MBF

2005

ACTIVITY BASED COSTING

Submitted in the partial fulfillment of the requirement by

THE INSTITUTE OF COST AND WORKS ACCOUNTANTS

OF INDIA

Under the Guidance of: Submitted by:

MR. INDER KUMAR ABHISHEK AGGARWAL

AICWA REGN. NO. : - NRS/002597

Dy. MANAGER (Finance) ENROLL. NO. : - N/NFR/1122
H.E.E.P., B.H.E.L
Ranipur, Haridwar
Uttaranchal
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DECLARATION

I hereby declare that the study entitled “ACTIVITY BASED COSTING” added
in the context of H.E.E.P., BHEL; HARIDWAR being submitted by me in the
partial fulfillment of the requirement by The Institute of Cost Works Accountants
of India is a record of my own work. The study was conducted in finance
department of H.E.E.P., BHEL.

The matter incorporated in this project report has not been submitted to any other
university or institution for the award of degree.

ABHISHEK AGGARWAL
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CERTIFICATE

This is to certify that the study entitled “ACTIVITY BASED COSTING”

has been carried out at ‘HEEP’ (Heavy Electrical Equipment Plant) of BHEL,
Ranipur, Haridwar Unit by Mr. ABHISHEK AGGARWAL under my guidance.

This ‘dissertation’ explains the demerits of the conventional costing and

problems arising in allocation of the indirect cost when company is engaged in
manufacturing of more than one product and suggest ‘Activity Based Costing’ as a
method to be used to identify and describe cost objects and terminology used
therein in a manner that would prove beneficial to the first time users and all
readers.

INDER KUMAR
AICWA
DY. MANAGER (FINANCE)
HEEP, BHEL,
HARIDWAR
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ACKNOWLEDGEMENT

Behind every study their stands a myriad of people whose help and
contribution make it successful. Since such a list will be a prohibitively long, I may
be excused for important omissions.

The guidance, help and co-operation of my supervisor Mr.Inder Kumar,

Dy. Manager, (Finance), is gratefully acknowledged with profound gratitude.

I have been benefited from discussion with Mr. Subodh Gupta, Dy. General
Manager (finance). I am also thankful to all others in Finance Department,
H.E.E.P, BHEL, Hardwar, Who provided me with all the required information for
my project.

CONTENTS
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About The Organization………………………………………………..

 Introduction to Activity Base Costing…………………………….

Necessity of Cost Accounting…………………………………………..

Conventional Costing……………………………………………………
Activity Based Costing…………………………………………………..
 Background………………………
What is ABC……………………….
 The Linkages………………………
 Objectives……………………………
 Framework…………………………
 Assumptions…..……………………
 Methodology……………………….
 Stages of ABC….……………………
 Cost Assignment views………….
 Traditional Vs ABC….…………..
 Key Terminology of ABC.……….

 Why are the Activities so important for analysis ……………..

 Activity Based Management – It’s Purpose and Benefits……

 Current Malpractice……………….
 The ABM Approach………………..…
 ABM and Marketing………………..
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BHARAT HEAVY ELECTRICAL LIMITED-
A CORPORATE GIANT

BHEL was established nearly 40 years ago to become the most important symbol of
Heavy Electrical Equipment industry in India and rank amongst the first few in
world. It is the largest heavy engineering and manufacturing enterprise of its kind in
India with well- recognized track record of performance, making profits continuously
since 1971-72.The Company achieved a turnover of Rs.105200 Million and Profit
before Tax Rs. 16060 Million. BHEL caters to core sector of Indian economy viz.
Power Generation and Transmission, Industry, Transportation, Telecommunication,
Renewal Energy Defense etc. The wide network of BHEL’s, 14 manufacturing
divisions, 4 Power sector regional centers, over 150 project site and service centers
and 15 regional offices enable the company to be closer to its customer and provide
them with suitable products, system and services at competitive prices. Having
attained ISO 9001, 14001certification, BHEL is now on its journey towards TQM
.The Company inherent potential coupled with its strong performance over the years
has resulted in it being chosen as on of the Navratna PSUs which enjoy the support
from the government their endeavors to become global players. with its prudent
financial management. BHEL occupies an all-important niche as evident by its
ranking by CII amongst top eight PSUs based on financial performance. Recently in
survey conducted by business India, BHEL has been rated as 7th Best Employer in
India.
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HEAVY ELECTRICAL EQUIPMENT PLANT, HARDWAR:

Heavy Electrical Equipment Plant, Hardwar of this Multi-unit corporation with its
7467 strong highly skilled technicians, engineers, specialists and professional experts
is the symbol of Indo Soviet and Indo German Collaboration. It is one of the four
major manufacturing units of the BHEL With turnover of 1400.25 crores and PBT of
Rs. 180.35crores. HEEP is engaged in the manufacture of Thermal and Nuclear Sets
up to 1000MW, Hydro Sets up to HT Runner dia 6300mm, associated Apparatus
Control gears, AC& DC Electrical machines and large size Gas Turbine of 60-200
MW. HEEP Hardwar contributes about 44% of India’s total installed capacity for
power generation with total capacity of Thermal, Nuclear & Hydro Sets of over
45000MW currently working at a Plant Load Factor of 76% and Operational
Availability of 86%..

HISTORICAL PROFILE:

The construction of heavy electrical equipment Plant commenced in Oct.”1963”after

indo-soviet technical co-operation agreement in Sept.”1959”The first product to roll
out from the plant was an electric motor in January 1967.This was followed by first
100 MW Steam Turbine in Dec.1969and first 100MW Turbo Generator in August
1971.The plant’s “break even” was achieved in March 1974.BHEL went in for
technical collaboration with M/s Siemens, Germany to undertake design and
manufacture to large size thermal sets Upto a unit rating of 1000 MW in the year
1976.First 200 MWTG set was commissioned at Obra in 1977.The continuum of
technological advancement subsequently saw the commissioning of 500 MW TG Set
in 1984 .The technical cooperation of Gas Turbine manufacture was also signed with
M/s Siemens Germany. First 150 MW ISO rating gas Turbine was exported to
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Germany in Feb”1995”.Our 250 MW thermal set up at Dahanu Plant of BSES made
a history by continuous operation for over 150 days and notching up a record plant
load factor greater than 100%.

KEY COMPETITORS:

Power Sector Giant of the World viz. Siemens Germany, ABB, General electric of
USA etc. are the major competitors of HEEP. All these are the MNC’s and enjoy
huge financial and R&D backup.

CORPORATE CITIZEN:

HEEP Hardwars Strategic plans and its policy & strategy are commensurate with
BHEL Corporate / strategic Plan . As first PSU to adopt Corporate Planning as a
process . Board meetings for long –range development , BHEL has always guided
other PSU’s in their Corporate planning process .Board meeting , monthly
Management Committee meetings, Annual Revenue Budget exercise , Mid term
reviews , Apex TQ council reviews, Personnel Heads Meet, Quality Heads Meet ,
Technology Meets , Product committees meetings, Inter-Unit Quality Circle Meets
etc. are the some of crore strengths of BHEL Corporation’s vast network.

