Traditional Costing System

The main objective of any costing system is to determine scientifically the cost of a product or service. For facilitating the calculation, costs are divided into direct and indirect. Direct costs are the costs which are traceable to the products/ services offered. On the other hand, indirect costs which are also called as overheads are not traceable to the products/services. Hence these costs are first identified, classified, allocated, apportioned wherever allocation is not possible, reapportioned and finally absorbed in the products/services. Conventional Costing Total Cost = Material + Labour+ Overheads Overheads are allocated to the products on volume based measures e.g. labour hours, machine hours, units produced Charging the direct costs to the products is comparatively a simple procedure and can be done with remarkable accuracy. However, the indirect costs present problems in charging them to the products and there is a possibility of distortion of costs though the basis of charging them is quite logical. This is one of the limitation of the traditional costing system. For example, one of the methods of absorption of overheads is direct labor cost and this method is quite satisfactory when the overhead costs of indirect activities is a small percentage compared to direct labor component in actual making of products. However, the increased technology and automation has reduced the direct labor considerably and so the indirect activities have assumed greater importance. Therefore, using the direct labor as a basis for absorbing the overheads can lead to distortions in the costs. Distortions in the costs resulting into incorrect cost calculations may lead to following wrong decisions.

_ Errors in fixation of selling prices. _ Wrong decisions regarding deciding of product mix. _ Ignoring customer orientation. _ Missing of profitable opportunities. In order to overcome the limitations of traditional costing systems Activity Based Costing has been introduced. Before we proceed to the other aspects of Activity Based Costing, let us see the limitations of traditional costing system. A brief mention of the same has already been made in the above paragraph. Some more points are discussed below. 16.2 Limitations of Traditional Costing System The following are the limitations of traditional costing system. _ In a traditional costing system, overheads i.e. indirect costs are allocated, apportioned and fi nally absorbed in the cost units. There can be distortion in computing costs due to the basis selected for absorption. The following example will clarify the situation. Suppose a manufacturing company is producing two products, A and B. The direct material cost for the products is Rs.1,00,000 and Rs.2,00,000 respectively. The total overheads are Rs.1,50,000 and the company adopts direct material cost as the basis for absorption. The absorption percentage of overheads will be 50% of the direct material. [1,50,000/3,00,000 X 100 = 50%] Thus the overheads absorbed in the product A will be Rs. 50,000 and for B, they will be Rs.1,00,000 [50% of the overheads] Product B has a larger share of the overhead costs as the material costs are higher than that of A. However, actually product B may be requiring lesser efforts in the indirect activities than A, but only because it has a higher material costs, it will be charged with larger amount of overheads. Thus there is a distortion in the total cost. This distortion in costs may lead to wrong decisions in several areas like make or buy, pricing decisions, acceptance of export offer etc. _ Another limitation of traditional costing system is the division between fi xed and variable may not be realistic as there are many complications due to the complexity of the modern business. _ There should be linkage between the activities and the costs. Similarly the information should be available simultaneously which means that information should be made available

while the activities are going on. Information available after the activity is over will not be of much use. As mentioned above, the Activity Based Costing system is developed due to the limitations of the traditional costing system. The limitations of the traditional costing system have been discussed above. Now, in the following paragraphs, we will proceed to discuss the various aspects of Activity Based Costing.

Activity Based Costing

Activity Based Costing Various Issues Meaning :- CIMA defines Activity Based Costing as, cost attribution to cost units on the basis of benefit received from indirect activities e.g. ordering, setting up, assuring quality. One more definition of Activity Based Costing is, the collection of financial and operational performance information tracing the significant activities of the firm to product costs. The following are the objectives of Activity Based Costing. 16.5 Objectives of Activity Based Costing The objectives of Activity Based Costing are discussed below. _ To remove the distortions in computation of total costs as seen in the traditional costing system and bring more accuracy in the computation of costs of products and services. _ To help in decision making by accurately computing the costs of products and services. _ To identify various activities in the production process and further identify the value adding activities. _ To distribute overheads on the basis of activities. _ To focus on high cost activities.

