Activity Based

Costin g

Learning Objectives After studying this topic, you should be able to, 1. To understand the limitations of traditional costing system. 2. To introduce the concept of Activity Based Costing including its features, benets and limitations. 3. To be familiar with concepts like Activity Based Budgeting, Activity Based Management and Activity Based Accounting.

Cost and Management Accounting 16.1 Introduction

We have already discussed the concepts of cost, costing, cost accounting in the previous chapters. The accounting of overheads is also discussed in detail in the chapter of overheads. The main objective of any costing system is to determine scientically the cost of a product or service. For facilitating the calculation, costs are divided into direct and indirect. Direct costs are the costs which are traceable to the products/ services offered. On the other hand, indirect costs which are also called as overheads are not traceable to the products/services. Hence these costs are rst identied, classied, allocated, apportioned wherever allocation is not possible, reapportioned and nally absorbed in the products/services. Charging the direct costs to the products is comparatively a simple procedure and can be done with remarkable accuracy. However, the indirect costs present problems in charging them to the products and there is a possibility of distortion of costs though the basis of charging them is quite logical. This is one of the limitation of the traditional costing system. For example, one of the methods of absorption of overheads is direct labor cost and this method is quite satisfactory when the overhead costs of indirect activities is a small percentage compared to direct labor component in actual making of products. However, the increased technology and automation has reduced the direct labor considerably and so the indirect activities have assumed greater importance. Therefore, using the direct labor as a basis for absorbing the overheads can lead to distortions in the costs. Distortions in the costs resulting into incorrect cost calculations may lead to following wrong decisions. ! Errors in xation of selling prices. ! Wrong decisions regarding deciding of product mix. ! Ignoring orientation. ! Missing opportunities. of customer protable

In order to overcome the limitations of traditional costing systems Activity Based Costing has been introduced. Before we proceed to the other aspects of Activity Based Costing, let us see the limitations of traditional costing system. A brief mention of the same has already been made in the above paragraph. Some more points are discussed below.

16.2 Limitations of Traditional Costing System

The following are the limitations of traditional costing system. ! In a traditional costing system, overheads i.e. indirect costs are allocated, apportioned and nally absorbed in the cost units. There can be distortion in computing costs due to the basis selected for absorption. The following example will clarify the 15 2

situation.

Cost and Management Accounting

Suppose a manufacturing company is producing two products, A and B. The direct material cost for the products is Rs.1,00,000 and Rs.2,00,000 respectively. The total overheads are Rs.1,50,000 and the company adopts direct material cost as the basis for absorption. The absorption percentage of overheads will be 50% of the direct material. [1,50,000/3,00,000 X 100 = 50%] Thus the overheads absorbed in the product A will be Rs. 50,000 and for B, they will be Rs.1,00,000 [50% of the overheads] Product B has a larger share of the overhead costs as the material costs are higher than that of A. However, actually product B may be

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Cost and Management Accounting

requiring lesser efforts in the indirect activities than A, but only because it has a higher material costs, it will be charged with larger amount of overheads. Thus there is a distortion in the total cost. This distortion in costs may lead to wrong decisions in several areas like make or buy, pricing decisions, acceptance of export offer etc. ! Another limitation of traditional costing system is the division between xed and variable may not be realistic as there are many complications due to the complexity of the modern business. ! There should be linkage between the activities and the costs. Similarly the information should be available simultaneously which means that information should be made available while the activities are going on. Information available after the activity is over will not be of much use. As mentioned above, the Activity Based Costing system is developed due to the limitations of the traditional costing system. The limitations of the traditional costing system have been discussed above. Now, in the following paragraphs, we will proceed to discuss the various aspects of Activity Based Costing.

16.3 Activity Based Costing Various Issues

Meaning :- CIMA denes Activity Based Costing as, cost attribution to cost units on the basis of benet received from indirect activities e.g. ordering, setting up, assuring quality. One more denition of Activity Based Costing is, the collection of nancial and operational performance information tracing the signicant activities of the rm to product costs. The following are the objectives of Activity Based Costing.

16.5 Objectives Costing

of Activity Based

The objectives of Activity Based Costing are discussed below.