COMPANY'S BUSINESS MISSION AND OBJECTIVES

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BUSINESS MISSION
**********************

To maintain a leading position as suppliers of quality equipment, systems and

services in the field of conversion of energy, for application in the areas of electric

power transportation, oil and gas exploration and industries. Utilize company's

capabilities and resources to expand business into allied areas and other priority

sectors of the economy like defence, telecommunications and electronics.

BUSINESS OBJECTIVES
************************

GROWTH:-

To ensure a steady growth by enhancing the competitive edge of BHEL defence,

telecommunication and electronics in existing business, new areas and

international operations so as to fulfill national expectations from BHEL.

PROFITABILITY:-

To provide a reasonable and adequate return on capital employed, primarily

through improvements in operational efficiency, capacity utilization , productivity

and generate adequate internal resources to finance the company's growth.

CUSTOMER FOCUS:-

To build a high degree of customer confidence by providing increased value for his

money through international standards of product quality, performance and

superior services.
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PEOPLE- ORIENTATION:-

To enable each employee to achieve his potential, improve his capabilities,

perceive his role and responsibilities and participate and contribute positively to

the growth and success of the company. To invest in human resources

continuously and be alive to their needs.

TECHNOLOGY:-

Achieve technological excellence in operations by development of indigenous

technologies and efficient absorption and adaptations of imported technologies to

suit business need and priorities and provide the competitive advantage to the

company.

IMAGE:-

To fulfill the expectations which stakeholders like government as owner,

employees, customers and the country at large have from BHEL.

UNITS OF BHEL

 HEAVY ELECTRICAL EQUIPMENT PLANT

HARDWAR DIVISION.

 CENTRAL FOUNDARY FORGE PLANT

HARDWAR DIVISION.
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 HEAVY POWER EQUIPMENT PLANT

HYDERABAD DIVISION.

 HIGH PRESSURE BOILER PLANT

TRICHY DIVISION.

 HEAVY ELECTRICAL PLANT

BHOPAL DIVISION.

 TRANSFORMER PLANT

JHANSI DIVISION.

 ELECTRONICS DIVISION,

BANGLORE.

 INDUSTRIAL VALVES PLANT,

GOINDWAL.

 BOILER AUXILIARIES PLANT,

RANIPET.

 ELECTRO PROCELAIN DIVISION,

BANGALORE.

 INSULATOR PLANT,

JAGDISHPUR.

 COMPOMENT FABRICATION PLANT,

RUDRAPUR.

 COMPONENT FABRICATION PLANT ,

RUDRAPUR

 HEAVY EQUIPMENT REPAIR PLANT , VARANASI .

PRODUCT PROFILE
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PRODUCT CAPACITY RATINGS

* Thermal Sets Upto 1,000 MW

* Hydro Sets Maximum hydro runner

Turbine diameter 6,600 manufacturing

Upto 115 MW

* Gas Turbines 60,200 MW 150 ratings

* Light Aircraft Two Seater

* AC / DC Machines 5, 20,000 KW

* Apparatus and Control Gears to match with the power equipment

* Steam Turbines for combined various combinations

Cycle power plant

* Heat Exchangers / condensers Manufacturing Upto 800 MW ratings

* Medical Equipment Linac (for cancer treatment)

* Super Rapid Gun Mount Naval Guns

KEY CUSTOMERS AND SUPPLIERS

The Power supplier of the country National Thermal Power Corporation, NHPC,
NPC, and other IPPs and various State electricity Boards, are the key external
customers of HEEP Hardwar. HEEP has a long standing-relationship with its
customers. Power Sector-Regions, Power Sector Technical Services and other sister
unit of BHEL are the key Internal customers. Manufactures of Casting and Forging,
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ETS, Steels including alloy steels, component of the product non-ferrous and
insulating materials, equipment etc. are its suppliers. Some of the key suppliers are
Collaborators M/s Siemens Germany, sister unit CFFP, SAIL, near by Ancillaries
developed by BHEL etc. To further strengthen the relations, one to one long term
cooperation meetings are being held by BHEL with its 200 major suppliers on regular
basis.

MAJOR MILE STONES

1975 Job Redesign concept launched for FIRST time in India.

1978 Well documented Suggestion Scheme launched.
1982 Launched Productivity Movement & Quality Circle. Concept
1993 Accreditation of ISO 9001 quality System.
1995 Adopted EFQM model of TQM for achieving Business
Excellence.
1997 BHEL one of the 9 PSE’s declared “Navratna” by Govt. of India.
1997 National Productivity Award for HEEP by the President of India.
1998 Certificate of Merit by National Productivity Council for
Outstanding performance for 2nd consecutive year.
1998 Accreditation of U stamp.
1999 Accreditation of R Stamp from National Board of Boiler and Pressure Vessel
Inspector, USA.
1999 AD-Merkblatt HPO Recertification by RWTUV for Gas Turbine Combustion
Chambers
1999 INSAAN Award for Excellence in Suggestion for 9th consecutive year
1999 Launching of 5s concept
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1999 PCRI recognized as Environmental Lab by Haryana State Board for
Prevention and Control of Pollution
1999 Accreditation of ISO 14001-Enviornment management system
2000 CII Site Visit for CII-EXIM Business Excellence Award-2000
2001 Top Management TQM Workshop at Rishikesh and HRDC
2001 INSAAN Award for excellence in Suggestion for 11th consecutive year
2001 Launching of QTM & RCA at HEEP Hardwar by CMD
2002 Launching of delivery Index, Turnover Index and Manufacturing Index
2002 Accreditation of ISO 9000-2k
2002 JBE Workshop of Apex TQM Group at Tehri to evolve Business policy
and CSF

TOTAL QUALITY FOCUS:

