Activity Based Costing (ABC) PDF

CHAPTER 3 Activity Based Costing (ABC) O Introduction Cost Accounting includes collecting, classifying, processing, information to managers in their planningand control activities andanalysing and reporting of...

CHAPTER 3 Activity Based Costing (ABC) O Introduction Cost Accounting includes collecting, classifying, processing, information to managers in their planningand control activities andanalysing and reporting of information system to be developed to help in decision making within the firm. Traditional cost accounting focused on product costing by tracing direct costs to the product and indirect costs are allocated cost centers. through In any system of costing direct costs are easier to handle as the end products but indirect costs are difficult to handle these are directly charged to because they need to be allocated to the end products by following a suitable basis of allocation. been allocated to the end products in three steps: first Traditionally, indirect costs have and service departments, taken from service from ledger accounts to production following reapportionment methods and then finallydepartments to production departments allocating the departments to the end products. In traditional costing there is no indirect costs of production general basis of allocation of indirect costs and it is left to the judgement of the cost accountant to select the most appropriate basis of allocation. The basis of apportionment of overheads may be machine hours, labour hours, direct costs, input, output, etc. based on These apportionment have some bottlenecks which tend to misinterpret proration normal methods of of different functions added to the product of common costs is shown below. cost. The conventional allocation of common costs Service and Production Product Departments Overheads Product Lines Assigning costs using measures of service usage Allocating costs usin9 ameasure of volumne CONVENTIONAL ALLOCATION OF COMMON COSTS W3-2 Absorption Overhead not truly Methods of OInadequacies of Traditional costs so allocated do in inflated r reflect the tradiretducet that indirect unnecessarily result the by resources consumed by the it is clear Fromthe above discussionend products and cost Inaccuratedecislons intormation thus for provided control If usedinformation purposes Or is further iona for fixing costs of the end products. to wrong Inaccurate cost whichis more likely costing methods may lead quotations. to be aggravated the case COsts selling prices or sending comparedtothe direct world. i the indirect costs are more as the present with more and more automation taking placein traditional accounting system is not s0 arrived in Thus the costs of product overheadrecovery basis knowr accurate due to the following reasons: convenient system has developed machine hour rate etc. Such blanke () Traditional costing such as labour hour rate, for financial as volume measure acceptable when valuing stocks typical product reporting Overhead recovery rates are used for decision making and over this period but they are inappropriate whenimplications over 3-5 years and many strategy decisions. Such decisions have fixed costs become variable. costs of products or serVices when acompany ha accurate () It is easy to determine Companies and these expand their product offeringscontrol only a few products. When superviSIon, quality it is resources such as products use different amount of costs of products. This situation is a main reason more difficult to determine accurate why companies use ABC. effect relationships, if focused on the () Traditional costing fails to capture cause and cost incurred. unrealistic and as (iv) The traditional fixed costs versus variable costs split is often business grows, this split gives inaccurate costs of products. (y Firms manufacturing and selling multiple products usually make decisions on pricing products mix, process technology etc. based on distorted cost information due to difficulties in traditional costing system in collection, classification, allocation and recovery of overheads to individual products resulting in large amount of overheads. (v) The cost structure is changing especially when cost of direct labour component isi smallproportion with more and more automation taking place in the present world. (vi) Traditional accounting was confined merely to furnishing information at The new manufacturing technology demands the feedback of product leve. production is performance wnle stillin progress rather than providing information after the been produced. products have (vii) There is also an urgent need to measurement. integrate the activity measurement and financie The conventional product cost range of products, when system was in practice when firms overhead costs Were relatively small and manufactured natt inappropriate overhead allocations measures like direct labour hours or were not significant. This distortions aris1ng volume In case of afirm using highly machine hours convention for charging system usedproducts labour is a srnall fraction of automated plant overhead' costsproducts, to by number of set up, cost and overheads manufacturing which a wide are large in range of direct influenced volume based method ofinspection, number of proportion are recovery of overheads purchases etc. In these the will give inaccurate product cost high volume products and costs. Hence, is no longer appropriate circumstances measure Therefore, in order to under cost conventional system low of volume products. costing was and such a found to ove absorption and overcome the short-term bias of marginalinadequacies of devised. costing, Activitytraditional methods Based Costing of overhead has been ACTIVITY BASEDCOSTING (ABC) /3-3 Activity Based Costing (ABC) system aims at refining the costing system used in automated plants in the following manner: 1 ABCsystems trace more costs as direct costs. 2 ABC systems create homogerneous cost pools linked to different activities. 