Overheads are absorbed on volume related measures like:

Number of units producedAmount of material consumedAmount of direct labour costMachine hoursDirect labour hours

But there are many activities not related to physical volume.

Overheads have been allocated to products by using three steps:

(i)From ledger accounts to production and service departments

(ii)From service departments to production departments

(iii)From production departments to end products

Overhead Cost

Stage 1: Overheads assigned to production

departmentsProduction Departme

nts

Products

Stage 2: Overheads allocated to products

Departmental overhead allocation

rates

1) Blanket overhead recovery acceptable when valuing stocks for financial reporting but 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.

2)Traditional fixed versus variable cost split is often unrealistic since as business grows they often become more complex.

3)Decisions based on distorted cost information because of difficulties in traditional costing system in collection, classification, allocation and recovery of overheads to individual products.

4)Traditional accounting confined merely to furnishing information at product level. The new manufacturing technology demands the feedback of performance while production is still in progress rather than history.To overcome these inadequacies of overhead absorption and short term biasing of marginal costing, Activity Based Costing (ABC) has been researched

ABC is a technique under which the overhead costs of the organization are identified with each activity, which is acting as the cost driver. Examples of cost drivers are:Machine set-ups, purchase orders, quality inspections, power consumed, miles driven etc.

Activity Based Costing (ABC) is that costing in which costs are first traced to activities and then to products.

The more complex an organization’s operations , the more cost driving activities it is likely to have.

Overhead Cost

Stage 1: Overheads assigned to cost

centres / cost pools

Activity Cost pools

Activity Cost driver rates

Products

Stage 2: Overheads assigned to products using

cost driver rates

The key areas of ABC are:Product Cost differentiationActivities and their cost drivers Identification of non-value added

cost

Identify the functional areas or major activities involved in production.

Examples: machine related activities, divert labour related activities, support activities like ordering, receiving etc.

The activities may fall into four categories Unit level activities or Primary Activities Batch Level Activities Product Level Activities Facility Level Activities

Activities performed each time a unit is produced.

They are repetitive activitiesExample: Direct labour hours,

Machine hours, Power are used each time a unit is produced

Costs of unit level activities vary with the number of units produced

Activities performed each time a batch of goods or products is produced

Costs of batch level activities vary with the number of batches but are fixed with respect to the number of units in each batch

Example: Machine setups, inspections, production scheduling, materials handling

Activities performed to support the production of each different type of product

Example: Maintenance of equipment, engineering charges, testing routines, maintaining bills of materials

Activities needed to sustain a factory’s general manufacturing process

These are common to a variety of products Most difficult to link to product specific

activities Examples: Factory management,

maintenance, security, plant depreciation

A cost centre also called a cost pool be created for each activity.

Cost of resources consumed over a specified period must be assigned to each activity

These costs will have to be apportioned on some suitable basis.

Example: Total costs of all set ups might constitute one cost centre for all setup related costs.

Cost Driver is a factor that influences cost

Most suitable cost driver in each activity under functional areas should be identified

Example: In production scheduling, driver will probably be the number of batches ordered.

FUNCTIONAL AREAS

ACTIVITIES SUITABLE COST DRIVERS

Materials Management

• Issue of purchase orders

• Number of purchase orders

• Inspection of materials

• Number of purchase orders

Stores Management

• Storing of materials • Value of materials stored

• Servicing of requisitions

• Number of requisitions

• Inspection & Verification

• Number of times inspected

• Stock Taking • Value of stock

Quality Control • Testing of Samples • Number of batches produced

FUNCTIONAL AREAS

ACTIVITIES SUITABLE COST DRIVERS

Marketing • Demand Creation • Increase in sales

• Advertising • Increase in sales

• Despatches •Number of orders

Personnel Management

• Recruitment of employees

• Number of employees recruited

• Maintenance of leave records & attendance

• Number of employees

Research & Development

• Research • Number of research Projects

Machining • Setup Cost • Number of production runs

• Power cost •Machine hours

Cost of the activities is traced to products on the basis of their usage of the activity, expressed in terms of the chosen cost driver(s).

Example:

Thus a batch generating 3 purchase orders would be charged 3 x Rs. 200 = Rs. 600 for purchasing overheads.

Total Costs of purchasing Rs. 2,00,000

Number of Purchase Orders

1,000

Cost Driver rate Rs. 200

ABC is needed in organizations for product costing where:

Production overheads are high in relation to direct costs

There is a great diversity in product range

Products use different amounts of overhead resources

Consumption of overhead resources is not primarily driven by volume

TRADITIONAL ABC

1. Cost Pools One or a limited number

Many, to reflect different activities

2. Applied Rate

Volume based, financial

Activity based, non – financial

3. Suited for Labour intensive, Low overhead companies

Capital intensive, product diverse, high overhead companies

4. Benefits Simple, inexpensive Accurate product costing, possible elimination of non-value –added activities

The following are the advantages of ABC:

Helps in reducing costs by providing meaningful information for cost management which helps in making the right decision

Provides due importance to non-manufacturing cost which constitute a substantial portion of total cost

Provides reliable and accurate cost information

Enables management in formulating an effective pricing policy while fixing prices

Accuracy in indirect cost allocation to products, helpful in make or buy decisions and transfer pricing

Uses multiple cost drivers since concerned with all activities within & beyond the factory

Can be more complex than traditional since uses numerous cost pools & multiple cost drivers

Difficulties in the implementation of ABC system such as selection of cost drivers, assignment of common costs, varying cost driver rates etc.

