NEW HORIZON COLLEGE

MARATHALLI, BANGALORE

VI SEM BCOM Study Material

COST MANAGEMENT

Prepared by
Ms. HARSHA NAMBIAR
CHAPTER 1:COST REDUCTION AND COST CONTROL

COST CONTROL

• CIMA, London has defined cost control as “the regulation by executive action of the
cost of operating an undertaking particularly where action is guided by cost
accounting”

• Cost Control is a process which focuses on controlling the total cost through
competitive analysis. It is a practice which works to maintain the actual cost in
accordance with the established norms. It ensures that the cost incurred on an
operation should not go beyond the pre-determined cost.
• Cost Control involves a chain of functions, which starts from preparation of the
budget in relation to the operation, thereafter evaluating the actual performance, next
is to compute the variances between the actual cost & the budgeted cost and further,
to find out the reasons for the same, finally to implement the necessary actions for
correcting discrepancies.

Steps in Cost control

• Establishing norms:
The first step in cost control is to set norms or standards which may serve as
yardsticks for measuring performance. these standards are set on the basis of past
performance adjusted for changes in future and on the basis of studies conducted.
• Comparison with actual:
The actual cost incurred are compared with established standard costs to know the level
of achievement. The variations are analysed so as toy arrive at the causes which are
controllable.
• Corrective Action:
Remedial measures are taken to avoid the recurrence of variation in future and for
revision of standards wherever necessary

COST REDUCTION

Cost Reduction is a process, aims at lowering the unit cost of a product manufactured or
service rendered without affecting its quality by using new and improved methods and
techniques. It ascertains substitute ways to reduce the cost of a unit. It ensures savings in per
unit cost and maximisation of profits of the organisation.
Cost Reduction aims at cutting off the unnecessary expenses which occur during the
production, storing, selling and distribution of the product. To identify cost reduction, the
following are the major elements:
• Savings in per unit cost.
 • No compromise with the quality of the product.
• Savings are non-volatile in nature.

DIFFERENCE BETWEEN COST REDUCTION AND COST CONTROL

• Cost Controlis the activity of maintaining cost as per the established norms.
Cost Reduction is the activity of decreasing per unit cost by applying new methods of
production in such a way that it does not affect the quality of the product .

• Cost Control focuses on decreasing the total cost

Cost Reduction focuses on decreasing per unit cost of a product.

• Cost Control is temporary in nature.

Cost Reduction which is permanent.

• Cost Control does not guarantee quality maintenance

Cost reduction100% quality maintenance is assured.

• Cost Control is a preventive function as it ascertains the cost before its occurrence.
Cost Reduction is a corrective action.

• Cost control is the achievement of pre- determined targets of costs.

Cost reduction is the achievement of the real and permanent reduction in costs.

• Cost control tends to assume a static state of affairs and that standard once set are not
challenged.
Cost reduction assumes the existence of concealed potential saving in the standards or
pre- determined costs set for cost control and that these standards are always subject to
challenge.

• Cost control is concerned with predetermining costs, comparing it with actual costs,
analysing the variances and taking corrective measures.
Cost reduction is not concerned with maintenance of performance according to
predetermined targets. it is rather concerned with finding out new product design,
methods,etc

• Cost control is a part of cost accounting function

Cost reduction may be achieved even when no cost accounting system is in operation

• Cost control lacks dynamic approach to cost improvement Cost reduction is more
dynamic approach to cost improvement
AREAS COVERED BY COST CONTROL AND COST REDUCTION

1. PRODUCT DESIGN –Product design is the efficient and effective generation and
development of ideas through a process that leads to new products. It covers :
a. Ensuring correct production designs so that faulty design may be discontinued.
b. Making research a regular feature to modify the existing minimum cost and
optimum quality.