3. For each activity cost pool, ABC systems seek a cost allocation base that has a cause-and-effect relationship with costs in the cost pool. ABC is arecent development in Cost Accounting which attempts to absorb overheads into product costs on a more realistic basis. Supporters of the technique argue that many costs are unnecessarily treated as common costs and are arbitrarily absorbed using a basis such as direct labour hours, machine hours etc. Many organizations have now adopted advanced manufacturing technology (AMT) with the result that overheads are ncreasingand labour costs are becoming a smaller portion of total costs. Costing systems which absorb overheads on a direct labour basis are, therefore, not relevant in an AMT environment. The basic idea of ABCis that costs are grouped accordingto what drives them or causes them to be incurred. The costs drivers are then used as an absorption base. ONeed for Emergence of Activity-based Costing Traditional product costing systems were designed when most of the companies manufactured a narrow range of products. Direct materials and direct labour were the dominant factors of production then. Companies were in the sellers' market. Overheads were relatively small and distortions due to inappropriate treatment were not significant. Cost of processing information was high. Today, companies produce a wide range of products. Overheads are of considerable importance. Simple methods of apportioning overheads based on direct labour are not justified. Intense global competition calls for correct costing of products to avoid errors in decision-making. Traditional systems can measure volume related costs. Non-volume related activities like material han dling, set-up etc. are important and their costs cannot be apportioned on volume basis. Hence, the need for emergence of activity based costing arises. Concept of ABC Activity BasedCosting (ABC) is a product costing technique which attributes overhead costs to products on an activity basis. ABC focuses on activities as fundamenta! cost obiects and uses the cost of these activities as building blocks for compiling the cost of other objects. Activity-based costing (ABC) 0s used to improve the accuracy of cost analysis byimpoving the tracing of coststo products or to individual customers. It is a system which tocuses on activities performed to produce product. In this system first costs are traced to activities anc then to products, where as in traditional system costs are first, traced not to activities but to ar organisattonat unt, such as department or plant and then to products. In ABC system, activy means a unitof work; here cost driver is a factor, such as the level of acivity or volume affects costs. Cost drivers signity factors, forces or events that determine the cosis o activities. This system brings accuracy and reliability in product cost determination y emphasingon cause and effect relationship in the cost incurrence. ABC is an accounting methodology that assigns costs (direct and indirect) to activities rather than products and services that consume them. This enables resources and overheac costs to be more accurately assigned to products and services that consume them. in order te Correctly associate costs with products and services ABC assigns cost to actvities based on their resOurces. It then assign cost objects, such as products and customers, based On tnei Use of activities. ABC can track the flow of activities in organization by creating a ink between the activity and the cost objects. The CIMA officialterminology defines ABC as "Cost attribution to cost units on the basis obenelit received from indirect activities e.g, ordering, setting up, assuringquality" ABG has  ACTIVITY BASED /3-4 COSTING (ABC) as "Ihe collection of prfionduct ancial costangs also been defined by CAM-1 organization of Arlinton Texas activities of the firm to operation pertormance information tracing the significant accounting) emphasises links and activity A Activity based performance of particular costing (also called activities the demands that those activities make on the organisation's resources. Resources are asslgned to activities and activities to cost objecte between a to attach activity costs V based on ABC approach, Under the consumption estimates and utilse a business is reviewed as collection of activities.to thal are cost drivers outputs b support its anddeveloped products Or servIces. Activitytobased penomed produce, design,costing is a deliver (ABC)market, new term for finding out the cost. The basiC, feature of ABC is its focus on actvities as the tündanønntal cost objects. I uses activities as the basis tor calculating the costs of products and services. To quote Horngren. Foster and Datar, "ABG is not an alternative costing system to job costing or process cosing. Rather. ABC is an approach to developing Lthe cost number^ used in job costing or process Costing SYstems.. The distinctive feature of ABC is its focus on activities as the Tund¡mental Objects. In contrast, more traditional approaches to developing the cost numbers used in in O process Costing systems rely on general purpose (generic) accounting systems not tailore to the activities found in individual organisations. The ABC approach is more expensive tha traditional approaches. ABC hasthe potential, however, to provide managers with informalia they Tind more useful for costing purposes" It is an effective method of excercising cost control and can be used in designing either a job costing system or process COsting system r ABC approach is used to refine a costing system to get better results. In ABC approach, the first step is to identity the activities for which costs are to be collected and controlled. The various activities may be identified as direct activities and indirect activities. Direct activities n may be taken as direct materials and direct labour. Indirect cost pools may be identified as order processing, materials handling, machine insertion of parts, manual insertion of parts repairs and maintenance, quality testing etc. The second step is the selection of suitable cos allocation burdened. base for assigning indirect costs to various activities so that all activities are suitaby In today's environment of globalisation, when each organisation has to continuously improve its products and benchmark its activities with the most efficient in the world, afim cannot do without activity based costing. A firm can have a hold on the market only if t manages properly the value hain at each stage. Value added at each stage is to be compared with the costs assOciated and on that basis decisions are taken about cutting the unnecessary activities or adding the new activities. Activity based costing makes availabe exact cost information which improves the quality of managerial decisions. In activity based costing the focus of attention is an activity rather than a department. A department may have anumber of activities which may be non-value adding. Such activities sizing exercise with the help of activity based costing for better are targeted in dow department. effectiveness of e Activity based costing (ABC) aims at rectifying the inaccurate cost intormatioa It s modern approach of tndirect cost allocation. ABC does not restrict itself to the allocationo indirect costs to departments as is done in the traditional approach but it recognises individua activity as the lowest unit for indirect cost allocation, Costs allocated to each activ1 represents the resources consumed by it. (Activity based costing 0s based on the bellef that activities give rise to cos[s Therelore, a link should be made