AN OVERVIEW -ACTIVITY BASED COSTING

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1 CHAPTER -II 48

2 AN OVERVIEW -ACTIVITY BASED COSTING This chapter deals with an overview of application of ABC system of costing. It also covers the conceptual framework of ABC analysis, process of activity based costing, logic and assumptions, models of ABC, traditional approaches of costing. 2.1 Volume Based Costing The volume based 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. Volume based costing systems utilizes a single, volume-based cost driver. 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 volume based cost systems often report inaccurate product costs. Each time a unit of product is manufactured, it is assumed 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 proportions of the activity actually consumed by a specific product, does not universally correspond with a single cost driver. This holds true for most modern companies where products are produced by a combination of manpower and 49

3 technology. The volume based cost accounting model employs a volumebased driver, such as direct labour hours or machine hours for the assignment of all manufacturing overhead costs and ends up with a cost of goods sold based on absorption costing and includes only product costs as defined in financial accounting. Fundamentally, volume based 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 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 producted 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. The volume based costing systems only have one or a few indirect cost pools for each department. Product costs are likely distorted when a firm uses a volume-based rate if the plant has more than one activity in its operations and not all activities consume overhead in the same proportion. The more diverse the product mixes of the plant are in volume, sizes, manufacturing processes, or product complexities, the greater the cost distortions are likely to be in using a volume- 50

4 based rate. Under costing a product may appear to have increased the reported profit the product earned (assuming the firm did not lower its selling price because of the reported lower product cost). However, the increased profit is, at best, a twist in truth. Costs of the product not charged to the product itself are borne by other products of the firm. Worse, under costing a product may result in managers erroneously believing the product to be more profitable than other products and shifting the limited resource the firm has into manufacturing, promotion, and sales of the product when, in fact, other products are more profitable to the firm. Severe cost distortions may lead firms not to drop unprofitable products because the cost data show these products are profitable. Over costing does not increase revenues. A firm can increase the selling price of a product, thereby increasing the total revenue from the product only if the market allows. Increases in the selling price of a product without experiencing noticeable decrease in the sales quantity of the product is likely an indication that the product was not priced properly, which might be a result of under costing of the product. Further, over costing a product is likely accompanied by under costing of the firm s other products and, as a result, under pricing of one or more of the firm s other products. When a firm sets a high selling price that is a result of over costing, competitors also are likely to enter the market and take away the firm s market share. A firm also may drop or de-emphasize an erroneously 51

5 over costed product when it erroneously believes the product is either unprofitable or having a low-margin. A product-costing system that uses a single volume-based cost driver is likely to over cost high-volume products because high-volume products do not consume support resources in proportion to their production volumes. As a result, a product-costing system that uses a single volume-based cost driver often over costs high-volume products or services and under costs low-volume products or services. The cross-subsidizations of low-volume products by high-volume products is likely to lead the firm not to price its products properly. This may also decrease the profits of the firm and reduce management s confidence in the product cost predictions. Poor pricing can lead a firm to promote less profitable products while not spending sufficient resources on more profitable items. In the recent past, there is a shift from conventional business to business competition to drastic increase in competition in domestic and foreign markets with responsive innovative information technology, followed by changes in the cost of the products (combined associated cost), producers of goods and services need to search and a better understand the concept of accounting system with regard to fast and accurate speed in information system. However, in the past decade manufacturers were not producing variety of products. Labour (direct labour), is the main ingredient in the product cost structure. But, currently due to increased customer demand for variety of products, decreased of labour rate and wages and increasing of 52

6 overheads, allocation of overheads cost of the product and services is difficult to calculate. Therefore, companies should adopt new methods for calculating the cost and a global world view approach to such overheads system calculation. Currently, different improved methods of allocating these overhead are available. 2.2 Concept of Activity-based Costing Turney (1996) defined ABC as a method of measuring the cost and performance of activities and cost objects. It assigns cost to activities based on their use of resources and assigns cost-to-cost objects based on their use of activities. Based on this definition, ABC is more than product costing; it provides a means to measure activity performance in order to determine how well work is done in that activity. He also defined ABM as a discipline that focuses on the management of activities as the means to continuously improve the value received by customers and the profit earned by providing this value. This discipline includes cost driver analysis, activity analysis and performance analysis. Thus, the goal of ABM is to improve customer value, which eventually improves the profit. Customer value is the difference between what a customer receives (customer realization) and what the customer gives in return (customer sacrifice). A customer receives a complete range of tangible and intangible benefits from a purchased product. These benefits include product features, quality, service, reputation and brand name. Customer sacrifice includes the cost of purchasing 53

