Activity Based Cost System (ABC System) | Cost Accounting

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  • Last Updated on 19 October, 2021

Table of Content:

1. Traditional Cost System
2. Definition and Meaning of Activity Based Costing (ABC)
3. Steps in ABC System
4. Cost Pools and its Cost Drivers
5. Advantages and Limitations of ABC
6. ABC System and Corporate Strategy
7. Activity Based Budgeting
8. Activity Based Management

activity-based-cost-system-abc-system-cost-accounting

Learning Objectives

After studying this chapter you are able to understand:

    • Conventional Cost System and Its Inadequacies
    • Reasons for Emergence of Activity Based Cost System (ABC)
    • Definition and Meaning of ABC
    • Objectives of ABC
    • Steps in ABC System
    • Distinction between Value Added and Non-Value Added Activities
    • Cost Pools and Its Cost Drivers
    • Difficulties in Adoption of ABC in Service Organization
    • Advantages and Limitations of ABC
    • ABC System and Corporate Strategy
    • Activity Based Information and Decision Making
    • Activity Based Budgeting
    • Activity Based Management
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1. Traditional Cost System

The Cost Accounting includes collecting, classifying, processing, analyzing and reporting of information to managers in their planning and control of activities and information system to be developed to help in decision making within the firm. Traditional cost accounting focused on product costing by tracing direct costs to the product and indirect costs are allocated through cost centres. The direct costs will be in proportion to the volume of production and the indirect costs like production, administration, marketing and distribution overheads etc., are apportioned depending upon the method used and absorbed to the individual product. The basis of apportionment of overheads may be based on machine hours, labour hours, direct costs, input, output, etc. These normal methods of apportionment have some bottlenecks which tend to misinterpret regarding proration of common costs of different functions added to the product cost. Traditional cost accounting over the years proved their inability and inadequacy to support management decision in a complex business environment since they are aimed at allocation of overhead to total cost on the basis of consistency rather than relevance. The conventional cost systems use direct labour consumption as the primary means of apportioning overhead.

This proved adequate when the overhead costs of indirect activities was a small percentage compared to direct labour consumption in actual making of products. The increased technology and automation has reduced the direct labour substantially, leaving indirect activities as a far more significant cost factor. Therefore, using direct labour as a primary apportioning device can cause significant costing distortions and poor strategic planning.

Classification of Manufacturing Costs

Traditionally, manufacturing companies classified the manufacturing costs to be allocated to the products into (a) direct materials, (b) direct labour and (c) indirect manufacturing costs. In the present day context, characterized by intensive global competition, large scale automation of manufacturing process, computerization and product diversification to cater to the changing consumer tastes and preferences has forced companies to refine their costing systems to provide better measurement of the overhead costs used by different cost objects. Accordingly, manufacturing costs are classified in to three broad categories as under:

    • Direct Cost – As many total costs relating to cost objects as feasible are classified into direct cost. The objective is to trace as many costs as possible into direct and to reduce the amount of costs classified into indirect because the greater the proportion of direct costs the greater the accuracy of the cost system.
    • Indirect Cost Pools – Increase the number of indirect cost pools so that each of these pools is more homogeneous. In a homogeneous cost pool, all the costs will have the same cause-and-effect relationship with the cost allocation base.
    • Use cost-and-effect criterion for identifying the cost allocation base for each indirect cost pool.

The change in the classification of manufacturing costs as above has lead to the development of ABC. ABC refines a costing system by focusing on individual activities as the fundamental cost objects. An activity is an event, task or unit of work with a specified purpose as for example, designing, set-up etc. ABC system calculates the costs of individual activities and assigns costs to cost objects such as products or services on the basis of the activities consumed to produce the product or provide the service.

Dangers of Incorrect Cost Information

The incorrect cost information can lead to face the following dangers:

    • Emphasizing and focusing on wrong products, wrong customers, wrong markets.
    • Neglecting and missing profitable opportunities.
    • Design of products that unnecessarily raise costs.
    • Moving of production to other places, which will increase cost instead of decrease in costs.
    • Customer orientation is neglected.
    • Acquisition of wrong type of equipment.
    • Centralization of cost control activities and adoption of cost cutting programs.

