One of the best tools for refining a costing system is Activity Based Costing. ABC is that costing in which costs are first traced to activities and then the products. It is costing system which focuses on activities performed to produce products. This system calculates the cost of individual activities and assign cost to cost objects such as products and services on the basis of the activities needed to produce each product or service.

Steps in Activity Based Costing

Identifying major activities
Identifying the supplier  Purchase requisition  Preparing purchase order  Mailing the purchase order  Follow up etc….. Perform an in-depth analysis of the operating processes of each responsibility segment, each process may consist of one or more activities required by outputs.


Assign resources costs to activities:
This is some times called ‘Tracing’. Trace ability refers to tracing costs to cost objects to determine why costs were incurred. DOD categories costs in three ways  Direct  Indirect.

General and Administrative:
Costs that cannot responsibly the activity produced be associated with any particular product or service produced. There costs would remains the same no matter what out put the activity produced.


Identify outputs: Identify all of the outputs for which
an activity segment performs activities and consumes resources . Outputs can be products ,services or customers.

Assign activity costs to out put: Assign activity
costs to outputs using activity drivers . Activity drivers assign activity costs to outputs based on individual outputs consumption or demand for activities. For example, a driver may be the number of times an activity is performed or length of time an activity is performed.

Stages And Flow Of Costs In ABC

As stated earlier there are two primary stages in ABC
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First tracing cost to activities Second tracing activities to product.

The different steps in the two stages of ABC are explained below:

Firstly activities are identified and then classified into different categories that have relation with different parts of the production process. Secondly factory overhead costs of the activities are determined and classified into homogeneous cost pools. Thirdly the factors that influence the cost of a particular activity should be identified they are knows as ‘cost drivers’.

Activities And Relevant Cost drivers

Activities drive costs .Costs are allocated based on appropriate cost drivers. ABC is based on the assumptions that cost behaviour is influenced by cost drivers. Given below are few examples of activities and the relevant cost drivers. Activities Cost drivers Machine set-up Purchasing materials Ware housing Packing Quality testing Stores delivery Number of production runs Numbered of orders placed Items in stock Number of packing orders Hours of test time Number of stores delivery

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Classification of Activities

The grouping of activities is preferably done using different levels at which activities at which activities are performed. Broadly activities are classified in to four. They are Unit level activities :These are the activities which are performed each time a unit is produced. Batch level activities: These are the activities which are performed each time a batch of goods or products are produced. Product level activities: These are the activities which are performed to support the production of each different type of production. Facility level activities: These are those which are needed to certain a factories general manufacturing process.

Activity Related Product Costs
Product Line
Costs varying with units Cost varying with number of batches material Machine hours energy Labour hours setups Inspection Purchase Order Materials movement Product specification Productenhancement Process engineering customersatisfaction

Unit level activities

Batch level activities

Costs varying with product line

Product substaining activities

Benefits of ABC

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Activity based costing brings accuracy and reliability in product cost determination by focusing on cause and effect relationship in the cost incurrence. Managers manage activities and not products. The changes in activities leads to changes in costs. Therefore if the activities are managed well ,costs will fall and resulting product will be more competitive. ABC highlights the problem areas that deserves the managements attentions and more detailed analysis. ABC system is used in setting priorities for action. Makes “Indirect” expenses “Direct”.


ABC fails to encourage managers to think about changing work processes to make business more competition. ABC is not conformed to generally accepted accounting principles in same area. Using ABC for short run decisions may sometimes prove costly in the long run. ABC does not encourage the identification and removal of constraints creating delays and excesses. An over emphasis on cost reduction with out regard to the constraints does not create an environment for learning about the problems and management.

Factors influencing application of ABC

High incidence of over head cost: If the proportion of over head cost to total cost is relatively high, it is necessary that over head cost is applied to products fairly and accurately in order to prevent over costing of some products and under costing of others .The extent of automation ,complexity of production ,etc generally increases the over head cost today .In such a situation cost assignment should be based on the suitable cost drivers .As result product cost are distorted. Actions taken on the basis of disorted product cost cannot give good result in the long run.


Product complexity or diversity: when products consume activities and inputs in different proportions product diversity occurs. In such a situation, there is a difference in the size, complexity, materials, components or other characteristics and demands made on a firms resources by product lines. The complex products may consume more non-unit level inputs such as machine setups than less complex products. Therefore unless the complexity or diversity of product is given due weightage in absorption of costs, product costs are likely to be distorted. Volume diversity occurs when there is a difference in the number of units manufactured by product lines.

Growing Interest In Activity Based Costing

Activity Based Costing is being implemented by a growing number of companies around the globe. Few organizations use ABC as their basic on going cost accounting system. Many ABC applications are selective -special studies with in sub parts of the organization such as business divisions or particular functions .

Indirect labour Indirect labour Prepare tooling

Inspect incoming materials Move materials No of receipts Maintain machines

Setup machines

No of moves

Maintainance hours

Setup hours

No of steps



$/Maintainance hours

$/Setup hours


Product services/customers

Installation of ABC
The macro economic factors which justify the implementation of ABC are  Relatively high proportion of overhead costs.  Product complexity.  Volume diversity

Steps involved in installation of ABC
Primary Steps:  Feasibility study.  IT support.  Selling the concept to the line employees.  Strategy and value change analysis.  Inventorization and screening of activities.  Identification of cost and cost drivers. Operational step: They represent the identification of activities, cost and cost drivers, computation of absorption rates and allocation of overhead costs based on the activities.

Presented by
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Sujatha .Bhupathi(7843) MBA 1st year. KBN college

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