Unit2 Components of Costing 2.7.13 Advantages # Activity costs: ABC is designed to track the cost of activities, so you can use it to see if activity costs are in line with industry standards. If not, ABC is an excellent feedback tool for measuring the ongoing cost of specific services as management focuses on cost reduction, # Customer profitability: Though most of the costs incurred for individual customers are simply product costs, there is also an overhead component, such as unusually high customer service levels, product return handling, and cooperative marketing agreements. An ABC system can sort through these additional overhead costs and help you determine which customers are actually earning you a reasonable profit, This analysis may result in some unprofitable customers being turned away, or more emphasis being placed on those customers who are earning the company its largest profits. + Distribution cost: The typical company uses a variety of distribution channels to sell its products, such as retail, Internet, distributors, and mail order catalogs. Most of the structural cost of maintaining a distribution channel is overhead, so if you can make a reasonable determination of which distribution channels are using overhead, you can make decisions to alter how distribution channels are used, or even to drop unprofitable channels, 4 Make or buy: ABC provides a comprehensive view of every cost associated with the in-house manufacture of a product, so that you can see precisely which costs will be eliminated if an item Is outsourced, versus which costs will remain, 4 Margins: With proper overhead allocation from an ABC system, you can determine the margins of various products, product lines, and entire subsidiaries. This can be quite useful for determining where to position company resources to earn the largest margins. 4 Minimum price: Product pricing is really based on the price that the market will bear, but the marketing manager should know what the cost of the product is, in order to avoid selling a product that will lose a company money on every sale. ABC is very good for determining which overhead costs should be included in this minimum cost, depending upon the circumstances under which products are being sold. Production facility cost: It is usually quite easy to segregate overhead costs at the plant-wide level, so you can compare the costs of production between different facilities 2.7.14 Disadvantages 4 Cost pool volume: The advantage ofan ABCsystem is the high quality of information thatit produces, but this comes at the cost of using a large number of cost pools - and the more cost pools there are, the greater the cost of managing the system. To reduce this cost, run an ongoing analysis of the cost to maintain each cost pool, in comparison to the utility of the resulting information. Doing so should keep the number of cost pools down to manageable proportions. 4 Installation time: ABC systems are notoriously difficult to install, with multi-year installations being the norm when a company attempts to install it across all product lines and facilities. For such comprehensive installations, it is difficult to maintain a high level of management and budgetary support as the months roll by without installation being completed. Success rates are much higher for smaller, more targeted ABC installations. 4 Multi-department datasources: An ABCsystem may require data input from multiple departments, and each of those departments may have greater priorities than the ABC system. Thus, the larger the number of departments involved in the system, the greater the risk that data inputs will fail over time. This problem can be avoided by designing the system to only need information from the most supportive managers. 4 Project basis; Many ABC projects are authorized on a project basis, so that information is only collected once; the information is useful for a company’s current operational situation, and it gradually declines in usefulness as the operational structure changes over time. Management may not authorize funding for additional ABC projects later on, so ABC tends to be “done” once and then discarded. To mitigate this issue, build as much of the ABC data collection structure into the existing accounting system, so that the cost of these projects is reduced; at a lower cost, itis more likely that additional ABC projects will be authorized in the future. 