To face the increased competition from MNC’s (due to liberalization policy of
Government) in early 90’s and to enter European market we moved towards ISO
9000 Certification. Concept of Business Excellence through EFQM Model was
launched in entire BHEL on pilot scale in Oct.”1995” In 1997 HEEP launched TQM
in the entire Plant and since then Self-Assessment is done every year in September.
Based on feedback Report of Assessment, critical success factors are identified and
TQ action plans are drawn. The philosophy of ISO 9001 ,TQM and ISO 14001 has
been integrated BHEL Hardwar for ultimately achieving “BUSINESS
EXCELLENCE”.HEEP Hardwar plant is accredited for ISO 9001 and ISO 14001
and is now on march towards TQM.5-S was launched in March 1999 in a big way
and now it has become a way of life in the organization. In 2000 HEEP applied for
CII-EXIM Business excellence award and site visit was conducted but CII team in
Seot.”2000.Cii feedback has gone a log way in carrying out further improvement
plans and giving a structured thrust to TQM movement
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In July 2001, Unit’s TQ Council reviewed the TQ Action Plans 2001-02 for its
effectiveness and impact on accelerating the pace of improvement and consequent
TQ Score. Executive Director laid the challenge of achieving the TQ score of
650.With an objective to bring awareness about he CII-EXIM Business Excellence
Model amongst the Sr. Executives, the first ‘Top Management TQM Workshop’s
held at Rishikesh during oct.2001Executive Director who is TQ Assessor also,
himself steered the Workshop with assistance from some experienced TQ Assessor of
HEEP. It followed by second Top Management TQM Workshop steered again by Ed
was held at HRDC on Oct’29,2001.Subsequantly the third Top Management TQM
Workshop was held in Nov’2001,where-in Sr. Counselor, CII deliberate the detail on
Best practices of TATA STEEL-the winner of ‘CII-EXIM Business Excellence
Award 2000’.Simultaneously ,TQ Assessors training program for the select group of
young managers(to be developed as Think Tanks)was organized in Nov’2001.To
give further boost Apex Group was formed. Apex Group developed “Roadmap to
Business Excellence” based on Criteria Linkage of CII-EXIM Business Model and
the initiatives taken at Hardwar was drawn by the group and it was widely circulated
amongst the employees through special issue of Hardwar Current in April 2002. To
be a responsible corporate citizen and to meet exacting international standards in
occupational health, safety and environment, BHEL continued re-certification of all
its units/ divisions for OHAS-18001 Occupational Health and Safety Management
System as well as ISO-14001 Environmental Management System. BHEL' journey in
Total Quality Management (TQM) received a boost when all Four major division
of BHEL viz. Trichy, Hardwar, Bhopal and Hyderabad along with Power Sector
Northern Region received the coveted CII- EXIM commendation certificates.
Other significant achievements included:
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- 'IMC Ramakrishna Bajaj National Quality Award 2004' to BHEL's Ranipet
plant making it the first PSE to win this award.
- BHEL's Hyderabad plant was adjudged the 'Best Organization in promoting
Quality Circles' for the second consecutive year by QCFI chapter convention.
For contribution to the Renewable Energy sector, the SESI2004: PVSEC Award
for Applications', was conferred on BHEL's Electronics Division, by solar Energy
Society of India.

BUSINESS POLICY:

“In-line with Company’s Vision, Mission and values, we dedicate ourselves to

sustained growth with increasing positive Economic Value Addition and Customer
focused business leadership in the Power and Industry Sector.

CRITICAL SUCCESS FACTORS:

• Increase Orders of Spares/Services to 230 Cr.
• Decrease Capital employed by Rs. 120 Cr.
• Saving in Material Cost by 16 Cr. i.e. 5%- Rs. 4 Cr.
• Decrease in indirect material +miscellaneous expenses by 5%- Rs. 4 Cr.
• Effective implementation of QTM/RCA/CTQ
• Strengthening Internal customer concept
• Development of an Incentive Scheme
• Reward Scheme including EXCEL Awards
• Effective implementation of PMS
• Effective Contract Management
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• Technology Up gradation
‘Excellence triangle’ for each Critical Success Factor is now being drawn comprising
improvement projects. These projects will be centrally registered under On-line
Central Registration system to be developed for it. While CSF Champion will take
the total stock of position in the improvement projects undertaken in his respective
CSF, progress of individual projects will be reviewed by Area TQ Council (ATQC)
and Functional TQ Council (FTQC).

One of the major strengths of HEEP Hardwar is its free, open and consistent work
culture for making continuous improvement evident from the participation of
employees in Suggestions and Quality Circles. To recognize their efforts various
productivity drives and competition are organized through out the year and Executive
director awards the winners in the special Award Distribution Functions. The journey
to excellence is unending .It is a continuous search with commitment and
belongingness. Sky indeed is not the limit for perfection. The transition has strongly
experienced a silent internalization with a blend of commitment of the existing
human resource for creating benchmarks for excellence. The emergence of role
models and clear-cut driving force at the top provide an anvil to unleash the potential,
which remain unexplored in search of “Attitude to perform”. The surge has started
and is getting communicated down the . BHEL today through TQM is on march
towards excellence.

----------------- SWOT ANALYSIS ------------------

-S-T-R-E-N-G-T-H- (S): -
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• Low cost producer of quality equipment due to cheap labour and fully
depreciated plants.
• Flexible manufacturing set up.
• Entry barrier due to high replacement cost of its manufacturing facilities.
• Comprehensive turnkey experience from product design to commissioning.

-W-E-A-K-N-E-S-S-E-S- (W) :-

• High working capital requirement due to its exposure to cash starved SEBs
(State electricity boards).
• Inability to provide project financing.

-O-P-P-O-R-T-U-N-I-T-I-E-S- (O) :-

• High expected growth in power sector (7000 MW/ p.a. needs to be added).
• High growth forecast in India’s index of industrial production would
increase demand for industrial equipment such as motors and
compressors.

-T-H-R-E-A-T-S- (T):-

• Technical suppliers are becoming competitors with the opening up of the

Indian economy.
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Fall in global power equipment prices can affect profitability.
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Sterling Performance with new landmarks

Company scoresa double
- Turnover above Rs.100,000 Million
- Net Profit over Rs. 10,000 million.
Units 2003-04 2004-05 % Change

Turnover Rs.Million 86620 105200 21

Economic Value Added (EVA) Rs. Million 3660 5180 42

Profit Before Tax (PBT) Rs. Million 10150 16060 58

Net Profit (PAT) Rs. Million 6580 10020 52

Orders Inflow Rs. Million 164770 180160 9.34

Value Added per employee Rs. Lakhs 8.37 9.92 19

Earnings Per Share (EPS) Rs. 26.89 40.90 52

Megawatt commissioned MW 2699 4092 52

\
 Turn over at Rs 10, 5200 Million was growth of 21%on top of 16% achieved
in 2003-04 Net profits at Rs. 10,020 Million witnessed a jump of 52% over
that of 2003-04. Further, this is the highest turnover growth rate achieved in last
two decades.
 EVA at Rs. 5,180 Million up by 42% over that of Rs. 3,660 million achieved
in 2003-04
 Highest ever order inflow of Rs. 180,160 Million- while operating in
intensely competitive national & international markets. Maximum
EPC/Turnkey contracts in a year-6 out of 8 orders for thermal power projects.
 New benchmark created in execution of power projects. Ramagundam
(500MW) STPS (unit7) was synchronized in a record time of 36 months & 10
days.
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 Installed equipment performance improves further BHEL supplied thermal
sets record a new high in PLF at 75.7% - 1.4% more than the national average
and operating Availability of BHEL supplied thermal sets reaches 84.3%.
Further, of the 27 power station awarded Govt. of India's Shield for excellent
performance 23were equipped with BHEL's power generating equipment.
 B Further success in overseas business achieved with first ever export order
for 63 MW (ISO) Combined Cycle Power Plant (CCPP) in Australia. A maiden
order for mainline Locomotives from Sudan marked BHEL's entry into a new
market with new product.
 BHEL is gearing up to enhance its annual manufacturing capacity from the
present 6,000 MW to 10,000 MW by March 2007 to cater to country's
ambitious power capacity addition programme.
 To maintain R&D edge World class centers of Excellence for Computational
Fluid Dynamics and Permanent Magnet Machines established - ceating
environment in crucial technology areas. Further, India's first indigenously
developed Thyistor Controlled Series Capacitors for improving power flow and
system stability in 400 KV systems, successfully test-commissioned at
Ballabhgarh.

