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Chapter 12Chapter 12

ActivityActivity Based Costing SystemBased Costing System

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Activity Based Costing System

Traditional Manufacturing

Costing system

Cost of Resource Capacity

Activity Based Costing/Management (ABC/ABM) System

ABC for Marketing, Selling and

Distribution Expenses

PROs and CONs

ABC for Service Companies

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TRADITIONAL MANUFACTURING TRADITIONAL MANUFACTURING COSTING SYSTEMCOSTING SYSTEM

The traditional costing system (TCS) assigns indirect costs/overheads to job/products in two stages:

First, the accumulated cost are allocated to production departments (cost centers).

Second, the accumulated costs in cost centres are assigned to individual job/products on the basis of an overhead allocation

rate based on/in proportion to some measure of volume of production such as direct labour cost, direct labour-hour

rate, machine-hour rate and so on.

It has the merit of being simple, easy to use and understand, and applied consistently from year to year. It is adequate

for financial reporting of inventory valuation.

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Exhibit 1: Montex Pen Total and Product Profitability

Particulars Blue Pens

Black Pens Red Pens Purple Pens

Total

(1) (2) (3) (4) (5)Production/Sales volume 25,000 20,000 4,500 500 50,000Unit sale price Rs 45 Rs 45 Rs 46.5 Rs 49.5Sales (a) 11,25,000 9,00,000 2,09,250 24,750 Rs 22,59,000Material costs 3,75,000 3,00,000 70,200 8,250 7,53,450Direct labour costs 1,50,000 1,20,000 27,000 3,000 3,00,000Overheads (300% of  direct labour) 4,50,000 3,60,000 81,000 9,000 9,00,000*Total costs (b) 9,75,000 7,80,000 1,78,200 20,250 19,53,450Total operating income  [(a) – (b)] 1,50,000 1,20,000 31,050 4,500 3,05,550Return on sales (%) 13.3 13.3 14.8 18.2 13.5

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Limitations/Inadequacies of Limitations/Inadequacies of Traditional Costing System Traditional Costing System

It has, however, serious limitations/inadequacies due to its assumption that all overheads are proportionate to volume of production. Many overheads costs are, actually, not proportionate to volume.

The use of volume-related allocation base of TCS for allocating overheads would result in product cost distortion in an environment of complex and high product variety. The ABC system eliminates this source of cost distortion.

As a result, simple high-volume products would be overcosted (i.e. receive a larger allocation of overheads) and low-volume complex products would be undercosted (i.e. receive a smaller allocation of overheads).

Examples of such costs are setup costs of machines/equipment, cost of inspection/handling of materials and so on. They are affected by complexity rather than volume.

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ACTIVITY BASED COSTING/MANAGEMENT ACTIVITY BASED COSTING/MANAGEMENT (ABC/ABM) SYSTEM(ABC/ABM) SYSTEM

(i) Tracing costs to activities

ABC System is a system based on activities linking spending on resources to the products/services

produced/delivered to customers. The ABC system also uses a two-stage

overhead allocation:

(ii) Tracing costs from activities to products/jobs

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1. Tracing Cost to Activities1. Tracing Cost to Activities

This step is to identify major activities that cause/drive overhead costs to be incurred. Some of the activities are related to production volume (such as production runs, salary of supervisors and so on) but others are not (such as inspection/handling of materials, setting up equipment and so on). The cost of resources consumed in performing these activities are grouped into cost pools.

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Exhibit 2: Common Activities and Associated Costs/Cost Drivers

Major Activities(1)

Associated Costs (2)

Cost Driver(3)

Processing purchase order for materials and parts

Handling material and parts

Inspecting incoming material and parts

Setting up equipment

Producing goods using manufacturing equipmentSupervising assembly workers Inspecting finished goods

Packing customer orders

Labour costs for workers determining order quantities, contacting vendors, and preparing purchase ordersLabour costs for workers handling material and parts, depreciation of equipment used to move material and partsLabour costs for workers performing inspections, depreciation of equipment used to test strength of materials, tolerances, etc.Labour costs for workers involved in setups, depreciation of equipment used to adjust equipmentDepreciation on manufacturing equipment

Salary of assembly supervisors

Labour cost for finished goods inspections, depreciation of equipment used to test whether finished goods meet customer specifications, etc.Labour cost for packing workers, cost of packing materials, etc.

