MANAGING COSTS STRATEGICALLY THROUGH ACTIVIW BASED COSTING

Prot. Priyanka ozaLecturer at Atharva lnstitute of Management Studies,

Mumbai

Prof, Jigar PatelAssistant Professor at PTVA'S lnstitute of ManaBement,Mumbai

lntroduction

ln the present scenario of fierce competition, galloping quality standards and price wars for customer attraction, the

costing of products or services has become an important success issue in today's business world. Companies are

zealous to make their product more competitive and affordable. Cost leadership is an effective strategy to maintain

competitive advantage, as suggested by Porter, and can even decide the corporate success gr failure

The conventional costing systems allocate fixed cost differently. lt has been empirically argued by most of the

researchers that ABC is more suitable for medium to long-range planning and flexible margin costing is more suitable

for short to medium range planning. ln traditional cost accounting systems, direct materials and labour are the only

costs that can be traced directly to the product. By using the ABC system, activities can be classified as value-added and

non-value-added activities. ln order to improve performance of the system, non value- added,can be eliminated

Therefore, cost accounting systems have greater flexibility in allocating and dealing with both variable and fixed costs

Activity-based costing (ABC) is a method for improving the accuracy of cost determination. While ABC is a relatively

recent innovation in cost accounting, it has been adopteal by companies in varying industries and within government

and not-for-profit organizations.

Stateihent ol Problem

Activjty Based Costing wjll help the organizations in managing costs in a strategic manner.

lmplementing Activity Based Costing helps in tracing and allocating costs in an effective manner as compared totraditional Volume based costing

Literature Review

From 1970s Activity Based Costing (ABC) was mainly developed to serve industrial companies, but from the early years

of its deveiopment, researchers have investigated the possibility of using it in the service sectoras well- Kaplan (1994)

reports that in the early 1980 ABC was already used in the service sectpr by logistics companies, by banks and hospitals

and had alreadV developed costing models similar to the ABC. "

Moreover, Brimson and Antos (1994) mention examples of American Public Sectors where Activity- Based Costing

succeeded when used. The writers quote that Activity-Based Costing has been implemented in telecommunication

companies, parcel post companies, hospitals, electricity and gas companies, helping them control their cost and letting

management concentrate on their customers.

Athanasios Vazakidis, loannis Karagiannis and Anthi Tsialta in their paper titled "Activity-Based Costing in the Public

Sector" (2010) mentioned the examples of Public Sectbr units of Greece where Activity Based Costing succeeded when

used. They helped the companies control their cost and found that Activity-Based costing works complementaryproviding detailed cost information for further analysis and propei decision making' i]

'

Sarbapriya Ray in her research "Relevance and Applicability of Activity Based costing: An Appraisal" evaluated the

relevance and potential applicability of Activity Based Costing. Through the analysis she studied that ABC

implementation leads to better understanding of the cost drivers that generate these costs, thereby focusing

management attention on the way resources are consumed by activities and supporting effective management of

these activities. The article also concluded that ABC is most suitable for service organizations, while traditional costing

is irrelevant for them.

ABC Framework

Activity Based Costing is an accounting system that assigns costs to products based on the resources they consume.

The costs of all activities are traced to the product for which these were incurred, e.9., material handiing, material

management, customer support service, etc. ABC is an economic modelthat identifies the cost pools or activity centers

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in an organization and assigns costs to cost drivers based on the number of each activity used. ln theory, Cooper

rlOSfribgs, tro stages in the ABC model. ln the first stage, costs are assigned to cost pools within an activity center,

bAscll 04qcost driver. There is no equivatent step in a traditional costing approach. ln the second stage, costs are

dllooqtd irom the cost pools to a product based on the product's consumption of the activities. Since the cost drivers

are related to the activities, they occur on several levels:

. tltlt level drivers, comprise increase in inputs for every unit that, is being produced.

. Bltti level drivers, comprise variatlon of inputs for every batch that is being produced.

u Product level drivers, comprise necessity of inputs to support the production of each of different types ofproducts.

r Facility level drivers are the drivers, related to the facility's manufacturin8 process.

Figure 2: The Volume-Based two stage procedure

A bj e ctive s q nd M ethod ology

The objectives ofthis study are as follows:

. To analyse the scope of activity based costing

i T! compare ABC with traditional volume based costing | . ,. To analyse the applicability of ABc technique in organizations

ThiC paper relies on the literature review of past and current relevant articles focusing on activity-based costing (ABC).

Except where a source was needed specifically for its perspective on broad issues relating to firms' overall business

eodrDnment, the papers were screened by "activity-based costing" and by numerous variants of keywords, focusing

specifically on activity-based costing in the service sector. Source papers included refereed research studies, empirical

tlgorb, and articles from professional jou rnals.

My;s ,lAtsCdilfers from traditional cost accounting in three ways. The first is that nonmanufacturing as Well as manufacturing

costs may be assigned to products, but only on a cause-and-effect basis.