2. TARGET COSTING –
Target costing can be defined as “a structured approach for determining the cost at
which a proposed product with specified functionality and quality must be produced
to generate a desired level of profitability at its anticipated selling price”. A critical
aspect of this definition is that it lays emphasis on the fact that target costing is much
more than a management accounting technique.
Target costing is a management technique aimed at reducing a product’s life-cycle costs.
A general concept of target costing is discussed here.
Target Costing is a disciplined process for determining and realizing a total cost at which
a proposed product with specified functionality must be produced to generate the desired
profitability at its anticipated selling price in the future. CIMA defines target cost as “a
product cost estimate derived from a competitive market price”
Target costing is a formal process that attempts to match a proposed product’s
features (benefits) with a viable market price that achieves the company’s
profitability goals by:
(a) Determining a price point (or range of prices) for an approximate combination of
features and benefits.
(b) Subtracting a desired profit from the market price to determine the maximum bearable
level of costs.
(c) Iterating the product design—eliminating or reducing unnecessary attributes with
costs that can’t be recovered in higher prices—until the cost target is met.
(d) Revising the market price for the redesigned product in view of changed market
conditions.

Steps in Target Costing:

Following are the main steps (or stages) involved in target costing:
(i) To conduct market research in order to see what products are in the market place, what
new products the competitors are trying to bring in the market, to ascertain customers’
requirement and the price they can afford for the product.
(ii) Determining the price, margin and cost feasibility. Target price is determined on the
basis of market survey, at which the product can be sold. On the selling price a standard
 margin is determined to finally come to the cost figure (Target Price − Target Profit =
Target Cost).
(iii) To meet margin target by design improvement. If the product designed cannot be
produced in the cost range decided, value engineering is used to drive down the product
cost to a level, at which target price and margin can be attained.
(iv) To implement continuous improvement. This is needed to ensure that targeted cost
levels are maintained subsequent to design phase. Value engineering technique is applied
for reduction of waste, misuse, etc. and for elimination of non-value added costs and
processes, etc.

Objectives of Target Costing:

Broadly speaking, a target costing system has three objectives:
a. To lower the costs of new products so that the required profit level can be ensured.
b. The new products meet the levels of quality, delivery timing and price required by the
market.
c. To motivate all company employees to achieve the target profit during new product
development by making target costing a companywide profit management activity.
For any system to be effective in supporting decision making in an organization, the staff
from the relevant departments must come together in order to tap their creativity so as to
achieve goals. In other words, the company requires a non-conflicting and rational system
for consensus building and decision-making.

Target Costing Process:

Just as there is no single definition of target costing, there is no single target costing
process.
Nevertheless, all companies share a series of general steps:
a. Establishing the target price in the context of market needs and competition;
b. Establishing the target profit margin;
c. Determining the allowable cost that must be achieved; this cost should motivate all
personnel to achieve;
d. Calculating the probable cost of current products and processes; and finally,
e. Establishing the target amount by which current costs must be reduced.

3. VALUE ANALYSIS
Value analysis is an approach to cost saving that deals with product design. Here, before
buying any equipment or materials, a study is made as to what purpose these things
serve? Would other lower- cost design work as well? Is there a cheap material which can
serve the same purpose? So value analysis is a procedure which specifies the function of
 products or components, establishes appropriate costs, determines the alternatives and
evaluates them.
Thus the objective of value analysis is the identification of such costs in a product that do
not in any manner contribute to its specification or functional value. Thus, it is the
process of reducing the cost without sacrificing the predetermined standards of
performance. It is a supplementary device in addition to the conventional cost reduction
methods.
Value analysis is closely related to Value Engineering. It is very helpful in industries
where production is done on a large scale and in such cases even a fraction of savings in
cost would help the firm significantly

4. VALUE ENGINEERING
Value engineering is a systematic and organized approach to provide the necessary
functions in a project at the lowest cost. Value engineering promotes the substitution of
materials and methods with less expensive alternatives, without sacrificing functionality.
It is focused solely on the functions of various components and materials, rather than their
physical attributes. Also called value analysis.
The reasoning behind value engineering is as follows: if marketers expect a product to
become practically or stylistically obsolete within a specific length of time, they can
design it to only last for that specific lifetime. The products could be built with higher-
grade components, but with value engineering they are not because this would impose an
unnecessary cost on the manufacturer, and to a limited extent also an increased cost on the
purchaser. Value engineering will reduce these costs. A company will typically use the
least expensive components that satisfy the product's lifetime projections.

