LIMITATION OF VOLUME BASED COSTING SYSTEM:

A company’s traditional cost-accounting system is often articulated with its general ledger System. In essence, this linkage is grounded in cost allocation..The traditional approach to cost-allocation consists of three basic steps:

Accumulate costs within a production or nonproduction department. Allocate nonproduction department costs to production departments. Allocate the resulting (revised) production department costs to various

products, services, or customers.

Costs derived from this traditional allocation approach suffer from several defects that can result in distorted costs for decision-making purposes.For example, the traditional approach allocates the cost of idle capacity to products. Accordingly, such products are charged for resources that they did not use. Seeking to remedy such distortions, many companies have adopted a different cost-allocation approach called activity-based costing (ABC).

Some other limitation of volume based costing is:

1) It not relate to unique manufacturing characteristics in different operations.2) It only uses a common plant wide or departmental cost driver and ignores differences in activities for different products or productions runs with in the plant.3) Employs a common activity volume of all products.

CHANGING SCEINARIO OF EXPENXES ON MANUFACTURING OF PRODUCT AND SERVICES:

ANALYSIS:The above figure indicate that there is a complete chage in overhead expences by industries from 19th century to 20th century.direct labour expenses is coming down while manufacturing overhead and administrative overhead growing with a full force . if a company apply volume based costing technique with one cost driver like direct labour or direct material than it will give less over head expences per unit .where the actual is not that . which leads to a defective costing system. So some modern teqniche is required to give the appropriate cost. That has given birth the holistic technique like(ACTIVITY BASED COSTING)

REAL LIFE EXAMPLE: if we take example of cold drinks companies “their cost of production is only 0.75 rupees but customer purchase it at RS 10. So this is just because of huge expenditure on advertisement and other indirect cost. So if we apply volume based costing than it will give us the cost of one bottle of coldrinks only 3to 4 rupees. So it will definite hamper the profitability of organization if these company will sell the product according to the cost of production by volume based technique.so due to huge indirect cost the sigle cost driver is not appropriate. So the companies follows activity based costing to calculate actual product cost .

WHAT IS ACTIVITY-BASED COSTING?

Activity-based costing (ABC) is a costing model that identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each: it assigns more indirect costs (overhead) into direct costs

In contrast to traditional cost-accounting systems, ABC systems first accumulate overhead costs for each organizational activity, and then assign the costs of theactivities to the products, services, or customers causing that activity.

Activity analysis is the processes of identifying appropriate output measures of activities and resources and their effects on the costs of making a product or providing a service.Activity analysis provides the foundation for eliminating the negative aspectin traditional cost-accounting systems.

VOLUME BASED COST-ACCOUNTING SYSTEMS VERSUS ABC:

Volume based cost-accounting systems often allocate costs based on single-volume measures such as direct-labor hours, direct-labor costs, or machine hours. While using a single volume measure as an overall cost driver seldom meets the cause-and effect criterion desired in cost allocation, it provides a relatively cheap and convenient means of complying with financial reporting requirements.In contrast to traditional cost-accounting systems,

ABC systems are not essentially forced by the view of financial reporting requirements. Rather, ABC systems have the inherent flexibility to provideSpecial reports to facilitate management decisions regarding the costs of activities undertaken to design, produce, sell, and deliver a company’s products orServices.

ABC systems focus on accumulating costs via several key activities; whereas volume based cost allocation focuses on accumulating costs via organizationalUnits. By focusing on specific activities, ABC systems provide superior cost allocation information—especially when costs are caused by non-volume-basedCost drivers. Even so, traditional cost-accounting systems continue to be used to satisfy conventional financial reporting requirements.

In most cases, a company’s volume based accounting system adequately measures the direct costs of products and services, such as material and labor. As a result,ABC implementation typically focuses on indirect costs, such as manufacturing overhead and selling, general, and administrative costs. Given this focus, the primary goal of ABC implementation is to reclassify most, if not all, indirect costs (as specified by the volume based cost-accounting system) as direct costs. As a result of these reclassifications, the accuracy of the costs is greatly increased.

