Activity Based Costing: An Emerging Cost Model for Financial Management & Decision Making

This presentation discusses Activity Based Costing, a method for ascertaining the cost related to the production of products and monitoring of production activities. It includes steps for implementation, advantages, and disadvantages. Suitable for students of BMP5006 Financial Management & Decision Making.

Activity Based
Costing
An Emerging Cost
Model

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Introduction
ABC, also known as Activity Based Costing, is a method which helps the firms to ascertain
the cost related to the production of products and monitoring of production activities. The
method identifies the consumption of resources and ascertain final results. Resources are
being allotted to various production activities and then these activities are assigned to
different cost objects. The method helps the management in making good understanding of
the products and services it offers, its customers and the profit it makes by selling products
to the target customer group. The method is being used by the firms to identify the indirect
expenses incurred on various products of the firm, to consider the direct and indirect costs
on the products, to set the of prices more precisely and to know which indirect cost could be
reduced or cut back. This report includes application of ABC in manufacturing firms, steps
for implementation of activity based costing, merits and demerits of activity based costing.

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Implementatio
n
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Activity based costing is a costing method that help the organization to
identify activities and assign the cost of each activity to all products
according to the actual consumption. As compared to conventional
costing this model assign more overhead cost into direct cost.
ACTIVITY BASED COSTING HELP IN:
BUDGETING
Activity based costing help
companies to know the flow of
money throughout the year
accurately. Creation of budget
for the year help decision
makers to evaluate department
performance through variance
analysis.
PRODUCT
PRICING
Activity based costing helps in
discovering accurate product
pricing because finalizing the
price of a product is the
challenging part of the business.
If any cost related to production
fails to take into consideration
results too low pricing which
cannot be wind up with the
healthy profit margin.
It help companies to know
the use of overhead costs
that help in determining
necessary activities for
production. Activity based
costing helps in identifying
the wastage which could be
close out to reduce
overhead cost or can be cut
down entire process.
DECISION
OVERHEAD
DECISION

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ABC Calculation:
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Identify all the activities related to production of product.
Divide the total overhead of each cost pool by total cost drivers that gives cost driver
rate
Multiply cost driver rate by number of cost drivers.
Divide the activities into cost pools.
Calculate total overhead of each cost pool.
Assign cost drivers (hours, units) of each cost pool.
Calculate cost driver rate by dividing total overhead.

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IMPLEMENETIN
G STEPS
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• ACTIVITY IDENTIFICATION – An activity is a process that consumes overhead cost. The
objective is to understand activities required to produce company’s products. Through this, All
the activities that have the biggest impact on overhead cost will be narrow
down.Manufacturing company identified the following activities as having the biggest impact
on overhead cost which are as follows:
Purchasing of material,Running cost of machines,Assembling of products,Setting of
machines,Inspecting materials to finished products
• ASSIGN OVERHEAD COSTS TO ACTIVITIES – in this step, cost pool is formed for each
activity in which overhead costs associated with each activity. Purchasing material includes of
salaries, rent, depreciation. In this all overhead cost includes not direct material direct labor
cost. In this step company gets estimated annual overhead cost.
• IDENTIFY COST DRIVERS – Cost driver that drives the cost associated with activity by
identifying cost drivers from various areas of the companies such as production, purchasing,
quality control which help the manufacturing business to know estimated annual cost driver
activity.Examples of cost drivers in manufacturing business are purchase requisition, machine
hours, direct labor hours, machine per setup etc.

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IMPLEMENETIN
G STEPS
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• PRE DETERMINED OVERHEAD RATE FOR EACH ACTIVITY – pre determined
overhead cost will be calculated by dividing estimated overhead cost and estimated cost driver
activity that shows overhead cost for each purchase requisition processes.
• ALLOCATE OVERHEAD COSTS TO PRODUCTS – Once activity pools and rates
known, the next step is to assign them cost. Overhead costs are assigned to products by
multiplying predetermined overhead rate by cost driver activity.
• PREPARE AND DISTRIBUTE MANAGEMENT REPORTS – After completing ABC
costing, the data should be send to cost object owners in a concise manner.

7ADVANTAGES OF
ACTIVITY BASED
COSTING
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ACCURATE PRODUCT COSTING – it produces reliable product cost by focusing on cause and
effect relationship of cost incurrence. It helps the manufacturing business to know the activities
which cause costs which consume activities. In a large organization overhead cost constitute a large
share of total cost which is important to know accurate costing of product.
COST BEHAVIOUR INFORMATION – help in cost behavior reduces cost and the activities that
do not add value in a product. Helps in decision making for manager to control fixed overhead cost
as it is visible to manager through variance analysis.
TRACING ACTIVITIES – with the help of knowing cost drivers, ABC help decision makers to
trace more overheads to the products and resulting in efficiency of operations.
OVERHEAD COST – ABC help many departments in an organization like production etc. will
know their overhead cost related to production of product through which it is easy to reduce cost per
unit and effective utilization of resources.
BETTER DECISION MAKING – Activity based costing helps in fixing selling prices of products
as the manager has reliable product cost data.
COST MANAGEMENT – Cost drivers is help to design new products or existing products as they
have overhead cost that can be applied in costing. Activity based costing useful for cost management
and performance appraisals.