5. BUSINESS PROCESS RE-ENGINEERING (BPR)

Michael Hammer and Champy, 1993 (in O’Neill, 1999) described the Business process
reengineering as the fundamental rethinking and radical design of the process to achieve
dramatic improvement in critical, contemporary measures of performance, such as cost ,
quality, service and speed.

BPR advocates that enterprises go back to the basics and reexamine their very roots. It
doesn’t believe in small improvements. Rather it aims at total reinvention.
BPR focuses on processes and not on tasks, jobs or people.
What to reengineer? :“A business process is a series of steps designed to produce a
product or a service. It includes all the activities that deliver particular results for a given
Customer(external or internal)”.
Talking about the importance of processes just as companies have organization charts,
they should also have what are called process maps to give a picture of how work flows
through the company.

The 3 C’s Of BPR

Customers
More discriminating than ever before – means more demanding and creating greater
pressure for value, service and quality.
Competition
Deregulation and technological change have intensified rivalry – new entrants can now
challenge dominant players – barriers to entry are falling and margins are declining
Change
Product and service lifecycles have been radically reduced, and product opportunities open and close
extremely rapidly

Some of the BPR Objectives

 Improve Efficiency e.g reduce time to market, provide quicker response to customers
 Increase Effectiveness e.g deliver higher quality
 Achieve Cost Saving in the longer run
 Provide more Meaningful work for employees
 Increase Flexibility and Adaptability to change
 Enable new business Growth

COMMON PROBLEMS WITH BPR

1. Process under review too big or too small

2. Reliance on existing process too strong
3. The Costs of the Change Seem Too Large
4. Isolated Activity not Aligned to the Business Objectives
5. Allocation of Resources
6. Poor Timing and Planning
7. the Team and Organization on Target
CHAPTER 2 –MARGINAL COSTING

Definition of marginal cost

The amount of any given volume of output by which aggregate costs are changed if the
volume of output is increased by one unit.

Definition of marginal costing

The Institute of Cost and Management Accountants, London, has defined Marginal Costing
as “the ascertainment of marginal costs and of the effect on profit of changes in volume or
type of output by differentiating between fixed costs and variable costs.”

The main characteristics of marginal costing are as follows

1. It is a technique of analysis and presentation of costs which help management in

taking many managerial decisions and is not an independent system of costing such as
process costing or job costing.

2. All elements of cost—production, administration and selling and distribution are

classified into variable and fixed components. Even semi-variable costs are analyzed
into fixed and variable.

3. The variable costs (marginal costs) are regarded as the costs of the products.

4. Fixed costs are treated as period costs and are charged to profit and loss account for
the period for which they are incurred.

5. The stocks of finished goods and work-in-process are valued at marginal costs only.

Prices are determined on the basis of marginal cost by adding ‘contribution’ which is the
excess of sales or selling price over marginal cost of sales.

Marginal costing vs. absorption costing or full costing

The basic differences between Absorption costing and Marginal Costing are as follows:

1. Absorption costing is the total cost technique. Absorption costing is “the practice of
charging all costs, both variable and fixed, to operations, processes, or products. In
marginal Costing technique only variable costs are treated as product costs, fixed cost
is treated as period cost and is charged to profit and loss account for that period.

2. In absorption costing, the stock of finished goods and work-in-process is valued at

total cost which includes both variable and fixed cost. In marginal costing, such
stocks are valued at marginal cost, i.e., variable cost only.
 3. In absorption costing arbitrary apportionment of fixed costs, over the products, results
in under or over-absorption of such costs. While marginal costing excludes fixed
costs, the question of under or over absorption of fixed costs does not arise.

