Question

Activity based costing and development in information technology- need to prepare a review of the literature in this topic in relation to activity based costing no longer than 1500 words

Answer 1

Literature Review on Topic: Activity Based Costing (ABC)

• Factors prompting the development of ABC system include:

1. Growing overhead costs because of increasingly automated production;
2. Increasing market competition which necessitated more accurate product costs;
3. Increasing product diversity to secure economies of scope & increased market share;
4. Decreasing cost of information processing because of continual improvements and increasing application of information technology;

• Meaning: ABC is an accounting methodology that assigns costs to activities rather than products or services. This enable resources & overhead costs to be more accurately assigned to products & services that consumes them.

ABC is a technique which involves identification of cost with each cost driving activity and making it as the basis for apportionment of costs over different cost objects / jobs / products / customers or services.

• Definition: “An Approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach costs to outputs.”

• Flow is characterised through Four Core Areas:

1. Activity: here, refers to an event that incurs cost.
2. Cost Object: It is an item for which cost measurement is required e.g. a product or a customer.
3. Cost Driver: It is any factor or activity that causes a change in the cost of an activity. It has a direct cause and effect relationship with the resources consumed. There are two categories of cost driver:
4. Resource Cost Driver: It is a measure of quantity of the resources consumed by an activity. It is used to assign the cost of a resource to an activity or cost pool.
5. Activity Cost Driver: It is a measure of frequency and intensity of demand, placed on activities by cost objects. It is used to assign activity costs to cost objects.

• Stages in Activity Based Costing:

1. The first stage is to identify the major activities in the organization. There can be machine related activities, direct labour related activities and various support activities such as ordering, receiving, material parts handling etc.
2. Assigning costs to cost pool for each activity both support and primary activities, that caused them. This creates ‘cost pools’ or ‘cost buckets’. This will be done using resource cost drivers that reflect causality.
3. Support activities are then spread across the primary activities on some suitable base, which reflects the use of the support activity. The base is the cost driver that is the measure of how the support activities are used.
4. Determine the Cost Drivers for each activity that will be used to relate the overheads collected in the cost pools to the cost objects / products. A Cost driver is a variable, which determines the work volume or work load of a particular activity. This is based on the factor that drives the consumption of the activity. The question to ask is – what causes the activity to incur costs?
5. Assigning the Costs of activities to products according to product demand for activities: The step involves tracing the cost of the activities to products according to products demand for these activities during the production process. This requires calculating cost driver rate for each activity, just as an overhead absorption rate would be calculated in the traditional system.

Activity Cost Driver Rate = Total Cost Activity

                                            Activity Driver

• Categories of Activities are:

1. Unit Level Activities- The cost of some activities (mainly primary activities) are strongly correlated to the number of units produced. For e.g. the use of indirect materials / consumables tends to increase in proportion to the number of units produced.
2. Batch Level Activities- The cost of some activities (mainly manufacturing support activities) is driven by the number of batches of units produced. For e.g. Material Ordering- where an order is placed for every batch of production.
3. Product Level Activities- The cost of some activities (often once only activities) are driven by the creation of a new product line and its maintenance. For e.g. designing the product, producing parts specifications and keeping technical drawings of products up-to-date.
4. Facility Level Activities- Some cost cannot be related to a particular product line; instead they are related to maintaining the building and facilities. For e.g. the maintenance of buildings, plant security, business rates, etc.

The First and Last categories above are the same as those in traditional absorption costing and so if an organisation costs are mainly made up of these two categories ABC, will not improve the overhead analysis greatly. But if the organisation’s cost fall mainly in the second and third categories an ABC analysis will provide a different and more accurate analysis.

• Purpose of Activity Based Costing:

1. Production overheads are high in relation to direct costs;
2. There is a great diversity in the product range;
3. Products are very different amounts of the overhead resources;
4. Consumption of overhead resources is not primarily driven by volume;

• Advantages of Activity Based Costing:

1. More accurate costing of products/ services, customers, distribution channels;
2. Better understanding overhead;
3. Utilizes unit cost rather than just Total Cost;
4. Integrates well with six sigma and other continuous improvements programs;
5. Make visible waste and non-value added;
6. Supports performance management and scorecards;
7. Enable costing of processes, supply chains and value streams;
8. Activity based Costing mirrors way work is done;
9. Facilitates Benchmarking.

• Activity based Cost system Installation and operation:

1. Staff Training: The co-operation of the workforce is critical to the successful implementation of ABC. They are closest to the process and most aware of the problems. Staff Training should be, as far as possible, Jargon-Free, and create an awareness of the purpose of ABC.
2. Process Specification: Informal, but structured, interviews with key members of personnel will identify the different stages of the production process, the commitment of resources to each, processing times and bottlenecks. The Interviews will yield a list of transactions which may, or may not, be defined as ‘activities’ at a subsequent stage, but in any case provide a feel for the scope of the process in the entirety.
3. Activity Definition: The problem must be kept manageable at this stage, despite the possibility of information overload from new data, much of which is in need of codification.
4. Activity Driver Selection: A Single Driver covering all of the transactions grouped together in an ‘activity’ probably does not exist. Multiple driver models could be developed if the data were available, but cost-benefit analysis has rarely shown these to be desirable.
5. Costing: A Single representative activity driver can be used to assign costs from the activity pools to the cost objects.

•   ABC: A Decision Making Tool

It is a useful tool for many of the management decisions facing companies today. It can bring a picture of the operation to light that may not be obvious through other analysis tools. Specifically, ABC is useful in analysing specific segments of an organization. This might include a market line, a group of products (even a single product), a customer, or an employee.