BHEL has maintained the momentum gained in the last fiscal and once again
recorded an excellent performance, notching up sizeable gains in all areas of its
activity and reaffirming its commitment to ' Brightening Lives & Powering
Progress'.
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ORDERS INFLOW
 During the Year, BHEL secured orders worth Rs. 180,160 Million from
domestic & overseas markets. At the end of the year, outstanding orders in hand
for execution in future, stands at over Rs. 318,000 Million- the highest ever
both in physical as well as financial terms.

INTERNATIONAL BUSINESS
 BHEL’s achieved a physical export order inflow of Rs.4,480 Million during
the year
 Several prestigious orders were secured, each one of which signifies a major
step forward towards for western consolidation in international business:
 First ever export order for 63 MW(ISO) Combined Cycle Power Plant
from Clough Australia fro western Energy Pvt. Ltd. Australia.
 Largest overseas orders for compressors- one for Lekhwair and three
for Yibal projects of Petroleum Development Oman.
 First- ever export order from Sudan for six 2200 HP & two 1700 HP
Diesel Electric Locomotives for Sudan Railways. This is the first ever export
order form Sudan as well as the maiden export order for mainline
Locomotive received by BHEL.
 First ever export order for supply and supervision of 15.3 MW STG
package from Thailand placed on BHEL Thai Carbon Black Co. Ltd.,
Thailand.
 Largest overseas orders for supply of solar cells and PV Modules to
Italy & Germany. The orders were secured from SE Projects, Italy and Iran,
Germany, further expanding BHEL's presence in the export market for
photovoltaic.
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 Continued focus on After-sales Services led to orders for spares & services
from Bangladesh South Korea, Kazakhstan, Cyprus, Oman, Sri Lanka, Malta,
Malaysia Greece and China.

CAPITAL INVESTMENT & ASSET MODERNISATION

 BHEL is implementing a phased investment programme of Rs.8000-10,000

Million aimed at enhancing its installed manufacturing capacity of power plant
equipment to 10,000 MW per annum. This should enable the company to pay a
major role in power plant capacity addition programme of country in future.

 An Investment of Rs. 1,550 Million was made under capital programme, during
the year, to enhance the competitiveness of key products/areas through
completion of ongoing modernization schemes, capacity augmentation and
replacement of ageing facilities. In addition, Rs. 390Million was spent on
refurbishment and modernization of existing machines tools for realizing better
accuracies and reliability leading to enhance productivity.

FINANCIAL PERFORMANCE

 BHEL’s notched up its highest turnover of Rs 105,200 Million, crossing the

Rs.100,000 Million figure mark for the first time compared to Rs. 86,620
Million of the previous year. The turnover growth of over 21% has been
achieved on top of 16% achieved in 2003-04. Further, this is the highest growth
rate received in last two decades.
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 The Company's Net profit (PAT) surged by 52% at Rs.10,020 Million against
Rs 6,580 Million in the previous fiscal, profit Before Tax (PBT) also rose by
58% at Rs. 16,060 Million, during the Year. An all- time high interim equity
dividend of 35% was paid for fiscal 2004-05, maintaining the track record of
paying dividends uninterruptedly for the last 29 years.

 Earning per Share (EPS) , during the year has gone up to Rs. 40.9 - an increase
of 52% over that achieved in 2003-04.

 EVA surged to Rs. 5180 Million registering an increase of 42% over that of Rs.
3,660 Million in 2003-04.

 Value Added per Employee went up to Rs.9.92 lakh from Rs.8.37 Lakh in
2003-04 and Net Asset Value (NAV) per share increased to Rs.248, from
Rs.216 in the previous year, indicating the intrinsic strength of the company.

 Total export turnover (Physical + Deemed) stood at Rs.23, 310 Million during
the year, accounting for over 22% of the company's turnover during the year.
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Sustained performance by the company became possible as a result of
strategic management with a blend of appropriate measure including
improvements in operational efficiencies, benchmarking against international
standards, prudent financial management, upgrading manufacturing facilities
and dynamic HRM policies.

Major credit rating agencies like ICRA and CRISIL have reaffirmed their
faith in BHEL's strong fundamentals and commendable performance during
the year, by retaining the highest rating for the company's debt and deposit
programmes. This also reflects the company's dominant position in the
domestic power generation and electrical equipment market.
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ACTIVITY BASED COSTING

There has been a sea change in the world of management owing to increasing
industrial competition and changing global economic scenario. In this context, a
world class company needs information that:
 Provide information about their quality of service
 Furnish information on its distribution network
 Capture the true cost of its products and or services
 Reveal how profitable its products or services are
 Identifies reasonable opportunity for improvement, and
 Encourages actions that enhance meeting customers needs
profitably
Thus it has been the normal practice of any company to create and maintain some
form of product information so as to capture the cost of producing such a product
and also its profitability.

After decades of bowing to the demands of the orthodox accounting practices to

calculate the cost of their products, CEOs are beginning to use a new script,
starting with ABC. Standing, respectively for activity based, and costing (ABC), an
exciting tool that has been reborn after its origin in the 1970s.

Captured from the cross currents of classic cost flows and remolded into a
powerful tool by Harvard University dons Robert S Kaplan and Robin Cooper in
1988, ABC as we know it is designed to wipe of the inadequacies in conventional
costing and provide more accurate cost information for strategic and management
decision making.
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COST ACCOUNTING (Necessity):

The company has to be cautious in collecting and allocating cost to a product as
incorrect costing may question the product viability. Incorrect costing may put the
firm in a crisis situation that the company may even not be aware, such
circumstances would arise when:
 Identifying profitable product becomes difficult
 Producing incorrect mix of product
 Designing product that raise cost
 Targeting the wrong market
 Neglecting opportunities to improve the quality of service
 Undertaking cost cutting measures that cut costs across the board
without regard for the underlying work, the inevitable the cost creeps
back up again

Conventional costing system thus emerged in the business entities engaged in

either manufacturing or service operations, which tried to overcome the above
stated problems to some extent.

CONVENTIONAL COSTING:
This system captures the information about the direct cost as well as the indirect
cost and thereby the total cost of production. The marginal costing and the
absorption costing were the two types of costing. While the former is more
concerned with the contribution of each product towards the fixed cost considering
only the variable cost, the latter took into account the total cost whether it is
variable or fixed to arrive at the profit.
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The confusion or the problem arises only when the company engaged in the
production of more than one product, arguments started as to how to allocate the
indirect cost of production amongst the products. Thus a methodology was evolved
which suggested the allocation of the cost on the basis of direct labour hour
consumed or the volume of production of each product. This type of costing led to
either over or under absorption of overhead cost of the product.

Thus the consequences of conventional costing such as selling the wrong products,
improper pricing norms for the products are not acceptable in today’s competitive
world, which only put the company in doldrums.

Let us now discuss in detail the overheads, which is the cause of concern in
measuring the cost of the product: -

OVERHEADS:
On a rational basis overheads could be categorized into four types, they are the
following:

Logical transactions: to order, execute and confirm materials movement.