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To remove the distortions in computation of total costs as seen in the traditional costing system and bring more accuracy in the computation of costs of products and services.

To help in decision making by accurately computing the costs of products and services.
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To identify various activities in the production process and further identify the value adding activities.

To distribute overheads on the basis of activities.

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To focus on high cost activities. To identify the opportunities for improvement and reduction of costs. To eliminate non value adding activities.

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Cost and Management Accounting 16.6 Working of Activity Based Costing

The working of Activity Based Costing is explained below. Understanding and analyzing manufacturing process :- For installation of any costing system, study of manufacturing process is essential. For Activity Based Costing system also, it is necessary to study the manufacturing process and ascertain various stages involved in the same so that activities involved in the same can be identied.

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Cost and Management Accounting

Study of the Activities involved :- The next step is to study the activities involved in the manufacturing process. This step is very crucial as the entire Activity Based Costing is based on identication of activities. In this step, the activities involved in a process are identied. For example, in a bank, opening of an account is one of the services offered to customers. In this service, activities involved are studied. It may be revealed that opening of a new account involves activities like issuing the application form, verication of the same and accepting the initial amount required for opening of an account. Similarly in case of a manufacturing company, purchase procedure may involve activities like receiving of purchase requisition for concerned department or the stores department, inviting quotations from various suppliers, placing of an order, follow up of the same and nally receiving and inspection of the goods. In case of an educational institute, activities in a library may include activities like issue of books, receipt of books, ordering new books, giving accession numbers, stock taking, removing obsolete and outdated books, identication of slow moving and fast moving items etc. In this manner, whether in manufacturing or in service sector, activities are identied and the next step is to divide the activities into value adding and non value adding. The objective behind this is that attention can be focused on the value adding activities while non value adding activities can be eliminated in the future. Activity Cost Pool :- Cost pool is dened by CIMA as, the point of focus for the costs relating to a particular activity in an activity based costing system. For example, in case of a library, the cost of issue and receipts, cost of ordering, stock taking costs etc. can be identied with Library Cost. In other words, Library will the cost pool in which all the costs mentioned above may be clubbed. In case of a manufacturing organization, as regards to stores, cost of classication, cost of issue of stores requisitions, inspection costs etc. can be pooled under the heading stores. Thus cost pool concept is similar to the concept of cost center. The cost pool is the point of focus or in other words, it is the total cost assigned to an activity. It is the sum of all the cost elements assigned to an activity. Cost Drivers :- According to CIMA, cost driver is 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. In other words, cost driver means the factors which determine the cost of an activity. For example, if we repeat the example of library, the number of receipts and issue of books will be cost drivers, in a stores, no. of stores requisitions will be cost drivers, in customer order processing the no. of customers as well as no. of orders will be cost drivers. Thus a cost driver is an activity which generates cost. Activity Based Costing is based on the belief that activities cause costs and therefore a link should be established between activities and product. The cost drivers thus are the link between the activities and the cost. Identication of costs with the products :- The nal stage in Activity Based Costing is to identify the cost with the nal products which can also be called as cost objects. Cost objects include, products, services, customers, projects and contracts. As mentioned earlier, direct costs can be identied easily with the products but the indirect costs can be linked with the products by identifying activities and cost drivers. Thus Activity Based Costing is the process of tracing costs rst from resources to activities and then from activities to specic products. Conclusion :- It can be concluded that the Activity Based Costing is a costing system 15 6

which tries to charge the indirect costs to the products and services fairly accurately. However for effective implementation there is a need of involvement of the staff and their training on continuous basis.

Cost and Management Accounting

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Cost and Management Accounting

Similarly there is a need to review the working of the system at periodic intervals and keep a follow up of the feedback received. These actions will ensure effective implementation of the system. Support of top management is also required for effective implementation of this system. Activity Based Costing system is denitely a better system but much depends on the implementation of the same.