The second major difference between ABC and traditional cost accounting is that some manufacturing costs may be

exdlrded from product costs.

The third major difference between ABC and traditional cost accounting is that numerous overhead cost pools are

used, each of which is allocated to products and other cost objects using its own unique measure of activity.

pZ Ud - an example

XYZ Ltd Company produces two automobile battery lines - a standard battery called the Secure and a deluxe, higher

qualiti battery called the Longer Life. Both batteries are sold through automobile parts retail stores. No design options

are available for the Secure, but XYZ produces the Longer Life with different battery casinB designs and battery handle

locations to customize the appearance for the auto parts stores. For example, the battery casing can be produced in

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2,OOO,o0o as shown on the income statement.

Table 1: lncome Statement of XYZ Ltd

different colors with different brand names to suit the customers' The company has reported its first loss ever of Rs.

ThefirststepinimplementingABcistodefineactivities,activitycostpools,andactivitymeasures.XYzselectedthefollowing five activity cost pools and corresponding activity measures:

Activity Cost Pool

Customer ordersDesign changes

Order size

Customer relationsOther

Activity MeasureNumber of customer ordersNumber of design changes

Machine-hoursNumber of active customers'Not applicable

ThesecondstepinimplementingABcistoassignoverheadcoststoactivitycostpools'Thisisalsocalledfirst.stageallocation.

Table 2: overhead Costs at XYz Ltd {Manufacturing and Non-manufacturing)

Production DePartment

lndirect Factory Wages 6,000,000

Factorv eqiupment dePreciation 3,500,000

Factory utilities 2,500,000

Factory building lease 2,000,000 14,000,000

ceneral Admin DePartment

Admin Salaries 4,000,000

Office Equipment DePreciation i 900,000

Admin Building lease 1,100,000 6,000,000

Marketing DepartmentMarketing Salaries 1,500,000

Selling Expense 500,000 2,000,000

Total Overhead Cost 22,000.000

Three costs included in xYz Ltd's income statement-direct materials, direct labor, and shipping-are excluded from

this slide because the company's existing cost system can directly trace these costs to products or customer orders'

XYZ Ltd's cross-functional interviews resulted in resource allocations as shown' 'l

Table 3: Percentage allocation of activities to cost drivers

lndirect FactorY Wages

Factory eqiupment dePreciation

Fa€tory building lease

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General Admin Department

Admin Salaries 30% 10% 70% 30% 20% 700%Office Equipment Depreciation 30% 70% o% 20% 40% 700%

Admin Building lease o% oo/" o% o% 700% \oo%Marketing Department

Itlarketing Salaries 30% 70% o% 500/" 70% 100%

Selling Expense 200/" o% o% 700/" 70% 700%

Total Overhead Cost

Once the percentage allocations have been determined, it is a simple matter to assign €osts to activity cost pools

Table 4: Amount allocation of activities to cost drivers

A€tivity Cost Pools

CustomerOrders

Design

Changes Order Size

CustomerRelations Other Total

Production Department

lndirect Factory Wages 1,800,000 1,800,000 1,200,000 600,000 600,000 6,000,000Factory eqiupment depreciation 700,000 350,000 2,100,000 350,000.. 3,500,000Factory utilities 250,000 1.500,000, 7s0,000 2,500,000

Factory building lease 2,000,000 2,000,000

General Admin Department

Admin Salaries 1,200,000 400,000 400,000 1,200,000 800,000 4,000,000

Office Equipment Depreciation 270,000 90,000 180,000 360,000 900,000Admin Building lease 1,100,000 1,100,000

Marketing Department

Marketing Salaries 450,000 150,000 750,000 150,000 1,500,000

Selling Expense 100,000 350,000 50,000 500,000Total Overhead Cost 4,520,000 3,040,000 5,200,000 3,080,000 6,160,000 22,000,000

The XYZ Ltd Pro team determined that the company has the following activity for the four cost pools,

. 10,000 customer orders,

. 4,000 designs changes,

. 800,000machine-hours,

. 2,000 customers served.

lhis information enabled the team to compute ABC rates for each activity by dividing the total cost in each activity costpool by the respective quantity of the activity measure.

Notice, the "other" cost pool does not have an activity rate. This is because these organization-sustaining costs will notbe assigned to products or customers.

Obe 5: Computation of Activitv Rates

Computation of Activity Rates

Activity Cost Pools Tota I Cost TotalActivity Activity Rate

Customer Order 4,520,O0O 10000 orders 452.O

Design changes 3,040,000 4000 changes 760.0

Order Size 5,200,000 800000 MHs 6.5

Customer Relations 3,080,000 2000 customers 1540.O

Other 6,160,000 NA NA

Total 22,000,000

As we can see above, the direct materials, direct labor and shipping costs are directly traceable to products orcustomer orders-

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Figure 4: Stage-Wise Allocation

The first-stage allocation process assigned the remaining overhead costs to the five activity cost pools. Then, actjvity

measures were identified, activity levels were determined, and activity rates were computed for each activity as shown

earlier

Assigning overheads to products

The data needed to assign overhead costs to XYZ Ltd's two products-Secure and Longer Life-are as shown. There

were 4,000 separate customer orders placed for 800,000 Secures and 6,000 customer orde.rs were placed for 400,000

Longer Lifes. All 4,OOO design changes related to the Longer Life batteries. The Secure battery consumed 480,000

machine hours, and the Longer Life consumed 320,000 machine-fiours.