According to Ray H. Garrison and Eric W. Noreen, there are six basic steps required to implement an ABC system:

1. Identify and define activities and activity pools2. Directly trace costs to activities (to the extent feasible)3. Assign costs to activity cost pools4. Calculate activity rates5. Assign costs to cost objects using the activity rates and activity measures previously determined6. Prepare and distribute management reports

COSTS AND BENEFITS:

While ABC systems are rather complex and costly to implement, many companies, in both manufacturing and nonmanufacturing industries, are adopting ABC systems for a variety of reasons:

1. Margin accuracy for individual products and services, as well as customer classifications, is becoming increasingly difficult to achieve given that direct labor is rapidly being replaced with automated equipment. Accordingly, company’s shared costs (i.e., indirect costs) are becoming the most significant portion of totalCost.2. Since the rapid pace of technological change continues to reduce product life cycles, companies do not have time to make price or cost adjustments once costing errors are detected.3. Companies with inaccurate cost measurements tend to lose bids due to over cost products, incur hidden losses due to under cost products, and fail to detect activities that are not cost-effective.4. Since computer technology costs are decreasing, the price of developing and operating ABC systems also has decreased.

Benefits:1. More accurate product costs2. Determining the costs of services3. Evaluating customer costs and related profitability4. Identifying market or distribution channel costs5. Tracking project costs accurately6. Quantifying contract costs7. Strategic analysis of what products, customers, or channels to emphasize8. Post sales review of direct mail catalog profitability9. Supporting measurement of economic value analysis10. Supplying rich detail for contract negotiations11. Growing revenue by helping customers understand their cost reductions through the use of a firm’s products and services12. Serving as a fundamental input to target costing13. Providing benchmarking measurements14.Communicating appropriate charge-out amounts for shared services at

various service levels

“ABC works better if it’s kept simple. Nevertheless, when implemented properly ABC yields benefits to the company, its business partners, and to consumers.STEPS IN ABC

STEPS IN ACTIVITY BASED COSTING

The following are the steps in activity based cost allocation:

Identification of the main activities:

First of all, major activities in the organization are identified. The number of activities in an organization should neither be too large or too small. Too large number will be costly and will be add to the complexity of the system while a too small number of activities will compromise with the accuracy of the cost. Total cost involved in the activity should be significant enough to ustify to give an activity a separate treatment.

Creation of cost pool:

Cost pool is grouping of individual cost items. A cost pool or cost bucket should be created for each activity. Cost pool is like cost centre which cost are accumulated. For example, the total cost of machine set up might constitute one cost pool for set up related cost.

Determination of activity cost drivers:

The factors that influence the cost cost of a particular activity is known as cost drivers. In other words, cost drivers signify the factors or events that determine the cost of activity.

Calculation of the activity cost driver rate:

Just as an overhead absorption rate is calculated in traditional costing system, in ABC a cost driver rate is calculated as follows:

Activity cost driver rate= total cost of activity/Cost driver

Charging the costs of activities to products:

The costs of activities are traced to products on the basis of demand by products. The cost drivers are used to measure product demand of activities.

Example:

The total cost allocated to cost centre for machine set up related costs is Rs 500000 and there were 100 set ups during the period. Thus the rate per set up is Rs 500000/100 = Rs 500. If a particular product needs 10 set ups, charge to that product will be Rs 500 *10 = Rs 5000. If 20 units of the product are produced, cost per unit will be Rs 5000 /20 unit = Rs 250. In this way, cost of other activities also be charged to product.

Products A B C

Output(units) 10000 20000 30000

Direct material 50 40 32

Direct labour per unit 30 40 48

Labour hour per unit 3 4 5

Machine hour per unit 4 4 7

No. of purchase requisitions 600 900 1000

No. of machine set ups 120 130 150

Production overhead split by department:

Department X Rs 1200000Department Y 1500000Total 2700000

Department X is labour intensive and Y is machine intensive.

Total labour hours in dept. X = 200000.

Total machine hour in dept Y = 500000

Production OH split by activity;

Received and inspection 1400000Production scheduling/set up 1300000Total 2700000

No of batch received/inspected- 2500

No of batch for scheduling/set up- 400

Required- if we calculate the cost statement under traditional absorption costing and activity based costing methods.

TRADIIONAL METHOD-

Overhead absorption rate:

Department X: Rs 1200000 = Rs 6 per labour hour

200000 labour hours

Department Y: Rs 1500000 = Rs 3 per machine hour

500000 machine hours

STATEMENT COST:

Cost per unit ______________________________________ A B Z Rs. Rs. Rs. ______________________________________________________________________________

Direct Materials 50 40 32

Direct Wages 30 40 32

Overhead-Dept. X

A-3 hrs. @ Rs.6 18

A-4 hrs. @ Rs.6 24

A-5 hrs. @ Rs.6 30

Dept. Y

A-4 hrs. @ Rs.3 12

A-4 hrs. @ Rs.3 12

A-4 hrs. @ Rs.3 21

______________________________________________________________________________ Product Cost 110 116 131______________________________________________________________________________

