ACTIVITY BASED COSTING (ABC)

- CONCEPT IN FOUNDRY INDUSTRY

By Prof. Shantanu Mehta, FCA, Ph. D.

(Abstract: This is concept article for benefit of common businessman. The illustrative focus is
on foundry industry. The detail application may vary from industry to industry).

The cost is very sensitive issue in any activity especially in a competitive business environment.
To know the right cost of product or services, it is necessary understand characteristics of
different cost incurred , its behavior with respect to the volume of activity and finally, treatment
of cost, means adding on the product or services with respect to the relevance of decision
making process. The important information is to know total cost per unit. The total cost includes
direct cost and overheads. Allocation of overhead is little complex in multi product
manufacturing set up. This article aims to explain basic issues proper allocation of overheads or
indirect cost and in arriving at true cost per unit.

BACK DROP

The main objective of any business is to earn profit to service the capital invested. The profit is function
of revenue and cost (Revenue less cost). The revenue is function of market force. This means the
demand, competitions, consumer behavior, and such other factors that are mostly external. Thus, cost
factor becomes very important to manage, control and more importantly to calculate. Yes, calculation of
correct cost of product

INTRODUCTION

The costing, cost accounting, cost management, cost reduction, etc., are often used in common
discussion on any platform especially with reference to a business context. The main objective of these
tools is to create information that create value in managerial decision making.

One of the decisions is the pricing of your product. The issue is relatively simple if the product range
offered very narrow and with minimum product differentiation. Normally, the per unit product cost is
easy to work out. But when the product portfolio is large with variety and almost customized for every
customer segment, then correct per unit product cost calculation is a challenge because many common
resources are used.

COSTING TERMINOLOGY

The total cost is classified as direct and indirect as well as variable and fixed.

Direct cost is one that is traceable on the product and is some time exclusively spent for a product.
While indirect cost is spent on more than one product and is not easily traceable on the product. Even if
an attempt is made then it is not worth tracing it because of cost of tracing may not be justified.
Variable and fixed cost classification is function of behavior of cost with respect to volume of
production or activity level. While variable per unit cost remain constant but in totality increase or
decrease in proportionate to the volume. The fixed cost on other hand, remain constant in totality,
within relevant range of capacity or period, but vary with volume of activity in terms of per unit cost.
Both indirect cost and fixed cost are commonly known as “overheads”

CHALLENGE IN ALLOCATING OVERHEADS

The direct cost can be easily accumulated on a product since it is traceable. But all indirect cost or
overheads are to be ascertained first and then allocated on some basis. The ascertainment needs detail
recording of cost transactions and it has to aggregate in logical group. Then on “some basis”, it is to be
added / allocated on the product. This is relatively simple if the product range is very narrow, say two or
three. Further, even when number products are more but they are alike and consumes almost similar
resources and same quantity, then also such allocation is not complex.

The challenge of allocating overheads is in the multi product environment that requires different
proportion of common resources. Traditional costing system follows to apply the common cost
allocation on single parameter like machine hour or labor hour. This conventional method, when applied
to allocate common overheads on various products, then the cost of one product may be subsidized to
another. This is called cost distortion.

Before, three decades, the direct cost components were more as compare to indirect one. The
manufacturing process were manual and labor intensive.With virtual no variants in product, large size of
production batches were possible. Technology had little role to play in incidental work to the production
runs, the customization was less, and after sale services were not to key to the success. Besides, applied
R&D for specific demands, exclusive product support system, small order size of purchases for different
products, its inspection and inventory handling cost, etc. are the features of recent changes in new
business environments.

ACTIVITY BASED COST SYSTEM (ABC)

Activity-based cost systems have been developed to eliminate this major source of cost distortion.
Activity-based cost (ABC) systems use a simple two-stage approach similar to but more general than
traditional cost systems. Unlike in traditional costing system where the overheads are allocated bases
either plant as a whole at the most department. In ABC, the overheads are identified and ascertained at
each activity level within even department. For example, in traditional approach, the purchase
department or store cost is allocated on uniform basis on every product, while in ABC system, the cost
of running purchase department is further traced to the activity like number order booking and
processing (item wise) inspection and material handling in store, special support system for unique
component for specific product, and likewise and then applied to relevant product in proportion of the
common resources used. Technically, this is described as under;
  Pooling of related activity and treating that as a “cost centre”
 Tracing Costs to Activities
 Deciding “cost driver” for each activity pool
 Calculating Activity Cost Driver Rate (ACDR)
 Allocating indirect cost to the product in proportion to the common resources used of
activities by applying ACDR

In addition, following point should also be considered.