Inadequacies of Traditional Cost Systems

The cost of product under traditional cost system is not accurate due to following reasons:

    • The conventional costing system has developed convenient overhead recovery basis and blanket overhead recovery are acceptable when valuing stocks for financial reporting, but they are inappropriate when used for decision making and typical product strategy decisions. Such decisions have implications over 3-5 years and over this period many fixed costs become variable.
    • The traditional fixed verses variable cost split is often unrealistic since, as business grows they often become more complex.
    • In case of companies manufacturing and selling multiple products usually make decisions on pricing, product mix, process technology etc., based on distorted cost information due to difficulties in traditional costing system in collection, classification, allocation and recovery of overheads to individual products.
    • The cost structure is changing especially when making direct labour component to small proportion.
    • Traditional accounting was confined merely to furnishing information at product level. The new manufacturing technology demands the feed back of performance while production is still in progress rather than history.
    • There is also an urgent need to integrate the activity measurement and financial measurement.

Reasons for emergence of Activity Based Costing System

Some of the reasons for emergence of ‘Activity Based Costing’ are:

    • Traditional product costing systems were designed when most companies manufactured a narrow range of products. Direct materials and direct labour were the dominant factors of production then.
    • Companies were in sellers’ market.
    • Overheads were relatively small and distortions due to inappropriate treatment were not significant.
    • Cost of processing information was high.
    • Today companies produce a wide range of products. Overheads are of considerable importance.
    • Simple methods of apportioning overheads on direct labour or machine hour basis 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.
    • In order to overcome the inadequacies of traditional methods of absorption of indirect costs and short-term biasing of marginal costing, ABC has been researched.
    • The new global competitive environment has caused to redesign the traditional manufacturing systems into world-class company by adopting new ways of conducting business, new ways of measuring performance and striving for improvement in all aspects of a company’s business.
    • The goal of a world-class company is to profitably meet the needs of its customers.

Features of Cost System in World-class Company

The cost system in a world-class company should enable:

(a) Customer orientation of cost information.

(b) Reveal the profitability of customers and products.

(c) The reasonableness of costs to be incurred for generating cost information.

(d) Identifies the opportunities for improvement.

(e) Enable to meet customers expectations profitably.

(f) Encourages the continuous improvement.

2. Definition and Meaning of Activity Based Costing (ABC)

Professors Kaplan and Cooper of Harward University has pioneered the ABC concept. CIMA Official Terminology defines ABC as “cost attribution to cost units on the basis of benefit received from indirect activities e.g., ordering, setting-up, assuring quality”. ABC has been defined as “the collection of financial and operational performance information tracing the significant activities of the firm to product costs”. The activity is aggregated of closely related task, which are associated with one another to accomplish a goal (objective).

ABC system aims at refining the costing system used in automated plants in the following manner:

    • ABC systems trace more costs as direct costs.
    • ABC systems create homogeneous cost pools linked to different activities.
    • For each activity cost pool, ABC systems seek a cost allocation base that has a cause-and-effect relationship with costs in the cost pool.

ABC is a simple concept ‘resources are consumed by activities’ and ‘activities are consumed by the product’. The activities can be associated with output or cost object of the organization, the cost objects consume activities is just the same way that activities consume resources. ABC is an attempt to ascertain more accurate product cost by redesigning the allocative system of support overheads like inspection, despatch, production planning, setup, tooling and similar costs. ABC is a recent development in Cost Accounting which attempts to absorb overheads into product costs on a more realistic basis. The basic idea of ABC is that costs are grouped according to what drives them or causes them to be incurred. The cost drivers are then used as an absorption base. ABC is the method of cost attribution to cost units on the basis of benefits received from indirect activities i.e., ordering, setting-up, assuring quality etc. It emphasizes links between performance of particular activities and the demands that these activities make on the resources of the organization. Methodology in allocation of overhead is different in ABC system. Under ABC, cost pools are created for each activity and such activities are related with each type of product to determine the cost of such product i.e. cost of only those activities are charged to the product which go in the making of the product. The technique of ABC involves identification of production path, identification of activities that go into making a product, selection of suitable drivers, creation of cost pools, calculating the overhead application rate and allocation of the costs based on the application rate.

The product costing using ABC is shown in figure 10.3.

Objectives of ABC

The primary objectives of ABC systems are as follows:

(a) To improve the accuracy of product costs by carefully changing the type and number of factors used to assign costs, and

(b) To use this information to improve product mix and pricing decisions.