7 the product, the time and effort spent acquiring and learning to use the product and the costs of using, maintaining and disposing of the product (Hansen, Mowen & Shank 2006). Swenson (1995) defined ABC as an information system that assists with decision making essentially a decision-support system. While he defined ABC broadly to include ABM, he claimed that some researchers prefer to use the term ABM when ABC information is used to support operating decisions. Roberts and Silvester (1996) point out that ABC and ABM are sometimes used interchangeably by researchers. They referred to ABC as the actual technique for determining the costs of activities and the outputs that those activities produce. They referred to ABM as the fundamental management philosophy that focuses on the planning, execution and measurement of activities as the key to competitive advantage. In turn, Hicks (1999) described ABC as a powerful management concept that can be adopted and used by any organization to gain a competitive advantage through greater understanding of product or service costs, process costs and the organization s overall cost behavior. These definitions commonly describe ABC/ABM as a method that can be used to gain competitive advantage. Competitive advantage is creating better customer value for the same or lower cost than the best offer of the competitors or creating equivalent value for lower cost than that offered by competitors (Hansen, Mowen & Shank 2006). Plowman (2001) described ABC as a means of establishing product costs more accurately. He described ABM as a means of enhancing profitability by focusing on a process view of the business 54

8 and a deeper understanding of product, channel and customer profitability. Generally speaking, ABC systems refer to the method used to determine the cost of activity and cost objects. In contrast, ABM systems refer to the use of ABC information in making strategic and operational decisions. Hence, the researcher intends to use the terms ABC and ABM interchangeably to describe a management information system that can be used by managers to support strategic and operational decisions. Activity-based Costing system basically differs from other costing system in the way it gives stress on indirect resources demanded by the product. It emphasizes the need to obtain a better understanding of cost behavior and thus ascertain what causes the overhead costs. After the collection of accurate data on direct material, direct labour and direct expanses under the system the next step is to examine the demands made by particular products on the indirect resources on the basis of the following three rules (Cooper and Kaplan, 1998). 1. Focus on expensive resources. 2. Emphasis on resources whose consumption varies significantly by product or product type; look for diversity. 3. Focus on resources whose demand patterns are uncorrelated with traditional allocation measures like direct materials, direct labour and processing time etc. The logic behind these three rules of ABC is that it is the activity which causes costs, not the products and it is the product which consumes activities in turn. 55

9 Hence, while computing the cost of a product due consideration is given to those factors that drive cost. In fact, analysis of resources consumption by the products with the help of cost driver is the essence of activity based costing. 2.3 Process of Activity-based Costing Based on the above logic of understanding the cost of activities and their relationship to the products the activity based costing traces costs to the products. Cooper (1989) describes the whole process by incorporating the following process. 1. Aggregating actions into activities 2. Reporting the cost of activities 3. Selecting the first stage allocation bases 4. Identifying the activity centers 5. Selecting second stage cost drivers It is beneficial, because the information that is available about the consumption of the resources by the centre is often different from that available by product. For instance, set up personnel might record their spent in each centre but not on each product. Using set up hours in first stage 56

10 permits the system, to capture some of the differences in resource consumption, by the centers even though the information is not available at the product level. 2.5 Activity-based Costing: The Logic and Assumptions There are a set of logics that guide the mechanism of Activity-based Costing. These logics are highlighted as below: 1. Resources consumption: activities directly consume resources. This logic is quite different from that of conventional costing where costs are traced to the products under the notion that product consumes resources. Conventional allocation bases thus measure only attributes of the individual product item. The number of direct labour or machine hours or material in rupees consumed. Under ABC, the logic in contrast is that resources are consumed to perform some activities and hence these activities are the focus of costing process. Resources are therefore, traced to activities. Products consume the activities in turn. Hence, the activities are traced to the products on the basis may be volume related or transaction related. Thus, the costing element is no longer the product but those elements the transaction affects. Under ABC system, the unit cost of a product is determined by dividing the cost of an activity by the number of units in the activity. 2. Management focus: managers do not manage costs; they manage the activities that cause costs. This logic has a lot of managerial considerations. Managers basically decide and control the activities 57