• If the amount of resources required to perform the activity varies considerably from product to
product then more accurate and more complex and detailed types of cost drivers should be
used

• The ABC system designer should balance the cost of errors resulting from inaccurate estimates
with the cost of measurement

• Most of the benefits from a more accurate cost system can be obtained with simple ABC
systems

• The calculation of activity cost driver rates are sometime based on the capacity actually used

• Analysts can obtain a better estimate for the cost of resources required to handle each
production run by dividing activity expenses by the practical capacity of work the resources
could perform

The broad difference in traditional approach and ABC can be summerised as under;

Traditional v. ABC System

(Source: Management Accounting by Anthony Atkinson and Robert Kaplan)

• Traditional:
– Uses actual departments or cost centers for accumulating and redistributing costs
– Asks how much of an allocation basis (usually based on volume) is used by the
production department
– Service department expenses are allocated to a production department based on the
ratio of the allocation basis used by the production department
• ABC:
– Uses activities, for accumulating costs and redistributing costs
– Asks what activities are being performed by the resources of the service department
– Resource expenses are assigned to activities based on how much of the resource is
required or used to perform the activities
FOUND RY INDUSTRY

Like any competitive industry, foundry industry is also customer driven who negotiate price reduction
every time. Further, the product range is fairly large ranging variety of end users with different
expectation form the product. An exemplary list could be as under;

Products in foundry industry: Illustrative list (source: internet)

Automotive parts Engineering applications

Telecommunication, leisure and, household

appliances

Architectural and street furniture

Many industry players may still follow the per kilogram cost approach to arrive at the cost per unit. This
approach may lead to cost distortion and consequently error in pricing the product.

The normal process in foundry industry may be described as under;

Description of process

Melting

Molding /Casting

Core making

Cleaning

Trimming and inspecting

Finishing and Shipping

Design cost to meet customers’ specification

Pattern maintenance and modification as per frequency and demand

Product specific cycle time

Quality control practice

Pre sell resources used for order procurement

Post sale cost on services as well as collection of dues

All abovementioned cost are part of “overhead cost” that is not easily traceable on the individual
product. Each of this stage of process can be further be split into small activity pool and separate cost be
ascertained for each of such pool. The exact grouping can be fine tuned according to the variety of
product and exact resources requirement each of such product.

Accurate cost information is must for each type of product for pricing decision. Even if the price are
completely market driven then also one should know how much is profit margin on each type product
and whether such margins are sustainable in long run. In such situation, per kilogram costing methods
may lead to incorrect cost of product because of good amount spent on following.

In fact, the correct knowledge of true cost leads to advantage in competitive market where the pricing
would beat the competition.

DESIGNING ABC SYSTEM

Designing ABC is not a rocket science that requires sophisticated knowledge and tools. The best people
for designing the system are the people engaged in daily shop floor routine with overall idea of
complete business operation. It is team effort with least behavioral issues. The process of designing ABC
can be briefly explained as under;

– Analysis of indirect expenses

– Interviewed department heads in charge of various departments

– Develop the activity dictionary: the list of major activities performed by both the
factory’s human and physical resources

– Obtain sufficient information to assign resource expenses to each activity in the

activity dictionary

As stated above, the ABC system design is detail home work of activity and pool in logical group with
cost ascertainment for each activity pool. Cost drivers to be selected and then record precisely, the
resources consumption by each product from such activity pool.

ISSUES IN IMPLENTATION

Problems may arise in practice from the approach to activity-based costing that assigns many resource
expenses to activities based on interviews, surveys, and direct observation of production and support
processes because these activities are time-consuming and expensive

– Inaccuracies and bias may affect the accuracy of cost driver rates derived from
individuals’ subjective estimates of their past or future behavior

– Companies must periodically repeat the interviewing and surveying processes if they
want to keep their activity-based cost systems updated

– Adding new activities to the system is also difficult, requiring re-estimates of the relative
amount of resource time and effort required by the new activity
A more subtle and serious problem arises from the interview or survey process

• People estimating how much time they spend on a list of activities handed to
them invariably report percentages that add up to 100%

• Few individuals report that a significant percentage of their time is idle or

unused

CONCLUSION

Activity Based Costing System (ABC) is widely accepted approach for allocation of common expenses
known as overheads. The competition, customization, variant in products, and such other business
phenomena, have almost forced the modern cost management to explore ABC. The information
technology (IT) has made the task of implementing ABC, easier. Further, the next step to ABC, that is
Activity Based Management (ABM) helps in cost reduction exercise because cost at each stage in
recorded and applied at micro level rather than aggregate and crude manner. The ABC is very much
needed to transform the business decision making process for better future.