 So, today we will continue our discussion on activity-based costing to give a little bit background towards the beginning when we started discussion on cost accounting we discussed about cost center. If you remember cost center is a unit of business popularly may be called as a department where all costs are accumulated and accounted for. So, the steps in traditional cost accounting is number one allocation. So, all costs are segregated into direct and indirect, direct costs are directly charged to the cost center. Indirect costs are apportioned to the cost center if required they may be reapportioned from service cost center to production cost center. First step is absorption in absorption the costs are charged from cost centers to units. So, essentially every cost has to be charged to cost center and then it gets charged to cost units or the products this is the traditional system. Activity-based costing is a challenge to traditional system it seeks to relate the cost directly to products. So, cost are incurred because of some cost. So, cost drivers are identified and costs are directly linked to the products without necessarily they going through a cost center. Let us see now more in detail about what is a procedure and methodology of activity-based costing and we will also solve some cases on the same. So, we had in the last session already started some discussion on activity-based costing. This is the broad coverage in the session. You already know why it is very very important to get the correct cost because most of the decisions are based on the cost. So, if we feel that our cost is high maybe we price it high then we lose out in the competitive market. As we feel the cost is low we may be selling it below the cost again there is a loss to the company. There may be lot of economic decisions like make or buy like whether to outsource or no they all depend on cost. So, it is very important that correct cost is calculated. Now, as far ABC is concerned this is how it happens very very simplistic system is plant based overhead where we have only one cost for the whole plant little bit improvement is a departmental or cost center based overhead rate where the costs are identified per cost center and then they are absorbed. In activity-based costing it is more complex more sophisticated where we identify each activity each cost driver for the activity and then the costs are charged. We have just now discussed this. So, in plant wise overhead rate we get the total overhead cost divided by the total hours we get the plant wise overhead rate and the departmental system we calculate the overhead for the department and then divided by some base here in this case machine hours is taken as an example which gives us departmental overhead rate. In cost ABC costing we try to relate the cost that is the resource consumed to work accomplished that is unit produced. This serves as a good management tool because it leads to better allocation of resources. How of you how does ABC move and how does the traditional cost accounting system move? In traditional cost accounting system the resources are allocated or apportion to cost centers and then they are charged to cost objects. In ABC first the cost objects are seen they are traced by activity drivers. So, cost objects are products services customers and so on. We look at the activity drivers so that we can identify the activity that what has actually been done and then activities are traced by resource drivers. So, that for particular activity which resource how much is consumed is seen so from objects to activities and from activities to resources this is how the costs are linked up to this we are done in the last session. The basic premise of a ABC is that cost objects consume activities so for a particular customer or for a particular product certain activity has to be performed. So, they consume activities and activities in turn consume resources so to do that activity let us say machining process is being done. So, you require 3 hours of machining so machining becomes an activity and that machining in turn consumes resources may be power, may be machine depreciation and so on. So, consumption of resources is something which drives the cost so in cost accounting we try to understand this relationship. Now, in ABC products are assigned to the overhead cost that are supposed to be related to the allocation base so various costs are identified and then they will be assigned. So, these are the basic steps in ABC first is analysis of activities gathering of cost data trace the data cost data to activities establish the output measures and then analyze the cost. So, for each activity we get the cost see for what it is incurred and then link that cost. So, if the advantage is we better able to determine the product cost to output then what are the important areas target areas for the management gets identified and alternate methods of production or outsourcing etcetera may be looked at. These are some more advantages that financial benchmarks can be easily identified for activity performance then there is a common managerial framework for the resource support activities and so on. There are some limitations also because activity based costing is more complicated process than the traditional costing it requires more efforts to identify the cost. So, one needs to see the trade off between expenses and accuracy and the need for more precise data need of support of the top management is also required for collection of data and for implementation of the system. Sometimes there may be cases of overstated cost or understated margins because here it is a more complex system so there could be some chances of errors. From ABC we will try to understand now activity based management, but before that we will see some cases so that we are able to more relate