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MANAGING COSTS STRATEGICALLY THROUGH ACTIVIW BASED COSTING

Prot. Priyanka oza Lecturer at Atharva lnstitute of Management Studies, Mumbai Prof, Jigar Patel Assistant Professor at PTVA'S lnstitute of ManaBement,

Mumbai

lntroduction
ln the present scenario of fierce competition, galloping quality standards and price wars for customer attraction, the costing of products or services has become an important success issue in today's business world. Companies are zealous to make their product more competitive and affordable. Cost leadership is an effective strategy to maintain competitive advantage, as suggested by Porter, and can even decide the corporate success gr failure

The conventional costing systems allocate fixed cost differently. lt has been empirically argued by most of the researchers that ABC is more suitable for medium to long-range planning and flexible margin costing is more suitable for short to medium range planning. ln traditional cost accounting systems, direct materials and labour are the only costs that can be traced directly to the product. By using the ABC system, activities can be classified as value-added and non-value-added activities. ln order to improve performance of the system, non value- added,can be eliminated
Therefore, cost accounting systems have greater flexibility in allocating and dealing with both variable and fixed costs Activity-based costing (ABC) is a method for improving the accuracy of cost determination. While ABC is a relatively recent innovation in cost accounting, it has been adopteal by companies in varying industries and within government and not-for-profit organizations.

Stateihent ol Problem
Activjty Based Costing wjll help the organizations in managing costs in a strategic manner. lmplementing Activity Based Costing helps in tracing and allocating costs in an effective manner as compared to traditional Volume based costing

Literature Review
From 1970s Activity Based Costing (ABC) was mainly developed to serve industrial companies, but from the early years of its deveiopment, researchers have investigated the possibility of using it in the service sectoras well- Kaplan (1994) reports that in the early 1980 ABC was already used in the service sectpr by logistics companies, by banks and hospitals " and had alreadV developed costing models similar to the ABC.

Moreover, Brimson and Antos (1994) mention examples of American Public Sectors where Activity- Based Costing succeeded when used. The writers quote that Activity-Based Costing has been implemented in telecommunication companies, parcel post companies, hospitals, electricity and gas companies, helping them control their cost and letting management concentrate on their customers.
Athanasios Vazakidis, loannis Karagiannis and Anthi Tsialta in their paper titled "Activity-Based Costing in the Public Sector" (2010) mentioned the examples of Public Sectbr units of Greece where Activity Based Costing succeeded when used. They helped the companies control their cost and found that Activity-Based costing works complementary i] providing detailed cost information for further analysis and propei decision making' ' Sarbapriya Ray in her research "Relevance and Applicability of Activity Based costing: An Appraisal" evaluated the

relevance and potential applicability of Activity Based Costing. Through the analysis she studied that ABC implementation leads to better understanding of the cost drivers that generate these costs, thereby focusing management attention on the way resources are consumed by activities and supporting effective management of these activities. The article also concluded that ABC is most suitable for service organizations, while traditional costing is irrelevant for them.
ABC Framework

Activity Based Costing is an accounting system that assigns costs to products based on the resources they consume. The costs of all activities are traced to the product for which these were incurred, e.9., material handiing, material management, customer support service, etc. ABC is an economic modelthat identifies the cost pools or activity centers
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in an organization and assigns costs to cost drivers based on the number of each activity used. ln theory, Cooper rlOSfribgs, tro stages in the ABC model. ln the first stage, costs are assigned to cost pools within an activity center,

04qcost driver. There is no equivatent step in a traditional costing approach. ln the second stage, costs are dllooqtd irom the cost pools to a product based on the product's consumption of the activities. Since the cost drivers
bAscll are related to the activities, they occur on several levels:

. tltlt level drivers, comprise increase in inputs for every unit that, is being produced. . Bltti level drivers, comprise variatlon of inputs for every batch that is being produced. u Product level drivers, comprise necessity of inputs to support the production of each of different types of
products.

Facility level drivers are the drivers, related to the facility's manufacturin8 process.

Figure 2: The Volume-Based two stage procedure

bj e ctive s q nd M ethod ology

The objectives ofthis study are as follows:

. i .

