Volume and activity based costing

Volume and activity based costing
Traditional volume based costing
Concept
A number of activities are involved in manufacturing products or providing services. Some of such activities are purchase of materials, production panning, processing of orders, technology assistance, quality control, accounting etc. if the per unit cost of product  or service is calculated without considering the above activities in allocation and absorption of overhead, it is called the traditional costing method. In other words, if per unit cost is calculated on the basis of allocation and absorption of overhead on production unit or direct labour hour machine hour basis only, it is called traditional costing method. This method is also termed as absorption costing or conventional costing. More specifically, under the traditional method, the overhead costing or conventional costing. More specifically, under the traditional method, the overhead are not absorbed according to the activities rather it is done according to production units or labour hours or machine hours. It gives due emphasis to the production units not to the activities.

Ascertainment of total cost and profit under traditional volume based costing

The way of calculating the cost per unit by preparing a cost statement is as under in seven steps.
a.    Ascertain total overhead by preparing a statement
b.    Find out the base of allocating the overhead. The bases may be production units or labour hours or machine hours.
c.    Calculate the overhead rate as per unit hour.
Overhead rate = total overhead/ total output or labour hour or machine hour
d.    Multiple the overhead rates with units of each product or department.
e.    Add the overhead share with prime cost.
f.    Calculate the cost per unit of each product/ department
g.    At find stage, the profit under traditional volume based costing is computed as presented.

Limitations of traditional costing
The following are the limitations of traditional costing system:
•    In traditional costing system, overhead are absorbed on the basis of volume based activity such as production unit or machine hour or labour hour. But there are some overhead which are not dependent on them. So, it may not ascertain the accurate figure of cost.
•    The traditional basis of segregating costs into fixed and variable elements on the basis of their behaviors is generally considered to be unrealistic. It is due to the fact that with the growth of business, the costs have becomes more complex and complicated.
•    The traditional method applied for absorbing overheads lays emphasis on the calculation and application of overhead recovery rates, which are acceptable for the valuation of stocks for the purposes of routine financial reporting. The management does not find these traditional methods helpful in making complicated decision related to product strategies.
•    The traditional absorption costing does not render any valuable assistance to multi-product concerns in making decision regarding process technology, product-mix, product pricing etc.

 Activity based costing
Concept of activity based costing
Activity based costing is a system of costing in which the overhead are assigned or related to activities or grouped into cost polls before they are assigned or related to cost objective i.e. products or services. It is a method of cost attribution to cost units on the basis of benefits received from indirect activities. Activities become the focal points for cost accumulation. According to this system total overhead re firstly traced into two or more production activities and then suitable cost drivers are used to calculate per unit cost of overheads. Product cost determination under activity based costing is made on the basis of cost drivers required for producing goods cost driver is the basis or indicators, which helps to trace overhead into allocated whereas cost drive is the basis or indicator, which helps to trace overhead into product. This costing system assumes that activities are responsible for the incurrence of costs and product creates the demands for activities. Costs are charged to products based on individual product's use of each activity. An activity us an event, task or unit of work with a specified purpose e.g., designing products, setting up machines, operating machines and distributing products.

R. cooper and R.S. Kaplan defines "ABC systems calculated the cost of individual activities and assign costs to cost objects such as products and services on the basis of the activities undertaken produce each product or service."

 Likewise, according to T. Lucey, "activity based costing can be through of as a method of charging overheads to cost units on the basis of benefits received from the particular indirect activity e.g. ordering panning, setting and so on. Activities based costing seeks not only to allocated to products cost on a more realistic based than simple production volume, but also attempts to show the relationship between overhead costs and the activities that cause them".

The relationship between activities and products has been shown in the figure.

