Teaching Note Management Accounting & Control

Dr. Paritosh Basu

What is an Activity? What is an Activity?

In ABC an activity refers to a Repeatable, adaptable action, or Series of actions that makes a meaningful contribution to the completion of the process or product in question The critical factor is that it acts as the cause for incurring costs

What is a Cost Driver?

A cost driver is a physical object or a subjective aspect which consumes cost

Environment & Genesis (Contd.)

Activities towards the Ultimate Criteria

Chain of activities are performed by a business unit to add value to inputs and generate the final product or service

Competitive advantages accrue when

There are differentiations in product, quality, price, after sales service / customer care There are minimum number of activities All activities are effective for value addition All activities are performed at a lower cost than that of both domestic and international competitors

Environment & Genesis Fundamental Principles of Value Creation 1. Value creation = Utility / Cost, or Result / Cost > 1 Max Value = Max. Utility / Min. Cost 2. Work InnoventivelyTM 3. Understand the strategic drivers of value 4. Formulate strategies for higher value addition 5. Develop superior organisational capabilities

Introspection & Repositioning Johuree Window Competitors The Organisation

Known Public Knowledge

Not Known Unique Strength

Known Not Known

Blindness

Unexplored

* Unique strength will lie in knowing what the competitors

do not know . * Continuous effort will be to move to the unexplored quadrant to achieve a state of readyness for delivering what the society will ask for tomorrow

ABC System Core Elements

Attempts to link the cost of each business activity to products or services, which benefit from the activity The fundamental assumption is that products / services and customers consume activities Products or services are not homogeneous by definition All activities are identifiable, measurable and cause costs Each activity is a cost centre and / or drives cost Cost in each centre is proportional to activity To control costs activities must be controlled

ABC System - Core Elements (Contd.) ABC System starts with

Identification of the activities performed in relation to Volume Quality Resources Supports Identification of Cost Drivers for those activities Finally work out the cost of the product or service

Steps for Activity based Cost Management

1. Detailed analysis of future demand with specific emphasis on Volume shifts and changes in customer-mix Changes in customers perception / mind-set about quality and product features in relation to its application utilities Premium if any due to higher product features from higher rung of the customer segment Gap between the perception of the company and the Customers about the product 2. Identification of the critical success factors and develop strategic directions for planning and execution teams

Steps for Activity based Cost Management (Contd.)

3. Analysis of each operation with break-up in minute parts, which are the cost drivers
4. Collection of data with specific identification of each cost with the related operation and cost driver

5. Challenge/ question/ assess the need for each operation and the related cost driver in the process of adding value to the inputs
6. Thus identify the avoidable ones or the ones which can be shortened or clubbed 7. Establish the logical sequence of all operations, which have finally been identified as adding value with specific reference to:

Steps for Activity based Cost Management (Contd.)

7. Establish the logical sequence of all operations, which have finally been identified as adding value with specific reference to: Plant Lay-out In-bound and out-bound logistics including storage and warehousing Avoidance of chasing and corrective actions Need for flexibility in procurement and marketing methods to suit changes in environment and perceptions of suppliers and customers Need for process re-engineering to implement the directional changes required to implement strategies

Steps for Activity based Cost Management (Contd.)

8. Plan resources to be put in place to execute action plans 9. Finally calculate the cost of each segment of operation and set targets for cost reduction in course of time by: Gradually shedding-off the activities, identified as not required; and Shortening or clubbing two activities which are not required to add value to the product or service. 10. Initiate actions for change management (Such actions are to be reviewed again and again with need based approach)

Advantage of ABC System

1. Traces each of the overheads incurred to a unique cost driver and number of events at each driver point. It obviates the traditional indices like Labour Hour Rate and Machine Hour Rate 2. Leads to decisions of cost reduction through Rationalisation of in-house activities product design, plant lay-out, etc. Outsourcing of activities/ components, and Rationalisation of bill of materials 3. Effects in 2 above lead to change in pricing policies, when high cost products are not found to be that much costly. This results in Increased turnover Snow-balling effect in profit and profitability

Advantage of ABC System (Contd.)

4. Enables analyses of product performance according to

different customer segments 5. The effects in 4 above facilitates: Segment-wise management of profitability, and Investment/ asset management with focus on customer segments

6. Provides fairly accurate cost information and thus helps

taking wide array of decisions 7. Makes it easy to establish linkages with other tools of management like: Business process re-engineering Total quality management JIT based inventory management

Advantage of ABC System (Contd.)

8 Reveals the hidden avoidable costs at each stage 9 Allows the CEO to take his cost management agenda to the point where the job is actually executed. This leads to: Shifting of onus of cost management to the operating line managers Bringing more cohesion between line and service functions

A Case Study on ABC System

A company manufactures the following two products:

X - a standard product Y - a low volume complex product requiring specialised skills and activities

Cost of production is as under (Rs.000):

Materials (equal for both) Labour (5000 hrs. @ Rs. 10/hr.) Overheads Total 300 50 100 450

The Company uses traditional costing system. Applies Direct Labour Hour Rate for allocation of overheads, utilisation of which is 3000 and 2000 hours for X and Y respectively.

Case Study on ABC System (Contd.) The management was concerned because demand for X was decreasing and for Y increasing. Overall profitability of the Company was falling.

Product costs using the given method of overhead allocation are as under (Rs 000)
Elements of Cost Materials Labour ( X 60% & Y 40%) Overheads ( X 60% & Y 40%) Total Cost of Production Prod - X 150 30 60 240 Prod - Y 150 20 40 210

Case Study on ABC System (Contd.) To apply ABC, the following information were collected after detailed analysis of operations: Activities Set Ups Material Handling Inspection Prod - X Prod - Y Cost 20 15 35

5 Times 10 Times 30% 45% 70% 55%

Maintenance Requests
Total Cost (Rs. 000)

15 Times 20 Times

30
100

Case Study on ABC System (Contd.) Based on ABC, product costs are as under (Rs.000) Activities Materials Labour Prod X 150.00 30.00 6.60 4.50 15.75 Prod Y 150.00 20.00 13.40 10.50 19.25

Overheads Set Ups Material Handling Inspection Maintenance Requests Total Cost as ABC System Total Cost - Traditional System Percentage (Decrease) / Increase

12.90 219.75 240.00 (8.44%)

17.10 230.25 210.00 9.64%

Long Term Key Drivers of Value for Money

1. Productivity High Capital-Output Ratio 2. Output based contracts for outsourcing 3. Whole Life-of-Asset Costing

4. Economies of scale in total volume of operation

5. Benefits of volume in procurement of inputs and utilities 6. Capital at risk capital structure and financing decision 7. Single Point responsibility scope for integration 8. Innovation - Systems, processes and their application/ execution 9. Competition and Competitors domestic and overseas 10. Risk transfer and avoiding repetition of mistake

Developed from the thoughts of Adrian Montague, Dy. Chairman of Partnerships, UK