An assignment

On

ACTIVITY BASED COSTING

Subject: MCIS

Date: 26/07/2008

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CONTENTS

Sr.No TOPICS Page .No1. Introduction to Activity Based Costing 32. Reason for Introduction of ABC 43. Activity Based Costing 53. Methodology & Implementation 114. Benefits of ABC 125. Limitation of ABC 136. Case study 147. Conclusion 178. Reference 17

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Introduction to Activity Based CostingManagement principles have undergone drastic changes over the last century and will continue to change. Organizations in all sectors are adding new dimensions to their management practices. ABC is one such new dimension. It accurately estimates the true cost of products, services, processes, customer segments, distribution channels by assigning cost to activities with the help of cost drivers. It improves the organization’s work processes and activities efficiently and effectively. ABC provides the fruitful information to the management as value analysis, cost drivers, etc.

These days, a new term ‘activity based costing’ is growingly used. It is necessary to view this term in the context of job costing and process costing. Job costing and process costing are the two basic methods of cost accounting. ABC is not a distinct method of costing like job costing and process costing. It is only a new practices or intermediate change in the process of attribution of costs to job or processes. Earlier cost were first collected for production department and service departments and finally cost the cost of production departments were absorbed by jobs or processes. Now in the context of ABC, the cost are collected according to activities such as material ordering, material handling, quality testing, machine set-ups, customer support service, etc. and jobs and process for which cost collection is being attempted are loaded with costs of these activities rationally.

In layman's terms, Activity-Based Costing (ABC) is a method for estimating the resources required to operate an organization's business processes, produce its products and serve its customers.

In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives.

Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.

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Reason for Activity Based Costing

Following are the factors, which led to the development of ABC.

Traditional costing fails to capture cause and affect relationship.

Traditional costing often fails to highlight inter- relationship among activities in different departments.

Growing dissatisfaction among the working executives regarding traditional costing which is based on averages and estimation.

Traditional costing systems are driven by the need to value stocks rather than to provide meaningful product cost.

Direct labour has shrunk as a percentage of total cost for majority of manufacturing companies. Still it is most common basis of over-loading overheads to products.

Overhead costs are not long a mere burden to be minimized. Overhead functions such as product design, quality control, customer service, production planning and sales order processing are as important to the customer as physical process on the shop floor.

Complexity has increased. Product ranges are wider. Product cycles are shorter and demand for quality is higher.

Market place is very competitive.

Availability of computer has enhanced requirement for improvement in information- gathering technology for advanced decision making o gain competitive advantage.

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Activity Based Costing

ABC is an economic model that identifies the cost pools or activity centers in an organization and assigns costs to cost drivers based on the number of each activity used. Since the cost drivers are related to the activities, they occur on several levels:

1) Unit level drivers which assume the increase of the inputs for every unit that is being produced.

2) Batch level drivers which assume the variation of the inputs for every batch that is being produced.

3) Product level drivers which assume the necessity of the inputs to support the production of each different type of product.

4) Facility level drivers are the drivers which are related to the facility’s manufacturing process.

Users of the ABC system will need to identify the activities which generate cost and then match the activities to the level bases used to assign costs to the products. While using the ABC system, the activities which generate cost must be determined and then should be matched to the level drivers used to assign costs to the products.

Below Figure shows an ABC model. In this model, costs are assigned to either products, customers or infrastructure. While ABC can allocate overheads more accurately, some costs will always be solely attributable to the functioning of the organization itself.

Figure 1: Activity Based Costing Model

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There are two fundamental components of ABC: costs and activities. Each of these components is briefly discussed below. Costs are based on resources or inputs, for such items as personal services, materials, office supplies, equipment, and the like. The second major component of ABC is activity. Activities are the steps or sequences of actions that convert inputs to outputs. Activities have a set of three distinct characteristics that define them. Every activity has 1) inputs, 2) a sequence of actions in the middle that occupies a period of time, and 3) an output. An output may be something other than a product or service, e.g., a student graduating with a specific set of skills, and a certain level of competencies and knowledge.

Activity-Based Costing recognizes a hierarchy of operations. Each level in the hierarchy is an aggregation of the levels below it. Agencies will define an activity at a level deemed appropriate for the costing objective to be achieved. The most difficult part of analyzing costs is framing the activity at the most appropriate level of detail to satisfy the costing objective. The amount of detail should be no greater than required for the purpose for which the data are to be used. For example, Accounts Payable could be identified as an activity and costed. Or, Accounts Payable could be split into smaller activities such as receiving invoices, cutting checks, and mailing checks. Or the activity to be costed could be framed at a level well above Accounts Payable, so that Accounts Payable was only one small aspect of the larger activity.

