Assignment (Case Study on ABC costing)

Assignment (Case Study on ABC costing)Prepared For: Shabbir Mubin (SBR)

Course: ACT 202

Sec: 07

Prepared By:

Name: Md. Motiur Rahman Name: Iftekhar ZakariaID: 0920012030 ID: 0930323030

Name: Safayet Amin Name: Zayn Faiyaz AlamgirID: 0920422030 ID: 0930378530Name: Rahimul AnamID: 0930205030

Question No. 1:

What is Activity Based Costing? Discuss the Activity Based Costing Method.Answer to Question No. 1:

Activity Based Costing (ABC) is an alternative to the traditional way of accounting. Traditionally it is believed that high volume customers are profitable customers, a loyal customer is also a profitable one, and profits will follow a happy customer. Studies of customer profitability have unveiled that the above is not necessarily true. ABC is a costing method that identifies the cost pools, or activity centers in an organization and assigns costs to products and services (cost drivers) based on the number of events or transactions involved in the process of providing a product or service. As a result, ABC method can support managers to see how to maximize shareholder value and improve corporate performance.

ABC is ordinarily used as a supplement to, rather than as a replacement for a companys usual costing system. Most organizations that use ABC method have two costing systems the official costing system that is used for preparing external financial reports and the ABC system is used for internal decision making and for managing activities.

Historical Development of ABC Method:

Traditionally cost accountants randomly added a broad percentage of expenses into the indirect cost. However as the percentage of indirect or overhead cost rose, this technique became increasingly inaccurate, because indirect cost were not caused equally by all products.

ABC is based on George Staubus' Activity Costing and Input-Output Accounting. The concepts of ABC were developed in the manufacturing sector of the United States during 1970s and 1980s. Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. In this way ABC often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products.

Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W.Bruns as a chapter in their book Accounting and Management: A Field Study Perspective. They initially focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative proportion of indirect costs. For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost.

Activity-based costing was later explained in 1999 by Peter F. Drucker in the book Management Challenges of the 21st Century. He states that traditional cost accounting focuses on what it costs to do something, for example, to cut a screw thread; activity-based costing also records the cost of not doing, such as the cost of waiting for a needed part. Activity-based costing records the costs that traditional cost accounting do not.

Steps To Carry Out ABC Method: 1. Identify and define activities and activity cost pools.

2. Wherever possible, directly trace costs to activities and cost objects.

3. Assign costs to activity cost pools.

4. Calculate activity rates.

5. Assign costs to cost objects using the activity rates and activity measures.

6. Prepare management reports.Activity based costing is a costing technique based on an analysis of the resources actually used to produce a product or provide a service. It takes into account, actual direct material cost, direct labor cost, and both manufacturing and non-manufacturing overhead costs incurred to produce the product or service.It also defines five levels of activity that largely do not relate to the volume of units produced. They are described below:

1. Unit-level activities are carried out each time a unit is produced. The unit level cost is proportional to the number of unit produced. For example providing a power to run processing equipment would be unit level activity.

2. Batch-level activity is performed each time a batch is handled, regardless of how many units are in the batch. For example tasks such as placing purchase orders, setting up equipment and arranging for shipments to customers are batch-level activities.

3. Product-level activities relate to specific products and typically must be carried out regardless of how many batches are run or units of product are produced or sold. For example activities such as designing a product, advertising a product and maintaining a product manager and staff are all product- level activities.

4. Customer-level activity relate to specific customers and include activities such as sells calls, catalog mailings and general technical support that are not tied to any specific product.

5. Organization-sustaining activities are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. For example heating the factory, cleaning executive offices etc.

Cost driver:

A cost driver is the unit of an activity that causes the change of an activity cost. A cost driver is any activity that causes a cost to be incurred. Cost drivers determine the cost behavior within the activities, reflecting the links that these have with other activities and relationships that affect them. A cost driver is also referred to an activity measure. There are two most common types of cost driver, they are: Transaction drivers are simple counts of the number of times an activity occurs such as the number of bills sent out to customers.

Duration driver measures the amount of time required to perform an activity such as the spent to prepare individual bills for customers.Question No. 2:

Using the information in the text and in Exhibit 2, calculate ABC based services cost for the TFC business.

Answer to Question No. 2:Activity Based Costing :

Activity

Cost PoolsTotal

CostTotal ActivityActivity Rate

Storage 15500003500004.43

Requisition handling18010003100005.81

Basic warehouse stock selection7610007750000.98

Pick-pack activity7340006975001.05

Data entry6120007750000.79

Desk top delivery250000850029.4

Cost of capital on monthly inventory balance--13

Annual freight charge--Actual

57,08,000

Question No. 3:Using your new costing system, calculate distribution services costs for Customer A and Customer B.

Answer to Question No. 3:

Activity Based Costing System for Customer A :

Activity

Cost PoolsActivity Rate ActivityABC costing

Storage 4.433501,550.5

Requisition handling5.813642115

Basic warehouse stock selection0.98910891.8

Pick-pack activity1.05910955.5

Data entry0.79910718.9

Desk top delivery29.4--

Cost of capital on monthly inventory balance1315,0001,950

Annual freight chargeActual-2,250

10,431.7

Activity Based Costing System for Customer B :Activity

Cost PoolsActivity Rate ActivityABC costing

Storage 4.437003,101

Requisition handling5.817904,590

Basic warehouse stock selection0.9825002,450

Pick-pack activity1.0525002,625

Data entry0.7925001,975

Desk top delivery29.426764.4

Cost of capital on monthly inventory balance1350,0006,500

Annual freight chargeActual-7,500

29,505.4

Question No. 4:What inference do you draw about the profitability of these two customers?

Answer to Question No. 4:

Customer Margin :DetailsAB

Sales79,32079,320

Less: Cost of product(50,000)(50,000)

Storage (1,550.5)(3,101)

Requisition handling(2115)(4590)

Basic warehouse stock selection(891.8)(2,450)

Pick-pack activity(955.5)(2,625)

Desk top delivery-(764.4)

Data entry(718.9)(1,975)

Freight cost(2,250)(7,500)

Cost of capital on monthly inventory balance(1,950)(6,500)

Customer Margin18,888.3(185.4)

By using the new costing system for calculating the distribution services costs, we can see that the customer margin for customer A is $18,888.3 and for customer B is ($ 185.4). The reason behind customer B's poor margin is due to higher average monthly inventory balance which was $ 50,000, while for customer A was $ 15,000 and also higher cost of capital on monthly inventory balance ( which is $6,500 for customer A and $1,950 for customer B ). Also due to greater activity on customer B's account, a shipment went out three times a week at an annual freight cost of $ 7,500 while customer A required only one shipment a week at an annual freight cost of $ 2250. In addition to the above, customer B has ordered 26 Desktop delivery (which costs $764.4) during the past year compared to customer A, who ordered none. We also see that customer B has a higher storage cost ( $ 3,101 ) then customer A ( $ 1,550.5 ). Due to the above stated factors, we see that customer A is enjoying a profit, on the other hand customer B isnt.Reference for this Assignment focusing on Activity based costing system

Articles:

1. www.cfo.com/article.cfm/3007694

2. www.articlebase.com

Text book:

1. Managerial Accounting 13th Edition by Garrison and Noreen Publishers: McGraw-Hill Irwin