From the above statements the following facts regarding activity based costing are summarized.
a.    Production requires activities.
b.    Production work needs direct cost as well as indirect costs (overhead).
c.    Direct cost and overhead cost are related with different activities.
d.    Overhead cost is charged by showing the relationship between overhead and activities that causes them.
e.    The overhead cost is charged by showing the relationship between overhead and activities that causes them.
f.    The overhead allocation on the basis of the activities gives accurate and realistic allocation to product. Thus, it gives the true pictures of cost.
Significant terms in activity based costing
The activity based costing systems involves the use of the following terms:
a.    Cost objects: generally, the products are cost objective, but the customers, services or location can also be the cost objects.
b.    Activities: these consist of the aggregate of different tasks and are concerned with functions associated with cost objectives. There are two types of activities:
a.    Support activities
b.    Production process activities
Support activities are, for example, schedule production, set up machine, purchase materials, inspect items, customer orders, and suppliers records etc. under the production process activity, machine products and assembled products are included within this production process.

Activity cost centers are, sometimes, similarly to cost centers used under traditional costing systems. In case the purchasing department and purchasing activities both are treated as cost system. The support activity cost center also becomes identical to cost center taken under traditional costing system.

c.    Cost pool: it is another name given to a cost center and, therefore, an activity cost center may also bartended as an activity cost pool.
d.    Cost drivers: the causes for incurrent of overhead cost are known as cost driver. A cost driver is a factor, the change of which, results in a consequential change in the total cost of a related object. It is any factor or force that causes a change in the cost of an activity. Cost driven may be divided into two parts.
a.    Resource cost driver
b.    Activity cost driver

A resource cost drive is a measure of the quantity of resources consumed by an activity. It is used to again the cost of a resource to an activity or cost pool. An activity cost driver is a measure of the frequency and intensity of demand, placed on activities by cost objective. It is used to assign activity costs to cost objects.

Classification of activities
As started earlier, activities are identified and classified into different categories or segments of their production process. The grouping of activities is preferably done using the different levels at which activities are performed. Broadly, activities are classified into one of four activity categories.

a.    Unit related activity: these are the activity which are performed each time of a unit is produced. They are repetivities. For example, direct labour hours, machine hours, powers are used each time of a unit is produced. Direct materials and direct labour activities are also unit related activities, although they are not overhead costs. Costs of unit related activities vary with the number of units produced.

b.    Batch related activities: these are same activities, which are performed each time a batch of goods or product is produced. The costs of batch related activities vary with the number of batches but are fixed with scheduling, materials handling are examples of batch related activities which are related to batch but not to individual products.
c.    Product related activities: these are the activities, which are performed to support the production of each different type of product. Maitatenace of equipment, engineering charge, testing routines, maitaititing bills of materials, handling materials are some examples of batch related activities.

d.    Facilities related activities: these are the activities, which are needed to sustain a factory's general manufacturing process. These activities are common to variety of products and are most difficult to link to product specific activities. Examples of facility related activities related activities and costs are treated as period cost as they are found difficult to assign to different products. the costs associate with the first three categories- unit 1 related, batch related, product related are assigned to product and using cost driver that reflect the cause and effect relationship between activities, consumption and cost.

Procedures of absorption of overhead cost under activity based costing
The procedures of absorption of overhead cost under activity based costing are as under:
a.    Identification of different activities: first the major activities are to be identified and then classified into different categories that have relationship with the different parts of the production process. Such identification is important because products require activities and activities consume costs. Examples of some such activities, are direct labour related activities, machine related activities and various support activities, such as ordering, receiving, materials handling, production scheduling, set up, packing and dispatching etc.

b.    Determination of cost drivers of each activity: activity based costing is based on the assumptions that cost behaviors are influenced by cost drivers. Therefore, in order to trace overhead costs to products, appropriate cost drivers should be identified. In traditional product costing, the number of cost drivers used are few such as direct labour hours, machine hours, direct  labour cost, units produced etc. but ABC may use a multitude of cost drivers that relate cost more closely to the resources consumed and activities occurring. The factors that influence the cost of particular are known as cost drivers. Cost drivers are the link and they can link a pool of costs in an activities centre to the product.
c.    Creation of cost pool or cost centre for each activity: in this step, factory overhead of the activities are determined and classified into homogeneous cost pools. A homogeneous cost pool is a collection of overhead costs that are logically related to the tasks being performed. A cost pool should be created for each activity. Cost pool is like a c ost centre or activity center around which costs are accumulated.