_ To identify the opportunities for improvement and reduction of costs. _ To eliminate non value adding activities. Steps Involved in Activity based Costing The working of Activity Based Costing is explained below. Understanding and analyzing manufacturing process :- For installation of any costing system, study of manufacturing process is essential. For Activity Based Costing system also, it is necessary to study the manufacturing process and ascertain various stages involved in the same so that activities involved in the same can be identified. Study of the Activities involved :- The next step is to study the activities involved in the manufacturing process. This step is very crucial as the entire Activity Based Costing is based on identification of activities. In this step, the activities involved in a process are identified. For example, in a bank, opening of an account is one of the services offered to customers. In this service, activities involved are studied. It may be revealed that opening of a new account involves activities like issuing the application form, verification of the same and accepting the initial amount required for opening of an account. Similarly in case of a manufacturing company, purchase procedure may involve activities like receiving of purchase requisition for concerned department or the stores department, inviting quotations from various suppliers, placing of an order, follow up of the same and finally receiving and inspection of the goods. In case of an educational institute, activities in a library may include activities like issue of books, receipt of books, ordering new books, giving accession numbers, stock taking, removing obsolete and outdated books, identification of slow moving and fast moving items etc. In this manner, whether in manufacturing or in service sector, activities are identified and the next step is to divide the activities into value adding and non value adding. The objective behind this is that attention can be focused on the value adding activities while non value adding activities can be eliminated in the future.
Activity Cost Pool :- Cost pool is defined by CIMA as, the point of focus for

the costs relating to a particular activity in an activity based costing system. For example, in case of a library, the cost of issue and receipts, cost of ordering, stock taking costs etc. can be identifi ed with Library Cost. In other words, Library will the cost pool in which all the costs mentioned above may be clubbed. In case of a manufacturing organization, as regards to stores, cost of classification, cost of issue of stores requisitions, inspection costs etc. can be

pooled under the heading stores. Thus cost pool concept is similar to the concept of cost center. The cost pool is the point of focus or in other words, it is the total cost assigned to an activity. It is the sum of all the cost elements assigned to an activity. Cost Drivers :- According to CIMA, cost driver is any factor which causes a change in the cost of an activity, e.g. the quality of parts received by an activity is a determining factor in the work required by that activity and therefore affects the resources required. An activity may have multiple cost drivers associated with it. In other words, cost driver means the factors which determine the cost of an activity. For example, if we repeat the example of library, the number of receipts and issue of books will be cost drivers, in a stores, no. of stores requisitions will be cost drivers, in customer order processing the no. of customers as well as no. of orders will be cost drivers. Thus a cost driver is an activity which generates cost. Activity Based Costing is based on the belief that activities cause costs and therefore a link should be established between activities and product. The cost drivers thus are the link between the activities and the cost. Identification of costs with the products :- The final stage in Activity Based Costing is to identify the cost with the final products which can also be called as cost objects. Cost objects include, products, services, customers, projects and contracts. As mentioned earlier, direct costs can be identified easily with the products but the indirect costs can be linked with the products by identifying activities and cost drivers. Thus Activity Based Costing is the process of tracing costs first from resources to activities and then from activities to specific products. Conclusion :- It can be concluded that the Activity Based Costing is a costing system which tries to charge the indirect costs to the products and services fairly accurately. However for effective implementation there is a need of involvement of the staff and their training on continuous basis. Similarly there is a need to review the working of the system at periodic intervals and keep a follow up of the feedback received. These actions will ensure effective implementation of the system. Support of top management is also required for effective implementation of this system. Activity Based Costing system is definitely a better system but much depends on the implementation of the same.

Limitations of Activity Based Costing

Though this system is quite effective, it suffers from some limitations. These limitations are given below. _ Activity Based Costing is a complex system and requires lot of records and tedious calculations. _ For small organizations, traditional cost accounting system may be more beneficial than Activity Based Costing due to the simplicity of operation of the former. _ Sometimes it is difficult to attribute costs to single activities as some costs support several activities. _ There is a need of trained professionals who are limited in number. _ This system will be successful if there is a total support from the top management. _ Substantial investment of time and money is required for the implementation of this system.
Contract Costing: Contract Costing is a method used in construction industry to

find out the cost and profit of a particular construction assignment. The principles of job costing are also applicable in contract costing. In fact Contract Costing can be termed as an extension of Job Costing as each contract is nothing but a job completed. Contract Costing is used by concerns like construction firms, civil engineering contractors, and engineering firms. One of the important features of contract costing is that most of the expenses can be traced to a particular contract. Those expenses that cannot be traced to a particular contract are apportioned to the contract on some suitable basis. The cost computation in case of a contract is done on the following basis. A. Material Cost: Direct Material required for a particular contract is debited to the Contract Account. There may be some quantity of material which is returned back to the store. In such cases, material returned note is prepared and is either credited to the Contract Account or deducted from the material debited to the Contract Account. Similar treatment is given to the material transferred from one contract to another one. Material Transfer Note is prepared to record these transactions of transfer. Material remaining at the site at the end of a particular accounting period is shown as closing stock after valuation of the same and carried forward to the next period.