35 Scanned with CamScannerUnit2 Components of Costing wo report on thet & Reporting of unused time: When a company asks its oa eported canto Sen, various activities, they have a strong aes one anyone's work day that eee . . | their time, However, there is a large a a maat administrative meetings, playing games on the Internet, a rena Emeloyess ust | mask these activities by apportioning more time to otheractvities.Theseinfated numbersrepra? | tnisallocations of costs in the ABC system, sometimes by quite substan See | ‘& Separate data set: An ABC system rarely can be constructed to pul i et Hon the | directly from the general ledger. Instead, it requires a separate database that pls nfomaty | from several sources, only one of which is existing general ledger account’, 7 equi dfiay maintain this extra database, since it calls for significant extra staff time for ha ha os here may neti | din adequate budget. The best work-around is to design the system to rid re the minimUr\ amy | aoa idtvonaltnformation other than that which i already available in the gencha! CoO 4 Targeted usage: The benefits of ABC are most apparent when costaccounting semetin isdificy to discern, due to the presence of multiple product lines, machines being usee @ Productig, of many products, numerous machine setups, and so forth - in other words, in complex productio, environments. Ifa company does not operate in such an environment, then it may spenda great de, of money on an ABC installation, only to find that the resulting information is not overly valuable, 2.7.15 Simple Problems on Activity Based Costing 1. Acompany manufacturing two products furnishes the following data for a year: Products] Annual output | Total machine | Total number of Total number of (units) hours purchase order set-ups A 5000 20000 160 20 B 60000 120000 384 44 ‘The annual overheads are as under: Volume related activity costs | Rs S50000 Set- up related costs Rs 820000 Purchase related costs Rs 618000 You are required to calculate the cost per unit of each product ‘W and 'B' bases on: a. Traditional method of charging overheads. b. Activity based costing method. Answer: a. Traditional method of charging overheads Total overheads = 550000 + 820000 +618000 = 19,88,000 Machine hour overhead rate (Total over heads) /(Total Machine hours) = 19,88,000/1,40,000 = 14.2 per hour Statement of cost Particulars Product A Product B Overhead @ 14.2 per hour 284000 1704000 5 (14.2*20000) (14.2*120000) No. of units out put 5000 60000 Per unit overhead rate 56.8 28.4 (284000 / 5000) (1704000 / 60000) 36 Scanned with CamScannerUnit2 Components of Costing b. Activity based costing method Calculation of overhead rates Volume related overhead rate. = = (Over heads)/(Total Machine hours) 5,50,000/1,40,000 Set-up overhead (ower neetay rate (Over heads}/(Total No.of set-ups) 8,20,000/64 Cost for one order foaria (Over heads) (Total No.of orders) 6,18,000/544 Statement of cost 218608 Particulars Product A Product B Volume related overheads @ 3,93 78600 471600 per hour, (3.93*20000) (3.93*120000) Set-up overhead @ 128125 per 256250 563750 set-up (12812.5*20) (02812544) Cost for orders @ 113603 per 1817648 436235.52 order (1136.03%160) (1136.03*384) Total overheads 5166148 1471585.52 No. of units out put 5000 60000 Per unit overhead rate 103.32 24.53 (5166148 / 5000) | (1471585.52 / 60000) 2. Alpha limited has decided to analysis of profitability of its Five new customers. It buys bottled water at Rs 90 per case and sells to retail customers at a list price of Rs 108 per case. The data pertaining to five customers are: Particulars customers a [| s8 C D E Cases sold 4680 | 19688 | 136800 | 71550 8775 List selling price (Rs) 108 | 108 | 108 | 108 108 Actual selling price (Rs) 108 106.20 99 104.40 97.20 Number of purchase order 1s | 2 | 30 | 2 | 30 Number of customer visit 2 3 6 2 3 Number of deliveries 10 | 30 | 6 | 40 | 20 Kilo meters travelled perdelivery| 20 | 6 3 10 | 30 Number of expedited deliveries 0 0 0 0 1 Its five activities and their drivers are: Activity Cost driver rate Order taking Rs, 750 per purchase order Customer visit Rs. 600 per customer visit Deliveries Rs, 5.75 per delivery km travelled Producthandling | Rs.3.75 per case sold Expedited deliveries _[ Rs.2250 per expedited delivery Required: Compute the customer level operating income of each of five retail customers now being examined (A,B,C, Dand E). Comment on results. 