Activity Based Costing

Meaning 

 Activity-based costing (ABC) is a new and scientific approach developed by Cooper and Kaplan (1988) for assigning overhead to end products, jobs, and processes. It aims to rectify the problems of inaccurate cost information due to the selection of wrong bases of indirect cost apportionment. In the words of Kooper and Kaplan "ABC system calculate the cost of individual activities and assigned cost to cost object such asproduct and services on the basis of activites undertaken to produce eachprodct or service" 

According to CIMA, London, Activity Based Costing is " Cost attribution to cost units on the basis of benefits received from indirect activities ie ordering, setting, assuring quality, etc.

Activity-based costing is not an alternative to Job Costing or Process Costing. Rather it is a modern tool of charging overhead costs in which costs are first traced to activities and then to product or job thus activities become the focal point for cost computation. 

Step in Activity Based Costing 

The following are the steps in activity-based cost allocation 

1. Identification of the main activities- 

first of all, all major activities in the organization are identified. The number of activities in an organization should neither be too large or too small.

2. Creation of cost pool 

A cost pool is the grouping of individual cost items. A cost pool or cost bucket should be created for each activity. a cost pool is like a cost center around which costs are accumulated e.g the total cost of machine setups might constitute one cost pool for all set up related costs. 

3. Determination of the activity cost driver 

The factor that influences the cost of a particular activity is known as the activity cost driver. In other words, cost drivers signify the factors or events that determine the cost of an activity. eg cost drivers as given above are number of machine setups, number of purchases orders.  

4. Calculation of the activity cost driver rate  

Just as an overhead absorption rate calculated in a traditional costing system in ABC, the activity cost driver rate is calculated as follows-

Activity cost driver =  total cost of an activity 

                                    ___________________

                                     Cost Driver 

5. Charging cost of activities to product 

the cost of activities is traced to the product on the basis of demand by product. The cost driver is used to measure the product demand of activities. e.g the total cost allocated to the cost center for machine setup related costs are Rs 50,000/- and that there were 100 setups during the period thus the rate per set up is Rs 50000/100= 500 

if a particular product needs 10 setups,  charge to that product will be Rs 5000. if 20 units of the product are produced,  cost per unit will be Rs 5000/20 = 250. In this way cost of other activities  also will be charged to product. 

Advantages of Activity Based Costing   

ABC is  being implemented by a growing number of companies around the world 

1. Accurate and reliable - ABC  is a more accurate and reliable system of determination of product cost as it is based on cause and effect relationships. 

2. Better pricing decision - It helps in overcoming the problem of overcasting and under costing. 

3. Realistic- This method is more realistic because the distribution of overhead based on activity-based costing is an objective approach It may be recalled that traditional costing uses a more arbitrary base for apportionment of overhead and is a subjective approach. 

4. Control of cost -  ABC produces more meaningful information regarding cost behavior and helps management to control many fixed overheads by exercising more control over those activities which caused this fixed overhead.

5. Greater cost-efficiency-  and helps to identify unnecessary activities so that these may be weeded out and thus achieving greater cost efficiency.  

Dr. Sucheta Dalvi 

T J College, Khadki,Pune 

Elements of Cost

 

Unit -2

Elements of cost

 

       Direct Material

Direct materials are those which can be identified in the product and can be measured. They can also be charged to the products directly. Thus direct materials directly enter the product and they form part of the finished product.  Eg. Cloth in a garment, Leather in shoe-making, timber in furniture, fruits in the food processing industry.

Indirect Material

Indirect materials are those materials that do not form a part of the finished product. It is defined as “materials which cannot be allocated, but which can be apportioned to or absorbed by cost centers or cost units. For example, lubricants oils, cotton wastes, small tools, etc. but sometimes the cost of small items like the nail in furniture or thread in the dress manufacturing are treated as indirect material though they go directly into production.

Direct Wages

Direct labor is that labor can be easily identified with and allocated directly to a particular job, product, process, e.g wages paid to workers working on a machine that manufactures toys. Thus direct labor is utilized for converting the raw materials into a finished product.  The wages paid to such workers are known as direct wages.