B. Labor Cost: Wages paid to the workers engaged on a particular contract should be charged to that contract irrespective of the work performed by them. If there are common workers on more than one contract and/or if the workers are transferred from one

contract to the other contract, time sheets must be maintained and wages may be distributed on the basis of time spent on each contract. Some of the workers may be working in the central office or central stores, their wages can be apportioned to a particular contract on suitable basis like time spent etc.

C. Expenses: All expenses incurred for a particular contract should be charged to that contract. In case of any indirect expenses incurred for the organization as a whole, they should be charged to the contract on some suitable basis. Direct expenses can be charged directly to the contract.

D. Plant and Machinery: Depreciation on the plant and machinery used for the contract is to be charged to the contract account. The depreciation may be charged on any of the following basis. _ If a plant is specially purchased for a particular contract and is expected to be used for the contract for long time, thus being exhausted at site, the total cost of the plant will be debited to the contract account. After the completion of the contract, if it is no longer required, it will be sold at the site itself and the sale proceeds are credited to the contract account. If it is not sold, the contract is credited with the depreciated [revalued amount value]. Thus the amount of depreciation is debited to the contract account. The main drawback of this method is that the debit side of the contract account is unnecessarily infl ated with the cost of the plant value and thus the cost of contract is shown very high. For removing this drawback, the difference between the original cost at the commencement of the contract and the depreciated value at the end of the period is worked out and charged to the contract account as depreciation. _ If a plant is used for a contract for a short period, there is no need of debiting the cost of the plant to the contract account. The amount of depreciation is worked out on the basis of per hour and charged to the contract on that basis. The hourly rate is calculated by dividing the depreciation and other operating expenses of the plant by the total estimated working hours of the plant. _ Sometimes plants may be taken on hire for a particular contract. In such cases the amount of rent paid should be debited to the contract account.

Subcontract: Sometimes due to certain situations, a sub contractor is appointed to carry out certain special work for the main contract. This special work done by the sub contractor becomes a direct charge to the main contract and accordingly debited to

the contract account. The payments made to the sub contractor are charged to the main contract as direct expenses and no detailed break up of the same is required. Material supplied to the sub contractor without any charge, is debited to the contract account as direct material and machinery, tools etc supplied to him on rent should be depreciated on appropriate basis and debited to the contract account. Rent received for the use of such tools and machines should be credited to the contract account or deducted from the final bill of the sub contractor.

Additional Work: Sometimes additional work may be necessary in addition to the work originally contracted for. This forms a separate charge and if the amount involved is large, a subsidiary contract is generally entered into with the contract. Special Aspects Of Contract Account: There are certain special aspects of contract accounts. These are discussed below. _ Certified Work: In contracts which are expected to continue for a long period of time, it is a normal practice that the contractor obtains certain sums from the contractee from time to time. This is done on the value of contract completed and certified by the architect/surveyor appointed by the contractee. The amount received by the contractor is not 100% of the value of the work certified but is less than the same, as the balance amount is kept as retention money. For recording this transaction, any of the following two methods may be used.

The four main components of costs are: (a) Prime Cost, (b) Works Cost, (c) Office Cost and (d) Total Cost. Prime Cost It consists of costs of direct material, direct labour and direct expense specifically attributable to the job. This is also known as flat, direct or basic cost. Works Cost It comprises of prime cost and factory overheads, (cost of indirect material, indirect labour and indirect expenses related to factory works). This cost is also known as factory cost, production or manufacturing cost. Cost of Production (Office Cost)

It is the sum total of works cost and office and administrative overheads <Cost of indirect material, indirect labour and indirect expenses related to office works). This cost is known as office cost. Cost of Production = Works Cost + Office and Administrative Overheads Total Cost It comprises of cost of production and selling and distribution overheads (Cost of indirect material, indirect labour and indirect expenses for selling and distribution activities). Total Cost = Cost of Production + Selling and Distribution Overheads