To analyse the scope of activity based costing

T! compare

ABC

with traditional volume based

costing

To analyse the applicability of ABc technique in organizations

ThiC paper relies on the literature review of past and current relevant articles focusing on activity-based costing (ABC). Except where a source was needed specifically for its perspective on broad issues relating to firms' overall business

eodrDnment, the papers were screened by "activity-based costing" and by numerous variants of keywords, focusing specifically on activity-based costing in the service sector. Source papers included refereed research studies, empirical tlgorb, and articles from professional jou rnals.

My;s

,l AtsCdilfers from traditional cost accounting in three ways. The first is that nonmanufacturing as Well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis.

The second major difference between ABC and traditional cost accounting is that some manufacturing costs may be

exdlrded from product costs.

The third major difference between ABC and traditional cost accounting is that numerous overhead cost pools are used, each of which is allocated to products and other cost objects using its own unique measure of activity.

pZ

Ud

- an example
two automobile battery lines

XYZ Ltd Company produces

qualiti battery called the Longer Life. Both batteries are sold through automobile parts retail stores. No design options are available for the Secure, but XYZ produces the Longer Life with different battery casinB designs and battery handle locations to customize the appearance for the auto parts stores. For example, the battery casing can be produced in
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a standard battery called the Secure and a deluxe, higher

its first loss ever of different colors with different brand names to suit the customers' The company has reported 2,OOO,o0o as shown on the income statement. Table 1: lncome Statement of XYZ Ltd

Rs.

ThefirststepinimplementingABcistodefineactivities,activitycostpools,andactivitymeasures.XYzselectedthe
following five activity cost pools and corresponding activity measures: Activity Cost Pool
Customer orders
Design changes Order size

Activity Measure Number of customer orders Number of design changes

Machine-hours Number of active customers' Not applicable

Customer relations

Other

ThesecondstepinimplementingABcistoassignoverheadcoststoactivitycostpools'Thisisalsocalledfirst.stage
allocation. Table 2: overhead Costs at XYz Ltd {Manufacturing and Non-manufacturing) Production DePartment 6,000,000 lndirect Factory Wages 3,500,000 Factorv eqiupment dePreciation 2,500,000 utilities Factory 2,000,000 lease building Factory

14,000,000

ceneral Admin DePartment Admin Salaries Office Equipment DePreciation Admin Building lease Marketing Department Marketing Salaries
Selling Expense Total Overhead Cost

4,000,000 900,000 1,100,000 1,500,000 500,000

6,000,000

2,000,000 22,000.000

direct labor, and shipping-are excluded from Three costs included in xYz Ltd's income statement-direct materials, these costs to products or customer orders' this slide because the company's existing cost system can directly trace
XYZ Ltd's

cross-functional interviews resulted in resource allocations as shown'

'l

Table 3: Percentage allocation of activities to cost drivers

lndirect FactorY Wages

Factory eqiupment dePreciation
Fatory building lease

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General Admin Department Admin Salaries Office Equipment Depreciation 30% 30%
o%

10% 70%
oo/"

70%
o%

30%
20%
o%

20%
40% 700%

700% 700%

Admin Building lease Marketing Department Itlarketing Salaries

Selling Expense Total Overhead Cost

o%

\oo%
100% 700%

30%
200/"

70%
o%

o%
o%

500/" 700/"

70% 70%

Once the percentage allocations have been determined, it is a simple matter to assign osts to activity cost pools

Table 4: Amount allocation of activities to cost drivers Ativity Cost Pools Customer Orders
Design

Changes

Order Size 1,200,000 2,100,000

Customer Relations 600,000

Other
600,000 350,000..

Total 6,000,000 3,500,000 2,500,000 2,000,000 4,000,000 900,000 1,100,000 1,500,000 500,000 22,000,000

Production Department lndirect Factory Wages

Factory eqiupment depreciation Factory utilities Factory building lease
General Admin Department

1,800,000 700,000

1,800,000 350,000 250,000

1.500,000,

7s0,000
2,000,000

Admin Salaries Office Equipment Depreciation

1,200,000 270,000

400,000 90,000

400,000

1,200,000 180,000

800,000 360,000 1,100,000

Admin Building lease Marketing Department Marketing Salaries

Selling Expense Total Overhead Cost 450,000 100,000 4,520,000 3,040,000 5,200,000 150,000 750,000 350,000 3,080,000

150,000 50,000 6,160,000

The XYZ Ltd Pro team determined that the company has the following activity for the four cost pools,

. . . .

