Activity Based Management (ABM)

•Activity Based Management is a cost reduction approach that first identifies the value added and non-value added activities
•Attempts to minimize non-value added activities by identifying the root cause(s) which are preventable and prevention is always cheaper.
•To improve customer value and overall profit.
Definitions
• Activity-Based Management:
A system wide , integrated approach that focuses management’s attention on activities.
Activity Management:
An assessment of the value of the activities to the organization, including a recommendation to select and keep only those that add value.

• Value-Added Activities Necessary, perfectly efficient activities. Example: Direct labor, Additional direct materials, and machining. The filing requirements of the IRS, reporting requirements of SEC, and preparing financial statements per GAAP requirements.
• Non-value-added Activities : Activities that are either unnecessary or necessary but inefficient and improvable. These activities cause non-value added costs.Example:Scheduling,moving,waiting,inspecting,and storing.
Dimensions of Activity Based management
• Cost Dimension Concerned with accurate assignment of costs to cost objects, such as products and customers.ABC is the focus of this dimension.
• Process Dimension Provides accurate information about why work is done and how well it is done.

Process Dimension Includes:
• Driver Analysis: Concerned with identifying the root cause(s) of activity costs. Knowing the root causes of activity cost is the key to improvement and innovation.
• Activity Analysis: The process of identifying, describing, and evaluating the activities an organization performs. It involves:
1. What activities are done.
2. How many people perform the activities.
3. The time and resources required to perform the activities.
4. An assessment of the value of activities to the organization, including
a recommendation to select and keep only those that add value.

Furthermore, activity analysis help management to select and keep- adding activities that brings about cost reduction and greater operating efficiency, thus providing support for the objective of continuous improvement. Moreover, activity analysis can reduce costs in four ways.
• Cost Reduction:
• Activity elimination: the identification and elimination of activities that fail to add value.
• Activity selection: the process of choosing among different sets of activities caused by competing strategies.
• Activity reduction: the process of decreasing the time and resources required by the activity.
• Activity sharing: Increasing the efficiency of necessary activities using economies of scale.
• Activity performance measurement: Assessing how well activities( and processes) are performed is the fundamental to management’s efforts to improve profitability. There are two types of measurement : Financial and non financial forms. These measures are designed to assess how well an activity was performed and the results achieved.

• Activity performance is evaluated on three dimensions:
• Efficiency :focuses on the relationship of activity inputs activity outputs. e.g.
producing the same output with lower costs for the inputs used.(financial and non financial)
• Quality: concerned with doing the activity right the first time it is performed. Otherwise the unnecessary costs will incur and will have adverse effect on efficiency.(financial and non financial)
• Time: the time it takes to develop and produce a product and delivering to customer.(non financial).

ABM STEPS
• Set a benchmark (standard) for value added activities.
• Identify activities
• Classify activities: Value added and Non-value added
• Search for the root causes for non-value added activities.
. Recommend how to improve non-value added activities by using:
1. activity selection
2. activity reduction
3. activity elimination
4. activity sharing

Illustration of ABM Application

• Setup time for a product is 5 hours. A firm that produces the same product and uses JIT has reduced setup time to 15 minutes. Setup labor is $10 per hour.
Value-added costs: (15/60)($10)=$2.50
Non value-added costs:(5-15/60)($10)=$47.50
15 minutes is considered to a benchmark .Root cause—product design—strategy—activity selection

• Warranty work costs the firm $1,000,000 per year. A competitor’s warranty costs are $200,000 per year.
• Value-added costs: $0.00
• Non-value added costs: $1,000,000
• With zero defects there should be no warranty costs.-- Root cause---.( Total Quality Management)—strategy: Activity elimination

• The company keeps 5 days of raw materials on hand to avoid shutdowns due to raw materials shortages. Carrying costs averages $1,000 per day.
• Value-added costs: $0.00
• Non-value-added costs: $1,000*5=$5,000.
• Delivery problem---Root Cause--(suppliers) Use JIT. Strategy: activity elimination

