Traditional Costing Systems

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1 Traditional Costing Systems Product Costs Direct labor Direct materials Factory Overhead Direct labor and direct materials are easy to trace to products. The problem comes with factory overhead.

2 Traditional Costing Systems Typically used one rate to allocate overhead to products. This rate was often based on direct labor hours. This made sense, as direct labor was a major cost driver in early manufacturing plants.

3 Today s Manufacturing Plants Are more complex Are often automated Often make more than one product Use proportionately smaller amount of direct labor making direct labor a poor allocation base for factory overhead.

4 Background The direct costs, which mainly includes material and labour, are chargeable to the end products without difficulty and are thus convenient to handle. Indirect costs, also known as overheads, creates problem for the cost accountant in determining the accurate product costs. In modern era, importance of indirect costs in the manufacturing operations is increasing.

5 ABC Definitions Activity based costing is an approach for allocating overhead costs. An activity is an event that incurs costs. A cost driver is any factor or activity that has a direct cause and effect relationship with the resources consumed.

6 Activity based costing Activity-based costing (ABC) is a costing model that identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each. In this way, an organization can precisely estimate the cost of individual products and services so they can identify and eliminate those that are unprofitable and lower the prices of those that are overpriced.

7 . Activity Based costing allows an organization to determine the actual cost associated with each product and service produced by the organization. The goal is to measure and then price out all the resources used for activities that support the production and delivery of products and services to customers

8 Steps in ABC 1. Identification of the main activities 2. Creation of cost pool 3. Determination of the activity cost drivers 4. Calculation of activity cost driver rate Activity cost driver rate= total cost of activity Cost drivers 5. Charging the cost of activities to products

9 Steps/ Stages and Flow of cost in allocating overheads in ABC Identify Main Activities Identify Cost Factors, Drivers Collect costs of each activity Charge Overheads Material handling, purchasing, receipt, dispatch, assembly etc. Number of Purchase orders, No. of Orders Delivered, No. of setups Cost pools which are directly equivalent to conventional cost centers. On basis of usage of activity expressed in terms of cost driver. from Cost Management by Jawahar Lal et al.

10 Identify Resources (Expenditure of an Organization) Resources represent the expenditures of an organization. These are the same costs that are represented in a traditional accounting view; unlike traditional accounting, ABC links these costs to products, customers, or services. Production Labour Sales and Marketing Labour Occupancy Utilities Expenses and Supplies Etc..

11 Identify Activities (Work Performed) Activities represent the work performed in an organization. ABC Activities for the sales department in a typical organization might include: Making sales calls to existing customers Making sales calls to potential customers Making customer service calls Training product representatives Evaluating products and improving product knowledge Distributing samples Attending trade shows and other events

12 Identify Cost Objects (Product/ Services/ Customers) ABC provides profitability by one or more cost object, usually represented by products, customers, and/or services. Cost Object profitability is utilized to identify money losing customers, to validate separate divisions or business units, or to measure the performance of individual projects, jobs, or contracts. Defining the outputs to be viewed is an important step in a successful ABC implementation.

13 Determine Cost Drivers (Expenditure of an Organization) Determination of Cost Drivers completes the last stage of the model. Cost Drivers trace, or link, the cost of performing certain Activities to Cost Objects. For example, taking orders for existing customers may be linked to specific customers based on the number of orders taken, if each order takes approximately the same amount of time. If order taking time varies based on the customer, this cost may be linked based on another driver or multiple drivers.

14 Charging cost of activities to products

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16 Possible Cost Drivers Machine hours Direct labor hours Number of setups Number of products Number of purchase orders Number of employees Number of square feet No. of receiving orders for the receiving department costs No. of setups for setup costs No. of inspections for inspection charges Number of employees for labour welfare expenses

17 Benefits of ABC ABC provides more accurate and informative product costs, which lead to more accurate product profitability measurements. ABC provides more accurate measurements of activity driven costs, which helps managers improve product and process value by making better product design decisions and controlling costs better. It identifies the real nature of cost behaviour and helps in reducing costs and identifying activities which do not add value to the product

18 Difficult to understand Limitations activity-cost rates needs to be updated regularly It can become complex due to multiple cost drivers Implementation of ABC system is difficult as to selection of cost drivers, assignment of common costs, varying cost driver rates, etc. It is a costly system to implement It may not be useful for small manufacturing firms especially where share of indirect costs in total cost is comparatively less.

19 DIFFERENCE TRADITIONAL ABC One or a limited number Labour intensive Simple and inexpensive Many, to reflect different activities capital intensive Accurate product costing

20 .