Activity Based Costing!!!!The abc of ABC

Activity Based Costing

The abc of ABC

A study report






Table of Contents

Full absorption costing…a historical overview 3

Some of the important terms used in the absorption costing method 5

Advantages / Disadvantages of absorption costing 6

Activity Based Costing 7

Consumption of resources versus activities 11

Volume related allocation bases versus drivers at many levels 12

Example 16

Activity based management 21

Full absorption costing…a historical overview

Full absorption costing (also known as full costing and absorption costing) is a traditional method where all manufacturing costs are capitalized in the inventory, i.e., charged to the inventory and become assets. This means that these costs do not become expenses until the inventory is sold. In this way, matching is more closely approximated. All selling and administrative costs are charged to expense however. Technically, full absorption costing is required for external reporting, although many companies apparently use something less than a pure full absorption costing system. The full absorption method is also frequently used for internal reporting

The absorption approach is used by many firms and is a costing approach that considers all factory overhead (both variable and fixed) to be product (inventoriable) costs that become an expense in the form of manufacturing cost of goods sold only as sales occur.

Absorption Costing is a method of costing that, in addition to direct costs, assigns all, or a proportion of, production overhead costs to cost units by means on one or a number of overhead absorption rates.
Generally accepted accounting principles require absorption costing for external reporting. Under absorption costing, normal manufacturing costs are considered product costs and included in inventory. As sales occur, the cost of inventory is transferred to cost of goods sold; meaning that the gross profit is reduced by all costs of manufacturing, whether those costs relate to direct materials, direct labor, variable manufacturing overhead, or fixed manufacturing overhead. Selling, general, and administrative costs (SG&A) are classified as period expenses.
[1]The rationale for absorption costing is that it causes a product to be measured and reported at its complete cost. Just because costs like fixed manufacturing overhead are difficult to identify with a particular unit of output does not mean that they were not a cost of that output. As a result, such costs are allocated to products. However valid the claims are in support of absorption costing, the method does suffer from some deficiencies as it relates to enabling sound management decisions.









Some of the important terms used in the Absorption Costing method
Overhead Absorption Rate
A means of attributing overhead to a product or service. For example, on direct labor hours, direct labor cost or machine hours.
Overhead Allocation Process
The various stages of the overhead absorption process are as follows:
Allocate overhead costs to cost centres that are directly identifiable to those centers.
Using appropriate basis apportion those overheads such as rent, heat and light, building insurance.
Apportion the indirect centres to the manufacturing centres such as the maintenance or research and development departments.
Absorb the cost of each direct cost centre in to the costs of production through that cost centre using a predetermined rate of absorption.
Common Rates of Absorption
v Direct labour hour
v % added onto the direct labour hour
v Machine hour rate
v Comparison of the two systems
v External vs. Internal
v Decision making
v Planning and control
v Variability of profit
Advantages / Disadvantaged of absorption costing

Advantages of Absorption Costing:
Disadvantages of Absorption Costing:
It recognizes the importance of fixed costs in production.
This method is used to prepare financial accounts.
When production remains constant but sales fluctuate, absorption costing will show less fluctuation in net profit.
Unlike marginal costing where fixed costs are agreed to change into variable cost, it is cost into the stock value hence distorting stock valuation.
As absorption costing emphasized on total cost namely both variable and fixed, therefore it is not so useful for management to use to make decision, planning, and control.
Since the decision maker’s emphasis is on total cost, the cost-volume-profit relationship is ignored. The decision makers needs to use the rule of thumb to make the decision.

