CLEANLINESS IS NEXT TO GODLINESS

Duration: 60 mins
Slides: 18

LMT SCHOOL OF MANAGEMENT, THAPAR INSTITUTE OF

ENGINEERING & TECHNOLOGY
Masters of Business Administration

Course: Managerial Accounting

Faculty: Dr. Sonia Garg (Email: sonia.garg@thapar.edu)

Session 6: Activity based costing (ABC)

 Session Learning Objectives
• Explain how indirect cost allocation using a single cost allocation
base can lead to undercosting and overcosting of products and
services

• Guidelines for refining a costing system

• Distinguish between simple and activity-based costing

• Describe cost hierarchies

• Describe activity based costing

• Discuss the usefulness of ABC

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 Single cost allocation base
• Historically, firms produced a limited variety of goods while their indirect costs
were relatively small. Allocating overhead costs was simple: use single indirect cost
allocation base

• The end-result: overcosting and undercosting

• Overcosting – a product consumes a low level of resources but is allocated high costs per unit
• Undercosting – a product consumes a high level of resources but is allocated low costs per
unit

• The results of overcosting one product and undercosting another

• The overcosted product absorbs too much cost, making it seem less profitable than it really is
• The undercosted product is left with too little cost, making it seem more profitable than it
really is

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 Example
• Plastim molds two types of lenses: a complex lens, CL5
and a simple lens S3.

• Plastim operates at capacity with low marketing costs.

Business environment is very competitive for S3 lens
but not competitive for the CL5 lens

• Recently, old time customer Tata, said Jain Motors was

ready to supply S3 for a Rs. 530 well below the
Plastim’s price of Rs. 630.

• What should Plastim do ?

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 Steps in Simple Costing System
1. Identify the Job that is the Chosen Cost Object
2. Identify the Direct Costs of the Job
3. Select the Cost-Allocation base(s) to be used for allocating Indirect Costs
to the Job
4. Match Indirect Costs to their respective Cost-Allocation base(s)
5. Calculate an Budgeted Overhead Allocation Rate:
Budgeted Overhead Cost pool/Budgeted Overhead Allocation Base

6. Allocate Overhead Costs to the Job:

Budgeted Overhead Allocation Rate x Actual Base Activity For the Job

7. Compute Total Job Costs by adding all direct and indirect costs together

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Graphical
representation
of a simple
costing system

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 Calculation of unit costs in simple
costing system

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 Refining the costing system
• Refining of cost system has become necessary with the
– Increase in product diversity
– Increase in indirect costs
– Competition in product markets

• Guidelines for refining a costing system

– Direct cost tracing: Identify as many direct costs as feasible
– Indirect-cost pools: Expand the number of indirect cost
pools until each of these cost pools are homogenous
– Cost-allocation bases: Use the appropriate cost driver for
each homogenous indirect cost pool

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 Activity Based Costing Systems
• ABC refines a costing system by identifying individual
activities as the fundamental cost objects

• An activity is an event, task or unit of work with a

special purpose, e.g. designing products, setting up
machines, operating machines, distributing products,
etc
Assignment to other
Fundamental cost objects cost objects
Cost of Cost of products
Activities or services
Activities

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 Cost hierarchy
• It categorizes various activity pools on the basis of
different types of cost drivers

• Common cost hierarchies used in ABC are

– Unit level costs: cost of activities performed on each unit
of product
– Batch level costs: cost of activities related to a group of
unit of products
– Product level costs: cost of activities that support
individual products regardless of number of units
produced
– Facility level costs: activities that cannot be traced to a
single product, support the organization as a whole

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 Identification of indirect cost activities
at Plastim
• Designing products
• Set up molding machines
• Operate molding machines
• Clean lens molds after manufacturing
• Prepare batches of finished lens for shipment
• Distribute lenses to customers
• Administer and manage all processes at
Plastim

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 To refine a costing system
• Cleaning of lens molds can be considered a direct
cost

• Other costs are taken as indirect cost

• Identify most realistic cost-drivers for each

activity cost pool, e.g. setup hours for setting up
of molding machines and not number of setups

• Use cost hierarchies

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 ABC at Plastim

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 Graphical representation

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Cost Description Total costs for 60000 S3 lens
Direct Costs
Direct Material 11250000
Direct labor 6000000
Cleaning mold 1200000
Indirect Costs
Design (30 parts sq. ft.) 30*45000 = 1350000
Setup (500 setup hours) 500*1500 = 750000
Operations (9000 machine-hrs) 9000*500 = 4500000
Shipment (100 shipments) 100*4050 = 4050000
Distribution (45000 cu. ft. delivered) 45000*58 = 2610000
Administration (30000 direct manu. labor-hrs) 30000*64.151 = 1924530
Total Costs 29989530
Cost per unit 29989530/60000 = 499.8

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 ABC v/s simple costing
• Each method is mathematically correct and acceptable

• Each method yields a different cost figure, which will lead to different
Gross Margin calculations

• Only Overhead is involved. Total Costs for the entire firm remain the same
– they are just allocated to different cost objects within the firm

• ABC is generally perceived to produce superior costing figures due to the

use of multiple drivers across multiple levels

• ABC is only as good as the drivers selected, and their actual relationship to
costs. Poorly chosen drivers will produce inaccurate costs, even with ABC
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 Activity Based Management
• A method of management that used ABC as an integral part in
critical decision-making situations, including:
• Pricing and product-mix decisions
• Should a product be pushed or dropped ?
• Cost reduction & process improvement decisions
• Design decisions
• Planning and managing activities

• Accounting for overhead costs is an imprecise science. Accordingly,

best efforts should be put forward to arrive at a cost that is fair and
reasonable.

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 Signals that suggest ABC
implementation will help a firm
• Significant overhead costs allocated using one or two cost pools

• Most or all overhead is considered unit-level

• Products that consume different amounts of resources

• Products that a firm should successfully make and sell consistently

show small profits

• Operations staff disagreeing with accounting over manufacturing

and marketing costs
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