An assignment On

ACTIVITY BASED COSTING
Subject: MCIS Date: 26/07/2008
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TOPICS Introduction to Activity Based Costing Reason for Introduction of ABC Activity Based Costing Methodology & Implementation Benefits of ABC Limitation of ABC Case study Conclusion Reference Page . 8.No 1. 5. 4. 3. 3. 6.CONTENTS Sr. 2.No 3 4 5 11 12 13 14 17 17 2 . 7.

Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities. the cost are collected according to activities such as material ordering. ABC is one such new dimension. These days. quality testing. ABC is not a distinct method of costing like job costing and process costing. processes. Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity-Based Costing (ABC) is a method for estimating the resources required to operate an organization's business processes. Now in the context of ABC. In a business organization. It accurately estimates the true cost of products. distribution channels by assigning cost to activities with the help of cost drivers. outsourcing and identification and measurement of process improvement initiatives. As such. ABC provides the fruitful information to the management as value analysis. ABC has predominantly been used to support strategic decisions such as pricing. It is only a new practices or intermediate change in the process of attribution of costs to job or processes. In layman's terms. a new term ‘activity based costing’ is growingly used. etc. and jobs and process for which cost collection is being attempted are loaded with costs of these activities rationally. machine set-ups.Introduction to Activity Based Costing Management principles have undergone drastic changes over the last century and will continue to change. 3 . customer support service. It is necessary to view this term in the context of job costing and process costing. the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. produce its products and serve its customers. etc. It improves the organization’s work processes and activities efficiently and effectively. Job costing and process costing are the two basic methods of cost accounting. cost drivers. material handling. Earlier cost were first collected for production department and service departments and finally cost the cost of production departments were absorbed by jobs or processes. It is generally used as a tool for understanding product and customer cost and profitability. customer segments. services. Organizations in all sectors are adding new dimensions to their management practices.

which led to the development of ABC.  Direct labour has shrunk as a percentage of total cost for majority of manufacturing companies.Reason for Activity Based Costing Following are the factors. quality control. customer service. Overhead functions such as product design.  Overhead costs are not long a mere burden to be minimized.  Market place is very competitive.  Growing dissatisfaction among the working executives regarding traditional costing which is based on averages and estimation.  Traditional costing often fails to highlight inter. Product ranges are wider.  Availability of computer has enhanced requirement for improvement in informationgathering technology for advanced decision making o gain competitive advantage. Still it is most common basis of over-loading overheads to products.relationship among activities in different departments. Product cycles are shorter and demand for quality is higher. 4 .  Traditional costing systems are driven by the need to value stocks rather than to provide meaningful product cost. production planning and sales order processing are as important to the customer as physical process on the shop floor.  Traditional costing fails to capture cause and affect relationship.  Complexity has increased.

3) Product level drivers which assume the necessity of the inputs to support the production of each different type of product. some costs will always be solely attributable to the functioning of the organization itself. Below Figure shows an ABC model. While ABC can allocate overheads more accurately. Users of the ABC system will need to identify the activities which generate cost and then match the activities to the level bases used to assign costs to the products. the activities which generate cost must be determined and then should be matched to the level drivers used to assign costs to the products. In this model. While using the ABC system. Since the cost drivers are related to the activities. 4) Facility level drivers are the drivers which are related to the facility’s manufacturing process. costs are assigned to either products. customers or infrastructure. 5 . they occur on several levels: 1) Unit level drivers which assume the increase of the inputs for every unit that is being produced.Activity Based Costing ABC is an economic model that identifies the cost pools or activity centers in an organization and assigns costs to cost drivers based on the number of each activity used. 2) Batch level drivers which assume the variation of the inputs for every batch that is being produced.

and a certain level of competencies and knowledge. Every activity has 1) inputs. The second major component of ABC is activity. and 3) an output. equipment.g..Figure 1: Activity Based Costing Model There are two fundamental components of ABC: costs and activities. Costs are based on resources or inputs. materials. 2) a sequence of actions in the middle that occupies a period of time. office supplies. for such items as personal services. Activities are the steps or sequences of actions that convert inputs to outputs. An output may be something other than a product or service. and the like. 6 . Each of these components is briefly discussed below. a student graduating with a specific set of skills. e. Activities have a set of three distinct characteristics that define them.