11 demanded by the products and hence accounting information need to be provided to them in order to facilitate the activity management. As pointed out earlier, activities demand resources consumption that is simply measured through costs. When the focus is on costs as it is in a typical budgetary control system under conventional management accounting, the managers are handicapped to understand the cause and effect relationship between the costs and resources. Under the ABC costing system, the focus of the management is taken care of by providing information regarding the cost of resources supplied and the cost of resources used. ABC system brings activity measures as a bridge in between the product cost and resources. A micro level understanding of the intermediary transformations has a lot of strategic managerial significance (Johnson and Kaplan, 1987) particularly in efficient and effective resource utilization through creative value adding process. Moreover, this logic causes a shift in managerial attention from spending the resources to efficient consumption of resources. This assumption is well supported by the experiences drawn from Weyerhaeuser s charge-back system where managers could control the use of resources that caused corporate overhead costs and be held responsible for that. The importance of such an assumption can be felt in the light of most perplexing insidious tendency for corporate overhead cost to rise steadily even though it is considered a fixed cost. 58

12 Assumptions of Activity-based Costing Although Activity-based Cost systems often provide better product cost data than conventional VBC system, they are based on a number of assumptions that should be evaluated before ABC costs are considered superior. According to Roth and Borthick, 1991) two assumptions underlying ABC are: 1. The costs in each cost pool are driven by homogeneous activities. 2. The costs in each cost pool are strictly proportional to the activity. The first assumption, homogeneity, means that the cost in each cost pool is driven by a single activity or by highly correlated activities. The second assumption, proportionality states that all costs in the cost pool vary proportionally with the changes in activity level. Costs which are subject to a non-linier function violate this proportionality assumption. But, in practice little violation is accepted because of cost effectiveness of the system. 2.6 Activity-Based Cost Model Determining the best product mix of a company correctly is an important requirement to increase the profitability of a company. To make the right decisions, management needs more accurate information about the optimal product mix and the restrictive bottlenecks of a company. ABC, together with the theory of constraints (TOC) philosophy and mathematical programming, can provide management with more accurate information about the optimal product mix of a company and can help to identify the bottlenecks that should be focused on to improve the system. 59

13 Based on the above logics and assumptions activity based total cost of production is computed as the sum of the cost of all activities performed. These cost vary with activities performed at different levels of production organization. The cost behaviour under ABC procedures a more complex cost function in a factory as compared to that under conventional product costing. The cost function is assumed is stated a follows: C= vu + bb + pp + S Where, C = Total cost v = per unit variable cost U = Number of units produced b = per batch variable cost B = Number of batches produced p = per product line variable cost P = Number of product lines S = All other costs that do not vary with some activity measures (Fixed). The cost function recognizes that varying costs are due to more than just changes in quantity of outputs (U). Costs also vary with the number of batches and the number of product lines. The above cost equation as compared to traditionally followed under marginal costing (Total cost = variable cost per unit x quantity produced + fixed costs) has more explanatory variable under 60

14 the assumption that additional variable correctly capture how cost vary in a particular factory under study (Zimmerman, 1995). The notable difference in this cost model is that the so called fixed cost under marginal costing is broken into three parts; part that varies with batch level activities and part that does not vary with any activity (fixed). Empirically it has been found that the third part as stated above constitutes a very small percentage of the total cost (Cooper and Kaplan, 1998). Thus, the cost model under ABC is more explanatory in nature as compared to the conventional cost function under marginal costing. 2.7 Cost Drivers: Key to Activity-Based Costing Cost drivers are technically defined as those activities or transactions that are significant determinants of costs. ABC relates the overhead costs to the forces behind them (activities or transactions) because the tracing of overhead costs to the products requires the cost behavior to be well understood and for the purpose, the appropriate cost drivers, better to say the dictators of cost behviour must be identified. Kaplan and Cooper, 1987) claim that traditional distinction between fixed cost variable and variable costs does not enough information to design a cost system. They advocate that variable cost should be analyzed between short term and long term costs. Short term variable costs are labeled as variable costs under conventional cost systems vary with measures of activity but not instantaneously. On the basis on this analysis they classify the cost drivers into the following two categories (Cooper and Kaplan, 1988). 61