what we have discussed to the practical situation. Now, let us see actually what is a cost driver and how does it operate here a small case for you. Now, the overheads incurred in a particular company or in a particular plant is given material handling and dispatch is 12000 inspection 17 stores receiving 16 machine operations 10 and set up cost 8. This is a typical cost structure some more data is given where you have got orders executed number of inspection number of production runs number of machine hours and requisitions raised they are three products A B and C. So, for each product the data about the orders inspections and so on has been collected. Now, how will you link the cost to the activities can you suggest what could be the cost drivers just think over that first item material handling what will be the appropriate cost driver for the same. Easily related that material handling has some relations with orders executed. So, we will try to link material or handling to orders executed next is inspection. Inspection what could be the appropriate cost drivers again if you look at the information given you can see that the number of orders are given. So, we can link inspections easily to inspection cost to number of orders then store receiving set up cost and so on. Now, let us try to look at the identified cost drivers. So, first cost was machine operation and maintenance you can just go up and check that machine operations and maintenance the best cost driver is naturally the number of machine hours. Set up cost we have got number of set ups or number of production runs which is same as set up then store receiving the requisition rest for inspections the number of inspection for material handling the number of orders. So, the cost as are given have been put here and the total for the related cost driver is given. So, you know now the activity you have identified the cost driver. So, we look at the cost of the activity and the cost driver unit for the same. So, number of machine hours is 925. So, 10,000 upon 925 we get 10.81 as the cost per machine hour. So, the cost is identified per unit of the driver. Set ups 8000 is a cost 40 set ups. So, 200 per machine hour and so on. So, for all the 5 activities 5 drivers are identified then we know we have calculated or we have collected the cost driver units for the same and now we know the cost driver rate or the cost per unit of the cost driver. Now go back to 3 products A, B, C we want to know the cost of A, B, C and it is easy now to go for it how to calculate now the cost for A, B, C. So, for product A we know how many orders are executed and now we know the cost per unit of that cost driver. So, we will try to calculate based on this data the cost for each of the products. So, now you know for A the number of orders executed and you also know the cost per order executed which is 3.24. So, what will be the cost of A is very easy to identify. So, 15 into 324.3 that is the number of order executed. So, you can see now each of this number of orders have been multiplied by 324. So, we get the cost of 4865, 3243 and 3892 for the 3 products. Now for number of inspections we know the number of inspections will multiply by cost per inspection I am adding a dollar so that it can be dragged later. So, you get 61827727 and 3091. Now number of production runs again we know the cost per production run which is 200. So, we have 25 multiplied by 200 so 5000, 2000 and 1000 respectively. Machine hours which is the major cost multiplied by cost per machine hour which is 10.81. Number of requisitions raised again we know the cost per requisition which is 800. So, now based on the per driver cost per cost unit of cost driver we could calculate the cost incurred overhead cost incurred on the 3 products. Now if you take sum you will get the total cost of each of the products A, B and C is it clear. So, again if you go back you will realize that we had the raw cost you can take a sum and check. So, total cost was 63000 in a traditional system you might have identified only one related factor. So, since this is a machining department you may have identified machine hours and gone for machine hour rate and then calculate the cost of 3 products. Here we have identified the cost driver for each of the cost calculated the cost per cost driver that is cost per machine hour, cost per production run, cost per requisition and so on and using that information calculate that the cost for 3 products. So, just check by doing the sum so 63000 so total overhead cost of 63 has now been properly charged to 3 products A, B, C for this particular period is it clear. Let us look at one more case for more clarity. Now here A, B, C limited has 4 products now the costs are given under different heads. Now the company is absorbing the overhead cost to individual products on labor hours. You can see here the major cost is on direct labor so they perceive that the labor is a major input and using labor hour rate and now company is thinking of moving from labor hour rate to activity based costing. So they have collected some more data as to their 3 products W, X, Y and Z. So they have calculated or identified the cost as well as testing hours, labor hours, production runs, machine hours and requisition rates for their 4 products. So you have been asked to calculate the total cost of the product using the traditional method and also using A, B, C. Now think over how will you do under traditional method? What will be the way? In traditional method first we will take the total overhead cost, we will take the total number of labor hours, divide the total cost by labor hours we will get cost per unit of labor hour that is cost per labor hour and then depending on the number of labor hour for each product W, X, Y and Z we will charge all the cost to the respective product. Let us