Personnel busy with logistical transactions include indirect shop floor workers as
well as people engaged in receiving, expediting, shipping, data entry.

Balancing transaction: to match the supply with demand. Purchasing, material

planning, production control, forecasting and scheduling personnel perform
balancing transactions.
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2005

Quality transactions: to validate that production is in conformance with

specifications. People in quality control, indirect engineering and procurement
perform quality transactions.

Change transactions: to update manufacturing information. Manufacturing,

quality engineers involved with schedules, ratings etc.

The above overhead classifications are all described as transaction based. Infact, all
therefore represent a series of activities (or transactions) undertaken to facilitate
production. However these activities are influenced by the pattern, mix, diversity
and complexity of the production workload rather than purely by the volume of
production.

Thus many of the most significant contemporary production overheads can be

viewed as resulting from specific transactions or activities which are relatively
independent of merely production volume. Indeed it is the volume of these
activities (not the volume of production) which consume resources and determine
the level of the overhead cost.

Thus to remove the lacunae in the traditional method of costing there arose a new
type of costing namely Activity Based Costing which would overcome the problem
of allocation of overheads and do correct costing in a situation of diversified
product range.

Most businesses today use standard costing techniques for their products or service
costing while it is easy to understand and apply, with the exception of factory or
 MBF
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operational direct costs they fail to apportion or allocate other business cost on a
realistic basis—cost such as manufacturing indirect, sales and marketing, customer

Service, R&D, purchasing, supply, IT support and personnel. Standard costing

apportions these on an arbitrary basis—direct labour hours, square meters, no. of
units produced or sold, no. of customers etc.
In a non-manufacturing or service business the problem is understandably even
more acute, with very little cost being allocated on a true basis. ABC takes a
rational
Approach to product, service and customer costing, identifying what major
activities are performed in each function across the business. An assessment of is
made of how much company resource is actually consumed by each activity,
‘resource’. These are allocated to activities using appropriate methods dependant
on the type of resource to be allocated, the aim being to establish a true cost for
each activity based on the consumption of all resources.
The next step establishes what causes or drives each activity and the relationship
between the driver and the product, service or customer, if such a relationship
exists.

ACTIVITY BASED COSTING:

This led to the development of a new methodology called activity based costing
which focused on the activities involved in developing a product rather than sheer
volume of production or the total direct labour hour consumed. It is a set of
managerial accounting method used to identify and describe cost objects and the
 MBF
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activities they consume, and the amount of the resources the activities consume.
The costs of all activities are traced to the product for which they are performed.
Overhead cots are also traced to a particular product rather than spread arbitrarily
across all product lines.

BACKGROUND:

ABC is a simple concept. "Products consume activities, activities consume

resources". Professors Robert S. Kaplan and Robin Cooper of the Harvard
Business School have noted that significant amounts of overhead activities, from
testing to material handling, are disproportionately consumed by certain parts,
products, and product families. Traditional burden-averaging and labor-based cost
systems do not capture the disproportion. Today's cost accounting systems do not
mirror the true economics of physical production and resource cost consumption.
ABC provides a closer match between costs and output.

Without ABC, executives and managers are forced into a guessing game about
what things really cost due to this disproportion. It is sometimes called the "Peanut
Butter" approach to applying overhead costs, that is, overhead gets spread equally
or spread according to direct labor or cycle time over a given group of products or
services.
The following is a very simplistic example of how overhead can get applied to a
product based on a direct labor ratio, which can severely distort product cost.

Illustration 1 - Base Case showing 2 products with same material, labor and
overhead costs.
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(Traditional Overhead Allocation)

Product A Product B
 Material $500 $500
 Labour $300 $300
 Overhead $500 $500

 Total Cost $1300 $1300

Illustration 2 - Purchasing new machine for product B reduces labor costs by

$200, and increases overhead by $200. New machine
for product B,
reduces direct
labour by $200
and adds $200 in
depreciation to
overhead
Product A Product B
 Material $500 $500
 Labour $300 $100 -$200
 Overhead $500 $700 +$200

 Total Cost $1300 $1300

Illustration 3 - Overhead ratio changes because direct labor ratio changed, hence

Since direct labour ratio

changes, overhead ratio
changes

Product A Product B
 Material $500 $500
 Labour $300 $100
 Overhead $900 $300

 Total Cost $900

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wrongful distortion to product A's cost.

What is ABC?
A methodology which 3:1 ratio
O.H. also
 measures cost and performance of activities become 3:1
ratio
 measures resources consumed $1700
by activities

**NOTE: Product A
was not affected by
purchase but is ,
disproportionately and
wrongfully allocated
most of the overhead

 traces costs by activities and resources consumed to cost objects

ABC

EVERY THING
RESOURCES CONSUMED BY THE
ORGANISATION

CONSUME TRACED BY RESOURCE DRIVER

What is actually
ACTIVITIES being done?

CONSUME TRACED BY ACTIVITY DRIVER

- Product or Services
COST OBJECTS - Customer
- Etc.
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The above linkage between the three expressions forms the basis for the ABC
system. The logic behind this system is that the resources are consumed by a set of
activities, which are used in the production of the products or service.

ABC OBJECTIVES:
Activity based costing is an analytical tool used to organize costs among key
activities of business. These activity costs can be used to calculate the profit of the
cost objects.
 ABC can be used to analyse and pinpoint potential areas of improvement.
 It can be used to eliminate redundancy, enhance communication and
information flow and identify poorly performing areas.
 It helps to measure results of new product “What if” analysis capabilities.
 It can be used to calculate the cost per unit of the product and can be used to
show the reports of the profitability of the products.

Key Terminology of ABC –

Resources:
• Are what organisations spend their money on. Economic element that is applied
or used in performance of activities.
• Resources are the costs involved in activities such as planning, HR, stores,
power, indirect materials.
• Resources are consumed by activities.
• Resources are :
 Materials/services/utilities
 Labour
 Equipment
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 Technology
 Space

Activity:
• Work performed in an organisation. It is an aggregation of all actions performed
within an organisation.
• Activities consume a company’s resources, as activities are performed.
• Results in performance
 Resolving of issues or
 Achievement of goals
• Performance can be measured.

Cost Objects:
• Any customer/product/service/contract/project or other work unit for which
separate cost measurement is required.
• Activities are traceable to cost objects
• Examples of cost objects (in context of BHEL)-
 Production centers
 Faridabad project
 Customer- NTPC
 Product- Steam turbine
Resource Driver:
• Measure of quantity of resources consumed by an activity.
• Examples of resources driver-
 Personal payments- head count
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 Power - connected load in KWH
 Rent - measure of square feet.
• Resource cost assignment: process in which costs are attached to activities from
the general ledger through the resource drivers.
Activity driver:
• Measure of frequency and intensity of demands placed on activities by cost
objects.
• Example of activity driver-
 Maintenance - number of machines
 Gas plant operation - number of tapping points
 Quality audit - volume of products.
• Activity cost assignment: process in which costs of activities are attached to
cost objects using activity drivers.
Illustration 1 -

A sample from the current study has been taken to explain the methodology on
which it works. Considering the case of melting a few sets of activities are
considered.

