SMART MANAGER

Cost management

Activity based costing

As customer value creation is the focus of cost improvement, cost
information system (CIS) forms the edifice of cost management. CIS
is not an extension of financial accounting system. To sustain the
focus of cost management, one needs a cost information system that
can articulate the financial reaction of the actions by addressing the
resource consumption. The previous articles discussed how customer
value is created at four levels - design, operations, post-sales utilisation
and buyer-supplier interface. This article focusses on activity based
costing, which is one of the methodologies of CIS.

M Hariharan and
Rema Lakshminarayanan

I
t is an unwritten analysis. However, ABC can also be used for
rule respected managing and controlling costs.
by many in the
business world Limitations of traditional costing
that one generally treats system
his best customer the best. Traditional product costing systems
The problem is, does he really were designed decades ago when most
know who his best customer companies manufactured a narrow range of
is, or he is being presumptious? products. Direct labour and materials were
Customer with the highest the dominant factory costs. Overhead costs
sales need not necessarily be were relatively small (and hence dismissed
the best customer, as he may be as ‘overheads’). Hence, the distortions arising
responsible for the biggest part of from inappropriate overhead allocations
his expenses as well. were not significant. Information processing
To understand this, one has costs were high, and it was therefore difficult
to analyse the customer account to justify more sophisticated allocation
profitability using customer based methods.
accounting (CBA). CBA is nothing Today firms produce a wide range of
but activity based costing (ABC), products; direct labour represents only a
and if correctly applied & utilised can small fraction of total costs, and overhead
help in ranking customers in terms costs are of considerable importance. The
of profitability. ABC systems can be word ‘overhead’ in today’s context is a
used for product costing and profitability misnomer. Simplistic overhead allocations

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cause costs and that products (and and set-up costs, the number of purchase
The fundamental assumption of
customers) create the demands for activities. orders for the cost of operating the purchase
Volume based costing
Costs are assigned to products based department and the number of dispatch
is
on individual products’ consumption or orders for the despatch department.
“ manufacturing organisation
demand for each activity. ABC systems For those resources that are consumed
is a place where we produce output”
simply recognise that businesses must at the unit level, ABC systems use volume-
Figure 1: Assumption of value-based costing
understand the factors that drive each related activity cost drivers such as direct
using a declining direct labour base cannot major activity, the cost of activities and how labour hours or machine hours. For example,
be justified, particularly when information activities relate to products. An outline of an power costs can be traced to products using
processing costs are no longer a barrier to ABC system is presented in Figure 2. machine hours as the activity cost driver,
introducing more sophisticated systems. The first stage is to identify the major since machine hours drive the consumption
Moreover, intensified competition has made activities in the organisation. Examples of of power. Figure 2 represents the third
decision errors due to poor cost information activities include machine-related activities stage, where a cost pool is created for each
more probable and dearer. It is ultimately a (for example, machining cost centres), activity. For example, the total cost of all
trade off between cost of error and cost of direct labour-related activities (for example, set-ups might constitute one cost pool for
measurement. Cost of error has increased assembly departments) and various support all set-up related costs. Cost pool may cut
while the cost of measurement has declined. activities such as ordering, receiving, across multiple departments. For example,
It makes more sense to strive towards a materials handling, parts administration, a set up in the shop floor may trigger a
more accurate cost measurement. It is production scheduling, packing and series of activities in stores, inspection and
against this background that ABC despatching. material handling.
has emerged. The final stage in Figure 2 is to trace the
1.
Volume is no more the single significant Identify the major activities that take place cost of the activities to products according
in the organisation
driver of resource consumption. Traditional to the product’s demand (using activity cost
systems measure accurately volume-related 2. drivers as a measure of demand) for these
Determine the cost driver for
resources that are consumed in proportion each major activity activities during the production process.
to the number of units produced of the A product’s demand for the activities is
individual products. Such resources include 3. measured by the number of transactions it
Create a cost pool for each major activity
direct labor, materials, energy and machine- generates for the activity cost driver. Assume,
related costs. However, many organisational 4. for example, that the total cost traced to
Trace the cost of activities to products
resources exist for activities that are according to a product’s demand for activities the cost pool for set-up related costs was
unrelated to physical volume. Significant Rs 1,00,000 and that there were 100 set-ups
Figure 2: Outline of an ABC system
resources are consumed by non-volume- during the period.
related activities like, logistical, balancing, The second stage is to identify the The charging out rate would be
quality and change transactions. These factors that influence the cost of a particular Rs 1,000 per set-up. To determine the set-up
consist of support activities such as material activity. The term ‘activity cost driver’ is costs for a particular product, the number
handling, material procurement, set-ups, used to describe the event or forces that of set-ups for the product would be
production scheduling, first-item inspection are the significant determinants of the cost multiplied by Rs 1,000. Thus, the cost per
activities, etc. Traditional product cost of the activities. For example, if production unit for one batch of 20 units will be
system, assumes that products consume all scheduling cost is generated by the number Rs 50 (Rs 1,000/20 units). ABC would trace
resources in proportion to their production of production runs that each product the costs of other activities to products
volumes, and thus report distorted generates then the number of set-ups using a similar approach.
product costs. would represent the activity cost driver for
production scheduling. ABC recognises that
Product costs using an activity- resource consumption is dictated by activity
Costs
based system cost drivers.
Where or
ABC emphasises the need to obtain a Hence, tracing of overhead costs for what Apportionment
the cost is base/allocation
better understanding of the behavior of to products requires that resource incurred?
Costs centres Cause/effect
or benefits
overhead costs, and thus ascertain what consumption pattern must be understood. received by the
cost centre
causes overhead costs and how they relate Therefore selection of appropriate costs
Absorption
to products. ABC recognises that in the long drivers is imperative. Examples of some of base
run most manufacturing costs are not fixed, the activity cost drivers used by ABC systems Products Major driver of
and it seeks to understand the forces that include the number of receiving orders production

