Activity Based Costing in Gem and Jewellery Industry

Transcription

1 Chapter-5 Activity Based Costing in Gem and Jewellery Industry Introduction Activity Based Costing Introduction of Traditional Costing System Traditional Product Costing System Traditional Costing System at Companies under Study Surana Jewellers Classic Diamonds Gitanjali Gems Vaibhav Gems Rajesh Exports Test of Significance for average Cost Per Unit Importance of Activity Based Costing to Manufacturing Organization Advantages of an Activity Based Costing System Disadvantages and Limitation of Activity Based Costing System

2 205 INTRODUCTION A costing system should provide information to help minimize waste but should not be wasteful in itself. In other words, the resources required to design implements and maintain a costing system should be less than the benefit derived from the uses of the system. Costing system are information system. They required specific type of information such as direct labour hours and unit produced to be that product costs and other information are determined according to the specific costing system defined methodology. The results, obtained would depend on the costing system used, since the same input data could be used in different ways. ACTIVITY BASED COSTING Activity Based Costing (ABC) is that costing in which costs are traced first to activities and then to product. ABC is a method for estimating cost for specific activities in the organization. ABC is helpful to think in terms of sub-division of a project into a quantifiable activities. The activity needs to be definable where productivity can be measured in units. As the project is segmented into its activities, a cost estimate is typically prepared for each activity. Each cost estimate is added to the others to produce an overall cost estimate for the entire project. ABC is a system in which staff timings and costs are produced by breaking down each activity into its constituents parts to determine the work effort required Armitage H.M. and Nicholson R. (2013), Activity based costing: a survey of Canadian practice, Issue Paper No.3, Society of Management Accountants of Canada, pp

3 206 ABC is being implemented by a growing number of companies around the globe. Specific ABC applications vary from organisation to organisation. Few organisations use ABC as basic, ongoing cost accounting system. The assumptions of activity based costing are entirely different from that of conventional costing systems. The conventional costing system assumes that products cause costs. Activity based costing systems have activities as the fundamental cost objects. Activity based costing systems also assumes that activities cause costs and that cost objects create the demand for activities. 2 Activity based costing is a different approach and improves control of overheads by a cost/cause relationship, that are activity and cost. The system is flexible enough to relate costs to customers, processors, management responsibility and not just products. As the name suggests, activity based costing is a system that focuses on activities as the basic cost objects and uses the costs of these activities as building blocks for compiling the costs of other cost objects. The use of an activity based costing system can also help a company to develop a way to analyze and justify manufacturing cycle-time improvements. 2. Berliner C. and Brimson J.A. (1998), Cost Management for Today s Advanced Manufacturing, Harvard Business School Press, p.43.

4 207 When applied correctly activity based costing will diminish the issue of cost distortion by forming a cost pool for each activity that can be isolated as a cost driver. In an activity based costing system, overhead costs are assigned to a large number of cost pools that represent the most significant activities involved in the production process. It is also true that activity based costing system utilizes several indirect cost pools because to the many activity areas. 3 INTRODUCTION OF TRADITIONAL COSTING SYSTEM It is a well-known fact that the traditional costing systems utilize a single, volume-based cost driver. This is the reason why the traditional product costing system distorts the cost of products. In most cases, this type of costing system assigns the overhead costs to products on the basis of their relative usage of direct labour. For this reason traditional cost systems often report inaccurate product costs. The problem is in the methodology of the traditional costing systems. They adhere to the assumption that products cause cost. Each time a unit of product is manufactured, it is assumption that cost is incurred. This assumption makes sense for certain direct costs. The assumption does not work for activities that are not performed directly on the product units. The problem with this approach is that for most overhead activities, the proportion of the activity actually consumed by a specific product, 3. Armitage H.M. and Nicholson R., op.cit., p.18.