10,000 customer orders,

4,000 designs changes,

800,000machine-hours,
2,000 customers served.
rates for each activity by dividing the total cost in each activity cost

lhis information enabled the team to compute ABC

pool by the respective quantity of the activity measure. Notice, the "other" cost pool does not have an activity rate. This is because these organization-sustaining costs will not be assigned to products or customers.

Obe

5: Computation of Activitv Rates

Computation of Activity Rates

Activity Cost Pools

Customer Order
Design changes

Tota I Cost

TotalActivity
10000 orders 4000 changes 800000 MHs
2000 customers

Activity Rate
452.O

4,520,O0O

3,040,000 5,200,000 3,080,000 6,160,000 22,000,000

760.0 6.5
1540.O NA

Order Size Customer Relations

Other
Total customer orders-

NA

As we can see above, the direct materials, direct labor and shipping costs are directly traceable

to

products or

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Figure 4: Stage-Wise Allocation

The first-stage allocation process assigned the remaining overhead costs to the five activity cost pools. Then, actjvity measures were identified, activity levels were determined, and activity rates were computed for each activity as shown earlier

Assigning overheads to products

The data needed to assign overhead costs to XYZ Ltd's two products-Secure and Longer Life-are as shown. There were 4,000 separate customer orders placed for 800,000 Secures and 6,000 customer orde.rs were placed for 400,000 Longer Lifes. All 4,OOO design changes related to the Longer Life batteries. The Secure battery consumed 480,000 machine hours, and the Longer Life consumed 320,000 machine-fiours.
Table 6: Overhead Cost for Secure

Activity Cost

Pools customer Orders Design Changes order Size

Total

Activity Rate
4s2.O

Activity
4,000 480,000

AgC Cost

1,808,000 3,120,000 4,928,000

760.0
6.5

Table 7: overhead Cost for Longer Life

Activity Cost Pools

Customer Orders
Design Changes

Activity Rate
452.O

Activity
6,000 4,000

ABC Cost

2,772,OOO

760.0
6.5

3,040,000 2,080,000
7,a32,OO0

Order Size Total

32droo

Assigning Overhedds to customers oftwelve orders. Note that the four orders for Longer Lifes required
Orders
Let's take a look at how XYZ'S system works for just one of the 2,000 customers - Makers Company who placed a total a design change.

1, 2. 1. 2.

Eight orders for 60 Secures per order. Four orders for 50 Longer Lifes per order. The 480 secures required 288 machine-hours The 200 Longer Lifes required 160 machine hours.

1.

Machine Hours

Table 8: Overhead calculation for Makers Company Cost Pools

Customer Orders
Design Changes

Order Size Customer Relations

Tota
I

Rate 452.0 760.0 6.5

.1,540.0

ABC Cost

5,424
3,040

2,972

-!Js_Ao
!2,9L6

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The total overhead cost of Rs. 12,916 assigned to Makers Company is calculated as shown.

Aft.er.this step, manage ment. reports are prepared. one of the most common management reports prepared with ABc Q'^ is -tduct profitability (product margin) reports. The first step in computing product margins is to gather each pfoduct s sales and direct cost data which are assumed to be as shown. The second step L to incoiporate the previously computed activity-based cost assignments pertaining to each product. The third step is to compute product for$rs bv deductin8 each product's direct and indirect costslrom its sales. The product margins can be reconciled rallth-tlt-co:npany's net operating loss. After this procedure, it will be noted that the traditional cost system overcosts tlp Serorcs, and consequently, reports an artificially low product margin for this product- conversely, the traditional cost system undercosts the Longer Lifes, and consequently, reports an artificially high product margin for this product. Table 9: Difference between ABC and Traditional Costing
Secure

Longer 6,900,000
a,372,OOO

tife

Product Margins - Tradional Product Margins - ABC

Change in reported margins

2,100,000
L,L32,OOO

t,472,OOO

(3,232,0001

There are three reasons why the reported product margins for the two costing systems differ from one another.

