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Activity Based Costing
By
Jan Van Deusen
Larry Inguagiato
Outline
Overhead Cost Discussion
History behind Activity Based Costing
Activity Based Costing
 What is it?
 Who does it?
 How is it done?
 What do you do with it?
Why activities – management uses
Target Costing
Conclusion
Questions
Traditional Accounting
This is how
manufacturing
has traditionally
tracked costs.
20%
50%
30%
Overhead
Direct Labor
Materials
Shifting Trends in Accounting
Traditionally overhead costs have been
allocated based on labor costs of a product.
As technology increases labor costs
constitute a lesser portion of product costs.
Also modern companies manage highly
diversified product lines, which makes
random assignment of overhead a…
PROBLEM
Overhead Example
Product A consists of 20
components costing $180
and has an assembly time
of 2 hrs at a labor cost of
$20. Overhead is applied
based on a direct labor
factor of 120% which
results in a cost of $44.
The total cost of
Product A is $244.
Product B consists of 5
components costing $180
and has an assembly time
of 2 hrs at a labor cost of
$20. Overhead is applied
based on a direct labor
factor of 120% which
results in a cost of $44.
The total cost of
Product B is $244.
Does this sound right????
Overhead example
The key to the example is the difference in
the number of components
Logically assembling 20 components must
have more cost associated with it than
assembling 5 components
The indirect overhead costs of ordering,
receiving, stocking and issuing the difference
in components are not accounted for
This is the problem with traditional
accounting
History behind ABC
ABC became practiced in the early 1980’s but
it has really become a force in industry in the
mid to late 1990’s
Most current approaches to ABC are based
on concepts developed by the Computer
Aided Manufacturing-International (CAM-I)
Project
Since then ABC plans have been further
developed and diversified down to mid and
small size companies
ABC – What is it?
ABC is the Activity Based Cost
accounting method.
ABC focuses on identifying all activities
associated with making a product or
doing a process.
ABC – What is it?
(cont)
Activity = Cost
Identifying activities will yield a total
cost system.
ABC – What is it?
(cont)
ABC has 3 strategic objectives:



Report accurate costs
Identify costs of activities
Identify future need for resources
Who is involved in it?
Engineers
Accountants
Management
Factory workers
Shipping personnel
Sales
……………….EVERYONE!
ABC Terms
Activity = work performed within an
organization.
Resource = financial input consumed by
activities.
Resource Driver = any measure of the
quantity of resources consumed by activities.
Activity Driver = any measure of the
frequency and intensity imposed by a cost
object.
Cost object = any customer, service, process
that a separate cost measurement is desired.
ABC Costs
Business
Process
Cost Activity
Cost Element
Product
Cost Pool - A
Cost Pool - B
Cost Activity
Cost Activity
Cost Element
Cost Pool - C
Resource
Driver
How is ABC done?
1. Identify activities.
2. Determine how resources are linked
3.
4.
5.
6.
to activities. (traced, assigned,
allocated costs)
Calculate activity costs.
Identify cost objects.
Determine how activities are related to
cost objects.
Calculate cost of object costs.
ABC Cost Example
Car
Transmission
Chassis
Motor
Production Line
Verify Packing Slip
Receiver Matching
Labor
Counting
Receiving
Updating Receipt
Material
QC Checks
Computer Time
Stocking
Administrative Time
Degrees of Implementation
Tier 1 – Direct Costs
Tier 2 – Incremental Costs
Tier 3 – Full Costs
Tier 1 – Direct Costs
Direct costs obviously associated with
product including managerial costs.
Ex: personnel payroll, supplies, rental
equipment.
Overhead and support costs not included.
Oriented for small projects or improving a
process vs focus on price of production or
where infrastructure is too large to determine
overhead and support costs accurately.
Tier 2 – Incremental Costs
Tier 1 costs + support costs of
organization.
Incremental costs typically include
over 95% of the organizational costs.
More difficult than Tier 1 due to
subjective distribution of expenses
across multiple elements.
Tier 3 – Full Costs
Tier 3 includes all organizational,
managerial, direct, support and
overhead costs. This is the most
comprehensive, difficult.
Least used method.
What do you do with it?
Use the collected data to make
smarter business decisions.
Why activities – management uses
Activities are actions
Improve product cost accuracy
Activities drive cost
Facilitates evaluation of alternatives
Encourages continuous improvement
Activities are easily understood by user
level
Improve decision support
Target costing
Key Japanese design technique
In Japan, cost is responsibility of design
engineer – same as US in the 1920’s
The Japanese treat cost as a symptom, not a
cause or solution
Begins with market-based pricing
independent of cost – what the customer can
pay
Target costing
Japan:

Target cost = Market-priced sales – Target
profit
Other countries:

Actual cost + Planned profit = Price
Conclusion: Costs are best managed
during concept and design phase
Conclusion
ABC is an excellent tool for identifying
areas of concern in your company as
well as being useful to integrate into
management
It is however just a tool and must be
set-up and used properly in order to be
beneficial
Questions?
Bibliography
Electronic College of Process Innovation,
Department of Defense at
http://www.c3i.osd.mil/bpr/bprcd/
Brimson, James. “Activity Accounting”. John
Wiley & Sons, Inc., 1991.
Cokins, Gary. “Activity Based Cost
Management”. McGraw-Hill, 1996.
Cooper, Robin and Slagmulder, Regine.
“Activity Based Budgeting, Part 1.” Strategic
Finance. Montvale, September 2000.
Bibliography
Deo, Baldinger S. and Strong, Doug. “Cost: The
Ultimate Measure of Productivity.” Industrial
Management. Norcross, May/June 2000.
Grieco, Peter & Pilachowski, Mel. “Activity Based
Costing: The Key to World Class Performance”. PT
Publications, Inc, 1995.
Marcino, George R. “Obliterate Traditional
Budgeting.” Financial Executive.
November/December 2000.
Yennie, Henry. “ABC: The New Cost – Cutting Tool.”
Behavioral Health Management. Cleveland,
September/October 1999.