2. Chapter 12 Activity Based Costing System © Tata McGraw-Hill Publishing Company Limited, Management Accounting 12-

3. 12- Activity Based Costing System Traditional Manufacturing Costing system Cost of Resource Capacity Activity Based Costing/Management (ABC/ABM) System ABC for Marketing, Selling and Distribution Expenses PROs and CONs ABC for Service Companies

5. 12- Exhibit 1: Montex Pen Total and Product Profitability Particulars Blue Pens Black Pens Red Pens Purple Pens Total (1) (2) (3) (4) (5) Production/Sales volume 25,000 20,000 4,500 500 50,000 Unit sale price Rs 45 Rs 45 Rs 46.5 Rs 49.5 Sales (a) 11,25,000 9,00,000 2,09,250 24,750 Rs 22,59,000 Material costs 3,75,000 3,00,000 70,200 8,250 7,53,450 Direct labour costs 1,50,000 1,20,000 27,000 3,000 3,00,000 Overheads (300% of direct labour) 4,50,000 3,60,000 81,000 9,000 9,00,000* Total costs (b) 9,75,000 7,80,000 1,78,200 20,250 19,53,450 Total operating income [(a) – (b)] 1,50,000 1,20,000 31,050 4,500 3,05,550 Return on sales (%) 13.3 13.3 14.8 18.2 13.5

6. Limitations/Inadequacies of Traditional Costing System © 12- It has, however, serious limitations/inadequacies due to its assumption that all overheads are proportionate to volume of production. Many overheads costs are, actually, not proportionate to volume. The use of volume-related allocation base of TCS for allocating overheads would result in product cost distortion in an environment of complex and high product variety. The ABC system eliminates this source of cost distortion. As a result, simple high-volume products would be overcosted (i.e. receive a larger allocation of overheads) and low-volume complex products would be undercosted (i.e. receive a smaller allocation of overheads). Examples of such costs are setup costs of machines/equipment, cost of inspection/handling of materials and so on. They are affected by complexity rather than volume.

7. ACTIVITY BASED COSTING/MANAGEMENT (ABC/ABM) SYSTEM © Tata McGraw-Hill Publishing Company Limited, Management Accounting 12- (i) Tracing costs to activities ABC System is a system based on activities linking spending on resources to the products/services produced/delivered to customers. The ABC system also uses a two-stage overhead allocation: (ii) Tracing costs from activities to products/jobs

8. 1. Tracing Cost to Activities © Tata McGraw-Hill Publishing Company Limited, Management Accounting 12- This step is to identify major activities that cause/drive overhead costs to be incurred. Some of the activities are related to production volume (such as production runs, salary of supervisors and so on) but others are not (such as inspection/handling of materials, setting up equipment and so on). The cost of resources consumed in performing these activities are grouped into cost pools.

9. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 12- Exhibit 2: Common Activities and Associated Costs/Cost Drivers Major Activities (1) Associated Costs (2) Cost Driver (3) Processing purchase order for materials and parts Handling material and parts Inspecting incoming material and parts Setting up equipment Producing goods using manufacturing equipment Supervising assembly workers Inspecting finished goods Packing customer orders Labour costs for workers determining order quantities, contacting vendors, and preparing purchase orders Labour costs for workers handling material and parts, depreciation of equipment used to move material and parts Labour costs for workers performing inspections, depreciation of equipment used to test strength of materials, tolerances, etc. Labour costs for workers involved in setups, depreciation of equipment used to adjust equipment Depreciation on manufacturing equipment Salary of assembly supervisors Labour cost for finished goods inspections, depreciation of equipment used to test whether finished goods meet customer specifications, etc. Labour cost for packing workers, cost of packing materials, etc. Number of purchase orders processes Number of material requisitions Number of receipts Number of setups Number of machine-hours Number of assembly labour-hours Number of inspections Number of boxes packed

10. 2. Tracing Costs from Activities to Products 12- The next step is to assign costs to products/jobs using cost drivers as a measure of activity. Cost drivers represent the quantity of activities used to produce individual products. (I) TRANSACTION (II) DURATION (III) INTENSITY (DIRECT CHARGING) They identify the linkage between activities and cost objects and serve as quantitative measures of the output of activities. In fact, they are the central innovation of ABC system. Three types of cost drivers are:

11. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 12- Transaction drivers are used to count the frequency of an activity/the number of times an activity is performed. Duration drivers represents the amount of time required to perform an activity. Intensity drivers are used to charge directly for the resources used each time an activity is performed. Transaction Drivers Duration Drivers Intensity Drivers

12. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 12- The next step is to compute the Activity Cost Driver Rate (ACDR). Finally, ABC Products Profitability Report is prepared. It combines activity expenses assigned to each product with their direct (labour and material) costs. Activity-Based Costing Products Profitability Report Activity Cost Driver Rate The activity expenses assigned to a product is arrived at multiplying the ACDR by the quantity of each activity cost driver used by each product. The ACDR is the amount determined dividing the activity expenses by the total quantity of the activity cost driver.

13. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 12- Example 1 We will now illustrate the step-wise cost allocation of overhead costs and the preparation of the ABC Products Profitability Report for the Montex Pen Manufacturing Company in Exhibit.1. (A) The total overheads (aggregating Rs 9,00,000) were comprised of the following: Expense category Expenses Indirect labour Fringe benefits Computer system expenses Machinery Maintenance Energy Total Rs 3,00,000 2,40,000 1,50,000 1,20,000 60,000 30,000 9,00,000

14. 12- 1 (Rs 4,20,000 × 0.50) + (Rs 1,50,000 × 0.80) = Rs 2,10,000 + Rs 1,20,000 = Rs 3,30,000 2 (Rs 4,20,000 × 0.40) = Rs 1,68,000 3 (Rs 4,20,000 × 0.10) + (Rs 1,50,000 × 0.20) = Rs 42,000 + Rs 30,000 = Rs 72,000 4 (Rs 1,20,000 + Rs 60,000 + Rs 30,000) × 1.00 = Rs 2,10,000 (B) The activities and activity expenses of the Montex Pen Manufacturing Company are summarised below: Overhead cost items Cost driver Handle production runs Set up Support machines Run machine products Total expenses (1) Indirect labour and 1/2 fringe benefits (2) Computer expenses (3) Machine depreciation (4)Maintenance (5) Energy Activity Expenses 50% 80% — — — Rs 3,30,000 1 40% — — — — Rs 1,68,000 2 10% 20% — — — Rs 72,000 3 — — 100% 100% 100% Rs 2,10,000 4 Rs 4,20,000 1,50,000 1,20,000 60,000 30,000 7,80,000

15. 12- Activity Cost Driver Products Blue Pens Black Pens Red Pens Purple Pens Total @ Direct labour-hour/unit Machine-hour/unit Production runs Setup time/run Total setup time (hour) Number of products 0.02 0.10 70.00 4.00 280.00 1.00 0.02 0.10 65.00 2.40 156.00 1.00 0.02 0.10 50.00 5.60 280.00 1.00 0.02 0.10 15.00 5.60 84.00 1.00 2,000 10,000 200 — 800 4 @Total labour and machine-hours are obtained by multiplying the unit amounts by the quantity of each type of pen sold (from Exhibit 1), that is, 25,000 blue, 20,000 black, 4,500 red and 500 purple pens.

16. 12- (C) The activity cost driver rates and the activity expenses assigned to products are shown below: Activity Activity expenses Activity cost driver Activity cost driver quantity Activity cost driver rate Handle Production runs Set up machines Support products Run machines Total Rs 3,30,000 1,68,000 72,000 2,10,000 ________ 7,80,000 Number of production runs Number of setup hours Number of products Number of machine-hours 200 800 4 10,000 Rs 1,650 per run 210 per setup hour 18,000 per product 2.10 per machine-hour

17. 12- Activity Expenses Assigned to Products ACDR ACDQ for Blue Activity Expenses: Blue ACDQ for Black Activity Expenses Black ACDQ for Red Activity expenses: Red ACDQ for purple Activity Expenses: Purple (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) Handle Production Run Setup Machines Support Products Run Machines Rs 1,650 210 18,000 2.10 70 280 1 5,000 Rs 1,15,500 58,800 18,000 1,05,000 65 156 1 4,000 Rs 1,07,250 32,760 18,000 84,000 50 280 1 900 Rs 82,500 58,800 18,000 18,900 15 84 1 100 Rs 24,750 17,640 18,000 210 Note: ACDR = Activity Cost Driver Rate; ACDQ = Activity Cost Driver Quantity

