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Cost-Volume-Profit Analysis

Introduction .Activity-based costing is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore “fixed” costs. Activity-based costing is ordinarily used as a supplement to, rather than as a replacement for, the company’s usual costing system.

Activity-Based Cost system has recently gained popularity. It is based on a simple idea: in an enterprise, overhead (or operating) expenses are generated by a number of activities needed to successfully perform manufacturing and business processes. Since activities consume overhead resources, and products (or projects or processes) demand activities, the cost of products is related to the cost of resources. By design, ABC provides not only relatively accurate cost data, but also information about the origin of the cost. ABC has been implemented in numerous companies, and managers familiar with the ABC method were able to manage costs more successfully. Costs were kept in-line through the removal of non-value-added activities, process improvement, or outsourcing. Even the most impressive cost reductions, however, do not automatically imply an improvement in value creation; often the shareholder value remained unchanged or was reduced. This results from the fact that the ABC method, however sufficient in the calculation of operating costs, is deficient in the handling of full capital costs. •

Why Activity-Based Cost Systems:

Activity-Based Costing (ABC) arose in the 1980s from the increasing lack of relevance of traditional cost accounting methods. The traditional cost accounting methods were designed around 1870 - 1920 and in those days industry was labor intensive, there was no automation, the product variety was small and the


overhead costs in companies were generally very low compared to today. However, from the 1960s particularly 1980s - this changed rapidly. For these reasons, and more, traditional cost accounting has been called everything from 'number 1 enemy of production' and questions whether it is 'an asset or a liability' have been raised. The question of course is whether ABC has overcome these deficiencies or not? It has. In fact, ABC has been called one of the most important management innovations the last hundred years. So what is really the difference between ABC and traditional cost accounting methods? Despite the enormous difference in performance, there are some major differences: 1. In traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities. 2. Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels. 3. Traditional cost accounting is structure-oriented whereas ABC is process-oriented. 4. The allocation bases often differ from those used in traditional costing systems. 5. Some manufacturing costs may be excluded from product costs. •

ABC versus Traditional Costing

Activity causes costs to be incurred. Traditional costing uses broad cost drivers that do not reflect cause and effect. 1 hour of activity A has different costs than 1 hour of activity B In traditional cost accounting, predetermined overhead rated are computed by dividing budgeted overhead costs by a measure of budgeted activity such as budgeted direct labor-hours this practice results in applying the costs of unused, or idle, capacity to products, and it results in unstable unit product costs. If budgeted activity falls, the overhead rate increases because the fixed components of overhead are spread over a smaller base, resulting in increased unit product costs. In contrast to traditional cost accounting, in activity-based costing, products are charged for the costs of capacity they use- not for the costs of capacity they don’t use. In other words, the costs of idle capacity are not charged to products. This results in more stable unit costs and is consistent with the objective of assigning only those costs of idle capacity to products, in activity-based costing these costs are considered to be period costs that flow through to the income statement as an expense of the current period this treatment highlights the cost of idle capacity rather than burying it in inventory and cost of goods sold. Accordingly, under traditional costing, cost targets (products, jobs, customers) involving complex (costly) activity tends to be under-costed while products involving simple (less costly) activities tend to be overcosted. The direction of the arrows are different because ABC brings detailed information from the processes up to assess costs and manage capacity on many levels whereas traditional cost accounting methods simply


allocate costs, or capacity to be correct, down onto the cost objects without considering any 'cause and effect' relations. •

Consumption of resources versus consumption of activities

ABC acknowledges that costs cannot be managed, the only thing that can be managed is what is being done and then costs will change as a consequence. In traditional cost accounting, however, the underlying assumption is that costs can be managed, but as most managers have found out the hard way - managing costs is almost impossible. The benefit of the ABC mindset is that it opens up for a much wider array of measures when it comes to improving productivity. By investigating systematically what is being done, i.e. the activities, one will not only be able to identify surplus capacity if it occurs, but also lack of capacity and misallocation of capacity. A result of this might be that costs are cut the traditional way, but it might as well lead to a reallocation of capacity to where it is most needed which will yield high productivity more effectively than the traditional way. •