d.    Calculation of cost driver rates: after cost pool is defined and cost drivers are identified, the cost per unit of the cost driver is computed for that pool. This is called the pool rate or which overhead absorption rates would be calculated under the traditional absorption costing system. There pool rates create link between costs and cost drivers used. 

e.    Tracing of cost of activities to products: the amount of overhead chargeable or trace to a product or cost object shall be calculated by multiplying the activities cost driver rate by different amount of each activity that each product or cost object consumes.

Total overhead product= total drivers for the product x cost driver rate

f.    Computation of total costs of products or cost objects: finally, the total costs of the products of cost objects shall be computed by adding all direct and indirect costs assigned to them.

g.    Determination of total profit: at final stage, the profit under of activity based costing is computed.

Comparison between traditional costing and activity based costing
Following are the main differences between activity costing and traditional costing system:
a.     Under ABC system, overhead costs are identified to each major activity instead of the department as under traditional costing system. It results in greater number of cost centers under ABC system.

b.    The term 'cost driver' is not used under traditional costing system. Popular terms are basis of allocation or apportionment. Under traditional costing system, cost drivers are fewer in number for the purpose of charging overhead to products.
c.    ABC system uses separate rates for supports centers and these is no re-apportionment to production centers, as is the case under traditional costing system.
 
Advantages of Activity based costing
The following are the main advantages of ABC system:
a.    It gives accurate and true figure of absorption of overhead, since the use of the principle of cost activities.
b.    It helps understanding the behavior of overhead and their relationship to products, services, customers and market segments.
c.    Since all the overheads are distributed on the basis of suitable cost drivers, so that, proper records keeping of different cost drivers are kept. So, it assists to control over the costs.
d.    It helps the management in taking better decision relating to product strategies, product designs, product mix and marketing.
e.    ABC systems are very helpful in making the evaluation of new process technologies in multi-product concerns.
f.    It provided the right information for performance measurement because it focuses on activities rather than resources.
g.     This system makes available a systematic report on the resources spending as well as on resources consumption.
h.    It provides accurate information on profit margin and performance measurement for profit improvement.

Limitations of Activity based costing system
The following are the limitations of the ABC system:
a.    It is complex in comparison of traditional costing, due to use of different cost drivers to distribute overheads.
b.    To identifying the suitable cost drive is tough task. If proper/right cost driver is not chosen the overhead absorption may not gives true result.
c.    It is costly, because it needs specialized accounting systems and skilled accountant for that one has to pay more.
d.    It is suitable for large organization only.
e.    Since ABC concept is still in primary stage of development, hence its applicability is still doubtful.

Impact of volume diversity
If the production of difference products is obtained in similar quantities, then there will not bea significant difference upon per unit cost and total profit between the traditional and activity based costing. On the other hand, when the quantities of the products being produced vary significantly, some abnormal differences may exist upon per unit cost as well as total profit between these costing methods. Such an abnormal difference in per unit cost and profit that cause due to the difference in volume is called the impact of volume diversity.

There is no difference in the per unit cost as well as total profit under traditional method irrespective of the volume difference. The per unit cost is Rs. 20 ad per unit profit is Rs. 5 under both the products. Contrary to this, there are differences in the per unit cost as well as profit under activity based costing. As a result, the cost per unit of product is high with product 'P1" resulting in loss whereas the per unit cost is low resulting in profit with the product 'P2'. Though the total profit remains the same, the p2 is more profitable than p1, in this way, activity based costing is helpful in assessing the profitability of each product.

Activity based profitability analysis
The methods of calculating the profit under traiditional and activity based costing are difference. Under, traditional method the gross profit/ loss Is calculated by subtracting the cost of goods sold from sales. The net profit/ loss are calculated by subtraction the operating expenses from the gross profit. But, profit/ loss is calculated with difference levels as unit level, production level, product line levels and plant level.