Activities Cost drivers

Charging the furnace No. of heats/liquid weight
Monitor and maintain the furnace No. of times (monitored)
temperature
Removal of Slag Time Spent

In the above activities resources like manpower, power, equipment cost are used.
The resources consumption are calculated for each activity and are thus assigned to
cost on the basis of cost drivers defined for each activities.
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TYPES OF ASSIGNMENT

Resource to Resource (R to R)
Resource to Activity (R to A)
Resource to Cost Object (R to C.)
Activity to Activity (A to A)
Activity to Cost Object (A to C.)
Cost Object to Cost Object (C. to C.)
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Assignment R to R
Resource Hierarchy
120 Heavy Fabrication Block
Personnel Payments
Executives
Supervisors
Indirect Workers
Direct Workers Exe
Workers Sup
Work
Workers
Remuner
Employee Benefits ation
Employee Benefits Ratio
Other Expenses
Other Expenses
Depreciation
Depreciation
Share of Support
Share of Support
Travel
Travel

Resource Hierarchy
120 Heavy Fabrication Block Activity Hierarchy
Fabrication Block II
Personnel Payments Material Planning
Executives B2MP Draw direct material from CPS
Supervisors B2MP Draw indirect material from CPS
Indirect Workers B2MP Issue direct material from CPS
B2MP Issue indirect material from CPS
% of time spent Shop Planning
Bay I Planning
Open Gantry
Bay I
Bay II
Bay III
Bay IV
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Assignments - R to A
Assignments - R to Assignments - R to

ssignments - R to
Resource Hierarchy
120 HeavyAFabrication Block
Cost Object Hierarchy
Projects Assignments - R to
Personnel Payments
A ents - R to
135MW
Direct Workers ssignm XYZ
Power & Fuel KW rating Production Blocks
Power & Fuel Block I
Indirect Material Gross Block Block I Maintenance
Indirect Material Block I Machines
Block II
Block II Maintenance
Block II Machines
Block III
Block III Maintenance
Block III Machines
 MBF
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ABC FRAMEWORK
TOR
• ABM Cost
Model for achieving
Product Costing.
• Arriving at Organization
the cost of Activities
• Identification For Review of
of Non-value adding Environment
activities
Drivers
• Identifying ABC Analysis
customer Product Costs Activity
profitability. Activity Costs Systems for
Costs benchmark Driver Data
(Unit wide; Collection
Department
with
wise) Competitors Co-coordinating
Driver . Driver data
information Collection
Reports Systems
VA / NVA Time Capture
Costs System
Knowledge TIME CAPTURE
Base
What-if To Capture through IT tools.
Activities data Increased
Cost Drivers Personnel costs
Pointers for
Re-engg
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ASSUMPTIONS UNDERPINNING ABC:
ABC assigns cost to activities based on the consumption of resources. These costs
are then assigned to products or services on the basis of their use of these activities.
There are 5 assumptions that underpin this simple proposition-
1) Activities consume resources.
2) Products and services consume activities.
3) ABC models the consumption of resources rather than spending.
4) There is only one activity per cost pool.
5) All costs in a cost pool are proportional to changes in activity.

 Activity Based Costing – Methodology

a) Understanding the organization

The first step is to segregate the organisation in such a way that the cost tracked
from the general ledger is compatible with how people in the organisation are
grouped. This makes it easier to relate the costs of resources incurred with the
corresponding activities which people in the organisation perform.

b) Identifying and collecting activity data

Data (type, frequency) regarding the various activities being performed by the
organisation is collected by the following methods:

1. From the general ledger maintained by the organisation

2. From financial statements of the organisaton
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3. Interviewing various key personnel in the organisation

Activity analysis is carried out by interviewing people who are involved in the
activities. Thus the definition of activities has to follow the circumstances of the
organisation in question and the use to which the information will be put. The
following guidelines for interviewees and interviewers help in appropriate data
collection

 Interviewees

The interviewees should be key personnel from the operational elements of the
organisation. This could be a manager in charge or any other knowledgeable
person. More than one person can be interviewed for the comparison and
confirmation; this does create more complexity if there are major differences in the
sample percentages. Regardless of the structure of the interviews, the interviewer
must end up with a set of percentages under methodology for the allocation of the
organisational costs using this data.

 Interviewers
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The interviewers should be members of the project team. Considering the number
of interviews and the time allowed, there should be as few individuals as
practicable. This also helps in maintaining a consistency in the questions asked in
the interview. The interviewers need to have a thorough understanding of the
activity model with its terminology and the bigger picture of the reengineering
project.

c) Building an Activity Database

After collecting information regarding the activities, the next step is to “Analyse
Activities”. During the analysis activities are segregated into different categories
like frontline, support, sustaining and infrastructure depending on the nature of the
activity.
From the data collected a database is to be developed. This database can also be
utilised for commercial decision making, resource management decisions and in
identifying opportunities for improvement.

d) Identifying Resources and their utilisation

Data regarding the various resources available in different departments of the

organisation are collected through interviews and questionnaires. An analysis of
these interviews or questionnaires will reveal the effective utilisation of these
resources. These results are maintained in a database.

e) Preparing the process map of Departments

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A process map describing the various activities undertaken by the department and
the resources it utilizes to perform these activities. The creation of the process
model (sometimes referred to as activity model) is not traditionally considered as
an integral part of the ABC costing structure, but also allocation cannot take place
without it, hence it is required.

f) Identifying Cost drivers

As each organisation has its own set of cost drivers, identifying them is a difficult
task and hence requires a clear understanding of the organisation cost stricture.
Even though the number and type of Cost drivers vary from organisation to
organisation they can be classified under the following headlines:

Volume cost drivers: It measures the volume of output produced by an

organisation. In a steel business it might be tons or in an insurance company it
might be the value of the premium paid. In essence, the greater the volume
produced the greater the raw value added to the business.

Structural Cost drivers: These reflect the range of components, suppliers, raw
materials, product variants etc. that a company has to manage. They often act as a
differentiator of profitability between competing organisations.

Change Cost drivers: These are of three types:

1. Introduction Cost driver
2. Quality Cost driver
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3. Churn Cost driver- Churn can be best described as a ‘new-for-old’ change. An
example of churn, which affects many organisations, is the employment
turnover.
The cost driver should be quantifiable measure of what causes resources to be
used. In essence, the cost of the resources used to support a particular activity
becomes a cost pool (refers to aggregation of all activities which are driven by the
same cost driver), and the cost driver is used to allocate the costs to produce or
allocate the costs to product or services.

g) Calculating the Cost of the product

The last and final step is to calculate the cost of the product depending on the
volume of the activity drivers the input consumes.

STAGES OF ABC:

ABC is a cost management tool, which consists of five primary steps.

