Activity-Based Costing

and Management

5-1
ABC Costing
https://www.youtube.com/watch?v=dwPrgnsU8qo&lis
t=PL_KGEFWqEaTD3jlLd-FghUl41QXByhLq-
In today’s healthcare industry, hospitals are facing
immense pressure to reduce costs while maintaining
the highest level of care for their patients. However,
reducing costs without a proper costing methodology
can lead to disastrous consequences.
This is where Activity-Based Costing (ABC) comes in
as the cornerstone of hospital cost strategies, stated Dr
Sayf Abdelrahman, CEO, Topmed (Health Catalyst
Exclusive Service Partner), MENA Region at Elets
Global Healthcare Summit & Awards in Dubai.
He explained, “Activity-Based Costing (ABC) is a cost
analysis methodology that enables hospitals to allocate
resources more accurately, reduce indirect costs, and
improve financial performance.
More than 90 per cent of hospitals miss out on this
methodology, which is crucial for their success. Hospitals
that have implemented ABC costing have seen significant
improvements in their financial performance. For instance,
a hospital in the United States implemented ABC costing
and reduced their lab services’ costs by 20 per cent,
resulting in annual savings of $200,000.
Another hospital in Singapore implemented ABC costing
and adjusted its pricing, increasing revenue by $2 million
annually.”
Traditional, Volume-Based
Costing System (1 of 2)

Total Budgeted Overheads: 48,96,000

Traditional, volume-based product-costing systems are usually based on a

single volume-based driver, such as direct labor hours, or machine hours.
5-10
Traditional, Volume-Based
Costing System (2 of 2)

5-11
Traditional, Volume-Based
Product-Costing System – Target Selling Price
With these product costs, Dronze Inc. established target
selling prices (Cost × 120%).

496.00 x 1.20
5-12
Activity-Based Costing System (ABC)
ABC systems follow a two-stage procedure to assign
overhead costs to products.

Stage One:
Identify significant activities and assign overhead
costs to each activity in proportion to resources
used.

Stage Two:
Identify cost drivers appropriate to each activity and
allocate overhead to the products.
5-13
Activity-Based Costing System
Activity Overhead Costs
must be Identification
Total budgeted cost = $4,896,000
done on of Activity
each unit Cost Pools
produced.
Activity
Cost
Pools

Unit- Batch- Product- Facility-

Level Level Sustaining- Level
Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,242,000 $210,000 $130,000 $2,300,000

Activity
Activities needed to support Activity required in order
performed
an entire product line for the production
on each
batch process to occur.
produced.
5-15
Overhead Cost Pools
Product-Sustaining- Facility-
Unit-Level Batch-Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,242,000 $210,000 $130,000 $2,300,000

Purchasing
cost pool 300,000

Material-Handling
All together is
cost pool $340,000 $48,96,000 which is
the total overheads.
Quality-Assurance
cost pool $110,000

Packaging/Shipping
cost pool $264,000
5-16
Stage One – Machinery Cost Pool
Various overhead
Maintenance Lubrication
costs related
to machinery Depreciation Electricity

Computer Support Calibration

Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1,242,000

5-17
Stage Two – Machinery Cost Pool
Budgeted Machinery Costs $1,242,000
=
Budgeted Machine Hours 230,000
= $5.40/hour

5-18
ABC Pool Cost Calculations –
First 4 Activities

5-19
ABC Pool Cost Calculations – Last
4 Activities

5-20
Product Costs from ABC
These are the new product costs when ABC is used.

5-21
Distorted Product Costs
Both original and ABC target selling prices are based
on (Cost × 120%).

5-22
Cost Distortion

5-23
Steps in ABC Costing
Identify all the activities required to create the product.
Divide the activities into cost pools, which includes all the
individual costs related to an activity—such as manufacturing.
Calculate the total overhead of each cost pool.
Assign each cost pool activity cost drivers, such as hours or
units.
Calculate the cost driver rate by dividing the total overhead in
each cost pool by the total cost drivers.
Divide the total overhead of each cost pool by the total cost
drivers to get the cost driver rate.
Multiply the cost driver rate by the number of cost drivers.
Cost Drivers
A characteristic of an event or activity that results in
the incurrence of costs. In selecting a cost driver, we
must consider . . .