In absorption costing, managerial decision-making is based upon ‘profit’ which is the excess
of sales value over total cost. While in marginal costing, the managerial dec1sjon are guided
by ‘contribution’ which is the excess of sales value over variable cost.

Breakeven analysis

The study of cost-volume profit analysis is often referred to as ‘break-even analysis. In its
broad sense, break-even analysis refers to the study of relationship between costs, volume
and profit at different levels of sales or production. In its narrow sense, it refers to a technique
of determining that level of operations where total revenues equal total expenses, i.e., the
point of no profit, no loss.

The break-even analysis is based upon the following assumptions:

1. All elements of cost, i.e., production, administration and selling and distribution can
be segregated into fixed and variable components.

2. Variable cost remains constant per unit of output irrespective of the level of output
and thus fluctuates directly in proportion to changes in the volume of output.

3. Fixed cost remains constant at all volumes of output.

4. Selling price per unit remains unchanged or constant at all levels of output.

5. Volume of production is the only factor that influences cost.

6. There will be no change in the general price-level.

7. There is only one product or in case of multi-products, the sales mix remains
unchanged.

8. There is synchronization between production and sales.

Illustration 1

From the following data, you are required to calculate:

a) P/V ratio
b) Break-even sales with the help of P/V ratio.
c) Sales required to earn a profit of Rs. 4,50,000

Fixed Expenses = Rs. 90000

Variable Cost per unit
Direct Material = Rs.5
Direct Labor = Rs.2
Direct Overheads = 100% of Direct Labor
Selling Price per unit = Rs. 12
Solution

Selling price per unit 12

Less: variable cost per unit
Direct material 5
Direct labor 2
Direct overheads 2 9
Contribution per unit 3

a) P/V ratio = contribution/ sales * 100

= 3/12 * 100
= 25%
b) Breakeven sales = fixed expense /P/V ratio
= 90,000 / 25%
= 90,000 * 100/25
= 3,60,000
c) Sales to earn a profit = (fixed expense + profit) /
of 4,60,000 P/V ratio
= (90,000 + 4,50,000) / 25%
= 5,40,000/25%
= 5,40,000 * 100/25
= 21,60,000

Illustration 2

Calculate
a) Amount of fixed expenses.
b) The number of units to break-even.
c) The number of units to earn a profit of Rs. 40,000.

The selling price per unit can be assumed at Rs. 100.

The company sold in two successive periods 7,000 units and 9,000 units and has incurred a
loss of Rs. 10,000 and earned Rs. 10,000 as profit respectively

Solution

Period 1 Period 2
Sales 7,00,000 9,00,000
Profit -10,000 10,000

P/V ratio = Change in profit / change in sales * 100

= 20,000 / 2,00,000 * 100
= 10%
Contribution of period 1 = 7,00,000 * 10%
= 70,000
Loss of period 1 (given) = -10,000
i. Fixed cost = contribution – profit
= 70,000 - (-10,000)
= 70,000 + 10,000
= 80,000
ii. Breakeven point = fixed cost / P/V ratio
= 80,000 / 10%
= 80,000 * 100/10
= 8,00,000
Number of units to breakeven = breakeven sales / S.P. per unit
= 8,00,000 / 100
= 8000 units
iii. Number of units to earn a profit of = (fixed cost + profit) / P/V ratio
40,000
= (80,000 + 40,000) /10%
= 1,20,000 / 10%
= 1,20,000 * 100/10
= 12,00,000

Advantages of marginal costing

1. Simple to operate and easy to understand

2. Removes complexities of under-absorption of overheads

3. Helps management in production planning.

4. No possibility of fictitious profits by over-valuing stocks

5. Facilitates calculation of important factors like B.E.P.

6. Valuable aid to management for decision-making

7. Facilitates study of relative profitability

8. Complimentary to standard costing and budgetary control

9. Helps in cost control.

10. Profit planning

11. Management reporting

Limitations of marginal costing

1. The technique of marginal costing is based upon a number of assumptions which may
not hold good under all circumstances

2. All costs are not divisible into fixed and variable. There are certain costs which are
semi-variable in nature. It is very difficult to classify these costs into fixed and
variable elements.