Volume related allocation bases versus drivers at many levels

Due to the historic background of traditional cost accounting methods, they tend to use direct labor - or other volume related allocation bases - for cost assignment purposes. But as overhead has grown and new technologies have come, it goes without saying that assigning costs based on only 5 - 15% (in most companies) of total costs is highly risky. In fact, the incurred errors are up to several hundred percent! In ABC, however, costs are assigned according to the ‘cause and effect' relationship between activities (the actual process) and cost objects, which is captured using drivers. The drivers are therefore not allocation bases in the traditional sense, although they work the same way mathematically - drivers are estimates of actual cost behavior and can therefore also be used to identify, or they are themselves, the critical cost factors. Because the drivers are related to the actual processes, they occur on several levels. The four most common levels are; 1. Unit level. Unit level drivers are triggered for every unit that is being produced. For example, for a man and a machine that produces one unit at a time, the associated direct labor will be a unit level cost driver. This is therefore a volume related driver similar to the traditional allocation bases. 2. Batch level. Batch level drivers are triggered for every batch produced. A good example of that is production planning, because the planning is done for each and every batch regardless of the size of the batch. Here, number of batches can be a good driver. 3. Product level. Product level drivers are triggered for every product regardless of the number of units and batches produced. These drivers occur by the sole existence of a product. A good example of a driver is the number of product development hours per product so that the more product development hours a product triggers the more product development costs should be assigned to that product. 4. Facility level. Facility level driver are drivers that are not related to the products at all. Costs that are traced by such drivers will therefore be allocated to products and not traced. The


difference between allocation and tracing is that allocation is quite arbitrary whereas tracing is based on 'cause and effect' relations. Hence, it can be seen that the traditional usage of fixed and variable costs is totally meaningless. In ABC, all costs are included. However, ABC employs a different usage and definition of fixed and variable costs. A fixed activity cost is a cost that exists due to the very existence of the activity whereas a variable activity cost changes as the output of the activity changes. This distinction is very helpful in various improvement efforts. In ABC there are two types of drivers: 1. Activity Cost Drivers: That keep track of how cost object behavior influences activity levels, i.e., the level of activity for each activity. ď‚Š Selecting activity cost drivers Activity cost drivers are the central innovation of activity-based cost systems. They are also the most costly to measure, particularly the quantity of each activity cost driver used by each product. The selection of an activity cost driver reflects a subjective trade-off between accuracy and the cost of measurement. An ABC system, with 50 activity cost drivers and 2000 products would require 100,000 data elements to be estimated (the quantity of each activity cost driver used by each product). Because of the large number of potential activity-to-product linkages, management accountants attempt to economize the number of different activity cost driver. ABC system designers can choose from three types of activity cost drivers:

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Transaction drivers: Transaction drivers are the least expensive type of cost driver but are also the least accurate because they assume that the same quantity of resources is required every time an activity is performed. For example, a transaction driver such as the number of setups assumes that all setups take about the same time to perform. For many activities, the variation in the quantity of resources used by each is small enough that a transaction driver will be fine for assigning activity expenses to the cost object. If however, the amount of resources required to perform the activity varies considerably from product to product, more accurate and more expensive types


of cost drivers should be used. •

Duration Drivers: Duration drivers represent the amount of time required to perform an activity. Duration drivers should be used when significant variation exists in the amount of activity required for different outputs. Examples of duration drivers include inspection hours and direct labor hours. In general, duration drivers are more accurate than transaction drivers, but duration drivers are more expensive to implement because they require an estimate of the time required each time an activity is performed.

Intensity Drivers: Intensity drivers charge directly for the resources used each time an activity is performed. Intensity cost drivers are the most accurate activity cost drivers but the most expensive to implement; in effect, they require a job order costing system to track all the resources used and their cost each time an activity is performed. Unless such measurement is inexpensive, intensity drivers should be used only when the resources associated with performing an activity are both expensive and variable each time an activity is performed.

2. Resource Cost Drivers: Resource cost drivers are drivers that keep track of how the subsequent activity level affects the resource consumption. In early terminology activity drivers were referred to as 'second stage cost drivers' whereas resource drivers were denoted 'first stage cost drivers'. But it is evident that the word 'cost driver' is misleading in this context because activity- and resource drivers do not tell what drives costs in the general case. Therefore, in Activity-Based Management (ABM) a third type of drivers is employed in addition to the two aforementioned drivers. This type of drivers is called cost drivers and they are the underlying causes of costs of activities and measured by non-financial performance measures. Today, the most important of these measures can be presented in Balanced Scorecard and they represent the process view in ABM. These are possibly the most difficult drivers to identify. •

