3163579-Activity-Based-CostingFINAL

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A ctivity b ased c osting

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Determining Cost of an Object Intuition Educated Guessing Conventional CA Activity Based Costing

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Total Cost for a Cost Object Direct Cost (Lab + Mat) + Overhead Cost = Total Object Cost

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CCA ABC &

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Conventional Cost Accounting In conventional cost accounting, overheads are first allocated and apportioned to various production departments and service departments, then overheads of service departments are re-apportioned to production departments and then overheads of production departments are charged to the end products on some suitable basis(like machine hours, labour hours, direct wages etc.)

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Departmentalization 1 Process of dividing the factory into number of Segments Is called Departmentalization P1 S1 P2 P3 S1 Prod Departments Service Dept. Conventional Cost Accounting

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Departmentalization 2 Process of allocating and apportioning POHEs to different departments or cost centers (Prod & Service ) P1 S1 P2 P3 S1 Prod Departments Service Dept. Factory Overheads

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Departmentalization P1 S1 P2 P3 S1 Prod Departments Service Dept. Factory Overheads Allocation & Apportionment

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Service Department (Cafeteria) Service Department (Accounting) Service Department (Personnel) Operating Department (Machining) Operating Department (Assembly) The Products Absorption

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CCA in an Organization ……………. Two Products A and Product B Product A Total Direct labor=200000 Annual output= 10000 units Product B Total direct labor=100000 Annual output=20000units

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CCA in an Organization (Contd) ……………. Total Overhead =Rs 3,00,000 Total Direct Labour=30000(20000+10000)ours OH Rate/hr=Rs 3,00,000/30000hours =Rs 10/hour Overhead cost @Rs. 10 per machine hour Product A: Rs 200000 Product B: Rs 100000 CCA overhead allocation(cost/unit) A: Rs 20 per unit(200000/10000) B: Rs 5 per unit(100000/20000)

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CCA in an Organization (Contd) ……………. CCA may lead to Under Costing & Over Costing Under absorption -under pricing product Over absorption - over pricing product

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-what is ABC? ABC is a method that measures cost of a Product/Service, based on the activities performed to produce the product / service

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-what is ABC? An Activity is an event, task or unit of work with a specified purpose Designing products Setting up Machines Operating Machines Distributing Products Administer Processes

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benefits Pricing and Product Mix Decisions Cost Reduction & Process Improvement Decisions Design Decisions Planning & Managing Activities

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limitations May require Substantial Resources Benefits must outweigh the additional Cost May be difficult to apply in certain cases Time consuming

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System Activities Costs of Activities Assigned to Cost Object Product Service Customer According to use

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When to use When Overhead is High Products are Diverse: complexity, Cost of Error is High Competition is Stiff

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Support for corporate strategy Accurate product costing Resource spending Accurate feedback Useful management decision making tool Total quality management Wholesale distributors Human resources Resource expansion decision highlights

DIFFERENCE :

DIFFERENCE Conventional Based on the assumption that end products consume resources in proportion to the volume of production. Overheads are calculated for each functional cost centres(production and service). Overheads are absorbed on the basis of volume measures like machine hours, direct labour hours. ABC Based on the assumption that end products consume resources in proportion to the volume of activities. Overheads are calculated for each activity like ordering, setting up. Overheads are absorbed on the basis of activities consumed.

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Conventional It is not so accurate as ABC. It is subjective approach because it uses arbitrary bases for apportionment of overheads. ABC It is an accurate system of costing because the distribution of overheads is based on cause and effect relationship. It is objective approach because it uses activities as bases for distribution of overheads.

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Conventional It does not facilitate the control over those activities which cause fixed overheads. It does not facilitate the identification of unnecessary activities. ABC It facilitates the control over those activities which cause fixed overheads. It facilitates the identification of unnecessary activities.

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Activity-Based vs. Traditional Costing Assume the Busy Ball Company makes two types of bouncing balls; one has a hollow center and the other has a solid center. The same equipment is used to produce the balls in different runs. Between batches, the equipment is cleaned, maintained, and set up in the proper configuration for the next batch. The hollow center balls are packaged with two balls per package, and the solid center balls are packaged one per package. During the year, Busy Ball expects to make 10,00,000 hollow center balls and 20,00,000 solid center balls. The overhead costs incurred have been allocated to activity pools as follows: Question-1

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Purchasing of materials Rs200,000 Setup of machines 350,280 Packaging 300,000 Testing 270,000 Cleaning and maintenance 288,540 Total overhead costs Rs1,408,820

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Activity Cost Driver Total Expected Units for Cost Driver (1) Total Cost (2) Unit Cost per Cost Driver (3) = (2)÷ (1) Purchasing of Materials #purchase orders 100 Rs200,000 Rs2,000.00 Set up of Machines #setups 252 350,280 1,390.00 Packaging #containers filled 2,500,000 300,000 0.12 Testing # tests 3,000 270,000 90.00 Cleaning and maintenance #of runs 252 288,540 1,145.00 By analyzing the activity pools, the accountants and production managers have identified the cost drivers, estimated the total expected units for each product, and calculated the unit cost for each cost driver. Solution

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Expected Use ABC Cost Assigned Activity Cost Driver Unit Cost (3)( Rs ) Hollow Center (4) Solid Center (5) Hollow Centre (3) × (4) ( Rs ) Solid Centre (3) × (4)( Rs ) Purchasing # purchase orders 2,000.00 50 50 100,000 100,000 Setup # setups 1,390.00 126 126 175,140 175,140 Packaging # containers filled 0.12 5,00,000 20,00,000 60,000 240,000 Testing # tests 90.00 1,000 2,000 90,000 1,80,000 Cleaning and maintenance #runs 1,145.00 84 168 96,180 1,92,360 Totals Rs5,21,320 Rs8,87,500 The activity by product is shown in the following table.