The other important objectives of ABC systems are summarized below:

    • To identify value-added activities in transactions.
    • To chalk out ways to eliminate non-value added activities.
    • To attach costs in response to the price resistance demonstrated by customers.
    • To distribute overheads on the basis of activities.
    • To validate the success of the quality drive with ABC.
    • To ensure accurate product costing for decision-making process.
    • To provide high quality information about activities, customers, non-manufacturing activities.
    • To focus the high-cost activities.
    • To identify the opportunities for improvement and reduction of costs.
    • To recognize the opportunities for profitably shifting the focus toward more profitable products, services and customers.

3. Steps in ABC System

The activity based cost system is summarized in the following steps:

Step 1: Process Specification

This involves identification of different stages of the production process, the commitment of resources to each processing times and bottlenecks. This will provide a list of transactions, which may, or may not, be defined as ‘activities’ at a subsequent stage.

Step 2: Identify Main Activities

The next step in ABC system is to identify the main activities in the organization. An aggregate of closely related tasks is called an ‘activity’. For example, customer processing activity involves a series of acts like receiving orders from customers, interacting with production regarding capacity to produce, giving commitment to the customer regarding delivery time etc. Thus any activity can comprise of one or more of tasks which are associated with one another to accomplish a goal or objective. Examples include: materials handling, store keeping, purchasing, inspection, despatch, assembly, setup, maintenance and so on. This ensures aggregation or grouping of common activities and elimination of immaterial activities. Activities are categorized into primary activities and support activities. The main activities can be categorized into the following:

  • Unit Level Activities – The cost of some activities (mainly primary activities) are strongly co-related to the number of units produced. These activities are known as unit level activities. Examples are:
      • The use of indirect materials
      • Inspection or testing of every item produced or say every 100th item produced
      • Indirect consumables
    • Batch Level Activities – The cost of some activities (mainly manufacturing support activities) are driven
      by the number of batches of units produced. These activities are known as batch level activities. Examples are:

      • Material ordering
      • Machine set-up cost
      • Inspection of products – like first item of every batch
    • Product Level Activities – The cost of some activities are driven by the creation of a new product line and its maintenance. These activities are known as product level activities. Examples are:
      • Designing the product
      • Producing parts to a certain specified limit
      • Advertising cost, if advertisement is for individual products
    • Facility Level Activities – The cost of some activities cannot be related to a particular product line, instead they are related to maintaining the building and facilities. These activities are known as facility level activities. Examples are:
      • Maintenance of buildings
      • Plant security
      • Production manager’s salary
      • Advertising campaigns promoting the company

Step 3: Identify Non-value Adding Activity

There are a large number of activities which continue to be carried out particularly in certain old factories, which do not contribute to the value of a product. The identification of non-value adding activities in the production process will help in focusing the attention for elimination.

Step 4: Identification of Activity Cost Pools

CIMA official terminology defines Cost Pool as ‘the point of focus for the costs relating to a particular activity in an activity based costing system’. Under ABC, costs are grouped into pools, according to the activities which drive them e.g. a cost pool may be of procurement of goods, in this all costs associated with ordering, inspection, storing etc. would be included in this cost pool. Cost pools are similar to cost centres in traditional cost systems. Costs are pooled or collected on the basis of activity that drives the costs regardless of conventional departmental boundaries. The activity cost pool is the total cost assigned to an activity. It is the sum of all the cost elements assigned to an activity.

Step 5: Selection of Activity Cost Drivers

CIMA official terminology defines a Cost Driver as ‘any factor which causes a change in the cost of an activity e.g. the quality of parts received by an activity is a determining factor in the work required by that activity and therefore affects the resources required. An activity may have multiple cost drivers associated with it’. The next step in ABC system is to identify the factors which determine the costs of an activity. These are called as ‘cost drivers’. Cost drivers are used to trace costs to products by using a measure of resources consumed by each activity. Cost drivers can be defined as those activities or transactions that are significant determinants of cost. Cost driver is a factor that determines the work load and effort required of an activity and the resources needed. An activity may have multiple cost drivers associated with it. Cost driver explains why an activity is performed and how much effort is extended to carryout the work. Cost drivers are useful because they reveal opportunities for improvement. Working to reduce the negative effects of cost drivers can yield important gains in efficiency. The following are examples of cost drivers:

(a) the number of purchase orders drives cost of the purchasing activity.

(b) the number of goods received notes drives the costs of material receiving activity.

(c) the number of items in stock drives the costs of warehousing.

(d) the number of sales invoices drives the costs of the sales, despatch and sales ledger activities.