Table 6: Overhead Cost for Secure

Activity Cost Pools Activity Rate

customer Orders 4s2.O

Design Changes 760.0

order Size 6.5

Total

Table 7: overhead Cost for Longer Life

Activity4,000

480,000

AgC Cost

1,808,000

3,120,000

4,928,000

Activity Cost Pools Activity Rate Activity ABC Cost

Customer Orders

Design Changes

Order Size

Total

452.O

760.0

6.5

6,000

4,000

32droo

. 2,772,OOO

3,040,000

2,080,000

7,a32,OO0

Assigning Overhedds to customers

Let's take a look at how XYZ'S system works for just one of the 2,000 customers - Makers Company who placed a total

oftwelve orders. Note that the four orders for Longer Lifes required a design change.

Orders

1, Eight orders for 60 Secures per order.

2. Four orders for 50 Longer Lifes per order.

Machine Hours

1. The 480 secures required 288 machine-hours

2. The 200 Longer Lifes required 160 machine hours.

Table 8: Overhead calculation for Makers Company

1.

Cost Pools Rate

452.0760.0

6.5.1,540.0

ABC Cost

Customer OrdersDesign ChangesOrder Size

Customer RelationsTota I

5,4243,0402,972

-!Js_Ao ,!2,9L6

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Secure Longer tifeProduct Margins - Tradional 6,900,000 2,100,000Product Margins - ABC a,372,OOO L,L32,OOOChange in reported margins t,472,OOO (3,232,0001

The total overhead cost of Rs. 12,916 assigned to Makers Company is calculated as shown.

Aft.er.this step, manage ment. reports are prepared. one of the most common management reports prepared with ABcQ'^ is -tduct profitability (product margin) reports. The first step in computing product margins is to gather eachpfoduct s sales and direct cost data which are assumed to be as shown. The second step L to incoiporate thepreviously computed activity-based cost assignments pertaining to each product. The third step is to compute productfor$rs bv deductin8 each product's direct and indirect costslrom its sales. The product margins can be reconciledrallth-tlt-co:npany's net operating loss. After this procedure, it will be noted that the traditional cost system overcoststlp Serorcs, and consequently, reports an artificially low product margin for this product- conversely, the traditionalcost system undercosts the Longer Lifes, and consequently, reports an artificially high product margin for this product.Table 9: Difference between ABC and Traditional Costing

There are three reasons why the reported product margins for the two costing systems differ from one another.

' The first reason is that the traditional cost system allocates all manufacturing overhead to products. The ABcsystem only assigns manufacturing overhead costs consumed by products to those products,

' The second reason why the reported product margins for the two costing systems differ from one another isthat the traditional cost system allocates all manufacturing overhead costs using a volume-related allocationbase (machine-hours) The ABc system uses volume-related and non.volume relted allocation bases to assignmanufacturing overhead to products.

' The third reason is that the traditional cost system disregards selltng and administrative expenses becausethey are assumed to be period expenses. The ABC system directly traces shipping costs to products andincludes nonmanufacturing overhead costs caused by products in the activity cost pools that are assigned toproducts.

Conclusion

' Effective implementation of ABc requires a lot of training and understanding of the technique. But if it islmplemented in a proper manner, it can help companies answering the market needs of better qualityproducts at competitive prices.

! This method can contribute in top management decision making procass because it hetps in ascertainingproduct profitability and customer profitability. ln the time of change,i,ivhich is ineVitabie in a brrinurr, it ,,imperative that the management decision makers must have an accurate, relevant, flexible, andcomprehensive cost accounting system to aid them in their decision making processes.

' As important as it is, however, ABc is not a full proofsolution. As mentioned earlier, cost management shouldalways be done in the broader context of performance management that integrates time, quariiy,.-servicelevels, risk, capacity planning, and costs.

Scope lor Further Research

' A'; discussed earlier, ABc is not a concrete system. ln fact it has its own flaws. gut then, the iinplementation ofABC is not vastly accepted in lndian companies.

' ln fact, a very few lndian companies have actually implemented it, There needs to be more awareness abouthow costing svstems can also be improved, not just by merely reducing costs but actually managing costsstrategically.

o Also, further research can be conducted in terms of using Activity based costing as a performancemanagement technique and not just cost management technique. lt can be merged with other performancemanagement systems like Balance Scorecard and can bring out efficient and effective resurts.

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References

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3. cooper, R., and Kaplan, R. S., "Measure cost Right: Make the Right Decisions," Harvard Business Review,

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