Activity based costing

What drives cost?

 Case on volume driven costing
Seligram Inc.
 What cost systems do?
Measurement of cost of goods sold
Cost estimate for cost objects
Feedback on process efficiency
and effectiveness
Input for decision making
 Volume driven costing
Total cost = M + L + OH
OH allocation: volume based base- LH,
MH, Units, Prime cost %, etc.
When OH share is larger, cost distortion is
possible
ABC might be a solution.
 Broad Averaging
Undercosting and overcosting
Cost cross subsidisation
 Plastim Corporation
Complex lense (CL5) and a simple lense
S3 for Giovanni Motors
Process:
1. Design products and processes
2. Manufacture lenses (molded, finished,
cleaned, and inspected
3. Distribute lenses (packed and sent)
 Cont
Operating at capacity
Low marketing cost
High-quality products, low customer-service costs
Highly competitive environment with respect to
simple lenses
For S3, Bandix is offering at $53 ($63 for Plastim)
SPU for CL5 is $137 (no competition)
 Options
Exit from simple lense (Bandix has cost
advantage)
Reduce price and accept lower margin or
aggressively cut cost
Requirement:
understand cost of design, making and
distributing lenses
 Present costing system
Assign all manufacturing and non-
manufacturing cost (not just an inventory
costing system)
All cost to be recovered
Single indirect cost-pool system
 Steps
1. Cost objects (CL5 & S3): volume- 15,000 &
60,000
2. Trace direct costs (M + L)
3. Select allocation base: budgeted DLHs 39,750
4. Budgeted indirect cost:$.23,85,000
5. Driver rate: $23,85,000/39,750 = $60/DLH
6. Driver quantity consumed by the cost objects
(total 30,000 DLHs for S3 and 9750 for CL5)
7. Add direct cost and indirect cost to find total cost
 Cost Sheet
S3 S3 CL5 CL5 Total

60,000 60,000 15,000 15,000

Total Per unit Total Per unit

DM 11,25,000 18.75 6,75,000 45.00 18,00,000

DL 6,00,000 10.00 1,95,000 13.00 7,95,000

Total Direct costs 17,25,000 28.75 8,70,000 58.00 25,95,000

Indirect cost allocated 18,00,000 30.00 5,85,000 39.00 23,85,000

Total costs 35,25,000 58.75 14,55,000 97.00 49,80,000

Bandix price 53.00

 Demand for refining a costing
system
1. Increase in product diversity
2. Increase in indirect costs
3. Competition in product markets
 Guidelines for refining costing
system
1. Identify as many direct costs as is
economically feasible
2. Expand the indirect cost pools to make
more homogenous cost pools (cost driver
based)
3. Use multiple drivers for allocation
Cont..

Volume based costing Activity Based Costing

Expenses Resources

Activities
Cost object

Cost objects
 ABC philosophy
Output consumes activities
Activities consume resources
Output cost = activity cost

Cost is traced to activities, then assigned to

products
Cont.
Many activities are support activities not
related to production of output
Cost of these activities should be related to
the product, process or customer
Expense is incurred not on output directly,
but on activities
Cost assignment under ABC captures
physical dynamics of the organisation
 ABC steps
Multiply the cost driver rate with qty. of each activity
consumed by the cost object
Identify support Quantity of each
activities cost driver
consumed by cost
object

Trace expenses to Activity cost

activities driver rate

Total cost of Cost driver for

each activity each activity
 Cost Hierarchy

Unit-level activities represent work performed for

each unit of output produced- related to volume
Support resources perform (not related to units of
output)
- Batch-level activity: activities which are
independent of the number of units of output in a
batch (machine setup)- traditional costing assumes
that cost of batch-level activity is fixed (wrong?)
- product (service) sustaining activity: activities
which enable production of individual products /
services to occur
Cont.

- Customer sustaining activities- activities

which enable output to be sold to an
individual customer irrespective of the units
or product mix sold

Traditional cost system cannot trace product

and customer sustaining activities to cost
objects
Cont..

- Facility level activity: residuary head of

activities (BOD meeting)
..
Unit-level activities are dominant:
traditional cost system will be OK. ABC not
necessary.
Cont

ABC, in addition to unit level drivers,

requires batch, product-sustaining and
customer sustaining cost drivers

System designer has to choose an activity

cost driver for each activity
 Plastim Move to ABC
Activity list:
Design products and processes
Set-up molding machines
Operate molding machines
Clean and maintain the moulds after manufacture
Prepare batches of finished lenses for shipment
Distribute lenses
Administer all processes at Plastim
 Activity costs with driver
Activity Design Machine Machine Shipment Distributi Admin.
activity set up operation set up -on activity
Activity 4,50,000 3,00,000 6,37,500 81,000 3,91,500 2,55,000
cost[$]
Driver 100 parts 2,000 set 12,750 200 67,500 39,750
square-ft. up hours molding shipments cubic feet direct
MHs delivered mfg. LHs

Driver 4,500 150 50 405 5.80 6.4151

rate [$]
Cause- Increases Increases Increases Increases Increases Demand
effect with more with set-up with with with cubic for admin
relation complex hours molding number of feet of resources
molds MHs shipments packages increases
(more parts delivered with more
and surface DLHs
area)