Number of purchase orders processes

Number of material requisitions

Number of receipts

Number of setups

Number of machine-hoursNumber of assembly labour-hoursNumber of inspections

Number of boxes packed

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2. Tracing Costs from Activities to 2. Tracing Costs from Activities to ProductsProducts

The next step is to assign costs to products/jobs using cost drivers as a measure of activity. Cost drivers represent the quantity of activities used to produce individual products.

(I) TRANSACTION

(II) DURATION

(III) INTENSITY (DIRECT CHARGING)

They identify the linkage between activities and cost objects and serve as quantitative measures of the output of activities. In fact, they are the central innovation of ABC system. Three types of cost drivers are:

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 Transaction drivers are used to count the frequency of an activity/the number of times an

activity is performed.

 Duration drivers represents the amount of time required to perform an activity.

 Intensity drivers are used to charge directly for the resources used each time an

activity is performed.

Transaction Drivers 

Duration Drivers

Intensity Drivers

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The next step is to compute the Activity Cost Driver Rate (ACDR).

Finally, ABC Products Profitability Report is prepared. It combines activity expenses assigned to each product with their direct (labour and material) costs.

Activity-Based Costing Products Profitability Report

Activity Cost Driver Rate  

The activity expenses assigned to a product is arrived at multiplying the ACDR by the quantity of each activity cost driver used by each product.

The ACDR is the amount determined dividing the activity expenses by the total quantity of the activity cost driver.

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Example 1

We will now illustrate the step-wise cost allocation of overhead costs and the preparation of the ABC Products Profitability Report for the Montex Pen Manufacturing Company in Exhibit.1.

(A) The total overheads (aggregating Rs 9,00,000) were comprised of the following:

Expense category Expenses

Indirect labour

Fringe benefits

Computer system expenses

Machinery

Maintenance

Energy

Total

Rs 3,00,000

2,40,000

1,50,000

1,20,000

60,000

30,000

9,00,000

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(B) The activities and activity expenses of the Montex Pen Manufacturing Company are summarised below:

Overhead cost items

Cost driver

Handle production

runs

Set up Support machines

Run machine products

Total expenses

(1) Indirect labour and 1/2 fringe benefits(2) Computer expenses(3) Machine depreciation(4)Maintenance(5) Energy Activity Expenses

50%

80%

———

Rs 3,30,0001

40%

—

———

Rs 1,68,0002

10%

20%

———

Rs 72,0003

—

—

100%100%100%

Rs 2,10,0004

Rs 4,20,000

1,50,000

1,20,00060,00030,000

7,80,000

1 (Rs 4,20,000 × 0.50) + (Rs 1,50,000 × 0.80) = Rs 2,10,000 + Rs 1,20,000 = Rs 3,30,0002 (Rs 4,20,000 × 0.40) = Rs 1,68,0003 (Rs 4,20,000 × 0.10) + (Rs 1,50,000 × 0.20) = Rs 42,000 + Rs 30,000 = Rs 72,0004 (Rs 1,20,000 + Rs 60,000 + Rs 30,000) × 1.00 = Rs 2,10,000

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Activity Cost Driver Products

Blue Pens

Black Pens

Red Pens

Purple Pens

Total@

Direct labour-hour/unit

Machine-hour/unit

Production runs

Setup time/run

Total setup time (hour)

Number of products

0.02

0.10

70.00

4.00

280.00

1.00

0.02

0.10

65.00

2.40

156.00

1.00

0.02

0.10

50.00

5.60

280.00

1.00

0.02

0.10

15.00

5.60

84.00

1.00

2,000

10,000

200

—

800

4

@Total labour and machine-hours are obtained by multiplying the unit amounts by the quantity of each type of pen sold (from Exhibit 1), that is, 25,000 blue, 20,000 black, 4,500 red and 500 purple pens.