37 Scanned with CamScannerUnit2 Components of Costing Answer: Calculation of customer level activity costs < F 7 Particulars A B 0 | 2: Order taking 71250 | 18750 | 22500 | 1875 2500 (No. of orders * 750) Customers visit 7200 | 1800 | 3600 | 1200 | 1800 (No. of customer visit * 600) {| Deliveries 1150 | 1035 | 1725 | 2300 | 3450 (No.of deliveries * kilo meters per delivery * 5.75) { Product handling 17550 | 73030 | 513000 | 268313 32906 (No.of cases sold * 3.75) A Expected deliveries 0 0 0 Oo | 225 (2250 * No. of expected deliveries) Total cost of customer level | 31150 | 95415 | 540825 | 290563 | 62906 operating activities Calculation of customer level profits: Particulars A B c D E Selling price percase | 108 | 10620 | 99 104.40 | 97.20 Less: cost of the sale 90 90 90 90 90 Gross margin for 1 ears 18 16.2 9 144 72 No. of Cases sold 4680 | 19688 | 136800 | 71550 | 8775 Total Gross margin | 84240 | 318946 | 1231200] 1030320] 63180 Less: Total cost of customer level 31150 | 95415 | s40a2s | 290563 | 62906 operating activities Customer level profits | 53090 | 223531 | 690375 | 739757 | 274 3. ABC Ltd. is a multiproduct company, manufacturing three products A, B and C. The budgeted coss and production for the year ending 31st March, 2020 are as follows: A B c Production quantity (Units) 4,000 3,000 1,600 Resources per Unit: Direct Materials (Kg.) 4 6 3 Direct Labour (Minutes) 30 45 60 The budgeted direct labour rate was Rs. 10 per hour, and the budgeted material cost was Rs 2 pert Production overheads were budgeted at Rs. 99,450 and were absorbed to products using the dre! labour hour rate, ABC Ltd, followed the Absorption Costing System. ABC Ltd. is now considering to adopt an Activity Based Costing system. The following addition! information is made available for this purpose. 38 Scanned with CamScannerUnit2 Components of Costing a, Budgeted overheads were analysed into the following: (Rs) 29,100 31,200 Electricity 39,150 b. ‘The cost drivers identified were as follows Material handling Storage costs Electricity Material handling Storage costs Weight of material handled Number of batches of material Number of Machine operations ©. Data on Cost Drivers was as follows? For complete productio Batches of material EmEi0 5 15 Per unit of production: Number of Machine operations 6 3 2 You are requested to: i Prepare a statement for management showing the unit costs and total costs of each product using the absorption costing method. Prepare a statement for management showing the product costs of each product using the ABC approach. State what are the reasons for the different product costs under the two approaches? Solution: i,_Traditional Absorption Costing A B c Total (a) Quantity (units) 4,000 | 3,000 | 1,600 | 8,600 (b) Direct labour (minutes) 30 45 60 - (c) Direct labour hours (a x b)/60 minutes | 2,000 2,250 1,600 | 5,850 ‘Overhead rate per direct labour hour: judgeted overheads / Budgeted labour hours Rs, 99,450 / 5,850 hours Rs. 17 per direct labour hour Unit Costs: : A(Rs) B(Rs) CRs) Direct Costs: Direct Labour 5.00 750 1099 Direct Material 8.00 12.00 x Production Overhead: | 8.50 (17x30 /60)| 12.75 (17 x 45 /60)| 17.00 (17 x 60 / 60) Total unit costs 21.50 3225 33.00 Number of units 4,000 3,000 1,600 Total costs : 86,000 96,750 52,800 39 Scanned with CamScannerUnit2 Components of Costing ii, Activity Based Costing a B c Total Quantity (units) 4,000 | 3,000 eae 7 Material Weight per unit (Kg.) 4 6 Total material weight 16,000 | 18,000 | 4,800 | 38,800 | 2 : Machine operations per unit 6 3 Total operations 24,000 | 9,000 | 3,200 36200 ‘Total batches of Material 10 5 . Material handling rate per kg, = Rs, 29,100 / 38,800 kg = Rs, 0.75 per kg Electricity rate per machine operations = Rs. 39,150 / 36,200 ; = Rs, 1.081 per machine operations Storage rate per batch = Rs, 31,200 / 30 batches = Rs, 1,040 per batch Unit Costs: A(Rs.) B(Rs) (Rs) Direct Costs: Direct Labour 5.00 750 10.00 Direct material 8.00 12.00 6.00 Production Overheads: Material Handling 3.00 450 225 (Rs.0.75 x4) CRs. 0.75x6) (Rs.0.75 x3) Electricity 649 3.24 2.16 (Rs. 1.081 x6) (Rs. 1.081x3) (Rs. 1.081 x 2) Storage 2.60 1.73 9.75 (40 x Rs, 1,040 / 4000) | (5 x Rs, 1,040 / 3000) | 5 x Rs. 1,040 / 3000) Total unit costs 25.09 28.97 30.16 Number of units 4,000 3,000 1,600 Total costs Rs, 1,00,360 Rs. 86,910 Rs. 48,256 iii, Comments: The difference in the total costs under the two systems Is due to the difference; in the overheads borne by each of the products. The Activity Based Costs appear to be more precise. 40 Scanned with CamScanner