ASSIGNMENT ON ACTIVITY BASED COSTING IN FOOD

PROCESSING INDUSTRY

Submitted to

DR. MURALI

Lecturer - DOMS - NITT

Submitted by

VISHNU MOHAN (215111001)

NISHANT SINGH CHAUHAN (215111052)

OSAMA ZAID (215111056)

JAGTAR SINGH (215111083)

NIATIONAL INSTITUTE OF TECHNOLOGY

DEPARTMENT OF MANAGEMENT STUDIES

TRICHY-15

Table of Contents

Introduction

The concept of Activity Based Costing

Evolution of Activity Based Costing

Food Processing Sector in India

o Overview

o Key segments in Food Processing Industry

o Major Players in Indian Food processing Industry

Implementation of Activity Based Costing in Nestle

An international comparison of American and Dutch food

producing companies based on implementing ABC

Advantages of Activity Based Costing System

Introduction

The goal of any cost system is to provide relevant and timely information to management. This information supports better management of corporate resources in production of products or provision of services, and improves competitiveness in terms of costs, quality and profitability. Amidst the changes, which the business world has witnessed during last few decades, traditional cost accounting systems have been found to be faltering. The criticism basically revolves around overhead allocation techniques used in traditional cost systems, thus Activity-Based Costing (ABC) is an alternative to the traditional way of accounting.

Dandago and Tijjani (2005) noted that the main difference between the two is that the traditional cost accounting systems operate on the assumption that producing goods and services is what causes cost to occur, while ABC assumption is that activities cause cost and that products or services and customers are the reasons that activities must be performed.

ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers (Wikipedia, 2008). It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives.

The ABC method was designed in the United-States during the 80’s (Cooper and Kaplan, 1988). “It is a refined cost system which enables classifying more costs as direct, to expend the number of indirect-cost pools and to identify cost drivers” (Wegmann, 2008). ABC favours better cost allocation using smaller cost pools called activities. Using cost drivers, the costs of these activities are the basis for assigning costs to other cost objects such as products or services.

Activity Based Costing (ABC) has demonstrated positive results for the companies that made it through the implementation process (Lowder, 2006).

The Concept of Activity Based Costing System

ABC is a system that first accumulates overhead costs for each of the activities of an organization, and then assigns the costs of activities to the products, services, or other cost objects that caused that activity. ABC system is a costing principle that relies on activities that have a cause and effect relationship with cost as a basis for allocating such cost to cost objects which jointly cause the cost (Dabor and Eragbhe, 2005). ABC provides management with a valuable new tool to assist in determining and allocating product costs more realistically. It also provides the means by which to isolate and account for costs in relation to the activities associated with those costs (Lowder, 2006). It is very critical we understand that ABC is not a quality improvement program like process reengineering, or statistical process control. This distinction is important so that we do not classify ABC as a fad or fashion (Cokins, 2002).

Under ABC, product costs are not strictly isolated to manufacturing costs and are expanded to include non-manufacturing costs such as selling, marketing, distribution, and administrative that can be directly traced to the product through activities (Garrison et al, 2006). ABC charges products for the cost of capacity they actually use and not for idle capacity like the absorption method. In addition, ABC does not allow costs shifting of batch level or unit-level costs from products produced in smaller volumes to products produced in larger volumes. These distinctions represented a tremendous improvement over the “lumpsum” allocation method used under the absorption costing methodology where there exists a strict application of manufacturing costs to product costs. However, the true worth of ABC from a managerial perspective is its ability to assign activity costs to cost objects. This enabling characteristic allows management accountants to reassign activity costs across business processes and identify relationships more accurately in decision-making processes.

Identifying and allocating costs based upon an activity rate assist in making many types of decisions spanning across functional areas that involve not only products, but also distribution and customer related decisions. Another important contribution of ABC is the use of specific naming of activity cost pools and activity rates (Lowder, 2006). Under ABC, these activities and rates more precisely link to the actual work or job currently performed.

ABC terminology is very work-centric verses absorption costing which is very transaction-centric (Cokins, 2002). As an example, Lowder (2006) said:

An assignment occurs between an activity cost pool called customer orders to the activity measure called the number of customer orders. As can be determined, this terminology is function and action driven which provides for a more accurate accounting of each cost and its relationship to specific activities throughout the organization. Because of this work-centric naming convention, ABC provides better tools for decision-making. The main positive characteristic of ABC is its effective influences on decision-making, which has resulted in a decision making process called activity-based management (ABM).

Evolution of Activity-Based Costing

Highlighting the limitations of traditional costing systems in overheads cost allocation in a situation of product diversity in terms of volume and complexity Cooper (1988a) illustrated the need for activity-based costing system. Consistent with this research, Cooper (1988b) found that the firms facing high level of competition and having diverse product mix are more likely to benefit from precise cost information and the introduction of activity-based cost systems with an added caution that the activity-based costing system introduction initiative itself should be cost effective.