18. 12- (D) The ABC product profitability report for the Montex Pen Manufacturing Company is shown in Exhibit 3. Exhibit 3 Activity-Based Costing Products Profitability Report Blue Pens Black Pens Red Pens Purple Pens Total Sales revenues Material cost Direct labour cost Gross Margin Overheads: — 50% fringe benefit on direct labour — Handle production runs — Setup machines — Support products — Run machines Total Operating income Return on sales (%) Rs 11,25,000 3,75,000 1,50,000 6,00,000 60,000 1,15,500 58,800 18,000 1,05,000 3,57,300 2,42,700 21.7 Rs 9,00,000 3,00,000 1,20,000 4,80,000 48,000 1,07,250 32,760 18,000 84,000 2,90,010 1,89,990 21.1 Rs 2,09,250 70,200 27,000 1,12,050 10,800 82,500 58,800 18,000 18,900 1,89,000 (76,950 ) (36.8) Rs 24,750 8,250 3,000 13,500 1,200 24,250 17,640 18,000 2,100 63,690 (50,190) (202.8) Rs 22,59,000 7,53,450 3,00,000 12,05,550 1,20,000 3,30,000 1,68,000 72,000 2,10,000 9,00,000 3,05,550 13.5

20. Cost of Resource Capacity 12- The expenses of resources unused during the production (difference between theoretical capacity and practical capacity) is the cost of unused capacity. Such a cost should be assigned to the person/customer/department/market segment concerned with/responsible for it. Practical capacity is a better measure of cost of resources to handle each production (i.e. capacity expenses ÷ practical capacity). It is the maximum amount of work that can be performed by resources supplied for production/services and is expressed as a percentage of theoretical capacity. Theoretical capacity means the normal working hours of a machine/working employee. The difference between theoretical capacity and practical capacity is the time utilised by the employees for breaks, arrivals, departures and so on, which are not related to actual work performance. It may also represent allowances for downtimes of machines due to maintenance, repair and rescheduling fluctuations and so on. Practical capacity Duration Drivers Unused Capacity

22. 12- Tracing Costs to Customers The focus of ABC system is on tracing marketing, selling and distribution costs to customer segments. To illustrate, consider two customers, Simple and Complex, of Avon Industries Ltd. Avon Ltd. currently uses the traditional/conventional cost accounting system and distributes the marketing, selling and distribution to customers based on sales revenue, that is, approximately one-third of total sales. The traditional costing-based profitability of Simple and Complex (customers) is summarised in Exhibit 4: Exhibit 4: Traditional Costing Based Customer Profitability Analysis Simple Complex Sales revenue Costs of goods sold Gross margin Marketing, selling, distribution and administrative expenses (0.33 × sales) Operating profit Profit (as percentage of sale) Rs 12,80,000 6,16,000 6,64,000 4,22,000 2,41,600 18.8 Rs 12,60,000 6,24,000 6,36,000 4,15,800 2,20,200 17.5

23. Identification of Activities and Cost Drivers 12- Activity Activity Cost Driver 1 Marketing and technical support 1 Estimated proportion of time spent on each customer 2 Travel to customers 2 Actual expenditure 3 Distribution of sales catalogue 3 Number of mailings 4 Servicing of customers 4 Estimated proportion of time spent on each customer and supplies used by them 5 Handle customer orders 5 Number or orders 6 Warehouse inventory for customers 6 Quality of inventory and space required by customer 7 Shipping/despatch to customers 7 Actual records