5 208 does not universally correspond with single cost driver. This hold true for most modern companies where products are produced by a combination of manpower and technology. The traditional cost accounting model employs a volume-based driver, such as direct labour hours or machine hours for the assignment of all manufacturing overhead costs. The conventional cost accounting model ends up with a cost of goods sold based on absorption costing and includes only product costs as defined in financial accounting. Fundamentally, traditional costing systems try to assign cost directly to products, rather than to activities first and then from the activities to product units. The typical cost report gives information on what is spent, but not why it is spent. When overhead costs are cut in order to reduce total costs it is the symptoms that are treated arid not the cause. In many cases the cutting of overheads is more likely to lead to a reduction in the quality of the products than to the long term reduction of the cost. The separation of traceable and fixed cost is crucial when doing segmented reporting of costs. This is important, since traceable fixed costs are booked to departments while common fixed costs are pooled in the traditional costing system approach. The guidelines suggested for using the traditional approach is to use a broad, general guideline in determining which costs are traceable. This approach has obvious inherent inaccuracies Drury C. and Tayles M. (1994), Product costing in UK manufacturing organisations, The European Accounting Review, 3(3),

6 209 The traditional approach to costing of products fundamentally utilize a system whereby the total costs to produce a number of products are divided amongst the various products. By making use of the traditional costing system, it thus means that all the costs incurred have to be allocated to one or other product. TRADITIONAL PRODUCT COSTING SYSTEM Traditional costing system distorts the cost of products because it utilizes a single, volume-based cost driver. Thus, traditional cost systems often report inaccurate product costs because this type of costing system assigns the overhead costs to products on the basis of their relative usage of direct labour, most of the times. The traditional cost accounting model employs a volume-based driver, such as direct labour hours or machine hours for the assignment of all manufacturing overhead costs. The conventional cost accounting model ends up with a cost of goods sold based on absorption costing and includes only product costs as defined in financial accounting. Fundamentally, traditional costing systems try to assign cost directly to products, rather than to activities first and then from the activities to product units. When overhead costs are cut in order to reduce total costs it is the symptoms that are treated and not the cause. In many cases the cutting of overheads is more likely to lead to a reduction in the quality of the products than to the long term reduction of the cost. The separation of traceable and fixed cost is crucial when doing segmented reporting of

7 210 costs. This is important, since traceable fixed costs are booked to departments while common fixed costs are pooled in the traditional costing system approach. The guidelines suggested for using the traditional approach is to use a broad, general guideline in determining which costs are traceable. This approach has obvious inherent inaccuracies. The traditional costing systems only have one or a few indirect cost pools for each department or whole plant. The application of costs in the traditional costing system is normally based on an indirect cost driver and that the indirect cost applications are often financially based. The traditional approach to costing of products fundamentally utilize a system whereby the total costs to produce a number of products are divided amongst the various products. By making use of the traditional costing system, it thus means that all the costs incurred have to be allocated to one or other product. 5 TRADITIONAL COSTING SYSTEM AT COMPANIES UNDER STUDY Surana Jewellers Copration Ltd The results in Table 5.1 summarize the traditional costing system for products manufactured at Surana Jewellers during the last five financial years using the traditional costing system. It can be observed that the direct material cost is the main cost for this company. 5. Kaplan R.S. and Cooper R. (1998), Cost and Effect: Using Integrated Systems to Drive Profitability and Performance, Harvard Business School Press, p

8 211 Table 5.1 Traditional Product Costing System at Surana Jewellers (From to ) (Rs. in lacs) Particulars Direct Material Cost 1,58,527 2,20,631 3,93,861 5,18,424 8,50,190 Direct Labour Expenses Manufacturing Overheads Total Cost Assigned to Products Number of Units Produced (1Unit = 100 gms) ,58,743 2,20,909 3,94,184 5,18,817 8,50, Cost Per Unit Source: Annual Reports and Accounts of the Company from to Table 5.1 shows that direct material cost had an increasing trend throughout the period under study. It was Rs lacs in which increased continuously as Rs. 220,631 lacs in , Rs. 393,861 lacs in , Rs. 518,424 lacs in and reached up to Rs. 850,190 lacs in the final year Direct Labour Expenses also have continuously increased trend. Initially, in the year , these expenses amounted Rs. 158 lacs which reached to Rs. 253 lacs in , Rs. 280 lacs in , Rs. 357 lacs in and up to Rs. 374 lacs in Manufacturing Overheads for Surana Jewellers showed a fluctuating trend during the study period. In , the amount of manufacturing expenses was Rs. 58 lacs which came down sharply to Rs. 25 lacs in , then increased to Rs. 43 lacs in but again decreased to Rs. 36 lacs in Finally, it increased and