A cost driver is an activity which generates cost. ABC system is based on the belief that activities cause costs and that a link should therefore be made between activities and products by assigning cost of activities to products based on an individual products demand for each activity. A single representative activity driver can be used to assign costs from the activity cost pools to cost objects. Such linking of total costs to cost objects is generally based on the activity driver rate.

Step 6: Tracing of Costs with Cost Objects

Cost object is the final point to which costs are traced. The cost objects are linked to the objective of the organization. Cost object is the reason for performing an activity. Cost objects include products, services, customers, projects and contracts. The cost object enables to identify the activities required to produce products etc. Direct costs like materials and labour are easily assigned directly to cost objects. The indirect costs are indirectly assigned to the cost object via cost pools and cost drivers. It involves the tracing of cost of activities to products according to a product’s demand for each activity. It requires to establish the demands made by a particular product on activities, using the cost drivers as a measure of demand. ABC is the process of tracing costs first from resources to activities and then from activities to specific products.

Step 7: Staff Training

The cooperation of the work force is critical to the successful implementation of ABC. Staff training should be oriented to create an awareness of the purpose of ABC. The need for staff cooperation in the concerned team effort for mutual benefit must be emphasized throughout the training activity.

Step 8: Review and Follow-up

The actual operation of the ABC system should be closely monitored. Periodic review and follow-up action is necessary for successful implementation of the system.

Distinction between Value-added and Non-Value-added Activities

A value added activity is an activity that customers perceive as adding usefulness to the product or service they purchase. In other words, it is an activity that, if eliminated, will reduce the actual utility or usefulness which customers obtain from using the product or service. For example, painting a car in a company manufacturing cars or a computer manufacturing company making computers with preloaded software. A non-value added activity is an activity where there is an opportunity of cost reduction without reducing the product’s service potential to the customer. In other words, it is an activity that, if eliminated, will not reduce the actual or perceived value that customers obtain by using the product or service. For example, storage and moving of raw materials, reworking or repairing of products etc. Value-added activities enhance the value of products and services in the eyes of the organization’s customers while meeting its own goals. Non-value added activities on the other hand do not contribute to customer-perceived value.

4. Cost Pools and its Cost Drivers

The important Cost pools and its Cost drivers are given below:

Cost Pools Cost Drivers
Customer Order Processing No. of customers
No. of order source (customer location)
No. of orders by quantity
No. of orders by value
No. of customer visits
Material Planning/Acquisition No. of items/parts/components
No. of deliveries
No. of material receipts
No. of material orders
No. of material movements
No. of stock shortages/discrepancies
No. of material transactions
Weight/volume of materials
No. of material movements
Inspection and Quality Control No. of inspections
No. of rejects
No. of receipts
No. of parts/volume
No. of customers
Batch sizes
No. of product changes
No. of setups
No. of suppliers
Production Control No. of product changes
No. of parts operational
No. of production hours
No. of machine changes
No. of order board changes
No. of personnel supervised
No. of schedule changes
No. of machine layout changes
No. of production batches
No. of setups
No. of work orders
Maintenance No. of setups
No. of machine breakdowns
Capital expenditure
No. of defects
No. of tool changes
Activity levels
No. of product changes
No. of production hours
No. of engineering changes
Maintenance schedule
Research & Development No. of research projects
Personnel hours on a project
Technical complexities of projects
Customer Service No. of service calls
No. of products service
No. of hours spent on servicing products
Customers Accounting No. of despatches
No. of deliveries
No. of invoices
No. of accounting reports
No. of sales orders
No. on payroll
No. of accounting changes

Difficulties in adoption of ABC in Service Organization

Facility sustaining costs (such as property, rents etc.) represent a significant portion of total costs and may only be avoidable if the organization ceases business. It may be impossible to establish appropriate cost drivers. It is often difficult to define products where they are of intangible nature. Cost objects can therefore be difficult to specify. Many service organizations have not previously had a costing system and much of the information required to set-up a ABC system will be non-existent. Therefore, introduction of ABC may be expensive.

