Activity Based Costing II
• Customer Profitability
• ABC in real life
• ABC in service setting
Overhead Allocation Conventional Vs. ABC
Units sold
Direct Material(Rs/unit)
Direct Labour(Rs/unit)
Total Direct Cost(Rs/unit)
Total Direct Cost (Rs)
Total Overhead (Rs.)
Product A
100,000
10
10
20
2,000,000
?
Product B
50,000
6
4
10
500,000
?
Total
2,500,000
5,000,000
Units sold
Direct Material(Rs/unit)
Direct Labour(Rs/unit)
Total Direct Cost(Rs/unit)
Total Direct Cost (Rs)
Conventional Allocation (Rs)
Product A
100,000
10
10
20
2,000,000
3,333,333
Product B
50,000
6
4
10
500,000
1,666,667
Total
150,000
2,500,000
5,000,000
Cost Allocation Conventional Vs. ABC
Units sold
Direct Material(Rs/unit)
Direct Labour(Rs/unit)
Total Direct Cost(Rs/unit)
Total Direct Cost (Rs)
Conventional Allocation (Rs)
Total Cost
Per Unit Cost
Product A
100,000
10
10
20
2,000,000
3,333,333
Product B
50,000
6
4
10
500,000
1,666,667
5,333,333
53
2,166,667
43
Total
150,000
2,500,000
5,000,000
7,500,000
ABC Stage 1 Allocation
Total Overhead (Rs)
Set Up Cost Pool (Rs)
Machining (Rs)
5,000,000
Cost Pools
2,000,000
3,000,000
Cost Pools and Drivers
Set Up Cost Pool (Rs)
Machining (Rs)
Cost Pools Drivers
# of Drivers Cost/Driver
2,000,000 set ups
100
20,000
3,000,000 units produced
150,000
20
Number of Set-ups
Product A
Set ups
Product B
20
80
Set-up Cost Allocated across products
Set ups
Set up Cost Allocated (Rs)
Product A
Product B
20
400,000
80
1,600,000
ABC Overhead Allocation
Set ups
Set up Cost Allocated (Rs)
Units Produced
Machining Cost
Total Overhead Cost Allocated (Rs)
Product A
Product B
20
400,000
100,000
2,000,000
2,400,000
80
1,600,000
50,000
1,000,000
2,600,000
Total Cost-ABC
Units sold
Direct Material(Rs/unit)
Direct Labour(Rs/unit)
Total Direct Cost(Rs/unit)
Total Direct Cost (Rs)
ABC OH Allocation (Rs)
Total Cost (Rs)
Product A
100,000
10
10
20
2,000,000
2,400,000
4,400,000
Product B
50,000
6
4
10
500,000
2,600,000
3,100,000
Total
2,500,000
5,000,000
7,500,000
Total Cost/unit ABC
Units sold
Direct Material(Rs/unit)
Direct Labour(Rs/unit)
Total Direct Cost(Rs/unit)
Total Direct Cost (Rs)
ABC OH Allocation (Rs)
Total Cost (Rs)
Per Unit Cost (Rs)
Product A
100,000
10
10
20
2,000,000
2,400,000
4,400,000
44
Product B
50,000
6
4
10
500,000
2,600,000
3,100,000
62
Total
2,500,000
5,000,000
7,500,000
Customer Profitability
A large Customer for Product B Places frequent orders of 100 units per
order and pays a relatively higher price of Rs 100 per order
(conventional total cost of B is Rs 43, whereas ABC cost is Rs. 62). Is
this a good or a bad customer?
Customer Profitability
Units
Sales Revenue
Less Costs
Direct costs
Machining Cost
Set up cost
Total Overhead
Customer Profitability
Rs/unit
100
100
100
100
1
20
20
20,000
Rs
10,000
2,000
2,000
20,000
22,000
(14,000)
Customer Profitability
Managerial Implications of ABC
• Better Pricing
• Better Cost Control
• Better Customer Profitability Strategies
• Better Operations Management
The Case Firm: Last Year’s Cost Break-Up
Cost of Sales
RM consumed
Salaries
Fuel & Power
Maintenance
Stores & spares
Insurance
Freight
Others
Research
Misc
Depreciation
74.4%
8.0%
4.5%
2.1%
4.2%
0.3%
0.7%
0.2%
0.4%
0.1%
5.1%
100.0%
The Case Firm: How bad is the Costing
Methodology?
• Material Cost is Directly Traced to the products
• Other costs are allocated to a product on the basis of direct material
costs of a product (using last year’s other costs to material costs ratio
as a basis)
• For Her… bed:
• D.M. Cost : Rs14,275
• L &O.H Cost: Rs 4,911
The Case Organization: Manufacturing
• Manufacturing takes place in 6 shops.
The Case Organization: Manufacturing
• The metal shop: consists of general purpose machines for cutting, grinding, welding and painting of furniture
metal parts.
• The board shop: provides boards for furniture items that are designed with veneer and laminate boards. This
section contains highly automated machines which are able to process boards. The only labor intensive part
is the application of veneer sheets to the boards.
• The Wood Shop: The sheets are marked and cut by hand and the pressing on the boards is done by the
machines. After all pieces are cut, they are sanded, polished and dried
• Assembly Shop
• Upholstery
• Polishing: 2 automated polishing lines in which pieces of wood are given a uniform coating in a controlled
environment.
Allocation Basis
Cost Items
Shop or Facility
Allocation Basis
to Products
Direct Material
Related to product
Labor
Related to shop
?
Depreciation
Related to shop
?
Electricity in shops
Related to shop
?
Maintenance
Related to shop
?
Supervisors Salary
Related to shop
?
Facility Electricity
Related to facility
?
Managerial salary
Related to facility
?
Building
Depreciation
Related to facility
?
Sample Costing for Har…. Bed
Cost of Herrington
• Overhead Cost:
2,104
• Raw Material Cost: 14,275
• Total Cost:
16,379
• Sale Price:
43,000
• Is this a better costing system?
ABC in Service
Setting?
• HBL Income Statement
• What has caused Net Interest Income
to go down by more than 50%?
Imagine a customer with an Average Balance
of Rs. 5,000
•
•
•
•
•
•
•
•
•
•
Net Interest Income (5% of Rs. 5,000): Rs.250
Expenses:
Form filling at the time of opening of A/C: 0.5 hour
Verifications/Approvals: 1 hour
Accounts/Audit: 0.5 hour
Withdrawals/Deposits (24x10): 4 hour
Check clearings: 2 hour
Total time: 8 hours
Average employee’s monthly salary (20 working days): Rs40,000
Administrative Expense on A/C: Rs. 2,000
Bank One Corp.
• At Bank One Corp., the fifth largest bank in U.S., “the line in the sand
between preferred and non preferred customer has become strikingly
obvious”. The bank is redesigning it 218 branch network so its
“premier one” customer can be whisked away to a special teller
window with no wait or to the desk of an appropriate officer.
Customers qualify by keeping at least $2,500 in a checking account or
by paying a $17 monthly fee. Bank estimates that this extra attention
will go to only 20% top customers.
“The Wall Street Journal”, January 7, 1999
ABC in an Insurance Firm
Logic of ABC
• Products/Customers/Processes Consume Activities
&
• Activities Consume Resource (Costs)
• ABC is an effort to develop a better understanding of the link
between Products/Customers/Processes-Activities-Costs
• This understanding will help us in:
• Better Costing of Products/Customers
• Better management of costs through controlling activities
Assignment Questions
• 4-15
• 4-19
• 4-20
• 4A-09
• 4A-10