Activity Based Costing
Activity Based Costing (“ABC”) can be defined as a subset of Activity-Based Management (“ABM”). The objective of ABC is to improve costing by tracing expenses (e.g., salaries, supplies, rent, insurance, etc.) to activities and tracing the activities to business processes, products, services, customers, distribution channels, etc.
Advocates of ABC believe that the major emphasis of a company such as continuous process improvement and simplification to boost productivity can only be attained if the real cost and time required to produce its goods and services is determined. This helps prevent arbitrary and indiscriminate cost-cutting measures (such as miscalculated downsizing) that may actually result in worse performance and profitability.
An activity is defined as a process, function, task, or step that occurs over time and generates results that the company uses to produce and sell its products and services. An activity consumes resources as it transforms its inputs into outputs, and therefore incurs a 'cost' every time it occurs. Allowing an organization or even every employee involved to better understand the cost of doing each activity gives a better chance to perform the activity better while minimizing costs. In fact, the cost attached to an activity may be used as a metric for organizational or personnel performance.
ABC entails the complex task of identifying discrete activities and identifying the measure of output for each of these activities. Each activity also needs to be classified as either 'value-added' or 'non-value-added.' Value-added activities are activities that add value to the product or service that the customer is willing to pay for. Thus, all steps required to manufacture a product or enhance its quality or reliability are value-added activities. On the other hand, non-value-added activities are activities that do not contribute any value to the final product, and are other activities that the customer doesn't really want to pay for. Staging of products and unnecessary inspection are examples of non-value-added activities. Non-value added activities, in general, must be eliminated if possible.
Activity-based costing consists of the following steps: 1) analysis of activities; 2) cost data gathering; 3) tracing of costs to activities; 4) establishment of output metrics; and 5) cost analysis.
Historically, cost accountants have arbitrarily added a broad percentage to the direct costs to allow for the indirect costs. However as the percentages of overhead costs had risen, this method became gradually inaccurate because the indirect costs were not caused equally by all the products. For example, one product might take more time in one expensive machine than another product, but since the amount of direct labor and materials might be the same, the additional cost for the use of the machine would not be recognized when the same broad 'on-cost' percentage is added to all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another.
The reasons behind identifying the need of a new cost management system is to analyze the ‘true’ cost for a cost object (product, job service, or customer). More generally speaking, the knowledge of the ‘true’ cost a product will lead to identifying the money makers / money losers, to come up to an economic break-even point, and to compare different options of investments.
As is defined, the total cost of a cost object is the sum total of Direct Cost (Labor, Material) plus overhead costs.
The traditional cost accounting was based on arbitrarily allocating overheads to the cost objects. The assumption was the relationship between the overheads and the volume-based measures.

An example of traditional cost accounting is given below


TCA in Alpha Beta Omega Pvt. Ltd.
Product A
Product B

Labor hour
1/u
Labor hour
2/u

Direct labor cost
1*Rs. 20 = Rs. 20
Direct labor cost
2*Rs. 20 = Rs. 40

Demand of product A
100
Demand of product B
200

Total Overhead = Rs. 100,000
Total Direct Labor Hours = 2,000
Labor rate per hour = 100,000/2,000 = Rs. 50 per hour
TCA Overhead Allocation
Rs. 50/u


