CoM ea y Co kee Orca Introduction A powerful tool for measuring performance, Activity-Based Casting (ABC) is used to identify, describe, assign costs fo, and report on agency operations, A more accurate cost management system than traditional cost accounting; ABG identifies opportunities to improve business process effectiveness aind efficiency by determining the “true” cost of a product or service, Activity Based Costing is a method for developing cost estimates in which the project is subdivided into discrete, quantifiable activities or a work unit, ABC systems calculate the costs of individual activities and assign costs to cost abjects such as products and services on the basis of the activities undertaken to produce each product or services. It accurately identifies sources of profit and loss. Limitations of Traditional Costing System The cost of product anived in traditional accounting system is not so accurate due to following reasons: (i) The present Costing system has developed convenient overhead recovery basis and blanket overhead recovery are acceptable when valuing stocks for financial reporting, but they are inappropriate when used for decision making and typical product strategy decisions. Such decisions have implications over 3-5 years and over this period many fixed costs become variable. (i) The traditional fixed verses variable cost split is offen unrealistic since, as business grows they often become more complex. (ii) tn case of companies manufacturing and selling multiple products usually make decisions on pricing, product-mix, process technology etc,, based on distorted cost information due to difficulties in traditional costing system in collection, classification, allocation and recovery of overheads fo individvall products, (iv) The cost structure is changing especially when making direct labour component to small propartion. (v) Traditional accounting was confined merely to turnishing information at product level. The new manufacturing technology demands the teed back of performance while production is stil in progress rather than history. (¥) Theres also an urgent need to integrate the activity measurement and financial measurement.Therefore, in order to overcome the inadequacies of traditional methods of overhead absorption and shor-term biasing of marginal costing, Activity Based Costing (ABC) has been researched sania: Production departments Product departments fines Stage 1 Stage 2 |_| os Assigning costs using Allocating costs using a measures of service usage measure of volume Activily-Based Costing The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s.tt is a practice in which activities are identified and all related costs of performing them are calculated, providing actual costs chargeable. The focus of activity based costing is activities. Thus identifying activities is a logical frst step in designing an activity based costing. An activity is an event, task or unit of work with a specified purpose. For example; designing products, setting up machines, operating machines and distributing products. Expenses Resource drivers Activity Costs Activity drivers Cost Object Costs The CIMA terminology defines ABC as a cost attribution fo cost units on the basis af benefit received from indirect activities, Peter 8. B. Turney defines ABC as “a method of measuring the cost and performance of aciivilies and cost objects. Assigns cost fo activities based on their use of resources and assigns cost 1o:cost objects based ontheir use of activities. ABC recognizes the causal relationship of cost drivers to activities.” ABC can be defined by the following equation: C/A=HD+M#E+S Where C/A = Estimated cost per activity H = Number of labor hours required to perform the activity one time D = Wages per labor hour M= Material costs required to perform the activity one time E s ‘quipment costs to perform the activity one time Subcontracting costs to perform the activity one time The tofal cost for performing the activity will be based on the number of times the activity is performed during a specific time frame. An activity based costing system fist traces costs to activities and then to products and other cost objects. The following figure diagrammatically explains the basic flow of Activity-Based Costing, Activity-based Costing Service department Acitivity cost pools Product and factory overheads lines e- Assigning costs of Application of cost individual activities driver rates Important Terms in Activity Based Costing The operation of the ABC system involves the use of the following terms: Activity: An activity means an aggregate of closely related tasks having some specific tunctions which are Used for completion of goal or abjectives. For example, customer order processing is an activity. Itincludes receiving order from customers, interacting with production department regarding capacity to produce and giving commitment fo the customer regarding delivery time. Other activities may be assembling, packaging, advertising etc. Resource : Resources are elements that are used for performing the activities or factors helping in the activities. For example, order receiver, telephone, computers etc. are resources in customer order processing activity. It may include material, labour, equipment, office