between_activities and producIs by assigning costof ctivities to products based on an individual product. th de O Kaplan and Cooper's Approach to ABC ar Kaplan and Cnrper of Harvard Business School, who have developed this ne approach in costing to calcuBal product costs, claim d variable costs and short-term variable costs. that the costsshort-term Traditionally should bevariable costs classified aS are know b SC ACTIVITY BASED COSTING(ABC) V3-5 as variable costs and long-termare known as fixed costs. Short-term variable costs are Vume related and change proportionatety with the votyme of production. Long-term variable costs vany in long term but not instantaneously. For example, production scheduling costs can be changed in the long-term by changing number of runs rather than changing number of units produced. They further claim that this approach relates overhead costs to the forces behind them. The forces behind overhead costs are named 'cost drivers'. Costs drivers can be definedas those activities or transactions that are significant determinants of costs. Under ABC system. product cost is determined by obtaininga greater understanding of cost behaviour and using new measures of quantity of resources consumed by each product. Acost driver is'an actiuity which generates cost. ABC system is based on the belief that activities cause costs and that alink should, therefore, be made between activities and products by assigning costs of activities to products based on an individual product's demand for each ativity. O Cost Drivers Activity based Information may be non-financial but concerns activities across the entire chainof value adding process and focuses the attention of managers on activities that cause rather than the costs themselves. These activities are known as cost drivers. Cost drivers are used to describe the events or forces that are the significant determinants of the cost activities, e.g. production scheduling cost is generated by tne number of production runs that each product generates. Any element that would causea change in the cost of activity is cost driver. Actually cost drivers are basis of changing cost of activity to cost object. Cost drivers are used to trace cost to product by using a measure of resources consumed by each activity. For example. frequency of order, numbet of order etc. may be cost drive of customer order processing activity; cost driver may be involved two parts : () Resources Cost Driver and (i) Activity Cost Driver. () Resource Cost Driver. It is a measure of a quantity of resources consumed by an activity, and (iD Activity Cost Driver. It is a measure of the frequency and intensity of demand placed on activities by cost objects. In R&D activity : Resources Staff, Equipment, Material. Cost Driver-Number of Research Projects, Time Spent on Project, Technical Complexities of Project. Then the number of set ups would represent the cost driver for production scheduling. Followingcost drivers were identified for various activity areas. Activity area Cost driver used as application base 1. Material handling Number of parts 2. Start station Number of printed circuit boards 3 Machine insertion of parts Number of machine inserted parts 4. Quality testing Hours of test time Afirm commits costs at the time of designing the product and deciding the methoc o production. It also commits cost at the time of deciding the delivery channel (e.9. deve through dealers or own retail stores). Costs are incurred at the time of actual production a delivery. Therefore, no significant cóst reduction can be achieved at the time whenthe coe are incurred. Therefore, it is said that costs can be managed at the point of commitmen: e drivers are factors that drive consumption of resources. Therefore, management d drivers is essential to manage costs. Structural cost driverscost aredrivers those are whichscale can ofbeoperaiOn, main Dy enecting structural changes. Examples of structural SCope ot operation (i.e. degree of vertical integration), complexity, technology and expeie  ACTIVITY BASED /3-6 COSTING (ABC) Thus, structural cost drivers arise from the business model adopted by the firm. Executiona executional cost cost drivers can be managed by executive decisions, product examples of configuration and linkages with point drisuppl versiers are capacity utilisation, plànt layout efficiency, be managed only at the of that cost drivers and customers. It is obvious commitresources to various can activVIties. activities structura and operatingdecisions. which of a Company's therefore,exist that virtually all should, to The assumptions underlying ABCofisgoods and services. They support all coste be production and delivery and corporate support the because nearly allfactory families products to productcontrolled Considered as product costs. And traced to individual On the and separable, they can be split apartphilosophy costs can be basis of this assumption, the of ABC is that cause the activities-the nmore on manaaing the forces that Signiticant activtiee etectively by focusing directly reporting of the costs consumed by the orivers' rather than costs, The provides the basis for understanding Wnat causes overheax business and their cost drivers, steps can be taken to improve protitability. Knowing ths COsts and direct attention to where many difterent components costs of material movements or the cost of producing need carry out these to activities mo high machines, highlights the decision making maintaining many different better and more aCCUrate information and eftectively. Thus, ABC provides control of manufacturing operations. prices and product mix and for the Cost Pools aims at to overcome the drawbacks by cutting across conventiona The ABC technique used to indicate departmental boundaries.(A cost pool is pools' aterm of ABC operation and which drive hen according to the activities grouped into grouping of cost. Costs are procurement be of of goods. In this, all the costs associated with the e.g. acost pool may be included in this cost pool andcost procurement (ordering, inspection, storing etc.) would driver tdentified. In R & D Activity examples of cost pools are : Salaries, Maintenance anta Material Cost. The procurement cost per requisition is then calculated and this provides means of tracingthe cost of procurement to product. The technique of ABO lays importance identification of just those costs which are on different costs for different purposes and the shown below relevant to particular decision. Product costing usingABC technique is Prime Costs Direct Materials Direct Labour Product , Other Direct Costs Costs Overheads Production Administration Non-Product Marketing Costs Sales Distribution R& D PRODUCT COSTING USING ABC OCharacteristics of ABC Lrnnortant characteristics of ABC are noted below : enouy 1. Simple traditional distinction made between fixed cost and is not de to provide quality intormation to design a cost system.variable cost ACTIVITY BASED COSTING (ABC) I/3-7 2. The more appropriate distinction between cost behaviour patterns are volume (scale) related, diversity (scope) related, events (decisions) related and time related. 