see now how it is done. Here I am able to see the total as per A, B, C system I am just looking for how it can be done in the traditional system. But let us start with A, B, C under the A, B, C system you know that the cost is identified per cost driver. So first cost you can see here was the direct material cost. Now the direct material is the cost driver for it and you know that the total is 27000, cost driver rate is 15, here the per unit cost was given, I will just try to take some for more clarity. So now direct material the amount was 27, cost driver rate is 15 it is calculated as C 30 that is the cost as given divided by the sum of B 15 to E 15 the figures which I have just now shown. So the total direct material consumed was 1800, now 27000 divided by 1800 we get the cost per cost driver as 15. Now for a particular product that is product W we have seen that it is 400 into 15. So we get 6000 and so on is it clear? So the total cost of 27 on material was charged to X, W, X, Y and Z. Now let us go to next cost, next cost is direct labor cost which is 50000 the appropriate driver for it number of labor hours which you know is 12500. So 50000 divided by 12500 we get direct labor hour rate as 4 rupees. Now this 4 rupees is multiplied by the number of hours for W, X, Y and Z. So 4 into 1500 that is 6000 then 4 into 5000 that is 20000 and so on. So 6000, 20000, 80000 and 16000 this is a labor cost for each product. Now machine maintenance cost, now machine maintenance cost is purely on machines. So it is charged on the basis of number of machine hours we know that the machine maintenance cost is 15 and the number of machine hours are 2500. So 15 upon 2500 6 rupees becomes a cost driver rate. Now that 6 based on 6 rupees it comes to 4200, 5400, 2400 and 3000. Now the testing cost, testing cost again the total testing cost is 9000 the number of testing hours which is already given to us becomes the cost driver. So 10 rupees is the rate per testing hour using that 10 rupees and the number of testing hours we can calculate 1500, 3000, 2000 and 2500. Now next is stores receiving. Now here the requisitions raised is the appropriate cost driver because you raise the more number of requisitions the more cost on receiving the stores. So now 75 rupees per requisition becomes the cost and here the costs are charged to W, X, Y and Z. Next is setup cost you know that the setup depends on number of machine runs. So each time the machine run is started some extra cost in the form of setup cost is incurred. So now 9200 divided by total runs that is 1115, 115 we get 80 as the cost per production run. So again the costs are calculated for W, X, Y and Z then take total we get 20800, 41000, 21, 225 and 32900. I hope it is clear to you. So activity cost driver was identified and then the rate was calculated. So using that we could get the total cost for each of the products. Now how will it happen in the traditional system? In the traditional system we have two direct costs which is direct material and direct labour which will be charged in the same way there is no problem. But all other overhead costs are to be absorbed on the basis of machine hours. So first we try to take some of overhead costs which you know is machine maintenance, testing, storing and setup we get 39200. So 39200 is the total cost we divided by the number of labour hours. That is the company's policy to take labour hours as the base. So 39200 charged using the total of labour hours which is 1200, we get the labour hour rate. I will just show for more clarity. So 39200 divided by 1250, 3.16 per labour hour is a rate. Now this rate is multiplied by number of labour hours for each product which is given to us 1500, 5000 and so on. So once you multiply that you get 4704, 15680, 6272 and 12544. This is a traditional system. In traditional system instead of segregating the overhead into machine maintenance, testing, storing, setup and so on, the total overheads are taken one base is decided. So total overheads for that plant divided by the base which is number of labour hours. So the total upon labour hours we have got 3.16 and using that rate the costs have been calculated. And then the total is done. So we get the cost of 4 products as 16704, 44680 and so on. Now you can compare the system under ABC system the cost of the product and under the traditional system. It has been compared in the table. Before comparison let us first make a total. So that it is clear to you that it is essentially the same costs which are divided. So you can see the total cost was 116200 in the ABC system and same under the traditional system. However, how it is charged is different. Now in the traditional system for product W the cost was 16704 whereas under ABC it is 20800. For product X under the traditional system it is more. It is 44680 whereas under ABC it is 41275. So you can see if you take the total cost which is charged it remains the same. However there is a difference from product to product. Some products are over charged in the traditional system. Under ABC we get a better cost calculation. I hope now it is more clear to you. But still let us do one more case. Now have a look at one more company ABC electronics. It makes three types of audio players 1, 2, 3 and monthly maintenance cost incurred is like this 1800 and so on. So as per their budget this becomes their typical maintenance cost. Now for each of the model they have identified they have collected some information like machine hours, units rework and so on. We have the calculate the total cost of product using ABC and under the traditional system and then naturally compare the two. So how to proceed now? Now no solution is available. I would like you to give a try and then we will try to solve it together. So how to go ahead? So if you take a sum you have total cost of 3, 2, 0, 0 