CASE STUDY: ACTIVITY-BASED-COSTING
The main purpose of any Costing Accounting System is to ascertain “True Cost" of a Product. If a company is making only one product, its true cost is the same as shown in the Profit & Loss account. Matter gets complicated as one deals with more than one product.
There are various accounting systems which have been developed over time. Product Cost would be different under different systems. Under "Traditional Cost Accounting" (TCA), only Manufacturing Costs are considered as Product Costs. On the other hand, "Activity Based Costing" (ABC) would add up Manufacturing costs and Selling, General & Administrative Expenses (SG&A) for the same purpose. Economic Value Added (EVA) only considers Cost of Funds provided by banks, bond-holders and owners. As such, ABC & EVA combined would embrace all costs.
The side chart shows cost classifications. Under TCA, the Cost of Production would be Rs.6,000 while in ABC the same would be Rs.7,500. As would be explained later, ABC is more near to "True Cost" and results in better decisions.
To keep it simple, this paper would concentrate only on ABC for a non-accounting person. Also, no difference would be made in Cost and Expense and all expenditure would be treated as Cost.
A TASTE OF ABC
A company was engaged in fabrication of steel parts in two categories: large parts and small parts. A sum of Rs.612,000 was incurred over repair, maintenance and depreciation of carts used for internal movements of these parts. Since both parts were fabricated in equal quantity, the cost was distributed equally.
While traditional accounts looks for apparent cause and effect relationship, ABC goes much deeper and finds out who is the real beneficiary of cost incurred. A study revealed that each small part required five internal movements while large parts required 20 internal movements. Further, a standard cart could carry 120 small parts or 30 large parts.
With this information, we can work out overall movements of carts and distribute the cost accordingly as shown below:
It would be observed that under TCA, small parts were being over-charged which would certainly reduce their profitability and the company might consider dropping their fabrication.
HOW ABC WORKS
Under ABC, the cost incurred is first assigned to activities performed and then the cost of those activities is charged to the products on the basis of their usage.
Ascertaining cost of each activity is a real challenge and a multiple approach is adopted for this purpose such as:
- Direct tracing cost to a particular product
- Cause and Effect Relationship
- Time and Motion study for ascertaining cost of an activity.
Suppose a small bank has an Administration Department which serves two main departments i.e. Investment Department and Loan Department. Traditionally, all costs incurred in Admn Dep’t are distributed between the beneficiaries according to number of employees.
Almost all companies keep operational statistics. Necessary figures are available about the activities performed. The only problem is finding out cost of each activity. This can be done through using a spread sheet.
Now we need to find out cost of each activity. This would be ascertained on the following basis:
A study was conducted to find out cost per job. It was observed that, in terms of rupees, staff and computer time was Rs.2,000 and Rs.1,500 respectively per job.
Some expenses were directly traced as under:
- Staff salaries included a sum of Rs.30,000 for court cases.
- Time Sheet shows that a sum of Rs.10,000 was due to computer time spent in record keeping.
The building area occupied by the staff in various activities was estimated as under:
- Recruitment 25%
- Court Cases 15%
- Record Keeping 60%
The misc. expanses can be distributed equally among these three activities.
Since we have Department-wise data on all activities, we can now distribute the cost on the basis activities consumed by each Department. This would show that Loan Department was charged 90% of total costs whereas its true share was only 28%. When performance awards are distributed, staff of Loan Department may suffer only because of unjustified cost-allocation by the Accounts Department.
This shown below:
Apart from finding cost of activities, ABC uses multiple Cost Drivers. The activities are divided into four categories as shown below:
- UNIT LEVEL: This is a volume related driver. If each student is given a set of book or a laptop, the cost would increase accordingly. In our case, admission and examination records are the same for each student. Therefore, Admn. & Staff Salaries would be distributed on the basis of number of students. (No difference from traditional basis).
- BATCH LEVEL: Batch level drivers are triggered for every batch produced. A teacher salary would remain whether he is teaching to 10 student or 100 students. It is in nature of step-variable cost. Since in MSc students per class are only 15 as against 45 in MBA, it should be given weight in allocation. (Of course, teachers in MBA are different from those in MSc but for the sake of simplicity, they are being treated as common or no records were kept separately.
- PRODUCT LEVEL: Here number of units or batches is of no consideration. The cost is applicable to entire product line or range. The consultants were asked to develop course contents for a particular subject and therefore the cost be charged to that subject alone.
- FACTILITY LEVEL: It includes library, canteen, laboratories, games and recreational facilities. These are used by the students irrespective of their subjects. So long as the students are required to remain in the campus as per their time-tables, they would use all facilities. Therefore number of students per program is used. This is under ‘cause and effect relationship’.
Their usage would be explained with the following example.
Under TCA, cost allocation in case of MSc students was Rs.12,057(,000) as against Rs.22,464(,000) as per ABC, the difference being Rs.10,406(,000). If we divide the difference with the number of students in MSc, we would know that each student was being lesser-charged to the extent of Rs.43,359. In other words, if number of MSc increases, each student would cause a cash out-flow the same amount. On the other hand, MBA Students were being over-charged and if they start leaving, the institute would collapse.
For a judicious cost allocation, one may treat Staff Salaries at Unit Level, teacher salaries at Batch Level, Consultant Fee at Product Level and Services at Facility Level. In this way, the cost-allocation would be entirely different and may give us a clue for loss despite increase in number of students.
More by this Author
Continued from: Types of Research Hypothetico is derived from the term "hypothetical" which means academic, contestable, contingent, disputable, imaginary, questionable, refutable, theoretical and...
Continued from: Theoretical framework and hypothesis development Research design is a roadmap for researchers. It is step by step approach. Research design is prepared keeping in view some basic questions like...
A financial market is a place for buying and selling of financial securities such as stocks and bonds. It facilitates: The raising of capital (in the capital markets) The transfer of risk (in the derivatives...