' '

The first reason is that the traditional cost system allocates all manufacturing overhead to products. The ABc system only assigns manufacturing overhead costs consumed by products to those products, The second reason why the reported product margins for the two costing systems differ from one another is that the traditional cost system allocates all manufacturing overhead costs using a volume-related allocation base (machine-hours) The ABc system uses volume-related and non.volume relted allocation bases to assign manufacturing overhead to products. The third reason is that the traditional cost system disregards selltng and administrative expenses because they are assumed to be period expenses. The ABC system directly traces shipping costs to products and

'

includes nonmanufacturing overhead costs caused by products in the activity cost pools that are assigned to products.

Conclusion

' !

Effective implementation of ABc requires a lot of training and understanding of the technique. But if it is lmplemented in a proper manner, it can help companies answering the market needs of better quality products at competitive prices.
This method can contribute in top management decision making procass because it hetps in ascertaining product profitability and customer profitability. ln the time of change,i,ivhich is ineVitabie in a brrinurr, it ,, imperative that the management decision makers must have an accurate, relevant, flexible, and comprehensive cost accounting system to aid them in their decision making processes.
As

'

important as it is, however, ABc is not a full proofsolution. As mentioned earlier, cost management should always be done in the broader context of performance management that integrates time, quariiy,.-service levels, risk, capacity planning, and costs.

Scope

lor Further Research

A'; discussed earlier, ABc is not a concrete system. ln fact ABC is not vastly accepted in lndian companies.

' ' o

it has its own flaws. gut then, the iinplementation of

ln fact, a very few lndian companies have actually implemented it, There needs to be more awareness about how costing svstems can also be improved, not just by merely reducing costs but actually managing costs strategically.
Also, further research can be conducted in terms of using Activity based costing as a performance management technique and not just cost management technique. lt can be merged with other performance management systems like Balance Scorecard and can bring out efficient and effective resurts.

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References

1. 2, 3. 4. 5. 6. 7. 8. 9.

Mohan Nair, "The Keys to lmplementing Activity based Management," Journal of Corporate Accounting & Finance, March/April 2000, pp. 37-42. Mohan Nair, "Helping Ensure Successful lmplementations of Activity-based Management," Journal of Corporate Accounting & Finance, January/February 2002, pp. 73-86.
R. S., "Measure cost Right: Make the Right Decisions," Harvard Business Review, September-October 1988, pp- 96-102.

cooper, R., and Kaplan, cooper, R., and Kaplan,

Review, 130-137.

R. S.

(1991, May-June). Profit priorities from activity-based costing. Harvard Business

R. Narayanswamy, "Strategic cost Management:5ome Reflections from pbst experience", The chartered Accountant, December 2003, pp 664-667

Rafiq, A., and Garg, A. (2002). Activity based costing and financial institutions: Old wine in new bottles or corporate panacea? The Journal of Bank Cost & Management Accounting, 15(2), 12-30.

Athanasios Vazakidis, loannis Karagiannis and Anthi Tsialta, "Activity-Based Costing in the Public Secto/', Journal of Social Sciences 6 (3): 376-382,2O1O, pp 376-31a Sarbapriya Ray, " Relevance and Applicability of Activity Based Costing: An Appraisal", Journal of Expert Systems (JEs), 2ol2, pp 7l-76 Manoj Anand,8.5. Sahay, Subhashish Jha, "Co5t Management Practices in lndia: An EmpericalStudy", ASCI Journal of Management 33(1&2), 1-15, 2005
L.

10. c.

Sharma, P, K. Gupta, "Activity Based Costing: Strategic lmplications for lndian Companies",

LBS

Journal of

Mangament & Research

11. Horngren c.
Ltd.:142.

T. et. al. (2003), Cost Accounting - A Managerial Emphasis, Pearson Education (Singapore) Pvt.

t.

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