Structure-orientation versus process-orientation

Traditional costing systems are more concerned about the organizational charts than the actual process. Traditional cost accounting systems are therefore structurally oriented and the process view is completely missing. The result is that one cannot ask 'what needs to be done?', because the process is unknown. The only questions such costing systems can give answers to, although often off the mark, is 'what do we have at our disposal to do the job?’ The latter question is a question of capacity, that is, how capacity is managed. Capacity is measured as an expense and found easily in the accounting system. The first question is a question of resource management, because resources is what you need in order to do a job and measured as a cost, but the


resource measures can only be found by investigating the processes. Thus, because ABC is process-oriented and gathers information from the processes it can be used to identify both 'what needs to be done?' and how to allocate resources most productively. ABC can therefore give managers the ability to match the resource needs with the available capacity as closely as possible and hence improving productivity. From this we understand that the structure oriented approach of traditional costing systems gives no decision support in allocating capacity to match resource needs. Over time this leads to cost inefficient organizations and poor profitability. There is also another aspect to process-orientation; how ABC is used and implemented. Because ABC can direct attention towards the causes of costs (critical success factors) related to both cost objects and processes and not to mention the cost of quality, ABC is viewed as more than a method for cost accounting - it invites to a whole new way of management, such as; The identification of critical success factors that enables continuous improvement of product- and process design. The link between cost information and other information enables a much wider array of improvement strategies than traditionally acknowledged. The identification of the cost of quality and the process-orientation in ABC open up for a very powerful link to various quality management methods. From the above discussion it should be evident that not only is ABC useful and powerful to any organization, but a need for companies that want to excel, and efficiently and effectively increase their Sustainable Competitive Advantage (SCA).

Two stage ABC systems

Sometimes two stage ABC system is used. The first stage cost drivers are used to allocate indirect resource costs to activities that require the resources. The cost drivers are usually expressed as percentages. And for the second-stage allocation, the cost driver for the production-support activity costs might be “number of customer-generated engineering changes” or “number of distinct parts,” whichever is a better measure of the consumption of production-support activity. •

How costs are treated under Activity-based Costing

Nonmanufacturing costs and activity-based costing: In traditional cost accounting, only manufacturing costs are assigned to products. Selling, general, and administrative expenses are treated as period expenses and are not assigned to products. However man of these nonmanufacturing costs are also part of the costs of producing, selling, distributing, and servicing


products in activity-based costing, products are assigned all of the overhead costs- nonmanufacturing as well as manufacturing-that they can reasonably be supposed to have caused.

Manufacturing costs and Activity-Based costing: In traditional cost accounting, all manufacturing costs are assigned to products—even manufacturing costs that are not caused by the products. For example, a portion of the factory security guard’s wages would be allocated to each product even though the guard’s wages are totally unaffected b which products are made or not made during a period. In activity-based costing, a cost is assigned to a product only if there is good reason to believe that the cost would be affected by decisions concerning the product. •

Plant wide Overhead Rate

On an economy wide basis, direct labor and overhead costs has been moving in opposite directions for a long time as a percentage of total cost, direct labor has been declining, whereas overhead has been increasing many tasks that used to be done b hand are now done with largely automated equipment-a component of overhead. Further more, product diversity has increased companied are creating new products and services at an ever-accelerating rate that differ in volume, batch size, and complexity managing and sustaining this product diversity requires many more overhead resources such as production schedulers and product design engineers, and many of these overhead resources have no obvious connection with direct labor. Finally computers, bar code readers, and other technology have dramatically reduced the costs of collecting and manipulating data- making more complex (and accurate) costing systems such as activity-based costing much less expensive to build and maintain. Nevertheless, direct labor remains a viable base for applying overhead to products in some companiesparticularly for external reports. Direct labor is an appropriate allocation base for overhead when overhead costs and direct labor are highly correlated and indeed, most companies throughout the world continue to base overhead allocations on direct labor or machine-hours. •

Departmental Overhead Rates

Rather than using a plant wide overhead rate, many companied have a system in which each department has its own overhead rate. The nature of the work performed in a department will determine the department’s allocation base. For example, overhead costs in a machining department may be allocated on the basis of the machine-hours incurred in that department. In contrast, the overhead costs in an assembly department may be allocated on the basis of direct labor-hours incurred in that department. Unfortunately even departmental overhead rates will not correctly assign overhead costs in situations where a company has a range of products that differ in volume, batch, size, or complexity of production. The reason is that the departmental approach usually relied on volume as the factor in allocating overhead cost to products. However, the department’s overhead costs are probably more complex than this and are caused by a variety of factors, including the range of products processed in the department, the number of batch setups that are required, the complexity of the products, and so on. Activity-based costing is a technique that is designed to reflect these diverse factors more accurately when costing products. It


attempts to accomplish this goal by identifying the major activities such as batch setups, purchase order processing and so on, that consumes overhead resources and thus cause costs.