• By redesigning the plant layout, the time required to move materials can be reduced from 2 hours to 30 minutes. The labor cost is $12 per hour.
Value-added costs: (30/60)($12)=$6
Non-value added costs= (2-.5)($12)=$18
Root cause: plant layout…Strategy: Activity selection

Summary

• Activities are classified into: Value-added and non-value added costs.
• Identify the root causes for non-value added costs
• Recommend how to eliminate and / or improve inefficiency related to non-value-added activities.
• ABC and JIT are complimentary to ABM.
• To improve customer value and overall company’s profitability
• Identifying non-value added

Balanced Scorecard

The balanced scorecard is a new management concept which helps managers at all levels monitor results in their key areas. An article by Robert Kaplan and David Norton entitled "The Balanced Scorecard - Measures that Drive Performance" in the Harvard Business Review in 1992 sparked interest in the method, and led to their business bestseller, "The Balanced Scorecard: Translating Strategy into Action", published in 1996.
There's nothing new about using key measurements to take the pulse of an organization. What's new is that Kaplan and Norton have recommended broadening the scope of the measures to include four areas:
• financial performance,
• customer knowledge,
• internal business processes,
• learning and growth.
This allows the monitoring of present performance, but also tries to capture information about how well the organization is positioned to perform well in the future.
Kaplan and Norton cite the following benefits of using the balanced scorecard:
• Focusing the whole organization on the few key things needed to create breakthrough performance.
• Helping to integrate various corporate programs, such as quality, re-engineering, and customer service initiatives.
• Breaking down strategic measures to local levels so that unit managers, operators, and employees can see what's required at their level to roll into excellent performance overall.
Similarity to Hoshin Planning
The balanced scorecard has strong similarities to Hoshin Planning or hoshin kanri, the organization-wide strategic planning system used widely in Japanese companies. Both seek breakthrough performance, alignment, and integrated targets for all levels. The balanced scorecard suggests which specific areas should be measured for a balanced picture, but this isn't contradictory to Hoshin Planning. One thing that the Japanese emphasize is "catchball", the process of give and take between levels that helps to define strategy in Japanese companies. The balanced scorecard method seems to be more of a one-way street -- the executive team creates the strategy, and it cascades down from there.
One cautionary note
You tend to get what you measure for, since people will work to achieve the explicit targets which are set. Dr. Deming feared this effect, noting that people would skew their work to meet particular incentive pay targets. For example, emphasizing traditional financial measures tends to encourage short-term thinking - like rigging shipping schedules to make the monthly sales look good, or aggressively discounting to meet year-end targets. Kaplan and Norton, recognizing this, urge a more balanced set of measurements, which is good. Even so, people will work to achieve their scorecard goals, and may ignore important things which are not on the scorecard. Or, if the scorecard is not refreshed often enough, what looked like an important goal in January may not be very germane in June. Kaplan and Norton recognize these risks, and they don't pretend that they have said the final word on scorecards.



The balanced scorecard forces managers to look at the business from four important perspectives. It links performance measures by requiring firms to address four basic questions:

(a) How do customers see us? - Customer perspective
(b) What must we excel at? - Internal perspective
(c) Can we continue to improve and create value? - Innovation & learning perspective
(d) How do we look to shareholders? - Financial perspective

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The Problems of Transfer Pricing