9 212 climbed up to Rs. 139 lacs in the year From this analysis, it seems that manufacturing was not consistent during the period under study. Total Cost Assigned to Products had an increasing trend during the period under study. It was Rs. 158,743 lacs in which increased to Rs. 220,909 lacs in , Rs. 394,184 lacs in , Rs. 518,817 lacs in and reached to Rs. 850,703 lacs in The total cost increased as per the increase in production but during , the production decreased but the total cost increased which denotes inefficiency of management. Number of units produced by the firm also had an increasing trend except in the year In the year , units were produced. This number increased to in and reached to in In , it came down slightly to but increased up to in the final year The cost per unit had an increasing trend from Rs lacs in , it reached up to Rs lacs in Classic Diamonds (India) Limited The results in Table 5.2 summarize the traditional costing system for products manufactured at Classic Diamonds (India) Limited during the last five financial years using the traditional product costing system. It can be observed that the main cost in a jewellery firm is material cost, other expenses are negligible.

10 213 Table 5.2 Traditional Product Costing System at Classic Diamonds (From to ) (Rs. in lacs) Particulars Direct Material Cost 56,382 54,489 58,070 44,335 20,793 Direct Labour Expenses Manufacturing Overheads Total Cost Assigned to Products Number of Units Produced (1Unit = 100 gms) ,123 57,652 60,142 45,461 21, Cost Per Unit Source: Annual Reports and Accounts of the Company from to Table 5.2 shows that direct material cost had a decreasing trend during the period under study except in the year It was Rs lacs in which decreased to Rs lacs in but increased to Rs lacs (maximum) in Then, it came down to Rs lacs in and declined up to Rs lacs (minimum) in the final year Direct labour expenses also had decreasing trend except in the year Initially, in the year , these expenses amounted Rs lacs (maximum) which decreased to Rs lacs in but increased to Rs lacs in Then it decreased sharply to Rs lacs in and came down further to Rs. 423 lacs (minimum) in

11 214 Manufacturing overheads for Classic Diamonds showed a sharp decreasing trend during the study period. In , the amount of manufacturing expenses was Rs lacs (maximum) which came down sharply to Rs lacs in , Rs. 219 lacs in , Rs. 101 lacs in Finally, it decreased up to Rs. 35 lacs (minimum) in the year From this analysis, it seems that manufacturing was decreasing continuously which indicate the decrement in business. Total cost assigned to products also shown decreasing trend except in the year It was Rs lacs in which decreased to Rs lacs in , then increased to Rs lacs in , but again decreased to Rs lacs in and came down further to Rs lacs in The decreasing trend was mainly because of decreasing trend of the production. Number of units produced by the firm also had a decreasing trend. In the year , units (highest) were produced. This number decreased to in , in , in , and came down to 6999 units (lowest) in the year To increase the production, the firm should try to increase demand by extensive sales promotion schemes. The cost per unit for Classic Diamonds had an increasing trend. Starting from Rs lacs in , it increased to Rs lacs in , Rs lacs in , Rs lacs in and finally reached to 3.04 lacs in

12 215 Gitanjali Gems The results in Table 5.3 summarize the traditional costing system for products manufactured at Gitanjali Gems Limited during the last five financial years using the traditional product costing system. Table 5.3 Traditional Product Costing System at Gitanjali Gems Ltd (From to ) (Rs. in lacs) Particulars Direct Material Cost 2,34,542 2,37,679 2,99,537 4,55,529 6,99,107 Direct Labour Expenses 1,163 1,580 1,505 2,480 2,651 Manufacturing Overheads Total Cost Assigned to Products Number of Units Produced (1Unit = 100 gms) 8,134 5,408 6,961 13,805 17,618 2,43,839 2,44,667 3,08,003 4,71,814 7,19, Cost Per Unit Source: Annual Reports and Accounts of the Company from to Table 5.3 shows that direct material cost had a continuously increasing trend throughout the period under study. It was Rs. 234,542 lacs in which increased to Rs. 237,679 lacs in , Rs. 299,537 lacs in , Rs. 455,529 lacs in and rose up to Rs. 699,107 lacs in the final year Direct labour expenses have increasing trend during almost entire period which indicate that manufacturing was increasing which indicate the improvement in business. The manufacturing overheads showed an increasing trend except in the year and Total cost assigned to products shows an increasing trend continuously. It was Rs. 2,43,839 lacs in which increased to