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Fixed Costs and Variable costs in activity-based cost systems:

The ABC system assigns most indirect costs to products, but this system does not assume that such costs will vary based on short-term changes in activity volumes. In fact, most indirect expenses assigned by an ABC system are committed costs. Committed costs become variable via a two step procedure.

First Demands for resources change either because of changes in the quantity of activities performed or because of changes in the efficiency of performing activities.

Second Managers must make decisions to change the supply of committed resources, either up or down, to meet the new level of demand for the activities performed by these resources.

If activity volumes exceed the capacity of existing resources, the result is bottlenecks, shortages, increased pace of activity, delays or poor-quality work. Such shortages occur often on machines, but the ABC approach makes clear that shortages can also occur for human resources who perform support activities, such as designing, scheduling, ordering, purchasing, maintaining and handling products and customers. Companies facing such shortages typically make committed costs variable. They relieve the bottleneck by spending more to increase the supply of resources to perform work, which is why many indirect costs increase over time.

Demand for indirect and support resources also can decline, either intentionally through activity-based management or inadvertently through competitive or economy wide forces that lead to declines in sales. For many unit level resources such as machines and direct labor, reduced demands for work do not immediately lead to spending decreases. People have been hired, space has been rented, and computers, telephones and furniture have been acquired. The expenses for these resources continue even though there is less work for the resources to perform. The reduced demand for organizational resources does lower the cost of resources used by products, services and customers. But this decrease is offset by an equivalent increase in the cost of unused capacity.


After unused capacity has been created, committed costs will vary downward if, and only if, managers actively reduce the supply of unused resources. Organizations often create unused capacity through activity-based management actions, such as process improvement, repricing to modify the product mix, and imposing minimum order sizes on customers. They keep existing resources in place, however, even though the demands for the activities performed by the resources have diminished substantially. They also fail to find new activities that could be done by the resources already in place but not being used. In this case, the organization receives no benefits from its activity-based management decisions that reduced the demands on its resources. The failure occurs because managers are unwilling or unable to take advantage of the unused capacity they have created, such as by spending less on capacity resources or increasing the volume of work processed by the capacity resources. The costs of these resources are only fixed if managers do not exploit the opportunities from the unused capacity they helped to create.

Activity-Based Pricing:

Pricing is the most powerful tool a company can use to transform unprofitable customers into profitable ones. Activity-based pricing establishes a base price for producing and delivering a standard quantity for each standard product. In addition to this base price, the company provides a menu of options, with associated prices, for any special services requested by the customer. The prices for special services on the menu can be set simply to recover the activity-based cost-to-serve, allowing the customer to choose from the menu the features and services it wishes while also allowing the company to recover its cost of providing those features and services to that customer. Alternatively, the company may choose to earn a margin on special services by pricing such services above the costs of providing the service. Price surcharges could be imposed when designing and producing special variants for a customer’s particular needs. Discounts would be offered when a customer’s ordering pattern lowers the company’s cost of supplying it.

Activity-based pricing, therefore, prices orders, not products. When managers base prices on valid cost information, customers shift their ordering, shipping, and distribution patterns in ways that lower total supply-chain costs to the benefit of both suppliers and customers. •

Activity-Based Management: A cost management system tool

ABC systems not only develop more accurate costs, they also aid control of costs. Activity based management is using the output of an activity based cost accounting system to aid strategic decision making and to improve operational control of an organization. In the broadest terms, activity-based management aims to improve the value received by customers and to improve profits by identifying opportunities for improvements in strategy and operations.


