J. BALASUBRAMANIAN.

,
B.Com.,ACA.,AICWA.,MBA.,CS

ABC Introduction :
Activity

based costing (ABC) systems refine costing systems by focusing on individual activities as the fundamental cost objects. An activity is an event, task, or unit of work with a specified purpose;
for

example, designing products, setting up machines, operating machines, and distributing products, setting up machines, operating and distributing products. ABC systems calculate the costs of individual activities and assign costs to cost objects such as products and services on the basis of the activities of the

ABC Introduction :
In relation to ABC, by activities we only mean the

activities of the support or service departments, such as, material handling, machine set-up, engineering change, quality testing, inspection, etc. An activity is a process or procedure that causes work. ABC differs from the traditional system only in respect of allocation of overhead or indirect costs. Direct costs are identified with, or assigned to, the cost object, in the same manner as done in case of traditional costing system. Cost of
Fundamental Cost Objects Service
Activities Costs of Activities Product Customer

COST OBJECT AND COST DRIVER :

a.Cost Object: It is an item for which cost measurement is required E.g. a product, a job or a customer. b. Cost Driver: It is the factor that causes a change in the cost of an activity. Cost Drivers are classified into: Resource Cost Driver: It is a measure of the quantity of resource consumed by activity. It is used to assign the cost of a resource to an activity or cost pool. Activity Cost Driver: It is a measure of the frequency and intensity of demand, placed on activities by cost objects. It is used to assign activity costs to cost objects.

Examples of Cost Drivers:

Function Research and Development Cost Drivers Number of research projects Personnel hours on a project Technical complexities of projects Number of service calls Number of products serviced Hours spent on servicing products Number of Products in design Number of parts per product Number of Engineering Hours Number of Advertisement / Insertions Number of sales Personnel Sales Revenue Number of items distributed Number of Customers Weight of items distributed

Customer Service

Product Design

Marketing

Distribution

Match each Funtion with its Representative Cost Drivers :

Funtion
1.Accounting 2.Personnel 3.Data Processing 4.Research and Development 5.Purchasing 6.Billing

Representative Cost Driver

A. Number of Invoices sent B. Number of Purchase Orders C. Number of Research Scientists D. Hours of Computer Processing unit E. Number of new Hires. F. Number of transactions processed.

STEPS INVOLVED IN ABC:

Step 1: Identify the various Activities within the organization. Step 2: Relate the Overheads to the Activities using Resources Cost Drivers Step 3: Apportion the costs of Support Activities over the Primary Activities Step 4: Determine the Activity Cost Drivers for each Activity Cost Pool Step 5: Calculate Activity Cost Driver Rate = Cost of Activity (Cost Pool) / Activity Cost Driver

Choice of Activities for ABC: While the number of departments or cost centres can be smaller activities can be numerous. Hence all activities are not considered for ABC purposes. The final choice of activities depends on the following factors: Cost of that activity should be significant / material enough to justify separate treatment. The activity should be driven / influenced by a single cost driver. For example, material procurement cost may be driven by the number of purchase orders. However, receiving and issuing materials is not driven by the same driver and should be separately identified.

Identification of activities for ABC Meaning of Activities: Activities comprise of units of work or tasks. For example, purchase of materials is an activity consisting a series of tasks like purchase requisition, advertisement inviting quotations, identification of suppliers, placement of purchase order, follow-up etc. Types of Activities: Activities basically fall into four different categories, known as the manufacturing cost hierarchy. These categories were first identified by Cooper in 1990 and help to determine the type of activity cost driver required. The categories are:

Type of Activity

Examples

Unit level activities: Use of indirect materials / consumables. These are activities for Inspection or Testing which the consumption of resources can be identified with the number of units produced. The costs of some activities (mainly primary activities) are strongly correlated to the number of units produced. Batch level activities: The costs of some activities (mainly manufacturing support activities) are driven by the number of batches of units produced. These are activities related to setting up of a batch or a production run. The costs of such activities vary with the number of batches made, but is fixed for 1. Material ordering-where an order is placed for every batch of production. 2. Machine set-up costs-where machines need resetting between each different batch of production. 3. Inspection of Products-where the first item in every batch is inspected.