Illustration 1 The following details have been recorded for 4 batches made in a period

Batch A B C D
Output in units 250 60 200 120
Cost per batch
        Direct material (`) 1,650 750 2,100 900
        Direct labour (`) 9,200 1,520 6,880 2,400
Labour hours per batch 1,150 190 860 300

 

The total production overhead for the period has been analyzed as follows: (`)
Machine related costs 14,600
Materials handling & despatch 6,800
Stores 8,250
Inspection/Quality control 5,850
Setup 6,200
Engineering support 8,300
Total 50,000

Cost drivers have been identified for the cost pools as follows:

Cost pool Cost driver
Machine costs Machine hours
Materials handling Materials movements
Stores Requisitions raised
Inspection No. of inspections
Setup No. of setups
Engineering support Engineering hours

The following cost driver volumes were recorded for the batches:

Batch A B C D Total
Machine hours per batch 520 255 610 325 1,710
Material movements 180 70 205 40 495
Requisitions 40 21 43 26 130
Inspections 18 8 13 8 47
Setups 12 7 16 8 43
Engineering hours 65 38 52 35 190

Required:

(a) The batch and unit costs using traditional costing based on a labour hour overhead absorption rate

(b) The batch and unit costs using ABC

(c) Compare the costs in (a) and (b)

(d) Comment on the likely position if the firm uses cost-plus pricing.

(a) Batch and unit costs using traditional overhead absorption based on labour hours.

(`)
Batch A B C D
Output (units) 250 60 200 120
Direct material 1,650 750 2,100 900
Direct labour 9,200 1,520 6,880 2,400
Prime cost 10,850 2,270 8,980 3,300
Add: Overhead (Labour hrs. × ` 20) 23,000 3,800 17,200 6,000
Total batch cost 33,850 6,070 26,180 9,300
Unit cost 135.40 101.17 130.9 77.50

(b) Batch and unit costs using ABC with various cost drivers

Calculation of Cost Driver Rates

Cost Driver Cost pool/Total number of
cost driver
Cost Driver Rate
Machine hours (` 14,600/1,710) ` 8.54 per machine hour
Material movements (` 6,800/495) ` 13.74 per movement
Stores (` 8,250/130) ` 63.46 per requisition
Inspection (` 5,850/47) ` 124.47 per inspection
Setups (` 6,200/43) ` 144.19 per setup
Engineering (` 8,300/190) ` 43.68 per hour

Batch unit costs using ABC

(`)
Batch A B C D
Quantity 250 60 200 120
Prime cost (a) 10,850 2,270 8,980 3,300
Add: Overheads:
Machine hrs. @ ` 8.54 (520) 4,441 (255) 2,178 (610) 5,209 (325) 2,775
Movements @ ` 13.74 (180) 2,473 (70) 962 (205) 2,817 (40) 550
Requisitions @ ` 63.46 (40) 2,538 (21) 1,333 (43) 2,729 (26) 1,650
Inspections @ ` 124.47 (18) 2,240 (8) 996 (13) 1,618 (8) 996
Setups @ ` 144.19 (12) 1,730 (7) 1,009 (16) 2,307 (8) 1,153
Eng. hrs. @ ` 43.68 (65) 2,839 (38) 1,660 (52) 2,271 (35) 1,529
Total overheads (b) 16,261 8,138 16,951 8,653
Total batch cost (a) + (b) 27,111 10,408 25,931 11,953
Unit cost 108.44 173.47 129.65 99.61

(c) The unit costs compared

(`)
Batch A Batch B Batch C Batch D
Traditional ABC Traditional ABC Traditional ABC Traditional ABC
135.40 108.44 101.17 173.47 130.9 129.65 77.50 99.61

It will be seen that in this example there are significant differences between the costs using the two systems. Batch C’s costs are broadly the same but the costs of Batch B and D are much higher using ABC, whereas Batch A is lower.

Study of the usage of support overheads by the batches shows that batches B and D have a higher relative usage of resources so incur greater overhead costs using ABC. Because the traditional method absorbs overheads on labour hours these differences in usage are effectively ignored. It is this feature which, admittedly, makes product costs more realistic when ABC is used.

(d) Cost-plus pricing is a pricing method where a margin (say 40%) is added to costs to produce the selling price. Cost-plus pricing is widely used in many jobbing and batch production firms.

If the firm in the example uses cost-plus pricing then the quoted selling prices will differ considerably depending on whether the traditional or ABC method was used to calculate costs. If it is accepted that the ABC costs are the more realistic then serious errors in pricing may occur if the traditional costs were used as the basis. This would mean that, based on traditional costs, Batch A would be overpriced and Batches B and D underpriced.