The Problems of Transfer Pricing

EXECUTIVE SUMMARY
 WHEN A COMPANY adds facilities in another stateor even worse, when it goes internationalit suddenly must contend with the complex process of transfer pricing.
 A KEY ELEMENT of transfer pricing is the presence of a buyer-seller relationship between units of a single company. Although owners and managers may not think of one location as selling services or parts to another unit, the various taxing authoritieswhether state or nationalmay impose that view. Under such circumstances, a company has to determine the monetary value of the goods or services and treat that amount as sales revenue of the selling unit and as a cost of the buying unit.
 A DANGER A COMPANY will want to avoid is being whipsawed between the taxing authorities of two jurisdictionsthat is, having its sales revenue from a single source taxed in two jurisdictions because of overlapping or conflicting tax rules.
 IN MOST STATES, companies compute taxable income by using the federal income tax rules as the starting point; however, in determining the portion of their net income subject to tax by each state, companies typically use allocation and apportionment formulaswhich, unfortunately, vary from state to state.
 THE TWO MOST COMMON approaches to setting and revising transfer prices are to apply cost-plus and market-based procedures. While cost-plus prices have the appeal of simplicity and ease of calculation, be aware that cost-plus transfer prices can provide exactly the wrong incentive for the producing unit.


Its hard enough for a company to do business when its situated in only one state, but consider the complexities when it adds facilities in another stateor, even worse, when it goes international. In addition to having to prepare multiple tax filings, a business with far-flung facilities suddenly must contend with another complication: transfer pricingin which local tax authorities view a company division in one political venue as a customer and/or a supplier of a related division in another political venue. The upshot is that the cost of any goods or services the two units exchange must be determined when the company calculates each units tax liability.
This article examines the processincluding its tax, accounting and corporate profit implications.
If you think transfer pricing affects only big companies, think again. Size is immaterial. The only condition that triggers transfer pricing is the existence of multiple facilities in more than one taxing jurisdiction. For example, a company with 45 employees in five locations in two states would activate transfer pricing concerns if one of its offices provides data processing, payroll or other services to the others. Similar situations arise in manufacturing, when one division ships parts or unfinished products for final assembly at another location in a different jurisdiction.
A key element is a buyer-seller relationship between units of a single company. Although owners and managers may not think of one location as selling services or parts to another unit, the various taxing authoritieswhether state or nationalmay impose that view. Under such circumstances, a company has to determine the monetary value of the goods or services and treat that amount as sales revenue of the selling unit and as a cost of the buying unit. Companies establish transfer prices in a variety of ways. Two of the most popular are by estimating competitive market prices and by adding a markup to costs.
To illustrate, look at Example, Inc., a producer of telephones and related equipment at its Alpha division, which is situated in an urban U.S. community with high taxes on property and income. Competitive pressures combined with those high taxes prompted Alpha to look for lower tax jurisdictions for expansion. An opportunity arose when a supplier offered to sell its entire operation. The supplier has two facilities: one, Beta, is in a state with no income tax; and the other, Gamma, is in Canada, near the U.S. border.
Beta produces a variety of molded plastic parts, including the hard-plastic exteriors or shells of telephones, using raw plastic purchased in bulk. Excluding shells, much of Betas output is shipped to Gamma, where it is combined with purchased parts to create telephone subassemblies. As a result of the planned acquisition, Example will produce shells at Beta for sale to unaffiliated or outside entities and also will produce shells for its own use in final assembly at Alpha and for subassemblies at Gamma; some of these subassemblies will be shipped from Gamma to Alpha for final assembly. In addition, Alpha will provide marketing and administrative services for all three locations.

