Activity- Based Costing

Traditional cost accounting systems

Until the 1990s almost all companies used

Traditional Cost Accounting systems (TCS).
Traditional cost accounting system works well
where a company makes only a few products
for which direct material and direct labour
costs are very high percentages of total costs
and indirect costs are a small percentage of
total costs.
But as companies grow and their operations
become more complex, they need to modify
their traditional costing systems to maintain
the accuracy of product or service costs.
It is very difficult to apply TCS in a complex
situation where a company makes hundreds
or thousands of different products and
indirect costs are a large percentages of total
costs. It is also difficult to apply where
products consume resources at widely varying
rates.
Activity Based Costing (ABC) has gained
popularity during the past two decades to
overcome the drawbacks of the traditional
system. Professor Kaplan and Cooper has
Pioneered the Activity Based Costing concept.
 Activity Based Costing
ABC is a costing system in which costs are first
traced to activities and then to products.
The underlying theme of ABC is that activities
consume resources and products consume
activities. So, the cost of product is related to
the cost of resources.
 Steps in ABC
Step 1: Identify the main activities in the organization.
(Exp.: Material handling, purchasing, receipt, despatch etc.)
Step 2: Identify the factors which determine the costs of an
activity. These are known as cost drivers.
(Exp.: number of purchase orders, no. of orders delivered etc.)
Step 3: Collect the costs of each activity. These are known as cost
pools.
Step 4: Allocate the overheads to products on the basis of the
usage of activity, expressed in terms of appropriate cost
driver(s).
Economic Value Added (EVA)
 Measures of Profitability
Return on Investment(ROI)
= Return on sales x Capital Turnover
= Profit / Invested capital
ROI is widely used measure of profitability . ROI
is focusing on income as a percentage of
investment. But, some mangers want to know
the absolute amount of income rather than a
percentage. They prefer Residual Income (RI).
RI is defined as after-tax operating income less
capital charge. The capital charge is the
company's cost of capital multiplied by the
amount of investment.
There are several ways to calculate RI. One
popular measure of RI, marketed by Stern
Stewart & Co., is economic value added (EVA).
EVA is an accounting-based measure of operating
performance. It is the difference between the
adjusted accounting earnings and the cost of
capital used to generate these earnings.
EVA = NOPAT – (WACC x Invested Capital)
Where, NOPAT = Adjusted net operating profit after
tax
WACC = Weighted average cost of capital
Invested Capital = Capital Employed
Stewart & Co. considered about 250 accounting
adjustments in moving to EVA and identified
over 120 shortcomings in conventional
accounting.
EVA can be calculated for a month, quarter, half
year and a year.
The entity could be a division or a firm
 EVA
EVA is a modified version of residual income concept.
The company creates shareholders value only if it
generates return in excess of its cost of capital. The
excess of return over cost of capital is known as EVA.
EVA measures whether the operating profit is
sufficient enough to cover cost of capital. While a
positive EVA increases shareholders’ wealth,
negative EVA indicates that shareholders’ is
destroyed.
 How EVA can be improved?
EVA can be improved in any one of the following ways:
 Increasing NOPAT with the same amount of capital
 Reducing the total capital employed by maintaining
the same earnings
 Reducing the cost of capital, i.e. employing more
debt which a cheaper source of fund.
 Investing in projects that earn return greater than
cost of capital