3. Cost drivers need to be identified. A cost driver is a structural determinarnt of cost related activity. The logic behind is that cost drivers dictate the cost behaviour pattern. In tracing overhead cost to product, a cost behaviour pattern must be understood so that appropriate cost driver could be identified. 4. nsignifies non-value added activities and thereby is helpful to the management to eliminate such activities and reduce the cost of the product. O How to Develop an ABC System ? Following are the three key areas of ABC : Product cost differentiation. Activities and their cost drivers. ldentification of non-value added cost. In ABC system a cost center is established for each cost driver and identification, measurement and control of cost drivers is essential in ABC. ABC is the planned and systematic study and determination of cost of each of the branches of business activities that add to the value of product and services. The matrix of activities showing the short-term and long-term cost strategy is presented as follows: Short-term Long-term Product value Value addition Pricing Corporate growth Categories in Activity Based Costing Followingare the main categories in Activity Based Costing : () Unit Level Activities. The cost of some activities (mainly primary activities) are strongly co-related to the number of units produced. These activities are known as unit level activities such as use of indirect materials: (in Batch Level Activities. The cost of some activities (mainly manufacturing support activities) are driven by the number of batches of units produced. These activities are known as batch level activities. Examples are: (a) Material ordering. (b) Machine set up cost. (c) Inspection of products--Iike first item of every batch. (iii) Product Level Activities. The cost of some activities are driven by as the creation of a activities are known product level new product line and its maintenance. These activities. Examples are : (a) Designing the product. (b) Producing parts to a certain specified limit. (c) Advertising cost, if advertisement is for individual products. cannot be related to a particular (iv) Facility Level Activities. The cost of some activities and facilities. These product line, instead they are related to maintainingthe building (a) Maintenance or activities are known as facility level activities. Examples are: (d) Advertising buildings. (b) Plant security. (c) Production manager's salary. campaigns promoting the company. O Main Activities and its Cost Drivers andE. Mitchell in their 'Activity Based COs Acase study conducted by J. Innes and Implementation ' the main activities and Management: A Case Study of Development Cost drivers are identified as shown on next page : Main Cost Drivers Main Activities Order value Order source(newlold customer) Customer Order Processing Order source(customer location)  ACTIVITY BASED COSTING(ABC V3-8 transactions material Number of material receipts Volume of material orders Material Planning / Acquisition Volume of Inspection plans suppliers Number of problem Inspection Gauge usage quality Lack of good Engineering changes Supplies performance operational Number of parts Make versus buy policy Production Control changes Number of machine Order board changes Number to be supervised Shift patterns Industrial relations issues Production assembly Flow of product from Volume.of service parts/kit packing breakdowns Number of machine Maintenance schedule Maintenance Capital expenditure Activity levels Number of systems operational Number of systems devices Systems Adequacy of existing systems Control Quality Inspection plans Number of accounting transactions Financial Accounting Number of times accounts produced Volume of activity Coordinated shipping process Accuracy of feeder systems Management Accounting Management requirements Corporate requirements Activity levels Recruitment activity Personnel Industrial relations climate Training requirements O Allocation of Overheads under ABC relatedc The short-term variable costs should be identified to products using drivers Such as direct labour hour, direct material cost, machine hours volume Kaloan a long-te etc. Cooper claimed that volume related cost drivers are variable costs to products because they are driven by inappropriate for tracingtransactio notl and volume and the key to understanding what causes (drivers) complexity and variety underA6 undertaken by support departments costs and factory overhead costs in system is shown in the following figure : overheads to product lines  /3"9 Sorvice Department Activity Cost Pools & Product Lines Factory Overheads Assigning costs of individual activities Application of cost driver rates ALLOCATION OF OVERHEAD COST UNDER ABC OSteps to Develop ABC System The steps required to develop an ABC system are as follows: ldentify the main activities performed in the organization, such as manufacturing. assembly etc., as well as support activities, including purchasing, packing and dispatching. Identifty the factors which influence the cost of each activity- the cost drivers. Collect accurate data on direct labour, material and overhead costs. Establishing the demands made by particular products on activities, using the cost drivers as a measure of demand. Trace the cost of activities to products according to a product's demand for each activity. ldentify the most suitable cost driver for each activity and calculate cost driver rate by dividing total cost of activity pool by total quantity of activity driver. The rules developed by Kaplan and Cooper for this process are: Focus on expensive resources, thus directingattention to resource categories where the new costing process has the potentialto make big differences on product cost. Emphasis on resources whose consumption varies significantly by product and product type-look for diversity. Focus on resources whose demand patterns are un-correlated with traditional allocation measures. Thus, ABC is the process of tracing costs first from resources to activities and then from activities tospecific products. The technique of ABC lays the importance of different costs for different purposes and the identification of just those costs, which are relevant to a particular decision. However, it does not challenge the conventional accounting methods and theory. instead, it refines the ideas and concepts of conventional methods. Traditional Versus ABC Approach to Designing a Costing System In traditional system of