13 216 Rs. 2,44,667 lacs in , Rs. 3,08,003 lacs in , Rs. 4,71,814 lacs in and reached up to Rs. 7,19,376 lacs in Number of units produced by the firm also had an increasing trend except in the year In the year , units were produced. This number decreased to units (lowest) in , which then increased to units in , units in and finally reached to units (highest) in the year The cost per unit had an increasing trend from Rs lacs in , it reached up to Rs lacs in Vaibhav Gems The results in Table 5.4 summarize the traditional costing system for products manufactured at Vaibhav Gems Limited during the last five financial years using the traditional costing system. Table 5.4 Traditional Product Costing System at Vaibhav Gems Ltd (From to ) (Rs. in lacs) Particulars Direct Material Cost 25,399 6,138 9,464 10,457 13,075 Direct Labour Expenses Manufacturing Overheads Total Cost Assigned to Products Number of Units Produced (1Unit = 100 gms) ,069 7,946 11,010 12,493 15, Cost Per Unit Source: Annual Reports and Accounts of the Company from to

14 217 Table 5.4 shows that direct material cost had a continuously increasing trend throughout the period under study except in the year It was Rs lacs in which decreased sharply to Rs lacs in , but increased in the next year to Rs lacs in , Rs lacs in and rose up to Rs lacs in the final year Direct labour expenses have decreasing cum increasing trend during the period under study which indicate that production was not consistent and an improvement is required to improve the business. Manufacturing overheads showed a decreasing cum increasing trend because of decreasing trend of production. Total cost assigned to products shows an increasing trend continuously except in the year It was Rs. 28,069 lacs in which decreased to Rs. 7,946 lacs in but increased to Rs. 11,010 lacs in , Rs. 12,493 lacs in and finally reached up to Rs. 15,511 lacs in It is quite alarming that despite decrease in production, the total cost showed an increasing trend which should be considered by the management of the firm. Number of units produced by the firm had a decreasing trend except in the year In the year , units (highest) were produced. This number decreased to units in , 5189 units in and further came down to 4205 units (lowest) in Lastly, it increased slightly up to 4401 units in the year

15 218 The cost per unit for the firm showed an increasing trend except in the year Initially in , it was Rs lacs in , which decreased to Rs lacs in but increased to Rs lacs in , Rs lacs in and finally reached to 3.52 lacs in Rajesh Exports Limited The results in Table 5.5 summarize the traditional costing system for products manufactured at Rajesh Exports Limited during the last five financial years using the traditional product costing system. Table 5.5 Traditional Product Costing System at Rajesh Exports Limited (From to ) (Rs. in lacs) Particulars Direct Material Cost 8,08,972 11,86,161 18,17,947 20,32,542 25,00,460 Direct Labour Expenses Manufacturing Overheads Total Cost Assigned to Products Number of Units Produced (1Unit = 100 gms) ,09,498 11,86,622 18,18,493 20,33,158 25,02, Cost Per Unit Source: Annual Reports and Accounts of the Company from to Table 5.5 shows that direct material cost had a continuously increasing trend throughout the period under study. It was Rs. 8,08,972 lacs in which increased to Rs. 11,86,161 lacs in , Rs. 18,17,947 lacs in , Rs. 20,32,542 lacs in and rose

16 219 up to Rs. 25,00,460 lacs in the final year The increasing trend was because of increasing production. Direct labour expenses and manufacturing overheads had an increasing trend during the period under study except in the year which indicate that manufacturing was consistent and increasing which should be maintained in future also. Total cost assigned to products shows an increasing trend continuously. It was Rs. 8,09,498 lacs in which increased to Rs. 11,86,622 lacs in , Rs. 18,18,493 lacs in , Rs. 20,33,158 lacs in and finally reached up to Rs. 25,02,541 lacs in The total cost showed increasing trend because of increasing trend of the production which shows an efficient management of production. Number of units produced by the firm had an increasing trend except in the year In the year , units (lowest) were produced. This number increased to units in and reached up to units (highest) in Then it came down to units in Lastly, it increased slightly up to units in the year The cost per unit for Rajesh Exports had an increasing trend during the period under study. Starting from Rs lacs in , it increased to Rs lacs in , Rs lacs in , Rs lacs in and reached up to 2.07 lacs in the year