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DISADVANTAGE
S OF ACTIVITY
BASED
COSTING
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EXPENSIVE AND COMPLEX METHOD – As there are numbers of cost pools and drivers which
makes it complex and costly therefore it is not recommended to use activity based costing in all firms
for all product lines.
SELECTION OF DRIVERS – As there are numerous cost drivers, common cost, varying cost
driver rates which makes difficult for the organization to select each drivers. It could be possible that
cost driver will not relate to product but it looks in a management view.
SMALLER FIRMS – All firms are not using activity based costing due to its cost of maintaining
therefore Activity based costing is not useful for small firms, it could be possible that it will be
beneficial for small firms if the costing of products will be beneficial, if it is costly resulting in high
selling prices and lowers the profitability.
LACK OF COMMUNICATION – As companies uses Activity based costing method affect
behavioral change management result in lack of communication and failed ti implement the ABC
method.
RESISTANCE – operational managers that would need to spend substantial time and efforts through
which employees pose resistance towards this method.

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Advantages of ABC over
traditional costing techniques:
ABC or Activity Based Costing and Traditional Costing are the methods which are being used in
allocation of overheads to the products that firm produces. Both of these methods estimates the
total amount of indirect cost on the overall production and assignment of these indirect costs to
individual product based on the rate of cost driver. The major difference in both the methods is
the accuracy of the results and complexity of the method. Traditional costing assign the overheads
to the products on the basis of average rate of arbitrary is considered to be more simple method
than ABC method. But the results from the traditional costing method are less accurate compared
to the ABC. ABC is more typical to understand and apply as it is a long method to assign the costs
to products. It firstly assign overheads to the activities that are being conducted to produce the
product and then it assigns overheads to the individual product on the basis of usage of the
products.
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Traditional
Costing:
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Traditional Costing is a method in which overheads are assigned to products on the basis of pre-
established indirect cost rate. This methods is considered to be the best when direct costs are more
than indirect costs. There are some steps to apply traditional costing method:
1. Firstly, indirect cost is needed to be identified.
2. Estimation of indirect cost is done for a specific period of time, i.e., for a year, quarter or month.
3. Cost driver needs to be selected which would have a link with the cost.
4. Estimation of a value for cost driver is done for a specific period.
5. Computation of pre-established indirect cost rate would be done.
6. Finally, indirect costs are assigned to the products with the help of indirect cost rate.

11ABC vs
TraditionalBasis ABC Costing Traditional Costing
Focus Activity based costing or ABC method has
a major focus on allocation of cost. In this
method, for different type of activity,
determination of various cost drivers is
done and allocation is done on the basis
of these cost drivers.
The allocation of indirect costs
to the production activities is
the major focus. Only one
standard is being set for
activities that are part of
production and allocation is
done on the basis of the level
of usage of that standard.
Application ABC is more typical to understand and
apply as it includes selection of criteria for
absorption of indirect costs which is
difficult and complex to adopt. Sometimes,
it is difficult to set a criteria for allocation
purpose.
This method is more simpler to
understand and apply because
only one cost driver is
determined for production
activities and the costs are
distributed into variable and
fixed costs of production.
Scope ABC costing is useful in allocation of all
the costs related to manufacturing and
non-manufacturing activities such as
selling and distribution costs,
administration costs, etc.
Traditional costing is used only
in allocation of costs related to
manufacturing.
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12ABC vs
TraditionalBasis ABC Costing Traditional Costing
Usage of method by
the Management
ABC could only be utilize for management
motive because it can not be used by more
than one user as they would not find it suitable
metric for their operations. It helps the
management in pooling of cost and allocation
of costs more properly.
The values determined by using
traditional costing method could
become a part of profit and loss
statement as a cost value as it only
determine the value of cost of
product.
Influence on
Operations
The firm requires to make deep investigation
of its activities related to production and cost
incurred by the firm for the same. ABC helps
the management in improving their processes
in long run. This method eventually helps
businesses to manage their production costs.
Using Traditional Costing method
makes things difficult for the
management in gathering the data
related to production as they do
not provide various cost centres to
the firm.
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Activity Based Costing (ABC) helps in improving the processes of business and indirect cost would be
allocated to each and every product that firm produces. In this method businesses would be able to
exclude the cost, such as factory costs, that are not related to the products that firm produces. When the
costs are allocated to each and every product or activity, it helps the firm to improve its processes. This
method also helps in determining the products that are useless for the business and then firm can stop
their production.

13The
Conclusion>
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From the above report it can be concluded that Activity Based Costing is proved
to be more useful in enhancing the cost process of the firm. Although it has
many uses to the firm, managers still hesitate to make use of this type of
costing method as it maximises the workload to ascertain the indirect expenses
that are needed to be allocated to each product firm produces and this method
requires expertise knowledge in the same area. Here, Traditional costing
becomes a more easier option for the managers as it easy to understand and
easy to adopt by the managers of the firm. Traditional costing is more better for
firms who have lower indirect costs.

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References
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