Activity Based Costing System TRADITIONAL MANUFACTURING COSTING SYSTEM The traditional costing system (TCS) assigns indirect

costs/overheads to job/products in two stages: First, the accumulated cost are allocated to production departments (cost centers). Second, the accumulated costs in cost centres are assigned to individual job/products on the basis of an overhead allocation rate based on/in proportion to some measure of volume of production such as direct labour cost, direct labour hour rate, machine-hour rate and so on. It has the merit of being simple, easy to use and understand, and applied consistently from year to year. It is adequate for financial reporting of inventory valuation. Limitations/Inadequacies of Traditional Costing System It has, however, serious limitations/inadequacies due to its assumption that all overheads are proportionate to volume of production. Many overheads costs are, actually, not proportionate to volume. Examples of such costs are setup costs of machines/equipment, cost of inspection/handling of materials and so on. They are affected by complexity rather than volume. As a result, simple high-volume products would be overcosted (i.e. receive a larger allocation of overheads) and low-volume complex products would be undercosted (i.e. receive a smaller allocation of overheads). The use of volume-related allocation base of TCS for allocating overheads would result in product cost distortion in an environment of complex and high product variety. The ABC system eliminates this source of cost distortion. ACTIVITY BASED COSTING/MANAGEMENT (ABC/ABM) SYSTEM ABC System is a system based on activities linking spending on resources to the products/services produced/delivered to customers. The ABC system also uses a two-stage overhead allocation: (i) Tracing costs to activities (ii) Tracing costs from activities to products/jobs 1. Tracing Cost to Activities

This step is to identify major activities that cause/drive overhead costs to be incurred. Some of the activities are related to production volume (such as production runs, salary of supervisors and so on) but others are not (such as inspection/handling of materials, setting up equipment and so on). The cost of resources consumed in performing these activities are grouped into cost pools. 2. Tracing Costs from Activities to Products The next step is to assign costs to products/jobs using cost drivers as a measure of activity. Cost drivers represent the quantity of activities used to produce individual products. They identify the linkage between activities and cost objects and serve as quantitative measures of the output of activities. In fact, they are the central innovation of ABC system. Three types of cost drivers are: (I) TRANSACTION (II) DURATION (III) INTENSITY (DIRECT CHARGING) Transaction Drivers Transaction drivers are used to count the frequency of an activity/the number of times an activity is performed. Duration Drivers Duration drivers represents the amount of time required to perform an activity. Intensity Drivers Intensity drivers are used to charge directly for the resources used each time an activity is performed. Activity Cost Driver Rate The next step is to compute the Activity Cost Driver Rate (ACDR). The ACDR is the amount determined dividing the activity expenses by the total quantity of the activity cost driver. Activity-Based Costing Products Profitability Report Finally, ABC Products Profitability Report is prepared. It combines activity expenses assigned to each product with their direct (labour and material) costs. The activity expenses assigned to a product is arrived at multiplying the ACDR by the quantity of each activity cost driver used by each product.

Activity-Based Management (ABM) The activity-based management (ABM) refers to a set of actions that management can take, based on information from an ABC study, to increase/improve profitability. These include a combination of: 1) Repricing of unprofitable products, 2) Increasing sales volume of highly profitable products, 3) Process improvement e.g. how to reduce setup times in contrast to faster run of production, equipment and 4) Engineering and design improvements. Their combined effect would be production of the same volume and mix of products with fewer resources. Cost of Resource Capacity Practical capacity Practical capacity is a better measure of cost of resources to handle each production (i.e. capacity expenses practical capacity). It is the maximum amount of work that can be performed by resources supplied for production/services and is expressed as a percentage of theoretical capacity. Duration Drivers Theoretical capacity means the normal working hours of a machine/working employee. The difference between theoretical capacity and practical capacity is the time utilised by the employees for breaks, arrivals, departures and so on, which are not related to actual work performance. It may also represent allowances for downtimes of machines due to maintenance, repair and rescheduling fluctuations and so on. Unused Capacity The expenses of resources unused during the production (difference between theoretical capacity and practical capacity) is the cost of unused capacity. Such a cost should be assigned to the person/customer/department/market segment concerned with/responsible for it. ABC FOR MARKETING, SELLING AND DISTRIBUTION EXPENSES Marketing, selling and distribution expenses are significant components of overhead costs of companies. Most of these costs are associated with customers, market segments and distribution channels rather than to individual products. The ABC is applicable to such costs also. Its focus is on tracing these costs to customer segments. The