supplies ete. ‘ost : Cost is amount paid for resource consumed by the activity. For example, salaries, printing stationary, telephone bill etc. are cost of customer order processing activity. tts ako known as activity Cost pool.Cost object: It refers to ain item for which cost measurement is required. €.g. a product, a service, or a customer. Cost pool: A cost poo! is a term used fo indicate grouping of costs incurred on a particular activity which drives them. Cost driver: Any element that would cause a change in the cost of activity is cost driver. Actually cost divers are basis of charging cost of activity 10 cost object. Cost drivers are used to trace cost to product by using a measure of resources consumed by each activity. For example, frequency of order, number of order etc. may be cost driver of customer order processing activity. Cost driver may be involved two parts: |. Resource cost driver 2. Activity cost driver A resource cost driver is a measure of the quantity of resources consumed by an activity, An activity cost driver is a measure of the frequency and intensity of demand, placed on activities by cost objects. For example Activities Resources Cost pools Cost driver ‘Consuiting ‘Consultant, computer | Employee cost, Level of consultant, time spent maintenance cost Laser printing Printing staff, printer | Colour cost, maintenance —_| No. of pages printed, font cost, printing stationary Accounting Administration staff Salaries No. of times account produced administration Cuslomerservice | Telephone, staff Telephone bil, salaries Frequency of order, no. of order, time spent in servicing, no. of service calls Research Stalf, equipment, Salaries, maintenance cost, | No. of research projects, time development material material cost spent on project, technical complexities of project The cost drivers for various functions i.e... production, marketing, research, and developments are given below. Production Number of units Number of set-ups Marketing Number of sales personnel Number of sales orders Research& development Number of research projects Personnel hours spend on projects Technical complexities of the projects Customer service Number of service calls Number of products serviced Hours spend_on servicing productsIllustration 2. A company produces four products, viz. P, @, R and §. The data relating to production activity are as under Product | Quantity of Materialcoslf | Direct labour | Machine hours/ | Direct Labour cost/ production unit 2 hours/unit unit unit 2 P 1,000 10 1 0.50 é @ 10,000 10 1 0.50 é R 1,200 32 4 2.00 24 s 14,000 34 3 3.00 18 Production ovetheads are as under: z (i) Overheads applicable to machine oriented activity: 149,700 (i) Overheads relating to ordering materials 7,680 (ii) Set up costs 17,400 (iv) Administration overheads for spare parts 34,380 (v) Material handling costs 90.294 The following further information have been compiled: Product | No.ofsetup | No. of materiats orders No. of times materials handled | No.of spare parts P 3 3 6 6 Q 18 12 30 15 R 5 Ss 9 3 s 24 12 36 12 Required: (i) Select a suitable cost driver for each item of overhead expense and calculate the cost per unit af cast driver. (i) Using the concept of activity based costing, compute the factory cost per unit of each product.Solution: Computation of Cost Driver Rates 1) Overheads relating to Machinery oriented activity Cost Driver —» Machine Hour Rate (1000 x 0.5) + (1000 x 0.5) + (1200 x 2) + (14000 x 3) 1.49,700/49,900 = 8 3 per hour 2) Overheads relating to ordering materials Cost diver > No. of Material orders 7680/30 = % 256 per order 3) Setup costs Cost driver —> No. of set ups 1740/50 = 8 348 perset up 4) Administrative Overheads for spare parts Cost driver > No. of spare parts 34380/36 = 2.955 per spare part 5) Material Handling costs Cost diver —> No, of times materials handled 30294/81 = 8374 per material handing Computation of factory cost for each product P Q R ‘Materials 10.00 10.00 32.00 34.00 Labour 6.00 6.00 24.00 18.00 Ovetheads Machine oriented activily 1.500 1.50 6.00 9.00 (Ordering of Materials 0.768 031 0.64 0.22 Set up costs 1.044 0.63 1.45 0.60 Administrative Spare Parts 5.730 1.43 2.39 0.82 Material handling 2.244] 129] 112 a99|_ 281] 1329] 096) 11.60 Factory Cost (2) 27.29 20.99 69.29 63.60Illustration 4, Relevant data relating fo. @ company are: Products P a Rg Total Production and sales (units) 60,000 | 40,000 14,000 Raw material usage in units 10 10 22 Raw material costs z 50 40 22| 2476000 Direct laisour hours 25 4 2| 342,000 Machine hours 25 2 4] 294,000 Direct labour costs z 16 24 12 No. of production runs é 14 0 0 No, of deliveries 18 é 0 4 No, of receipts eo] 140] 880 1,080 | No. of production orders 30 20 50, 100 Overheads: z Setup 60,000 Machines 15,20,000 Receiving 8,70,000 Packing 5,00,000 | Engineering 746,000 The company operates a JIT inventory policy and receives each component once per production run Required: (i Compute the product cost based on direct labour hour recovery rate of overheads, (i) Compute the product cost using activity based costing. Solution: 0 Traditional Method of absorption of overhead ie. on the basis of Direc! Labour Hours 36,96, 000 Total overhecds = Hours (60000 * 2.5) + (40000 x 4) + (16000% 3) = 10.81 per labour hour Calculation