Rs. 100/u


Activity Based Costing on the other hand is a more accurate cost management methodology as it focuses on indirect costs (overhead), it traces costs on each expense category rather than merely allocating it to the particular cost object, and it makes the ‘indirect expense’ a ‘direct’.
The fundamental premises on which Activity Based Costing is performed are depicted in the following graphic.
Activity-Based Costing (ABC) gained momentum in the 1980s from the increasing lack of relevance and irreverence of traditional cost accounting methods. The traditional cost accounting methods were designed around 1870 - 1920 and in those days industry was labor intensive. With very little or no automation, the product variety was relatively small and the fixed and variable overhead costs in companies were significantly low as compared to today. Nevertheless, gaining momentum from the 1960s and particularly in 1980s - this scenario changed rapidly.
The question, however, of course remains whether ABC has overcome these deficiencies or not? It has. In fact, ABC has been called one of the most important management innovations of the last hundred years.
So what is really the difference between ABC and traditional cost accounting methods? Despite the enormous difference in performance, there are three major differences:
In traditional cost accounting, it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities.
Traditional cost accounting mostly utilizes volume-related allocation bases while ABC uses drivers at various levels.
Traditional cost accounting is structure-oriented whereas ABC is process-oriented.
To be more specific, ABC brings detailed information from the processes up to assess costs and manage capacity on many levels whereas traditional cost accounting methods simply allocate costs, or capacity to be correct, down onto the cost objects without considering any 'cause and effect' relations.
Consumption of resources versus activities
The fundamental assumption behind ABC is that it acknowledges you cannot manage costs, you can only manage what is being done and then costs will change as a consequence. In traditional cost accounting, however, the underlying assumption is that costs can be managed, but as most managers have found out the hard way - managing costs is almost impossible.
The advantages of the ABC approach is that it helps open up a wider array of measures when it comes to the matter of improving productivity. By investigating systematically what is being done, i.e. the activities, one will not only be able to identify surplus capacity if it occurs, but also lack of capacity and misallocation of capacity. A result of this might be that costs are cut the traditional way, but it might as well lead to a reallocation of capacity to where it is most needed which will yield high productivity more effectively than the traditional way.
Volume related allocation bases versus drivers at many levels
Due to the historic background of traditional cost accounting methods, the tendency was to use direct labor - or other volume-related allocation bases - for cost assignment purposes. But as overheads have grown and new technologies have emerged, it goes without saying that assigning costs based on only 5 – 15 percent (in most companies) of total costs is highly risky. In fact, the incurred errors are up to several hundred percent!
In ABC, however, costs are assigned according to the “cause and effect” relationship between activities (the actual happenings) and cost objects, which is captured using drivers. The drivers are therefore not allocation bases in the traditional sense, although they work the same way mathematically - drivers are estimates of actual cost behavior and can therefore also be used to identify the critical cost factors. Since the drivers are related to the actual processes, they occur at several levels. The four most common levels are;
Unit level. Unit level drivers are triggered for every unit that is being produced. For example, for a man and a machine that produces one unit at a time, the associated direct labor will be a unit level cost driver. This is therefore a volume related driver similar to the traditional allocation bases.
Batch level. Batch level drivers are triggered for every batch produced. A good example of that is production planning, because the planning is done for each and every batch regardless of the size of the batch. Here, number of batches can be a good driver.
Product level. Product level drivers are triggered for every product regardless of the number of units and batches produced. These drivers occur by the sole existence of a product. A good example of a driver is the number of product development hours per product so that the more product development hours a product triggers, the more product development costs should be assigned to that product.
Facility level. Facility level driver are drivers that are not related to the products at all. Costs that are traced by such drivers will therefore be allocated to products and not traced. The difference between allocation and tracing is that allocation is quite arbitrary whereas tracing is based on 'cause and effect' relations.
Hence, it can be seen that the traditional usage of fixed and variable costs is totally meaningless. In ABC, all the costs are included. ABC employs a different usage and definition of fixed and variable costs. A fixed activity cost is a cost that exists due to the very existence of the activity whereas a variable activity cost changes as the output of the activity changes. This distinction is very helpful in various improvement efforts.
In discussing cost drivers, it is important to mention that in ABC there are two types of drivers with respect to cost assignment;
Activity drivers that keep track of how cost object behavior influences activity levels, i.e., the level of activity for each activity.
Resource drivers that keep track of how the subsequent activity level affects the resource consumption.
In early cost accounting terminology, drivers were referred to as 'second stage cost drivers' whereas resource drivers were denoted 'first stage cost drivers'. But it is evident that the word 'cost driver' is misleading in this context because activity and resource drivers do not tell what drives costs in the general case.
Therefore, in Activity-Based Management (ABM) a third type of drivers is employed in addition to the two aforementioned drivers. This type of drivers is called cost drivers and they are the underlying causes of costs of activities and measured by non-financial performance measures. Today, the most important of these measures can be presented in a Balanced Scorecard and they represent the process view in ABM. These are possibly the most difficult drivers to identify.
For example:
Traditional
ABC
Salaries Rs. 100
Clean door Rs. 40
Equipment Rs. 80
Paint door Rs. 75
Supplies Rs. 20
Inspect door Rs. 75
Overhead Rs. 45
Send door to assembly Rs. 55
TOTAL Rs. 245
TOTAL Rs. 245

In the above mentioned example, ABC doesn’t eliminate or change costs, but it provides data about how costs are actually consumed. In this example, if you want to reduce costs using traditional data you would have to decrease salaries, or decrease costs of supplies. You don’t know enough to change the equipment or overhead costs. Using ABC data you can see that it costs the same to paint and inspect the door.

Traditional accounting systems have been considered inaccurate in the way that they allocate costs. Large batch or high volume products and services typically incur somewhere from 50% to 200% LESS overhead than they are assigned. Small batch or low volume products and services typically incur 200% to 1000% MORE overhead than they are assigned.\
What does this mean???
This means that products and services that are considered highly profitable may in fact be profit eaters. This inaccuracy is becoming more and more critical as companies aim to move toward customer-defined products and services (which could often mean a batch size of one).
In order to correctly associate costs with products and services, ABC assigns cost to activities based on their use of resources. It then assigns cost to cost objects, such as products or customers, based on their use of activities. This information assists in making decisions about pricing, outsourcing, capital expenditures and operational efficiency.
Here
Resources are people and machines.
The resource drivers are the measure of the frequency and intensity of the demands placed on resources by activity
Activities are the processes performed by people and machines.
Activity drivers measure the frequency and intensity of the demands placed on activities by cost objects enabling costs to be assigned to cost objects.
Cost objects are the products and services produced.
Cost drivers are the factors that affect the cost of an activity, e.g., poor quality
A broader definition of a Cost Driver is that any activity that causes a cost to be incurred. The Activity Based Costing (ABC) approach relates indirect cost to the activities that drive them to be incurred. In traditional costing the cost driver to allocate indirect cost to cost objects was volume of output. With the change in business structures, technology and thereby cost structures, it was found that the volume of output was not the only cost driver. Some examples of indirect costs and their drivers are: maintenance costs are indirect costs and the possible driver of this cost may be the number of machine hours; or, handling raw-material cost is another indirect cost that may be driven by the number of orders received; or, inspection costs that are driven by the number of inspections or the hours of inspection or production runs.
Generally, the cost driver for short-term indirect variable costs may be the volume of output/ activity; but for long term indirect variable costs, the cost drivers will not be related to volume of output/ activity. According to John Shank and Vijay Govindarajan, cost drivers are listed into two categories:
1. Structural cost drivers that are derived from the business strategic choices about its underlying economic structure such as scale and scope of operations, complexity of products, use of technology, etc.
2. Executional cost drivers that are derived from the execution of the business activities such as capacity utilization, plant layout, work-force involvement, etc. To carry out a value chain analysis, ABC is a necessary tool. To carry out ABC, it is necessary that cost drivers are established for different cost pools.
Example
Explained here is an example based on the fictitious Bainbridge University’s cost accounting systems. To make matter simple, only four service centers, three activity centers, and two cost objects are considered.
Bainbridge University has two professional management education programs: eMEP is a low volume program for working professionals (with 2,000 students and a faculty-student ratio of 1:10), and the regular PGP which is a high volume program (with 4,000 students and a faculty-student-faculty ratio of 1:20).
Costs for faculty remuneration average up to Rs. 30,000 in each department, and each department has approximately 200 faculty members; thus, the total salary cost in each department is Rs. 60 lakh.
The total overhead costs of providing these programs is Rs. 32 lakh per year (two and two-thirds the amount of salaries). Although each program has the same number of faculty members and PGP B has more students, eMEP requires more space for laboratories and classrooms than PGP Program.
So far, the University has not attempted to assign overhead costs to programs. Thus, the costs of operating each program were considered to be only the salaries of faculty members. The cost per student for each program was determined by dividing the faculty salaries by number of students. Using this method, the cost per student for eMEP is Rs. 3,000; for PGP Rs. 1,500.
This approach ignores the overhead costs of operating the programs. Last year, the college allocated overhead to programs based on the total number of students in each program (i.e., a volume-based costing method). The overhead application rate is computed as follows:
Total overhead costs/Total students = Rs. 32,000,000/6,000 = Rs. 5,333/per student
Using this rate, the cost per student of operating each program is given below:

eMEP
PGP
Salaries
Rs. 3,000
Rs. 1,500
Overhead rate
Rs. 5,333
Rs. 5,333
Total costs per student
Rs. 8,333
Rs. 6,833

