The direct costs will be in proportion to the volume of production and the indirect costs like production, administration, marketing and distribution overheads etc. The basis of apportionment of overheads may be based on machine hours, labour hours, direct costs, input, output, etc.
These normal methods of apportionment have some bottlenecks which tend to misinterpret regarding proration of common costs of different functions added to the product cost. Traditional cost accounting over the years proved their inability and inadequacy to support management decision in a complex business environment since they are aimed at allocation of overhead to total cost on the basis of consistency rather than relevance.
The conventional cost systems use direct labour consumption as the primary means of apportioning overhead. This proved adequate when the overhead costs of indirect activities was a small percentage compared to direct labour consumption in actual making of products. The increased technology and automation has reduced the direct labour substantially, leaving indirect activities as a far more significant cost factor. Therefore, using direct labour as a primary apportioning device can cause significant costing distortions and poor strategic planning.
Traditionally, manufacturing companies classified the manufacturing costs to be allocated to the products into a direct materials, b direct labour and c indirect manufacturing costs.
In the present day context, characterized by intensive global competition, large scale automation of manufacturing process, computerization and product diversification to cater to the changing consumer tastes and preferences has forced companies to refine their costing systems to provide better measurement of the overhead costs used by different cost objects.
Accordingly, manufacturing costs are classified in to three broad categories as under:. The change in the classification of manufacturing costs as above has lead to the development of ABC. ABC refines a costing system by focusing on individual activities as the fundamental cost objects.
An activity is an event, task or unit of work with a specified purpose as for example, designing, set-up etc. ABC system calculates the costs of individual activities and assigns costs to cost objects such as products or services on the basis of the activities consumed to produce the product or provide the service.
The activity is aggregated of closely related task, which are associated with one another to accomplish a goal objective. The activities can be associated with output or cost object of the organization, the cost objects consume activities is just the same way that activities consume resources.
ABC is an attempt to ascertain more accurate product cost by redesigning the allocative system of support overheads like inspection, despatch, production planning, setup, tooling and similar costs.
ABC is a recent development in Cost Accounting which attempts to absorb overheads into product costs on a more realistic basis. The basic idea of ABC is that costs are grouped according to what drives them or causes them to be incurred. The cost drivers are then used as an absorption base. ABC is the method of cost attribution to cost units on the basis of benefits received from indirect activities i.
It emphasizes links between performance of particular activities and the demands that these activities make on the resources of the organization. Methodology in allocation of overhead is different in ABC system. Under ABC, cost pools are created for each activity and such activities are related with each type of product to determine the cost of such product i.
The technique of ABC involves identification of production path, identification of activities that go into making a product, selection of suitable drivers, creation of cost pools, calculating the overhead application rate and allocation of the costs based on the application rate.
This involves identification of different stages of the production process, the commitment of resources to each processing times and bottlenecks. The next step in ABC system is to identify the main activities in the organization. For example, customer processing activity involves a series of acts like receiving orders from customers, interacting with production regarding capacity to produce, giving commitment to the customer regarding delivery time etc.
Thus any activity can comprise of one or more of tasks which are associated with one another to accomplish a goal or objective. Examples include: materials handling, store keeping, purchasing, inspection, despatch, assembly, setup, maintenance and so on.
This ensures aggregation or grouping of common activities and elimination of immaterial activities. Activities are categorized into primary activities and support activities. The main activities can be categorized into the following:. There are a large number of activities which continue to be carried out particularly in certain old factories, which do not contribute to the value of a product. The identification of non-value adding activities in the production process will help in focusing the attention for elimination.
Under ABC, costs are grouped into pools, according to the activities which drive them e. Cost pools are similar to cost centres in traditional cost systems. Costs are pooled or collected on the basis of activity that drives the costs regardless of conventional departmental boundaries.
The activity cost pool is the total cost assigned to an activity. It is the sum of all the cost elements assigned to an activity. The next step in ABC system is to identify the factors which determine the costs of an activity. Cost drivers are used to trace costs to products by using a measure of resources consumed by each activity. Cost drivers can be defined as those activities or transactions that are significant determinants of cost.