 Value-added cost Value added cost is the cost of an activity that a company cannot eliminate without affecting a product’s value to the customer. Value-added costs are necessary s long as the activity that drives such costs is performed efficiently.  Non-value-added cost Companies try to minimize non-value-added costs in contrast to value-added costs. Non-value-added costs mean costs that a company can eliminate without affecting a product’s value to the customer. Activities such as storing and handling inventories, transporting partly finished products from one part of the plant to another, and changing the setup of production-line operations to produce a different model of the product are all non-value-adding activities. A company can rescue, if not eliminate, them by careful redesign of the plant layout and the production process.  Benchmarking Another ABC related technique that has gained popularity is benchmarking, the continuous process of comparing products, services, and activities to the best industry standards. Benchmarking is a tool to help an organization measure its competitive posture. Benchmarks can come from within the organization, from competing organizations, or from other organizations having similar processes. Companies must exercise caution when benchmarking, especially when using financial benchmarks. •

Benefits of activity-based costing and activity-based management

Activity-based costing systems are more complex and costly than traditional systems. So companies that have relatively simple operating systems may not realize sufficient benefits and thus may not want to use ABC systems. But more and more organizations in both manufacturing and non-manufacturing industries are adopting activity-based costing systems for a variety of reasons: 1. Fierce competitive pressure has resulted in shrinking profit margins. Companies may know their overall margin, but they often do not have confidence in the accuracy of the margins for individual products or services. Some are winners and some are losers. Accurate costs are essential for these purposes. 2. Greater diversity in the types of products and services as well as customer classes results in greater business operating complexity. Therefore, the consumption of a company’s shared resources also varies substantially across products and customers. 3. New production techniques have increased the proportion of indirect costs. That is indirect costs are far more important in today’s world-class manufacturing environment than they have been in the past. In many industries automated equipment is replacing direct labor. Indirect costs are sometimes more than 50% of total cost. 4. The rapid pace of technological change has shortened product life cycles. Hence, companies do not have time to make price or cost adjustments once they discover costing errors.


5. The rapid pace of technological change has shortened product life cycles. Hence, companies do not have time to make price or cost adjustments once they discover costing errors. 6. The cost, associated with bad decisions that result from inaccurate cost determinations are substantial. Examples include bids lost due to overcosted products, hidden losses from undercosted products, and failure to detect activities that are not cost effective companies with accurate costs have a huge advantage over those with inaccurate costs 7. Computer technology has reduced the costs of developing and operating ABC systems. •

An Activity-Based Costing Model:

Like most other ABC implementations, the new ABC system would supplement, rather than replace, the existing cost accounting system, which would continue to be used for external financial reports. The new ABC system would be used to prepare special reports for management decisions such as bidding on new business. In the above chart the accounting managers have shown the general model of ABC system. Cost objects such as products generate activities. For example, a customer order for a brass cup holder requires the activity of preparing a production order. Such an activity consumes resources. A production order uses a sheet of paper and takes time to fill out. And consumption of resources causes costs. The greater the number of sheets used to fill out production orders and the greater the amount of time devoted to filling out such orders, the greater the cost. Activity-based costing attempts to trace through these relationships to identify how products and customers affect costs. •

Design of an Activity-based cost accounting system

How do managers actually design ABC systems? A team of managers from the billing department and regional controller used the following four-step procedure to design their new cost accounting system: •

Step 1: Determine the Key Components of the Activity-Based Cost Accounting System:

They key components of an activity- based cost accounting system are cost objectives, key activities, resources, and related cost drivers. These components, together with the purpose of the new system, determine the scope of the ABC system. The system is –


a. Determine the billing department cost per account for each customer class in order to support the strategic decision regarding outsourcing accounts to the local service bureau, and b. Enhance the managers’ understanding of key billing department activities to support operational cost control. Because the bid from the local service bureau includes performing all the activities of the department, the ABC system must include all department cost. Further, because management wants to understand the key activities and related costs, the team designed an activity-based system. •

Step 2: Determine the relationships among cost objectives, activities, and resources:

An important phase of any activity-based analysis is identifying the relationships among key activities and the resources consumed. The management team does this by interviewing personnel and analyzing various internal data. Implementing an ABC system requires a careful study of operations. As a result, managers often discover that they can trace directly to cost objectives some previously indirect or even unallocated costs, thus improving the accuracy of product or service costs.

 Process maps: A process map is a schematic diagram with symbols that captures the inter-relationships between cost objects, activities, and resources. These maps can be efficient method to enhance managers’ understanding of operations. Many ABC teams find it useful to develop a process map. There are two examples following, which contain the basic concepts of drawing process maps. Let us assume that there is no way to physically trace the costs of resource A to activities 1 and 2, so we must use a cost driver to allocate the costs, making them indirect costs.


