Activity Based Costing

Activity Based Costing
Direct and Indirect Cost

Direct
costs are transparent and how

they will be affected by decisions is
clearly observable
How indirect costs will be affected by
decisions is not clearly observable
Tendency to assume that these costs
are fixed and irrelevant in the short run
Long run
Overhead costs have escalated over the

years and they cannot be assumed to be
fixed and irrelevant for long run or strategic
decision making
ABC
During the 1980s the limitations of product

costing systems began to be widely
publicized
These systems were designed decades ago
when companies manufactured a narrow
range of products and direct labor and
materials were the dominant factory costs
Overheads were relatively small, Information
processing costs were high
ABC
Now
, wide range of products

Direct labor only a small fraction of total
costs
Overheads are of considerable
importance
Information processing are no longer a
barrier to introducing sophiscated cost
system
Both
traditional and ABC systems

assign indirect costs to cost objects
In traditional system, overheads are
pooled by departments and are
allocated to products based on volume
related drivers such as labor hours or
machine hours
With ABC systems , first step is to identify

major activities of the organization
Costs are allocated to activity cost centres or
cost pools
Selecting appropriate cost drivers for
assigning the cost
Cost drivers includes non volume based
drivers such as number of production runs for
production scheduling
Assigning costs to products
Activity cost Drivers

Transaction
drivers such as number of

orders, number of inspections etc
Duration drivers such as setup time
Intensity drivers directly charge for the
resources consumed each time a
activity is performed
Activity hierarchy
Unit level Activities- Consume resources in

proportion to number of units produced
(Energy costs)
Batch related activities- Cost varies with
number of batches
Product sustaining activities- performed to
enable production and sale of individual
products (Cost of product enhancements,
technical support for individual products)
Facility sustaining- General administrative
support , property tax etc
Product Costs
In traditional system , product cost distortion

happens because
Unit level cost driver will not be able to assign
the costs of non unit- level activities
Product diversity with different consumption
ratios of resources
Traditional system may report fairly accurate
product cost for organizations with fairly
standardized product range or if indirect costs
are a low proportion of product cost
ABC
system may be optimal when

there is intense competition
high proportion of indirect costs
product line complexity
Service companies are ideal candidates
for ABC since most of costs are fixed
and indirect
Cost Management Systems
The emphasis of a cost management system

is on the firms activities so much so that
CMS is synonymous, in certain respects, to
Activity Accounting or Activity-based
Costing (ABC).
Using ABC to improve the operations of an
organization is called activity-based
management or ABM
Objectives of Cost
Management System
6-7
Elimination of Non-Value-Added
Costs
Activities
Analysis and
Classification
Nonvalueadded
Activities
Valueadded
Activities
Reduce or
Eliminate
Continually Evaluate
and Improve
McGraw-Hill/Irwin
Just-in-Time Inventory and

Production Management
No materials are purchased and no products
are manufactured until they are needed.
The primary goal of a
JIT production system is
to reduce or eliminate
inventories at every
stage of production.
Key Features of the JIT

Approach
Smooth, uniform production rate
Pull method of production
Purchase is small lot sizes

Quick, inexpensive setups
High quality of materials

Effective preventive maintenance
Teamwork
Multiskilled workers
JIT Purchasing
Long-term
contracts with
suppliers.
Only a few
suppliers.
Grouped
payments to
vendor.
Minimal
inspection of
materials.
Parts delivered
in small lots.
Customer Profitability Analysis
Customer Profitability Analysis uses ABC to

determine activities, costs and profits
associated with serving particular customers
Profitable product but customer related costs
making certain customers unprofitable
Costly customer orders frequently,small
quantities, requires special packaging, faster
delivery, customized services

Activity Based Costing

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Activity Based Costing

Direct and Indirect Cost

costs are transparent and how

Overhead costs have escalated over the

During the 1980s the limitations of product

, wide range of products

traditional and ABC systems

With ABC systems , first step is to identify

Activity cost Drivers

drivers such as number of

Unit level Activities- Consume resources in

In traditional system , product cost distortion

system may be optimal when

Cost Management Systems

The emphasis of a cost management system

Just-in-Time Inventory and

Key Features of the JIT

Purchase is small lot sizes

High quality of materials

Customer Profitability Analysis

Customer Profitability Analysis uses ABC to

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