which is to be allocated to three products or three models, model 1, 2 and 3. So now suggest how to go about. Let us first do what will happen under a traditional system because it is more simplistic in nature. We will also try to take a sum of each of the cost drivers. Yeah, tell me now how to proceed? Because we try to calculate under traditional system. In traditional method what we essentially do is first we will look at the direct cost. Now there are two direct costs, direct material and labor. In direct cost there is no change whether it is traditional system or ABC. We have the direct units which we will be using. So for direct material the number of units are given and we also know the total. So we will take the total here. Next is direct labor. Again the number of direct labor hours are known to us. So we get cost per unit for material and labor which is anyway going to be common whether it is a traditional method or under the ABC. So we will say this is for direct cost, they are not going to change. Now let us look at overheads. In the traditional system all overheads will be clubbed and we will calculate a single rate for all the overheads. So let us take all the overheads. So the total overheads, production overheads are 1400. In the traditional system whether it is testing or machining or rework etcetera is ignored. We say that the total production overheads are 1400, we will use some basis. Typically the basis is number of machine hours. So what is the total number of machine hours as is given to us? You can see here the total number of machine hours are 1200, I am just pushing down the solution so that we get to do it on our own. So 1400 is a total production overheads and number of machine hours are 1200. So 1400 upon 1200 we get 1.16 as the overhead rate. This is known as overhead absorption rate per machine hour which is 1.67. Now how will you calculate the cost for the product or for the particular model? Now that we have three models, please have a look at it again. See we have got direct material cost as a first cost item. We are first doing in the traditional system, direct material cost we know that it will go by cost per unit. So we have got 1000 as a total cost 2400 units. So 0.41 is a rate, 0.400 is a rate for direct labour hour. Now for a particular model the number of machine hours are given which is given here sorry not machine hours. The number of direct material units we have to go by which is given in B16. So we will try to take that and multiply it by cost driver. So 1000 into 417 in the second case it is 800 into 0.467 which is 333 and in case of third product it is 2400 sorry it is 600 into rate. So this is how we get it. Every time we have multiplied it by the rate 0.416. So we get 417, 333 and 250 as a material cost for each of the models. Same way for labour cost we will look at the number of labour hours and we will multiply it by the rate. So number of labour hours is 700 multiplied by rate which is 0.6, now it can be drag. So you get 280, 200 and 320. Now as far as the production overheads are concerned, now in production overheads in the traditional system there is no concept of cost driver. In traditional system we have calculated the overhead absorption rate per machine hours. So we will go by number of machine hours to charge the production overheads and we know that the total cost is 1400 it will be absorbed using machine hour rate which is 1.167. Now for each of the models we will look at the number of machine hours and multiplied by rate per machine hour which is 1.167. So you get 466, then 253 and 250, we will also take total. So the total for model 123 is 1800 and 1400. So the cost as was originally allocated has been now a portion to the three products. Now if you take the sum, you will get the cost per model for model 1 as 1163, cost for model 2 as 1117 and cost for model 3 as 920. This is what is done in the traditional system. You can see that the total cost of 3200 has been absorbed. Now let us see what will happen in ABC? I hope now you will be able to calculate it on our own, this is our third case. So now can you tell me what should be done in ABC? In ABC anyway labor and material cost there is no change because they are the direct cost. But as far as the overheads is concerned instead of looking at the total overheads as 1400, we look at testing, machining, river cost, ordering cost and engineering cost separately. And for each of the overhead head identify the cost driver. Now go back to the data and look at the cost driver. So the first is testing cost. What will be the cost driver for it? Testing hours becomes the right cost driver. Next is machining cost. What will be the cost driver? Here it is machine hours, river cost, ordering cost. In ordering cost you have got number of orders. For river cost you have got units reworked and so on. So we identify the cost driver for each head and then calculate the rate per cost driver. Now let us see how it has been done. So in ABC system this is how it will look like. For direct material and labor it is known for testing cost, testing hours, machining cost, machine hours, river cost, units reworked, ordering cost, number of orders and engineering cost, engineering hours. So we have taken the cost for each of them cost driver units have been identified and then the cost driver rate has been identified separately for each cost driver. System rates are now used here to charge the cost. So you get the cost like this. So you can see total 3400 has been now charged to the products. So model 1, now the total cost is 1158, model 2 it is 1059 and model 2 is 983. You can see how it compares with the traditional system. This was under the traditional system. This is under ABC. So once again I think it will be clear to you that now it is slightly improved cost charging because we are