ABC Method

Cost Driver Rates =Overhead Cost of the activity/Cost of Drivers

Receiving and inspection =Rs.14,00,000/2,500 Batches=Rs.560 per batch

Scheduling and set up =Rs.13,00,000/400 batches=Rs.3,250 per set up

Statement of Cost

Cost per unit ___________________________________________ A B Z Rs. Rs. Rs

Direct Materials 50.00 40.00 . 32.00Direct Wages 30.00 40.00 48.00Overhead Receiving 33.60 25.20 18.67-set up 39.00 21.13 16.25______________________________________________________________________________ Product cost 152.60 126.33 114.92_____________________________________________________________________________

Receiving over head per unit

Product A = (Rs 560* 600 requisitions)/10000 units= Rs 33.60

Product B = (Rs 560*900 requisitions)/20000 units = Rs 25.20

Product C = (Rs 560*1000 requisitions)/30000 units = Rs 18.67

Machine set up overhead per unit

Product A = (Rs 3250*120 requisitions)/10000 units = Rs 39 .00

Product B = (Rs 3250*130 requisitions)/20000 units =Rs 21.13

Product C = (Rs 3250*150 requisitions)/30000 units =Rs 16.25

Comments

Statement of cost prepared under traditional method and activity based costing produced different results. Under traditional method, product Z appears quite costly as compared to activity based costing. on the contrary, product A shows higher cost under activity based costing than traditional method. As ABC is consider more logical, it may be presumed that results produced by ABC are more accurate. If selling priced are fixed on the basis of cost, product Z would be priced higher on traditional costing and product A would be priced lower. This will result in loss of sales of Z and loss per unit on A, leading to a loss to the company.

Advantages of ABC –

ABC is being implemented by a growing number of companies around the world. It has primarily developed on account of the limitation of traditional system of charging overhead. Its main advantages are the followings:

Accurate and reliable-

ABC is more accurate and reliable system of ascertaining product costs as it is based on caused and affect relationship in cost incurrence.

Better pricing decision-

It overcomes the problems of under costing and over costing as a result of which management is able to make more judicious selling price decisions based on accurate costs.

Realistic approach-

Distribution of overhead based on activities is an objective and realistic approach. As against this, traditional method of overhead costing uses more arbitrary based of apportionment of overhead and is a subjective approach.

Control of costs-

ABC produces more meaningful information regarding cost behavior and enables management to control many fixed overhead by exercising more control over those activities which cause these fixed overhead.

Greater cost efficiency

ABC helps to identify those activities which are unnecessary and may be weeded out and thus achieving greater cost efficiency.

Useful cost driver rates

ABC helps through its cost driver rates, in th modification of existing products and also in the development of new product

ACTIVITY-BASED MANAGEMENT:In order to manage costs, a manager should focus on the activities that give rise to such costs. Accordingly, given the activity focus of ABC, managers should implement ABC systems in order to facilitate cost management. Using ABC systems to improve financial management is called activity-based management(ABM). The goal of ABM is to improve the value received by customers and, in doing so, to improve profits.

The key to ABM success is distinguishing between value-added costs and non-value-added costs.A value-added cost is the cost of an activity that cannot be eliminated without affecting a product’s value to the customer. In contrast,Anon-value-added cost is the cost of an activity that can be eliminated without diminishing value. Some value-added costs are always necessary, as long as the activity that drives such costs is performed efficiently. However, non-value-addedcosts should always be minimized because they are assumed to be unnecessary. Examples of non-value-added activities include storing and handling inventories;transporting raw materials or partly finished products, such as work-in-process inventory items, from one part of the plant to another; and redundanciesin production-line configurations or other activities. Oftentimes, such non-value activities can be reduced or eliminated by careful redesign of the plantlayout and the production process.

Activity based management (ABM) manages to improve the value of products or services to customers and increases the firm profit . ABM draws on ABC assist major source of information focuses on the effiency and effectiveness of key business process and activities .using ABM , management can pinpoint avenues for improving operations, reducing cost, or increase value to customers.

Cooper and Kaplan classify ABM enhances into two categories: operational ABM and strategic ABM.

Operational ABM enhances operational efficiency and asset utilization , and lower costs. Its focuses are on doing things right and performing activities more efficiently. Operational ABM application use management techniques such as activity management, business process reengineering, total quality management, and performance management.

Strategic ABM attempts to alter the demand for activities and increase profitability at the current or improved activity efficiency . strategic ABM focuses o choosing appropriate activities for the operation. By using strategic ABM firms improve profitability by reducing unprofitable activities, eliminating and selecting the most profitable customers.

