Activity based costing and management

It increases understanding of overheads and cost drivers; and makes costly and non-value adding activities more visible, allowing managers to reduce or eliminate them.

Activity-based costing provides more detailed measures of costs than traditional allocation methods. For the two indicated reasons, the information generated by an ABM analysis cannot be used to drive all management decisions - it is simply information that can then be inserted into the general context of how an organization should be operated.

Importance of activity based costing

Pool: Product packaging. For example: The total cost of for the activity pool Processing purchase orders is driven by the number of purchase orders processed. Overhead includes costs like electricity to run machines and salaries of product designers and inspectors. There are two categories of activity measures: transaction drivers, which involves counting how many times an activity occurs, and duration drivers, which measure how long an activity takes to complete. Activity-based costing is based on the premise: Products consume activities; activities consume resources. Activity-based costing ABC has revealed startling information in these companies. For example, we typically allocate overhead based on machine-hours required to stitch and fasten snaps. Sales revenues and direct costs for Products A and B. Step 4A. Cost Driver: Number of tests. For example, one product might take more time in one expensive machine than another product—but since the amount of direct labor and materials might be the same, additional cost for use of the machine is not being recognized when the same broad 'on-cost' percentage is added to all products. To determine the total profitability of a new product, based on its sales, warranty claims, and repair time required for returned goods. An activity is a cost driver, such as purchase orders or machine setups. Nevertheless, accountants have discovered that they can improve the ways costs are assigned, such as to movies in this case, by using activity-based costing.

Activity-based costing and management Suppose you go to a movie theater that has five screens showing five different movies.

In ABC, analysts view the indirect or overhead cost contributors as activity pools. Jerome Justin works for the movie theater selling tickets for all five movies.

Activity based costing example company

Compare Investment Accounts. But exactly how would activity-based costing help us cut production costs? Lean accounting is primarily used within lean manufacturing. Or you could figure out how many tickets he sold to each movie, and allocate his wages on the basis of ticket sales. The formula for activity-based costing is the cost pool total divided by cost driver, which yields the cost driver rate. While that is probably a reasonable way to allocate the costs of electricity to run machines, its not a desirable way to allocate the cost of quality control inspectors. Main article: Management accounting Lean accounting methods have been developed in recent years to provide relevant and thorough accounting, control, and measurement systems without the complex and costly methods of manually driven ABC.

We really do not know how much it costs to make an inspection and how much inspection cost is required by each product. Activity-based costing ABC has revealed startling information in these companies.

Activity based costing and management

A cost driver, also known as an activity driver, is used to refer to an allocation base. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product. For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost. Activity-based costing identifies and measures the costs of performing the activities that go into a product much better than traditional cost methods. Divide the total overhead of each cost pool by the total cost drivers to get the cost driver rate. Traditional absorption costing tends to focus on volume-related drivers, such as labour hours, while activity-based costing also uses transaction-based drivers, such as number of orders received. Several examples of how ABM can be used are: To determine the total profitability of a customer, based on its purchases, sales returns, and use of the time of the customer service department. In this ABC example, as well, Product manufacturing direct costs consist of direct labor costs and direct materials cost. For example: The total cost of for the activity pool Processing purchase orders is driven by the number of purchase orders processed. Prevalence[ edit ] Following strong initial uptake, ABC lost ground in the s compared to alternative metrics, such as Kaplan's balanced scorecard and economic value added. Objectives[ edit ] With ABC, a company can soundly estimate the cost elements of entire products, activities and services, that may help inform a company's decision to either: Identify and eliminate those products and services that are unprofitable and lower the prices of those that are overpriced product and service portfolio aim Or identify and eliminate production or service processes that are ineffective and allocate processing concepts that lead to the very same product at a better yield process re-engineering aim In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. Under the ABC system, an activity can also be considered as any transaction or event that is a cost driver. An independent report concluded that manually driven ABC was an inefficient use of resources: it was expensive and difficult to implement for small gains, and a poor value, and that alternative methods should be used. Calculate the total overhead of each cost pool.

Kaplanproponents of the Balanced Scorecardbrought notice to these concepts in a number of articles published in Harvard Business Review beginning in Lean accounting is primarily used within lean manufacturing.

Pool: Machine setup. Objectives[ edit ] With ABC, a company can soundly estimate the cost elements of entire products, activities and services, that may help inform a company's decision to either: Identify and eliminate those products and services that are unprofitable and lower the prices of those that are overpriced product and service portfolio aim Or identify and eliminate production or service processes that are ineffective and allocate processing concepts that lead to the very same product at a better yield process re-engineering aim In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers.

The problem in this area is that a new strategic direction may be quite expensive in the short-term, but has prospects for a long-term payoff that are difficult to quantify under an ABM analysis. Using activity-based management, managers would identify what Justin did with his time and perhaps find ways to help him become more efficient.

Historical development[ edit ] Traditionally, cost accountants had arbitrarily added a broad percentage of analysis into the indirect cost.

characteristics of activity based costing
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Activity Based Costing vs. Traditional Steps, Results Compared