Degree of Cost of Behavioral

Correlation Measurement Effects

In activity-based costing systems, the most significant cost drivers are identified.
Then a database is created, which shows how these cost drivers are distributed
across products

5-25
COLLECTING ABC DATA
INTERVIEWS AND PAPER TRAILS - The information
for ABC systems initially comes from interviews with
employees in the support departments and a review of each
department’s records.

STORYBOARDING - A procedure used to develop a

detailed process flow chart, which visually represents activities
and the relationships among activities.

MULTIDISCIPLINARY ABC PROJECT TEAMS - To

gather information from all facets of an organization’s
operations, it is essential to involve personnel from a variety of
functional areas. A typical ABC project team includes
ACCOUNTING, FINANCE, PRODUCTION, OPERATIONS,
ENGINEERS, MARKETING, etc.
5-26
Activity-Based Management

The use of
ABC costing
information
to help
management
make decisions

Using activity-based costing (ABC) information to support organizational strategy,

improve operations, and manage costs is called activity-based management
5-27
Activity-Based Management (ABM)

Activity-based costing establishes relationships

between overhead costs and activities so that
we can better allocate overhead costs.
Activity-based management focuses
on managing activities to reduce costs .

5-28
Elimination of Non-Value-Added Costs
Activities

Non-value-
added
activities
Unnecessary Necessary

Reduce or Continually Evaluate

Eliminate
and Improve 5-29
Using ABM to Eliminate Non-Value-
Added Activities and Costs (1 of 2)
1. Identify Activities.
2. Identify Non-Value-Added Activities.
3. Understand Activity Linkages, Root Causes, and
Triggers.(PVA)

Inspect Rework
Specify Select Receive Produce
finished defective
parts vendor parts goods
goods products

4. Establish Performance Measures.

5. Report Non-Value-Added Costs.

5-30
Using ABM to Eliminate Non-Value-
Added Activities and Costs (2 of 2)

Inspection time Process time

Move time Storage time

Waiting time

5-31
Customer Profitability Analysis (1 of
2)

Customer profitability analysis uses

activity-based costing to determine
the activities, costs, and profit associated
with serving particular customers.

5-32
Customer Profitability Analysis (2 of
2)
Requires
special
packaging
Orders
small Demands
quantities fast
service
A costly
customer
Often Orders
changes frequently
orders

5-33
Customer Profitability Analysis
(Costs)
Cost Drive
Customer-Related Activities Cost Driver Base Rate
Order processing Purchase orders $ 150
Sales contacts (phone calls, faxes, etc.) Contacts 100
Sales visits Visits 1,000
Shipment processing Shipments 200
Billing and collection Invoices 160
Design/engineering change orders Design changes 4,000
Special packaging Units packaged 40
Special handling Units handled 60

A company may use these customer

related costs to help determine the
profitability of each customer.

5-34
Customer Profitability Analysis
(Graph)
Customer Profitability
Cumulative Operating Income as a % of Total

125.0%

100.0%
Operating Income

75% of actual operating income

75.0%

50% of actual operating income

50.0%

25% of actual operating income

25.0%

0.0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

5-35
ABC Costing in the Service
Industry
The overall objectives of ABC in service
firms are no different than they are in
manufacturing companies.
Identify the activities.
Create activity cost pools.
Identify activity cost drivers.
Follow similar steps as used for
manufacturing companies (as discussed in
the session).
5-36
Industry Examples –ABC Costing
UPS, Ford, Chrysler Corporation, Safety-Kleen
Corporation, Taipei Fubon Bank, Air France, American
Airlines, American Express, and Bank of America are
few examples implemented ABC costing.

Castorl India, TCS, Bharat Earth Movers, Bharat Forg and

Air Asia in India are few examples using ABC costing to
improve business processes.
“Setting up an activity-based costing system is
a prerequisite for improving business
processes and for any re-engineering of
functions. The benefits are sure to be achieved
in the long run”
Dempsey’s ABC model