15 1. Volume based costs drivers 2. Transaction based cost drivers. The above mentioned costs drivers are not independent but they are determine by the number of cost drivers. Accordingly of a single cost driver depends on the factors include: (i) Product activity (ii) Relative cost of the activities (iii) Volume diversity, etc. The goal of ABC is to improve the accuracy of product costs and provide a means for the improved management of process and support activities. It is part of a process of continuous improvement aimed at improving the value received by the customer and enhancing profitability by providing this value. It is worth noting that manufacturing a product or serving a customer is constrained by the desirable level of profits. A firm would discontinue manufacturing unprofitable products or serving unprofitable customers. In this regard, management should focus on the manufacturing costs in making their product decisions. Customer service costs can burden product costs, causing the product to be unprofitable. ABC systems separate product-driven costs from customer-driven costs. Product-driven costs are the costs required to manufacture a product. These costs include design, procurement, quality control and engineering; in contrast, customer-driven costs are the costs of delivering, serving and supporting customers and markets. These costs include distribution, research and development (R&D) and customer orders. 62

16 Thus, ABC helps managers to determine the loading between product-driven and customer-driven costs. This analysis will allow management to discontinue supporting unprofitable products, customers or markets. In a rigorous business environment, manufacturing and supply services have become very hard to maintain satisfactory returns or profits. Therefore, the role of cost estimation for products and services has become more critical. Before the modern business management times, accounting was being just used to record the cost of products and/or services. However, the important role of cost estimation and cost information appeared after the advent of modern business management techniques. This is especially because the traditional cost systems are known to distort the cost information by using traditional overhead allocation methods. However, decision makers, assuming information is relevant, prefer more accurate product cost information to less. The best method so far is ABC system which is related to manufacturing overhead cost. The customer driven environment of today s manufacturing systems and the competitive pressure of the global economy force manufacturing services and organizations to become more ^exible, integrated and highly automated in order to increase their productivity at reduced costs. But it is impossible to sustain competitiveness without an accurate cost calculation mechanism. The rapid advancement of enormously expanding information technologies and vigorous global competition have caused the irrelevance of conventional management accounting systems (MAS) in 63

17 providing useful information to assist management s decision making, planning and control in both service and manufacturing organizations. 2.8 Relevance of ABC System The Activity-Based Costing system as one of the best costing systems was introduced by two researchers of the Harvard University named Robert S. Kaplan and Robin Cooper for the first time. The above system makes the strategic decision like costing the products and determining the optimized component possible by the correct measurement of the cost of costing objects. Further, it provides appropriate management by representing the useful nonfinancial information associated to organization s process and gives numerous guidelines in order to improving the performance of organization activities (Osmani and Yousefian, 2000). In manufacturing companies, marketing, selling, distribution, service research and development and general administration functions have become more significant expense categories than in the past. Conventional cost accounting systems, which emphasize inventory valuation, have neglected the huge investments and expenses in an organization s service functions. Again, conventional cost system cannot accurately assign the costs of non-volume-related overhead activities. Assigning overhead costs by using only volume as a basis can supply management with an incorrect picture of how costs are established. Similarly, products cost can be distributed if the non-volume related overhead costs are significant proportion of total overhead costs. The solution to this problem in service firms, as well as in 64

18 manufacturing is to implement activity based cost management (Hussain & Gunasekaran, 2001). Research works that have been carried out on the activity-based costing (ABC) system in respect of service firms so far are scanty to some extent. The main focus has been on manufacturing firms, even though the use of ABC in manufacturing firms is not common, most of the firms in this sector stick unto traditional cost accounting system (Kock 1995; & Hussain and Gunasekaran, 2001). ABC can be defined as a method of costing activities that are necessary for the production of products or services (i.e. activities being undertaken) (Dandago, 2003). According to Turney, ABC is a method of measuring the cost and performance of activities and cost objects. Hence, the system assigns cost to activities based on their use of resources, and assigns cost to objects based on their use of activities.furthermore; ABC was described as a full absorption costing method that gain more and more ground than conventional methods, due to more correct cost assessments and superb tracing of the costs (Emblemgrag, 2001). ABC was also defined (Drive, 2001) as a system that allows organizations to track the cost associated with activities performed to produced products or to deliver services.abc can be a powerful tool for industrial decision makers (Lere, 2000). Global competition and rapid advancement of information and communication technology have made the irrelevance of conventional management accounting system in providing useful information for managerial decision making, in both service and manufacturing organizations (Hussain & Gunasekaran, 2001). The 65

