Activity based costing is a method of cost attribution to cost units on the basis of benefits received from indirect activities. Their performance of particular activities and demands made by these activities on the quantity of resources of organisation are linked together so that the cost of product is arrived at as per the quantum of actual activities performed to produce a product or service.
Thus activities based costing is a method that measures the cost and performance of process related activities and cost objects that assigns cost activities based on their use of resources and assigns cost to cost objects, such as products, or customers based on their use of activities.
Contents
- Introduction to Activity Based Costing
- Meaning of Activity Based Costing
- Definitions of Activity Based Costing
- Basics of Activity Based Costing
- Features of Activity Based Costing
- Characteristics of Activity Based Costing
- Requirements of Activity Based Costing
- Factors Leading to the Development of ABC
- Terms Of Activity Based Costing
- Steps Involved in Activity Based Costing
- Cost Drivers
- Benefits of ABC
- Advantages of Benefits of Activity Based Costing
- Disadvantages and Limitations of of Activity Based Costing
Activity Based Costing: Meaning, Definitions, Basics, Features, Requirements, Factors, Terms, Steps, Advantages, Disadvantages, Uses and Examples…
Activity Based Costing – Introduction
These days, a new term ‘activity based costing’ is growingly used. It is necessary to view this term in the context of job costing and process costing. Job costing and process costing are two basic methods of cost accounting.
Activity based costing is not a distinct method of costing like job costing and process costing. It is only a new practice or intermediate change in the process of attribution of costs to jobs or processes.
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Earlier costs were first collected for production departments and service departments and finally the costs of production departments were absorbed by jobs or processes.
Now in the context of activity based costing, the costs are collected according to activities such as material ordering, material handling, quality testing, machine set-ups, customer support service etc. and jobs and processes for which cost collection is being attempted are loaded with costs of these activities rationally.
Activity Based Costing – Meaning
ABC is a new term used for finding out cost. It focuses on activities as the fundamental cost objects.
It uses activities as the basis to calculate the costs of goods and service. ABC is an effective method of exercising cost control and can be used in designing either job costing system or process costing system. ABC approach is used to refine a costing system to get better results.
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ABC system is to identify the activities for which costs are to be collected and controlled. Its objective is rectifying the inaccurate cost information. This system recognises individual activity as the lowest unit for indirect cost allocation. Cost allocated to each activity represents the resources consumed by it.
In traditional methods, many costs are treated as common costs and are arbitrarily absorbed by using a basis such as direct labour hours, machine hours, etc. But traditional methods suffer from certain drawbacks.
This technique has been of recent origin and is primarily concerned with absorption of overheads (indirect costs) in an organisation having products that differ in volume and complexity of production. The crux of activity based costing is in accurately assigning the overhead cost to the end product.
The traditional costing system does not serve effective purposes of product costing and pricing decisions. Charging overhead to the products on the basis of labour hour rate or machine hour rate may provide faulty data as to costs which should be properly attributed to a product.
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If the direct labour cost is taken as the base for charging overhead cost, high volume products may tend to get a greater share of overhead cost than the low volume products. Every overhead cost does not directly vary with the volume of production. The improper cost attribution would give a distorted picture of the cost information, the result of which shall be arriving at a wrong decision.
Activity based costing is a method of cost attribution to cost units on the basis of benefits received from indirect activities. Their performance of particular activities and demands made by these activities on the quantity of resources of organisation are linked together so that the cost of product is arrived at as per the quantum of actual activities performed to produce a product or service.
The reason for such a basis is that products themselves do not consume resources directly rather several activities are required to be performed for them, and these activities consume the resources of organisation as driven by cost drivers, (activities generating cost). Cost centres pay for these resources, depending upon the number of activities required for a product.
Thus, the overhead costs of organisation are identified with each activity which is acting as a cost driver i.e., the cost for incurrence of the overhead cost. The number of these activities in an organisation depends upon the complexity of operations. The more complex an organisation’s operations are, the more cost driven activities it is likely to have.
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After identifying the overhead cost with each cost centre, the cost per unit of cost driver can be ascertained and cost assigned to jobs (cost objects) on the basis of number of activities required for their accomplishment. Thus, ABC serves as a basis for product costing besides aiming for managing overhead cost.
