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© Confederation of Indian Industry

Presentation On

Activity Based Costing


Outcome of the ABC Workshop for DelegatesOutcome of the ABC Workshop for Delegates

• Key process concepts and their importance

• Activity Based Costing (ABC) model components and relationships

• Role of activities in cost determination of output and outcomes

• Key inputs for ABC implementation• Myths on ABC


Pricing Strategies As Economy Scales Tilt

• PRICE = COST+PROFITOkay in a supply controlled

Economy where cost means

accounted data in system

PROFIT= PRICE - COST

Price is market driven in a freeEconomy with competition.Costs need to be managed better


Why do you need a good costing Why do you need a good costing system ?system ?

To avoid

Sale of wrong products /services

Service / Focus on wrong customers

Design of costly products

Institution of cost cutting programs

that fail

Wrong “sell / buy” decision


What types of businesses can go for ABC?What types of businesses can go for ABC?

Absolutely ALL !!!!


Single product Industry

Process re-engineering

Customer wise profitability

Multi product Industry

Costing products

Operational improvement

Strategic decision making


Traditional product costing simplistically allocates costs. ABC traces costs based on cause and effect

Traditional product costing simplistically allocates costs. ABC traces costs based on cause and effect

Activity-Based Costing

ProductsProducts

Consumed ByConsumed By

ActivitiesActivities


CostsCosts

Traditional Product Costing

CostsCosts


ProductsProducts


Variations in the per unit indirect

cost from model to model

Customer costs are not shown

customer wise

Pricing based on traditional costing may not be accurate


Accurate product and customer costs. Includes non-manufacturing and manufacturing costs

Reveals profit sources

Information about what matters to the customer, when you want it

Is Customer focused

Why ABC worksCriteria of world-class cost information

Activity Based Costing (ABC)


Cost and nonfinancial information about activities, helps direct and reinforce improvement efforts

Identifies opportunities

Does not require necessary measurements. Can be as simple or as complex as necessary

Economical




Direct measures of activity performance. Activity drivers help identify improvement opportunities. The problem of excess capacity is confronted.

Encourages improvement





Identify activities

Allocate resources to activities

Calculate product costs based on activities performed

Features

Not a peanut butter approach

Closer to real cost

Effective MIS

• Helps pricing decisions

• Identifies high cost activities


What is ABC?

Method of measuring the cost and performance of activities / products /customer

Based on resources spent for various activities

Costs to products by the actual activities and resources consumed in

Producing Marketing Delivering Servicing

More closer to real costs


Pareto’s rule

20% of products account for 80% of revenues

Accurate product cost essential for identifying the 20% of the products


Cost Accounting View

Cost SheetParticulars Rupees

Chemicals consumed @ Rs. 50 1250

Power consumed 1500

Wages 500

Overheads 750

Total 4000Plating cost pre part Rs.

4.00


Cost Management View

Activities VA NVA

Amount

Plating time 2250 2250

Plating over run 500 500

Ampere variation 500 500

Rework due to peel off

250 250

Bath temperature 500 500

Total 4000VA – Value Adding NVA – Non-value adding


Facility

Customer

Technology

Product

Batch

Unit

A B C

Variable

Fixed

Traditional

Traditional cost introduces distortions into product costing by wrong allocation.

Conversely, ABC turns indirect costs to direct by tracking the drivers


ProductionVolume

High

Low

Overcosted

Undercosted?

?

AccurateCosts

Product complexity

Low High

Traditional Systems Distort Product & Customer Costs


0

50

100

150

200

250

0 1 5 10 15 20 30 40 50 60 70 80 90 95 99 100

Percentage of Total Products

Per

cent

age

of T

otal

Pro

fits

Typical product profitability profile

Do you have information to draw this curve?


Re-price products

How do you modify this curve?

Substitute products

Redesign products

Improve production processes

Change operating policies and strategy

Invest in flexible technology

Eliminate products


Accurate costing system!!!


I – Generation ABC

Developed for arriving at product cost

Used only as a strategic tool

II – Generation ABC

Arriving at product cost strategic tool

Activity analysis – operational improvements


ABC Model

Cost objects

Activities

Resources

Cost drivers

Performance measures

Cost Assignment view

Process view


ABC Model (cont’d)

Cost assignment views

Assign costs to activities and cost objects

Process view

Interpret and improve activity

How well the activity is performed?