Type of Activity

Examples

Product level activities: Designing the product. The costs of some activities (often once Producing parts specifications and only activities) are driven by the keeping technical drawings of creation of a new product line and its products up-to-date. maintenance. These are activities performed to support different Advertising of individual products rather than companys products in the product line. name.

Facility Level Activities: General Administration Costs These are activities necessary for Plant Security sustaining the manufacturing process Production Managers Salary and cannot be directly attributed to individual products.

Traditional Absorption Costing Overheads are first related to departments cost centres (Production and Service Cost Centres) Only two types of activities viz. Unit Level Activities and Facility Level Activities are identified. This method relates overheads to cost centres i.e. locations. It is not realistic of the behaviour of costs.

Activity Based Costing Overheads are first related to activities or grouped into Cost Pools. All levels of activities in the manufacturing cost hierarchy viz. Unit Level, Batch Level, Product Level and Facility Level are identified. This method relates overheads to the causal factor i.e. driver. Thus, it is more realistic of cost behaviour.

Overhead Rates can be used to ascertain Activity Cost Driver Rates can be used to cost of products only. ascertain cost of products and also cost of other cost objects such as customer segments, distribution channels. Etc.

Need for ABC:

Manufacturing organizations need ABC for product costing where: (a)Production overheads are high in relation to direct costs. (b)There is great diversity in the product range. (c)Products use very different amounts of the overhead volume resource by (d)Consumption of overhead resources is not primarily driven

Purposes and benefits of ABC 1. To link the cost to its casual factor i.e. the Cost Driver 2. To identify costs of activities rather than cost centres 3. To ascertain product costs with greater accuracy by relating overheads to activities 4. To overcome the inherent limitations of traditional absorption costing and use of blanket overhead rates.

Steps involved in the installation of an Activity Based Costing System: Specification of Objectives
a. To improve product costing b. To identify non-value adding activities in the production process

Identification of Costs for ABC Process Specification Activity definition Activity driver selection Activity Cost Driver Rate Staff Training Review and Follow-up

EXAMPLES OF ACTIVITY COST POOLS AND ACTIVITY MEASURES

ACTIVITY COST POOL POTENTIALLY USEFUL ACTIVITY MEASURES Number of machine hours. Number of purchase orders or ordering hours. Number of purchase orders or shipments received. Number of engineering work orders or hours. Number of shipments, number of cubic feet or packing hours. Number of tons shipped. Number of setups or setup time. Number of times handled or material handling hours. Number of part numbers or administrative hours. Number of inspections or inspections time. PROBABLE COST CLASSIFICATION Unit level. Product or batch level. Product or batch level. Product level. Product or batch level. Product or batch level. Batch level. Product or batch level.

Machining parts Purchasing Receiving and Storing Engineering Packing Shipping Machine Setup Materials handling

Inventory control and materials planning Inspection and quality control

Product or batch level.

Product or batch level.

Activity Based Management (ABM) ABM is a discipline that focuses on the management of activities as the route to improving the value received by the customer and the profit achieved by providing this value. This discipline includes (a) Cost Driver analysis; (b) Activity analysis; and (c) Performance measurement. ABM utilizes cost information gathered through ABC. Through various analyses, ABM manages activities rather than resources. It determines what drives the activities of the organization and how these activities can be improved to increase the profitability.

Various analyses under ABM

Cost Driver analysis identifies the factors that cause activities to be performed in order to manage activity costs. Activity Analysis: involves identification of the activities of an organization and the activity centres (or activity cost pools that should be used in an ABC system). Activity analysis also identifies Value Added (VA) and Non Value Added (NVA) activities. Performance Analysis: involves the identification of appropriate measures to report the performance of activity centres or other organizational units, consistent with each units goals and objectives. aims to identify the best ways to measure the performance of factors that are important to organizations in order to stimulate continuous improvement.