TAX CONSIDERATIONS

A danger that Example will want to avoid is being whipsawed between the taxing authorities of two jurisdictionsthat is, having its sales revenue from a single source taxed in two jurisdictions because of overlapping or conflicting tax rules. Further, because Alpha is in a high-tax state, any transfer pricing system that shifts taxable income away from Alpha will probably be challenged almost automatically by the state in which Alpha is situated.
In most states, companies compute taxable income using the federal income tax rules as the starting point; however, in determining the portion of their net income subject to tax by each state, companies typically use allocation and apportionment formulaswhich, unfortunately, vary from state to state.
Generally, its to the taxpayers advantage to establish high transfer prices for goods and services provided by a unit in a jurisdiction with low tax rates. The result is to have more revenue subjected to a lower rate and less to a higher rate. If the operating unit receiving the goods and services is in a high-rate jurisdiction, the high transfer price also produces a large expense deduction for that division. When goods and services must flow in the opposite directionfrom high- to low-tax jurisdiction, its better for the transfer price to be set as low as possible. Of course, tax authorities usually have a different interest: They want to maximize tax revenues.
In the illustration, suppose Beta produces plastic parts at a cost of $10,000 and ships them to Gamma, which processes them further at an additional cost of US$1,000 and then ships them to a nonaffiliated Canadian customer, which pays Alpha a total of US$20,000 for them. A transfer pricing mechanism will attribute some of the $9,000 profit to each unit and to the tax return for each country.
Now suppose Example assigns a transfer price of $17,000, resulting in Canadian taxable income equivalent to US$2,000 and taxable income from U.S. sources of $7,000. If the U.S. authorities reject Examples transfer prices, they may tax the entire $9,000 profit even though Canadian income tax also is paid on the Canadian portion. The result is double taxation on $2,000 of income.
A similar problem can arise if Example later changes its transfer pricing system. The prospective loss of tax revenue may lead one jurisdiction to reject the new system, while a prospective increase in taxes may lead the other jurisdiction to leave the new system in place. The key is not simply to set individual transfer prices at the right level but to have a defensible system in place for setting transfer prices and to make sure that that system wins government approval in all tax jurisdictions. CPAs should be aware that some national taxing authorities, including the IRS, will examine and may approve a taxpayers proposed transfer pricing method in advance, thus removing the uncertainty.
A business wishing to reduce the uncertainty concerning IRS approval of its transfer pricing method can participate in the IRS advance pricing agreement (APA) program, as set out in revenue procedure 96-53 (1996-2 CB 375). More than 100 businesses have secured protection under this program. In Notice 98-10 (1998-6 IRB), the IRS announced plans to institute special APA procedures for small businesses.
A critical issue is establishing a transfer price for marketing and administration services. Assuming Alpha charges Beta and Gamma a low price (in relation to what Alpha incurs to provide those services) for marketing and administration services, taxable income effectively would shift away from Alphas high-tax jurisdiction and to Betas and Gammas low-tax jurisdictions. Thus, if Alpha received a transfer price of $80,000 ($40,000 each from Beta and Gamma) for marketing and administration services that cost $100,000 to provide, Alphas income would be reduced by the $20,000 difference. Correspondingly, Betas and Gammas income would be $20,000 higher because they are paying only $80,000 as opposed to the full $100,000 that Alpha incurs to provide the services. To be sure, the company would have to justify that price.
Suppose Example faces effective income tax ratesstate, local and federal combinedof 52% in the Alpha location, 39.6% in Beta and 50% in Gamma. If Example successfully establishes an $80,000 transfer price for marketing and administration services, compared with using the actual costs of $100,000 incurred by Alpha to provide those services, it will save $1,440.

THE WRONG INCENTIVE

The two most common approaches to setting and revising transfer prices are to apply cost-plus and market-based procedures. While cost-plus prices have the appeal of simplicity and ease of calculation, be aware that cost-plus transfer prices can provide exactly the wrong incentive for the producing unit.
For example, suppose Betas manager wants to improve profits, including the profits that result from transfer pricing. Suppose also that Example sets transfer prices at cost-plus-10%. Then what happens if excessive amounts of scrap and rework raise the actual cost by $1,000 for some output transferred from Beta to Alpha? The result of Betas inefficiency is that a larger profit will be reported for Beta, whose costs increase by only the $1,000 inefficiency, while the transfer price increases by $1,100. The net effect is a $100 increase in Betas reported income.
Sample Calculation of Transfer Prices for a Dozen of Part #22
Competitive baseline cost of procurement $3.20

