ACTIVITY BASED COSTING (ABC)

MADE BY

MUHAMMAD IMRAN KHAN SM11-EX-0060 MBA-WEEKEND

ACKNOWLEDGMENTS

I am grateful to ALLAH, who give me power to make this report and took me under his wing when I needed it most. And I am thankful to my parents and brothers who have provided assistance in the development of this report.

ABSTRACT

This study investigates the improvement in financial performance that is associated with the use of Activity-Based Costing (ABC). Internal auditors furnish information regarding company financial performance, extent of ABC usage, and enabling conditions that have been identified in the literature as affecting ABC efficacy. Confirmatory factor analysis and structural equation modeling are used to investigate if, and under what conditions the use of ABC is associated with improved financial performance. Results show that there indeed is a positive association between ABC and improvement in ROI when ABC is used concurrently with other strategic initiatives, when implemented in complex and diverse firms, when used in environments where costs are relatively important, and when there are limited numbers of intra-company transactions. In addition, measures of success of ABC used in prior research appear to be predictors of improvement in financial performance.

Summary
Using ABC costing management technique as well as Economic Profit or EVA can dramatically improve the financial health of a Company as it presents the real picture or the factsheet, as the ABC tracks the cost objects consumed in the activities and therefore the resources consumed in those activities, to know accurate individual overheads instead of simply relating on the volume. The ABC concept is defined as costing technique that takes into consideration both factors the resource drivers as well as the activity drivers to determine the price of a product/service. The objective of this summary is to show that using Activity based Costing model and Economic profit unlike traditional financial management techniques can affect the profitability of an Enterprise in a major way. It should be realized that the profitability of a company does not alone rely on the sales of the product/services but also on the expenses involved in the production of that particular product/service. As the companies usually mix up the overheads cost with the direct costs it may not be ended up the accurate price setting method of the product, so a scrutinizing of accounts on Bill of Materials (BOM) should be done. It was found that the Companys largest product line had a very low operational profitability which in turn gave a negative EP. To be honest, sale of such products should be discontinued. In another study conducted on the same products, the SWOT (strengths, weaknesses, Opportunities and threats) framework was employed. It was found that the products that generated a positive EP had more weaknesses than strengths. So to conclude, we can say that Activity Based forecasting model combined with or without EP is an effective financial tool in the management of a company.

TABLE OF CONTENT

TITLE Introduction

PAGE 1

Activity based costing

Resources, activities, cost driver

Benefits

Limitation

Suggestion

Introduction "Activity based costing (ABC) is the perfect cure for the problem of overhead allocation within

organizations." This statement demonstrates the relationship between activity based costing and the
process of overhead allocation. Activity based costing is simply an accounting method that identifies all activities and the costs associated with these activities; it then assigns the cost associated with the activity directly to the pricing of the output of that activity, rather than averaging the cost across all outputs (Proctor, 2009). This is obviously not required in organizations that produce only one good or service, but in most organizations there is more than a single good or service produced. The use of activity-based costing reduces the potential for overpricing or under pricing, thus allowing the firm to offer more precise prices to its consumers. However it is much more complex to implement and depends on data that firms may not have access to, which can reduce its utility particularly for smaller firms and those that make less use of information technology (Proctor, 2009). Thus, ABC can be a strong tool for budgeting and costing in some organizations, but is not necessary in others. Activity-based costing, as noted above, is used to precisely identify cost centers for each product or service offered by a firm and build those costs into the price of the product (Proctor, 2009). For example, in a manufacturing plant that produces two dissimilar products, it is likely that these products will use not only different materials (which can be easily directly costed), but different amounts of worker labour, electricity, machine time, human resources and management efforts, and marketing requirements (Proctor, 2009). If one product requires twice as much marketing effort as the other product, it is clearly fair that the price of the first product reflects this increased cost for marketing. Thus, the use of ABC allows the firm to precisely price its products in reflection of their actual cost of production (Proctor, 2009). The process also allows for elimination of waste by identifying areas where there are excessive expenditures and allowing the firm to limit these expenditures (Proctor, 2009). These all provide compelling reasons why a firm might want to use ABC to control its costs and determine prices. There are five steps to setting up an activity-based costing system. These include identifying the activities a firm engages in; determining the costs of these activities; identifying activity centres; selecting first-stage cost drivers; and selecting second-stage cost drivers (Proctor, 2009). These activities may be performed in different was depending on the system that is currently in place for tracking and identifying work processes (Proctor, 2009). For example, a firm that uses an online tracking system for its customer service management processes will find it relatively simple to implement activity-based costing for these services, as will a manufacturing firm that uses an ERP system to drive manufacturing processes. The advantages to ABC include careful control of costing, which can be a strong advantage when there is fierce competition, when the products being produced are already very expensive, or when a firm is

