UNIT – 5: - ABC Analysis Teaching Hours: 18Hrs

Activity based costing–Meaning and concept-Characteristics of ABC-Benefits from

adoption of ABC-Just in Time Costing (JIT)

ACTIVITY-BASED COSTING:
Activity-Based Costing - Meaning
Activity-Based costing is allocating costs to the activities involved in the production.
It can be defined as a system of costing that recognizes activities involved in producing a
product and then traces the cost incurred in performing each activity.
Activity-Based Costing - Definition
As per the Chartered Institute of Management Accountants (CIMA), the ABC has
been defined as: "ABC is the cost attribution to cost units based on benefits received from
indirect activities, e.g., ordering, setting up, assuring quality, etc."
From the above definition, ABC is the costing system in which cost is attributed to each
activity, and then it is summed up to the product.
Features of ABC
1) ABC costing system consists of two stages of the cost of the product. In the first
stage, the cost is assigned to the production activities, and then in the final stage, the
cost is allocated to the final product.
2) It follows the approach of accumulated activity-related costing.
3) The activity considered for estimation of cost should be any task undertaken for the
production of any product or for delivering any services.
4) ABC system follows the concept that the products consume activities, and the
activities consume resources.
5) ABC costing method can be used by any manufacturing or service delivery firm that
wants to ease cost accounting.

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Objectives of the ABC System of Costing
1) To effectively estimate the cost of the product or the services.
2) Identifying which activities are value-adding and non-value-adding in the production
process can help eliminate unnecessary activities.
3) To provide correct and accurate information for decision-making.
4) To identify high-cost activities and take proper action to reduce costs.
5) To identify non-essential activities involved in the production of goods and services.
6) It can help to motivate managers through the evaluation of the efficiency of activities
in production.

Difference between the Traditional Absorption Costing Method and the Activity-Based
Costing Method.

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Traditional Absorption Costing Activity-Based Costing

In this, the overhead expenses are first In this system, the overhead expenses are assigned to
allocated to departments or units. production activities or passed to cost pools.

It consists of only two types of activities; they Here the cost is assigned to all the activities included
are Unit level activities and Facility level under the manufacturing hierarchy, like Unit level, batch
activities. level, product level, and facility level.

In this system, the cost is allocated to the cost In this system, the costs are assigned to the production
centres or locations where costs are incurred. activity factors.

Here only the cost of production of products In this system, apart from the cost of the product, other
can be ascertained. objects or activities involved in the production process
can be ascertained, like costs incurred under customer
segments, distribution, packaging, etc.

What are the steps involved in setting up the Activity- Based costing?
In developing the ABC method of cost, several steps are needed to be followed:
1) Identifying Resources
Identifying resources means finding out the possible expenditure of the organization,
which is to be assigned to the cost of the product. So, resources mean expenses that are to be
incurred at each activity, which will be allocated first to the activity, and then to the product.
2) Identification of Activities
The method of ABC costing is based on the activities performed during the
production of the product or delivery of the services. Therefore, it is very necessary to point
out the activities associated with the production of the product to allocate the incurred
expenses. In this step, activities are identified for the allocation of cost.
3) Identification of Cost Drivers
The identification of cost components is the cost drivers involved in different
activities. Cost drivers or cost objects are the factors that impact the cost of a particular
activity. It is very important to find out the things that determine the cost of an activity.

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4) Assigning Cost to the Product
The final step is assigning the cost to the product after tracing all the incurred costs to the
product.
What is the importance of the ABC method of cost?
1) ABC costing method is important to bridge the cost to its cost drivers.
2) This method allows us to determine the cost of the activities involved rather than the
centre of the cost.
3) It helps to assign the cost with greater effectiveness due to the cost related to its
activities.
4) It eliminates the blanket expenses used in the traditional absorption method of
costing.
5) ABC method effectively reduces and controls costs due to the effective identification
and allocation of overheads.
6) It presents the cost associated with the product in the most accurate form.
Uses of Activity-Based Costing Method
The information gained from the ABC method of costing is useful in different areas of
decision-making, which are discussed below:
1) Activity Cost
The motive of the ABC method of costing is to allocate the overheads involved in the
activity. This helps us track whether the cost of the activities is in line with the industry's
standards. Therefore, it acts as a tool for measuring the cost of activities and thus helps in
decision-making.
2) Customer Profitability
The company has to bear various customer costs apart from the cost of product
production, like consumer services, return product handling, cooperative marketing, etc. The
ABC costing system can help sort this additional cost and help the management identify
profitable customers.
3) Distribution Cost
Efficient distribution of products to consumers is a major task for any entity.
Organizations use distribution channels like retail, e-commerce, wholesalers and distributors,
etc. In the distribution of products through any of these channels, an overhead is involved in
maintaining the channel. So, with the help of ABC, the company can determine which form

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of distribution channel and how much it costs, and on that, decisions can be made to
determine which type of channel is profitable and which is not.
4) Domestic or Outsource
The ABC provides information about the cost incurred on each production activity;
with that help, the management can decide which activity is profitable to perform
domestically and which is required to be outsourced. Management can outsource any activity
if that incurs a higher cost domestically than outsourcing.
5) Determination of Margins
For any business, the margin is a very important component as it is the profit earned
after selling the product. By properly allocating overheads under the ABC costing method,
management can determine the maximum desired margin of the product. It also helps
position the company's resources to earn the highest margins.
6) Minimum Price Fixation
Product pricing is the price the market can bear, and the manager's motive should be
to avoid selling the product below the minimum profitable price. Therefore, the ABC costing
method helps the management to determine which activity cost