Activity based costing may be defined as a technique which involves identification of costs with each cost driving activity and making it as the basis for absorption of costs over different products or jobs.
Activity Based Costing – Definitions
CAM – I organisation of Arlington taxes defined ABC as, ‘the collection of financial and operational performance information tracing the significant activities of the firm to product costs.’
The CIMA official terminology defines ABC as, “Cost attribution to cost units on the basis of benefit received from indirect activities e.g. ordering, setting up, assuring quality.”
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The Chartered Institute of Management Accountants (CIMA), London, defines it as “a technique of cost attribution to cost units on the basis of benefits received from indirect activities, e.g., ordering, setting up, assuring quality.”
According to Horngren, “ABC is a system that focuses on activities as fundamental cost objects and utilises cost of these activities as building blocks or compiling the costs of other cost objects.”
Thus activities based costing is a method that measures the cost and performance of process related activities and cost objects that assigns cost activities based on their use of resources and assigns cost to cost objects, such as products, or customers based on their use of activities.
The idea behind ABC is that costs are grouped according to what drives them or causes them to be incurred. The cost drivers are then used as on absorption base.
Basics of Activity Based Costing
The basics of activity based costing are as follows:
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1. Identify the major activities such as material handling, mechanical insertion of parts, manual insertion of parts, wave soldering, quality testing etc.
2. Determine the ‘cost drivers’ for each activity. The cost driver is the underlying factor(s) which causes the incurrence of cost relating to that activity. Examples of cost drivers are labour time, machine time, quantity handled, invoices processed, number of components/parts handled and number of setups. A company was manufacturing printed circuit boards has successfully implemented Activity Based Costing.
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Following cost drivers were identified for various activity areas:
Cost drivers link activities and resources consumption and thereby generate less arbitrary costs for decision making.
3. Create cost pools to collect activity costs having the same cost driver.
4. Attribute the cost of activities in the cost pools to products/services based on the cost drivers.
Salient Features of Activity Based Costing
The salient features of ABC are listed below:
1. The more appropriate distinction between cost behavior patterns are volume related, diversity related, events related and time related
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2. Simple traditional distinction is made. Fixed and variable cost are not enough guides to provide quality information to design a cost system.
3. Cost drivers need to be identified. In tracing overhead cost to product, a cost behavior pattern must be understood so that appropriate cost driver could be identified.
Activity Based Costing – Important Characteristics
The following are the important characteristics of ABC system:
1) A clear cut distinction is made between cost behaviour patterns like scale related, scope related, event related and period related.
2) ABC system concentrates on determination of cost drives related with various business functions i.e. activities.
3) Conventional distinction made between fixed and variable cost is not sufficient to develop a proper cost system for reporting purposes.
Conventional System:
1. Basis for distribution –
Overheads are absorbed on the basis of recovery rate calculated by following different methods.
2. Reducing setup time –
Setup time is not considered while reducing cost.
3. System –
It is an old system.
4. AC Rate –
Costs are not accurate.
Activity Based Costing – Requirements of ABC System
ABC system requires the following:
1. Setting-up of an information system which could help trace all the costs to cost objects.
2. Support from top to bottom because the system involves people at all levels.
3. Integration of system into financial system. For it, computerization may be required.
The final words of comment over the ABC system are that adoption, implementation and operation of the system is not an end in itself. The benefits can be derived by translating the system design and its operation into action-oriented managerial performance. Ultimately, it amounts to effective cost management for the success of the system.
Activity Based Costing – 9 Factors Leading to the Development of ABC
Following are the factors, which led to the development of ABC:
1. Traditional costing fails to capture cause and effect relationship.
2. Traditional costing often fails to highlight inter-relationship among activities in different departments.
3. Growing dissatisfaction among the working executives regarding traditional costing which is based on averages and estimation.
4. Traditional costing systems are driven by the need to value stocks rather than to provide meaningful product cost.
5. Direct labour has shrunk as a percentage of total cost for majority of manufacturing companies. Still it is most common basis of over-loading overheads to products.
6. Overhead costs are no longer a mere burden to be minimised. Overhead functions such as product design, quality control, customer service, production planning and sales order processing are as important to the customer as physical processes on the shop floor.
7. Complexity has increased. Product ranges are wider. Product cycles are shorter and demand for quality is higher.
8. Market place is very competitive.
9. Availability of computer has enhanced the requirement for improvement in information gathering technology for advanced decision making to gain competitive advantage.