Adjustments:
• Lack of credit risk, risk of an uncollectible account (.01)
• Time value of money equivalent to value held in payment terms (.04)
• Procurement burden (.14)
• Purchase order management
• Supplier quality management
• Supplier delivery management
• Profit objective (1%) .03
__________
Betas local (hypothetical) transfer price $3.04

Geographical adjustment
For Canada: Gamma:
• Proportion 105%
• Price ($3.04 x 1.05) $3.19
For high-tax U.S. location: Alpha:
• Proportion 99%
• Price ($3.04 x .99) $3.01


Using the market-based approach, assume a division producing the transferred goods and services also sells some of the same outputs to unaffiliated entities in arms-length transactions: Those transactions can serve as a starting point in a system of market-based transfer prices.
The latter approach not only avoids the incentive drawbacks of a cost-plus system but in theory it also is the preferred way to value the output of each unit. Its weakness is that its difficult to defend the system as being truly market-based. For example, a single item may have different prices in different markets, depending on local supply and demand, regulation, shipping costs and many other factors. Transfer prices must reasonably reflect those differences, and when market conditions change significantly, the transfer prices must be revised.
For the transfer pricing system to be defensible, it must be treated consistently throughout the company. So, for example, if credit risk is considered in one situation, it must be considered in others, too.
$ [10,000 x (.52 - .396)]
+ [10,000 x (.52 - .500)] 1,240
+ 200 $ 1,440


Another consideration: Because only a book entry at headquarters is necessary to recognize the payment and collection of a transfer price, the transfer is the equivalent of an immediate cash payment. This should result in an adjustment representing the time value of money. When great distances or national borders separate the different business units, a company must make several adjustments to arrive at defensible market-based transfer prices. The exhibit above is a summary of the adjustments used to arrive at a market-based transfer price.
The business must make a similar calculation for each category of item shipped to each location. For a large, vertically integrated company with dozens of locations and hundreds of products, this could entail thousands of calculations and frequent revisions.

ACCOUNTING AND REPORTING

Any transfer pricing system creates internal revenues and expenses recorded for the goods and services transferred between units. The company must eliminate them to calculate the overall entitys income. If transfer prices exist between only two units of a company, the recordkeeping may be simple. It must create a structure to justify the many eliminations needed when transfer pricing is used at multiple levels of a company, such as in Examples production of plastic parts at Beta, the use of plastic parts in making subassemblies at Gamma and the use of subassemblies in making telephones at Alpha.
As business gets more complex, the likelihood grows that your company will eventually have to deal with transfer pricing issues. Its prudent to understand the subject nownot when the taxing authorities are breathing down your neck.

BASIC CONCEPT OF COST ACCOUNTANCY

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1. DEFINITION: Cost Accountancy

Applications of Costing and Cost Accounting principles, methods and technique to the art, science and practice of cost control and ascertainment of profitability. It includes presentation of information derived there-from for the purpose of managerial decision-making’.

1.1 PRINCIPLES

• Maintaining Professional Competency, Integrity, Confidentiality and Objectivity
• Continuous development of knowledge & skill.
• Refrain from disclosing or misusing confidential information.
• Refrain from engaging in or supporting any activity that would discredit the profession.
• Communicate information fairly and objectively.

1.2 OBJECTIVE

• Application of right Methods or ways of correct cost findings at variant situations,
• Application of suitable Techniques of cost control and assessing operational profitability.
• Development of Art of presentation for quick and easy interpretation of performance.
• Enhancing Professional expertise to the best use of Management.


1.3 METHODS

Costing has been stated as method of classifying, recording and charging of cost to the products and services through appropriate and logical process or system depending on the nature of industry, Costing methods have been broadly divided into the following categories, viz.

1.3.1 JOB COSTING for jobbing industries engaged in production on specific order of customer and

1.3.2 PROCESS COSTING for process industries engaged in production of repetitive nature of products in a continuous process.