Indirect Wages

The wages which cannot be charged directly to production are known as indirect wages. Thus the wages which cannot be allocated but which can be apportioned to or absorbed by cost centers or cost units is known as indirect labor. Example- salaries and wages to foremen, supervisors, charge men, inspectors, maintenance workers clerical staff working in the production department, overtime, and night shift allowance paid.  

Direct Expenses

Direct expenses include all types of expenses other than direct materials, direct labor, which are incurred specifically for a particular product or process. Direct expenses form a part of the Prime Cost.

Examples-

Cost of drawings and patterns

Repairs and maintenance of plants and machinery

Architect’s fees

 Research fees or expenditure

Excise duty paid

Royalty paid

Indirect Expenses

The expenses which are neither indirect material nor indirect labor are known as indirect expenses. These expenses are not charged directly to production.

Examples –

Rent, rates, taxes, salary to staff, general manager salary, canteen expenses, telephone expenses, lighting expenses, power fuel

 

Overheads

Definition - ICMA defines overhead as ‘total of indirect material, indirect wages and indirect expenses.

1) Factory Overhead – factory overhead includes all overhead the cost incurred from the stage of procurement of material till the completion of the finished product but excludes the expenses on administration, selling and distribution.

Rent, rates, and dep. of factory building

Insurance of factory building

Salary of foremen, time-keeper, works manager

Fuel, power, coal

 Facto y lighting heating,

Welfare expenses, canteen exp, telephone charges of factory

2) Administrative Overheads

This overhead includes the expenses of managerial functions of direction, planning, and controlling the operation of business, other than selling and distribution, research, and development.

For example- office rent, office salary

Printing and stationery, lighting, telephone charges of office

Audit fees

Director’s fees

Legal expenses

Bank charges 

3) Selling and Distribution

Selling expenses include the expenses in promoting sales and retaining customers

Advertisement, market research

Salaries and commission of salesman and selling agents

Traveling expenses of salespeople

Salary, telephone, printing and stationary of the sales department

Cost of free samples

4) Distribution Overhead

The expenses related to the delivery of sold goods to customers fall under this group –

Cost of secondary packing

Carriage outward and transport charges

Warehouse rent, depreciation of warehouse and repairs

Salary of warehouse staff

Repairing of empties

Expenses of warehouse van, trucks, etc.

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Process Costing

                                                               

Meaning

Process Costing is a method of costing under which all costs are accumulated for each stage of production and cost per unit of product is ascertained by dividing the total cost of each process by the normal output of that process.

Definition-

i) According to ICMA, London Process Costing is “that form of operation costing which applies where standardized goods are produced”

ii) Kohler defines Process Costing as “a method of costing whereby costs are charged to processes or operations and averaged over units produced”.

Applicability –

It is suitable for

1. Cotton, wool jute textile mill

2. Sugar Industry

3. Food processing Industry

4. Cement industry

5. Chemical plants

6. Mining industries such as coal and oil 

Features of Process Costing

1.      Each plant is divided into a number of process cost centers or departments.

2.      Output of one process becomes the input of the next process.

3.      It is not possible to distinguish finished products while they are in the stage of processing.

4.      Cost incurred in the earlier process are transferred to the later process along with the output

5.      Each process is treated as a separate cost center.

6.      Under process costing method every process is treated as a cost unit.

7.      Total cost of the finished product in the last process is cumulative i.e.  It comprises of costs of all processes.

8.      The cost of normal loss is included in the cost of the total units produced.

9.      Due to continuous nature of production, work in progress is a regular feature of process costing 

10.  Production of one article may give rise to two or more by-products or joint products.

11.  The finished products are homogeneous in all respect such as shape, size, color, weight etc

 

Process Loss

Process Losses and wastages are usually of two types viz. Normal Process Loss and Abnormal Process Loss.

The term process loss may be defined as “the difference between the input quantity of raw material and the output quantity.

ICMA defines ‘waste and scrap from the recovery point of view as follows-

Waste: “Discarded substances having no value”.

Scrap:  Discarded material having some recovery value which is usually disposed of without further treatment or re-introduced into the production process in the place of raw material”

Normal Loss:

Normal loss is the loss which is expected under normal conditions

Because of nature of the raw material, some loss is inherent and unavoidable. This is known as normal wastage or normal loss.