Factors to be Considered before Installing Activity Based Costing System
Such a system is different from entity to entity. It depends upon an in-depth analysis of costs and benefits associated with designing of an appropriate costing system. ABC system is definitely more scientific because it produces more accurate product cost, but such a system should be implemented when it is more economical vis-a-vis traditional costing system.
Following factors should be taken into consideration before installing activity based costing system:
1. Extent of competition,
2. Standardisation of product and
3. Proportion of overhead cost to total cost.
To conclude, activity based costing system may be more appropriate when competition is fierce, enterprise produces varied products, without standardisation with regard to consumption of resources and when overhead cost assumes large proportion of total cost.
Activity Based Costing Terms – Activities, Cost Driver, Cost Object and Process
Following terms are commonly used in ABC:
i. Activities
An activity may include one or more than one task to achieve an objective. For instance, placing an order, providing information to the customer, taking their feedback. All these are purchase department related activities.
ii. Cost driver
It is a factor which causes a change in cost of an activity. For example, number of setup is the cost driver of machine setup related activity.
iii. Cost object
It is an item/object for which cost is ascertained. For instance any product, service, customer job etc.
iv. Process
Group of related activities is called a process.
Steps Involved in Activity Based Costing
The steps involved in activity based costing are:
Step # 1. Evaluation of Prevalent Costing System:
The already existing costing system should be able to adopt the activity based costing system so that product costs can be accurately determined and correct pricing decisions can be taken in a competitive business environment.
Step # 2. Identifying Activities:
A physical plan of the work place and listing of pay-rolls can be examined, to begin with, supplemented by holding interviews with staff. Such an activity analysis can throw light on how the work spaces have been utilised and how the staff members have spent their time.
After chalking out the different tasks in detail, the prime activity can be identified. For it, a cost-benefit analysis is required to be performed. An activity can be a very small job or a combination of several small jobs.
Step # 3. Selection of Cost Basis:
The immediate past actual cost or average cost of a specified period may be used under the system.
Step # 4. Determining Cost Pools:
Cost centres on cost pools should have a similarity under financial accounting and cost accounting systems in order to have a comparative utility.
Step # 5. Assigning Costs Pools:
Cost of resources consumed are to be associated or allocated (apportioned) to each activity, in order to find out the amount spent by the enterprise on each of its activity. Methods of direct attribution, apportionment on a reasonable basis in case of joint costs and the methods of estimation of certain costs may all be appropriately utilised for assignment of costs to activity cost centres.
Step # 6. Determining Activity Hierarchies:
Copper classified manufacturing activities as under:
A. Unit-level activities;
B. Batch-level activities;
C. Product-sustaining activities;
D. Facility-sustaining activities.
A. Unit-level activities –
These are activities which are performed each time a unit of product or service is produced. Such activities consume resources proportionate to the production or sales quantity.
B. Batch-level activities –
These are performed each time a batch operation is carried out. Such a cost varies with number of batches made but is the same for all units within the batch.
C. Product-sustaining activities –
These are performed to support diversity of products. Such costs are not in any way connected with the number of production units or batches made.
D. Facility-sustaining activities –
These are performed to support manufacturing process. Such costs are common to all the products manufactured. These are not assigned to products individually.
Step # 7. Identifying Outputs:
Outputs are required to be categorically identified because without it, the basic purpose of applying the system cannot be meaningful.
Step # 8. Selecting Suitable Cost Drivers:
Interviews should be conducted with concerned employees to determine the cost drivers for each activity. The cost drivers should be easily measurable. Past data should be made available in order to ascertain potential cost drivers. The management can finally choose a single cost driver or multiple cost drivers for the activities.
Step # 9. Computing Cost Driver Rates:
The cost driver rates are required to be calculated on a suitable basis.
Step # 10. Identifying Cost to Products:
The cost driver rates are applied to products. The aggregate cost can be computed by multiplying the rate of consumption of resources (cost driver rate) with the number of activities.
Step # 11. Test Run:
The activity cost and all the relevant data used for computation purposes should be tested to evaluate and judge the reliability of activity based costing system adopted.
Activity Based Costing – Cost Drivers (With Main Activities)
The events for activities which cause costs relating to work are called cost drivers.