Different levels of utility for different organizations such as beneficial for large manufacturing firms as compared to smaller firms, advantageous for firms following cost plus pricing as it gives accurate product cost.

Can prove costly to manage ABC System

Most common motives for establishing ABC System are:

To improve product costing where a belief exists that existing methods undercost some products and overcost others, or

To identify non value adding activities in the production process which might be a suitable focus for attention or elimination

Number of distinct practical stages in ABC implementation are:

Staff Training: Co-operation of work force is critical to successful implementation of ABC as they are closest to the process and most aware of the problems

Process Specification: Informal but structured interviews with key personnel will identify different stages of production process, commitment of resources to each, processing times and bottlenecks.

Activity definition: listed transactions must be rationalized in order to aggregate those in similar categories and eliminate those deemed immaterial.

Activity Driver Selection: Single driver covering all transactions grouped together in an ‘activity’ probably does not exist and multiple driver models are not desirable as seen from the cost benefit analysis

Costing: Single representative activity driver can be used to assign costs from activity pools to the cost objects.

‘Service organizations ideal candidates for ABC’ Kaplan & Cooper

Due to privatization, deregulation & increasing competition, service organizations need to accurately measure cost and resulting profitability for their services, customers and markets.

ABC can understand their cost base and make decisions on value added/ non value added activities

ABC supports Corporate Strategy in many ways:

Accurate product costing helps management compare profits from various customers, product lines, brands or regions. Takes decisions on pricing strategy, dropping unprofitable products, lines etc.

Helps in redesigning products Evaluate new process technologies

Reduce setup times Rationalization of plant lay out to reduce

material handling cost Reduction in demand for organizational

resources by comparing resource spending and resource consumption

Helps managers to focus their attention & energy on improving activities

Activity performance and efficiency can be measured – helps in budgeting

XYZ Co. has 3 clerks responsible for processing purchase invoices. Salary paid to them is Rs. 3,00,000 p.a. and invoices processed by them are 5000 per year. In addition to salary, company spends Rs. 90,000 per year for forms, postage etc. During the year 12,500 invoices were processed. Required (i) activity rate for purchase order activity and break it into fixed & variable components (ii) total activity availability and break it into activity usage & unused activity (iii) total cost of resources supplied broken into activity usage & unused activity.

(i) Activity Rate =

= Rs. 66 per invoice

Fixed Activity Rate = = Rs. 60 per invoice

Variable activity rate = = Rs. 6 per invoice

(ii) Activity availability = Activity usage + unused activity = 12,500 invoices + 2500

invoices = 15,000 invoives

3. Costs of resources supplied = Cost of activity used + cost of unused activityRs. 9,00,000 + (Rs. 6 x 12,500)= (Rs. 66 x12,500) + (Rs. 60 x 2500)Rs. 9,75,000 = Rs. 8,25,000 + 1,50,000

A company manufacturing two products furnishes the following data for a year:

Product

Annual Output (units)

Total Machine

hours

Total number of purchase

orders

Total number of

set-ups

A 5,000 20,000 160 20

B 60,000 1,20,000 384 44

The annual overheads are as under:

Volume related activity costs Rs. 5,50,000

Set up related costs Rs. 8,20,000

Purchase related costs Rs. 6,18,000

Calculate cost per unit of each Product A&B based on (a) Traditional Method of charging overheads (b) Activity based costing method

(a) Traditional method of charging overheads:

Rs.

Volume related activity costs

5,50,000

Set-up related costs 8,20,000

Purchase related costs 6,18,000

Total Costs 19,88,000

Total Machine Hours (20,000 +1,20,000) = 1,40,000

Total cost per hour (Rs. 19,88,ooo/ 1,40,000) = Rs. 14.20

Cost per unit of A = (20,000 x Rs. 14.20)/5000 = Rs. 56.80

Cost per unit of B = (1,20,000 x Rs. 14.20)/ 60,000 = Rs. 28.40

(b) Activity based costing method of charging overheads:

Volume related activity cost per machine hour: Rs. 5,50,000/ 1,40,000

= Rs. 3.9286

Set-up costs per set up: Rs. 8,20,000/ 64 = Rs. 12,812.50

Purchase related costs per purchase order: Rs. 6,18,000/ 544

= Rs. 1136.029

Cost per unit of product

Particulars Cost Driver A B

Volume related costs

Machine hours Rs. 78, 572 Rs. 4,71,432

Set-up Costs Number of set ups 2,56,250 5,63,750

Purchase related Costs

Number of Purchase Orders

1,81,765 4,36,235

Total Costs Rs. 5,16,587

14,71,417

Cost per unit Rs. 103.32 Rs. 24.52