ACTIVITY BASED COSTING

GROUP 8
LYSANDER 1302 ANOUSKHA 1304 ADELAIDE 1315 ANA 1316 PRADNYA 1333 VIBHAV 1353

TRADITIONAL COST SYSTEM

How Traditional Cost System Works?

Traditional accounting focused on product costing by tracing direct costs to the product and indirect costs are allocated through cost centres. Traditional Cost Accounting over the years proved their inability and inadequacy to support management decision in a complex business environment. The conventional cost system use direct labour consumption as the primary means of apportioning overhead.

 This proved adequate when the overhead costs of indirect activities was a small percentage compared to direct labour consumption in the actual making of products.
The increased technology and automation has reduced the direct labour substantially leaving indirect activities as a far more significant cost factor. Therefore direct labour as a primary apportioning device can cause significant costing distortions and poor strategic planning.

Classification of Manufacturing Costs

Traditionally, manufacturing companies classified the manufacturing costs to be allocated to the products into a) Direct material b) Direct labour c) Indirect manufacturing costs Companies have refined their costing systems to provide better measurement of the overhead costs used by different cost objects.

 Accordingly, manufacturing costs are classified in to three broad categories: 1. Direct Cost 2. Indirect Cost Pools 3. Use cost-and-effect criterion for identifying the cost allocation base for each indirect cost pool.

Dangers of Incorrect Cost Information.

The incorrect cost information can lead to face the following dangers.

a) Emphasizing and focusing on wrong products, wrong customers, wrong markets. b) Neglecting and missing profitable opportunities.
c) Design of products that unnecessarily raise costs. d) Customer orientation is neglected. e) Acquisition of wrong type of equipment

Inadequacies of Traditional Cost Systems.

The cost of product under traditional cost system is not accurate due to following reasons: a. The traditional fixed verses variable cost split is often unrealistic since, as business grows they often become more complex. b. The cost structure is changing especially when making direct labour component to small proportion.

c. Traditional accounting was confined merely to furnishing information at product level. d. Companies make decisions on pricing, product mix etc. based on distorted cost information due to difficulties in traditional costing system.

Reasons For Emergence Of Activity Based Costing System

Some of the reasons for emergence of Activity Based Costing are: Traditional product costing system were designed when most companies manufactured a narrow range of products. Direct materials and direct labour were the dominant factors of production then. Companies were in sellers market.

Overheads were relatively small and distortion 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 method of apportioning overheads on direct labour or machine hour basis are not justified. Intense global competition calls for corrects costing of products to avoid errors in decision making.

Traditional systems can measure volume related costs

Non volume related activities like material handling, set-up etc. are important and their costs cannot be appropriated. Therefore in order to overcome the adequacies of traditional methods of absorption of indirect costs and short term biasing of marginal costing, ABC has been researched.

MEANING OF ACTIVITY BASED COSTING (ABC)

ABC is the method of cost attribution to cost units on the basis of benefits received from indirect activities i.e. ordering, setting-up, assuring quality etc. It emphasizes links between performance of particular activities and the demands that these activities make on the resources of the organization. Under ABC, cost pool are created for each activity and such activities are related with each type of product to determine the cost of such product i.e. cost of only those activities are charged to the product which go in the making of the product.

 The ABC system aims to overcome the drawbacks by cutting across conventional departmental boundaries.
ABC is more accurate and has increases focus on tracing the overhead rather than allocation. ABC is an information system, useful in the situation where overheads are high; products are of diverse nature and where committing errors may prove fatal.

Objectives of ABC
Primary objectives To improve the efficiency of product cost by carefully changing the types and number of factors used to assign costs To use this information to improve product mix and pricing decision. Other important objectives To identify value added activities in transaction To chalk out ways to eliminate non value added activities. To attach costs in response to price resistance demonstrated by customers. To distribute overheads on the basis of activities. To ensure accurate product costing for decision making process. To focus the high-cost activities.