A cost driver can be defined as a factor that causes activity performance to vary in a way that results in the activity’s consuming lesser or greater amounts of resources.
Cost drivers explain the events, forces or factors which determine the costs of activities. ABC system is based on the assumption that cost behaviour is influenced by cost drivers.
Therefore, in order to trace overhead costs to products or services, appropriate cost drivers should be identified. A cost driver is taken as on activity which generates cost.
Thus cost driver is any factor or force that affects or drives the cost in ABC system, which is known as refined costing system also concentrates on various cost drivers and involves the cost manager in efficiency managing the use of the cost drivers in value added activities.
Main Activities and Cost Drivers:
The main activities and their cost drivers were identified as follows:
Activity Based Costing – Benefits of ABC
The benefits of ABC are as follows:
ABC brings reliability in cost determination and focuses on cause and effect relationship during incurrence. It improves greatly the decision making of the manager as they can use more reliable product cost data.
It also enables managers to control many fixed overhead costs by exercising more control over the activities. This is possible since behavior of many fixed overhead costs in relation to activities now become more reliable.
The traditional does not pay attention to the cause and effect relationships between resources and production activities. Also, the traditional costing uses more arbitrary bases for apportionment of overheads than the ABC system. The traditional costing rolls many overhead costs into the total overhead and does not identify them directly to specific products.
On the other hand, ABC allocates directly a large amount of overhead costs to specific products. ABC helps in fixing selling prices of products as more correct data of product is readily available.
8 Main Advantages of Activity Based Costing
The main advantages of activity based costing are as follows:
1. It helps understanding the behaviour of overhead costs and their relationship to products, services, customers and market segments.
2. It helps to allocate the resources to those activities that will increase shareholders value.
3. It links profitability analysis to operational decisions.
4. It ensures that the cost of non-value added activities is visible to management.
5. It provides the right information for performance measurement because it focuses on activities rather than resources.
6. The understanding of the cost driver for each activity gives better control over the factors that cause costs.
7. It provides accurate information on profit margin and performance measurement for profit improvement.
8. It gives businesses an opportunity to improve their competitive position through better informations.
Disadvantages of Activity Based Costing
1. It is essentially not the panacea for all ills.
2. It absorbs a lot of resources.
3. Too much emphasis on customer viability can lead to problems such as cheaper products and, therefore, potentially lower sales.
4. It may lead to weaker customer segmentation.
5. It takes no account of opportunity cost.
Some other disadvantages of ABC System are as follows :
It is based on historical costs. While for planning decisions future costs are more relevant.
1. ABC system tends to be more costly than the traditional method of applying costs to products.
2. The accuracy of ABC system fully depends upon the quality of cost drivers.
3. Sometimes it is difficult to establish cause and effect relationship between cost driver and costs.
4. It is time consuming and expensive system.
5. It is suitable for small scale units.
What is Activity Based Costing: Concept, Activity Hierarchies and Two-Stage Approach
In this article we will discuss about:- 1. The Concept of Activity Based Costing 2. Activity Hierarchies 3. The Two-Stage Approach of ABC Systems 4. Activity-Based Cost Management.
The Concept of Activity Based Costing:
Weakness of the Conventional System:
Under traditional cost accounting system, accounting for overheads involves the following steps:
(1) Allocation of overheads to different cost centres including cost centres providing support services,
(2) Apportionment of common overheads to different cost centres including cost centres providing support services,
(3) Reapportionment of overheads collected under service cost centres to production cost centers, and
(4) Assignment of overheads collected under production cost centres to units produced.
Thus, overheads are aggregated at the production cost centre level and are assigned to units produced. Assignment is based on average rate(s) determined by dividing the overhead expenses by the volume of units produced or a surrogate for the same. Usually, labour hour or machine hour is used as a surrogate for the ‘volume’ of units produced.
Traditional cost accounting system assumes that ‘volume’ is the only cost driver. Use of an average rate calculated using volume as denominator, for assigning overheads to products distorts the product cost, if the firm produces variety of products.
When the Conventional System Fails?
Conventional costing system provides accurate results in the manufacturing set-up, which produces homogeneous products. The demand of these products on resources at different production cost centres are proportional to time spent on the cost centres. Therefore, use of machine-hour rate or labour-hour rate to assign overheads to different products does not distort the product cost.