17 220 TEST OF SIGNIFICANCE FOR AVERAGE COST PER UNIT For the test of significance t-test has been applied for which the comparison of average cost per unit of one company has been compared with another company by making groups as follows: 1. Between Surana Jewellers and Classic Diamonds Null Hypothesis (H o ): There is no significant difference in the average cost per unit of Surana Jewellers and Classic Diamonds. Computed Value of t = 0.20 Degree of Freedom (v) = 8 Table Value of t at 5 percent level of significance = Decision: Since the computed value of t is less than the table value of t at 5 percent level of significance, hence the null hypothesis is accepted and it is concluded that the difference in the average cost per unit of Surana Jewellers and Classic Diamonds is not significant. 2. Between Surana Jewellers and Gitanjali Gems Null Hypothesis (H o ): There is no significant difference in the average cost per unit of Surana Jewellers and Gitanjali Gems. Computed Value of t = 0.30 Degree of Freedom (v) = 8 Table Value of t at 5 percent level of significance = Decision: Since the computed value of t is less than the table value of t at 5 percent level of significance, hence the null hypothesis is

18 221 accepted and it is concluded that the difference in the average cost per unit of Surana Jewellers and Gitanjali Gems is not significant. 3. Between Surana Jewellers and Vaibhav Gems Null Hypothesis (H o ): There is no significant difference in the average cost per unit of Surana Jewellers and Vaibhav Gems. Computed Value of t = 0.24 Degree of Freedom (v) = 8 Table Value of t at 5 percent level of significance = Decision: Since the computed value of t is less than the table value of t at 5 percent level of significance, hence the null hypothesis is accepted and it is concluded that the difference in the average cost per unit of Surana Jewellers and Vaibhav Global is not significant 4. Between Surana Jewellers and Rajesh Exports Null Hypothesis (H o ): There is no significant difference in the average cost per unit of Surana Jewellers and Rajesh Exports. Computed Value of t = 0.02 Degree of Freedom (v) = 8 Table Value of t at 5 percent level of significance = Decision: Since the computed value of t is less than the table value of t at 5 percent level of significance, hence the null hypothesis is accepted and it is concluded that the difference in the average cost per unit of Surana Jewellers and Rajesh Exports is not significant.

19 Between Classic Diamonds and Gitanjali Gems Null Hypothesis (H o ): There is no significant difference in the average cost per unit of Classic Diamonds and Gitanjali Gems. Computed Value of t = 0.10 Degree of Freedom (v) = 8 Table Value of t at 5 percent level of significance = Decision: The null hypothesis is accepted because the computed value of t (0.10) is less than the critical value of t at 5 percent level of significance, hence it can be concluded that the difference in the average cost per unit of Classic Diamonds and Gitanjali Gems is not significant. 6. Between Classic Diamonds and Vaibhav Gems Null Hypothesis (H o ): There is no significant difference in the average cost per unit of Classic Diamonds and Vaibhav Gems. Computed Value of t = 0.09 Degree of Freedom (v) = 8 Table Value of t at 5 percent level of significance = Decision: The null hypothesis is accepted because the computed value of t (0.09) is less than the critical value of t at 5 percent level of significance, hence it can be concluded that the difference in the average cost per unit of Classic Diamonds and Vaibhav Global is not significant. 7. Between Classic Diamonds and Rajesh Exports Null Hypothesis (H o ): There is no significant difference in the average cost per unit of Classic Diamonds and Rajesh Exports.

20 223 Computed Value of t = 0.23 Degree of Freedom (v) = 8 Table Value of t at 5 percent level of significance = Decision: The null hypothesis is accepted because the computed value of t (0.23) is less than the critical value of t (2.306) at 5 percent level of significance, hence it can be concluded that the difference in the average cost per unit of Classic Diamonds and Rajesh Exports is not significant. 8. Between Gitanjali Gems and Vaibhav Gems Null Hypothesis (H o ): There is no significant difference in the average cost per unit of Gitanjali Gems and Vaibhav Gems. Computed Value of t = 0.07 Degree of Freedom (v) = 8 Table Value of t at 5 percent level of significance = Decision: The null hypothesis is accepted because the computed value of t (0.07) is less than the critical value of t (2.306) at 5 percent level of significance, hence it can be concluded that the difference in the average cost per unit of Gitanjali Gems and Vaibhav Gems is not significant. 9. Between Gitanjali Gems and Rajesh Exports Null Hypothesis (H o ): There is no significant difference in the average cost per unit of Gitanjali Gems and Rajesh Exports.

