Activity Based Costing

Is now receiving more attention because of need to meet “ pressure and prices” due to increased competition.

            What it does is prorate overhead and support cost (indirect) incurred to produce a product or service ore precisely.  This allows obtaining a truer cost.

            Overhead costs used to be a small component of the total cost (direct material and direct labor accounted for the majority cost).  To say the direct labor cost % has shrunk while overhead cost % making it necessary to:

1.      Understanding its composition

2.      Determine it more precisely

3.      Control it more effectively

4.      Have a basis for managing it

By allocating the cost of an overhead activity on the basis of direct consumption needed to produce the product or service (for instance “purchasing department cost”) would:

a)      Charge a produce that involves a lot of purchased parts with a higher cost.

b)      Show excess capacity (i.e. cost) if say the purchasing department costs were not 95% consumed as a consequence of purchasing activity required.

c)      Serve as the basis for overhead cost justification Allow more precise valuation of cost of goods sold and inventories than one that only used it minimally.

Activity based costing is:

1)      Expensive to set up

2)      Expensive to maintain since it requires updating

3)      Requires estimate by management where activity consumption cannot be measured

4)      Not 100% accurate but is an improvement over the average production level allocation method

5)      Facilitated by computers.  Could not be done cost wise without computer

6)      Most effectively employed in industries/organizations where:

a)      There is need to control and reduce cost in order to maintain profits

b)      Where overhead costs are large

Activity based costing like any cost accounting method does not deal well with complex cost allocation to departments, products, divisions ect. of generic and administrative costs.

Definitions

Cost Pool.              A group of individual costs that is allocated using a single cost driver. (Done to reduce accounting costs.  There costs should be related to the cost drivers)

Customer Driver- Output measure that motivates overhead activity cost.

(i.e. salaries of support personnel driver by hours required to service   products)

Cost Estimating – ABC Method

A more detailed example contrasting traditional product costing and ABC Method of product costing for part 25 being produced in Dept A, of Plant X, of Company Y is shown (to keep things simple we are assuming the production is done in one department.  In practice most likely a number of departments will be involved, each one adding cost)

Relevant Data

Annual production quantity projected to be produced is 100,000 units.  Estimated direct cost for the 100,000 units of Part A is:

Direct Material Cost   $ 300,000

Direct Labor Cost       $ 192,000

Dept A – Annual budgeted indirect cost and related activity    (It produces a variety of other parts in addition to Part A)

Estimated total annual direct labor cost -  $ 1,650,000 for Plant X

Traditional cost estimate to produce Part A

Estimated total overhead cost  = 6,600,000

Estimated total direct  labor cost 1,650,000    = 400%*

Total Cost    1,260,000

No of units      100,000   =  $126/unit cost

Overhead cost Part A using ABC Method

Total estimated of Part A cost using ABC Method

636,800  = $63.68unit cost

100,000