Detailed cost information on activities benefits operational managers and assists them in improving operations. Summary cost information on activities provides information for program managers for budgeting and other purposes. Simply increasing awareness of costs and the cost structure of your operation can lead to efficiency improvements and greater cost discipline. You need to identify the activity consistent with your costing objective. Another way to identify the

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costing objective is to ask why you are doing the ABC. What is the business need for the information?

The keys are flexibility and adaptability. Be sure your costing objective is determining the way to define your activity for ABC purposes.

Why do you need ABC? What is your costing objective? Are you getting ready to establish rates to recover your costs of providing a service? If so, you will need total costs to facilitate your rate setting objective. Will you be preparing a managed competition bid or looking to outsource or privatize a service? If so, you will need total costs, less unavoidable costs (such as the Department Director) to achieve your costing objective. What about service redesign or process improvement? If you are undertaking a service redesign or process improvement project, you will need comparable costs of the existing process and the redesigned or improved process to see if you achieved a cost saving. Are you getting ready to prepare an activity based budget to submit for? Then you will need budgeted estimated costs at the activity level. A summary of the business and costing objectives follow:

Business Objective Costing Objective

Rate or Fee Setting Total Costs(all direct and indirect costs)

Managed Competition Avoidable Total Costs(all direct and indirect costs less

those costs that would not be avoided if the activity was outsourced)

Cost Awareness Process Improvement

Reengineering Benchmarking

Comparable Costs(a flexible concept: those costs that are most easily determined; costs over which the work unit has the most control; direct cost total that can most

easily be compared to other providers' direct costs)

Activity Based Budgeting Budget Estimates

Some of these reasons for performing ABC require a greater degree of exactness than others. And the chart above is not exhaustive. You may have other reasons to do ABC. The important point is to tailor your ABC to your business objective. Tailoring is important so that you achieve the level of accuracy and precision that you need, but do not waste resources by going further than needed. In balancing these demands, you should also be mindful of the ongoing data gathering and tracking requirements of your ABC. An ABC system that is too complex or cumbersome will not be used.

ABC costing assigns resources (inputs) that are consumed (activities) to produce certain outputs (counts of what was produced). ABC assigns or allocates costs to activities based on some rationale. Costs are assigned to activities based on the activities' consumption of resources. Activity costs are then assigned to outputs based on their use of activities. This is known as the cost assignment or cost view. For example, salaries, material, and equipment are assigned to

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various activities to determine the costs of the activities that are then divided by activity outputs to derive cost per unit of output.

ABC also provides an opportunity to understand how resources are expended to achieve results. The ABC process allows personnel to view the flow of tasks within an activity to understand how results and service quality are achieved. A task by task flow chart or outline of the activity allows deeper insights into how an activity works. This concept is called the "activity view." This view looks at the activity from the customer's or stakeholder's perspective. This view explains the why or why not of an activity's timeliness, accuracy or cost effectiveness and identifies how much was performed (number of units produced) as well as the inputs and efficiency of the activity. Activity performance measures of input, output, efficiency and service quality are aligned to the program results measure. The activity view feeds into Activity Based Management and leads to process improvement, service redesign, or other ways to continuously improve activities or processes.

The focus of ABC is on activities and their outputs/results. Activity based cost data provides more informative reports than the traditional line-item or organizationally based accounting

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reports produced by current accounting systems. These traditional reports provide important information for the line item or organizational framework they were intended to address. Activity-based costing however cuts through or supplements the traditional costing reports to mirror what was actually done. It presents the same information by activity to see how the resources are spent. ABC shows what it actually costs to produce a given output or result. ABC also directly links service levels with costs through unit costs.

Seeing the cost data in this form usually leads to action. Sometimes, viewing ABC data is the first time program managers and program staff have seriously considered costs. This awareness alone often leads to cost cutting or reallocations from less to more productive resource use.

Another common response is an analysis of spending. ABC data makes it easier to see that some parts of the activity add more value to the results for less cost or vice versa. These cues naturally lead to process improvement and reengineering changes.

Comparing unit costs across different groups doing the same tasks, or across regional offices, leads to the obvious question: Why are there differences? Again, the answers to that question often lead to greater efficiencies and effectiveness as the operations with the best data share their best practices with the other groups or offices. Similarly, comparing unit cost information with comparable data from other public or private sector partners allows us to benchmark our

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performance. That benchmarking too supports process improvement, reengineering, and other decision making.

