ACTIVITY BASED COSTING (ABC) Introduction

In any system of costing direct costs are easier to handle as these are directly changed to the end products but indirect costs are difficult to handle because they need to be allocated to the end products by following a suitable basis of allocation. In traditional costing there is no general basis of allocation of indirect costs and it is left to the judgement of cost accountant to select the most appropriate basis of allocation.

NEED FOR EMERGENCE OF ACTIVITY BASED ACCOUNTING

Traditional product costing systems were designed when most of the companies manufactured a narrow range of products. Today company produces a wide range of products. Overheads are of a considerable importance. Simple methods of apportioning overheads based on direct labour are not justified. Intense global competition calls for correct 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 apportioned on volume basis. Hence, the need for emergence of activity based costing arises.

CONCEPT OF ABC
The basic feature of ABC is its focus on activities as fundamental costs objects. It uses activities as the basis for calculating the costs of products and services.

ABC approach is used to refine a costing system to get better results . In ABC approach , the first step is to identify the activities for which costs are to be allocated and controlled. The various activities may be identified as direct activities and indirect activities. Direct activities may be taken as direct material and direct labour .Indirect costs pools may be identified as order processing, materials handling, machine insertion of parts, manual insertion of parts, repairs and maintenance, quality testing etc. The next step is the selection of suitable cost allocation base for assigning indirect costs to various activities so that all activities are suitably burdened. In activity based costing the focus of attention is an activity rather than a department. A department may have a
number of activities which may be non-value adding. Such activities are targeted in down sizing exercise activities with the help of activity based costing for better effectiveness of department.

Activity based costing (ABC) aims at rectifying the inaccurate cost information. It is modern approach of indirect cost allocation.

KAPLAN AND COOPERS APPROACH TO ABC

Kaplan and Cooper of Harvard Business School, who have developed this new approach in costing to calculate product costs, claim that the costs should be classified as long term variable costs and short term variable costs. Short term variable costs are volume related and change proportionately with the volume of production. Long term variable costs vary in long term but not instantaneously. The forces behind overhead costs are named as cost drivers. Cost drivers can be defined as those activities or transactions that are significant determinants of costs. Under ABC system, product cost is determined by obtaining a greater understanding of cost behavior and using new measures of quantity of resources consumed by each product . A cost driver is an activity which generates cost.

COST DRIVERS AND COST POOLS

ABC provides better and more accurate information and decision making on prices and product mix and for the control of manufacturing operations. The ABC technique aims at to overcome the drawbacks by cutting across conventional departmental boundaries. Costs are grouped into pools according to the activities which drive them e.g. a cost pool may be of procurement of goods.

Product Costs PRIME COSTS

Direct Material Direct Labour

Other Direct Costs

OVERHEADS
Production Administration Marketing Sales Distribution R&D

Non Product Costs

CHARACTERISTICS OF ABC
Important characteristics of ABC are as follows: Simple traditional distinction made between fixed costs and variable costs is not enough guide to provide information to design a cost system. The most appropriate distinction between cost behaviour patterns are volume(scale)related ,diversity (scope)related ,events related and time related. Cost drivers need to be identified . A cost driver is a structural determinant of cost related activity.The logic behind is that cost drivers dictate the cost behaviour patterns . In tracing overhead cost to product ,a cost behavior pattern must be understood so that appropriate cost driver must be identified.

HOW TO DEVELOP ABC SYSTEM ?

Following are the three key areas of ABC: Product cost differentiation. Activities and their cost drivers. Identification of non-value added cost.

IMPLEMENTATION OF ABC

I. II. III. IV.

The following steps are involved in implementation of ABC : Identifying the functional areas (like production, material management, quality control etc.) involved. Identifying the key activities involved in functional area. Allocating the common indirect costs to various activities in each functional area. Identifying the most suitable cost driver in each activity under functional area for better allocation of indirect costs to get accurate cost information. A cost driver is any factor that influences cost. A change in the cost driver will lead to a change in the total cost of related cost object. Preparing the statement of expenditure activitywise and comparing it with the value addition activitywise to know activities which are to be eliminated or need improvement for better performance of the organization.

V.

SUITABILITY OF ABC SYSTEM

From the above discussion of the system , it can be concluded that ABC system is suitable: a. When there is acute competition and there is urgent need of reduction in cost to sell the product at most competitive price. Intense global competition calls for correct costing products to avoid errors in fixing selling price. b. When overheads are of considerable importance and simple methods of apportioning overheads based on direct labour are not justified. c. When non-volume related activities like material handling , production set-up, quality control etc. are important and their cost cannot be suitably apportioned on volume basis.

BENEFITS OF IMPLEMENTING ABC

There are several benefits that can be derived from ABC system in gaining competitive advantages .It can be understood in the form of the following figure:

Which product should we promote? Analyze the profit contribution & impact of inter relationship of product services .

What prices should we set? Identify the true cost / profitability of products & services.

GAINING COMPETITIVE ADVANTAGE.

Which customers are profitable & why? Identify the true cost/profitability of customers or types of customers.

How should performance?

Identify /responsibility behaviour.

we

measure

Which distribution should we follow?

channels

accountability for cost

Analyze the cost & performance of alternative distribution channels.

HOW ABC STRATEGY ?

SYSTEM

SUPPORTS

CORPORATE

ABC supports corporate strategy in many ways such as:

ABC system can be helpful to the management by furnishing data at the operational level and strategic level. Accurate product costing will help management to compare the profits that various customers, product lines, brands or regions generate and to decide on pricing strategy , dropping unprofitable products, lines etc. Information generated by ABC system can also encourage management to re-design the products for improving their quality. ABC analysis helps managers focus their attention and improving activities. ABC system provides accurate information on product costs which enables better decisions to be made on pricing, marketing, product design and product mix. The cost driver rates established by ABC system can be used to measure activity performance and efficiency and provide a more suitable basis for budgeting.