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(C) The activity cost driver rates and the activity expenses assigned to products are shown below:

Activity Activity expenses

Activity cost driver

Activity cost driver quantity

Activity cost driver rate

Handle

Productionruns

Set up machines

Support products

Run machines

Total

Rs 3,30,000

1,68,000

72,000

2,10,000

________

7,80,000

Number of

production

runs

Number of

setup hours

Number of

products

Number of

machine-hours

200

800

4

10,000

Rs 1,650 per run

210 per setup

hour

18,000 per

product

2.10 per

machine-hour

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Activity Expenses Assigned to Products

ACDR ACDQ

for

Blue

Activity

Expenses:

Blue

ACD

Q for

Black

Activity

Expenses

Black

AC

DQ

for

Red

Activity

expenses:

Red

AC

DQ

for

purp

le

Activity

Expenses:

Purple

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Handle

Production

 Run

Setup

 Machines

Support

 Products

Run

 Machines

Rs 1,650

210

18,000

2.10

70

280

1

5,000

Rs 1,15,500

58,800

18,000

1,05,000

65

156

1

4,000

Rs 1,07,250

32,760

18,000

84,000

50

280

1

900

Rs 82,500

58,800

18,000

18,900

15

84

1

100

Rs 24,750

17,640

18,000

210

Note: ACDR = Activity Cost Driver Rate; ACDQ = Activity Cost Driver Quantity

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(D) The ABC product profitability report for the Montex Pen Manufacturing Company is shown in Exhibit 3.

Exhibit 3  Activity-Based Costing Products Profitability Report

Blue Pens Black Pens Red Pens Purple Pens

Total

Sales revenuesMaterial costDirect labour costGross MarginOverheads:—50% fringe benefit on direct labour—Handle production runs—Setup machines—Support products—Run machinesTotalOperating incomeReturn on sales(%)

Rs 11,25,0003,75,0001,50,0006,00,000

60,000

1,15,50058,800

18,0001,05,0003,57,3002,42,700

21.7

Rs 9,00,0003,00,0001,20,0004,80,000

48,000

1,07,25032,760

18,000 84,000

2,90,0101,89,990

21.1

Rs 2,09,25070,20027,000

1,12,050

10,800

82,50058,800

18,000 18,900

1,89,000(76,950)

(36.8)

Rs 24,750

8,2503,000

13,500

1,200

24,25017,640

18,000 2,100

63,690(50,190)(202.8)

Rs 22,59,0007,53,4503,00,000

12,05,550

1,20,000

3,30,0001,68,000

72,0002,10,0009,00,0003,05,550

13.5

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Activity-Based Management (ABM)Activity-Based Management (ABM)

The activity-based management (ABM) refers to a set of actions that management can take, based on information from an ABC study, to increase/improve profitability. These

include a combination of

1) Repricing of unprofitable products,

2) Increasing sales volume of highly profitable products,

3) Process improvement e.g. how to reduce setup times in contrast to faster run of production, equipment and

4) Engineering and design improvements.

Their combined effect would be production of the same volume and mix of products with fewer resources.

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Cost of Resource CapacityCost of Resource Capacity

The expenses of resources unused during the production (difference between theoretical capacity and practical capacity) is the cost of unused capacity. Such a cost should be assigned to the person/customer/department/market segment concerned with/responsible for it.

Practical capacity is a better measure of cost of resources to handle each production (i.e. capacity expenses ÷ practical capacity). It is the maximum amount of work that can be performed by resources supplied for production/services and is expressed as a percentage of theoretical capacity.

Theoretical capacity means the normal working hours of a machine/working employee. The difference between theoretical capacity and practical capacity is the time utilised by the employees for breaks, arrivals, departures and so on, which are not related to actual work performance. It may also represent allowances for downtimes of machines due to maintenance, repair and rescheduling fluctuations and so on.