of Factory cost of the products P a z z Raw Material 50000 40500 22500 Direct Labour 16=000 24=00 12500 ‘Overheads (2.5 x 1081) 27-025 43524 21=62 Factory cost 93-000 107=24 ‘55562(li) Under Activity Based Costing system ‘Computation of Cost Drivers Rates. a 2 3) 4 3) Set up cost: Cost diver > No. of Production run, 60000/60 = % 1000/per run Machines : Cost driver —» Machine hour rate 15,20,000/2,%4,000 = @ 5.17 per Machine hour rate Receiving cost: Cost driver —> No. of Receipts 8,70,000/1080 = ¢ 805.56 Packing : Cost driver —» No. of deliveries 5,00,000/64 =% 7812.5 per delivery Engineering: Cost driver —» No. of Production order 7,46,000/100 =2 7,480 per order Calculation of Factory Cost per unit of Production P z z g z z z. ‘Materials 50.00 40.00 22.00 Direct Labour 16.00 24.00 12.00 ‘Overheads Setup cost 0.10 0.35 2.50 Machines 12.93 10.34 20.68 Receiving cost 081 282 4431 Packing 2:34 Laz 19.53 Engineering 373 91] 373 18.41 [ 2331) 110.33 Factory Cost 85.91 82.41 144.336.1 LEARNING CURVE Learning Curve Theory is concemed with the idea that when a new job, process or activity commences for the fist time it is tkely that the worktorce involved will not achieve maximum efficiency immediately. Repetition of the task is kely fo make the peaple more confident and knowledgeable and will eventually result in a more efficient and rapid operation. Eventually the learning process will stop after continually repeating the job. As a consequence the time to complete a task wil initially deciine and then stabilise once efficient working isachieved The cumulative average time per unit is assumed to decrease by a constant percentage every time that output doubles, Cumulative average time refers fo the average time pet unit for all units produced so far, from and including the first one made. Learning is the process by which an individual acquires skill, knowledge and abiity. When a new product or process is started, the performance of a worker is not at its best and learing phenomenon takes place. As the experience is gained, the performance of a worker improves, time taken per unit of activity reduces and his productivity goes up. This improvement in productivity of ci worker is due fo leaming effect. Cost predictions especially those relating to direct labour cost must allow for the effect of leaming process, This technique is a mathematical technique. tt can be very much used to accurately and graphically predict cost. itis a geometrical progression, which reveals that there is steadily decreasing cost for the accomplishment of a given repetitive operation, as the identical operation is increasingly repeated. The amount of decrease is less and less with each successive unit produced. The slope of the decision curve can be expressed as a percentage. Experience curve, improvement curve and progress curve are other terms which can be synonymously used. Learning curve is essentially a measure of the experience gained in production of an article. by an individual or organization. As more units are produced, people involved in production become more efficient than before. Each subsequent unit takes tewer man-hours to produce. the amount of improvement will differ with each type of article produced. This improvement or experience gain is teflected in a decrease in man-hours or cost. Phases in Learning Curve The leaming curve will pass through three different phases. In the first phase, there will be gradual increase in production rate until the maximum expected rate is reached and this phase is generally steep. In the second phase, the learning rate will gradually deteriorate because of the limitations of equipment. in the third phase, the production rate begins to decrease due fo a reduction in customer requirements and increase in costs. Under the Learning curve model, the cumulative average time per unit produced is assumed to fall by a constant percentage every time total output of the unit doubles. Learning curve is a. geometrical operation, as the identical operation is increasingly repeated.Learning curve is essentially a measure if the experience gained in production of an arficle by an organization. ‘As more and more units re produced, workers involved in production become more efficient than before. Each subsequent unit takes fewer manhours fo produce. The Learning curve exists during a worker's startup or familiarization period on @ parficular job. After the limits of experimental learning are reached, productivity tends to stabilize and no further improvement is possible, The learning curve ratio can be calculated with the help of the following formula : Average labour cost of frst 2 units Leami i Saming curve ratio “ average labour cost of fist units Areas of consequence: (i) A Stanclard Costing system would need to set standard labour times after the learning curve had reached a plateau. (il) A budget will need to incorporaite a learning cost factor until the plateau is reciched. (ii), A budgetary control system incorporating labour variances will have to make allowances for the anticipated fimechanges. (iv) Identification of the learning curve will permit the company to better plan its marketing, work scheduling, recruitment and material acquisition activities. (v) The deciine in labour costs will have to bé