Similarly we must use cost drivers for the allocation of the costs of activities 2 and 3 to the products. In contrast, any resource cost that is used by only one activity (as for resources B and C) is direct with respect the activity cost that is required by only one product (as for activities 1 and 4). There is no ambiguity about which cost objective is responsible for these direct costs. A process map depicts in a concise manner the same information that was gathered from interviews. Process maps can be a key tool for managers to gain an understanding of operations. •

Step 3: Collect relevant data concerning costs and the physical flow of the cost-driver units among resources and activities:

Using the process map as a guide, the managers can collect the required cost and operational data by further interviews with relevant personnel. Sources of data may include the accounting records, special studies and sometimes best estimates of managers. They can collect resource cost information from the general ledger and data on the flow of cost drivers from various operational reports. •

Step 4: Calculate and Interpret the New Activity-Based Cost Information:

After collecting all required financial and operational data, we can calculate the new activity-based information. Traditional systems generally overcost high- volume cost objects with simple processes. Which system makes more sense- the traditional allocation system that “spreads” all support costs to customer classes based solely on the number of inquiries, or the activity-based costing system that identifies key activities and assign costs based on the consumption of units of cost drivers for each key activity can be measured from ABC systems. •

Steps for Implementing Activity-Based Costing:

Step 1: Identify and difine activities and activity cost pools:

The first major step in imolementing an ABC system is to identify the activities that will form the foundation for the system. A common procedure is for the individuals on the ABC imolementation team to interview people who work in overhead departments and ask themto describe their major activities. A useful way to think about activities and how to combine them is to organize them into five general levels: 1. Unit level activities:


These are performed each time a unit is produces. The costs of unit-level activities should be proportional to the number of units produced. For example, providing power to run processing equipment would be a unit-level activity since power tends to be consumed in proportion to the number of units produced. 2. Batch-level activities: These are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, tasks such as placing purchase orders, setting up equipment and arranging for shipments ot customers are batch-level activities. They are incurred once for each batch (or customer order). Costs at the batch level depend on the number of batches processed rather than on the number of units produced, the number of units sold, or other measures of volume. For example, the cost of setting up a machine for batch processing is the same regardless of whether the batch contains one or thousands of items. 3. Product-level activities: These are related to specific products and typically must be carried out regardless of how many batches are run or units of product are produced or sold. For example, activities such as designing a product, advertising a product, and maintaining a product manager and staff are all product-level activities. 4. Customer-level activities: These are related to specific customers and include activities such as sales calls, catalog mailings, and general technical support that are not tied to any specific product.

5. Organization-sustaining activities: These are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. This category includes activities such as heating the factory, cleaning executive offices, providing a computer network, arranging for loans, preparing annual reports to shareholders and so on. System of combining activities to ABC: Activities should be grouped together at the appropriate level while combining activities in an ABC system. Batch-level activities should not be combined with unit-level activities or product-level activities with batch-level activities and so on. In general, it is best to combine only those activities that are highly correlated with each other within a level. And it can only be possible when they tend to move in tandem. ď‚Š

Activity Cost Pool:

It is a bucket in which costs are accumulated that relate to a single activity measure in the ABC system. ď‚Š The Product Design Cost Pool:


The product design cost pool will be assigned all costs of resources consumed by designing products. The activity measure for this cost pool is the number of products designed. This is a product-level activity, since the amount of design work on a new product does not depend on the number of units ultimately.  Order Size Cost Pool: The order size cost pool will be assigned all costs of resources consumed as a consequence of the number of units produced, including the costs of miscellaneous factory supplies, power to run machines, and some equipment depreciation. This is unit-level activity since each unit requires some of these resources.  Customer Relations cost pool: The customer relations cost pool will be assigned all costs associated with maintaining relations with customers, including the costs of sales calls and the costs of entertaining customers.  Other cost pool: The other cost pool will be assigned all overhead costs that are not associated with customer orders, product design, the size of the orders, or customer relations. These costs mainly consist of organizationsustaining costs and the costs of unused, idle capacity. •

Step 2: Whenever possible, directly trace overhead costs to activities and cost objects:

The second step in implementing an ABC system is to directly trace as many overhead costs as possible to the ultimate cost objects. Let us assume, a company’s cost objects are products, customer orders and customers. In the ABC system at this company, all the annual manufacturing overhead and selling, general and administrative costs are considered to be overhead and will be assigned to cost objects where appropriate. •