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To calculate the per unit overhead costs under ABC, the costs assigned to each product are divided by the number of units produced. In this case, the unit cost for a hollow center ball is Rs0.52(521320/1000000) and the unit cost for a solid center ball is Rs0.44(887500/2000000) . Under the traditional method of allocating overhead based on direct labor, the total costs for all balls would be divided by total direct labor for all balls to determine the per unit cost. Estimated direct labor costs for the year are Rs15,12,000, of which Rs378,000 is for hollow center balls and Rs11,34,000 is for solid center balls. The per unit direct labor costs are Rs0.38 for hollow center balls (Rs378,000 ÷ 1,000,000) and Rs0.57 for solid center balls (Rs1,134,000 ÷ 2,000,000). The per unit cost to produce balls is calculated in two steps: Calculate the predetermined overhead rate by dividing total overhead costs by total direct labor dollars. Allocate overhead to each type of product by multiplying the overhead cost per direct labor dollar by the per unit direct labor dollars for hollow center balls and for solid center balls.

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Busy Ball Company 20X0 Overhead per Unit ABC Traditional Hollow Center Ball Rs0.52 Rs0.35 Solid Center Ball Rs0.44 Rs0.53

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A comparison of the overhead per unit calculated using the ABC and traditional methods often shows very different results: In this example, the overhead charged to the hollow ball using ABC is Rs0.52 and much higher than the Rs0.35 calculated under the traditional method. The Rs0.52 is a more accurate cost for making decisions about pricing and production. For the solid center ball, the overhead calculated is Rs0.44 per unit using the ABC method and Rs0.53 per unit using the traditional method. The reason for the differences is the traditional method determines the cost allocation using direct labor only, so a product with high direct labor gets allocated more of the overhead costs than a product with low direct labor. The number of orders, setups, or tests the product actually uses does not impact the allocation of overhead costs when direct labor are used to allocate overhead. ABC provides a way to allocate costs more accurately when overhead costs are not incurred at the same rate as direct labor. The more activities identified, the more complex the costing system becomes. Computer systems are needed for complex ABC systems. Some companies limit the number of activities used in the costing system to keep the system manageable. While this approach may result in some allocations being arbitrary, using ABC does provide a more accurate estimate of costs for use in making management decisions.

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--Steps 1 Identify Activities 2 Determine Cost for Each Activity 3 Determine Cost Drivers 4Calculate Activity Rate 5 Assign Cost To Cost Object

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--Steps 1 Identify Activities Purchasing Setting Material handling Inspection Machining

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--Steps 2.Determining cost for each activity Purchasing-75000 Setting-112000 Material handling-96000 Inspection -70000 Machining -150000

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--Steps 3 Determine Cost Drivers Purchasing — purchase order Setting — batches produced Material handlings – material movements Inspections —batches produced Machining —machine Hours

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Activity Cost Driver Cost Driver Cost Pools vol./yr RS. Purchasing Purchase 1500 75000 order Settings Batches 2800 112000 produced Materials Material 8000 96000 Handling movements Inspections batches 2800 70000 produced Machining machine 50000 150000 Cost hours s Question-2

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Purchase Order 25 Materials movements per batch 6 Output 15000 Machine hours per unit 0.1 Production batch size 100 units Calculate the budgeted overhead cost using absorption costing( using machine hours) ? Calculate the budgeted overhead cost using activity based costing?

Computation of Budgeted overheads cost using Conventional costing:

Computation of Budgeted overheads cost using Conventional costing Budgeted overheads=Rs.75000+96000+112000+70000+150000= Rs5,03,000 Budgeted absorption cost/ machine hours= 503000/50000=Rs10.06 Budgeted absorption overhead =1500x Rs.10.06= Rs15,090 Computation of the Budgeted overheads using Activity Based costing Step 4: Compute ACTIVITY RATE= Cost pool/ cost driver volume . Solution

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Activity Cost driver Cost pool(a) Cost driver (b) Cost driver Rate(a/b) Purchasing Purchase order Rs.75000 1500 Rs.50 purchase order Setting Batches produced Rs. 112000 2800 Rs.40/batch Materials movements Materials movements Rs.96000 8000 Rs.12/movements Inspection Machining Batches produced Machine hours Rs. 70000 Rs.150000 2800 50000 Rs.25 /batch Rs.3 machines hr.

Step 2: Compute the volume of cost drivers consumed by the product:

Step 2: Compute the volume of cost drivers consumed by the product Purchase order (given)= 25 Batches= 15000units/100=150 Materials movements=150batches x 6= 900 Machine hours= 15000units x 0.1= 1500

Step 3: Compute the budgeted overheads costs using ABC:

Step 3: Compute the budgeted overheads costs using ABC Activity Cost driver Cost driver rate (Rs.) Activity based overheads Purchasing Purchase orders 50 25 order x Rs 50= Rs.1250 Setting Batches produced 40 150 batches x 40= Rs.6000 Material handling Material movements 12 900movements x 12= Rs. 10800 Inspection Batches produced 25 150batches x 25= Rs. 3750 Machining Machine hours 3 1500 hours x 3= Rs.4500 Total = Rs. 26,300

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SUMMARY ABC is more accurate Cost Management System than Traditional Cost System CCA is unable to calculate True Cost of A Product/Service

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