The activity-based approach tends to shift costs from volume products to volume products.
ABC is a costing system where indirect costs are assigned to products and services. The system establishes a relationship between overhead costs and production activities by allocating overhead costs to them with high precision. As a result, overhead costs are allocated more accurately based on their relevant activity levels. The system has eliminated the defects of the traditional/absorption costing
system. ABC is used both as a planning tool and as a controlling instrument after the production is finished. ABC provides the basis for pricing decisions, inventory valuation, profitability analysis and overhead allocation. The system can effectively be used for both products and services. FCMA (Pak), ACMA (UK), CGMA, FPFA ABC is a costing system where indirect costs are assigned to products and services. The system establishes a relationship between overhead costs and production activities by allocating overhead costs to them with high precision. As a result, overhead costs are allocated more accurately based on their relevant activity levels. The system has eliminated the defects of the traditional/absorption costing system. ABC is used both as a planning tool and as a controlling instrument after the production is finished. ABC provides the basis for pricing decisions, inventory valuation, profitability analysis and overhead allocation. The system can effectively be used for both products and services. Table of Content: 1. Traditional Cost System Learning ObjectivesAfter studying this chapter you are able to understand:
Check out [6th Edition] of Taxmann's Cost & Management Accounting by Ravi M. Kishore. It is a student-oriented book with a simple, systematic and comprehensive explanation of concepts. This book includes several illustrations & diagrams, practical problems and their solutions, chapter-wise PPTs, and students' & teachers' manuals. 1. Traditional Cost SystemThe Cost Accounting includes collecting, classifying, processing, analyzing and reporting of information to managers in their planning and control of activities and 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 through cost centres. The direct costs will be in proportion to the volume of production and the indirect costs like production, administration, marketing and distribution overheads etc., are apportioned depending upon the method used and absorbed to the individual product. The basis of apportionment of overheads may be based on machine hours, labour hours, direct costs, input, output, etc. These normal methods of apportionment have some bottlenecks which tend to misinterpret regarding proration of common costs of different functions added to the product cost. Traditional cost accounting over the years proved their inability and inadequacy to support management decision in a complex business environment since they are aimed at allocation of overhead to total cost on the basis of consistency rather than relevance. The conventional cost systems 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 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, using direct labour as a primary apportioning device can cause significant costing distortions and poor strategic planning. Classification of Manufacturing CostsTraditionally, manufacturing companies classified the manufacturing costs to be allocated to the products into (a) direct materials, (b) direct labour and (c) indirect manufacturing costs. In the present day context, characterized by intensive global competition, large scale automation of manufacturing process, computerization and product diversification to cater to the changing consumer tastes and preferences has forced companies to refine 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 as under:
The change in the classification of manufacturing costs as above has lead to the development of ABC. ABC refines a costing system by focusing on individual activities as the fundamental cost objects. An activity is an event, task or unit of work with a specified purpose as for example, designing, set-up etc. ABC system calculates the costs of individual activities and assigns costs to cost objects such as products or services on the basis of the activities consumed to produce the product or provide the service. Dangers of Incorrect Cost InformationThe incorrect cost information can lead to face the following dangers:
Inadequacies of Traditional Cost SystemsThe cost of product under traditional cost system is not accurate due to following reasons:
Reasons for emergence of Activity Based Costing SystemSome of the reasons for emergence of ‘Activity Based Costing’ are:
Features of Cost System in World-class CompanyThe cost system in a world-class company should enable: (a) Customer orientation of cost information. (b) Reveal the profitability of customers and products. (c) The reasonableness of costs to be incurred for generating cost information. (d) Identifies the opportunities for improvement. (e) Enable to meet customers expectations profitably. (f) Encourages the continuous improvement. 2. Definition and Meaning of Activity Based Costing (ABC)Professors Kaplan and Cooper of Harward University has pioneered the ABC concept. CIMA Official Terminology defines ABC as “cost attribution to cost units on the basis of benefit received from indirect activities e.g., ordering, setting-up, assuring quality”. ABC has been defined as “the collection of financial and operational performance information tracing the significant activities of the firm to product costs”. The activity is aggregated of closely related task, which are associated with one another to accomplish a goal (objective). ABC system aims at refining the costing system used in automated plants in the following manner:
ABC is a simple concept ‘resources are consumed by activities’ and ‘activities are consumed by the product’. The activities can be associated with output or cost object of the organization, the cost objects consume activities is just the same way that activities consume resources. ABC is an attempt to ascertain more accurate product cost by redesigning the allocative system of support overheads like inspection, despatch, production planning, setup, tooling and similar costs. ABC is a recent development in Cost Accounting which attempts to absorb overheads into product costs on a more realistic basis. The basic idea of ABC is that costs are grouped according to what drives them or causes them to be incurred. The cost drivers are then used as an absorption base. 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. Methodology in allocation of overhead is different in ABC system. Under ABC, cost pools 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 technique of ABC involves identification of production path, identification of activities that go into making a product, selection of suitable drivers, creation of cost pools, calculating the overhead application rate and allocation of the costs based on the application rate. The product costing using ABC is shown in figure 10.3. Objectives of ABCThe primary objectives of ABC systems are as follows: (a) To improve the accuracy of product costs by carefully changing the type and number of factors used to assign costs, and (b) To use this information to improve product mix and pricing decisions. The other important objectives of ABC systems are summarized below:
3. Steps in ABC SystemThe activity based cost system is summarized in the following steps: Step 1: Process SpecificationThis involves identification of different stages of the production process, the commitment of resources to each processing times and bottlenecks. This will provide a list of transactions, which may, or may not, be defined as ‘activities’ at a subsequent stage. Step 2: Identify Main ActivitiesThe next step in ABC system is to identify the main activities in the organization. An aggregate of closely related tasks is called an ‘activity’. For example, customer processing activity involves a series of acts like receiving orders from customers, interacting with production regarding capacity to produce, giving commitment to the customer regarding delivery time etc. Thus any activity can comprise of one or more of tasks which are associated with one another to accomplish a goal or objective. Examples include: materials handling, store keeping, purchasing, inspection, despatch, assembly, setup, maintenance and so on. This ensures aggregation or grouping of common activities and elimination of immaterial activities. Activities are categorized into primary activities and support activities. The main activities can be categorized into the following:
Step 3: Identify Non-value Adding ActivityThere are a large number of activities which continue to be carried out particularly in certain old factories, which do not contribute to the value of a product. The identification of non-value adding activities in the production process will help in focusing the attention for elimination. Step 4: Identification of Activity Cost PoolsCIMA official terminology defines Cost Pool as ‘the point of focus for the costs relating to a particular activity in an activity based costing system’. Under ABC, costs are grouped into pools, according to the activities which drive them e.g. a cost pool may be of procurement of goods, in this all costs associated with ordering, inspection, storing etc. would be included in this cost pool. Cost pools are similar to cost centres in traditional cost systems. Costs are pooled or collected on the basis of activity that drives the costs regardless of conventional departmental boundaries. The activity cost pool is the total cost assigned to an activity. It is the sum of all the cost elements assigned to an activity. Step 5: Selection of Activity Cost DriversCIMA official terminology defines a Cost Driver as ‘any factor which causes a change in the cost of an activity e.g. the quality of parts received by an activity is a determining factor in the work required by that activity and therefore affects the resources required. An activity may have multiple cost drivers associated with it’. The next step in ABC system is to identify the factors which determine the costs of an activity. These are called as ‘cost drivers’. Cost drivers are used to trace costs to products by using a measure of resources consumed by each activity. Cost drivers can be defined as those activities or transactions that are significant determinants of cost. Cost driver is a factor that determines the work load and effort required of an activity and the resources needed. An activity may have multiple cost drivers associated with it. Cost driver explains why an activity is performed and how much effort is extended to carryout the work. Cost drivers are useful because they reveal opportunities for improvement. Working to reduce the negative effects of cost drivers can yield important gains in efficiency. The following are examples of cost drivers: (a) the number of purchase orders drives cost of the purchasing activity. (b) the number of goods received notes drives the costs of material receiving activity. (c) the number of items in stock drives the costs of warehousing. (d) the number of sales invoices drives the costs of the sales, despatch and sales ledger activities. A cost driver is an activity which generates cost. ABC system is based on the belief that activities cause costs and that a link should therefore be made between activities and products by assigning cost of activities to products based on an individual products demand for each activity. A single representative activity driver can be used to assign costs from the activity cost pools to cost objects. Such linking of total costs to cost objects is generally based on the activity driver rate. Step 6: Tracing of Costs with Cost ObjectsCost object is the final point to which costs are traced. The cost objects are linked to the objective of the organization. Cost object is the reason for performing an activity. Cost objects include products, services, customers, projects and contracts. The