Step 3: Assign costs to activity cost pools:

For example, if the ABC system has an activity called purchase order processing, then all of the costs of the purchasing department could probably be traced to that activity. To the extent possible, costs should be traced directly to be activity cost pools. But it is quite common for an overhead department to be involved in several of the activities that are tracked in the ABC system. In such situations, the costs of the department are divided among the activity cost pools via an allocation process called first-stage allocation. It is the process by which overhead costs are assigned to activity cost pools. The immediate problem is to figure out how to divide. The point of activity-based costing is to determine the resources consumed by cost objects. Soften, the best way to get this kind of information is to ask the people who are directly involved. Members of the ABC team may interview the workers related to the resources. Those who are interviewed must thoroughly understand what the activities encompass and what is expected of them in the interview. •

Step 4: Calculate Activity Rates

The next step is to calculate activity rates that will be used for assigning overhead costs to products and customers. The activity rates are computed by dividing the total cost for each activity by its total activity.


But the activity rates will not be computed for the other category of costs. This is because the other cost pool consists of organization-sustaining costs and costs of idle capacity that are not allocated to products and customers. •

Step 5: Assign costs to cost objects:

The fifth step in the implementation of activity-based costing is called second-stage allocation. In the second-stage allocation, activity rates are used to apply cots to products and customers. •

Step 6: Prepare Management Reports:

And the last step for implementing ABC system is to prepare a report showing activity-based costing margins from an activity view. Such customer analyses can be easily accomplished by adding together the product margins for each of the products a customer has ordered and then subtracting the average charge for customer relations. •

Managing Relationships:

Companies can transform unprofitable customers into profitable ones by persuading such customers to use a greater scope of the company’s products and services. The margins from increased purchases contribute to covering customer-sustaining costs. Let us consider a commercial bank with a basic entrylevel product: commercial loans. The interest spread on such loans-the difference between the bank’s effective borrowing rate and the rate it charges the customers-may be insufficient to cover the bank’s cost of making and sustaining the loan because of intense competition and the customer’s low use of the lending relationship. However, the bank may make enough profit on other services that the customer uses- for example, investment banking services and corporate money management-that in aggregate the customer is a highly profitable one. Alternatively, however, a small borrower who uses no other commercial banking or investment banking services may be quite unprofitable. In this case, the bank would ask the customer to expand its use of the loan facility, such as to borrow more, and use other and more profitable services offered by the bank’s services. If these efforts fail, the bank may then contemplate “firing” the customer by encouraging it to take its demands for a commercial loan to another institution.

Implementation issues:

Although activity-based costing has provided managers in many companies with valuable information about the cost of their activities, processes, products, services and customers, not all ABC systems have been sustained or have contributed to higher profitability for the company. Companies have experienced difficulties and frustrations in building and using activity-based cost and profitability models. Here are some pitfalls that have occurred and suggest ways to avoid them.

Lack of clear Business Purpose:


Often, the ABC project is initiated out of the finance or accounting department and is touted as “a more accurate cost system�. The project team gets resources for the project, builds an initial ABC model, and then becomes disappointed and disillusioned when no one else looks at or acts upon the new ABC cost and profitability information.

To avoid these problems, all ABC projects should be launched with a specific business purpose in mind, the purpose could be to redesign or improve processes, to influence product design decisions, to rationalize the product mix, or to better manage customer relationships. By defining the business purpose at the start, the team will identify the line manager or department whose behavior and decisions are expected to change as a consequence of the information. The decision maker could be the manufacturing or operations manager (for process improvement), the engineering manager (for product design decisions), the sales organization (for managing customer relationships), or the marketing department (for decisions about pricing and product mix).

Many ABC projects were aborted when they did not provide operating managers with frequent feedback on the costs and expenses under their responsibility. These operating managers needed a feedback system, in addition to the ABC system, that could be specifically designed for the purpose of providing operational feedback on process efficiencies. Some projects foundered because the company expected its new ABC system model to also be the basis for costing inventory for financial reporting. Such companies failed to realize that their traditional costing system already worked fine for external reporting and did not need to be replaced right away with the ABC system. Companies should allow some experimentation and flexibility with their first ABC system, customizing its design for maximum managerial benefits, before imposing the additional burden of also satisfying external, regulatory reporting.