Advantages of Activity Based Costing (ABC):

1. Accurate Product Cost:
ABC brings accuracy and reliability in product cost determination by focusing on
cause and effect relationship in the cost incurrence. It recognizes that it is activities which
cause costs, not products and it is product which consumes activities. In advanced
manufacturing environment and technology where support functions overheads constitute a
large share of total costs, ABC provides more realistic product costs.
2. Information about Cost Behaviour:
ABC identifies the real nature of cost behaviour and helps in reducing costs and
identifying activities which do not add value to the product. With ABC, managers are able to
control many fixed overhead costs by exercising more control over the activities which have
caused these fixed overhead costs. This is possible since behaviour of many fixed overhead
costs in relation to activities now become more visible and clear.

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3. Tracing of Activities for the Cost Object:
ABC uses multiple cost drivers, many of which are transaction based rather than
product volume. Further, ABC is concerned with all activities within and beyond the factory
to trace more overheads to the products.
4. Tracing of Overhead Costs:
ABC traces costs to areas of managerial responsibility, processes, customers,
departments besides the product costs.
5. Better Decision Making:
ABC improves greatly the manager’s decision making as they can use more reliable
product cost data. ABC helps usefully in fixing selling prices of products as more correct data
of product cost is now readily available.
6. Cost Management:
ABC provides cost driver rates and information on transaction volumes which are
very useful to management for cost management and performance appraisal of responsibility
centres. Cost driver rates can be used advantageously for the design of new products or
existing products as they indicate overhead costs that are likely to be applied in costing the
product.
7. Use of Excess Capacity and Cost Reduction:
ABC, through the processes of pooling of activity costs and the identification of cost
drivers, can lead to a range of applications. These include the identification of spare capacity
and the fostering of cost reduction by comparing the resources required under ABC with the
resources that are currently provided. This provides a platform for the development of
activity-based budgeting in which the resource relationships identified by ABC are used to
project future resource requirements.
8. Benefit to Service Industry:
Service organizations, such as banks, hospitals and government departments, have
very different characteristics than manufacturing firms. Service organizations have almost no
direct costs, most of the costs are overheads and they do not hold stocks of service as the
service is consumed when it is produced. ABC offers the potential of benefits from improved
decision making and cost management.

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Demerits of Activity Based Costing (ABC):
1. Expensive and Complex:
ABC has numerous cost pools and multiple cost drivers and therefore can-be more
complex than traditional product costing systems. It can prove costly to manage ABC system.
2. Selection of Drivers:
Some difficulties emerge in the implementation of ABC system, such as selection of
cost drivers, assignment of common costs, varying cost driver rates etc.
3. Disadvantages to Smaller Firms:
ABC has different levels of utility for different organisation such as large
manufacturing firm can use it more usefully than the smaller firms. Also, it is likely that firms
depending on cost-plus pricing can take advantages from ABC as it gives accurate product
cost.
4. Measurement Difficulties:
The main costs and limitations of an ABC system are the measurements necessary to
implement it. ABC systems require management to estimate costs of activity pools and to
identify and measure cost drivers to serve as cost allocation bases. Even basic ABC systems
require many calculations to determine costs of products and services. These measurements
are costly. Activity cost rates also need to be updated regularly.

Just-in-Time (JIT)
Introduction
Just-In-Time is a Japanese manufacturing management method developed in 1970s. It
was first adopted by Toyota manufacturing plants by Taiichi Ohno. The main concern at that
time was to meet consumer demands. Because of the success of JIT management, Taiichi
Ohno was named the Father of JIT. The just in time manufacturing system considered as a
pull system. The principle of Just in time (JIT) is to eliminate sources of manufacturing waste
by getting right quantity of raw materials and producing the right quantity of products in the
right place at the right time.

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What is Just-in-Time (JIT)?

. Just-In-Time (JIT) is a purchasing and inventory control method in which materials

are obtained just-in-time for production to provide finished goods just-in-time for sale. JIT is

a demand-pull system. Demand for customer output (not plans for using input resources)

triggers production. Production activities are “pulled” not “pushed” into action. Just-in-time,

or JIT, is an inventory management method in which goods are received from suppliers only

as they are needed. The main objective of this method is to reduce inventory holding costs

and increase inventory turnover

The Goals of JIT:

The ultimate goal of JIT is a balanced, smooth and rapid flow of materials through the
system. This can be achieved by approaching the following supporting goals first;
1. Zero defects.
2. Zero inventories.
3. Zero set – up time.
4. Zero handling.
5. Zero break – down.

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Objectives of JIT:

The objectives of JIT can be mentioned as shown:

1. Produce with perfect quality.

2. Produce with minimum lead time.

3. Produce products with only those features the customer wants.

4. Produce with no waste of labor, material or equipment, every movement must have a

purpose so that there are zero idle inventories.

5. Produce with methods that allow for the development of people.

The major differences between JIT manufacturing and traditional manufacturing are
as follows:

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