21 224 Computed Value of t = 0.24 Degree of Freedom (v) = 8 Table Value of t at 5 percent level of significance = Decision: The null hypothesis is accepted because the computed value of t (0.24) is less than the critical value of t (2.306) at 5 percent level of significance, hence it can be concluded that the difference in the average cost per unit of Gitanjali Gems and Rajesh Exports is not significant. 10. Between Vaibhav Gems and Rajesh Exports Null Hypothesis (H o ): There is no significant difference in the average cost per unit of Vaibhav Gems and Rajesh Exports. Computed Value of t = 0.07 Degree of Freedom (v) = 8 Table Value of t at 5 percent level of significance = Decision: The null hypothesis is accepted because the computed value of t (0.24) is less than the critical value of t (2.306) at 5 percent level of significance, hence it can be concluded that the difference in the average cost per unit of Vaibhav Gems and Rajesh Exports. F-Test Following hypotheses have been set for testing by the application of two way analysis of variance-

22 225 (i) (ii) Null Hypothesis (H 0 ) : There is no significant difference in the cost per unit of Gem and Jewellery Companies under study (Inter Company) Null Hypothesis (H 0 ): There is no significant difference is the year-wise cost per unit of Gem and Jewellery Companies under study (Intra Company) Table 5.6 ANOVA TALE Source Sum Degree of Freedom (d.f.) Between Companies (SSC) Within Companies (SSR) Variance (Sum/d.f) F-Ratio 0.07 (c-1)=(5-1)= F = 3.25 (Between Companies) (r-1)=(5-1)= F = (Within Companies) Error (SSE) 0.91 (c-1)(r-1)= (i) F-Test Between the Companies (Inter Companies) F HigherVariance SmallerVariance Critical value of F at 5 percent level of significance (V 1 = 16 and V 2 = 4) is 5.84 Decision: Since the calculated value of F (3.25) is less than the critical value of F (5.84) at 5 percent level of significance, therefore the null hypothesis is accepted and it is concluded that the difference in the cost per unit of the companies under study is not significant.

23 226 (ii) F-Test within the Years (Intra Company) F HigherVariance SmallerVariance Critical value of F at 5 percent level of significance (V 1 = 4 and V 2 = 16) is 3.01 Decision: Since the calculated value of F is more than the critical value of F at 5 percent level of significance, therefore the null hypothesis is rejected and it is concluded that the intra company difference in the cost per unit of the companies under study is significant. IMPORTANCE OF ACTIVITY BASED COSTING TO MANUFACTURING ORGANIZATION In a manufacturing organization some costs and expenses are directly identified with products and services they produce. However, overheads cannot be directly identified with products and services. In these instances they have to be allocated to productive departments and they in turn have to be allocated on a predetermined basis to products and services In traditional costing methods, overheads are allocated on the basis of machine hours or direct labour hours If overheads are not correlated to machine hours, or direct labour hours then they may not indicate the true cost of overhead used by products and services This may lead to incorrect pricing of products and may lead to wrong decisions made by management and even they are profitable. They may stop producing these products and lead management to concentrate on

24 227 less profitable products and services and waste resources and more costs incurred in activities, which do not produce value. 6 In Activity Based Costing System or ABC, the costs are assigned based on the real cause of these overheads then the overhead is only allocated to products if it uses these activities or demanding these activities. For example, say a manufacturing organization produces two products one is a low volume item and one is a high volume item The low volume item uses certain activities such as special engineering, testing, and many machine set ups compared to the high volume item If one allocates overheads on the basis of machine hours, then the high volume item uses more machine hours compared to low volume item. This leads the overhead allocated more to the high volume item than low volume item, even though the low volume item uses more of the overhead activities than the high volume item. That is, the result of using traditional overhead allocation method leads to miscalculation of true overhead cost of manufacturing overhead Activity based costing will use more than one activity to allocate of overhead costs to products, rather than using only machine hours. Activity based costing in the first place, recognizes that the special engineering, special testing, machine set ups, and others are activities that cause costs and they cause the company to consume resources. Under Activity Based Costing, the company may calculate the cost of the resources used in each of the activities In our example, low volume 6. Berliner C. and Brimson J.A., op.cit., p.56.