ABC For Marketing, Selling And Distribution Expenses

Expenses related to marketing, selling and distribution have become significant components of the overheads cost of companies. Many of these expenses do not relate to individual products/product line but are associated with individual customers, market segments and distribution channels.

 Tracing costs to customers : - The focus of ABC system in on tracing marketing, selling and distribution costs to customer segments.

Identification of activity and cost drivers: - The first step in the ABC system for marketing, selling and distribution overheads is identifying the activities performed by the resources and selecting activity cost drivers linking each activity to individual customers.

The activity, activity cost and cost description and activity cost drivers are listed below:
Activity 1. Marketing and technical support 2. Travel to customers Activity cost drivers 1. Estimated proportion of time spent on each customer 2. 3. 4. Actual expenditure Number of mailings Estimated proportion of time spent on each customers and supplies used by them Number of orders Quality of inventory and spaces required by customers Actual records

3.
4. 5. 6. 7.

Distribution of sales catalogue

Servicing of customers Handle customer orders Warehouse inventory for customers Shipping/ despatch to customers

5. 6. 7.

 Indentifying resources spending: - The next step is to identify the resources spending in the various accounts. Customer profitability analysis report: - The next step is to prepare a customer profitability analysis.

ABC for service comapnies

ABC is as important to companies in the merchandising and service sectors as to manufacturing companies. Cost structure of service companies: Service companies have a unique cost structure. All the cost of a service company are indirect/ fixed. A service company has little or no direct material hence the company does not have direct/traceable cost to serve as allocation base. - Variable cost is practically zero, therefore , the cost to provide a service based on variable costs by a service company may be close to zero.

 Customer cost: - Basic operating costs of service companies are determined by customer behaviour. - Therefore, service companies should identify the differential profitability of individual customers as they determine the quantity of demand for the operating activity. - The service company should act on total relationship profitability of a customer and not on profitability of just a single service.

Steps In ABC system

Step 1: Process specification
Identification of different stages of production process The commitment of resources at each processing times and bottlenecks.

Step 2: Identify main activities Main activities cant be categorizes as

I. Unit level activities : the cost of activities which are strongly co-related to number of units produced.

II. Batch level activities: cost of activities which are driven by the number of batches of units produced.
III. Product level activities: The cost of activities which are driven by creation of new products and its maintenance. IV. Facility level activities: the cost of activities cannot be related to a particular product line, instead they are related to maintaining the building and facilities.

 Step 3: Identifying non- value adding activities

There are large number of non value adding activities that continue to be carried out in particularly old factories. This helps in focusing on eliminating these activities.

Step 4: Identification of activity cost pools

Under ABC costs are grouped into pools according to activities which drive them. Activity cost pool is the total cost assigned to an activity. Its a sum of all the cost elements assigned to an activity.

 Step 5: Selection of activity cost drivers

Cost drivers any factor that causes a change in the cost of an activity Cost drivers are used to trace costs to products by using a measure of resources consumed by each activity Cost drivers are important since they reveal opportunities for improvement

 Step 6: Tracing of costs with cost objects

Cost object is a reason for performing an activity A cost object is a tangible input for a product manufactured/Service provided, like labor or material. Cost object enables to identify the activity required to produce products. Direct costs are directly assigned to cost objects.

 Step 7: Staff training

The cooperation of staff is necessary for the successful implementation of ABC Staff training should be oriented to create awareness of the purpose of ABC

Step 8: Review and follow-up

The actual operation of the ABC system should be closely monitored. Periodic review and follow-up action is necessary for successful implementation of the system

Distinction Between Value-added And Non-value-added Activities

Value-added Non-value-added 1. Its an activity that customers perceive as adding usefulness to the product/service. A non-value-added activity is an activity where there is an opportunity of cost reduction without affecting the product.

2. If eliminated it will reduce the actual utility or usefulness of product/service.

Examples are Painting a car in car company Making computers with preloaded software in computer company

If eliminated will not reduce the actual utility or usefulness of product.