cause overhead costs to change over time. for receiving department, the number of Figure 3: Methodology of traditional
costing system
ABC systems assume that activities production runs undertaken for scheduling

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costs are not only variable costs but also included in the purchase order. Other
Costs Salary Dept Chemical
fixed costs like depreciation. Resource examples of batch-driven costs include
Resources Manpower machine
Cleaning consumption is variable with the unit, but resources devoted to production scheduling,
agent
Resource Mach
the costs may be fixed. Unit-level activities first-item inception and materials
driver Man hrs hrs kg
consume resources in proportion to the movement.
Activities Setup Ch over Prodn number of units produced. For example, if a Product-sustaining activities are
Activity Ch over
cost driver No. of hrs No. of firm produces 10 per cent more units, it will performed to support different products
setups pieces
Costs object consume 10 per cent more labour hours, 10 in the product line. They are performed to
Product
per cent more machine hours and 10 per enable individual products to be produced
Figure 4: Methodology of ABC system
cent more energy costs. and sold. But the resources consumed by
Difference between activity-based Batch-related activities, such as setting these activities are independent of how
and traditional costing systems up a machine or processing a purchase many units or batches of the product
With an ABC system, one uses the order, are performed each time a batch are produced. For instance engineering
activity cost drivers to relate the activities of goods is produced. The resource resources devoted to maintaining an
(and thus assign the cost of the activities) consumption of batch-related activities accurate bill of materials and routing each
to the products. This is illustrated in varies with the number of batches made, product are examples of product-sustaining
Figure 5. In practice, the ABC system uses but is independent for all units within the activities. Other examples are the resources
many drivers as allocation bases for tracing batch. For example, set-up resources are to prepare and implement engineering
costs to the products. Traditional cost consumed when a machine is changed from change notices (ECNs), to design process
systems use historically convenient, volume one product to another. As more batches and test routines for individual products
related bases like machine hours or labour are produced, more set-up resources are and to perform product enhancements.
hours or volume. consumed. It consumes same resources The expenses of the product-sustaining
whether you set the machine for 10 or 5000 activities will tend to increase as the number
Resource consumption vs cost items. Thus the demands for the set-up of products manufactured is increased. ABC
incurrence resources are independent of the number uses product level bases such as number of
Activity based costing is an extreme of units produced after completing the active part number and number of ECNs to
form of absorption costing. It focusses set-up. Similarly, purchasing resources are assign these costs to products.
on resource consumption. When salary consumed each time a purchasing order There is yet another additional
is paid, it is paid for having a resource is processed, but the resources consumed expense category that cannot be directly
called manpower. When one pays rent, it are independent of the number of units attributed to individual products. They are
is paid for having a resource called space. Volume based costing Activity based costing
The cost is incurred irrespective of the Cost analysis
By functions By activities
usage of resources. However, the usage of
Theme of the system
resources varies with activity cost drivers. Resource consumtion (Why the cost is incurred and
Cost incurrence (where the cost is incurred)
ABC assigns the costs based on the resource how the resource is consumed)
consumption. Hence, it does not differentiate Cost behaviour
costs as variable or fixed. System can be Short term: Variable, fixed or semi-fixed Long term nature of activity and related drivers
configured to take care of this as well.
Cost collection