25 228 products will be assigned some of the company s costs of special engineering, special testing, and machine setups. Other products that use any of these activities will also be assigned some of these costs. High-volume products will not be assigned any costs of special engineering or special testing, and it will be assigned only small amount of machine set up. 7 Activity Categories While using cost drivers to assign overhead costs to individual units works well for some activities such as setup costs, the costs are not incurred to produce an individual unit but rather to produce a batch of the same units. For other costs, the costs incurred might be based on the number of product lines or simply because there is a manufacturing facility. To assign overhead costs more accurately, activity-based costing assigns activities to one of four categories: Unit-level activities occur every time a service is performed or a product is made. The costs of direct materials, direct labour, and machine maintenance are examples of unit- level activities. Batch-level activities are costs incurred every time a group (batch) of units is produced or a series of steps is performed. Purchase orders, machine setup, and quality tests are examples of batch-level activities. Product-line activities are those activities that support an entire product line but not necessarily each individual unit. Examples 7. Innes J. and Mitchell F. (1991), ABC: A survey of CIMA members, Management Accounting, October,

26 229 of product-line activities are engineering changes made in the assembly line, product design changes, and warehousing and storage costs for each product line. Facility support activities are necessary for development and production to take place. These costs are administrative in nature and include building depreciation, property taxes, plant security, insurance, accounting, outside landscape and maintenance, and plant management s and support staffs salaries. The costs of unit-level, batch-level, and product-line activities are easily allocated to a specific product, either directly as a unit-level activity or through allocation of a pooled cost for batch level and product-line activities. In contrast, the facility-level costs are kept separate from product costs and are not allocated to individual units because the allocation would have to be made on an arbitrary basis such as square feet, number of divisions or products, and so on. 8 ADVANTAGES OF AN ACTIVITY BASED COSTING SYSTEM 1. The first and most important advantages is the accuracy in the process of costing with regards to the product line, the end-users of the product, the stock-keeping units employed by the management and the channel and category which streamline the flow of product form the producer to the end user. 8. Innes J. and Mitchell F. (1995), Activity-based costing, in Issues in Management Accounting (eds D. Ashton, T. Hopper and R.W. Scapens), Prentice-Hall,

27 This system better assists in the process of understanding the concept of overhead costs i.e. the allocation of common business resources as they are used by specific product lines and their relation to specific cost driver. 3. The system is easy to understand and interpret as it is accessible, flexible and practically implementable across all norms of business set-ups. 4. This process uses unitary cost, or marginal cost as the computation base is contrast to the traditional cost accounting methods which employ total cost. 5. The system works exceptionally well with quality improvement and up gradation programs e.g. six sigma. 6. The system also works exceptionally well with performance management systems which are employed by most human resource departments in contemporary businesses. 8. This process allows companies to implement costing strategies across another diagonal of the firm as business processes, supply chains and value addition channels are ably and optimally analyzed in this process. 9. This system resembles the actual business process as the appropriation of common pool resources takes place in the same way as common resources are used in the business. 10. This system aids in the process of benchmarking which is an integral part of equality control system Armitage H.M. and Nicholson R., op.cit., p.19.

28 231 DISADVANTAGES AND LIMITATION OF ACTIVITY BASED COSTING SYSTEM Disadvantages 1. Data collection process for this system is very time consuming. 2. The capital expenditure on the activity based system and its subsequent running costs can be a road block for firms. 3. The system is very transparent which some managers would not approve of as they would like to keep some things out of the view of the owners of the company. 10 Limitations The major technical limitation that will be faced is testing the hypothesis in the real world. Testing the hypothesis whether ABC is a more appropriate accounting solution is certainly possible on paper but its desirable effects in the real world cannot be properly gauged unless it is directly implemented by companies operating in the world today and the analysis is conducted in a kinetic time mechanism. This is a major stumbling block for most organizations which remain transfixed to their current accounting mechanism and don t want to change over to this new system, which despite its obvious benefits, seems to come to a great switching or even multi-homing cost. ***** 10. Innes J. and Mitchell F., op.cit. p.30.

29 232