In this article we will discuss about the relevant cost information provided by activity based costing system for analytical approaches.
The activity-based analytical approaches to a cost reduction programme include:
(1) Activity mapping,
(2) Value-chain analysis, and
(3) Analysis of core/support/diversionary activities.
The successful implementation of these approaches needs micro cost information. The traditional cost systems based on over simplistic cost model fail to provide micro-level relevant cost information.
ABC system can provide relevant cost information for implementation of the above analytical approaches through:
(i) Resourced focused concept,
(ii) Management-oriented logic and
(iii) Rational assumption.
These are discussed below in brief:
1. Activity Mapping:
The activities are analysed in terms of their flow of work by location and duration.
This enables the firm to focus on three aspects of process development:
(i) Cause of the activity: What is causing the activity to take place, so frequently?
(ii) Resource consumption: Why does the activity consume so much resources every time?
(iii) Activity linkage: How does the activity affect or is affected by other activities with which it is connected as a part of business process.
Analysis of the above three factors brings opportunity for process redesign with a view to reducing the cost of the process. And the process redesign scheme tries to avoid complexity of the activities and duplication of activities and thereby minimises the resource consumption by reconfiguration.
2. Value-Chain Analysis:
The value chain concept being broader in scope than the traditional value-added concept highlights four profit improvement areas:
(i) Linkage with suppliers,
(ii) Linkage with customers,
(iii) Linkage with processes, and
(iv) Linkages across unit value chains within the firm.
The analysis with a cost reduction perspective involves three steps:
(i) Identification of industry’s value chain and assigning costs, revenues and assets to value activities;
(ii) Diagnosing the cost drivers regulating each value activity (both structural cost drivers and operational cost drivers); and
(iii) Developing sustainable competitive advantage either through controlling cost drivers better than the competitors or by reconfiguration the value chain.
Activity Based Costing, by analysing the activities and their cost drivers, addresses to the following key questions from a strategic view-point:
(i) Can the firm reduce costs in a particular activity, holding the value constant?
(ii) Can the firm increase the value in this activity, holding the costs constant?
(iii) Can the firm reduce assets in this activity, holding the costs and revenues constant?
(iv) Is there any surplus facility (spent but unutilised resources) that creates value?
3. Analysis of Core/Support/Diversionary Activities:
This three-tier classification of activities facilitates analysis that helps the firm to meet divergent competitive situations. ABC system helps identification of such activities and determination of costs associated with them.
When micro-activities are analysed with regard to their cost effectiveness, managers can get insights into the areas where unnecessary activities can be dropped or their costs can be reduced.
4. Resource Focused Concept:
ABC system gives stress on indirect resources demanded by the product. It emphasises the need to obtain a better understanding of cost behaviour and thus ascertains what causes the overhead costs.
The system examines the demands made by a particular product on the indirect resources along three lines:
(i) Focus on expensive resources;
(ii) Emphasis on resources whose consumption varies significantly by product or product type; and
(iii) Focus on resources whose demand patterns are not correlated with traditional allocation measures like direct materials, direct labour and processing time, etc.
The logic behind the above is that it is the activity which causes costs, not the products, and it is the product which consumes activities in turn. In fact, analysis of resource consumption by products with the help of cost driver is the essence of ABC.
5. Management-Oriented Logic:
Managers do not manage costs, they manage the activities that cause costs. They basically decide and control the activities demanded by the products. Hence accounting information is needed to be provided to them for facilitating the management of activities.
When the focus is on costs, it is a typical and conventional budgetary control system and the managers find difficulty to understand the cause and effect relationship between the costs and resources.
Under ABC system, the focus of the management is taken care of by providing information regarding cost of resources supplied and cost of resources used i.e., capacity created and capacity used. ABC system brings in activity measures as a bridge in between the product costs and resources.
A micro-level understanding of intermediary transformations has a lot of strategic managerial significance particularly in efficient and effective resource utilisation through creative value adding process.
6. Rational Assumptions:
Costs revealed by ABC system are considered superior to that of conventional volume based system because of two assumptions underlying the ABC:
(i) The costs in each cost pool are driven by homogeneous activities; and
(ii) The costs in each cost pool are strictly proportional to the activity.
Based on the above resource focused concept, management-oriented logic and assumptions, activity based total cost of production is computed as the sum of the cost of all activities performed. These costs vary with the activities performed at different levels of production organisation.