In effect, if pricing decisions were based on the less realistic costs then Batch A products would be subsidizing Batch B and Batch D products and, in the long-run, the firm would tend to receive more orders for the underpriced B and D products. This would be likely to lead to declining profits as these products place relatively higher demands on resources which should be reflected in higher prices.

5. Advantages and Limitations of ABC

Advantages of ABC

    • ABC is more precise, accurate and reliable in comparison to traditional costing systems.
    • ABC provides analytical information for the purpose of strategic decision-making.
    • ABC helps in achieving the objective of cost-effectiveness as many fixed and variable overheads become controllable in ABC.
    • In ABC, costs/overheads are charged specifically and relevantly to the products.
    • ABC attempts to segregate allocable and non-allocable overhead costs and also segregates the costs on the basis of level of operations.
    • ABC increases the efficiency of cost-control system. On the basis of information provided by ABC, effective measures can be adopted for cost cutting.
    • ABC helps in performance evaluation, through the comparison of budgeted and actual performance.
    • ABC helps in revision of standard performance and aids in identification of forthcoming profitable opportunities.
    • ABC facilitates in reorganizing and redefining of allocation of costs to activities, which ultimately enhances profitability.
    • ABC needs detailed analysis of costs. It helps in the process of fixation of selling price and the bottom line to which selling price can be lowered in competitive situation.
    • The analysis of break-even point, margin of safety etc. through ABC, helps in effective decision making.

Limitations of ABC

    • Some costs like production-sustaining costs are highly difficult to trace even in ABC.
    • ABC requires segregation of activities upto the root level, specialization as well as involvement and commitment. It sometimes becomes difficult to break all the tasks into clearly identified activities.
    • Cost estimation, ascertainment, allocation and apportioning, along with deciding on the cost groups and drivers can become difficult in the absence of adequate knowledge.
    • Implementation of ABC requires sincerity and continuity in efforts. It also calls for the ability to strategically utilize the gathered information.
    • ABC is a system designed to provide information to management and it does not provide decisions.
    • ABC is a complex system which consists of various cost pools and cost driver rates.
    • ABC is beneficial to the complex and large organizations. For small organizations, traditional system is more economical and simple.
    • Sometimes, the use of multiple cost drivers is necessary. Often it is difficult to attribute costs to single activities, some costs support several activities.
    • ABC is based on the assumption that there is a direct and linear relationship between the usage of activities and application of cost driver rates.

6. ABC System and Corporate Strategy

ABC is an accounting methodology that assigns costs to activities rather than products and services. This enables resources and overhead costs to be more accurately assigned to products and services that consume them when compared to traditional methods where either labour or machine hours are considered as absorption basis over cost centres. In order to correctly associate costs with products and services, ABC assigns cost to activities based on their resources. It then assigns cost to ‘Cost objects’, such as products and customers, based on their use of activities. ABC can track the flow of activities in organization by creating a link between the activity and the cost objects. ABC supports corporate strategy in many ways such as:

    • ABC system can effectively support the management by furnishing data, at the operational level and strategic level. Accurate product costing will help the management to compare the profits of various customers, product lines and to decide on price strategy etc.
    • Information generated by ABC system can also encourage management to redesign the products.
    • ABC system can change the method of evaluation of new process technologies, to reduce set-up times, rationalization of plant lay out in order to reduce or lower material handling cost, improve quality etc.
    • ABC system will report on the resource spending.
    • ABC analysis helps managers’ focus their attention and energy on improving activities and the actions allow the insights from ABC to be translated into increased profits.
    • Performance base accurate feedback can be provided to cost centre managers.
    • Accurate information on product costs enables better decisions to be made on pricing, marketing, product design and product mix.

Activity Based Information and Decision Making

ABC may not be appropriate for all companies, particularly those where overheads are relatively small and which do not produce a wide range of products. But many of the benefits of ABC can still be obtained by implementing a partial system which focuses only on the most important activities. Traditional methods can be used for to produce monthly profit statements, leaving ABC to support strategic decision making, profitability analysis and the control of manufacturing costs. ABC supports decision making in many ways such as:

    • ABC system can effectively support the management by furnishing data, at the operational level and strategic level. Accurate product costing will help the 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 redesign the products.
    • ABC system can change the method of evaluation of new process technologies, to reduce setup times, rationalization of plant layout in order to reduce or lower material handling cost, improve quality etc.
    • ABC system will report on the resource spending vis-a-vis resource consumption, and reduced demand in organizational resources lead to increase in profits.
    • ABC analysis helps managers focus their attention and energy on improving activities and the actions allow the insights from ABC to be translated into increased profits.