attempting to gain or maintain a cost-leader position (Proctor, 2009). It can also help to ensure that a firm with a diverse product line can price its products competitively in all cases, which allows for increased competitiveness within each of these areas (Proctor, 2009). It also provides a good way for service organisations to handle costing (Geri & Ronen, 2005). However, there are also some disadvantages to ABC. First, ABC is highly complex and may be difficult for firms to implement with accuracy; for some costs, such as upper management compensation, there is simply no way to identify an appropriate costing method, leaving some portion of expenses in the traditional undifferentiated overhead bucket (Geri & Ronen, 2005). Second, ABC does not take into account resource constraints or excess capacity; although it may be possible to identify these issues with careful examination, there is nothing inherent in the methodology that does so, making it difficult for the firm to engage in waste management (Geri & Ronen, 2005). Finally, there is some feeling that the activity centres chosen in ABC may be to some extent arbitrary, and that these activity centres do not necessarily apply directly to the products involved (Geri & Ronen, 2005). Finally, in some cases, like in cases where firms produce only one product, ABC is simply unnecessary and traditional costing is a more appropriate and simpler approach to overhead allocation (Proctor, 2009). Activity-Based Costing To develop a costing system we need to understand relationships among resources, activities, and products or services. Resources are spent on activities and products or services are a result of activities. Many of the resources used in an operation can be traced to individual products or services and identified as direct materials or direct labor costs. Most overhead costs relate only indirectly to final products or services. Nevertheless, overhead costs are resources spent on a firms activities to manufacture products, provide services, or facilitate manufacturing. A good costing system identifies costs with activities that consume resources and assign resource costs to cost objects such as products, services, or intermediate cost pools based on activities performed for the cost objects. Resources, Activities, Resource Consumption Cost Drivers, and Activity Consumption Cost Drivers Before discussing activity-based costing, we need to define several important terms: activity, resource,

cost driver, resource consumption cost driver, and activity consumption cost driver.
An activity is a specific task or action of work done. An activity can be a single action or an aggregation of several actions. For example, moving inventory from workstation A to workstation B is an activity that may require only one action. Production set-up is an activity that may include several actions. A resource is an economic element needed or consumed in performing activities. Salaries and supplies, for example, are resources needed or used in performing manufacturing activities.

A cost driver is a factor that causes or relates to a change in the cost of an activity. Because cost drivers cause or relate to cost changes, measured or quantified amounts of cost drivers are excellent bases for assigning resource costs to activities and for assigning the cost of activities to cost objects. A cost driver is either a resource consumption cost driver or an activity consumption cost driver. A resource consumption cost driver is a measure of the amount of resources consumed by an activity. It is the cost driver for assigning a resource cost consumed by or related to an activity to a particular activity or cost pool. Examples of resource consumption cost drivers are the number of items in a purchase or sales order, changes in product design, size of factory buildings, and machine hours. An activity consumption cost driver measures the amount of an activity performed for a cost object. It is used to assign activity cost pool costs to cost objects. Examples of activity consumption cost drivers are the number of machine hours in the manufacturing of product X, or the number of batches used to manufacture Product Y.

Benefits Initially, many firms adopt activity-based costing to reduce distortions in product costs often found in their volume-based costing systems. Volume-based costing systems generate product or service costs bearing little or no relationship to activities and resources consumed in operations. ABC clearly shows the effect of differences in activities and changes in products or services on costs. Among the major benefits of activity-based costing that many firms have experienced are: Better profitability measures. ABC provides more accurate and informative product costs, leading to more accurate product and customer profitability measurements and to better-informed strategic decisions about pricing, product lines, and market segments. Better decision making. ABC provides more accurate measurements of activity-driving costs, helping managers to improve product and process value by making better product design decisions, better customer support decisions, and fostering value enhancement projects. Process improvement. The ABC system provides the information to identify areas where process improvement is needed. Cost estimation. Improved product costs lead to better estimates of job costs for pricing decisions, budgeting, and planning. Cost of unused capacity. Since many firms have seasonal and cyclical fluctuations in sales and production, there are times when plant capacity is unused. This can mean that costs are incurred at the batch-, product-, and facility-level activities but are not used. Capacity is supplied but not used in production ABC systems provide better information to identify the cost of unused capacity and maintain a separate accounting for this cost. For example, if a particular customers order requires the addition of a certain type of capacity in the plant, then the customer can be charged for that additional capacity.

Alternatively, if a plant manager decides to add capacity in expectation of future increases in sales and production, then the cost of that additional capacity should not be charged to current production but charged as a lump sum in the plants costs. Overall, the goal is to manage capacit y levels to reduce the cost of underutilization of capacity and to price products and services properly.

Limitations Although activity-based costing provides better product or service costs than volume based systems, managers should be aware of its limitations: Allocations. Not all costs have appropriate or unambiguous activity or resource consumption cost drivers. Some costs require allocations to departments and products based on arbitrary volume measures because finding the activity that causes the cost is impractical. Examples are facility-sustaining costs such as the costs of the information system, factory managers salary, factory insurance, and property taxes for the factory. Omission of costs. Product or service costs identified by an ABC system are likely to not include all costs associated with the product or service. Product or service costs typically do not include costs for such activities as marketing, advertising, research and development, and product engineering even though some of these costs can be traced to individual products or services. Product costs do not include these costs because generally accepted accounting principles (GAAP) for financial reporting require them to be treated as period costs. Expense and time. An ABC system is not cost free and is time-consuming to develop and implement. For firms or organizations that have been using a traditional volume-based costing system, installing a new ABC system is likely to be very expensive. Furthermore, like most innovative management or accounting systems, ABC usually requires a year or longer for successful development and implementation.