Cost driver is a factor that determines the work load and effort required of an activity and the resources needed. An activity may have multiple cost drivers associated with it. Cost driver explains why an activity is performed and how much effort is extended to carryout the work. Cost drivers are useful because they reveal opportunities for improvement.
Working to reduce the negative effects of cost drivers can yield important gains in efficiency. The following are examples of cost drivers:. A cost driver is an activity which generates cost. ABC system is based on the belief that activities cause costs and that a link should therefore be made between activities and products by assigning cost of activities to products based on an individual products demand for each activity.
A single representative activity driver can be used to assign costs from the activity cost pools to cost objects. Such linking of total costs to cost objects is generally based on the activity driver rate. Cost object is the final point to which costs are traced. The cost objects are linked to the objective of the organization. Cost object is the reason for performing an activity. Cost objects include products, services, customers, projects and contracts.
The cost object enables to identify the activities required to produce products etc. Direct costs like materials and labour are easily assigned directly to cost objects. The indirect costs are indirectly assigned to the cost object via cost pools and cost drivers. It requires to establish the demands made by a particular product on activities, using the cost drivers as a measure of demand. ABC is the process of tracing costs first from resources to activities and then from activities to specific products.
The cooperation of the work force is critical to the successful implementation of ABC. Staff training should be oriented to create an awareness of the purpose of ABC. The need for staff cooperation in the concerned team effort for mutual benefit must be emphasized throughout the training activity. The actual operation of the ABC system should be closely monitored.
Periodic review and follow-up action is necessary for successful implementation of the system. A value added activity is an activity that customers perceive as adding usefulness to the product or service they purchase. They suggest four main groups of activities:.
A product unit is typically a good or a service, and examples of the corresponding activities are consumption of raw materials, consumption of power, and the working process, that is directly related to the specific unit. Costs that are caused by activity series do in principle not vary with the number of units produced in each series. Typical activity series are: reorganization of machinery for a new series, or quality control of a given existing series.
Thus the activity is independent of how many product series the specific product type is produced in, and the quantity of units produced. Examples: product development and product design. Broadly speaking, these activities do not vary with the number of units, series, and products that are produced in the company, and as such they are irrelevant to distribute.
It is reasonable to consider the unit determined activities in the ABC equal to the variable costs from the contribution margin model not to be confused with variable costs from the cost theory.
In both circumstances, the terms vary wholly with the particular product. However one should be aware of the differences of activities in the ABC and costs in the contribution margin model. Activities are actions that can not be fully determined financially, whereas costs are always listed in kroner and 0re. Herein lies ABC requirement for some kind of distribution key in order to distribute the activities between the cost pools that represent the costs.
Calculating a differentiated customer profit contribution via activity- based costing After the calculation of relevant costs at the individual levels of the hierarchy, the customer profit contribution may be determined for a period defined in advance. First, the sales realized from a customer within the reference period are recorded. Next, sales deductions e. In activity-based approaches, one The ABC model is explained fully later in this paper, but its terms are introduced here.
Dynamic Costing ABC and the full distribution cost model ABC and the full costs model differ from each other on the following points: o ABC does not have the ambition of distributing all costs, as some activities are considered business preserving activities.
This principle is in opposition to the full cost model, which seeks to distribute all costs. Using ABC costing formula, find out the new overhead rates for the company. We have here given two activities. The first one is a machine set-up activity, and the second one is inspecting the same. So the drivers areas the number of machine setup would increase the cost would also increase, and similarly as the number of inspecting hours increases, that would lead to an increase in inspection cost as well.
These are the structural determinants of the activities on which cost is being incurred and determine the behavior of the costs on an activity. Calculation of Machine Setup Cost. The following details pertain to different activities and their costs for Gamma Ltd. You are required to calculate the overhead rate for each activity. We are here given five activities; hence, we need to allocate those costs based upon their cost drivers.
Mamata Inc. It is activity-based costing so that the two products Z serum and W serum can be sold at their proper cost and make them price competitive in the market.
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