19 shortcomings of traditional costing system, in terms of validity, accuracy, consistency and relevance, increased the need for modern management accounting system, hence, ABC can be used as a tool for planning, control and decision making in service management. 2.9 ABC and Cost Allocation The assignment of costs to products, customers, or other cost objects has always been a thorny issue. For external reporting, production costs must be assigned to products for both income and asset reporting purposes. For operational cost control, strategic decision making, and performance measurement purposes, however, many organizations also capture and assign costs from the other functions in the internal value chain. What methods are used to measure costs and profits across the value chain, and does their usage vary by function? We identified the most frequently used types of methods as: Actual costing, Normal costing, Standard costing, and Activity-based costing Activity Based Costing as a Catalyst Performance management has become the key driver for profitable growth of organizations. Corporate Performance Management (CPM) comprises all processes, methodologies, metrics and systems needed to measure and manage the performance of an organization. It works best in a performance driven culture and needs to adapt to the specifics of the organization. An 66

20 efficient CPM empowers executives with necessary information for appropriate decision making. It creates focus on the business, processes, performances, profits and customers. It is a management process which effectively links strategy, measurement and operational processes to the end of creating shareholder value. An effective CPM entails developing a framework where corporate performance management is built on a process framework and facilitates true cost and profitability insights. To succeed in an increasingly competitive global market, besides having an efficient measurement system, it should also have continuous profitability improvement plan. To achieve this, a company has to know the cost of its entire economic chain and has to work with others in the chain to manage cost and maximize profitability. 67

21 Chart 2.1 Source: CAM-I Activity Based Costing is a method of determining cost for an activity thereby enabling process costing. It assigns cost to activities based on the use of their resources and assigns cost to cost objects (product/customer/channels) based on their use of activities. Activity Based costing methodology helps to analyze not only the product profitability but also customer and channel profitability. These are not possible in traditional costing. Activity Based Costing enables to find true cost. Activity Based Costing increases the accuracy of cost information by linking overhead and other indirect costs to products or customer products more precisely. Moreover, Activity Based Costing analysis will provide process cost measures that, along with quality and cycle time measurement will enable an organization to become truly a Total Quality 68

22 Management company. Activity Based Costing is a catalyst for an effective CPM Time Driven Activity Based Costing Time Driven ABC simplifies Activity Based Costing by removing the need for time consuming interviews and employee surveys that are prone to error and expensive to maintain. Time Driven Activity Based Costing needs only two parameters; 1. The cost of supplying resources to activities and 2. The time it takes to carry out activities. In order to do this Time Driven ABC uses estimates or calculations of how much time it takes to carry out an activity. Cost and time equations: For many Manufacturing Companies 'average' and 'approximate' times are adequate for their product costing calculations, but for companies with a high investment in plant and equipment, accurate times are needed as activity, process and manufacturing costs represent a high percentage of the cost of their products. Cost and time equations are therefore a key feature of Time Driven ABC as they enable companies to quickly and accurately calculate the time needed to complete an activity. They also mean that fewer people are needed to set up and maintain the company's cost models, so less time is spent generating data and more time is spent using it. Available Capacity: Time Driven ABC has a concept of 'available capacity. Because this takes idle and un-used activity time into account, it takes a 69

23 realistic approach to costing that enables you to model the complexity of real operations and accurately assign costs to products in a way that is in line with the way in which the activities are consumed. As a consequence, a key differentiator between conventional Activity Based Costing and Time Driven ABC is that excess capacity costs are not automatically assigned to products. Product costs are therefore not distorted by automatically burdening them with the cost of unused capacity. Time Driven ABC has many advantages over conventional Activity Based Costing and Cost Accounting methods and it delivers many benefits, especially when it is combined with the type of cost-pull consumption methods used by SBM s Activity Based Process Model. Like Time Driven ABC, SBM's Activity Based Process Model needs only 2 parameters, the cost or price of supplying a resource and the time or quantity in which the resource is consumed Activity Based Costing in Various Sectors (i) ABC in Electricity Industry In a deregulated context, the competition between electricity or gas suppliers is savage. Indeed, with raw materials where nothing, or almost nothing, is applied in term of transformation, suppliers have for main levers of diversification their price structure which is basically based on a mathematical modeling approach. To make their customers portfolios grow, those suppliers can basically use market characteristics commonly shared by all of them. That s why, after a few years of market opening, the suppliers 70