24. Identify Resource Spending The next step is to identify the resource spending in the various accounts. The customer profile of Simple and Complex is as follows. Simple orders only a few products in large quantities, places order predictably and with long lead times, and requires little sales and technical support. But Complex requires a great deal of handholding and continuously inquires whether products could be modified to meet his specific needs. In addition to marketing resources, many technical resources are required to service Complex. Complex also places many small orders for special products, requires expeditious delivery and pays slowly, increasing the demands on order processing, invoicing and accounts receivable process of Avon Ltd. Suppose the following marketing, selling, distribution and administrative costs are identified for the two customers. Simple Complex 1 Marketing and technical support 2 Travel to customers 3 Distribution of sales catalogue 4 Servicing of customers 5 Handling customer orders 6 Warehouse inventory 7 Ship/despatch to customers Total activity expenses Rs 28,000 4,800 400 16,000 2,000 3,200 50,400 1,04,800 Rs 2,16,000 28,800 400 1,68,000 72,000 35,200 168,000 6,88,400

25. Customer Profitability Analysis Report Exhibit 5: Activity-Based Costing Customer Profitability Analysis Simple Complex Sales revenue Cost of goods sold Gross margin Marketing, selling and distribution expenses: Marketing and technical support Travel to customers Distribution of sales catalogue Servicing of customers Handling customer orders Warehouse inventory Ship/dispatch to customers Total activity expenses Operating profit Profits as percentage of sales (operating margin) Rs 12,80,000 6,16,000 6,64,000 28,000 4,800 400 16,000 2,000 3,200 50,400 1,04,800 5,59,200 43.7 Rs 12,60,000 6,24,000 6,36,000 2,16,000 28,000 400 1,68,000 72,000 35,000 1,68,000 6,88,400 (–52,400) (–4.2) According to the ABC customer profitability analysis (Exhibit 5), Simple is a highly profitable customer while Complex is a very unprofitable customer. The reason is that ordering and support activities of Simple places few demands on the Avon’s marketing, selling, distribution and administrative resource as a result of which its operating margin is much higher.

28. Cost Structure of Service Companies Service companies have a unique cost structure. Virtually all their costs are indirect/fixed. In contrast to manufacturing companies, customer behaviour determines the basic operating costs of products/services of service companies. They should, therefore, identify the differential profitability of individual customers as they determine the quantity of demands for their operating activities.

29. ABC Model Illustrated Example 2 The structure/construction of the ABC system in a service company is almost identical to that of a manufacturing company, that is, (i) identify activities, (ii) assign resources expenses to activities, (iii) determine activity cost drivers, (iv) calculate activity cost driver rate and (v) compute product/customer cost. We illustrate below the ABC model for a service company with reference to IBM-Daksh. The billing department of IBM-Daksh customer care centre requires accurate and useful information about the cost of providing account inquiry and bill printing services for its 1,20,000 residential and 20,000 commercial customer accounts. A local service centre has offered to provide all the functions currently performed by IBM-Daksh’s billing department at Rs 21.5 per residential account and Rs 40 per commercial account. All costs in the billing department are indirect. There are no direct or unallocated costs. The resources used to support the billing department of IBM-Daksh in the previous month are summarised below:

30. Expense Expense amount Telecommunications Computer expenses Supervisors Paper Occupancy Account inquiry labour Printing machines Billing labour Verification labour Other resources Rs 2,92,600 8,90,000 1,68,000 36,000 2,35,000 8,67,300 2,75,000 2,81,750 56,250 3,35,000 34,37,500 The billing department of IBM-Daksh uses a traditional costing system that allocates all indirect costs based on (i) the number of account inquiries, namely, 20,000 (80 per cent) for residential customers and 5,000 (20 per cent) for commercial customers.

31. Suppose IBM-Daksh wants to introduce ABC system for its billing department. They have identified the following activities and the related cost drivers: Activity Cost driver Account billing Bill verification Account inquiry Correspondence Other activities Number of printed pages Number of accounts verified Number of inquiries Number of letters Number of printed pages

32. The resources used to perform the activities and the activities performed are shown here: Resources Used to perform activity Activity Performed (%) Account Inquiry Correspondence Billing Verification Others Total Supervisor 40 10 30 — 20 100 Account inquiry labour 90 10 — — — 100 Billing labour — — 30 70 — 100 Verification labour — — — 100 — 100 Paper — — 100 — — 100 Computer 45 5 35 10 5 100 Telecommunications 90 — — — 10 100 Occupancy 65 — 15 — 20 100 Printing machines — 5 90 — 5 100 All other resources — — — — 100 100