Value Added and Non-value Added activities

Value-added activities (VA) These are activities necessary for the performance of the process. These represent work that is valued by the external or internal customer. They improve the quality or function of a product. Hence, the customers are usually willing to pay for the service. VA activities result in Cost and not in losses. Non-value-added activities (NVA) These are additional and extraneous activities, not fully necessary for the performance of the process. These represent work that is not valued by the external or internal customer. NVA activities do not improve the quality or function of a product or service but they can adversely affect costs and prices. NVA activities create waste, result in delay of some sort, add cost to the products or services for which the customer is not willing to pay. Examples: Moving materials and machine set up for a production run.

Example: Making product more versatile for certain other uses.

The areas in which activity based information is used for decision making are as under: Pricing Market segmentation and distribution channels Make or Buy decisions and outsourcing Transfer Pricing Plant closed down decisions Evaluation of offshore production Capital Investment decisions Product line profitability

Difference between ABC and ABM :

ABC ABC refers to the technique of determining the costs of activities and the cost of output that those activities produce. ABM It refers to BM the management philosophy that MM focuses on the MM planning, execution and MB measurement of activities as the key BM to competitive advantage. mm mM The ABM is a much broader concept. Its aimis to use information generated by ABC, for effective business processes and profitability.

The aim of ABC is to generate improved cost data for use in managing a companys activities.

Business applications of ABM: 1. 2. Cost reduction Activity Based Budgeting 3. 4. 5. Business process re-engineering

Benchmarking Performance measurement

ASSIGNMENT PROBLEM : The Jackson Company produces two products, A and B. Information for the previous year is provided in the table below.
Type of Information Total units produced Total direct labor costs Total number of machine hours Total number of machine setups Total number of purchase orders Total direct materials costs Total number of engineering work orders Product A 1,000 Rs.25,000 6,000 4 50 Rs.30,000 20 Product B 9,000 Rs.135,000 34,000 2 50 Rs.270,000 20 Total 10,000 Rs.160,000 40,000 6 100 Rs.300,000 40

Assignment Problem : The Company is currently using machine hours as a basis for allocating all overhead costs to products, but is considering the ABC method based on the activity cost pools and activity measurements below.
Activity Cost Pool Annual Activity Costs Activity Measurements

1. Machine Processing 2. Machine set-up 3. Purchasing

Rs.100,000 5,000 10,000

Number of machine hours Number of machine setups Number of purchase orders Number of material (in Rs.)

4. Materials planning & handling

20,000

5. Engineering Total

15,000 Rs.150,000

Number of engineering work orders

QUESTIONS : 1.The total overhead (activity) costs allocated using the current method is a. 3,750 to A and 33,750 to B b. 15,000 to A and 135,000 to B c. 22,500 to A and 127,500 to B d. 23,437.50 to A and 126,562.50 to B e. None of the above. 2. Based on the information given above, what is the minimum number of homogeneous cost pools that can be used to accurately allocate the Companys activity costs using the ABC method? a. 5 b. 4 c. 3 d. 2 e. 1 3. Using the ABC method, the machine setup costs allocated (rounded to dollars) is a. 3,333 to A and 1,667 to B b. 500 to A and 4,500 to B c. 750 to A and 4,250 to B d. 2,500 to A and 2,500 to B e. None of the above. 4. Now, considering only purchasing costs, the current allocation method based on machine hours a. overstates the allocation to A by approximately Rs.4,500. b. understates the allocation to A by approximately Rs.4,500. c. overstates the allocation to A by approximately Rs.3,500. d. understates the allocation to A by approximately Rs.3,500. e. None of the above.

5. The ABC activity cost per unit for product A (rounded to Rupees) is a. Rs.15.00 b. Rs. 22.5 c. Rs. 32.83 d. Rs. 100.00 e. None of the above. 6. The current cost allocation method based on machine hours a. accurately states the costs allocated to A for all five activity cost pools. b. distorts the costs allocated to A for all five activity cost pools. c. accurately states the costs allocated to A for only activity cost pool number 4. d. accurately states the costs allocated to A for only activity cost pool number 1. e. None of these. 7. Comparing the production volume based allocations and ABC allocations, the total cost distortion for this company is approximately a. Rs.7,500 b. Rs.10,330 c. Rs.67,170 d. Rs.150,000 e. None of these.