1. Identify the activity and processes performed in an organisation
2. Identify the resources required to produce products and services within the
organisation
3. Assign resource cost to activities
4. Identify the outputs
5. Link these activities and processes to the products or services and to customers

COST ASSIGNMENT VIEW

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Direct Cost

Product A
Engineering
Overhead
Product B

Factory Activity Driven Cost

Overhead Management Product C

Product D
Admin
Overhead
Product E

TRADITIONAL VS ABC
 MBF
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Traditional view ABC view

Process Engineering Dept Process Engineering Dept

Create BOM (Rs.) 31500

Salaries (Rs.) 600,000
Maintain BOM 12100
Equipment 150,000
Create routings 32500
Travel expenses 60,000
Process routings 101500
Supplies 40,000
Process spl Orders 83000
Use&occupancy 30,000
Improve processes 45000
Using Study capacities 119000
Design tooling 145000
Resourc Train employees 43000
e/ Administer dept 158000
Total Rs. 880,000
Activity
Cost Total Rs. 880,000
Drivers

WHAT IS SPENT HOW RESOURCES ARE SPENT

ILLUSTRATION
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Classifying resource expenses by activities performed accomplishes a 90 degree

shift in thinking about expenses.

Salaries & Occupancy Equipment& Materials & Total

Fringes Rs. 1, 11,000 Technology Supplies Rs. 6, 00,000
Rs. 3, 13,000 Rs.1, 46,000 Rs. 30,000
=

Activity
Based
Costing

Activity Salaries Occupancy Equipment Materials

and fringes and and Total
technology supplies
Process customer orders Rs. 31,000 Rs. 5,300 Rs. 12,600 Rs. 800 Rs.
49,700
Purchase materials 34,000 6,900 8,800 1,500 51,200
Schedule production orders 22,000 1,200 18,400 300 41,900
Move materials 13,000 2,100 22,300 3,600 41,000
Set up machines 42,000 700 4,800 200 47,700
Inspect items 19,000 13,000 19,700 800 52,500
Maintain product information 36,000 2,800 14,500 400 53,700
Perform engineering changes 49,000 32,000 26,900 2,400 1,10,300
Expedite orders 14,000 900 700 500 16,100
Introduce new products 35,000 44,000 16,100 18,700 1,13,800
Resolve quality problems 18,000 2,100 1,200 800 22,100
TOTAL Rs. Rs. Rs. Rs Rs.
3,13,000 1,11,000 1,46,000 30,000 6,00,000

ABC shifts analysis from expense categories to activities performed.

 MBF
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Data from the organisations’ financial system categorises expenses by
spending code; for example, salaries, fringe benefits, overtime, utilities, indirect
materials, depreciation etc. The resource cost drivers collect expenses from this
system and drive them to the activities being performed by the organisational
resources. Thus, after going through this step, organisations learn, usually for the
first time, how much they are spending on activities like purchasing materials and
introducing new products.

WHY ARE ACTIVITIES SO IMPORTANT FOR

ANALYSIS

 They are actionable. They are what the company does.

 They consume resources, which are consumed by products and processes.
 They can be easily understood by diverse groups of people and their cost can be
tracked and measured by the beneficiaries.
 They link planning and control and integrate financial and non-financial
performance measures.
 They highlight cross-departmental interdependencies.
 They facilitate understanding of cost drivers.

QUESTIONNAIRES-
For collecting Data required for developing the ABM software, the TCS team
circulated the following questionnaires, among the various departmental heads in
BHEL, Hardwar-
OBJECTIVE-
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• This document provides an overview of how the various types of data necessary
for ABC assignment were collected.
• The information, which the TCS team, intended to collect focuses primarily on
the product variant that had been identified for ABC implementation. It also
includes other relevant information.
• The methodology and the questionnaires are also included.

METHODOLOGY-
• Interviews and discussions were conducted to gather information relevant for
ABC implementation.
• Draft questionnaires had been prepared relating to the
 Unit’s operations
 Products
 Processes
 Resources
 Cost objects
These questionnaires were used during the interviews and discussions with the
BHEL personnel.
The questionnaires were provided to the BHEL co-coordinator of the ABM
implementation project for:
• Enabling BHEL personnel to understand the nature and type of information to
be gathered during the course of the project.
• Facilitating the collection of preliminary data from the respective departments
prior to the scheduled meeting with them.
QUESTIONNAIRE – TEMPLATES:
Unit Overview
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• Brief note about the site
• Organisation structure
• Number of people/strength- department wise
• Quality initiatives
• Product lines/products and customers
• Contribution of each product line to the production volume and sales
turnover
• Profitability of each product line and return on investment for that
particular line
• Contribution of each product in a product line with reference to the
production volume and sales turnover.

PRODUCT RELATED:

• How many variations of the product are being manufactured?

• Who are the main customers for the selected product variant?
• What are the key manufacturing processes?
• What is type of manufacturing deployed?
• Is the production planned with respect to specific customer orders or
towards building stock?
• What is the existing method of costing adopted for costing products
and the period for which it is attempted?
• Kindly provide cost sheets for the product variant.
• What are the support division processes that relate to the product
variant?
PROCESS/ACTIVITY RELATED:
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• For process manuals:

 Is the production process manual available (as ISO document or Process
documents or any flow charts available)? Kindly provide a copy of the
same.
 How often is the manual updated?
 Does the manual provide support function linkages? If no, what are the
support processes for the production of the product?

• For processes/Activities:
 What are the triggers to initiate the core production process?
 What are the data inputs to each core production process?
 What are the departments, which interact and /or involved in the
production process? Kindly explain as to ‘for what’ each of these
departments interacts.
 What are the sub-processes involved w.r.t the parent production process?
 Would it be possible to list down the various activities that are being
performed in each of these sub-processes?
 What are the resource constraints and impact of each?
 What are the materials and information outputs?
 What are the key documents that act as triggers for these processes?
 What is the material flow in the process?
 What is the data flow in the process?

RESOURCE RELATED:
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• What are the major categories of expenses?

• What are the specific expense heads under each of these categories?
• How is the expense currently tacked-work order, departments etc?
• Kindly provide the copies of the general ledger, trial balance, P&L
and Balance sheet

COST OBJECT RELATED:

• Who are all the customers for this product variant?

• Is there a separate mechanism for arriving at customer/product variant
profitability?
• What is the geographic segmentation of the customers for this product
variant?
• What is the industry wise segmentation of customers for this product
variant?

ACTIVITY BASED MANAGEMENT- ITS PURPOSE AND BENEFITS

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Activity based management is the management and control of enterprise
performance using activity based information as the primary means of decision
support. The true ABM involves the use of activities in planning, budgeting,
costing, and modeling and performance measurement. It is therefore of
fundamental importance for organizations to have clear vision of how they want
their ABM system to look and to define the information such a system should
deliver. This vision should be agreed prior to implementing such a system. Very
few organizations have undertaken true ABM since more often than not it is used
as a one of performance improvement tool. The most common approaches
commence with some kind of activity analysis followed by Activity Based Costing
which is then used to generate performance improvement ideas. ABC is not ABM.
(ABC is the tracing of activity costs onto cost objects. These cost objects can be
products, services, projects, customers, distribution channels etc.) .