Steps involved in developing the model

Understand and define the cost object

Formation of an ABC team

Carrying out interviews• List out activities & sub activities• List out resources• Identify resource drivers


Steps involved in developing the model (cont’d)

Carrying out interviews

Compute activity cost

Identify / list out activity cost drivers

Arrive at product


Method of measuring cost of the

product based on the activities

performed to produce these

products

Activity Based Costing


Activities Resource Cost objectsResource

DriversActivity

cost driverActivities Resource Cost objects

Resource Drivers

Activity cost driver

ABC Important Terminologies


1.It is a unit of work performed in an organisation

Let us see what a resource means…

Activity

2.It costs money (consumes “resources”)

3.It need not necessarily add value


An example

1.Buy raw materials

2.Process rubber

3.Carry out moulding

4.Carry out post moulding

5.Pack and transport them

To produce and sell an oil seal, what does XYZ do?


Elements used in the performance of activities

E.g. Manpower, machine, compressed air, power etc

Resources


Link between resource and

activities

Resource Drivers

Estimate of efforts

• % of manpower utilised

• % of machine time used

Actual measurements

• Power consumption

• Consumables


Reason why an activity is performed

Cost Object

Product, service, customer etc


Activity Cost Driver

Factor used to assign the cost

of activity to cost object


A simple example

Chennai to Coimbatore

“A” transports apples (1000) & oranges (2000)

Cost of activity of transporting is Rs 3000/- (diesel + wages + maint etc)

Activity

Resource

Resource Driver

Cost Object


How do you relate this activity cost to the cost object (apples &

oranges)?

Apples occupy half the space & oranges the other half

Chennai to Coimbatore

“A” transports apples (1000) & oranges (2000)

Cost of activity of transporting is Rs 2975/- (diesel + wages + maint etc)


Fruit TraderFruit Trader

• Chennai to CoimbatoreChennai to Coimbatore

• Apples and OrangesApples and Oranges

• By Truck By Truck

• Distributes with an AgentDistributes with an Agent


ResourcesResources

• ManpowerManpower

– ( Agent, Driver & Packing Labour)( Agent, Driver & Packing Labour)

• TruckTruck

• DieselDiesel

• Packing MaterialPacking Material


ActivityActivity

• PackingPacking

• TransportationTransportation

• DistributionDistribution


Resource MappingResource Mapping

Resources Activities Packing Transport DistributeManpower

Agent Driver

Pack ing labour Machine

Truck Material

Diesel


Resource DriverResource Driver

Resources Activities Packing Transport Distribute Cost outlay

Agent 100% 1000

Driver 95% 5% 500

Packing labour 100% 100

Machine

Truck 100% 500

Material

Diesel 100% 2000


Activity CostActivity Cost

Resources Activities Packing Transport DistributeAgent - - 1,000

Driver - 475 25 Packing labour 100

Machine

Truck - 500 - Material

Diesel 2,000

Activity Cost 100 2,975 1,025


Cost DriverCost Driver

Quantity 2000 2000

Cost Driver Oranges Apples

Packing 100 Time to Pack(Mnts.) 1 3

Transporting 2,975 Boxes( Nos.) 15 25

Distribute 1,025 Purchase Orders( Nos.) 5 20


Activity-based costingActivity-based costingQuantity 2000 2000Costing Oranges Apples

Packing cost 25.00 75.00 Transporting Cost 1,115.63 1,859.38 Distributing Cost 205.00 820.00

Total cost (without Direct Material) 1,345.63 2,754.38

Material costs( Includes Packing Material) 2,250.00 8,250.00 Total including Material Costs 3,595.63 11,004.38

Product Cost per unit 1.80 5.50

Selling Price 2.00 6.00 Profit 0.20 0.50


Standard CostingStandard Costing

Quantity 2000 2000Standard Costing Oranges ApplesOranges and Apples 2250 8250Packing and Transportation 1550 1550Distribution 500 500Total 4300 10300Cost per unit 2.15 5.15Selling Price 2.00 6.00 Profit (0.15) 0.85 Profit -8% 14%