16.6 Limitations of Activity Based Costing

Though this system is quite effective, it suffers from some limitations. These limitations are given below. Activity Based Costing is a complex system and requires lot of records and tedious calculations.
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For small organizations, traditional cost accounting system may be more benecial than Activity Based Costing due to the simplicity of operation of the former. Sometimes it is difcult to attribute costs to single activities as some costs support several activities.
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There is a need of trained professionals who are limited in number. This system will be successful if there is a total support from the top management. Substantial investment of time and money is required for the implementation of this system.

16.7 Budgeting

Activity

Based

A budget is a statement expressed in quantitative/monetary/both terms prepared prior to a dened period of time for the policy to be pursued during that period for the purpose of achieving a given objective. In other words, a budget is always prepared ahead of time, it is expressed either in quantitative terms or monetary terms or both, it reects the objective to be achieved during that period and hence the policy to be followed during that period is put in the budget. Budget helps in planning for the future. It also helps in controlling as there is a continuous comparison of actual with budget. Any deviation between the two is identied for taking suitable action. The traditional budgeting is based on traditional cost accounting i.e. on the basis of allocation, apportionment and absorption of overheads in the products. However, the Activity Based Budgeting is different from the traditional budgeting in the sense that it provides a strong link between the objectives of organization and objectives of a particular activity. In other words, it involves identication of activities and dividing them in value adding and nonvalue adding activities. The non value adding activities are eliminated in due course of time. Activity Based Budgeting, thus requires identication of activities of the organization, establishing the factors which cause costs, the cost drivers and then collecting the costs of the activities in cost pools. The following are the features of Activity Based Budgeting. 15 8

! activities. ! It identies cost improvement opportunities. ! There is a clear link between strategic objectives and planning and the tactical planning of the ABC proces s.

Cost and Management Accounting It uses the activity analysis to relate costs to

16.9 Accounting

Activity

Based

Activity Based Accounting is a broader term which involves in, collection, recording, analysis, controlling and reporting of activity related costs rather than departmental or cost centers related costs. It involves

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Cost and Management Accounting

several activities like Activity Based Budgeting, Cost management based on activities, performance measurement of activity, reducing the costs through elimination of non value adding activities and also initiating innovative measure for reduction of costs. Solved Problems 1. The budgeted overheads and cost driver volumes of XYZ are as follows. Cost Pool Material procurement Material handling Set-up Maintenance Quality control Machinery Budgeted Cost Driver Overheads (Rs.) 5,80,000 2,50,000 4,15,000 9,70,000 1,76,000 7,20,000 No. of orders No. of movements No. of set ups Maintenance hours No. of inspection No. of machine hours Budgeted Volume 1,100 680 520 8,400 900 24,000

The company has produced a batch of 2,600 components of AX-15, its material cost was Rs. 1,30,000 and labor cost Rs. 2,45,000. The usage activities of the said batch are as follows. Material orders 26, maintenance hours 690, material movements 18, inspection 28, set ups 25, machine hours 1,800 Calculate cost driver rates that are used for tracing appropriate amount of overheads to the said batch and ascertain the cost of batch of components using Activity Based Costing. Solution The cost driver data will be determined as given below. 1. Cost driver data The rate will be determined by dividing the amount by relevan factors. The calculations are shown below. Particulars Material procurement Material handling Set up Maintenance Quality control Machine Details Rs. 5,80,000 Rs. 2,50,000 Rs. 4,15,000 Rs. 9,70,000 Rs. 1,76,000 Rs. 7,20,000 /1100 / 680 / 520 /8400 /900 /24,000 Rate of cost drivers Rs. 527 Rs. 368 Rs. 798 Rs. 115 Rs. 195 Rs.30

2. Calculation of a Batch of 2,600 components of AX - 15 Particulars Direct Materials Direct Labor Prime Cost Direct Materials + Direct Labor Add : Overheads Particulars Details Amount in Rupees 1,30,000 2,45,000 3,75,000

Details

Amount in Rupees

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Cost and Management Accounting

Material Procurement Material handling Set-up cost Maintenance Quality control Machine Total 26X Rs. 527 18 X Rs. 368 25 X Rs. 798 690 X Rs. 115 28 X Rs. 195 1,800 X Rs. 30 13,702 6,624 19,950 79,350 5,460 54,000 5,54,086