CURRENT MALPRACTICE
ABM is fundamentally different from the way in which we manage today. In fact
the way we manage today can actually hinder performance improvement.
Following are the common current practices-
1) Budgeting by Cost Element - Problem is that the work is not visible .All cost
center statements appear similar- only the numbers against the cost types
changes for ex. Every cost center could have the following cost types in its
budget -
Staff costs, Local purchase, communications, IT, travel and subsistence etc.
However an outsider cannot see what the cost center actually does. ABM gives
cost summary in such a manner that all the work done in the different cost
centers becomes visible.
 MBF
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2) Organizing Functionally - Problem : There is optimization within individual
Departments, internal competitions and little or no cross-functional
coordination.
Imagine the case where the sales team promotes new products without liaison
with the service providers. The service providers are then forced to create /
adapt new products regardless of the overall effect on the business. ABM
allows all activities to be linked to business processes and hence encourages
managers to take a cross-functional view of the organization.

3) Incremental Budgeting - Problem: Wasteful activities are hidden. Managers

assume that activities performed during previous years are all adding value to
the department - which is fundamentally incorrect. ABM involves a review of
every activity within a department.

4) Hierarchical Organizations - Problem: Improvement is seen as management’s

responsibility. Staff does not feel empowered to make decisions and
communication channels are long and complex. ABM encourages people to
focus on business processes and hence eliminate the need for complex
management structures often associated with functional organizations.

5) After- the-event reporting - Problem: Variances are not prevented and by the
time that they are reported it is often too late to take corrective action. ABM
provides a performance- management system, which, like statistical process
control, provides "feed forward" as opposed to "feedback". ABM is especially
powerful if integrated with total quality.
 MBF
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6) Fixed and variable costs are separated - Problem: Fixed cost is a cost that we
can not change therefore we ignore it. We must move towards used and unused
capacity. For example do not apportion all property cost across all departments.
ABM identifies how much space that is required and highlights the rest as
excess capacity.

7) Improvement is the responsibility of the accountants - Problem: No one else

in the organization signs up to the improvement initiative. Managers feel bitter,
staff loses commitment and the improvement initiative fails. ABM requires
company wide involvement.
ABM has evolved to alleviate many of the above problems but in order to
succeed there are a number of steps that must be followed.

THE ABM APPROACH

The ABM approach can be broken down into 7 steps

1) Planning - This is not to be overlooked. Planning should involve developing
a detailed project plan and should include and an implementation phase. All
too often companies embark on an ABM assignment and lose many of the
benefits by not committing enough resource to the implementation phase.
 MBF
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2) Education and awareness - Are key to the success of ABM. ABM is
company wide and ALL those involved need to be included in training.
Training should be fun and preferably should include realistic simulation
exercises that demonstrate the benefits of ABM. ABM is a tool for
management and not to be undertaken by accountants in isolation.
3) Process/ Activity definition- should be done "top down" and in a workshop
environment. The aim of this phase is to refine a structure for your activity
database. A simple model linking activities to the business process is all that
is required. High-level process mapping should be undertaken prior to
defining activities.
4) Data Collection (activity analysis) - should exploit technology. Use standard
packages for tracing general ledger costs to activities (especially during pilot
studies or trials). A good activity analysis should be flexible enough to be
used for ABM, BPR (Business Process Reengineering), Benchmarking and
total quality.
5) Performance improvement techniques - should include cost driver analysis,
activity classification, performance measurement and ABC. A cost driver is
the root cause or reason for an activity to occur. It should not be confused
with an output measure which a volumetric measure is quantifying how
many outputs an activity produces. It is the output measure that should be
traced to the cost object.
Activity classification should always include some kind of value added/
non value added analysis and more importantly all staff involved in
classifying activities should understand these definitions. A simple
definition of non-value added activity is "anything that can be eliminated
without detriment to the final product or service".
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Performance measure should be defined at the process level and for key
activities. They should be used to measure and control activities / processes
and must be used to promote continuous improvement.
All of the improvement techniques are consistent with the total quality
philosophy of "right first time / zero defects", "conformance to customer
requirements" and "continuous improvement".
6) Planning the ongoing system - is probably the most challenging step .The
ABM system is a fully integrated Planning,, budgeting, costing, modeling,
reporting and performance management system. The vision of such a system
should be defined as early as all potential users should specify possible and
the information requirements. Failure to involve users will lead to
construction of a system, which will be extinct, before it evolves.
7) Implementation- should be well planned and care should be taken to address
“change management" issues. A sponsor and owner should be identified for
each major change. These people should be held responsible for the
successful implementation of the change.
ABM is therefore a fundamental shift in emphasis. People do activities and
activities consume resources- so controlling activities allows controlling
costs at their source.
ABM AND MARKETING
In the 1980s' most companies an ABC system were focused on strategic
issues and used ABC to identify those products and customers which were
subtracting values. In 1990s' the focus shifted to ABC as starting point for
improving performance. ABC raised important cross-functional issues and
the increased transparency helped companies manage multi functional
teams. At the end of 1990s' the focus has changed again, this time on using
ABC to get closer to the customer. ABC helps in understanding the impact
 MBF
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of processes over and beyond the borders of an organization, reaching into
the supplier, the customer and beyond the customer to the end consumer.
Combined with this new thinking on marketing, this provides a powerful
tool.
ABC differs from conventional costing in a way that it uses cost drivers to
assign costs. By understanding the overheads, that a particular customer or
product really uses, ABC pinpoints customer profitability in a way that
conventional costing cannot. Customers and products believed to be
profitable are often not, while those believed not to be contributing might
well be. Knowing the cost of your range sets a target. Implementing that
target requires careful steps. It requires input of various players:
multifunctional teams that negotiate joint solutions with suppliers and
customers. Often this leads to dramatic solutions that no one party would
have reached on its own- standard packaging, availability of forecasts, more
frequent deliveries, and cheaper material for non-critical parts. ABC
provides the tools to negotiate these solutions. By negotiating what the
customer is prepared to pay for, the company is able to minimize total costs
across the entire value chain and add value for the final user.
This is maximized when ABC is used as part of a process to bring the
organization closer to the customer, building a customer focused
organization.
Segmenting the customer based on needs-
The process of building a customer-focused organization is a multi step
process. It is based on need-based segmentation. The basis for this type of
segmentation is the transparency of ABC.
Need based segmentation starts with customer, which necessitates opening a
dialogue. It starts with structured interviews with key users. If a market is
 MBF
2005
fragmented it may be necessary to interview sufficient number of customers
to understand the spectrum of needs and to represent the customers by a
combination of R&D, operations, procurement, sales and marketing. This
may be followed by workshops to understand the customers' needs.

Asking the customer what he wants and what he will pay for-
ABC allows us to put a cost on each activity and assigns cost accurately to
customers and products. This process sets a value to the customer needs. The
stage where costs and needs are matched, often result in creative solutions.
Each segment is examined for what customers want and what they do not
want. Price as a key factor in the marketing mix is looked at as well as
fragmentation of the segment. Loyalty and alternatives for the customers are
scrutinized and related back to the capability to deliver.
Some segments will never be profitable. Here ABC plays a valuable role.
With the value to the customer and price to the company known, all
permutations can be exhausted.
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2005