Summary cost information on activities provides information for program managers for budgeting and other purposes. Or the activity to be costed could be framed at a level well above Accounts Payable. cutting checks. What is the business need for the information? The keys are flexibility and adaptability. direct cost total that can most easily 7 . The most difficult part of analyzing costs is framing the activity at the most appropriate level of detail to satisfy the costing objective. so that Accounts Payable was only one small aspect of the larger activity. Be sure your costing objective is determining the way to define your activity for ABC purposes. Are you getting ready to prepare an activity based budget to submit for? Then you will need budgeted estimated costs at the activity level. The amount of detail should be no greater than required for the purpose for which the data are to be used. less unavoidable costs (such as the Department Director) to achieve your costing objective. What about service redesign or process improvement? If you are undertaking a service redesign or process improvement project. Simply increasing awareness of costs and the cost structure of your operation can lead to efficiency improvements and greater cost discipline. Each level in the hierarchy is an aggregation of the levels below it. you will need total costs to facilitate your rate setting objective. A summary of the business and costing objectives follow: Business Objective Rate or Fee Setting Managed Competition Cost Awareness Process Improvement Reengineering Costing Objective Total Costs(all direct and indirect costs) Avoidable Total Costs(all direct and indirect costs less those costs that would not be avoided if the activity was outsourced) Comparable Costs(a flexible concept: those costs that are most easily determined.Activity-Based Costing recognizes a hierarchy of operations. Detailed cost information on activities benefits operational managers and assists them in improving operations. you will need comparable costs of the existing process and the redesigned or improved process to see if you achieved a cost saving. For example. Agencies will define an activity at a level deemed appropriate for the costing objective to be achieved. Another way to identify the costing objective is to ask why you are doing the ABC. Accounts Payable could be split into smaller activities such as receiving invoices. Or. Accounts Payable could be identified as an activity and costed. and mailing checks. Why do you need ABC? What is your costing objective? Are you getting ready to establish rates to recover your costs of providing a service? If so. you will need total costs. costs over which the work unit has the most control. Will you be preparing a managed competition bid or looking to outsource or privatize a service? If so. You need to identify the activity consistent with your costing objective.

This view explains the why or why not of an activity's timeliness. accuracy or cost effectiveness and identifies how much was 8 . Costs are assigned to activities based on the activities' consumption of resources. ABC assigns or allocates costs to activities based on some rationale. This concept is called the "activity view. The important point is to tailor your ABC to your business objective. material. A task by task flow chart or outline of the activity allows deeper insights into how an activity works. ABC costing assigns resources (inputs) that are consumed (activities) to produce certain outputs (counts of what was produced). The ABC process allows personnel to view the flow of tasks within an activity to understand how results and service quality are achieved. Activity costs are then assigned to outputs based on their use of activities. but do not waste resources by going further than needed. For example. An ABC system that is too complex or cumbersome will not be used.Benchmarking Activity Based Budgeting be compared to other providers' direct costs) Budget Estimates Some of these reasons for performing ABC require a greater degree of exactness than others. Tailoring is important so that you achieve the level of accuracy and precision that you need. And the chart above is not exhaustive. In balancing these demands. You may have other reasons to do ABC. This is known as the cost assignment or cost view. and equipment are assigned to various activities to determine the costs of the activities that are then divided by activity outputs to derive cost per unit of output. salaries." This view looks at the activity from the customer's or stakeholder's perspective. you should also be mindful of the ongoing data gathering and tracking requirements of your ABC. ABC also provides an opportunity to understand how resources are expended to achieve results.

Activity performance measures of input. ABC shows what it actually costs to produce a given output or result. These traditional reports provide important information for the line item or organizational framework they were intended to address. The activity view feeds into Activity Based Management and leads to process improvement. or other ways to continuously improve activities or processes. ABC also directly links service levels with costs through unit costs. 9 . Activity-based costing however cuts through or supplements the traditional costing reports to mirror what was actually done.performed (number of units produced) as well as the inputs and efficiency of the activity. output. efficiency and service quality are aligned to the program results measure. The focus of ABC is on activities and their outputs/results. It presents the same information by activity to see how the resources are spent. service redesign. Activity based cost data provides more informative reports than the traditional line-item or organizationally based accounting reports produced by current accounting systems.

the answers to that question often lead to greater efficiencies and effectiveness as the operations with the best data share their best practices with the other groups or offices. These cues naturally lead to process improvement and reengineering changes. viewing ABC data is the first time program managers and program staff have seriously considered costs. Sometimes. This awareness alone often leads to cost cutting or reallocations from less to more productive resource use. comparing unit cost information with comparable data from other public or private sector partners allows us to benchmark our performance. Comparing unit costs across different groups doing the same tasks. ABC data makes it easier to see that some parts of the activity add more value to the results for less cost or vice versa. and other decision making. reengineering. or across regional offices. 10 . leads to the obvious question: Why are there differences? Again. Similarly. That benchmarking too supports process improvement.Seeing the cost data in this form usually leads to action. Another common response is an analysis of spending.

following procedure should be adopted so that it can be skillfully implemented with excellent results.Methodology & Implementation For Implementation of Activity Based Costing in any firm.  Identify Resources  Identify Activities 11 .

