BBA Cost Accounting Topic wise Study Material Of Activity Based Costing

Step 3 – Identify Non – value Adding Activity

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.

 Step 4 – Identification of Activity Cost Pools

CIMA official terminology defines cost pool as ‘the point of focus for the costs relating to a particular activity in an activity based costing system ‘. Under ABC, costs are grouped into pools, according to the activities which drive them e.g., a cost pool may be of procurement of goods, in this all costs associated with ordering, inspection, storing etc. would be included in this cost pool. 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 assigned to an activity. It is the sum of all the cost elements assigned to an activity.

Step 5 – Selection of Activity Cost Drivers

CIMA official terminology defines a cost driver as ‘any factor which causes a change in the cost of an activity e.g. the quality of parts received by an activity is a determining factor in the work required by that activity and therefore affects the resources required. An activity may have multiple cost drivers associated with it’.

The next step in ABC system is to identify the factors which determine the costs of an activity. These are called as ‘cost drivers’. 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 carry out 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:

  • The number of purchase orders drives cost of the purchasing activity.
  • The number of goods received notes drives the costs of material receiving activity.
  • The number of items in stock drives the costs of warehousing.
  • The number of sales invoices drives the costs of the sales, dispatch and sales ledger activities.

A cost driver is an activity which generates cost. ABC system is based on the belief that activities cause cost and that a link should therefore be made between activities and products by assigning cost of activities to product 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 cost to cost objects is generally based on the activity driver rate.

Step 6 – Tracing of Costs with Cost Objects

Cost object is the final point to which costs are traced. The cost objects are linked to the objective of the organisation. 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 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 involves the tracing of cost of activities to products according to a product’s demand for each activity. It requires establishing 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.

Step 7 – Staff Training

The co-operation of the work force is critical to the successful implementation of ABC. Staff training should be oriented to create an awareness to the purpose of ABC. The need for staff co-operation in the concerned team effort for mutual benefit must be emphasised throughout the training activity.

Step 8 – Review and Follow – up

The actual operation of the ABC system should be closely monitored. Period review and follow – up action is necessary for successful implementation of the system.

Different Categories of Cost Pools and its cost Drivers

The important cost pools and its cost drivers are given below:

Bba Cost Accounting Topic wise Study Material Of Activity Based Costing

Advantages and Limitations of ABC

The reasons for support of ABC concept and criticism leveled against is summarised below:

Advantages

  • By adopting ABC, it is possible to ascertain most accurate and realistic product cost.
  • The application of advanced manufacturing technologies and its resultant increase in support overhead can be easily traced with different products.
  • It cuts across the traditional allocation, apportionment of overheads to different cost centres or departments. ABC emphasis the identification of different activities and products are charged with portion of support overhead based on the consumption of activities.
  • ABC helps in ascertainment of product cost based on both financial and non – financial information.
  • ABC incorporates the concept of long – run variable product cost which is relevant to strategic decision making.
  • ABC recognises the cost behavior and identifies the value added and non – value added activities.
  • ABC is the most suitable method in tracing the costs of different product lines, customers, responsibility centres, locations etc.
  • Management information system is strengthened with better and accurate information.
  • It provides insight into elements of cost. Redundant costs can, therefore, be identified and remedial measures taken.
  • Valuation of inventory requires assessment of cost rates. By the process of ABC, accurate cost rates can be determined. Accurate assessment of cost rate is a prerequisite for proper valuation of inventory and especially in the case of work – in – process.
  • It helps managers in fixing of competitive selling price.
  • Information regarding capacity untilisation is available for decision making.
  • It helps in identifying and elimination of bottlenecks in the production for maximising use of resources.
  • It identifies non – value added activities, for effective control and maximising margin.

Limitations

  • ABC is criticised for the following reasons:
  • ABC is a complex system which consists of various cost pools and cost driver rates.
  • ABC is beneficial to the complex and large organisations. For small organisations, traditional system is more economical and simple.
  • Sometimes, the use of multiple cost drivers is necessary.
  • Often it is difficult to attribute costs to single activities, some costs support several
  • ABC is based on the assumption that there is a direct and linear relationship between the usage of activities and application of cost driver rates.
  • ABC system requires total commitment and support from top level management.
  • It requires positive attitude and employs support for successful implementation.
  • Substantial amount of money and time is necessary for implementation of ABC.
  • Trained professionals, who are limited in number, are required for implementation of ABC system.

Bba Cost Accounting Topic wise Study Material Of Activity Based Costing

Activity Based Information and Decision Making

ABC may not be appropriate for all companies, particularly those where overheads are relatively small and which do not produce a wide range of products. But may of the benefits of ABC can still be obtained by implementing a partial system which focuses only on the most important activities. Traditional methods can be used for to produce monthly profit statement, leaving ABC to support strategic decision making, profitability analysis and the control of manufacturing costs. ABC supports decision making in many ways such as:

  • ABC system can effectively support the management by furnishing data, at the operational level and strategic level. Accurate product costing will help the management to compare the profits that various customers, product lines, brands or regions generate and to decide on pricing strategy, dropping unprofitable products, line etc.
  • Information generated by ABC system can also encourage management to redesign the products.
  • ABC system can change the method of evaluation of new process technologies to reduce set – up – times, rationalisation of plant layout in order to reduce or lower material handling cost, improve quality etc.
  • ABC system will report on the resource spending Vis –a – Vis resource consumption, and reduce demand in organisational resources lead to increase in profits.
  • ABC analysis helps managers focus their attention and energy on improving activities and the actions allow the insights from ABC to be translated into increased profits
  • The cost driver rates established by the system can be used to measure activity performance and efficiency and provide a more suitable basis for budgeting.
  • The accurate feedback can be provided to cost centre managers on their performances based on their consumption of resources during a period rather than the allocations of cost over which they have no control.
  • The provision of accurate information on product costs enables better decisions to be made on pricing, marketing, product design and product mix.

Bba Cost Accounting Topic wise Study Material Of Activity Based Costing

Activity based Budgeting

Activity based budgeting (ABB), sometimes termed ‘activity cost management’. Is a planning and control system which seeks to support the objective of continuous improvement. It is a development of conventional budgeting system based on activity analysis. ABB requires the identification of the activities of the organisation, establishing the factors which cause costs, the cost drivers, and then collecting the cost of the activities in cost pools. ABB recoginses that:

  • It is activities which drive costs and the aim is to control the causes (drivers) of costs directly rather than costs themselves. In the long – run, costs will be managed and better understood and controlled.
  • Not all activities add value, so it is essential to differentiate and examine activities for their value – adding potential.
  • The majority of activities in a department are driven by demands and decisions beyond the immediate control of the budget holder. Conventional budgets, expressed in financial terms against established cost headings , ignore this casual relationship.
  • More immediate and relevant performance measures are required than are found in conventional budgeting systems.

ABB provides stronger links between an organisation’s strategic objectives and the objectives of the individual activities within a business for which departmental managers are responsible.

Additionally, important strength of ABB is its ability to tackle across – organisational issues by a participative approach and activity analysis techniques, all of which promote continuous improvement. The key features of ABB can be summarised thus:

  • A clear link between strategic objectives and the tactical planning of the ABB process.
  • The use of activity to relate costs to activities.
  • The identification of cost improvement opportunities.
  • A focused, participative approach by all levels to guide and sustain continuous improvement. 


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