Practical capacity

Duration Drivers

Unused Capacity

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ABC FOR MARKETING, SELLING AND ABC FOR MARKETING, SELLING AND DISTRIBUTION EXPENSESDISTRIBUTION EXPENSES

Marketing, selling and distribution expenses are significant components of overhead costs of companies. Most of these costs are associated with customers, market segments and distribution channels rather than to individual products. The ABC is applicable to such costs also.

Its focus is on tracing these costs to customer segments. The activities performed by these services are first identified together with activity cost drivers linking each activity to individual customers.

The resource spending in the various customer accounts are then identified.

The final stage is preparation of customer profitability analysis.

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Tracing Costs to Customers

The focus of ABC system is on tracing marketing, selling and distribution costs to customer segments. To illustrate, consider two customers, Simple and Complex, of Avon Industries Ltd. Avon Ltd. currently uses the traditional/conventional cost accounting system and distributes the marketing, selling and distribution to customers based on sales revenue, that is, approximately one-third of total sales. The traditional costing-based profitability of Simple and Complex (customers) is summarised in Exhibit 4:

Exhibit 4:  Traditional Costing Based Customer Profitability Analysis

Simple Complex

Sales revenue

Costs of goods sold

Gross margin

Marketing, selling, distribution and

  administrative expenses (0.33 × sales)

Operating profit

Profit (as percentage of sale)

Rs 12,80,000

6,16,000

6,64,000

4,22,000

2,41,600

18.8

Rs 12,60,000

6,24,000

6,36,000

4,15,800

2,20,200

17.5

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Identification of Activities Identification of Activities and Cost Drivers and Cost Drivers

Activity Activity Cost Driver

1 Marketing and technical support 1 Estimated proportion of time spent on each customer

2 Travel to customers 2 Actual expenditure

3 Distribution of sales catalogue 3 Number of mailings

4 Servicing of customers 4 Estimated proportion of time spent on each customer and supplies used by them

5 Handle customer orders 5 Number or orders

6 Warehouse inventory for customers

6 Quality of inventory and space required by customer

7 Shipping/despatch to customers 7 Actual records

Identify Resource Spending

The next step is to identify the resource spending in the various accounts. The customer profile of Simple and Complex is as follows. Simple orders only a few products in large quantities, places order predictably and with long lead times, and requires little sales and technical support. But Complex requires a great deal of handholding and continuously inquires whether products could be modified to meet his specific needs. In addition to marketing resources, many technical resources are required to service Complex. Complex also places many small orders for special products, requires expeditious delivery and pays slowly, increasing the demands on order processing, invoicing and accounts receivable process of Avon Ltd. Suppose the following marketing, selling, distribution and administrative costs are identified for the two customers.

Simple Complex

1 Marketing and technical support2 Travel to customers3 Distribution of sales catalogue4 Servicing of customers5 Handling customer orders6 Warehouse inventory7 Ship/despatch to customersTotal activity expenses

Rs 28,0004,800

40016,0002,0003,200

50,4001,04,800

Rs 2,16,00028,800

4001,68,000

72,00035,200

168,0006,88,400

Customer Profitability Analysis ReportCustomer Profitability Analysis ReportExhibit 5: Activity-Based Costing Customer Profitability Analysis

Simple Complex

Sales revenueCost of goods soldGross marginMarketing, selling and distribution expenses:

Marketing and technical supportTravel to customersDistribution of sales catalogueServicing of customersHandling customer ordersWarehouse inventoryShip/dispatch to customers

Total activity expensesOperating profitProfits as percentage of sales (operating margin)

Rs 12,80,0006,16,0006,64,000

28,0004,800

40016,0002,0003,200

50,4001,04,8005,59,200

43.7

Rs 12,60,0006,24,0006,36,000

2,16,00028,000

4001,68,000

72,00035,000

1,68,0006,88,400

(–52,400)(–4.2)

According to the ABC customer profitability analysis (Exhibit 5), Simple is a highly profitable customer while Complex is a very unprofitable customer. The reason is that ordering and support activities of Simple places few demands on the Avon’s marketing, selling, distribution and administrative resource as a result of which its operating margin is much higher.