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Methodology & ImplementationFor Implementation of Activity Based Costing in any firm, following procedure should be adopted so that it can be skillfully implemented with excellent results.

Identify Resources Identify Activities Identify Cost Objects Define Resource Drivers Define Activity Enter Resource Costs Enter Resource Driver Quantity Enter Activity Driver Quantity Calculate Costs

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Benefits of ABCFollowing are Advantage of Activity Based Costing:

It helps understanding the behavior of overhead costs and their relationship to products, services, customers and market segments.

It helps to allocate the resources to those activities that will increase shareholders value.

It links profitability analysis to operational decisions.

It ensures that the cost of non-value added activities is visible to management.

It provided the right information for performance measurement because it focuses on activities rather than resources.

The understanding of the cost driver for each activity gives better control over the factors that cause costs.

It provides accurate information on profit margin and performance measurement for profit improvement.

It gives businesses an opportunity to improve their competitive position through better information’s.

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Limitation of ABCFollowing are the Limitation of Activity Based Costing:

It is essentially not the panacea for all ills.

It absorbs a lot of resources.

It may lead to weaker customer segmentation.

It takes no account of opportunity cost.

Too much emphasis on customer viability can lead to problems such as cheaper products and, therefore, potentiality lower sales.

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Case study- ABC in Indian Retail Sector

The retail sector is based on customer-supplier network called as Supply Chain. It is growing by leaps and bounds. The retail sector, particularly in food and grocery, clothing and textiles, consumer durables, jewellery and watches, home décor and furnishing, beauty care and other constitute a major chunk of the market. The retail sector movement from local mom and pops shop, i.e., kirana wala to Hyper Market, Super Market, Departmental Stores, Exclusive Outlet, Discount Stores, Cash-n-Carry, and Pick-n-Pay makes it versatile. Some of the major Challenges which the retail sector is facing are:

Competition Technology Movement Mall revolution Private label brands Collaboration with manufacturers Managing sourcing Innovative retail format Cost competition

In view of these challenges, it is imperative to consider the following functional areas in the retail sector for identifying the activities:

Logistic Movement Effective branding and labeling Material management Stores management Production scheduling and management Quality control management Repairs and maintenance R & D Administration Personnel Management Accounts Secretariat Public Relations Finance & Fund raising Marketing Management Sales managaement Import Export

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Retail giants like Reliance Fresh, Spencer’s, Subhiksha, Pantaloon Retail (India) Pvt. Ltd., Vishal Mega Mart, MORE, Shoppers Stop, Hyper City and Easy Day are following the directional path of ABC as a tool to reduce their costs by identifying functional areas and their activities as well as cost drivers related to them. CEO of Pantaloon Retail Kishore Biyani has made a tremendous growth in FMCG segment by emphasizing the ABC concept.

Figure: The Strategic Move Adopted by the Retail Sector

The activities in various functional areas of the retail outlets are explained below:

Functional Areas Activities Involved Cost DriversMaterial Management Receive of Indent Number of Indents

Follow of Delivery Number of IndentsInspection of materials Number of Indents

Store Management Physical custody of materials Number of times custody tookInspection and verification Number of times inspected

Production Recording of materials consumption for each batch of consumption

Number of cost drivers required

Quality Control Testing the finished goods as per standard

Number of batches produced

R & D Innovations ideas for new Time Spent for development

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Customer Expectation

Cost Price Leadership

Activity-Based Costing

Functional Areas

Activities

Cost Drivers

Competitive Advantage

Manage Business Process

Value Delivery

Building Brand Image

Manage Product Portfolio

product timesAdministration Canteen Number of People took meals

Watch & Ward Number of Security involvedPersonnel Training Number of employees

Regular Increment Number of employeesAccounts (Finance) Sales Accounting Number of people

Wages Accounting Number of people engagedSalary Accounting Number of StaffBill passing of Miscellaneous Value of purchase

Public Relations Issue of Corporate brochure Time SpentAdvertisement in trade journal Time Spent

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ConclusionActivity Based costing is a managerial costing tool that traces the resources costs to activities and assigns cost-based upon the drivers. In the retail sector by identifying various activities and their cost drivers in functional areas, cost control can be undertaken for each activity. It will help in joint problem solving, information-sharing diversified customer supplier network and cost price leadership. It also helps to improve decision-making at operating and strategic levels. So the implementation of ABC is a management philosophy adopted by the retail secor.

References1. The Accounting World – ICFAI Journal2. Basics of Cost and Management Accounting – V.K.Saxena & C.D.Vashist3. Internet.4. Economic Times

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