3. Variable costs do not always remain constant and do not always vary in direct
proportion to volume of output because of the laws of diminishing and increasing
returns.

4. Selling prices do not remain constant for all levels of output due to competition,
discounts for bulk orders, changes in the general price level, etc.

5. Fixed costs do not remain constant after a certain level of activity.

6. Stocks valued on marginal costing are undervalued and the profit and loss account
cannot reveal true profits.

7. Although the technique of marginal costing overcomes the problem of under or over-
absorption of fixed overheads, the problem still exists in regard to under or over-
absorption of variable overheads.

8. Marginal costing completely ignores the ‘time factor’.

9. Cost control can be better be achieved with the help of other techniques, viz., standard
costing and budgetary control than by marginal costing technique.

10. Fixation of selling prices in the long run cannot be done without considering fixed
costs. Thus, pricing decisions cannot be based on marginal cost alone

Illustration 3

Company A and Company B both under the same management makes and sells the same type
of product. Their budgeted profit and loss accounts for the year ending 1996 are as follows:

Company A Company B
Rs Rs Rs Rs
Sales 3,00,000 3,00,000
Less variable 2,40,000 2,00,000
costs
Fixed costs 30,000 2,70,000 70,000 2,70,000

Profit 30,000 30,000

You are required to:

1. Calculate the break-even points for each company.

2. Calculate the sales volume at which each of the two companies will make a profit of
Rs. 10,000.
3. State which company is likely to earn greater profits in conditions of:
i. Heavy demand for the product.
ii. Low demand for the product.

Solution

Break even point

= fixed costs / P.V. ratio
P.V ratio
= contribution / sales
Contribution
= Sales – variable costs
P.V. ratio, Company A= (3,00,000 – 2,40,000)/ 3,00,000 * 100
= 60,000/ 3,00,000 * 100
= 20%
P.V. ratio, Company B = (3,00,000 – 2,00,000)/ 3,00,000 * 100
= 1,00,000/ 3,00,000 * 100
= 33.33%
Breakeven point, Company A = 30,000/20%
=1,50,000
Breakeven point, Company B = 70,000/33.3%
= 2,10,000

Sales to earn a desired profit = (fixed cost + desired profit) / P.V. ratio
Company A = (30,000 + 10,000) / 20%
= 40,000 / 20%
= 2,00,000
Company B = (70,000+ 10,000) / 33.33%
= 80,000 / 33.33%
= 2,40,000

i. In case of high demand, company B is better because it has a high P.V. ratio and it
will earn large profit in conditions of heavy demand
ii. In case of low demand, company A is better because breakeven point as well as fixed
costs are low

Break Even Chart [Graphic Method]

It is the graphical presentation of breakeven point. It shows the relationship between sales
volume, variable and fixed costs. It also shows the profit or loss at different levels of output
or volume of sales.

Construction of Break even Chart

A Break even chart shows the total sales line, total cost line and the point of intersection
called the breakeven point. It is constructed using a database of variable costs, fixed costs,
total costs and sales at different levels of output.

The units of output or sales revenue are plotted along the X axis, using suitable scale of
measurement. The costs and sales are plotted along the Y axis. The fixed costs line is plotted
first. It forms a parallel line to the X axis indicating that the fixed cost remain constant at all
levels of output. The variable cost line is plotted next, starting from zero it progresses
continuously indicating that the variable cost increase with the volume fixed cost line of
sales. The total cost line is plotted above the variable cost line. It starts from the fixed cost
line on the Y axis and follows the same pattern of variable cost line. The sales line is plotted
finally. It starts from the zero and progresses continuously, indicating that the sales increase
with larger units of output. The point of intersection of sales line and total cost line indicates
the Break even point. A vertical line drawn to the X axis from this point shows the volume of
output required to Break even.