Meanwhile Kaplan (1988) observed that many companies used single cost system to meet their three diverse needs, namely inventory valuation & financial reporting, product/service/customer costing and providing ‘operational feedback to frontline employees’ in the plant. However, he apprehended that, in a complex manufacturing environment with ‘product and process diversities’, and ‘concern for excellence’, ‘single cost system’ for all the three needs might not suffice.

With the help of case studies of Siemens Electric Motor Works, John Deere Component Works, and Schrader Bellows Cooper (1989b) demonstrated that the ‘management objectives’ and ‘diversity of product mix’ determine the extent of the complexity in the design of activity-based cost

management systems. The competitive environment in which the firm is operating drives the need for activity-based costing.

Cooper & Kaplan (1997 & 1998) argued that operational control and activity-based cost systems are two separate systems as they have different purpose and different requirements for accuracy, timeliness, and aggregation. Any attempt to integrate the both be made with utmost care otherwise it would perform neither function well. The operational learning & control system provides economic feedback about process efficiencies by using actual & highly accurate data on continual basis in respect of each responsibility centre. The emphasis is on short-term fixed and variable cost and the cost centres are expenses actually recorded in the financial system.

Product, customer, and business-unit profitability are the objectives of the activity-based cost systems. It uses standard cost data based on standard cost driver rates and practical capacity of organizational resources and updates it periodically for the entire value chain. The well-designed integrated cost management system will help the management of company to identify opportunities for continuous improvement and point out unused capacity or capacity constraints, if any and will facilitate the introduction of activity-based budgeting in the organization. The activity based budgeting mindset makes all cost variable and attempts to match resource supply to resource demand.

The Food Processing Sector in India

An Overview

The food processing sector is critical to India’s development, for it establishes vital linkage and synergy between the two pillars of the economy Industry and Agriculture. India is the world’s second largest producer of food and holds the potential to acquire the numero uno status with sustained efforts. The enormous growth potential of this sector can be understood from the fact that food production in the country is expected to double in the next 10 years, while the consumption of value-added food products will also correspondingly grow. The growth of this industry will bring immense benefits to the economy, raising agricultural yields,

enhancing productivity, creating employment and raising life-standards of a large number of people across the country, especially those in rural areas.

The liberalisation of the Indian economy and world trade and rising consumer prosperity has thrown up new opportunities for diversification in the food-processing sector and opened new vistas for growth. A recent study has revealed that there is tremendous potential in India to build a profitable business in the sector. This industry ranks fifth in the country and employs16 lakh workers, comprising 19% of the country’s industrial labour force. It accounts for 14% of the total industry output with 5.5% of the GDP. Its turnover is estimated at Rs.1,44,000 crore, of which Rs.1,11,200 crore is in the unorganised sector. The industry has started producing many new items like ready-to-eat food, beverages, processed and frozen fruit and vegetable products, marine and meat products, IQF products, etc. The Indian consumer is being fast introduced to newer high quality food products made by using the latest state-of-the-art technology that is also giving the industry a competitive edge.

Key segments in the food processing industry

Fruits & vegetable processing

Fruits and vegetables is one of the most important and fast growing

sub-sectors of the food processing sector. Over the last few years, there has

been a positive growth in ready-to-serve beverages, fruit juices and pulps,

dehydrated and frozen fruits and vegetable products, tomato products,

pickles, convenience vegspice pastes, processed mushrooms and curried

vegetables reasons being increase in consumption by nuclear families,

working women, students and single employees staying alone.

There are abundant investment opportunities are there in expanding the

export market. An increasing acceptance of new products with market

development efforts has been witnessed lately given the fact that there is a

good international demand for certain fruits and vegetable products. The

Indian food processing industry is primarily export oriented. India's

geographical situation gives it the unique advantage of connectivity to

Europe, the Middle East, Japan, Singapore, Thailand, Malaysia and Korea.

In 2008-09, India's export of fresh fruit and vegetable was estimated at US$

0.79 billion and in case of processed fruits and vegetables it stood at US$

0.68 billion.

Meat Processing

In meat and meat processing sector, poultry meat is the fastest

growing animal protein in India. The estimated production of meat was 6.5

million tonnes during 2007-08. India exports more than 500,000 million

tonnes of meat of which major share is buffalo meat. Buffalo meat

production during 2008-09 is estimated at 2.8 million tonnes and out of this

about 21% is exported. Indian buffalo meat is witnessing strong demand in

international markets due to its lean character and it's near organic nature.

India is the 6th largest exporter of bovine meat in the world.

In 2008-09, India's export of meat products (including buffalo meat,

sheep/goat meat, poultry products, animal casings and processed meat)

stood at U$ 1.25 billion.