assigning manufacturing overheads, overheads are first allocated and apportioned to cost centres (production and support service cost centres) an absorbed to cost objects (e.g. products). Under ABC. overheads are first assigned to aCtVities or activity pools (group of activities) and then they are assigned to cost objects. Inus. he  ACTIVITY BASED V3-10 COSTING ((ABC, include cost centres a a refinement over the traditional costing system. Usually on those activities sere3 different activities. If different products create different dermands Costing system fails to determine the product cost acCurately. In that trbecor aditioirea situation, it necessary to usearedifferent Following rates for for the reasons different activities orofactivity the adoptlon ABC by Poosmanufacturing and non. manufactring () Fierceindustries: competitive pressure has resulted in lower profit margin. ABC helps to, estimate cost of individual product or service more accurately. This helps to fornulate appropriate marketing / corporate strategy. by producte () There is product and customerproliferation. Demand on resources 7 Customer CUstomers differ among products/customers. Therefore, product can be profitability can be measured accurately, only if consumption of resources traced to each individual product/ customer. (n) New production technigues have resulted in the increase of the proportion of Support service costs in the total cost of delivering value to cUstomers. ABC improves the accuracy of accounting for support service costs. (iV) Costs associated with bad decisions have increased substantially. () Reduction in the cost of data processing has reduced the cost of tracking resources consumption to large number of activities. In traditional approach, there is lack of cause and effect relationship between the cost allocation bases and indirect cost pools because one ora few cost pools for each department or entire plant having little homogeneityy are used. In ABC approach, many homogeneous indirect cost pools for various activity areas rather than a department or entire plant are used. There is a cause and effect relationship between the cost allocation bases and the indirec: cost pools. The traditional approach usually uses a few pools of indirect costs, so cost allocations are oftenly based on broad averages. The costs of products thus, ascertained may be either overcosted or undercosted which may lead managers to make wrong pricing decisions resulting in loss of market share by fixing higher selling prices or selling prices for some products may be below the costs incurred to produce them. Activity based costing is a rational way of assigning indirect costs to various activities and pricing decisions taken by managerswill be rational. The activity based job costing method or process costing method is helpful in ascertaining areas where cost reductions are possible. Activity based costing can lead to improvee decision making such as fixing seling price and pinpointing the area where cost reduction s p0ssible because it provides more detailed information about various activities involved in product or service. In ABC approach, indirect costs are grouped to what drives them and of indirect cos machine drivers are used as an absorption base expenses rather than a single done hour rate or labour hour rate for all indirect expenses caused by different activities as is in traditional costing. tothe Activity Based Budgeting. Activity based principles can be successfully appliedemphasison art of budgeting. Activity based budgeting is an approach to budgeting that lays budgeting the costsof activities necessary in to produce and sell products and services. steos ACINi based budgeting is especially useful follows : case of budgeting of indirect costs. Important activity based budgeting are as budgetec 1. Determining the demand for each individual activity on the basis of production. 2. Determining the budgeted cost of performing each activity. 3. Ascertaining the actual cost of each activity. downthe 4. Comparing the actual cost with the budgeted cost of each activity, noting difference and taking corrective action, wherever necessary. ACTIVITY BASED COSTING (ABC) /3-11 O Implementation of Activity Based Costing In ABC the hidden weaknesses and high cost segments are identitied for maximum eftectivenessof cost accounting system. The process of designing andimplementing an ABC system for support departments usually by way of interviewing the concerned departmental heads to have an insight into the departmental operations and into the factors that trigger departmental activities. Subsequent analysis traces these activities to specific products. Suppose the inventory control department is responsible for raw materials and purchased components. The relevant questions that could be asked are: How many people work in the department ? What do they do? What determines the time required to process an incoming shipment ? Does itmatter if the shipment is large or small? What other factors affect your department's workload ? Do you usually disburse the total amount of material required for a production run all at once or does it go out in smaller quantities ? After the interview the system designer can use the number of people involved in each activity to allocate the departments costs. ABC calls for high level costing policy, cost technology and modules for activities effectiveness in a competitive economy for survival and prosperity. Since alocation of indirect costs to various products or departments on a reasonable basis is a complicated job, activity based costing technique helps acost accountant to find out product cost to a greater accuracy. Following steps are involved in implementing ABC to achieve the desired results : I. ldentitying the functional areas (like material management, production, quality control etc.) involved. II. ldentifying the key activities involved in each functional area. Il. Allocating the common indirect costs to various activities in each functionalarea. IV. identifying the most suitable cost driver in each activity under functional areas for better allocation of indirect costs to get accurate cost information. Acost driver is any factor that influences cost. A change in the cost driver will lead to achange in the total cost of arelated cost object. V. Preparing the statement of expenditure activitywise and comparing it with the value addition activitywise to know the activities which are to be eliminated or need improvement for better performance of the organisation. Functional areas may be as follows : (a) Material Management, (b) Stores Management, (c) Production Management, (0) Quality Control Management, (e) Personnel Management, () Marketing Management, (9 Repairs &Maintenance, (h) Administration and () Public Relations. drivers are given Some of the functional areas along with activities involved and cost below: Cost driver Functional Activities Involved Areas issued Material 1. Issuing tenders No. of tenders No. of indents Management 2. Receivingof indents of purchase orders No. 3. Analysis of offers from suppliers purchase orders No. of 4 lssue of purchase orders purchase orders No. of 5 Inspection of materials purchase orders materials No. of 6 Information to stores for receiving the  ACTIVITY BASED /3-12 COSTING (AB AC Value of materials No. of requisitions stored Stores 1 Storingthe materials Servicing of requisitions No. of times inspected Su Management 2 Inspection and verification Value of stock handled 3 taking 4 Taking perpetualstock No. of batches produced 1 Receipt of Samples Quality Control Testing the samples Management Certificates No. of employees recruiteM 3 Issue of Test Recruitment attendance, loave, No. of employees Personne! 