?

10. What are the areas in which Activity Based information is used for decision making? 11. Explain briefly four different categories of activities that drive the expenses at product level.

12. Tithi (P) Ltd. has the following activities and associated cost behaviours: Activities Labour Set Up Cost Behaviour Rs.10 per direct labour hr. Variable Rs.100 per set up Step fixed- Rs.30000 per step set up =10set
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SCM-ABC

ups Receiving Step-Fixed- Rs.40000 per step set up =2000hrs Activities with step cost behavior are being fully utilized by existing products. Thus any new product demands will increase resources spending on these activities. Two designs are being considered for a new product- Design I and II. The following information is provided about each design (1000 units of the product will be produced). Cost Driver Design I Design II Direct labour Hrs 3000 2000 No. of set ups 10 20 Receiving Hrs 2000 4000 The Co. has recently developed a cost equation for manufacturing costs using direct labour hrs as the driver. The equation had R2= 0.60 and is given below Y= Rs150000+ Rs.20X Required:
1. Compute the cost of each design (based on the direct labour cost equation). If the

design engineering is told that only direct labour hours drive manufacturing costs. Which design would be choen based on this unit based cost assumption? 2. Now compute the cost of each design using all driver and activity information. Which design will now be choose? Are there any other implications associated with use of more complete activity information set?
3. Consider the following statement: Strategic Cost Analysis should exploit internal

Linkages. What does this mean? Explain, using the results of requirements (a) and (b)
4. What other information would be useful to have concerning the two design? Explain

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