Managing Customer ProfitabilityManaging Customer Profitability

The ABC customer profitability analysis can be used to manage its profitable and unprofitable customers. To protect them from competitive inroads profitable customers may be offered discounts/incentives and special services to retain them. The unprofitable customers can be transformed into profitable customers through a number of actions:

(i) Process improvement,

(ii) Activity-based pricing and

(iii) Managing customer relationships.

ABC for Service CompaniesABC for Service Companies

The ABC system is as much applicable and useful to a service company as it is to a manufacturing company. Service organisations include companies in

a) Financial services (i.e. banks, insurance organisations, money managers),

b) Transportation (i.e. airlines, roads and railways),

c) Telecommunications,

d) Wholesale and retail,

e) Healthcare and so on.

Cost Structure of Service CompaniesCost Structure of Service Companies

Service companies have a unique cost structure. Virtually all their costs are indirect/fixed.

In contrast to manufacturing companies, customer behaviour determines the basic operating costs of products/services of service companies. They should, therefore, identify the differential profitability of individual customers as they determine the quantity of demands for their operating activities.

ABC Model IllustratedABC Model IllustratedExample 2

The structure/construction of the ABC system in a service company is almost identical to that of a manufacturing company, that is, (i) identify activities, (ii) assign resources expenses to activities, (iii) determine activity cost drivers, (iv) calculate activity cost driver rate and (v) compute product/customer cost. We illustrate below the ABC model for a service company with reference to IBM-Daksh.

The billing department of IBM-Daksh customer care centre requires accurate and useful information about the cost of providing account inquiry and bill printing services for its 1,20,000 residential and 20,000 commercial customer accounts. A local service centre has offered to provide all the functions currently performed by IBM-Daksh’s billing department at Rs 21.5 per residential account and Rs 40 per commercial account.

All costs in the billing department are indirect. There are no direct or unallocated costs. The resources used to support the billing department of IBM-Daksh in the previous month are summarised below:

Expense Expense amount

TelecommunicationsComputer expensesSupervisorsPaperOccupancyAccount inquiry labourPrinting machinesBilling labourVerification labourOther resources

Rs 2,92,6008,90,0001,68,000

36,0002,35,0008,67,3002,75,0002,81,750

56,250 3,35,00034,37,500

The billing department of IBM-Daksh uses a traditional costing system that allocates all indirect costs based on (i) the number of account inquiries, namely, 20,000 (80 per cent) for residential customers and 5,000 (20 per cent) for commercial customers.

Suppose IBM-Daksh wants to introduce ABC system for its billing department. They have identified the following activities and the related cost drivers:

Activity Cost driver

Account billingBill verificationAccount inquiryCorrespondenceOther activities

Number of printed pagesNumber of accounts verifiedNumber of inquiriesNumber of lettersNumber of printed pages

The resources used to perform the activities and the activities performed are shown here:

Resources Used to perform activity

Activity Performed (%)

Account Inquiry

Correspondence

Billing Verification Others Total

Supervisor 40 10 30 — 20 100

Account inquiry labour

90 10 — — — 100

Billing labour — — 30 70 — 100

Verification labour — — — 100 — 100

Paper — — 100 — — 100

Computer 45 5 35 10 5 100

Telecommunications 90 — — — 10 100

Occupancy 65 — 15 — 20 100

Printing machines — 5 90 — 5 100

All other resources — — — — 100 100

The number of cost driver units for the billing department of IBM-Daksh is shown

below:

Activity Cost driver units Number of cost driver units

Residential Commercial Total

1 Account inquiry

2 Correspondence

3 Bill printing

4 Verification

5 Other activities

Number of inquiries

Number of letters

Number of printed

pages

Number of accounts

verified

Number of printed

pages

20,000

1,800

1,20,000

—

1,20,000

5,000

1,000

40,000

20,000

40,000

25,000

2,800

1,60,000

20,000

1,60,000

Required:

(a) Using the traditional costing system, should the IBM-Daksh accept the offer

of the local service centre to perform all the functions?