 Features-

1. Normal loss is unavoidable.

2. Normal loss arises under efficient operating conditions.

3. Normal loss consists of losses that are inherent in the production process.

4. It is caused by the factors such as evaporation, chemical change, and withdrawals for test or testing, unavoidable spoilage, due to the nature of raw material    

5. Normal loss can be estimated in advance

6. Normal loss is recorded in terms of quantity.

7. Normal loss is generally calculated at a certain percentage of the input of units introduced in the respective process.

8. The normal loss cost is borne by the good units produced.

Accounting treatment of normal loss

The units of normal loss are recorded on the credit side of a process account in the quantity column only. The value of the normal loss, if any, should be included in the amount column on the credit side of the process account as a realizable value. This reduces the cost of normal output.

Example 1 (Normal loss without scrap value)

The cost of production of 40 units consisting of material Rs 1500; labor Rs 1300 and overhead Rs 164 the normal waste is 5% of input.  Show process Account

Process Account

	Units	Amount		Units	Amount
To material To Labour  To overhead	40     40	1500 1300 164 2964	By normal loss By Final product @ Rs 78	2   38 40	-   2964 2964

 

Per Unit Rate = 2964 

                         (40-2)

= Rs 78

 

Example 2 (Normal loss with scrap value)

Material (200 units)          Rs 4000

Labour                               Rs 3000

Indirect Expenses              Rs 2000

Normal wastage is 5% of the input. One unit of wastage is sold at Rs 16.50. Prepare Process Account.

Process Account

	units	Amount		Units	Amount
To material To labor To indirect expenses	200         200	4000 3000 2000     9000	By normal loss By Next process Rs 46.50	10   190     200	165   8835     9000

 

When the normal wastage has a scrap value, good unit rate is calculated as follows

Rs 9000-165=8835

8835/190=46.50

Abnormal Loss

 Any loss exceeding the normal loss is called abnormal loss. Where the loss is caused by unexpected or abnormal conditions and if it is beyond the limit, it is called an abnormal loss. eg use of defective material, carelessness, fire, machine breakdown, power failure, strike, accidents, natural calamities like floods, fire, cyclone, etc.

Features   

1. Abnormal loss is avoidable.

2. It can be controlled by management action.

3. The difference between normal output and actual output is termed abnormal loss

4. Abnormal loss is valued just like good units and transferred to separate an account called abnormal loss   

Accounting Treatment of Abnormal Loss

The amount of abnormal loss is credited to a process account. A separate Abnormal Loss Account is opened and scraps value, if any, is credited to Abnormal Loss Account and balance on it transferred to costing profit loss Account.

Value of Abnormal Loss is calculated as follows –

Step 1. Cost per unit =    Normal cost of Normal Output                                                                                                                

Normal Output     

 

Step 2.        Value of Abnormal Loss = Cost P U × unit of Abnormal loss

 

·         Normal Output = Input – Normal Loss

·         Normal Cost   = Total Process Cost – scrap value of Normal loss if any    

 

Normal Loss and abnormal loss with no scrap value

Prepare Process Account from the following

Material issued 1000 kg @ Rs 125

Wages       Rs 28000

Overheads Rs 8000

Normal loss 5% of input

Output 900 kg          

Process Account

	Units	Amount		Units	Amount
To material To wages To overheads	1000 (input)       1000	1,25,000 28,000 8000     1,61,000	By normal loss(5% of Input ) By Abnormal loss By Next Process c.p.u = 169.47	50   50 900   1000	----   8474 1,52,526   1,61,000

 

 

Note – Normal output = 1000 kg -50 kg = 950 kg

Actual Output = 900 units

Unit of Normal Loss = 5% of 1000 =50 kg

Unit of abnormal loss = normal output – actual output

                                                950kg -900 kg

                                                = 50 kg

Normal cost of Normal output = 1, 61,000-nil = 1, 61,000

Cost per unit = 161000/950= 169.47

Value of abnormal loss= unit of abnormal loss × cost per unit

Amount of Good units = actual output × cost per unit

                                                900× 169.47= 1, 52,526