It fails to provide accurate results when the manufacturing set-up produces different products, which make diverse demand on resources. In that situation, number of hours of operation in a particular cost centre is not an appropriate basis for allocation of the cost of the cost centre to different products.
Under the conventional method, support service costs are re-apportioned to production cost centres and then assigned to products on the basis of hourly rates calculated for different cost centres.
The assumption is that production cost centres create demand on support services. This assumption fails when the company produces variety of products, which are different in terms of product complexity and customer complexity. As in the case of volume, use of conventional method results in products with low complexity subsidizing products with high complexity.
Product complexity results in one or more of the following:
(a) Small batch size,
(b) Long set-up times,
(c) Unique components,
(d) Special inspection and tests,
(e) Extensive material handling, and
(f) Special vendors.
Product complexity results in one or more of the following:
(a) Customized product,
(b) Short lead times,
(c) Unpredictable orders,
(d) Extensive technical support,
(e) Extensive post-sales support, and
(f) Special tests and requirements.
ABC system is a refinement over the conventional costing system. It provides more accurate results in situations where conventional cost accounting fails.
Symptoms of Product Cost Distortions:
The following symptoms reflect distortions of product costs under traditional costing system:
(a) Products that the firm produces without much support from supporting services show small profit, whereas products that demand high level of support services show large profits.
(b) Complex products appear to be more profitable than simple products.
(c) Operating staff disagrees with cost accounting information.
The ABC Concept:
ABC system is refinement over accounting for overheads under traditional costing accounting systems. ABC system aims at reducing product cost distortions. It recognizes that volume is one of many cost drivers and uses multiple cost drivers to assign overheads to products.
The fundamental principle is that products, markets, and customers create demand on activities and activities create demand on resources. Therefore, costs should be accumulated against activities, and then they should be assigned to products, markets, and customers.
ABC system focuses on activities required to produce each product (or service) based on each product’s or service’s consumption of the activities. It focuses on support services, particularly which are influenced by the diversity and complexity of output rather than simply by the volume of output. It improves the accuracy of product cost.
ABC system can also be used to assign selling and distribution overheads to customers and market. Therefore, it is appropriate for determining customer profitability.
Activity Hierarchies:
Activities performed to produce outputs can be classified into a hierarchy similar to as follows:
1. Unit- or Output-Level Activities:
Unit- or output-level activities are performed for each unit produced. Therefore, resources used by unit-level activities are proportional to the volume of production or sales. Costs associated with unit-level activities are often termed as unit-level costs. An example of unit-level activity is machine operation or any operation in the manufacturing process, other than activities that are necessary to make the machine or process ready for operation.
Therefore, activities for setting up of machines are not unit- or output-level activities. Cost drivers for unit-level activities include labour-hour, machine-hour, and quantity of materials processed.
Unit-level activities in support services refer to activities performed for each unit. E.g., inspection of each unit of incoming material is a unit-level activity in the context of the cost of inspection.
Batch-level activities are activities performed for batch of units produced or services provided. Use of resources for a batch-level activity is independent of number of units in the batch. Example of batch-level activity is setting up a machine for a new production run. Batch- level costs are independent of the number of units processed in the batch but vary with the number of production runs, the number of purchase orders, or the number of invoices.
Batch-level activities in support services refer to activities performed for each batch. E.g., inspection of one unit of incoming material in a batch is a batch-level activity in context of the cost of inspection.
3. Product-Sustaining Activities:
Product-sustaining (or service-sustaining) activities are activities performed to support individual products or services. These activities are not part of a chain of activities that takes place when a product is produced or a service is provided. They are not always performed every time a new unit or batch of product is produced.
Examples of product-sustaining activities in a manufacturing setting are designing products, maintaining products, testing for quality assurance for individual products, tooling for individual products, and technical support provided to individual products.
Product-sustaining cost is a function of the complexity of the product. No cause and effect relationship can be established between product-sustaining costs and units produced. Therefore, these costs are assigned to units or batches of products based on some appropriate measure of complexity. E.g., designing cost is assigned to products based on number of parts.
4. Organization or Facilities Support Activities:
Organization or facilities support activities cannot be traced to products. These activities support the organization or facilities as a whole. Examples of organization or facilities support activities are planning, general administration, building and ground maintenance and central air-conditioning, and depreciation of equipment. In absence of cause and effect relationship between those costs and products, organization and facility support costs are usually not assigned to products. They are deducted from operating income.