Questions

2 marks:-
1. What is marginal costing?
2. What is marginal cost equation?
3. What is break even chart?
4. How do you calculate margin of safety?
5. How can P/V ratio be improved?
6. Write any two advantages of contribution?
7. What is absorption costing?
 CHAPTER 3–BUDGETARY CONTROL
Meaning of Budget

A budget is the monetary or/and quantitative expression of business plans and policies to be
pursued in the future period of time

Objectives of budgetary control

Budgetary control is essential for policy planning and control. It also acts as an instrument of
coordination. The main objectives of budgetary control are as follows:

To ensure planning for future by setting up various budgets. The requirements and expected
performance of the enterprise are anticipated.
To co-ordinate the activities of different departments.
To operate various cost centers and departments with efficiency and economy.
Elimination of wastes and increase in profitability.
To anticipate capital expenditures for future.
To centralize the control system.
Correction of deviations from the established standards.
Fixation of responsibility of various individuals in the organization.

Advantages of budgetary control

The budgetary control system helps in fixing the goals for the organization as a whole and
concerted efforts are made for its achievements. It enables economies in the enterprise. Some
of the advantages of budgetary control are:

Maximization of Profit. The budgetary control aims at the maximization of profits of the
enterprise. To achieve this aim, a proper planning and co-ordination of different functions is
undertaken.

Co-ordination. The working of different departments and sectors is properly coordinated. The
budgets of different departments have a bearing on one another. The co-ordination of various
executives and subordinates is necessary for achieving budgeted targets.

Specific Aims. The plans, policies and goals are decided by the top management. All efforts
are put together to reach the common goal of the organization. Every department is given a
target to be achieved.

Tool for Measuring Performance: By providing targets to various departments, budgetary

control provides a tool for measuring managerial performance. The budgeted targets are
compared to actual resultsand deviations are determined.

Economy. The planning of expenditure will be systematic and there will be economy in
spending. The finances will be put to optimum use.
Determining Weaknesses. The deviations in budgeted and actual performance will enable
thedetermination of weak spots. Efforts are concentrated on those aspects where performance
is less than stipulated.

Corrective Action. The management will be able to take corrective measures whenever there
is a discrepancy in performance. The deviations will be regularly reported so that necessary
action is taken as soon as possible.

Consciousness. It creates budget consciousness among the employees. By fixing targets for
the employees, they are made conscious of their responsibility. Everybody knows what he is
expected to do.

Reduces Costs. In the present day competitive world budgetary control has a significant role
to play. It helps in reducing costs.

Introduction of Incentive Schemes. Budgetary control system also enables the introduction of
incentive schemes of remuneration. The comparison of budgeted and actual performance will
enable the use of such schemes.

Limitations of budgetary control

Uncertain Future. The budgets are prepared for the future period. Despite best estimates made
for the future, predictions may not always come true.

Budgetary Revisions Required. Budgets are prepared on the assumptions that certain
conditions will prevail. Because of future uncertainties, assumed conditions may not prevail
necessitating the revision of budgetary targets.

Discourages efficient persons. Under budgetary control system the targets are given to every
person in the organization. The common tendency of people is to achieve the targets only and
nothing more.

Problem of Co-ordination. The success of budgetary control depends upon the co-ordination
among different departments. The lack of co-ordination among different departments results
in poor performance.

Conflict among different departments. Budgetary control may lead to conflicts among
functionaldepartments. Every departmental head worries for his department goals without
thinking of business goal.