cost object enables to identify the activities required to produce products etc. Direct costs like materials and labour are easily assigned directly to cost objects. The indirect costs are indirectly assigned to the cost object via cost pools and cost drivers. It involves the tracing of cost of activities to products according to a product’s demand for each activity. It requires to establish the demands made by a particular product on activities, using the cost drivers as a measure of demand. ABC is the process of tracing costs first from resources to activities and then from activities to specific products. Step 7: Staff TrainingThe cooperation of the work force is critical to the successful implementation of ABC. Staff training should be oriented to create an awareness of the purpose of ABC. The need for staff cooperation in the concerned team effort for mutual benefit must be emphasized throughout the training activity. Step 8: Review and Follow-upThe 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 ActivitiesA value added activity is an activity that customers perceive as adding usefulness to the product or service they purchase. In other words, it is an activity that, if eliminated, will reduce the actual utility or usefulness which customers obtain from using the product or service. For example, painting a car in a company manufacturing cars or a computer manufacturing company making computers with preloaded software. A non-value added activity is an activity where there is an opportunity of cost reduction without reducing the product’s service potential to the customer. In other words, it is an activity that, if eliminated, will not reduce the actual or perceived value that customers obtain by using the product or service. For example, storage and moving of raw materials, reworking or repairing of products etc. Value-added activities enhance the value of products and services in the eyes of the organization’s customers while meeting its own goals. Non-value added activities on the other hand do not contribute to customer-perceived value. 4. Cost Pools and its Cost DriversThe important Cost pools and its Cost drivers are given below:
Difficulties in adoption of ABC in Service OrganizationFacility sustaining costs (such as property, rents etc.) represent a significant portion of total costs and may only be avoidable if the organization ceases business. It may be impossible to establish appropriate cost drivers. It is often difficult to define products where they are of intangible nature. Cost objects can therefore be difficult to specify. Many service organizations have not previously had a costing system and much of the information required to set-up a ABC system will be non-existent. Therefore, introduction of ABC may be expensive. Illustration 1 The following details have been recorded for 4 batches made in a period
Cost drivers have been identified for the cost pools as follows:
The following cost driver volumes were recorded for the batches:
Required: (a) The batch and unit costs using traditional costing based on a labour hour overhead absorption rate (b) The batch and unit costs using ABC (c) Compare the costs in (a) and (b) (d) Comment on the likely position if the firm uses cost-plus pricing. (a) Batch and unit costs using traditional overhead absorption based on labour hours.
(b) Batch and unit costs using ABC with various cost drivers Calculation of Cost Driver Rates
Batch unit costs using ABC
(c) The unit costs compared
It will be seen that in this example there are significant differences between the costs using the two systems. Batch C’s costs are broadly the same but the costs of Batch B and D are much higher using ABC, whereas Batch A is lower. Study of the usage of support overheads by the batches shows that batches B and D have a higher relative usage of resources so incur greater overhead costs using ABC. Because the traditional method absorbs overheads on labour hours these differences in usage are effectively ignored. It is this feature which, admittedly, makes product costs more realistic when ABC is used. (d) Cost-plus pricing is a pricing method where a margin (say 40%) is added to costs to produce the selling price. Cost-plus pricing is widely used in many jobbing and batch production firms. If the firm in the example uses cost-plus pricing then the quoted selling prices will differ considerably depending on whether the traditional or ABC method was used to calculate costs. If it is accepted that the ABC costs are the more realistic then serious errors in pricing may occur if the traditional costs were used as the basis. This would mean that, based on traditional costs, Batch A would be overpriced and Batches B and D underpriced. In effect, if pricing decisions were based on the less realistic costs then Batch A products would be subsidizing Batch B and Batch D products and, in the long-run, the firm would tend to receive more orders for the underpriced B and D products. This would be likely to lead to declining profits as these products place relatively higher demands on resources which should be reflected in higher prices. 5. Advantages and Limitations of ABCAdvantages of ABC
Limitations of ABC
6. ABC System and Corporate StrategyABC is an accounting methodology that assigns costs to activities rather than products and services. This enables resources and overhead costs to be more accurately assigned to products and services that consume them when compared to traditional methods where either labour or machine hours are considered as absorption basis over cost centres. In order to correctly associate costs with products and services, ABC assigns cost to activities based on their resources. It then assigns cost to ‘Cost objects’, such as products and customers, based on their use of activities. ABC can track the flow of activities in organization by creating a link between the activity and the cost objects. ABC supports corporate strategy in many ways such as:
Activity Based Information and Decision MakingABC may not be appropriate for all companies, particularly those where overheads are relatively small and which do not produce a wide range of products. But many of the benefits of ABC can still be obtained by implementing a partial system which focuses only on the most important activities. Traditional methods can be used for to produce monthly profit statements, leaving ABC to support strategic decision making, profitability analysis and the control of manufacturing costs. ABC supports decision making in many ways such as:
7. Activity Based BudgetingActivity Based Budgeting (ABB) complements Activity Based Costing (ABC) by focusing on the cost activities necessary for production and sales. ABB determines the cost of performing certain activities, in contrast to traditional budgeting, which budgets cash for functional or spending categories. ABB, thus, produces a qualitative expression of the expected cost of performing various activities. To facilitate continuous improvements, the ABB process is designed to highlight opportunities for Cost Reduction and for the elimination of wasteful activities. Thus, ABB serves to reduce the workload to the minimum level necessary to achieve the organizational objectives. ABB increases the effectiveness of budgeting by identifying cost-to-performance relationships. ABB involves the following stages:
ABB, sometimes termed ‘activity cost management’, is a planning and control system which seeks to support the objective of continuous improvement. It is a development of conventional budgeting system based on activity analysis. ABB requires the identification of the activities of the organization, establishing the factors which cause costs, the cost drivers, and then collecting the costs of the activities in cost pools. Illustration 2 A purchasing department has two main activities; investigating and liaising with suppliers and issuing purchase orders. Two major cost drivers have been identified: the number of suppliers and the number of purchase orders placed. The resources and costs of the department have largely been spread over the two main cost drivers. The balance of costs have been termed ‘Department Sustaining Costs’. These include some general clerical costs and part of the manager’s costs. Based on the activity expected for the period, cost driver volumes of 270 suppliers and 1,850 purchase orders have been forecast. Using these volumes and cost analysis, cost driver units and resource item costs have been budgeted for the department after discussion with the Departmental manager. The budget is as follows: Budget for Purchasing Department
Notes: (a) The apportionment of costs to activities will, of course, be partly subjective. The object however is that the resource has to be justified in supporting one or more of the activities or the sustaining function. There is no place to hide the costs. (b) ABB highlights the cost of activities and thus encourages new thinking. (c) ABB enables a more focused view of cost control because the activity level is taken into account. Trends can be monitored and comparison with other organizations can be made. This is known as benchmarking. (d) The cost driver rates ` 150 and ` 30 are used in calculating the product costs in the Activity Based Costing system. (e) The identification of activities and their costs helps to focus attention on those activities which add value and those that do not. 8. Activity Based ManagementABC, which is now being called ‘Activity Based Management (ABM)’ used cost information generated by ABC about an activity for controlling the activity itself, rather than just using cost information of the final product. ABC is also useful in daily operation and controlling over the activities. The focus of the management is taken care by providing information regarding cost of resources supplied and cost of resources used. ABM is a further development on ABC. ABM is a discipline that focuses on the efficient and effective management of activities as the route to continuously improving the value received by customers and the profit received by providing this value. ABM utilizes cost information gathered through ABC. Through various analysis, ABM manages activities rather than resources. ABM analyzes and manages cost drivers to manage costs. In that process ABM also analyzes value added and non-value added activities in order to eliminate non-value added activities and simplify or improve upon value added activities. ABM involves:
Cost drivers link activities and resources consumption to generate less arbitrary costs for decision-making. ABM is being used for a variety of business applications such as:
Disclaimer: The content/information published on the website is only for general information of the user and shall not be construed as legal advice. While the Taxmann has exercised reasonable efforts to ensure the veracity of information/content published, Taxmann shall be under no liability in any manner whatsoever for incorrect information, if any. Which of the following is true about activityWhich of the following is true about activity-based costing? Explanation: ABC assumes that the resource-consuming activities that generate costs are activities and not outputs. ABC is appropriate for all types of cost accumulation systems, including both job order and process costing.
How does activityThe formula for activity-based costing is the cost pool total divided by cost driver, which yields the cost driver rate. The cost driver rate is used in activity-based costing to calculate the amount of overhead and indirect costs related to a particular activity.
What absorption cost system uses a volume related?Traditional absorption costing tends to focus on volume-related drivers, such as labour hours, while activity-based costing also uses transaction-based drivers, such as number of orders received.
What is activityAbsorption costing assigns costs to individual units, whereas activity-based costing focuses on company activities as a central cost and then attempts to assign indirect costs to units.
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