However, some firms assign the costs to products on some basis, such as direct manufacturing labour-hours or machine-hours. It is almost impossible to identify the cost driver that would trace these costs directly to a product or service. Therefore, selection of the cost driver for assigning the costs to products is almost arbitrary.
The Two-Stage Approach of ABC Systems:
Most ABC systems use two-stage process in assigning costs to cost objects such as products or batches of products.
In this approach, items of overheads are assigned to various activities in the appropriate proportions using ‘first-stage’ cost drivers. The costs accumulated in those activities are then assigned to cost objects using ‘second-stage’ cost drivers. E.g., employee-related costs may be assigned to activities based on number of employees or direct wages or direct labour hours.
Similarly, cost of power may be assigned to activities based on machine hours. Costs accumulated in various activities are then assigned to cost objects based on second-stage cost drivers such as set-ups, orders, purchase orders, machine hours, labour hours, and so forth.
1. Identification of Activities:
The first step in the implementation of the ABC system is to identify activities. Usually, firms identify key activities using a flowchart of all the steps and processes needed to design, manufacture, and distribute products. Homogeneous activities are grouped under activity pools. E.g., activities related to designing products are grouped together under the activity pool ‘designing products’.
The function of designing products is not decomposed into constituent activities because such decomposition may not provide much benefit. However, the purchasing function is usually decomposed into constituent activities such as purchasing of direct materials, purchasing of indirect materials, purchasing of capital goods, and managing the department.
Purchasing of direct material is further decomposed into developing vendors, negotiating contracts, and facilitating timely delivery. The decomposition is necessary because the intensity with which these activities are performed differs from product to product. A complex product has higher demand for activities related to vendor development as compared with a standard commodity-type of product.
However, both types of products have almost the same demand on activities related to negotiating contracts. Therefore, identification of purchasing as a single activity distorts product costs.
It is difficult to handle large number of activity pools. Therefore, materiality should be the guiding principle in identifying activity pools.
(i) Top-Down Approach:
Activity list is developed based on the team’s understanding of the organization’s process. It is quick and inexpensive. In order to develop correct activity dictionary, the team should have thorough understanding and experience of the business process.
(ii) Interview or Participatory Approach:
In this method, the team interviews employees. The team consists of managers drawn from different functional areas. Although the same team conducts interviews to develop the activity dictionary for a particular production facility, the manager of the concerned department is co-opted to facilitate the interview and to validate the information provided by employees.
Team of employees identifies the activities that they perform. This method provides higher level of accuracy as compared with top-down approach. However unless an environment of trust is created, the process may lack of truthful disclosures. False recall is another danger in this method.
In most situations, firm use the interview method to prepare the activity dictionary.
(iii) Recycling Approach:
It may be possible to reuse documentation of processes developed for other purposes. E.g., documents developed for ISO 9000 certification may be used. This method is cheaper than the interview method.
The second step is the identification of activity cost pools by assigning costs to activity pools. The assignment is determined by the relationships between various activities and elements of cost. The elements of cost can be assigned to activities by charging them in some directly measurable manner. E.g., cost of power may be assigned by metering electric consumption, and maintenance cost may be assigned via a work order.
Costs that cannot be assigned in directly measurable manner are assigned by estimation, which is determined through questionnaires and interviews. E.g., costs of the purchasing function are assigned to purchase-related activities based on estimation determined by interviewing employees of the purchasing department. The ABC team estimates the resources, including employee time, consumed by different activities.
The third step is the identification and measurement of cost drivers. Cost drivers are variables that explain the behaviour of activity costs. They reflect consumption of resources by activities and consumption of activities by products or services.
Selection of cost drivers involves trade-offs between accuracy and cost, as well as the difficulties of operating a more complex costing system.
The following are the three different types of cost drivers:
(a) Transaction drivers
(b) Duration drivers
(c) Intensity drivers
A transaction driver determines the number of times an activity is performed. Examples are number of set-ups, number of receipts, and number of products supported. Transaction drivers are the least expensive type of cost driver, but they might provide inaccurate results. They provide accurate result only if every time the activity is performed, it uses resources uniformly.