Cost-centre wise (Heterogenous) Activity wise (Homogenous)

Four different categories of
activities Overhead tracing to cost object
Three major categories of activities Absorption - single volume related bases like output, Multiple rates to suit unit, batch, product sustaining and
DL Hrs, MHrs facility sustaining acitivities
consume resources at the product level.
Cost control
They are unit-level activities, batch-related
Triggered by the effect Triggered by the cause
activities and product-sustaining activities.
Unit-level activities are performed each Planning
time a unit of the product is produced. Natural account head driven Activity driven and need based
They are consumed in direct proportion to Decision making
the number of units produced. Expenses in Abberation due to cross subsidisation of cost under Refined due to homogenous activity cost pools and
this category include direct labour, direct heterogenous cost centres hence cross subsidisation is minimised
materials, energy costs and expenses that Pricing
are consumed in proportion to machine Undifferentiated Differentiated
processing times (such as machine
Figure 5: Comparison between VBC and ABC
depreciation and maintenance). Unit level

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M Hariharan is the director Rema Lakshminarayanan heads

classified as facility-sustaining activities, of Savoir Faire Management the cost information system
which are performed to sustain a facility’s Services, Mumbai. He has been initiatives at Savoir Faire. She is a
general manufacturing process. Examples helping firms across sectors in Chartered Accountant
of these activities include administration, identifying their core problem, and an MBA in marketing.
plant management, accounting services, aligning their processes She has implemented CIS
and lighting and heating of the factory. according to customer needs in several companies
These activities are necessary to sustain and enable sustenance of the efforts. He preaches across industries and has hands
the manufacturing process, and are what he practices and has successfully trained on experience on ABC. She also
more than 5,000 executives on these aspects. conducts training programmes
common and joint to all products
Email: [email protected] on costing.
manufactured in the plant. Therefore
these costs are not assigned to products.
Instead, they are regarded as common
costs to all products made in the plant
and deducted in a lumpsum from the
total of the activity operating margins
from all product lines.

Where is ABC appropriate?

ABC is closer to the reality of shop floor
and processes. It is superior to volume based
costing (Figure 5). ABC is applicable where:
z There are multiple products or
customers
z Who consume common resources
differently
z The drivers of the resource consumption
vary significantly
It is generally felt that ABC is too
complicated. The problem lies in
configuration of the costing system. We
need to remember whether the detailing is
worth it. We have observed in many cases
that due to the sheer weight of the design,
the systems have collapsed. As designer
we have to remember that it is ultimately a
trade off between cost of measurement and
cost of error. Remember ABC is not a snake
oil to cure all your ailments. It is an improved
method of articulating the resource
consumption with a long-term perspective.

Conclusion
ABC attempts to approximate
the cost of resources consumed in
the production of a given product. It
presents attention-directing information
and is not a decision-making tool.
ABC systems are designed to identify
priorities for managerial attention
and not to provide decision-relevant
costs. The tool is as good as the user.
Interpreting ABC numbers and using
them for activity based management is
the road ahead. MPP

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