7. Activity Based Budgeting

Activity Based Budgeting (ABB) complements Activity Based Costing (ABC) by focusing on the cost activities necessary for production and sales. ABB determines the cost of performing certain activities, in contrast to traditional budgeting, which budgets cash for functional or spending categories. ABB, thus, produces a qualitative expression of the expected cost of performing various activities. To facilitate continuous improvements, the ABB process is designed to highlight opportunities for Cost Reduction and for the elimination of wasteful activities. Thus, ABB serves to reduce the workload to the minimum level necessary to achieve the organizational objectives. ABB increases the effectiveness of budgeting by identifying cost-to-performance relationships. ABB involves the following stages:

    • Estimate the production and sales volume by individual products and customers.
    • Estimate the demand for the organizational activities.
    • Determine the resources that are required to perform organizational activities.
    • Estimate for each resource the quantity that must be supplied to meet the demand.
    • Take action to adjust the capacity of resources to match the projected supply.

ABB, sometimes termed ‘activity cost management’, is a planning and control system which seeks to support the objective of continuous improvement. It is a development of conventional budgeting system based on activity analysis. ABB requires the identification of the activities of the organization, establishing the factors which cause costs, the cost drivers, and then collecting the costs of the activities in cost pools.

Illustration 2 A purchasing department has two main activities; investigating and liaising with suppliers and issuing purchase orders. Two major cost drivers have been identified: the number of suppliers and the number of purchase orders placed.

The resources and costs of the department have largely been spread over the two main cost drivers. The balance of costs have been termed ‘Department Sustaining Costs’. These include some general clerical costs and part of the manager’s costs. Based on the activity expected for the period, cost driver volumes of 270 suppliers and 1,850 purchase orders have been forecast. Using these volumes and cost analysis, cost driver units and resource item costs have been budgeted for the department after discussion with the Departmental manager. The budget is as follows:

Budget for Purchasing Department

(`)
Cost drivers No. of suppliers No. of purchase orders Dept. sustaining cost Total
Cost:
Management salaries 12,000 2,000 18,000 32,000
Clerical salaries 3,000 21,500 6,500 31,000
Space costs 1,000 14,500 2,000 17,500
Consumables, travelling etc 17,500 3,000 4,500 25,000
Information technology 3,000 8,500 1,000 12,500
Other costs 4,000 6,000 7,500 17,500
Total 40,500 55,500 39,500 1,35,500
Activity volumes 270 1,850
Cost/unit of cost driver (`) 150 30 39,500

Notes:

(a) The apportionment of costs to activities will, of course, be partly subjective. The object however is that the resource has to be justified in supporting one or more of the activities or the sustaining function. There is no place to hide the costs.

(b) ABB highlights the cost of activities and thus encourages new thinking.

(c) ABB enables a more focused view of cost control because the activity level is taken into account. Trends can be monitored and comparison with other organizations can be made. This is known as benchmarking.

(d) The cost driver rates ` 150 and ` 30 are used in calculating the product costs in the Activity Based Costing system.

(e) The identification of activities and their costs helps to focus attention on those activities which add value and those that do not.

8. Activity Based Management

ABC, which is now being called ‘Activity Based Management (ABM)’ used cost information generated by ABC about an activity for controlling the activity itself, rather than just using cost information of the final product. ABC is also useful in daily operation and controlling over the activities. The focus of the management is taken care by providing information regarding cost of resources supplied and cost of resources used. ABM is a further development on ABC. ABM is a discipline that focuses on the efficient and effective management of activities as the route to continuously improving the value received by customers and the profit received by providing this value. ABM utilizes cost information gathered through ABC. Through various analysis, ABM manages activities rather than resources. ABM analyzes and manages cost drivers to manage costs. In that process ABM also analyzes value added and non-value added activities in order to eliminate non-value added activities and simplify or improve upon value added activities. ABM involves:

    • Identification of major activity areas
    • Assigning costs to cost pool for each activity
    • Spreading of support activities across the primary activities
    • Determination of ‘cost driver’ for each activity that may be used as cost application base.

Cost drivers link activities and resources consumption to generate less arbitrary costs for decision-making. ABM is being used for a variety of business applications such as:

    • Activity Based Budgeting
    • Benchmarking
    • Cost Reduction
    • Performance Management etc.
    • Business Process Re-engineering

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