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ASSIGNMENT ON ACTIVITY BASED COSTING IN FOOD PROCESSING INDUSTRY

Submitted to DR. MURALI Lecturer - DOMS - NITT

Submitted by
VISHNU MOHAN (215111001) (215111052)

NISHANT SINGH CHAUHAN OSAMA ZAID JAGTAR SINGH (215111056) (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 80s (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 decisionmaking, which has resulted in a decision making process called activitybased 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 activitybased 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 Indias development, for it establishes vital linkage and synergy between the two pillars of the economy Industry and Agriculture. India is the worlds 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 countrys 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 Nestl S.A. is the world's largest food and nutrition company. Founded and headquartered in Vevey, Switzerland Nestl originated in a 1905 merger of the Anglo-Swiss Milk Company, established in 1867 by brothers George Page and Charles Page, and Farine Lacte Henri Nestl, founded in 1866 by Henri Nestl. 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 companys 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.

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