24 have to find other levers to provide competitive prices: the costs used to make the pricing can be optimized for many suppliers by following an analytic approach based on the analytical accounting. The main objective that a supplier should stand is to optimize the costs of the activities used to provide customers with products and services. In this context and since IT is now closely linked to the business activities, it becomes possible to propose the suppliers an approach using the analytical accounting figures to calculate faithfully the costs of their products and services. Several methodological approaches (e.g. Balanced Scorecard, Activity Based Costing / Activity Based Management, UVA) can be applied to reach such objectives of costs optimization without deterioration of the quality and the performance of the processes. Energy suppliers therefore could take advantage from an Activity Based Costing (ABC) and Activity Based Management (ABM) methodology by following a rigorous analytical approach that could be designed. (ii) ABC in Banking Sector The Activity-based costing (ABC) is a completely new corporate cost control theory and approach that started extensively in the western countries in the end of 1980 s and was first applied by the advanced manufacturers. It establishes the basis for business process reengineering through distinguishing value-added activities and non-value-added activities. Based on the cost driver of every activity, ABC can overcome many defects in the conventional cost accounting, provide plenty of relevant and accurate cost information to help managers implement the strategic management and seek 71

25 for sustainable development opportunity.abc has been adopted by more and more international commercial bank such as CITI Bank, etc. In the commercial bank, it is not such a success to apply the ABC as the cost management. The reason lies in the fact that most of businesses are not modernized and there is still a lack of some coordination in the management work, so they are not completely qualified for the application of ABC. Based on the study of application of ABC in Bank of China, the article analyses the differences between the conventional cost approach and ABC on cost analysis and management, inquire into how to raise the core competitiveness of domestic commercial bank. (iii) ABC in Telecom Sector Activity Based Costing (ABC) has been discussed widely in industry in the past five years as an alternative to or improvement of previous costing practices. In most full (or absorption) costing systems, overhead has been allocated by adding pre-calculated percentage charges to the direct costs. To applying for ABC, telecommunication networks have to be standardized, flexible, and value -added chain. Also cost is measurable and homogeneous in each process step. The activity in telecommunication network can be process steps and switching is a typical process. For example, a long distance call passes by several switching processes. In this case, we can calculate cost per switching following to call time and distance used by subscriber. In the central process steps in telecommunication network, cost varies according to traffic. In the access process, access is getting shorter by multiplexing and switching 72

26 decentralization and expense becomes to decrease, while it will be happened the additional cost with the demand of the increase of access capacity. Call consists of switching, connection before call, and call connection. In this operating level, cost driver is the number of switching (or CPU process time) in switching process and the time to call in channel and transmission process respectively. Applying procedure of ABC in Telecommunication Network is as following. First step, organizing systems to measure labour hour, varied statistical data, and production cost occurred in the process. Second step is recognizing cost driver in each process. Third step, aims at separating the nontraffic sensitive cost (NTS) with the traffic sensitive cost (TS) in each process of production activity. Fourth step, coding in product unit and beginning to measure and record statistical data to separate direct cost based on activities. Fifth step, allocating indirect cost following to allocation standard based on cost driver analysis. (iv) ABC in Health Care Sector Healthcare organizations use cost accounting to estimate the unit cost of services they provide. Such information helps establish a realistic budget; prices, identify inefficiencies and project the effect that changes in demand would have on resource requirement. The processes involved in the production of a labouratory test result include procurement of the sample, logistical services, administrative procedures, performance of testing procedure, professional consultation and oversight, rendering and administering an account and information technology and communication 73

27 cost. Activity Based Costing (ABC) began appearing as a costing methodology in industries other than healthcare in the 1990 s. Since then ABC has continued to evolve, now encompassing Time-Driven ABC and Activity-Based Management (ABM). Many healthcare executives continue to ask how ABC can be applied in healthcare and how it relates to existing costing methods. Some hope it can offer a breakthrough or at least advantages over current methods, which are perceived variously as inaccurate or too costly to build and maintain. In Canada, spending on health care has come under increased scrutiny. In times of fiscal restraint, there is a constant pressure to effectively manage costs. Recent federal fiscal reforms include reductions in transfer payments for health care, placing an increasing responsibility for these costs under provincial jurisdiction. Direct provincial funds contributed 39.5 per cent of total health care funding in 1980 and federal financing assumed 32.8 percent. By 1993, these figures had evolved to 46.5 % provincial and 23.5% federal (federal contributions including transfers). Funding for health care now amounts to over one third of provincial expenditures. A significant proportion of these funds is allocated to provide care in the long term care (LTC) sector. Recent experience gives rise to greater concern. Between 1980 and 1995, Ontario residential and community long term care expenditures have increased more than 400% (from $ 426 million to $ 2.14 billion). This experience is not limited to Ontario as other provinces are also faced with increasing health care expenditures. Most Canadian governments are making 74