The lacuna with the volume-based costing method is that it looks only at the number of students and disregards the impact of other factors, such as the space occupied or the number of computers used by the programs. Because other factors are being ignored, each program is assigned an equal amount of overhead costs per student. While this method is simple to apply, it is only relevant when other factors affecting overhead are not significant.
As it’s never too late, Bainbridge University has decided to design and implement an activity-based costing (ABC) system. With ABC, costs that were considered to be indirect costs (overhead) are traced directly to cost objects (programs). The first step in the design of the ABC system is to determine the activity centers. Bainbridge University analyzed its operations and identified three activity centers: course enrollment activities, student support activities, and academic activities. The second step in ABC system design is to assign costs to the activity centers. Bainbridge University has four service centers whose costs are assigned to activities--human resources, computing, duplicating, and maintenance services.
The determination of the costs per item for each of the service centers is presented in the following table.
Costs per Item
Service Center
Cost Driver
Traceable Costs
No. of Items
Cost per Item
Human resources
Number of employees
Rs. 1,000,000
1,000 employees
Rs. 1,000/employee
Computing
Number of computers
Rs. 2,000,000
200 computers
Rs. 1,000/computer
Duplicating
Number of copies
Rs. 100,000
100,000 copies
Rs. 1/copy
Maintenance
Square feet occupied
Rs. 5,000,000
50,000 square feet
Rs. 100/square foot
Total costs

Rs. 8,100,000



The number of items that are consumed by the activity centers (enrollment, student support, and academic activities) and the cost objects (eMEP and PGP) are given in the following table. These items are the first-stage cost drivers for the service centers.
First-Stage Cost Drivers

Service Centers
Activity/Object
Human Resources
Computing
Duplicating
Maintenance
Course enrollment activities
300 employees
150 computers
10,000 copies
2,000 square feet
Student support activities
200 employees
100 computers
7,000 copies
5,000 square feet
Academic activities
100 employees
50 computers
3,000 copies
3,000 square feet
eMEP
200 employees
1,100 computers
30,000 copies
25,000 square feet
PGP
200 employees
600 computers
50,000 copies
15,000 square feet
Total items
1,000 employees
2,000 computers
100,000 copies
50,000 square feet

The cost of each activity center is presented in the following table.
Cost of Activity Centers
Costs
Enrollment Activities
Student Support Activities
Academic Activities
Human resources
Rs. 300,000*
Rs. 200,000
Rs. 100,000
Computing
Rs. 150,000
Rs. 100,000
Rs. 50,000
Duplicating
Rs. 10,000
Rs. 7,000
Rs. 3,000
Maintenance
Rs. 200,000
Rs. 500,000
Rs. 300,000
Direct costs
Rs. 12,000,000
Rs. 8,000,000
Rs. 3,900,000
Total costs of activity
Rs. 12,660,000
Rs. 8,807,000
Rs. 4,353,000
Total of all activities
Rs. 25,820,000


*300 employees at a cost of Rs. 1,000 per employee

All the costs, except for direct costs, are computed by multiplying the number of events consumed by each activity center by the cost per event. For example, the human resources costs for enrollment activities is computed as the 300 employees in that activity center multiplied by Rs. 1,000 per employee. The direct costs are the costs specifically related to that activity. The salaries of employees in the enrollment activities area is an example of a direct cost. Direct costs usually make up a large part of the total costs of an activity.
The next step in the ABC is to define the cost objects. As explained previously, Bainbridge University has two programs that are considered cost objects, eMEP and PGP.
The final step in ABC system design is to link activity costs to cost objects. This is done in a similar fashion to assigning service center resource costs to activities. Before making this link, service department costs are assigned to cost objects. The number of service activities consumed by the two programs (as shown above) are repeated here.
Service Center
eMEP
PGP
Human resources
200 employees
200 employees
Computing
1,100 computers
600 computers
Duplicating
30,000 copies
50,000 copies
Maintenance
25,000 sq. ft.
15,000 sq. ft.
For activity centers, the costs per item are determined as shown in figure 6. The number of activities consumed by each cost object are:
Activity Center
eMEP
PGP
Enrollment activities
500 new students
1,000 new students
Student support
2,000 total students
4,000 total students
Academic activities
200 instructors
200 instructors