1 records of Maintenance of Management 2 increment, etc. No. of employees No. of employees 3 Training No. of employees 4 Industrial relations disputes No. of employees replaced 5 Settlement of industrial Labour turnover %age increase insaies 6 Demand creation %age increase in sales 1. S Marketing Advertising effort Time spent with distributors 2 sales Management 3. Analysis of feedback from customers Time spent 4. Preparation of Sales Forecasts Activities O Classification of of activities : Following are two classification perceive as addin is an activity that customers () A value added activity service they purchase. In other words it is an activity that.the usefulness to the product or utility or usefulness which customers obtain from using S eliminated, will reduce the actual acar in acompany manufacturingcars orcomputE example, painting product or service. For computer manufacturing company. with preloaded software in a activity is an activity where there is an opportunity for cos (in Anon-value added the product's service potential to the customer. In otheË reduction without reducing eliminated will not reduce the actual or perceived value inë words. it is an activity that, if product or service. Customers obtain by using the independent activities is value-at: EXAMPLE. State whether each of the following or non-value-added: engineer in asoftware firm. () Polishing of furniture used by a system Softwarefori company of receivables management (in Maintenance by a software banking company. (ii) Paintingof pencils manutactured by a pencil factory. (is Cleaning of customers' computer key boards bya computer repair centre. adjustments Service station. () Providing brake in cars received for service by a car SOLUTION Item SI. No. Non-value () Polishing furniture used by a System Engineer in a software firm added Value-added Maintenance by a software company of receivables management () software for a banking company Value-added (üi) Painting of pencls manutactured by a pencil factor Value-added (iv) Customers' computer key board cleaning by a computer repair centre Value-added () Providing brake adjustments in cars for repairs by a care service station ACTIVITY BASED COSTING (ABC) V3-13 O Suitabilityof ABC System From the above discussion of the system, it can be concluded that ABC systen is suitable: 1. When there is acute competition and there is urgent need of reduction in cost to sel the product at the most competitive price. Intense global cornpetition calls for correc costing of products to avoid errors in fixing selling prices. 2. When overheads are of considerableimportance and simple methods of apporioning overheads based on direct labour are not justified. 3 When non-volume related activities like material handling. inspection set-up. contro quality etc. are important and their costs cannot be suitably apportioned on volume basis. 4 When companies produce a wide range of products without standardisation with regard toconsumption of resources. EXAMPLE.State with brief reasons whether you wOuld recommend an actrvity based system of costing in each of the following independent situations : () Company K produces one product. The overhead costs mainly consist of depreciation. (i) Company Lproduces 5 different products using ifferent production facilities. (i) Aconsultancy firm consisting of lawyers, accOuntants and computer engineers provides management consultancy services to clients. (iv) Company S produces two different labour intensive products. The contribution per unit in both products is very high. The BEP is very low. All the work is carried on efficienty tomeet the target costs. SOLUTION SI. No. Description Recommend Reasons ABC Yes/No K produces one No (1) One product situation. For allocation of product. Overhead is overhead, ABC is not reguired. mainly depreciation (2) ABC for cost reduction not beneficia since most of the overhead s depreciation. () L produces 5 different Yes (1) Muti product situation. ABC is require products with different for allocation of overheads facilities. (2) ABC is necessary for pricing (3) Cost drivers are likely to be aiferent (4) Cost reduction may be possibe (5) Production facilities are diferent (u) Professional services Yes (1) Variety of services. Hence ABC S lawyers/accountants/ required for cost allocation computer engineers (2) Serices are very different. (3) ABC is necessary tor pncing (4) Cost reducton poss bie these are abour (M S produces 2 difterent No () Diferent products but labour intensive intensve Henceovernead allocabon raceabie drect abou products. High unit Dased on reaaly Hence, ABCS N contribution and Cost will be accurate efficient operations required for cost allocation  AC /3-14 Low BEPIevelimplies low level of (2) Cost as a % of sale price or as a fixboeg cle totalcost. (3) Many fixed costs are likely to align with eli labour costs. Hence the direct not required for Cost allocation operation. Hence ABCin 2. (4) Efficient even for cost reductionABC SU required or AB, hu management. S us Conventional Cost System & W Cost Reduction Under O Ways of Achieving ar Conventional Cost System Activity Based Cost System by ABC System Ways of Achieving Cost 3. Reduction Reduce set up time to achieve direct labour. low cost. Ignore or reduce 1. Reducing set-up time. th reduce direct labour. Eliminate activities to rediea irn handling lanore or the cost of handling. 2. Eliminating materia! in To activities. cost alternative pro- Pick alternative with lowest Pick lowest 3. Choosing an insertion unit level activitities. 4 Use common components cess. Using common components|wherever possible. 4. Using common components. toachieve cost savings; Using pr non-common components CO which creates no Costly penalty. 