For decisions about pricing, customer relationships and product mix, the ABC model should be simpler, using fewer than 50 activities and with data readily available for all the important activity cost drivers. A model intended for product designers and engineers should use activity cost drivers that would be meaningful to them. Drivers such as number of parts placements, number of unique parts and number of unique vendors are understandable and actionable to product designers.

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Lack of senior management commitment:

The most successful ABC projects occur when clear business purpose exists for building the ABC model and this purpose is led, or at least understood and fully supported by, senior line managers in the organization. A steering committee of senior managers from various functional groups and business units provides guidance and oversight, meeting monthly to review project progress, make suggestions on how to enhance the model, and prepare for the decisions that will be made once the model has been completed.


Even when the ABC project is initiated from the finance group, a multifunctional project team should be formed. The team should include, in addition to a management accountant or other finance group representative, members from operations, marketing/sales, engineering, and systems. In this way, the expertise from diverse groups can be incorporated into the model design and each team member can build support for the project within his or her department and group.

Delegating the project to consultants:

Some projects may fail when they were outsourced to an external consulting company. Constants may have considerable experience with ABC but not the needed familiarity with a company’s operations and business problems. Nor can they build management consensus and support within the organization either to make decisions with the ABC information or to maintain and update the model. The companies may use the software but it cannot provide the thinking required to build a cost effective ABC model. ABC consultants and ABC software can play valuable roles for many companies, but they are not substitutes for leadership and sponsorship and a dedicated, multifunctional internal project team. These functions cannot be bypassed just because external consultants and prepackaged software have also been purchased.

Poor ABC Model Design:

Sometimes, even with strong management support and sponsorship, the project team gets lost in the details and develops an ABC model that is both too complicated to build and maintain and too complex for managers to understand and act upon. ABC model design should be like any design or engineering project. It should be regularly evaluated, with continual appropriate trade-offs to enable the essential function of the system to be accomplished at minimal additional cost. If the ABC project team keeps endusers clearly in mind and gets good advice from its senior management steering committee, it should make good cost-effective design decisions along the way. These decisions can help avoid the problem of having an over complex system or misidentified casual relationships between cost objects (products and customers), activities and resources.

Individual and organizational resistance to change:

Not all managers welcome technically superior solutions. Individuals often resist new ideas and change and organizations have great inertia. The resistance to a new ABC model may not be overt. Managers can politely sit though an ABC presentation about product and customer profitability but continue to behave just as they have in the past. Or they will ask the project team to re-estimate the model, using a more recent period or at another company site. Sometimes, however, the resistance is more overt. Managers may exclaim the company has been successful in the past with its existing cost system. Or, if


it has been a finance-led project, they may accuse the finance people of not understanding the complexity of the business or wanting to run the company.

Activity Based Costing – Pros & Cons:

Pros: Identifies Non-Value Added Activities Identifies cost savings opportunities (untraceable costs) Provides very detailed cost/profitability information Differentiates complex versus simple processes More data can lead to more information = better decisions

Cons: Very costly to implement and maintain Historical in nature (same as traditional absorption costing) Detail versus Accuracy Discourages novel approach’s to processes Encourages activity Assumes equal and proportionate benefits result from common activity

Conclusion

ABC systems drive the cost of indirect and support resources-manufacturing resources in factories and marketing, selling, distribution and administrative resources-to the activities they perform and then to the cost objects-the products, services and customers- that generate the demand for the activities.

To develop an ABC model, management accountants should estimate activity cost driver rates using the practical capacity of the resources supplied. They should also make appropriate trade-offs in the design of the model, balancing the cost of more accurate measurement for more complex models, with the benefits from the greater accuracy. Managers use the information on activity costs to improve profitability. They can identify high-cost and inefficient processes that are prime candidates for operational improvements projects. By driving activity costs down to cost objects, managers identify


profitable and unprofitable products, services and customer. They can make better decisions on pricing, product mix, product design, customer and supplier relationships and technology that transforms unprofitable products and customers into profitable ones. These are examples of activity-based management in action.

Despite the apparent attraction of increased accuracy and managerial relevance from activity-based costing, individual and organizational resistance can arise to block the effective use of these systems. Management accountants must be sensitive to the conditions that cause such resistance to arise and devise good countermeasures to overcome them.

Cost volume profit analysis  

Activity-based costing is a costing method that is designed to provide managers with cost information for strategic and other decisions that...

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