Depends upon Support of Management. Budgetary control system depends upon the
supportof top management. If at any point of time there is a lack ofsupport from top
management then this system will collapse.
Difference between flexible and fixed budget

Basis Fixed budget Flexible budget

Rigidity A fixed budget remains the A flexible budget is recast to
same irrespective of changed suit the changed
situations. It remains circumstances. Suitable
inflexible even if volume of adjustments are made if the
business is changed. situation so demands.
Conditions A fixed budget assumes that This budget is changed if
conditions will remain level of activity varies.
constant.
Cost Classification In fixed budgets costs are not
The costs are studied as per
classified according to their
their nature, i.e., fixed
nature. variable, semi-variable.
Changes in Volume If the level of activity The budgets are redrafted as
changes then budgeted and per the changed volume and
actual results cannot be a comparison between
compared because of change budgeted and actual figures
in basis. will be possible.
Forecasting Forecasting of accurate Flexible budgets clearly
results is difficult. show the impact of expenses
on operations and it helps in
making accurate forecasts.
Cost Ascertainment Under changes circumstances The costs can be easily
costs cannot be ascertained ascertained under different
levels of activity. This helps
in fixing prices.

Illustration 1

From the following data for 60% activity, prepare a flexible budget for 80% and 100%
capacity.

Production (60% capacity) 600 units

Materials 100 per unit
Labor 40 per unit
D. Expenses 10 per unit
Factory O/H 40,000 (40% fixed)
Administration expenses 30,000 (60% fixed)
Solution

Flexible production budget

60% capacity (600 units) 80% capacity (800 units) 100% capacity (1000
units)
Unit cost Total cost Unit cost Total cost Unit cost Total cost
Materials 100 60,000 100 80,000 100 1,00,000
Labor 40 24,000 40 32,000 40 40,000
D. Expenses 10 6000 10 8000 10 10,000
Prime cost 150 90,000 150 1,20,000 150 1,50,000
Factory O/H
Fixed(40% * 26.67 16,000 20 16,000 16 16,000
40,000)
Variable 40 24,000 40 32,000 40 40,000
Works cost 216.67 1,30,000 210 1,68,000 206 2,06,000
Administrative
expenses
Fixed(60% * 30 18,000 22.5 18,000 18 18,000
30,000)
Variable 20 12,000 20 16,000 20 20,000
Total cost 267.67 1,60,000 252.5 2,02,000 244 2,44,000
 UNIT 5 : ACTIVITY BASED COSTING
Activity-Based Costing

Activity-based costing is a method of assigning indirect costs to products and services which
involves finding cost of each activity involved in the production process and assigning costs to
each product based on its consumption of each activity.

Activity-based costing is more refined approach to costing products and services than the
traditional costing method. It involves the following steps:

 Identification of activities involved in the production process;

 Classification of each activity according to the cost hierarchy (i.e. into unit-level, batch-level,
product level and facility level);
 Identification and accumulation of total costs of each activity;
 Identification of the most appropriate cost driver for each activity;
 Calculation of total units of the cost driver relevant to each activity;
 Calculation of the activity rate i.e. the cost of each activity per unit of its relevant cost driver;
 Application of the cost of each activity to products based on its activity usage by the product.

Cost Hierarchy
The first step in activity-based costing involves identifying activities and classifying them according
to the cost hierarchy. Cost hierarchy is a framework that classifies activities based the ease at
which they are traceable to a product. The levels are (a) unit level, (b) batch level, (c) product
level, and (d) facility level.

Unit level activities are activities that are performed on each unit of product. Batch level activities
are activities that are performed whenever a batch of the product is produced. Product level
activities are activities that are carried out separately for each product. Facility level activities are
activities that are carried out at the plant level. The unit-level activities are most easily traceable
to products while facility-level activities are least traceable.

Example
Alex Erwin started Interwood, a niche furniture brand, 10 years ago. He ran the business as a sole
proprietorship. While he has 50 skilled carpenters and 5 salesmen on his payroll, he has been
taking care of the accounting by himself. Now, he intends to offer 40% of the ownership to public
in next couple years, and is willing to make changes and has hired you as the management
accountant to organize and improve the accounting systems.

