Q. 156   Activity-based costing (ABC) is a way of accounting which identifies and assigns costs to overhead activities. These costs are in turn assigned to products. Cite examples where using such a way of accounting has clear advantages and cite examples where using this method creates complications.

 

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Advantages of ABC Analysis,

 

For example we consider a company manufacturing, Product A & Product B.

Product A,

Production volume: 19,000 units

Unit cost of direct materials and labor: ₹45

 

Product B,

Production volume: 11,000 units

Unit cost of direct materials and labor: ₹55

 

Manufacturing Overhead :

Total manufacturing overhead costs: ₹30000

Factory supervisor salaries: ₹80000

 

Further, as product B is more complex to manufacture and needs more attention, the company decides the salaries of the supervisor should be allocated with ₹30,000 to product A and ₹50,000 to product B.

 

Now if we use Full-costing allocation method, we get

Total cost of production for Product A: ₹55

Total cost of production for Product A: ₹65

 

Using ABC method,

Product A,

Allocation of factory supervisors: ₹30000/19000 = ₹1.6

Manufacturing overhead to be applied to total production volume: ₹2,20,000/30,000 = ₹7.3

Unit cost of manufacturing overhead: ₹1.6 + ₹7.3 = ₹8.9

Total unit cost of production: ₹45 + ₹8.9 = ₹53.9

 

Product B,

Allocation of factory supervisors: ₹50,000 /11,000 = ₹4.5

Manufacturing overhead to be applied to total production volume: ₹2,20,000/30,000 = ₹7.3

Unit cost of manufacturing overhead: ₹7.3 + ₹4.5 = ₹11.8

Total unit cost of production: ₹55 + ₹11.8 = ₹66.8

 

• This proves that, ABC analysis shows that the total cost of production for product A is actually ₹53.9 per unit, not ₹55 as originally calculated. Product B costs ₹66.8 instead of the previous ₹65.
• These variations in prices of production have implications for profit forecasting, production planning and budget for marketing campaigns.

Instances where ABC Analysis will create complications,

 

• When we take the above example with only one product or overheads are relatively small or no allocation done on supervisory salaries based on product's complexity, there is no need of ABC Analysis.
• When the product range is large, cost accumulation and data collection are complex and requires an advanced cost recording system and properly trained staffs.
• When it is difficult to assign cost to different activities.

 

Benchmark Six Sigma Expert View by Venugopal R

 

Any organization that deals with multiple product lines or services will have activities and expenses that are highly specific to the product lines or service verticals. There would also be many activities and expenses that are considered more in general and applies across the organization. Examples of such activities that are applicable across the organization are Administration, Infrastructure, Employee welfare related, Communication and IT, Energy consumption, Dealing with regulatory bodies and so on.. The method of costing that finds ways of allocating the ‘overhead’ expenses to functions, products or services is known as Activity Based Costing (ABC).

 

Activity Based Costing will invoke more responsibility and cost consciousness within each function. Each function knows that they are being monitored for the share of ‘common’ expenditure related to them.

 

From a Lean Six Sigma perspective, this helps in allocating 'base line costs' and 'post-project' cost benefits more specifically. For instance, there is an efficiency improvement project taken up by a testing laboratory within a factory, and one of the components of cost saving is the energy consumption.  ABC will help to track whether there is reduction in energy consumption by the testing laboratory after the project is implemented. Another example could be a project where the ‘Learning & Development’ department brings out innovative training methods and one of the benefits is to reduce need for employees to travel from distant locations to attend training programs. If the ABC allocates the portion of travel costs associated with the training to Learning & Development department, the related savings associated to their project can be quantified objectively.

 

While the ABC has many benefits, it does pose certain challenges as well. One example is where ABC is used to allocate the costs for a "Enterprise Business Excellence Program" to every function. Sometimes, when the Business Excellence team tries to drive certain initiatives, some functions may show resistance, since they become overtly cost conscious and may not even envision the long term organizational benefit due to such initiatives. This will require good conviction building to gain acceptance. Some organizations maintain the costs for such company-wide programs as part of the "corporate cost head", so that the individual functions cannot debate on such programs in the name of their P&L getting impacted.

 

There could be certain expenses, where it would be practically difficult to do the ABC. For example, if an organization has multiple floors, it may be difficult to allocate the expenses for running and maintaining the elevators across functions, products or services!

 

Overall, Activity Based Costing is a very useful methodology and may be applied with prudence as per the tolerance of the organization

Activity Based Costing (ABC) is a method for assigning costs to the products or services or projects on the basis of activities that go in them and resources consumed by these activities.

 

ABC has following benefits.

1. Identify specific products or service (basically line item) that is unprofitable.
2. Improve process efficiency by targeting specific area.
3. Allocating right price with the help of accurate product cost information.
4. Find the unnecessary cost and eliminate them

However, on some instances, ABC may create complications, like.

1. Requires substantial resources and can become complicated.
2. ABC can be misinterpreted and thus may results in entirely wrong cost allocation.
3. These reports do not conform to GAAP.

 

Activity based costing is extremely helpful and essential costing technique for effectuating the Top down decision making in Strategic and Operational cases. By offering an opportunities to allocate costs in direct proportion to the activities being performed it helps to develop powerful cost centers in an organisation in layered format ,,say Facilities sustaining activities,Product sustaining activities, Batch level activities and unit level activities.

 

With above advantages these techniques are highly beneficial in industries where higher transactions are happening at different levels in direct and indirect cost components. industries like Pharma, consumer goods and automobiles are the sectors where there are huge burden on overheads reduction ,if not the elimination for cost cutting.Using ABC Techniques help to channelize and prioritize the cost centers for focus and carrying out cost related maidens.

 

However in sectors like  sales and marketing ,after sales service,it might seem complicated coz of lack if organized and structured costing modules.

It becomes slightly difficult to have an organised cost centers in these sectors and hence ABC techniques might not be practical.

The chosen best answer is that of Sreyash. Do read through each of the answers as every answer has a piece of information to offer. 

 

For Benchmark Expert view, please read Venugopal's answer.