Dairy processing

India is number one milk producing country in the world with an

estimated production of 105 million tonnes in comparison to world milk

production of 693 million tonnes during 2007-08.Buffalo milk is estimated

to account for 57% of the total milk production in India.

India has a unique pattern of production, processing and

marketing/consumption of milk, which is not comparable with any large

milk producing country. Approximately 70 million rural households in the

country are engaged in milk production. Over 11 million farmers are

organised into about 0.1 million village Dairy Cooperative Societies (DCS).

About 35% of milk produced in India is processed. The organised sector

(large scale dairy plants) processes about 13 million tonnes annually, while

the unorganized sector processes about 22 million tonnes per annum. In

2008-09, export of dairy products was estimated at US$ 0.21 billion.

Fisheries Sector

In India nearly 10 million people, living in 4,000 coastal villages and

more number of interior villages, depend on fisheries sector. The export of

marine products has steadily grown over the years - from a mere US$ 0.84

million in 1961-62 to US$ 1,849.08 million in 2008-09. Marine products

account for approximately 1.1 % of the total exports from India.

Frozen shrimp continued to be the single largest item of export in terms of

value accounting for about 44% in the total export earnings. In terms of

quantity, fish accounted for the major share at 40% (shrimp 21%).European

Union (EU) was the largest market during the year 2008-09 with a

percentage share of 32.6% followed by China 14.8%, Japan 14.6% , USA

11.9%, South East Asia 10%, Middle East 5.5% and Other Countries

10.6%.

Grain processing sector

India during the year 2007-08, accounted for 8.73% of the world's

oilseed production of 7.63%; 7.31% of the world's oil meal production of

6.74%; 7.53% of the world's meal export of 6.78%; 6.03% of the world's oil

production of 5.86%; 9.22% of world oil imports of 9.58% and 9.33% of

the world's oil consumption of 9.28%.

On the export front, export of oil meals, oilseeds, minor oils (fats) and

castor oil during the financial year 2007-08 is reported at 62.6 lakh tonnes

valued at US$ 2.32 billion against the exports of 58.9 lakh tonnes valued at

US$ 1.39 billion in the previous year.

The solvent extraction processing of oilseed, oilcakes and rice bran during

2007-08 is reported at 121.2 lakh. However, the overall production of

solvent extracted oils during 2007-08 form rice bran, oilcakes & minor

oilseeds and soybean is reported at 19.4 lakh tonnes.

Consumer food industries

Consumer food industry includes pasta, breads, cakes, pastries, rusks,

buns, rolls, noodles, corn flakes, rice flakes, ready-to-eat and ready-to-cook

products, biscuits etc. Bread and biscuits constitute the largest segment of

consumer foods. India's biscuits industry is the largest among all the food

industries and has a turnover of around US$ 0.64 billion. India is known to

be the second largest manufacturer of biscuits, the first being USA.

Indian consumer food inustry is classified under two sectors: organised and

unorganised. Bread and biscuits are the major part of the bakery industry

and cover around 80 percent of the total bakery products in India. Biscuits

stand at a higher value and production level than bread. This belongs to the

unorganised sector of the bakery industry and covers over 70% of the total

production.

Major Players in Indian Food processing Industry

ITC Limited

Parle Products Pvt. Ltd.

Agro Tech Foods

Amul

Perfetti India Ltd.

Cadbury India Ltd.

PepsiCo India Holdings

Nestle India Pvt. Ltd.

Britannia Industries Ltd.

Hindustan Lever Limited

Milkfood

MTR Foods Limited

Godrej Industries Limited

Gits Food Products Pvt. Ltd.

Dabur India Ltd.

Unilever

Conagra Foods

Nissin Foods

Walmart

Venky's

Implementation of Activity based costing in Nestle

Nestlé S.A. is the world's largest food and nutrition company.

Founded and headquartered in Vevey, Switzerland Nestlé originated in a

1905 merger of the Anglo-Swiss Milk Company, established in 1867 by

brothers George Page and Charles Page, and Farine Lactée Henri Nestlé,

founded in 1866 by Henri Nestlé. The company grew significantly during

the First World War and again following the Second World War, eventually

expanding its offerings beyond its early condensed milk and infant formula

products. Today, the company operates in 86 countries around the world,

and employs over 280,000 people.

Nestle company is using activity based costing method for inventory

valuation. Firstly they identify all activities that use resources. Cost pools

are set up for each of the activities identified. They assign overhead costs to

the cost pools based on the cost driver. Cost pools are used to assign costs.

Then costs are assigned to units, batches or products.

Activity based costing helps Nestle in determining accurate product cost.