Examples are Storage or moving of raw materials Reworking or repairing of products

ADVANTAGES

 ABC provides analytical information for the purpose of strategic decision making. ABC increases the efficiency of cost control system. ABC helps in performance evaluation , through the comparison of budgeted and actual performance. ABC helps in identifying the under performing or non-performing activities and through selection, sharing, reduction or eliminating activity it achieves the eventual objective of cost reduction.

 ABC helps to identify costs and activities that can be minimized or eliminated because ABC pinpoints cost drivers in the total product order to delivery cycle. ABC translates costs into a language that people can understand and into elements of costs, namely the work activities, which can be more flexibly linked or assigned to business processes or objects or customers/markets channels or brands

LIMITATIONS

 ABC requires segregation of activities to the root level, specialisation as well as involement and commitment. It sometimes becomes difficult to break all the tasks into clearly defined activities. ABC is beneficial to the complex and large organisation. For small organisations, traditional system is more economical and simple. ABC system requires total commitment and support from top level management.

 It requires positive attitude and employee support for necessary implementation. Substantial amount of time and money is necessary for implementation of ABC. It requires ability to strategically utilize the gathered information.

HOW ABC SYSTEM SUPPORTS CORPORATE STATEGY

ABC system can effectively support management by furnishing data, at the operational level and strategic level. Accurate product costing will help the management to compare the profits of various customers, product lines and to decide on price strategy. Information generated by ABC system can also encourage management to redesign the products.

 ABC system will report on resource spending. Accurate information on product cost enables better decisions to be made on pricing, marketing, product design and product mix.

Other concepts of Activity Based Costing

Activity based information and decision making

ABC supports decision making in many ways such as

Information generated by ABC system can also encourage management to redesign the products. ABC system will report on the resources spending vis-a-vis resource consumption, and reduced demand in the organisational resources lead to increase in profits. The cost driver rates established by the system can be used to measure activity performance and efficiency and provide a more suitable basis for budgeting.

The provision of accurate information on product costs enables better decision to be made on pricing, marketing, product design and product mix

Activity Based Budgeting

Activity based budgeting compliments activity based costing by focusing on the cost activities necessary for production and sales.

ABB involves the following stages

Estimate the production and sales volume by individual products and customers. Estimate the demand for organisational activities. Determine the resources that are required to perform the organisational activities. Estimate from each resource the quantity that must be supplied to meet the demand. Take actions to adjust the capacity of resources to match the projected supply.

 ABB sometimes termed as Activity Cost Management is a planning to control system which seeks to support the objective of continuous improvement.

 ABB requires the identification of activities of the organisation, establishing the factors which cause cost, the cost drivers, and then collecting the costs of the activities in cost pools.

ABB recognizes that

It is activities that drive costs and the aim is to control the causes(drivers) of costs directly rather then the costs themselves. Not all activities add value, so it is essential to differentiate and examine activities for their value adding potential. The majority of activities in a department are driven by demands and decisions beyond the immediate control of the budget holder. More immediate and relevant performance measures are required than are found in conventional budgeting systems.

Activity Based Management

ABC, which is now being called Activity Based Management used cost information generated by ABC about an activity for controlling the activity itself, rather than just using cost information of the final product.

ABM also analyzes value added and non-value added activities in order to eliminate non-value added activities and simplify and improve upon value added activities.

ABM involves
Identification of major activity areas. Assigning cost to cost pool for each activity. Spreading of support activities across the primary activities. Determination of cost driver for each activity that may be used as cost application base.

 ABM is being used for a variety of business application such as a) Activity Based Budgeting b) Cost Reduction c) Business Process Re-engineering. d) Benchmarking e) Performance Management etc.

Activity Based Accounting

It is an extension of activity based costing concept, which involves collection, recording, analysis, controlling and reporting of activity related costs rather than departmental or cost centre related costs.

ABC includes the following

Activity based costing for costing of products and services. Activity based budgeting. Activity cost management used for planning and control. Activity performance measurement for performance monitoring through financial and non-financial indicators