activities performed by these services are first identified together with activity cost drivers linking each activity to individual customers. The resource spending in the various customer accounts are then identified. The final stage is preparation of customer profitability analysis. Tracing Costs to Customers The focus of ABC system is on tracing marketing, selling and distribution costs to customer segments. To illustrate, consider two customers, Simple and Complex, of Avon Industries Ltd. Avon Ltd. currently uses the traditional/conventional cost accounting system and distributes the marketing, selling and distribution to customers based on sales revenue, that is, approximately one-third of total sales. The traditional costing-based profitability of Simple and Complex (customers) is summarised in Exhibit 4: Identification of Activities and Cost Drivers Activity 1 2 3 4 Marketing and technical support Travel to customers Distribution of sales catalogue Servicing of customers 1 2 3 4 Activity Cost Driver

Estimated proportion of time spen on each customer Actual expenditure Number of mailings

Estimated proportion of time spen on each customer and supplies used by them Number or orders Quality of inventory required by customer Actual records and

5 6

Handle customer orders Warehouse customers inventory for

5 6

space

Shipping/despatch to customers

Identify Resource Spending The next step is to identify the resource spending in the various accounts. The customer profile of Simple and Complex is as follows. Simple orders only a few products in large quantities, places order predictably and with long lead times, and requires little sales and

technical support. But Complex requires a great deal of handholding and continuously inquires whether products could be modified to meet his specific needs. In addition to marketing resources, many technical resources are required to service Complex. Complex also places many small orders for special products, requires expeditious delivery and pays slowly, increasing the demands on order processing, invoicing and accounts receivable process of Avon Ltd. Suppose the following marketing, selling, distribution and administrative costs are identified for the two customers. Customer Profitability Analysis Report According to the ABC customer profitability analysis (Exhibit 5), Simple is a highly profitable customer while Complex is a very unprofitable customer. The reason is that ordering and support activities of Simple places few demands on the Avons marketing, selling, distribution and administrative resource as a result of which its operating margin is much higher. Managing Customer Profitability The ABC customer profitability analysis can be used to manage its profitable and unprofitable customers. To protect them from competitive inroads profitable customers may be offered discounts/incentives and special services to retain them. The unprofitable customers can be transformed into profitable customers through a number of actions: (i) (ii) (iii) Process improvement, Activity-based pricing and Managing customer relationships. ABC for Service Companies The ABC system is as much applicable and useful to a service company as it is to a manufacturing company. Service organisations include companies in a) Financial services (i.e. banks, insurance organisations, money managers), b) Transportation (i.e. airlines, roads and railways), c) Telecommunications, d) Wholesale and retail, e) Healthcare and so on. Cost Structure of Service Companies Service companies have a unique cost structure. Virtually all their costs are indirect/fixed.

In contrast to manufacturing companies, customer behaviour determines the basic operating costs of products/services of service companies. They should, therefore, identify the differential profitability of individual customers as they determine the quantity of demands for their operating activities. PROs And CONs The ABC system has advantages as well as limitations. Its major benefits are: 1) it does not undercost complex low-volume products and overcost high-volume simple products, 2) it may result in improved cost control. The limitations of ABC system are two-fold: (a) it is costly to develop and maintain and (b) it is used to develop full costs and does not measure the incremental costs needed to produce an item.