1.3.3 Variants of those broad methods of costing.

i) Contract or Terminal Costing: This is a variant of JOB Costing. This method is followed in huge single contract like, Building, Bridge, and Road etc. Separate accounts are being opened for different contracts.
ii) Batch Costing: This is an extension of Job costing. When a number of units of homogeneous type are produced in a batch, the said batch is being treated as a job. Cost arrived at for the batch as a whole in the card is divided by the number of units in that in order to arrive at the average cost per unit in that batch. Such method is followed in Cycle Industry.
iii) Single or output Costing: This is a method of costing being followed where the output is single like Coal Industry.
iv) Multiple/ Composite Costing: Different kinds components, sub-assemblies are produced in batches or through a continuous process for ultimate use in the main Job order. Different method of costing is applied for each segment and job costing for the main job undertaken as per specific order of the customer. Boiler industry is an example of application of such method
v) Operation Costing: This is an extension of Process Costing. In certain Process industries, when a process is divided into certain operations and Management need to have thorough costing of each and every operation for the purpose of control and decision-making. Food products and Chemical industry can be ideal examples for application of such costing.
vi) OPERATING COSTING for operating industries rendering services; viz., Transport Industries

2. COSTING TECHNIQUES
Besides such methods of assessment of cost of a job or a process, certain costing techniques followed for the purpose of cost control and management decision.

2.1. a) Standard Costing: This is a technique to assess standard cost of the product, recording the actual, comparing the actual with that of the standard, finding out the variation with reasons for ultimate control or revision of standard, if necessary. This technique can be well use of in cases standard and repetitive nature of work having all kinds of standard facilities.


2.2. b) Marginal Costing: This is a technique to assess marginal cost (Prime Cost and variable overhead) of products and contribution there-of by deducting marginal cost from sales. Fixed cost is kept away from cost structure. Profitability of each product is assessed through a ratio of contribution to sale (P/V ratio). The main idea behind this technique is assessment of true profitability of each product. Arbitrary distribution of fixed overheads, in absence of suitable bases makes it difficult to calculate correct profitability of the various products. Cost Accountants can assist management in various decision making areas like ‘Optimum product mix, pricing, make or buy and a host of other decisions in day to day business in a competitive world.

2.3. c) Uniform Costing: This is a technique of cost control by applying method of costing uniformly in various production units of homogeneous type so that it makes possible to compare the product-wise cost incidence of each unit. This is a technique to control cost through ‘Inter firm comparison’.

2.4. d) Differential Cost Analysis: This is a technique applied to find out optimum capacity utilization by comparing incremental revenue with that of differential cost at different level of capacity. This is a contribution of Cost Accountant in managerial decision- making where there is a limitation of Marginal Costing.

3. COST ACCOUNTING

As defined, Cost Accounting is a process of accounting for the cost from the point at which it is incurred or committed to the establishment. Cost accounting necessarily starts from the same original sources like vouchers and primary document. Cost accounts relates to the operational side of the business. It classifies accounting information and records, arranges and interprets such expenses by the cost elements like materials, labour and expenses.

As in the case of general accounting system, transactions relating to factory operations, to be finally reflected in cost accounts, are recorded in the books of original entry. Summaries of these books are initially journalized and posted in the general ledger, which contains control accounts and subsidiary books.

In Ordnance factories PRINCIPAL LEDGER with 30 heads serves the purpose of Cost Accounting.




4. Activity Based Costing

A latest technology incorporated by many organizations with their scientific and updated cost accounting system. ABC has its’ genesis in the growing incidence of indirect expenditure in the manufacturing operations with the increasing trend of management cost consciousness to ensure its’ survival in the global competition.

This is, specifically, a process of distribution of indirect cost amongst the various products and services more accurately and scientifically.


4.1. What it aims
• Overcome the problem of inaccurate cost findings and cost reporting due to wrong selection of bases of cost distribution.
• Identification of no value added activities and improvement in performance and activities.
• Cost cutting and down-sizing (Indirect cost).
• Activity based Budgeting.
• Target Costing

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