28 efforts to control rising costs in all sectors, including long term care. With limits placed on government spending, responses to changing client needs will have to be accomplished through redirection of existing resources. Early initiatives to control swelling budgets have focused on global cost reductions. Internal cost control measures have also been initiated. In the health care sector, the ability of cost accounting to act as a control mechanism depends upon how precisely the financial data relate to the clinical work. The literature suggests that internal cost control can come from managing cost drivers. Cost drivers are factors which are thought to have a strong relationship with actual costs. In health settings researchers have established associations between care costs and broad diagnostic groupings. Diagnoses and measures of health status have been used as cost drivers in the development case mix funding formulas. Drivers of care costs in long term care are somewhat different from those in an acute care setting. For example, the presence of expensive technologies is less common in LTC while nursing care and geriatric pharmacy are significant cost items. Currently hospitals support a detailed cost accounting system. Hospital cost information is available in conjunction with diagnoses and procedure based resource intensity weights (RIWs). Researchers and administrators have failed to develop and implement a similar initiative for long term care. Residents of long term or continuing care are not easily classed by a one dimensional diagnosis. Lacking the required information for a more exact approach, funding for LTC facilities and services in Canada is based on average per diem rates, historical global budgets, or 75

29 case-mix classification based on broad diagnoses and care requirements. An assessment of costs in long term care must be linked to resident care planning, care activities, and resource requirements. Currently, there is no ability to assess what care related activities account for the costs. To be used to improve the effectiveness of care, costs must be assessed through the activities where they are incurred. We can understand care costs through Activity Based Costing (ABC). The approach defines costs in terms of an organization s processes or activities. In this way, resources are attributed to the care being provided and cost management is aligned with outputs and outcomes rather than with management structure. The method evolved in the manufacturing industry and is applicable as a method of accurate case and episode costing. ABC is useful because it models the flow of resources in the care process. Traditional cost accounting techniques allocate costs to all units based on an average unit cost. Although the average cost method provides acceptable product costs in general, it often fails to provide accurate costs on individual products 17. The resulting allocation is often not reflective of the degree to which a given unit actually uses the resources 6. With average cost methods, total costs vary with volume only. An example for long term care is seen in the per diem funding schedule used in many provinces. The per-diem rates provide an average cost for resident care and cannot distinguish whether any residents cost more to care for than others. In a health care context, ABC systems focus on care activities to measure each individual resident s consumption of the resources. 76

30 The ABC allocation results in costs that vary with the health status of residents, and not only with the total volume. Summary indicators from a cost system must address the goals of care and funding for health services. If the care of residents is individually determined, then the costing system must be able to allocate costs on a resident specific basis. ABC accomplishes this to the extent that accurate information is available with respect to staff utilization. The best measure of staff activity can be obtained through a time study analysis. By assessing the cost-related practice patterns, time study data provide the best assessment of variable care costs. This data also provides key information for determining individual case-mix index or resource intensity weight. Prospective payment based on case-mix is believed to provide a reimbursement mechanism that reflects the needs of residents rather than facility characteristics. Cost analyses in health care are typically restricted to assessing costs, often without explicit consideration of the outcomes or benefits. When outcomes are examined, we are able to consider cost minimization, cost-benefit, and cost-effectiveness analyses. Cost-minimization analyses assume that all outcomes of treatment are of equal value. Costbenefit analyses are rare in health care as they require the difficult step of placing a dollar value on health-related outcomes. A review of health care cost-effectiveness literature, notes a lack of quality research on the topic, with many studies examining costs as charges and only rarely considering marginal costs. In health care, marginal costs can be expressed either in terms of severity of illness or in terms of the associated care 77

