Question

Explain the use activity-based costing to allocate costs in a modern manufacturing environment to products or services.

Answer 1

Activity-Based Costing-

A process using multiple cost drivers to predict and allocate costs to products and services; an accounting system collecting financial and operational data on the basis of the underlying nature and extent of business activities; an accounting information and costing system that identifies the various activities performed in an organization, collects costs on the basis of underlying nature and extent of those activities, and assigns costs to products and services based on consumption of those activities by the products and services.

Activities and Types
An activity is a work performed within an organization. All manufacturing units or service units have various functions such as finance, accounting, human resources, production processes etc. each of these businesses and production processes is composed of defined steps or activities. An activity is a discreet unit of work for which anorganization can define inputs (resources used) and outputs. In the first stage of Activity-Based Costing, activities are identified, costs are associated with individual activities, and their associated costs are divided into homogenous sets. An activity is also defined as an aggregation of actions performed within an organization that s useful for purposes of Activity-Based Costing. Thus, activity identification requires a listing of all the different kinds of work, such as:
•Material handling;
•Inspections;
•Process engineering;
•Product enhancement etc.

A firm may have hundreds of different activities. Once an activity is defined, the cost of performing the activity is determined. At this point, the firm could determine the cost driver associated with each activity and calculate individual activity overhead rates. Activities play a vital role in cost management i.e. cost reduction and cost control. Even highly talented, experienced professionals and managers could seldom directly control costs without controlling activities that drive these costs. It could be explained in a cotton textile industry, if some of unit or batch-level activities could be improved, costs could perhaps be controlled. If certain quantum of “non-value adding waste” is removed, costs are reduced automatically. Such cost reduction is contrasted with the famous “across-the-board-cost-cuts” followed in many industries today. The distinction between these two cost reduction methods is that the larger might tend to unscientifically cut even some of the value-adding activities, which would be ultimately detrimental to the objective of such cost reduction exercises. Activities may be classified into five types depending on the type of decision to use resources:
a)Unit Level Activities:
the work efforts that transform resources into individual products and services are called unit level activities. A decision to produce more units of product or service proportionately causes more unit level activities. Unit level activities are performed for every unit of product or service.
b)Batch Level Activities:
it reflects the organization’s manufacturing or service technology to perform certain activities that affect multiple units of output equally and simultaneously. A batch refers to a number of units of service or product that requires the same set up of personnel, software or equipment. Different technology allows different batch sizes and activities.
c)Product Level Activities:
product level activities may include design, advertising, supervision, manufacturing and quality management that are specific to each type of product or service. These specific activities would not be necessary if, for example, the company decided it would no longer provide a certain product or service. However these product-level activities may use both product and facility-level human and physical resources.
d)Customer Level Activities:
these activities are performed to meet the needs of specific customers. Customer-level activities may include supply and distribution if these are specific to customers.
e)Facility Level Activities:
these activities may support all the organization’s processes, and are at the highest level of hierarchy. Examples of facility level activities are activities of top management, personnel, supply, distribution, advertising and promotion, research and development and so on that are common to all the company’s products, services and customers. Facility-level activities also include the work ofservice departments such as Finance and Accounting, Management Information System and Human Resources.
4. Cost Driver Base and Rate
A cost driver base is a measurable cause or driver, of performing an activity; i.e., it is what causes a cost to be incurred. Increases or decreases of the cost-driver base cause increases or decreases in the level of activity performed. There are many possible cost-driver bases is critical to the validity of activity analysis. An appropriate cost driver base should:
•Logically have a cause-and-effect relationship with the activity and the use of resources (cost);
•Be feasible to measure;
•Predict or explain activities’ use of resources (cost) with reasonable accuracy;
•Be based on the practical capacity of the resource to the support activities. The cost driver rate is estimated cost of resource consumption per unit of cost-driver base for each activity.

5. Traditional Cost/Actual Cost System
It is a valuation method that uses actual direct material, direct labor, and overhead charges in determining the cost of Work-in-Progress inventory. In conventional costing, all overheads are absorbed on production volume, as measured by labor or machine hours. This means that high volume standardized products would be charged with most overheads and short run production with lower overheads in spite of the fact that short run production causes more set-ups, retooling, production planning and thereby generates more support overhead costs. Hence, traditional volume related overhead absorption tends to over cost products made in long runs and under costs products made in short runs. ABC seeks to remove this problem by relating support overheads to products, not by production volume, by a number of specific factors known as cost drivers. A cost driver is an activity which causes cost.

6. Activity Center and driver
Activity center is a segment of the production or service process for which management wants to separately report the cost of the activities performed. Activity driver is a measure of the demands on activities and thus, the resources consumed by products and services; often indicates an activity output.