5. firi Benefits of Implementing ABC in management budgeting ABC System have the greatest potential for contributing to cost accuracy and IS contro! and performance evaluation. It is valuable aid for planning and brings relationship in th8 div reliability in product cost determination by focusing on cause and effect 6. costs U cost incurrence. ABC provides not only a base for calculating more accurate product o also a mechanism for managing costs. An ABCsystem focuses management attention Costsand underlying causes of costs. It assumes that resources--consuming activities cause he that products incur cost through the activities that require for designing, engineriy 7 manufacturing, marketing, delivery, invoicing and servicing. Activity Based Costing System has more accurate costing of products/serviceS underslar A Customers, SKUs, distribution channels; Better understanding overhead: Easier to for everyone; Utilizes unit cost rather than just total cost; Integrates well with Six Sigma an kn activites im other continuous improvement programs; Makes visible waste and non-value added pro Supports perfornmance management and scorecards; Enables costing of processes, supp! infc chains, and value streams; and Activity Based Costing mirrors way work is done. Followry are the main benefits of implementing ABC: 1. Cost Management and Downsizing ABC heips to reduce costs by providing opportunile Cor meaningful available for reducing costs. If the company's financial information performance is notonSatisfactorv., the it md) have to resort to extreme measures like layoffs. ABC helps in making the right decisionsas ACTIVITY BASED COSTING (ABC) V3-15 clearlv defines the various activities. Thus one can focus on value adding activities and eliminatingthe non-value adding activities. 2. Determination of Products Service Costs Now-a-days, non-manufacturing costs can no longer be neglected as they constitute a substantial portion of the total cost. e.g. ,softdrink giants of the world, Coke and Pepsi have huge Marketing and Advetising Costs. On the contrary manufacturing Costs constitute a very Small proportion of the total cost. These non-manufacturing costs can be allocated easily using ABC because the relationship between costs and its causes is better understood. Wrong allocation of these costs leads to a tendency of overvaluing the high volume products and undervaluing the low volume products which causes cross subsidisation of one product bythe other unknowingly. This may lead to a faulty pricing policy. 3. Improvements in Performance ABC involves preparing the statement of expenditure activity-wise and comparing it with the corresponding value addition to know the activities which are to be eliminated or need improvement for better performance of the organisation. ABC provides accurate cost information which is essential for most of the recent productivity improvement approaches like Total Quality Management (TQM),Business Process Reengineering (BPR). 4. Product/Service Pricing ABC enables the management to fix the product/service prices by formulating an efective pricing policy. ABC helps in price fixation by providing information about the product/service Cost. 5. Make or Buy Decision ABC enables the manager to decide whether he should get the activity done within the firm or subcontract the same to an outside agency. Subcontracting may be done if the firm is incurring higher overhead cost as compared to the subcontractor. On the contrary if the cost is not going to decrease or the resources fed by sub-contracting can not be economically diverted eisewhere, the company should get the activity done internally. 6. Preparation of Budgets ABC establishes relationship between activities and overheads. This relationship is heipful in preparing proper budgets. 7. Transfer Pricing ABC helps to determine the cost of each activity. Thus when finished good of deparne A is transterred to department 'B, the cost of the product to department Bcan be easly Kiown. Moreover,acCuracy of indirect cost allocation to the product being transferred is very Important as the performance evaluation of both departments A and B depends on the proportion of indirect costs being passed on to department B. ABC provides accurate cost information to evaluate the performance of the transteror and transferree deparnie OGaining Competitive Advantage Through ABC Thus, there are several benefits that can be derived from ABC system in gaining competitive advantage. It can be easily understood in the form of the table given below.  Which product should we promote ? Analyze the profit contribution & impact of inter relationship Which customers are of products/services. profitable & why ? What prices should Identify the true cost we set ? profitabiliy of customers Identity the true cost/ or types of customers profitability of products & services. Gaining Competitive Advantage. Which distribution channels should we follow ? How should we measure Analyse the cost & pertormance ? performance of ldentify accountability/ alternative distribution responsibility for cost channels. behaviour. ABC may not be appropriate for all companies, particularly those where overheads ars many of the benefis relatively small and which do not produce a wide range of products. But focuses of ABC can still be obtained by implementing a partial system, which only on th: most important activities. ABC method should not be used to produce monthly prot statements. Traditional methods can be used for that, leaving ABC to support strateg: decision-making, profitability analysis and the control of manufacturing costs. OHowABC System Supports Corporate Strategy ? ABC supports corporate strategy in many wayssuch as: ABC system can be helpful to the management by furnishing data at the operaticra level and strategic level. Accurate product costing will help the management. compare the profits that various customers, product lines, brands or regions genera andto decide on pricing strategy, dropping unprofitable products, lines etc. Information generated by ABGsystem can also encourage the products for improving their quality. management to re-oe ABC system can change the system of reduce setup times, rationalization of plantevaluation of new layout in order technolog1es process material to reduce handir cost, improve quality etc. ABC System will report on the resources consumed. ABC analysis helps managers focus their attention and energy on Improv' activities. The cost driver rates peformance established and elliciency and by ABC system can be used to measure actv The accurate provide a more suitable basis for teedback can be provided performance based on their consumption to cost during of resources budgeting. a period onthe ratne than the allocations of cost over which center manageTs ABC system prvides they have no control. decisions to be made onaccurate information on enables belte pricing, marketing, productproduct costs which mix. design and product ACTIVITY BASED COSTING (ABC) V3-17 OWhen to Use ABC ? In discussing the question 'Does your company need a new cost system ? Cooper suggested that the managers should ask themselves 'Do really know what my products cost?", If the answer to this question is 'no', he urged that managers should consider whether it is necessary to undertake a detailed analysis of their cost accounting system. But rather than undertaking a major and costly analysis in every case, he suggested that managers look for the following symptoms which are indicative of a need for ABC : Products that are very difficult to produce are reported to be very profitable. eventhough they are not premium-priced. Cooper argues that products are difficult to produce should be expected to cost more and, therefore, to be profitable only if they are priced at a premium. Profit margins cannot be easily explained. If managers believe certain products to be more profitable than the accounting system suggests, it may be necessary to analyze costs using ABC. Some products, not sold by competitors, have high reported margins. Competitors would normally be expected to produce products which are more profitable. Why are they not producing these products? They may consider the cost to be too high. It calls for examining of the costing system. Competitors' high volume products are priced at apparently unrealistically low levels. If competitors are able to price their products at levels, which appear unrealistically low, it may be that the firm's costing system needs examining. Suppliers offer to produce parts at prices considerably lower than expected. Managers considering buying in parts currently produced internally who find that suppliers offer them at unexpectedly low prices should examine their costing systems. Cost p0ols are too large and contain machines have very difficult overhead structures. This creates considerable complexity and could mean. that the procedures for allocating the overheads will be toosimplistic. The cost of marketing and delivering the products varies dramatically by distribution channel, andyet the costaccounting system effectively ignores marketing Costs. Managers should look for these symptoms and ask themselves whether they have confidence in their product cost information. As symptoms may have other explanations, it is important to consider the range of possibilities and to evaluate which is more likely. However, even if it appears that existing product costs are misleading, it may not always be necessary to incorporate ABC into the accountingsystem. It.must be remembered that the introduction of the ABC system involves major expense and thus managers must ask themselves whether the benefits to be derived from the superior information exceed the cost of the new accounting system. OConclusion When Overheads are Large in Proportion to Labour Cost In the present industrial scenario it becomes difficult in the industry to survive unlesS the overhead costs are correctly accounted for, controlled and reduced so as to sustain, rema and grow in the industry. We cannot reduce the direct cost of the product, (unless material cheapervalues are used) but we can control very much the overheads. This can be done on when one has the information of the cost centers with respect to function or aciY Overmead costs involved-for aproduct do not usually aive a clear picture so as to contro ae reduce these costs. Therefore, it becomes necessary to have a costing system od activities done. Because of this need for ABC arises. Thus ABC has a wide sCope context of cost reduction and cost control. V3-18 ACTIVITY BASED COSTING It may be made clear that ABC cannot be applied where a distinction cannot be made for (ABC) Implementation of ABCshoulcd be time the costs trom shop attached floor to to various activities managerial or functions. level. If ABC is applied correctly at the correct place and made the company can attain more profits than betore. Athoughthe activity based approach looks attractive, it is unlikely to be practical to ral approach implicitly assumes a all overheads behaviour to specific among activities. Operating units andMoreover betweentheoperating CO-operative units and service functions.Il does prOcess of Overheads. An from their narrow the not acknowledge concern conflict and Over ofefficiency possibilitv the allocation over optimal profitability, the advocates of activity firms insist on using simple methode esea approach have not attempted to explain why allocation of overheads. In recent years many companies have operationaladopted an activity-based approach to cne management gaining substantial benefit at an level tor proceSs improvement and detailed costing. However, ABC system has been widely implementedsegments in large organizations in US and Europe. ABC system can be successfully used in other of the organization i,e banks administration, selling, distribution etc. It can equally be applied in service sectors like insurance, hospitals and other institutions providing services. various analyses Activity Based Cost management (ABM) uses the information in than resources. t rather designed to yield continuous improvement. ABM manages activity these activities can be determines what drives the activities of the organization and how improve to increase the profitability. ABM utilizes the cost information gathered to activity to based cost. ABM is a discipline that focuses on the management of activities as thethisroute value improve the value received by the customers and the profit achieved by providing The various analyses under ABM are: () Cost Driver Analysis. It identifies the factors that cause activities to be performed in order to manage activity costing. (in Activity Analysis. It involves identification of an organization and the activity centres or activity cost pools. This analysis also identifies the Value Added and Non-Valued Added activities. (iD Performance Analysis. It aims to identify the best ways to appropriate measure tie performance of factors that are important to organizations in order to stimulat continuous improvement, consistent with each unit's goals and objectives. MISCELLANEOUS ILLUSTRATIONS ILLUSTRATION 1. DEF Bank operated for years under the assumption eCos! Volume. But that has not been the Case. profitability can be increasedI by increasing analysis has revealed the following:. Activity Activity Activity Cost Activity Driver Capacity ) ProvidingATM Service 2.00,000 1,00,000No. of Transactions Computer Processing 10,00,000 No. of Transactions 25,00,000 5,00,000 Issuing Statements 8,00,000 No. of Statements 6,00.000 Customer Inquiries 3,60,000 Telephone Minutes The following annual intormation on three products was also made available GoldVis Checking Accounts Personal Loans 10.000 Units of Product 30,000 20,000 5,000 ATM Transactions 1,80,000