The total cost and cost per unit of each cost object are computed in the following figure.
Total Cost and Cost per Unit of Cost Objects
Costs
eMEP
PGP
Total
Human resources (Rs. 1,000/employee)
Rs. 200,000
Rs. 200,000
Rs. 400,000
Computing (Rs. 1,000/computer)
Rs. 1,100,000
Rs. 600,000
Rs. 1,700,000
Duplicating (Rs. 1/copy)
Rs. 30,000
Rs. 50,000
Rs. 80,000
Maintenance (Rs. 100/square foot)
Rs. 2,500,000
Rs. 1,500,000
Rs. 4,000,000
Subtotal (service costs)
Rs. 3,830,000
Rs. 2,350,000
Rs. 6,180,000*
Enrollment (Rs. 456/ per new student)
Rs. 4,220,000
Rs. 8,440,000
Rs. 12,660,000
Student support (Rs. 112/student)
Rs. 2,935,667
Rs. 5,871,333
Rs. 8,807,000
Academic (Rs. 440/lecturer)
Rs. 2,176,500
Rs. 2,176,500
Rs. 4,353,000
Subtotal (activity costs)
Rs. 9,332,167
Rs. 16,478,833
Rs. 25,820,000
Total (service + activity costs)
Rs. 13,162,167
Rs. 18,837,833
Rs. 32,000,000
Number of students
2,000
4,000
6,000
Costs per student
Rs. 6,581
Rs. 4,709
Rs. 5,333
*Rs. 6,180,000 service costs charged to the programs plus Rs. 1,920,000 charged to activities equals the total costs of service departments of Rs. 8,100,000
In the past using traditional absorption cost accounting, Bainbridge University was charging Rs. 5,333 in overhead cost per student in either program. The university should have been charging Rs. 6581 in overhead cost to each student in eMEP A, and only Rs. 4,709 to each student in PGP.

As a result of using the volume-based costing method, a relatively less overhead has been charged to eMEP eMEPnd too much has been charged to PGP program.
Through ABC, overhead costs that are traceable to each program have been identified, and thus cost data are more accurately determined.




ACTIVITY BASED MANAGEMENT
Definition
"A discipline that focuses on the management of activities as the route to continuously improving the value received by customers and the profit achieved by providing this value. This discipline includes cost driver analysis, activity analysis and performance analysis. Activity Based Management draws on activity based costing as a major source of information."
-- Peter B. B. Turney
Activity Based Management (ABM) focuses on managing activities/business processes to achieve organizational objectives. It helps reduce cost drivers and non-value and transfers resources to economic value-creating activities/business processes the customer wants and is willing to pay for. It also creates performance measures for cost, time, quality, and outcomes so everyone understands how their activities contribute to the mission and strategy. It aims to supports the Balanced Scorecard by creating performance measures. Some other feature of ABM is that it helps improve cash flow, quality, and cycle time reduction.
Activity Based Management adds optima value to an organization when it is used as the informational basis of managing and improving the business. Activity analysis leads to an Activity Based Management business model from which management can make decisions to improve the effectiveness of the organization. These improvements can take the form of incremental process improvement using Total Quality, Just-in-Time, or Reengineering.
Once these changes are made, the ABM model provides mechanisms to measure the relative success of the changes implemented and make business decisions leading to further analysis and improvement.
In order for a model to accomplish these ambitious goals, even in a limited department, division or strategic business unit, it must be, first, a clear and accurate representation of the actual business process. Care must be taken to insure that the model is not a representation of "what we think we are or should be doing". Second, costs must be attached to the resources from the financial accounting system. Finally, the model must be verified both operationally and financially to the satisfaction of the management who will be using it to make business decisions. Only then will the model have the credibility required for management to trust it and rely on it.

Nine Steps to Activity Based Management
1. Define the project scope.
2. Identify activities and their drivers.
3. Lay out the process flow.
4. Collect related date and rules.
5. Identify the ABC modeling tool to be used.
6. Build the model using the selected tool.
7. Test and validate the model.
8. Analyze the model results.
9. Take Action.
References:
http://maaw.info/5partsofcostsystem.htm#Full%20absorption

http://www.principlesofaccounting.com/chapter%2023.htm

http://www.emblemsvag.com/abc.htm

http://www.theacagroup.com/activitybasedcosting.htm

http://www.siliconfareast.com/abc.htm

http://en.wikipedia.org/wiki/Activity-based_costing

www.directives.doe.gov/pdfs/doe/doetext/neword/430/g4301-1chp24.pdf

www.pitt.edu/~roztocki/abc/abctutor
[1] http://www.principlesofaccounting.com/chapter%2023.htm