Activity Based Costing used for Costing the different products based on the activities involved

1. Activity Based Costing

2. What is ABC? Activity Based Costing is a management accounting approach which allocate all direct and indirect (overhead) costs to cost objects (products and services) in order to help management understand critical business information. It allocates direct and indirect costs to products and services based on the level of activities used to create and deliver those products and services.

3. Direct & Indirect Costs? Direct costs A cost that can be directly traced to producing specific goods or services., e.g., salaries for project staff and materials required for a particular project. Indirect costs are costs that are not directly accountable to a cost object (such as a particular function or product). Indirect costs may be either fixed or variable. Indirect costs include taxes, administration, personnel and security costs, and are also known as overhead.

4. Activities such as purchasing, design, production, sales, marketing and customer service are utilized by different products and services (cost objects) based on their complexity and business requirements. Compared to traditional accounting, activity based costing is a decision making tool which provides more accurate cost and profit information and allows management to understand the cost and profit drivers and improve their business.

5. ABC Vs. Traditional Methods Resources Resources Everything in the organization Consume Traced by Resource Drivers Activities What is actually being done Allocation Basis Allocate Consume Traced by Activity Drivers Objects Objects -Products -Services

6. Difference between Traditional & ABC Method In traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities. Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels. Traditional cost accounting is structure-oriented whereas ABC is process-oriented.

7. Steps necessary to develop ABC System: Identifying available resources & resource-consuming activities Assigning costs of available resources to activities Assigning costs of activities to cost objects(i.e. products, batches of products) How ABC Works

8. 1. Identifying available resources & resource-consuming activities Identify resources Resource Consumption Cost Drivers Transaction Drivers Duration Drivers Activity Levels: There are different activity levels such as: unit level activities (activities performed on each unit such as packaging), batch level activities (activities performed on batch level such as scheduling and set up), product level activities (activities performed on each product such as design, engineering and marketing) and facility level activities (activities performed at each facility such as safety and maintenance).

11. Example of ABC Friends company, a manufacturer of valves, produces and sells two types of valves: Gas Safety Valves(GSV) and MSC Valves(MSC). Friends company has following data for two products: In addition, Friends company has identified the following activities, costs, and activity consumption cost drivers:

12. Friends company also collected the activity data for each product: Using the total cost for each activity & the total amount of activity cost driver we can determine the activity cost rate:

13. Calculating per-unit cost of each product manufactured by Friends Company.

14. Using the obtained data we can perform the product profitability analysis; that is, we will determine the unit margin profit of each product Comparing the product profitability analysis under traditional and activity-based costing.