31 intensity required. Both require patient specific information which ABC is able to determine. Health care providers in the United States, including those operating under managed care and capitation arrangements are beginning to recognize and implement this strategy. The application and research of ABC in Canada, the U.S., and the U.K. has provided examples of its utility in diverse care settings. The purpose of applying ABC is to accurately depict and assess costs, by aligning them with care related activities. This paper presents the development and application of an activity based costing model in residential and community long term care settings Activity Based Costing in Various Countries (i) ABC In India Activity-based costing (ABC) is a two-stage product costing method that first assigns costs to activities and then allocates them to products based on the each product s consumption of activities. ( Dr Manoj Anand, Dr B S Sahay, Subhashish Saha, All India Council for Technical Education (AICTE), New Delhi (India), The cost pools in the two-stage approach now accumulate activity-related costs. An activity is any discrete task that an organization undertakes to make or deliver a product or service. Activity-based costing is based on the concept that products consume activities and activities consume resources. Activity-based costing can be used by any organization that wants a better understanding of the costs of the goods and services it provides, including manufacturing, service, and even nonprofit organizations. Activity- 78

32 based costing recognizes that resources are spent on activities and the cost of a product or service is the sum of the costs of activities performed in manufacturing the product or providing the service. An activity-based costing system traces costs to the activity that consumes resources. Costs are determined based on the activities performed for cost objects and their underlying cost drivers that consume resources. Product or service costs determined using activity-based costing reflect costs of resources consumed for activities performed in manufacturing products or providing services. In contrast, a volume-based costing system uses cost allocations to channel indirect costs to products or services. As a result, the cost of a product or service often bears little or no relationship to activities performed in the manufacturing of the product or service. Based on the activities of most manufacturing firms, the general levels of cost hierarchy of an activity-based costing system are: a) Unit-level cost; b) Batch-level cost; c) Product-level cost; and d) Facility-level cost. In an activity-based costing system, the second-stage procedure in tracing costs to products or services is a process by which the costs of activities or activity pools are assigned to cost objects using one or more appropriate activity consumption cost drivers. All firms should use an ABC system when the benefits of such a system exceed the costs of implementing it. It is especially beneficial to firms with product diversity and/or process 79

33 complexity. Unit-level activities are activities performed on individual units of product or service. The frequency of a unit-level activity varies in proportion with the units of product manufactured or service provided. Examples of unit-level activities are using direct materials, using direct labour hours, inserting a component, inspecting each unit, and consuming power to run machines. Batch-level activities are activities performed for a group of units of products or services rather than for each individual unit of product or service. The frequency of batch-level activity is determined by both the size of the group and the total number of units to be manufactured or provided. Examples of batch-level activities are setting up machines, processing and placing of purchase orders, scheduling production runs, inspecting products by batch, and handling materials. Product-level activities are activities undertaken to support individual products or services rather than for each individual unit of product or service or a group of individual units of products or services. Facility-level activities are activities performed for the entire organization or division to meet the required operating procedure or support the operation of the organization or division. Service organizations such as banks, hospitals, transportation companies, law firms, and trading companies can use activity-based costing and management in all phases of their operations as manufacturing firms do. Many studies in India reveal that the corporate India has more than one cost management system in use. Half of the respondents do use absorption costing system for product costing and financial reporting purpose. These results are consistent with the findings of 80

34 Joshi (2001) in the Indian context. International surveys reports 50% to 70% of the companies use 13 absorption costing for external reporting and tax reporting purpose ( Inouse, 1988; Blayney and Yokoyama, 1991). The use of standard costing is popular worldwide. More than 75% of the firms use it in USA, UK, Ireland, and Sweden ( Cornick et al., 1998; Drury et al. 1993; Clarke and Brislane, 2000; and Ask and Ax, 1997). Scarbrough et al. (1991) finds that 65% usage of standard costing in Japan. In India, slightly less than two-third of the respondents use standard costing as a cost control technique as compared to 68% usage found by Joshi (2001). The activity-based costing system introduction in corporate India has picked up momentum as 20.75% of the respondents are using it as supplementary/ offline and 28.30% of the respondents have integrated the activity based costing systems with ERP systems. The survey shows an encouraging response of the Indian corporate sector to the activity based costing with 49% (n = 26) of the respondents adopting it. The firms are successful in 22 capturing accurate cost and profit information from their ABC cost systems for their value chain and supply chain analysis vis-à-vis non-abc user firms. The need for activity-wise cost information in budgeting, product pricing decision and customer profitability analysis has urged the management of the Indian firms to adopt activity-based costing systems. No significant difference has been found in the in the motivation to adopt ABCM across the manufacturing as well as service sector and across the stages of activity-based cost system adoption (supplementary/offline). This implies that 81