Activity Activity Cost Driver

Assembling Cycle time

Setup Machines No. of Setups or Setup

Hours

Schedule Production

Jobs

No. of Production Runs

Receiving Materials No. of Material Receipts

Introduce New

Products

No. of New Products

Introduced

Maintaining Machines Maintenance Hours

Some Activity Cost Driver


Activity Activity cost driverProvide ATM service No. ATM transactions

Handle customer enquiries Duration of telephone calls

Process visa transactions No. Visa transactions

Open/close accounts Accounts opened/ closed

Issue visa statements Visa statements issued

Issue personal cheque books

No. of cheque books issued

Prepare statements & mail Statements issued

Activity & Activity Cost Driver


Shifting Costs to Activities

Salaries and

Wages16100000

Rent2920000

Machinery &

Equipment8660000

Consumabl.720000

ABC

ActivitySalaries and

WagesRent

Machinery and Equip

Consumables Total

Process Customer Orders

3100000 530000 1260000 80000 4970000

Purchase materials 3400000 690000 880000 150000 5120000

Schedule Production Orders

2200000 120000 1840000 30000 4190000

Move Materials 1300000 210000 2230000 360000 4100000

Set up Machines 4200000 70000 480000 20000 4770000

Inspect Items 1900000 1300000 1970000 80000 5250000

Total 16100000 2920000 8660000 720000 28400000


ActivityResources

Organising materials

Making impellers

Assembling MIS

Manpower – Manager

Manpower – Wkr

Machinery –imp

Machinery –assy

Power

Pump making department


ActivityResources


Making impellers

Assembling MIS


10% 20% 20% 50%

Manpower – Wkr

5% 45% 50%

Machinery –imp

100%

Machinery –assy

100%

Power 65% 35%



ActivityResources


Making impellers

Assembling MIS Total(Rs)


10000

Manpower – Wkr

40000

Machinery –imp

2500

Machinery –assy

3500

Power 5000

Total 61000



ActivityResources


Making impellers



1000 2000 2000 5000 10000

Manpower – Wkr

2000 18000 20000 40000

Machinery –imp

2500 2500

Machinery –assy

3500 3500

Power 3250 1750 5000

Total 3000 25750 27250 5000 61000



ActivityResources


Making impellers



1000 2000 2000 5000 10000

Manpower – Wkr 2000 18000 20000 40000

Machinery –imp 2500 2500

Machinery –assy 3500 3500

Power 3250 1750 5000

Total 3000 25750 27250 5000 61000


No. of purchases

Cycle time

No. of products

assembled

Deduct from dept cost



Deduct from dept cost

No. of products assembled

Cycle timeNo. of purchases pdt wise


61000500027250257503000Total

MISAssembling Total(Rs)

Making impellers


ActivityResources

181679083

1471511035

10002000

Total pdt costAB

2010

4030

1020

Product A (20 nos.)B (10 nos.)

16942212

908908

7361104

50200

Per pdt costAB



Secondary ResourcesSecondary Resources

• Human Resource DepartmentHuman Resource Department

• Maintenance DepartmentMaintenance Department


Treatment in ABCTreatment in ABC

• ActivityActivity

– Maintain other Maintain other

department resources department resources

(Manpower, Machinery)(Manpower, Machinery)

• ResourcesResources

– HRD – ManpowerHRD – Manpower

– Utilities – MachineryUtilities – Machinery

(Compressor, (Compressor,

Generator)Generator)

Maintenance PM BM TOTALAssembly 1500Forklift 250 250 500Crane 250 750 1000Impeller 1500Air compressors 500 500Surface Grinders 200 800 1000

TOTAL 13793 6492 20285

Maintenance PM BM TOTALAssembly 1500Forklift 250 250 500Crane 250 750 1000Impeller 1500Air compressors 500 500Surface Grinders 200 800 1000

TOTAL 13793 6492 20285

Human ResourceWorkers Managers

Staff Related 6400 600Canteen Expenses 3600 400

10000 1000

Pump DeptHuman ResourceWorkers Managers

Staff Related 6400 600Canteen Expenses 3600 400

10000 1000

Pump Dept


Treatment in ABCTreatment in ABC

• Resource MappingResource Mapping

• Costs are driven toCosts are driven to– Departments Departments

– Cost Drivers Cost Drivers • For HR it is No. of For HR it is No. of

EmployeesEmployees

• For Utilities it is No of For Utilities it is No of

machinesmachines

• Part of other department Part of other department

resourcesresources

(Secondary Resources)(Secondary Resources)