Note :- From the above calculations, it is clear that by using Activity Based Costing, there can be substantial accuracy in the overhead absorption. The overheads are charged on the basis of cost drivers and not on the basis of absorption rate. 2. A company manufactures two products, X and Y. The product X is a low volume and its sales are only Rs.5,000 p.a. Product Y is high volume and labor intensive, its sales are 25,000 units pa. Product X takes 6 labor hours to make one unit but Y requires 8 hours per unit. Details of costs for materials and labor for each product are as follows. Particulars Direct Materials Rs. Direct Labor -@ Rs.10 per hour Total Product X 200 60 260 Product Y 100 80 180

The company works 1,00,000 direct labor hours p.a. Total manufacturing overhead costs are Rs.17,50,000 p.a. You are required to compute per unit cost of each product using, I. Direct labor hour rate method for absorption of overhead Activity Based Costing technique for absorption costs and II.

of overhead costs Solution Firstly, we will calculate the Product Cost based on Direct Labor Hour Rate. The calculations are shown below. A. Direct Labor Hour Rate :- Total manufacturing overheads / Total direct labor hours Rs.17,50,000/1,00,000 = Rs. 17.50 B. Absorption of manufacturing overheads :Particulars Manufacturing Overheads Product X Rs.17.50 X 6 Direct Labor Hours = Rs. 105 Product Y Rs. 17.50 X 8 Direct Labor Hours = Rs.140

Overheads based on Activity Based Costing :-

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Cost and Management Accounting

A. Identication of Activities and Rate for each Activity :Rate per Activity [Rs.] 45 per set up 20 per inspection 300 per order 12.5 per hour 130 per receipt Particulars Total Overheads Details of Activity Machine Set up 4,50,000 10,000 Quality inspection 3,00,000 15,000 Production order 1,80,000 600 Machine hours worked 6,25,000 50,000 Material receipts 1,95,000 1,500 Total overheads 17,50,000

B. Allocation of overheads to Products on the basis of Activity Rates :Particulars Machine Set up Quality inspection Production order Machine hours worked Material receipts Total overhead costs Units produced Overhead cost per unit Frequency of activity 10,000 15,000 600 50,000 1,500 Rate per activity 45 20 300 12.5 130 Product X Rs 6,000 X Rs. 45 = Rs.2,70,000 10,000 X Rs. 20 = Rs. 200 X Rs. 300 = 12,000 XRs. Rs.12.5 =300 Rs. X Rs. 130 = Rs. 7,19,000 5,000 143.80 Product Y Rs 4,000 X Rs.45 = Rs.1,80,000 5,000 X Rs.20 = Rs.1,00,000 400 X Rs.300 = Rs.1,20,000 38,000 X Rs.12.5 = Rs. 12,000 X Rs.130 = Rs. 10,31,000 25,000 41.24

Computation of Total Cost under Traditional Cost Accounting and Activity Based Costing Particulars Product X Activity Based Costing 200 60 143.80 Product Y Activity Based Costing 100 80 41.24 221.24 Product X Traditional Costing 200 60 105 365 Product Y Traditional Costing 100 80 140 320

Direct Material Direct Labor Manufacturin g overheads

Total cost of 403.80 Manufacture

From the above comparative analysis it is clear that, under Traditional Costing, Product X is charged with Rs. 105 per unit as manufacturing overheads while in case of Product Y, the share of overhead cost is Rs. 140. Under Activity Based Costing the amount is Rs. 143.80 and Rs. 41.24 per unit. Thus due to Activity Based Costing, the distortion in cost is avoided. 3. A company manufacturing two products furnishes the following data for a year.
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Cost and Management Accounting

Product Annual Output [Units] 5,000 60,000 Total machine hours 20,000 1,20,000 Total number of purchase orders 160 384 Total number of set ups 20 44

A B

The annual overheads are as under Particulars Volume related activity costs Set up related costs Purchase related costs Total costs Amount in Rupees 5,50,000 8,20,000 6,18,000 19,88,000

You are required to calculate the cost per unit of each Product A and B, based on, I. Traditional method of charging overheads II. Activity Based Costing method.

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