Considered when estimating the overhead apportionment rate. (vi) As the employees gain experience they are more likely to reduce material wastage. Graphical presentation of learning curve The leaming curve (not to be confused with experience curve) is a graphical representation of the phenomenon explained by Theodore P. Wright in his “factors Affecting the Cost of Airplanes", 1936. It refers to the effect that Jearning had on labour productivity in the aircraft industry, which translates into a relation between the cumulative number of units produced (X) and the average time (or labour cost) per unit (Y|. which resulted in a convex downward slope, as seen in the adjacent aiagram. There Is a simple rationalisation behind alll this: he more unils produced by a given worker, the less time this same worker will need fo produce the following unils, because he will eam how to do it faster and better. Therefore, when @ firm has higher cumulative volume of production, ifs time (or labour cost) per unit will be lower. Wright's learning curve models defined by the folowing function: Y= ax (9b log? where: Y= average time (or labour cos!) per unit a= time (or labour cost) per unit X= cumulative volume of production b= learning rate (%) ic Average time per unit < Cumulative volume of productionSome important implications arise from this curve. if the time (or labour cost) per unit decreases as the cumulative output increases, this will mean that fms that have been producing more and for a longer period, will have lower average time per unit and thus dominate the market, Uses of Learning curve. Learning curve is now being widely issued in business, Some of the uses are as follows ls Where applicable the leaming curve suggest great opportunities for cost reduction to be achieved by improving learning. The leaming curve concept suggests a basis for comect staffing in continuously expanding production. the curve shows that the work force need not be increased at the same rate as the prospective output. This also helps in proper production planning through proper scheduling of work: providing manpower at the right moment permitting more accurate forecast of delivery dates. Leaming curve concept provides a means of evaluating the effectiveness of training programs. What level of cumulative cost reduction do they accomplish? How does the learning curve for this group or shop compare with others? Whether any of the employees who lack the aptitude to meet normal learning curve should be eliminated, Learning curve is frequently used in conjunction with establishing bid price for contracts. Usually, the bid price is based on the cumulative average unit cost for all the units to be produced for a given contract. If production is not interupted. Additional units beyond this quantity should be costed af the increment costs incumed, and not at the previous cumulative average. if the contract agreement so provides, a contract may be cancelled and production stopped betare the expected efficiency isreached. This would mean that the company having quoted on the basis of cumulative average uni! cost is at a disadvantage because it can not reap the benefit of leaning. The contractor must provide for these contingencies so that it will be reimbursed for such loss. The use of leaming curve, where applicable, is important in the working capital required. if the requirement 's based on average cumulative unit cost, the revenues from the first few units may not cover the actual expenditures. For instance, if the price was based on the average cumulative unit cost of 328 hours the frst unit when produced and sold will cause a deficit of 4.72 hours (8.00 ~ 3.28). Provision should therefore, be made fo cover the deficit of working capital in the initial stages of production. As employees become more efficient, the rate of production increases and so more materials are needed, the work-in-progress inventory tums over faster, and finished goods inventory grows at an accelerated rate. A knowledge of the learning curve assistsin planning the inventories of materials, Work-in-progréss, and finished goods. Leaming curve techniques are useful in exercising control, Variable norms can be established for each situation, and a comparison befween these norms and actual expenses can be made. Specific or average incremental unit cost should be used for this purpose The learning curve may be used for make-or- buy decisions especially if the outside manufacturer has reached the maximum on the learning curve. Help to calculate the sensitive reites in wage bargaining. Limitations to the usefulness of the learning curve: The following points limiting the usefulness of learning curves should be noted: 1. The leaming curve is useful anly for new operations where machines do nat Constitute a major part of the production process. tts not applicable to all productions. E.g. new and experienced workmen. The learning curve assumes that the production will continue without any major intemuptions. If forany reason the work in interupted, the curve may be deflected or assume a new slopes Charges other than learning may effect the leaming curve: For example, improvement in facilities, amangements, and equipment as well as personnel morale and performance may be factors influencing