Manpower Salary HR Cost Total

Manager 9000.00 1000.00 10000.00

Workers 30000.00 10000.00 40000.00

Machinery Depreciation& Insurance

Maintenance Total

Impeller 1000.00 1500.00 2500.00

Assembly 2000.00 1500.00 3500.00

Manpower Salary HR Cost Total

Manager 9000.00 1000.00 10000.00

Workers 30000.00 10000.00 40000.00

Machinery Depreciation& Insurance

Maintenance Total

Impeller 1000.00 1500.00 2500.00

Assembly 2000.00 1500.00 3500.00


Precautions during Listing of Activities

Extremely important step in ABC model building

Sufficient care should be taken while listing

Activities common for all models need not be listed separately

Activities unique for models to be listed separately

Facilitate the cost of those activities for specific models


Precautions during Listing of Activities

Activities consuming huge resources to be listed separately

Listing of sub activities under main activity facilitates improvements

A Dictionary for activities including sub- activities should be a “Bible” for operating team


The top management commitment and

drive for ABC is a necessity.

Prime requirements of A B C…

A Strategy has to be evolved to take full

advantage of ABC’s potential – “both

operational and strategic”

Generate interest and create awareness

through display of posters, circulation of

newsletters and meetings to remove

barriers to acceptance


The model must be carefully designed to

suit the organization and cater to the

needs.

Prime requirements of A B C…

Complete co operation and a high interest

level from the operational level is a prime

requisite. ABC is not an accountants purview. It is

much more than the normal accounting

job and a management tool which gives

enormous information.


Low Optimal Cost System High

Low

Cost of MeasurementCost of

Errors

Cost

High

Total Cost of developing ABC system

Accuracy

Designing the Optimal ABC system


Activity-Based Cost Management: Strategic Decisions and Operational Improvements

StrategicView

Product design Product-line and customer mix Supplier relationships Customer relationships

- Pricing- Order size- Delivery- Packaging

Market segmentation Distribution channel

OperationalView

Activity-BasedCosting

Resources Activities Business processes Cost drivers Product costs Customer costs

What activities should we perform?

Activity management Business process reengineering Total quality Performance measurement

What drives activity cost?

©1996 Robert S. Kaplan


Level Objectives Illustration

Top Management Strategic Decision Making

Tactical AnalysisMiddle Management

Operational Management

Cost Accounting

Make Vs Buy

Product / Customer rationalisation

Cost reduction

No-Value-Add Activity reduction

Product costing

Process costing

ABC - AN ORGANISATION WIDE PERSPECTIVE


Strategic and Operational Objectives :Strategic and Operational Objectives :

Objectives

Product Profitability with a built in focus of Model Variations

Customer Profitability with a built in focus of the product wise performance

Corporate Profitability in terms of the market & product segment

Implementation of Shop Floor Improvement projects with cost as the focus


Myths on ABC

1. ABC is too difficult to implement Depends on the understanding by the

implementation team

IT support – makes it easier to sustain

2. Improving existing systems will do the job Product diversity could be addressed

through ABC

High over head cost – conventional system can not address the improvements


Myths on ABC (cont’d)

3. We do not need more accurate product costs Accurate products set the Business Focus ABC helps in costing the activity Facilitate analyzing the activities for

improvements

4. Cost systems play a limited role in process improvement Basis or information for ABM is from ABC Stimulates cost reduction Provides non-financial information


Myths about ABC

Myth : ABC focusses on Cost Cutting ?

Reality : Activity Based Cost and Management rationalises costs and optimises resources for better efficiency and profitability.


Myths about ABC

Myth : ABC is a an Accountant’s Job ?

Reality : ABC as a system pervades throughout the organisation and it requires cross functional effort and responsibility


Myths about ABC

Myth : Either TPM/TQM or TCM only can be implemented ?

Reality: TPM, TQM & TCM One complements the other


Further reading….• Kaplan, R.S. and Cooper, R., “Make Cost Right:

Make the Right Decisions”, Harvard Business Review, September–October 1988

• Kaplan, R.S. and Cooper, R., “Cost and Effect: Using Integrated Cost Systems to Drive Profitability and Performance”, Harvard Business School Press, 1997

• Kaplan, R.S. and Anderson, S., “Time-Driven Activity Based Costing”, Harvard Business School Press, 2007

• Ness, J.A. and Cucuzza, T.G., “Tapping the Full Potential of ABC”, Harvard Business Review, July–August 1995

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