33. The number of cost driver units for the billing department of IBM-Daksh is shown below: Activity Cost driver units Number of cost driver units Residential Commercial Total 1 Account inquiry 2 Correspondence 3 Bill printing 4 Verification 5 Other activities Number of inquiries Number of letters Number of printed pages Number of accounts verified Number of printed pages 20,000 1,800 1,20,000 — 1,20,000 5,000 1,000 40,000 20,000 40,000 25,000 2,800 1,60,000 20,000 1,60,000 Required: (a) Using the traditional costing system, should the IBM-Daksh accept the offer of the local service centre to perform all the functions? (b) Would the decision be different with ABC system?

34. Solution: (a) Cost Computation for Billing Department (Traditional Costing System) Residential Commercial 1 Cost 2 Number of inquiries 3 Number of accounts 4 Cost per account (1 ÷ 3) Rs 27,50,000 @ 20,000(0.80) 1,20,000 22.9 Rs 6,87,500 @@ 5,000(0.20) 20,000 34.4 @ Rs 34,37,5000 × (0.80) @@ Rs 34,37,500 × (0.20) Decision: The billing department should accept the offer of the local service centre to service residential accounts as there is a saving of Rs 1.4 per account (Rs 22.9 – Rs 21.5). But it should continue to service the commercial accounts because of lower cost of Rs 5.6 (Rs 40 – Rs 34.4). (b) The computation of activity-based cost per account for each customer class (residential and commercial is illustrated below).

35. (b) (i) Total Traceable Costs Resource Cost Activity Cost Pool Account Corres- Billing Verification Others Inquiry pondence 1. Supervisors 2. Account inquiry labour 3. Billing labour 4.Verification labour 5. Paper 6. Computer 7. Telecommuni- cations 8. Occupancy 9. Printing machines 10. Others Rs 1,68,000 8,67,300 2,81,250 56,250 36,600 8,90,000 2,92,600 2,35,000 2,75,000 3,35,000 Rs 67,200 a 7,80,570 — — — 4,00,500 2,63,340 1,52,750 — — Rs 16,800 b 86,730 — — — 44,500 — — 13,750 — Rs 50,400 c — 84,375 — 36,600 3,11,500 — 35,250 2,47,500 — — — Rs 1,96,875 56,250 — 89,000 — — — — Rs 33,600 d — — — — 44,500 29,260 47,000 13,750 3,35,500 Total traceable cost 34,37,500 16,64,360 1,61,780 7,65,625 3,42,125 5,03,610 a (Rs 16,8,000 × 0.40) b (Rs 16,8,000 × 0.10) c (Rs 1,68,000 × 0.30) d (Rs 16,8,000 × 0.20)

36. (b) (ii) Costs Driver Activity Traceable costs Number of Driver Units Cost per Driver Units (1) (2) [(1) ÷ (2)] Account inquiry Rs 16,64,360 25,000 inquiries Rs 66.5744 Correspondence 1,61,780 2,800 letters 57.7786 Account billing 7,65,625 1,60,000 printed pages 4.7852 Bill verification 3,42,125 20,000 accounts verified 17.1062 Other activities 5,03,610 1,60,000 printed pages 3.1476

37. (b) (iii) Cost per Customer Class Cost Per Driver Unit Residential Customer Accounts Commercial Customer Accounts Number of Driver Units Cost Number of Driver Units Cost (1) (2) (3) (4) (5) (6) Account inquiry Rs 66.5744 20,000 inquiries Rs 13,31,490 5,000 inquiries Rs 3,32,870 Correspondence 57.7786 2,800 letters 1,04,001 1,000 letters 57,779 Account billing 4.7852 1,20,000 pages 5,74,224 40,000 pages 1,91,408 Billing verification 17.1062 — — 20,000 accounts 3,42,124 Other activities 3.1476 1,20,000 pages 3,77,712 40,000 pages 1,25,904 Total Costs 23,87,415 10,50,085 Number of accounts _______ 1,20,000 ______ 20,000 Cost per account Rs 19.90 Rs 52.50 Cost per account 22.90 34.40 (traditional system)