 Identify Cost Objects  Define Resource Drivers  Define Activity  Enter Resource Costs  Enter Resource Driver Quantity  Enter Activity Driver Quantity  Calculate Costs Benefits of ABC Following are Advantage of Activity Based Costing: 12 .

 It helps to allocate the resources to those activities that will increase shareholders value. services.  The understanding of the cost driver for each activity gives better control over the factors that cause costs.  It provided the right information for performance measurement because it focuses on activities rather than resources. 13 .  It ensures that the cost of non-value added activities is visible to management.  It gives businesses an opportunity to improve their competitive position through better information’s.  It provides accurate information on profit margin and performance measurement for profit improvement.  It links profitability analysis to operational decisions. It helps understanding the behavior of overhead costs and their relationship to products. customers and market segments.

14 . therefore.  Too much emphasis on customer viability can lead to problems such as cheaper products and.  It takes no account of opportunity cost.Limitation of ABC Following are the Limitation of Activity Based Costing:  It is essentially not the panacea for all ills.  It absorbs a lot of resources.  It may lead to weaker customer segmentation. potentiality lower sales.

and Pick-n-Pay makes it versatile.. clothing and textiles.e. The retail sector. kirana wala to Hyper Market. The retail sector movement from local mom and pops shop. jewellery and watches. Exclusive Outlet. i. particularly in food and grocery. Discount Stores.ABC in Indian Retail Sector The retail sector is based on customer-supplier network called as Supply Chain.Case study. Some of the major Challenges which the retail sector is facing are:  Competition  Technology Movement 15 . Super Market. consumer durables. Cash-n-Carry. Departmental Stores. It is growing by leaps and bounds. beauty care and other constitute a major chunk of the market. home décor and furnishing.

it is imperative to consider the following functional areas in the retail sector for identifying the activities:  Logistic Movement  Effective branding and labeling  Material management  Stores management  Production scheduling and management  Quality control management  Repairs and maintenance  R&D  Administration  Personnel Management  Accounts  Secretariat  Public Relations  Finance & Fund raising  Marketing Management  Sales managaement 16 . Mall revolution  Private label brands  Collaboration with manufacturers  Managing sourcing  Innovative retail format  Cost competition In view of these challenges.

Subhiksha. CEO of Pantaloon Retail Kishore Biyani has made a tremendous growth in FMCG segment by emphasizing the ABC concept. Ltd.. Manage Business Process Cost Price Leadership Value Delivery Customer Expectation Activity-Based Costing Building Brand Image Functional Areas Manage Product Portfolio Activities Cost Drivers Competitive Advantage Figure: The Strategic Move Adopted by the Retail Sector The activities in various functional areas of the retail outlets are explained below: Functional Areas Material Management Store Management Production Activities Involved Receive of Indent Follow of Delivery Inspection of materials Physical custody of materials Inspection and verification Recording of materials consumption for each batch of Cost Drivers Number of Indents Number of Indents Number of Indents Number of times custody took Number of times inspected Number of cost drivers required 17 . Spencer’s. Shoppers Stop. MORE. Hyper City and Easy Day are following the directional path of ABC as a tool to reduce their costs by identifying functional areas and their activities as well as cost drivers related to them. Import  Export Retail giants like Reliance Fresh. Pantaloon Retail (India) Pvt. Vishal Mega Mart.

Quality Control R&D Administration Personnel Accounts (Finance) Public Relations consumption Testing the finished goods as per standard Innovations ideas for new product times Canteen Watch & Ward Training Regular Increment Sales Accounting Wages Accounting Salary Accounting Bill passing of Miscellaneous Issue of Corporate brochure Advertisement in trade journal Number of batches produced Time Spent for development Number of People took meals Number of Security involved Number of employees Number of employees Number of people Number of people engaged Number of Staff Value of purchase Time Spent Time Spent 18 .

Saxena & C. Economic Times 19 .Conclusion Activity Based costing is a managerial costing tool that traces the resources costs to activities and assigns cost-based upon the drivers.Vashist 3.D. Internet. It also helps to improve decision-making at operating and strategic levels. In the retail sector by identifying various activities and their cost drivers in functional areas. cost control can be undertaken for each activity. Basics of Cost and Management Accounting – V. 4. It will help in joint problem solving.K. References 1. The Accounting World – ICFAI Journal 2. information-sharing diversified customer supplier network and cost price leadership. So the implementation of ABC is a management philosophy adopted by the retail secor.

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