(b) Would the decision be different with ABC system?

Solution: (a) Cost Computation for Billing Department (Traditional Costing System)

Residential Commercial

1 Cost

2 Number of inquiries

3 Number of accounts

4 Cost per account (1 ÷ 3)

Rs 27,50,000@

20,000(0.80)

1,20,000

22.9

Rs 6,87,500@@

5,000(0.20)

20,000

34.4

@ Rs 34,37,5000 × (0.80)@@Rs 34,37,500 × (0.20)

Decision: The billing department should accept the offer of the local service centre to service residential accounts as there is a saving of Rs 1.4 per account (Rs 22.9 – Rs 21.5). But it should continue to service the commercial accounts because of lower cost of Rs 5.6 (Rs 40 – Rs 34.4).

(b) The computation of activity-based cost per account for each customer class (residential and commercial is illustrated below).

(b) (i) Total Traceable Costs

Resource Cost Activity Cost Pool

Account Corres- Billing Verification Others

Inquiry pondence

1. Supervisors2. Account inquiry labour3. Billing labour4.Verification labour5. Paper6. Computer7. Telecommuni- cations8. Occupancy9. Printing machines10. Others

Rs 1,68,000

8,67,3002,81,250

56,25036,600

8,90,000

2,92,6002,35,000

2,75,0003,35,000

Rs 67,200a

7,80,570—

——

4,00,500

2,63,3401,52,750

——

Rs 16,800b

86,730—

——

44,500

——

13,750—

Rs 50,400c

—84,375

—36,600

3,11,500

—35,250

2,47,500—

—

—Rs 1,96,875

56,250—

89,000

——

——

Rs 33,600d

——

——

44,500

29,26047,000

13,7503,35,500

Total traceable cost 34,37,500 16,64,360 1,61,780 7,65,625 3,42,125 5,03,610

a (Rs 16,8,000 × 0.40) b (Rs 16,8,000 × 0.10) c (Rs 1,68,000 × 0.30) d (Rs 16,8,000 × 0.20)

(b) (ii) Costs Driver

Activity Traceable costs

Number of Driver Units Cost per Driver Units

(1) (2) [(1) ÷ (2)]

Account inquiry Rs 16,64,360 25,000 inquiries Rs 66.5744

Correspondence 1,61,780 2,800 letters 57.7786

Account billing 7,65,625 1,60,000 printed pages 4.7852

Bill verification 3,42,125 20,000 accounts verified17.1062

Other activities 5,03,610 1,60,000 printed pages 3.1476

(b) (iii) Cost per Customer Class

Cost Per Driver Unit

Residential Customer Accounts

Commercial Customer Accounts

Number ofDriver Units

Cost Number of Driver Units

Cost

(1) (2) (3) (4) (5) (6)

Account inquiry Rs 66.5744 20,000 inquiries Rs 13,31,490 5,000 inquiries Rs 3,32,870

Correspondence 57.7786 2,800 letters 1,04,001 1,000 letters 57,779

Account billing 4.7852 1,20,000 pages 5,74,224 40,000 pages 1,91,408

Billing verification 17.1062 — — 20,000 accounts 3,42,124

Other activities 3.1476 1,20,000 pages 3,77,712 40,000 pages 1,25,904

Total Costs 23,87,415 10,50,085

Number of accounts

_______1,20,000

______20,000

Cost per account Rs 19.90 Rs 52.50

Cost per account 22.90 34.40

(traditional system)

PROs And CONsPROs And CONsThe ABC system has advantages as well as limitations. Its major benefits are:

The limitations of ABC system are two-fold:

1) it does not undercost complex low-volume products and overcost high-volume simple products,

2) it may result in improved cost control.

(a) it is costly to develop and maintain and (b) it is used to develop full costs and does not measure the incremental costs needed to produce an item.