A Suggested Framework for the Integration of Activity-Based Costing (ABC) in a Lean Environment to Enhance Companies Competitive Position

In todays global market, a change in strategic and manufacturing practices to a more customer focused system such as the lean manufacturing/lean management system becomes crucial to help companies achieve a good competitive position. At the same time, the current traditional costing system is almost obsolete with respect to lean manufacturing systems. The development of a lean accounting system may have resolved the problems faced by lean firms due to their traditional costing systems. However, the suggested lean accounting Value Stream Costing (VSC) tool proposes another dilemma with respect to

the conditions required for its effective implementation especially when it comes to the necessity of eliminating shared resources. Also, very few has been written on the management accounting tools to be used in a lean environment, which indicates that the management accounting literature seems to lag behind lean transformation. This study sets a framework that integrates Activity-Based Costing (ABC) in a lean environment in a condition where shared resources are still present. This has the objective of computing accurate product unit costs in order to assist a lean manufacturing system enhance organizational competitive stand. A case study is conducted on one factory of a multinational manufacturing company operating in Egypt which has recently moved to lean manufacturing. The suggested ABC framework is used to compute the product unit cost for one of the factory products. Within the implementation of the suggested framework different approaches to product costing in lean firms are being compared from which various empirical implications are being discussed. The findings of the study gives positive implications of the use of ABC, in the studied factory - given a condition of shared resources- which shall help the Companys studied factory to achieve a good competitive position. This research seeks to establish why ABC adoption rates are low given the claimed benefits of the system. The view is taken that there are likely to be two sets of interacting variables influencing ABC adoption, contingent variables and the companys ability or willingness to address implementation barriers. The contingency approach is a recent and important development in ABC research. From the perspective that there is no one universally appropriate MAS system, but that the appropriateness of any system is dependent on the factors facing the firm, it can be argued that ABC system adoption and success will depend upon specific contingent factors such as product diversity, cost structure, firm size, competition, and business unit culture. A contingency model of ABC adoption has been developed in order to examine and investigate the reasons why the take up or adoption of ABC systems remains low. This model seeks to incorporate contingency theory relating to a set of variables which will be identified from the literature as likely to be influential in ABC adoption. The view is taken that such contingency variables will not of themselves explain ABC adoption rates, rather such contingency factors may be viewed as rendering ABC suitable or otherwise for adoption by companies but that there are also implementation issues which influence adoption. The implementation factors can be classified based upon a review of the literature into three main types Behavioural, Systems and Technical. This study seeks to establish which of these three sets of factors constitutes the dominant barriers to ABC implementation. Based upon the contingency model, companies are classified into groups, each group having a different profile with regard to the individually established contingent variables. Thus, one such

group will have a good match with the contingent variables and another will have a poor match, e.g. if size is found to be a contingent variable, one group will comprise the larger firms, and another group will comprise the smaller firms, with a number of intermediate groups. The grouping is based on all established contingent variables. Each such group is subdividing into ABC adoption or non-adoption, and the reasons for non-adoption establish for each such group. A mail questionnaire survey was considered an appropriate method for this study. The survey undertaken comprised all firms listed in Business and Finance (2004) Irelands Top 1000 Companies (the total number of companies included in the list were only 925 companies). 218 questionnaires were returned, generates a 23.6% response rate. The quantitative data were processed using a SPSS program, leading to appropriate descriptive and inferential statistical analysis, including frequencies, means, standard deviations, chi-square, t-test, MannWhitney and ANOVA tests. Cluster analysis was used to profile the companies according to the individually significant contingent factors. Seven contingent variables were identified from the literature, six of which were found to be statistically significantly associated with ABC adoption. Companies were clustered using these variables into three groups, and reasons for non -adoption were identified. Based upon an analysis of the given reasons for non-adoption, Technical Issues were dominant amongst these companies in the cluster which profile most closely matches the contingent factors. The findings suggest that in the adoption of ABC, two distinct sets of variables are at work. The Contingent Variables which likely render it appropriate or useful for the company to adopt ABC, and the companys ability, or willingness to address the Barriers and difficulties associated with ABC adoption. The results show a strong significant association between contingent variables and the adoption of ABC. The results suggest that the contingent variables alone may not of themselves adequately explain the actual take up of ABC systems. Moreover, it suggests that two companies which have similar profiles with regard to contingent variables (with higher overheads, more product diversity etc.) may yet reach different decision with regards to ABC adoption, due to their differing abilities or willingness to address and overcome the issues relating to ABC implementation, the results completely support this suggestion. The results also show that Technical Issues are the most common factor militating against ABC adoption within companies who are rejecting and actively considering its adoption within the cluster whose profile most closely matches the prime factors.

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