looking at each cost separately and charging it as per the activity which absorbs those of resources. Now the ABC system also has some more advantages because it helps us to implement what is known as activity based management. Now let us look at that. So activity based costing leads us not only better cost allocation and absorption. It also takes us to a new system of management which is known as activity based management. Now have a look at what it is. Now activity based management involves use of ABC information to support some managerial decisions like organization strategy or for improving the operations or for cost control and so on. ABC based costing you already know it establishes relationship between overhead cost and activities. So that overhead cost can be better allocated. In activity based management we focus at managing the activities. Here we just identified the cost. Here we try to managing the activities so that the cost can be controlled or reduced. This is how the flow happens. So we look at the root cost. Root cost lead to activity triggers. So this is the activity analysis. Then we look at cost assignment view. So we look at the resource cost and we also look at the cost objects. So resource costs are for certain activities from which we get the cost objects and then we go to activity evaluation where we look at performance measures. So now under ABM we are looking more concentrating on performance measures. So in activity based cost management what is tried out is non-value based costs are intended to be avoided. So identifying such activities because there may be some costs or some resources which are used for doing some activity which really does not add value. So they can be eliminated they can be avoided so that the total cost can be reduced. So first step is to identify such activities which are not actually adding any value. So of the total activities we identify as to which activities are non-value adding. Then understand the linkage root cost and the trigger because we cannot simply eliminate some activity. We have to look at it effect. Then we establish the performance report and then report the non-adding non-value added activities. So ABC tries to satisfy the following needs. It looks at first of all lowering the cost without affecting quality. So high quality is maintained while lowering the cost. Response time is improved because some of the unwanted activities are nullified. So that much time is saved and customer queries can be responded fast or in production set up the production time may reduce so you can produce faster. And it also leads to more innovation because sometimes alternate method may be found. Sometimes alternate raw material may be found. So such advantages happen because of ABC. Now consumer profitability analysis is also done. So consumer profitability analysis uses activity based costing to determine the activities cost and profits associated with serving a particular customer. So in traditional system profitability of a product is seen or profitability of a department is seen. In activity based management apart from first two we also look at profitability per consumer or per customer. So it is seen as to which dealing with which customer is more profitable because by using less resources we are able to satisfy the needs of such customer. So an effort is done to identify who are the costly customers otherwise we feel that profitability only is there for a product but here we look at those customers which are costly. So you can look at the features of costly customers. So they order in small quantity they often change the order. So because of small quantity orders the number of setups increase the costs of billing and admin costs increase sometimes they change orders. So that lead to some requirements of some changes. Those which who require special packing those who demand faster service because that for that we have to sometimes change our schedule and those who order too frequently and particularly smaller orders. So in customer profitability analysis an effort is made to identify such customers so that they can be charged more and we can serve better more profitable customers. So we have seen now some features of activity based costing. In our next lecture we will look at very interesting tool for decision making before that a quick review of what we have done today. So in the earlier session we had seen the basics of activity based costing. Today we have done three cases on activity based costing. We have seen how the cost drivers are identified cost per each cost driver is calculated and then that data is used to calculate the cost of each product. So we get under ABC a better cost calculation per product. In traditional system we had plant wise rates which give a overall rate for the whole plant and improvement was to have a department wise or cost center wise rate but much more improvement if we know the cost per cost driver. So that the product costs as are calculated are much better. Then we moved to discussion on activity based management. So the data from activity based costing can now be used for better managing. So an attempt is made to eliminate non-value added activities, concentrate on important activities, reduce the service time and so on. And towards the end we have seen consumer profitability analysis under this we try to see who are the costly customers and which customers are more profitable. So that we can serve profitable customers more concentrate on them our marketing efforts on them so that we get more profitable customers. In next session we will look more in detail on the analysis of cost into fixed cost and variable cost which is also known as breakeven point analysis or cost volume profit analysis. The analysis is extremely useful particularly for taking a variety of decisions. Thank you so much.