Interwood's total budgeted manufacturing overheads cost for the current year is $5,404,639 and
budgeted total labor hours are 20,000. Alex applied traditional costing method during all of the 10
years period, and based the pre-determined overhead rate on total labor hours.

Interwood's sofa range includes the 2-set, 3-set and 6-set options. Platinum Interiors recently
placed an order for 150 units of the 6-set type. The order is expected to be delivered in 1 month
time. Since it is a customized order, Platinum will be billed at cost plus 25%.

You are not a fan of traditional product costing system. You believe that the benefits of activity-
based costing system exceeds its costs, so you sat down with Aaron Mason, the chief engineer, to
identify the activities which the firm undertakes in its sofa division. Next, you calculated the total
cost that goes into each activity, identified the cost driver that is most relevant to each activity
and calculated the activity rate. The results are summarized below:

C=A/B (in
Activity A (in $) Relevant Cost Driver B
$)
Production of 2,313,132 Machine hours 25,000 93
components
Assembly of 1,231,312 Number of labor 20,000 62
components hours
Packaging 213,123 Units 5,000 43
Shipping 231,230 Units 5,000 46
Setup costs 34,243 Number of setups 240 143
Designing 123,132 Designer hours 1,000 123
Product testing 24,234 Testing hours 500 48
Rent 1,234,233 Labor cost $1,645,644 75%
Once the order was ready for packaging, Aaron gave you a summary of total cost incurred and a
statement of activities performed (also called the bill of activities) as shown below:

Order No: 15X2013

Customer: Platinum Interiors
Units: 150
Type: 6 unit
Amounts in $

Cost of direct materials 25,000

Cost of purchased components 35,000
Labor cost 15,600

Activity Relevant Cost Driver Activity Usage

Production of components Machine hours 320
Assembly of components Number of labor hours 250
Packaging Units 150
Shipping Units 150
Setup costs Number of setups 15
Designing Designer hours 70
Testing Testing hours 22
Rent Labor cost 4500

Part A

Calculate the total cost of the order and the invoice value of the order based on traditional costing
system.

Solution

In the traditional costing system, cost equals materials cost plus labor cost plus manufacturing
overheads charged at the pre-determined overhead rate.

The pre-determined overhead rate based on direct labor hours = $5,404,639/20,000 = $270 per
labor hour

The actual number of labor hours spent on the order is 250. Once we have this data, we can
estimate the manufacturing overheads and the total cost as follows:

Direct materials 25,000

Purchased components 35,000
Labor cost 15,600
Manufacturing overheads ($270 × 250) 67,500
Total cost under traditional product costing system 143,100
Platinum is billed at cost plus 25%, so the amount of sales to be booked would amount to
$178,875 (= $143,100 × 1.25).
Part B

You know activity-based costing is a more refined approach. Now, since you have all the data
needed, calculate the order cost using activity based costing.

Solution

In activity-based costing, direct materials cost, cost of purchased components and labor cost
remains the same as in traditional product costing. However, the value of manufacturing
overheads assigned is more accurately estimated. The following worksheet estimates the
manufacturing overheads that should be assigned to the order of Platinum Interiors:

(A) (B) (A × B)
Activity Activity Rate Activity Usage Activity Cost Assigned
Production of components 93 320 29,760
Assembly of components 62 250 15,500
Packaging 43 150 6,450
Shipping 46 150 6,900
Setup costs 143 15 2,145
Designing 123 70 8,610
Product testing 48 22 1,056
Rent 75% 15,600 11,700
82,121
Total cost of the order is hence:

US$
Direct materials 25,000
Purchased components 35,000
Labor cost 15,600
Manufacturing overheads 82,121
Total cost under activity-based costing 157,721
Based on the more accurate estimation of the order cost, the invoice should be raised at $197,150
(=$157,721 × 1.25) instead of $178,875 calculated under traditional product costing system.

The example highlights the importance of correct estimation of the product cost and the usefulness
of activity-based costing in achieving that goal.