Complex companies like Nestle may see the most benefit from this type of

costing because it is most helpful when the costing information is difficult

to understand or evaluate. ABC provides information to Nestle regarding

processes that should be improved and the product or services that are

contributing the most to company’s profitability. ABC also helps Nestle in

knowing the factors that contribute most to the cost, which in turn assists

management in choosing best alternative in reducing overall costs incurred

by the company. ABC can be the best tool to be utilized in implementing

environmental accounting at the firm level.

An international comparison of American and Dutch food

producing companies

A US survey of 96 food producing companies and a Dutch survey of

117 food producing companies provide information on the use of ABC in

the food sector, on the organizational and production related characteristics

of ABC using food companies and on experiences with designing and

implementing ABC systems.

Given the specifics of the food sector, we try to draw some conclusions on

the reasons behind successful or unsuccessful adoption of ABC. The

availability of similar statistics from US and Dutch food companies also

provides the opportunity to see if national circumstances have their

influence on the acceptance of ABC, the process of ABC implementation

and the use of ABC information. In October 1994 Ernst Young conducted a

survey among 564 food manufacturers, retailers, distributors and brokers in

the US. In this survey, 96 usable responses (17 were obtained from

companies generating average revenues of three billion dollar and

employing on average 9,179 workers (Ernst Young, 1995).

In The Netherlands, a similar survey’ was administered among 480 Dutch

food manufacturers and retailers employing more than 30 workers. In this

study 117 usable responses were obtained (24.4 %), including all food

sectors in the Netherlands. The Dutch food companies employed on

average 520 workers, with a minimum of 32 and a maximum of 20,878

employees. As can be appreciated, the average size of the Dutch sample

companies is much smaller than the average size of the US sample

companies. This difference may have an impact on the survey results.

In the Dutch sample, 86 % of the ABC using companies reported that

introducing ABC has been a worthwhile experience. This experience was

not without any difficulty however.

Most problems were encountered in collecting information, assigning costs

to activities, and the identification of activities and cost drivers. The most

difficult part of the implementation of ABC was the problem to convert

ABC-information into action. As Cooper already noted, no organization

ever made more money merely because it had a more accurate

understanding of its economics. Only when understanding is translated into

action is the potential for profit improvement unleashed. The difficulty of

translating ABC-information into profit generating actions is reported to be

the top problematic area in the Dutch food industry.

The least problematic areas were those related to gaining support from top

management, business unit management and workers to cooperate in the

implementation of an ABC system. This seems obvious since only the

responses of food companies who actually implemented ABC are

considered here.

The main differences between companies in the Dutch sample using ABC

and not using ABC can be attributed to two dimensions: one organizational

characteristic and one production related characteristic. The dominant

organizational characteristic proves to be the size of the company,

expressed in terms of number of employees. Net income and overhead costs

(in absolute or relative terms) do not make a difference between ABC-users

and non-users. This could be explained by the nature of the factor ‘number

of employees’, which seems to combine two dimensions working in the

same direction. A large number of employees characterize large companies

which also employs labour-intensive production systems. Since most of the

production technology in the food sector is highly mechanized and

automated, a large part of the employed is supposed to carry out overhead

activities.

Typical benefits of Activity-Based Costing:

Identify the most profitable customers, products and channels.

Identify the least profitable customers, products and channels.

Determine the true contributors to- and detractors from- financial

performance.

Accurately predict costs, profits and resources requirements

associated with changes in production volumes, organizational

structure and costs of resources.

Easily identify the root causes of poor financial performance.

Track costs of activities and work processes.

Equip managers with cost intelligence to stimulate improvements.

Facilitate a better Marketing Mix

Enhance the bargaining power with the customer.

Achieve better Positioning of products

With the costing now based on activities, the cost of serving a customer can

be ascertained individually. Deducting the product cost and the cost to

serve each customer, one can arrive at customer's profitability. This method

of dealing separately with the customer costs and the product costs, enables

the identification of the profitability of each customer and Positioning the

products and services accordingly.

Continuous Improvement

The implementation of ABC can make the employees understand the

various costs involved. This will then enable them to analyze the cost, and

to identify the activities that add value and those that do not add value.

Finally, based on this, improvements can be implemented and the benefits

can be realized. This is a continuous improvement process in terms of

analyzing the cost, to reduce or eliminate the non value added activities and

to achieve an overall efficiency.

ABC has helped enterprises in answering the market need for better quality

products at competitive prices. Analyzing the product profitability and

customer profitability, the ABC method has contributed effectively for the

top management's decision making process. With ABC, enterprises are able

to improve their efficiency and reduce the cost without sacrificing the value

for the customer. Many companies also use ABC as a basis for a balanced

scorecard.

This has also enabled enterprises to model the impact of cost reduction and

subsequently confirm the savings achieved. Overall, Activity Based

Costing (ABC) is a dynamic method for continuous improvement. With

Activity Based Costing any enterprise can have a built-in competitive cost

advantage, so it can continuously add value to both its stakeholders and

customers.