E.g., the use of ‘number of set-up’ provides accurate result only if each set-up takes the same time to perform and uses same resources in the same quantity.
In most manufacturing set-ups, which produce different types of products, it is rare that each set-up takes same time to perform and uses same resources in the same quantity. In situations in which different set-ups take different time to perform, the use of set-up hours is more appropriate than the use of number of set-ups. Set-up hour is an example of duration drivers.
Duration drivers represent the amount of time required to perform an activity. Examples are set-up hours, inspection hours, labour hours, and machine hours. Use of duration drivers is more expensive than the use of transaction drivers. Let us take an example. If the ‘number of set-up’ is in use, the system records the number of set-ups performed during the period. On the other hand, if ‘set-up hours’ is in use, the system records number of hours each time a set-up is performed.
The cost of collection of this additional information makes the use of the duration driver (set-up hours) more expensive than the use of the transaction driver (number of set-ups). The choice between a duration driver and a transaction driver involves balancing between increased accuracy and increased cost.
Intensity drivers directly charge for the resources used each time an activity is performed. Intensity drivers are used when duration drivers fail to provide accurate results.
Let us take an example. A particularly complex product requires a special set-up. In addition to use of resources required for normal setting up activity, the set-up activity uses resources of quality assurance and testing functions. Use of set-up hours as the cost driver fails to capture the use of additional resources. Therefore, in this situation, it is appropriate to charge activity costs directly to the product.
Another example is the repair and maintenance activity. The use of different tools and equipment and people of different skills depends on the complexity of the machine and the nature of fault. Therefore, use of ‘maintenance- hours’ does not provide accurate result. Therefore, it is appropriate to charge costs directly to the machine.
Use of intensity drivers is more expensive than the duration drivers. They should be used only when resources associated with performing an activity are both expensive and variable each time an activity is performed.
An appropriate cost driver base:
(a) Should logically have a cause and effect relationship with the activity and the use of resources.
(b) Should be feasible to measure.
(c) Should predict or explain activities’ use of resources with reasonable accuracy.
(d) Should be based on practical capacity of the resource to support activities.
Activity-Based Cost Management:
Activity-based cost management (ABM) is an extension of the concept of ABC system to cost management. ABM aims at improving the operating process including the manufacturing process continuously. It facilitates elimination of non-essential activities and simplification of essential activities.
Value-Added and Non-Value-Added Activities:
Value-added activities are those activities that enhance the value of the product in the eyes of customers, and non-value-added activities are those activities that do not add to customer-perceived value.
By this definition activities that are in the chain of activities being performed to produce the goods or service are called value-added activities. Non-value-added activities are support service activities such as purchasing, maintaining of facilities, inspecting, storing, and moving raw materials. They also include administrative activities like book keeping.
Classification of activities into value-added and non-value-added activities by this definition fails to highlight waste. Waste is an activity that can be eliminated without impairing the value perceived by customers. Therefore, firms further classify non-value-added activities into essential and non-essential activities. The non-value-added non-essential activities can be eliminated.
Managers prioritize elimination of non-value-added non-essential activities by reconfiguring internal value chain and by improving the system. Managers also explore the possibility of doing value-added and non-value-added essential activities more efficiently by simplifying the internal process.
Activity-based budgeting (ABB) focuses on budgeted cost of activities necessary to produce and sell products and services. ABB primarily requires activity planning to achieve the planned production and sales. E.g., ABB requires estimation of the number of customer orders to be handled and the number of times the machine is to be set-up.
In ABB, expenditure for each activity is estimated. But in the short run, most resources (people, facilities, and systems) are committed. Therefore, ABB does not help to reduce cost. But it helps to highlight the amount of idle resources and to identify resource constraints. Thus, it improves the planning process. E.g., if the budget process reveals that the resources available for performing the ‘set-up’ activity are inadequate, managers may plan to increase the length of the production run per batch.
Similarly, if the current resources for handling the planned number of customer orders are inadequate, managers may decide to re-deploy resources from other activities or simplify the process.
Production and sales are planned using the traditional budgetary control process.
ABB leads to more detailed planning as compared with traditional budgeting, which uses only output-related cost drivers.
ABB should be perceived as a building block for the master budget, which is an essential component of the traditional budget.
ABB may also be perceived as a process for continuous improvement. Activity planning and knowing costs by activities trigger the actions necessary to become competitive.