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5.1. Activity-based costing (ABC) – an overview

Course video 49 of 72

In Week 5 we will study the more advanced approaches to costing – activity-based costing (ABC) and relevant costs – that provide for the more accurate costing of products, projects, and divisions, and allow to reveal actual relationship between numbers and people. We start with the analysis of ABC on an example of a small retail firm. Then we move on to the more detailed example of the use of ABC in manufacturing. Both examples will help us gain insight in the role of ABC in identifying ways to improve performance. Finally, we analyze the idea of relevant costs and its application to managerial actions –make-or-buy decisions, product mix under capacity constraints, customer profit analysis. Of special attention will be the role of relevant and opportunity costs in valuation.

Core Concepts of Accounting – Numbers and People

Institut de physique et de technologie de Moscou

Cours 3 de 5 dans Understanding Modern Finance Spécialisation

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

Visualiser le programme de cours

Enseigné par

Konstantin Kontor
Director and Professor of Finance and Strategy

Transcription

Welcome, everyone, to the fifth week of

our accounting course and the second week of [inaudible] counting part.

This week, we will talk about two important things.

We will talk about activity-based costing and about relevant costs.

The first half of this week will be devoted to ABC costing.

So what is ABC?

ABC is the abbreviation that stands for Activity Based Costing.

Now, in order to understand that better,

we have to step back a little bit and say a few words of recalling what we did last week.

We said that, in our studies of cost,

we identify indirect cost pools as intermediate cost objects,

from which later we reassign or reallocate cost of the final cost objects.

And in the examples that we dealt with last week,

those were, for example,

a real estate cost center or cost pool in which we said that

the proper allocation would be in accordance

with the area of that is occupied by this or that process.

Now, here we talk about the following approach.

We take activities as main cost objects at the first stage and we

see that what actually determines these activities happens to be a cost driver and,

accordingly, the cost allocation base.

Now, all of this,

as of now, might sound vague,

but as soon as we study an example starting the next episode it will become much clearer.

Now, why is that important?

Because basically until or unless we realize these processes,

these activities, these tasks, these events,

we may make gross mistakes in our cost allocation.

So, let me summarize that.

So we talk about ABC, Activity Based Costing.

And, like I said,

an activity is any event,

task, or anything that has the special purpose.

For example, in manufacturing,

you prepare all the parts for being assembled.

Now, this is a process of handling.

So, you put them in boxes,

you put these boxes somewhere.

Let me give you an example, supposedly,

you talk about building a house,

all parts of which have been manufactured on the plant.

So the truck arrives at the site and then everything is prepared.

So the foreman and these people,

they just take all these screws,

all these hoses, whatever,

together with huge panels,

walls, and pieces of the roof.

So, all that has been prepared before they load in this truck and then went to the site.

But the main focus is the following.

So first of all, we identify these activities.

And they, from here, we identify a cost of these activities.

Now, this is somewhat different from what we had before because here,

we talk about cost of activities.

So, we have to quantify that somewhat.

Well, if we do some operations,

if we put some parts,

if we do customer support or whatever,

then clearly we can count that and quantify.

And from here, finally,

from this cost of activities,

we redistribute on final cost objects.

And these may be products,

services, customers, whatever.

So basically here, the general ideas is that activities,

they allow us to see cost drivers.

And these cost drivers,

I specifically put that in really big letters,

they actually serve as cost allocation bases.

So the whole idea here is that,

and again, at the first glance it doesn't seem to be very natural.

Instead of just counting certain pieces or money,

because in financial counting, as you remember,

people count money, everything is in monetary terms.

Here, we talk about these activities

and the corresponding drivers as the main interim cost objects.

This a non-trivial idea,

but, as we will see throughout this discussion,

it oftentimes results in a much more accurate stock,

much more accurate cost understanding and cost assignment.

And the next thing for us,

as always, is, Why study ABC?

Why is ABC important to us?

Because, like I said,

and as I've always been saying,

we use accounting concepts and issues as

sometimes direct or sometimes very indirect support or ideal validation

of finding the real value in companies and projects.

And what we can say is,

one thing is clear, because ABC reveals actual cost drivers.

Oftentimes, when we talk about some monetary bases,

we can either ignore or we may be misled by the vague cause and effect thing.

Here in ABC, it's clear.

And, as a result, we see, understand and use cost components better,

whatever this better means.

So, we can say that the quality or drivers,

because cost drivers are part of value drivers too,

so we see that we enjoy

the greater quality of the inputs and on top of that, so we can say,

better inputs, and we can talk

about better decisions by the management of the company.

And although we know that sometimes these decisions,

they are sort of indirect,

but it is the quality of these decisions that in the long run makes the development of

any company or project potentially

better organized and potentially leading to the greater value.

So, we can see that the ABC approach is perfect

to link to idea of understanding of reviewing core,

cause and effect links and seeing how the results of

that contribute to the utmost evaluation procedures.

That is what we will do further,

and in order to better understand that,

we will go to an example.

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