Activity –based management uses cost driver analysis, and performance measurement to improve operations. a cost driver analysis examines, quantifies, and explains the effects of the cost driver on the cost of an activity. Its purpose is to search for the root cause of activity costs. tools used in cost driver analysis include benchmarking, cause and effect diagrams, and pareto analysis.

Activity Analysis

To be competitive a firm must assess each of its activities based on its need by the product or customer, its efficiency , and its value content. A firm performs an activity because it is:

Required to meet the specification of the product or service or satisfy customer demand.

Required to sustain the organization; or

Deemed beneficial to the firm.

High-Value-Added and Low - Value added Activities

A high-value-added activity increases significantly the value of the product or service to the customers. Removal of a high- value activity decreases perceptively the value of the product or service to the customer.

High value activities are those…

Necessary or required to meet customer requirements or expectations;

That enhance purchased materials or components of a product;

That , if more of them are accomplished, the customer would pay more for the product or service.

That are critical steps and cannot be eliminated in a business process

That are performed to resolve or eliminate quality problems.

That are performed upon request of a satisfied customer;

And that you would do more of, if time permitted.

A Low –value- added –activity consumes time, resources, or space, but adds little in satisfying customer needs. If eliminated, customer value or satisfaction decreases in perceptively or remains unchanged.

Low –value-added activities are those that:

Can be eliminated without affecting the form, fit, or function of the product or service:

Being with prefix” re” (such as rework or returned goods).

Result in waste and add little or no value to the product or service.

Are performed due to inefficiencies or error in the process stream:

Are duplicated in another department or add unnecessary steps to the business process

Are performed to monitor quality problems ;

Are performed to monitor quality problems;

Are performed due to request of an unhappy or dissatisfied customer;

Produce an unnecessary or unwanted output; and

If given the option , you would prefer to do less of.

Firms need to realize that low-value-added activities decrease competitiveness and profitability

BENIFIT OF ABM : Identification of redundant costs Analysis of value-added and non value added costs Quantification of the cost of quality by element Summarizing customer focused activities

PRACTICAL GUIDANCE ON IMPLIMENTING ABM:

Focus on critical needsBefore implementing an expensive information system or a more sophisticated costing system, decide what are the organisation's most important issues or decisions and what types of information would help address those issues. Get top management supportIf you think ABM might be a useful tool in your organization, be sure to get top management's support first. With their help, identify critical information needs, and show how an activity-cost approach could provide valuable information. Seek approval for small, relatively quick projects, such as a single process or a pilot plant. If these are successful, managementwill drive further implementation and help make it a priority for other areas. The main cost systemIf pilot projects are successful, try to incorporate ABC methods into your organization’s financial reporting process. Successful implementers of ABC systems are six times as likely to have integrated ABC into their primary financial system and almost twice as likely to use ABC for budgeting.

Consider a separate modelIf integrating ABC into the main cost reporting system is not feasible, consider developing a separate PCbased ABC system that can be used on an infrequent basis for strategic decision making. The model should be relatively simple and can be updated with data that already is available or easily collected. But even a relatively simple model can be far more accurate thanmany traditional cost allocation methods.

The existing information system

If you implement an ABC costing system, make sure that the input requirements can be easily supported by the existing information system. If not, either change the model or install a more sophisticated integrated system.

Smaller companiesSmaller companies need to be especially creative to find reasonable activity cost drivers from their often more limited data. For example, use material cost as a proxy for its weight. Look for available drivers that have some correlation with how resources are spent.

The implementation teamMake sure the people who will be actual users of the ABM information are represented on the implementation team. A common mistake is putting managers on the team and not getting enough input from the cost accountants or other analysts.

Start simplyThe best advice is to start simply. Implement ABM at a high level in order to get concepts across. Once you have created an interest, there will be a “demand pull” for more information. Use spreadsheets until you identify exactly what your needs are, and then buy the software that meets your needs.

From manufacturing companies to all industriesFor a long time ABM was viewed as relevant to manufacturing. Experience has demonstrated that activities are universal to all organizations, including service companies, schools, government, and non-profit organizations. To varying degrees, every organization has processes and activities in place to convert capital, materials and purchased services to products/servicesrequired by its customers and users. Regardless of industry, activities represent the core of what the organization does to create value for its customers and shareholders.

Start with product costingProduct/service costing is the dominant initial application of ABM in most organizations. Don'tProduce a list of activities which:— runs into the 1,000s, many with insignificant amounts of cost allocated to them;— does not identify the cost of wasted activity;— does not identify customer or product specific activity;— takes many hours for a PC to calculate each month; and is so detailed that the benefits of ABM are lost.

CONCLUSION: