Month: August 2020

Bank Management

A bank is a financial institution which acknowledges deposits, pays interest on pre-defined rates, clears checks, makes loans, and regularly goes about as a go-between in financial transactions. It additionally gives other financial administrations to its customers.

Bank management oversees different concerns related with bank keeping in mind the end goal to boost benefits. The worries comprehensively incorporate liquidity management, asset management, liability management and capital management.

Origin of Banks

The origin of bank or banking exercises can be followed to the Roman empire amid the Babylonian time frame. It was being honed on a little scale when contrasted with advanced banking and edge work was not systematic.

Modern banks manage banking exercises on a bigger scale and keep the principles made by the legislature. The legislature assumes a pivotal part with its control over the banking system. This calls for bank management, which additionally guarantees quality administration to customers and a win-win circumstance between the customer, the banks and the government.

The Evolution of Banking in India

The advancement in the Indian banking system can be classified into three different phases:

• The pre-independence phase, i.e., before 1947
• After independence phase, i.e. from 1947 to 1991
• The LPG (1991) era and beyond, i.e. 1991 and beyond

1. The Pre-Independence Phase

This phase is categorized by the presence of a considerable number of banks in India. Nearly 600 banks were present in India.

The banking system started with the foundation of Bank of Hindustan in the then capital, Calcutta (present-day Kolkata) in 1770. The bank ceased its operations in 1832.

Post Bank of Hindustan, many other banks evolved such as the General Bank of India (1786-1791) and Oudh Commercial Bank (1881-1958), but they did not continue their operations for long.

Oudh Commercial Bank was the first commercial bank of India.

Some banks of the 19th century continue to operate even now establishing themselves as an institution of excellence. For example, Allahabad Bank was established in 1865, and Punjab National Bank was established in 1894.

Also, some banks such as Bank of Bengal (est. 1806), Bank of Bombay (est. 1840), Bank of Madras (est. 1843) were merged into one entity.

The new body was called Imperial Bank of India which was later renamed as the State Bank of India.

In the year 1935, the Reserve Bank of India was commissioned upon the recommendation of the Hilton Young Commission.

During this phase, due to the failure of the majority of small-sized banks, the confidence of the public was low, and people continued to engage with money lenders and unorganized players.

2. After independence Phase – 1947 to 1991

One of the main features of the period was the nationalization of the bank.

Why was Nationalization Needed?

• The banks primarily catered to large businesses
• Critical sectors such as agriculture, small-scale industries and exports were lagging
• The moneylenders exploited masses

Thus, in the year 1949, the Reserve Bank of India was nationalized. In two decades, fourteen commercial banks were nationalized in July 1969 during the reign of Smt. Indira Gandhi.

In 1975, based on the recommendation of the Narasimham committee, Regional Rural Banks (RRBs) were constituted with an objective of serving the unserved. The primary goal was to reach masses and promote financial inclusion.

Some other specialized banks were also set up to promote the activities that were required for the economy.

For example, NABARD was established in 1982 to support agriculture-related work. Similarly, EXIM bank was built in 1982 for export and import.

National Housing Bank was set up in 1988 for the Housing sector, and SIDBI was established in 1990 for small-scale industries.

Was Nationalization Successful?

Nationalization was a significant step in the banking sector, and it helped improve people’s confidence in the system.

Small and critical industries started getting access to capital that helped boost economic growth.

Additionally, the move added to the country’s growth across the global banking sector.

3. Third phase – The LPG (1991) Era and Beyond

1991 saw a remarkable change in the Indian economy.

The government opened up the economy and invited foreign and private investors to invest in India. This move marked the entry of private players in the banking sector.

The RBI provided banking license to ten private entities of which some of the notable ones survived such as ICICI, HDFC, Axis Bank, IndusInd Bank, and DCB.

In 1998, the Narsimham committee again recommended the entry of more private players. Thus, the RBI provided a license to Kotak Mahindra Bank in 2001 and Yes Bank in 2004.

Nearly after a decade, the third round of licensing took place. The RBI in 2013-14, allowed a license for IDFC bank and Bandhan Bank.

The story didn’t end here, with an aim to make sure that every Indian gets access to finance, the RBI introduced two new set of banks Payments bank and small banks, and this marked the fourth phase in the banking industry.

(i) Payments Bank

These banks are allowed to accept a nominal deposit (Rs. 1 lakh per currently).

These banks are not allowed to provide credit (both loans and credit cards), but can operate both current account and savings accounts.

Other services include ATM/debit cards, net-banking, and mobile banking. Bharti Airtel started first payments’ bank in India.

Following the six most active payments bank currently:

• Aditya Birla Payments Bank
• Airtel Payments Bank
• India Post Payments Bank
• Fino Payments Bank
• Jio Payments Bank
• Paytm Payments Bank

(ii) Small Finance Bank

These banks are niche banks, with basic banking service, which include acceptance of deposits and lending.

The primary objective is to serve the unserved, such as small business units, small and marginal farmers, micro and small industries, and unorganized sectors.

Following are the small finance bank currently operational in India:

• Ujjivan Small Finance Bank
• Jana Small Finance Bank
• Equitas Small Finance Bank
• AU Small Finance Bank
• Capital Small Finance Bank
• Fincare Small Finance Bank
• ESAF Small Finance Bank
• North East Small Finance Bank
• Suryoday Small Finance Bank
• Utkarsh Small Finance Bank

We believe rapid digitization in banks coupled with the new model of banking will continue to remain the key theme for the fourth and ongoing phase of the banking industry.

There has been a big revolution in the banking sector over the years and it is bound to evolve further. With various steps and new features that the banking industry is introducing, this sector will grow further.

Banking industry is a backbone of Indian financial system and it is afflicted by many challenging forces. One such force is revolution of information technology. In today’s era, technology support is very important for the successful functioning of the banking sector. Without IT and communication we cannot think about the success of banking industry, it has enlarged the role of banking sector in Indian economy. For creating an efficient banking system, which can respond adequately to the needs of growing economy, technology has a key role to play. In past 10 years, banks in India have invested heavily in the technology such as Tele banking, mobile banking, net banking, ATMs, credit cards, debit cards, electronic payment systems and data warehousing and data mining solutions, to bring improvements in quality of customer services and the fast processing of banking operation. Heavy investments in IT have been made by the banks in the expectation of improvement in their performance. But important in the performance depends upon, differences in the deployment, use and effectiveness of IT.

Information technology in banking sector refers to the use of sophisticated information and communication technologies together with computer science to enable banks to offer better services to its customers in a secure, reliable and affordable manner and sustain competitive advantage over other banks. The significance of technology is greatly felt in the financial sector in view of the competitive advantage for banks resulting in the efficient customer service.

In the development of Indian Economy, Banking sector plays a very important and crucial role. With the use of technology there had been an increase in penetration, productivity and efficiency. It has not only increased the cost effectiveness but also has helped in making small value transactions viable. Electronic delivery channels, ATMs, variety of cards, web based banking, and mobile banking are the names of few outcomes of the process of automation and computerization in Indian banking sector.

Transformation of Indian Banking

Indian banking has undergone a total transformation over the last decade. Moving seamlessly from a manual, scale-constrained environment to a technological leading position, it has been a miracle. Such a transformation takes place in such a short span of time with such a low cost.

Entry of technology in Indian banking industry can be traced back during the 1990s, the banking sector witnessed various liberalization measure. One of the major objectives of Indian banking sector reforms was to encourage operational self-sufficiency, flexibility and competition in the system and to increase the banking standards in India to the international best practises. With the ease of licensing norms, new private and foreign banks emerged-equipped with latest technology. Deregulation has opened up new opportunities to banks to increase revenues by diversifying into investment banking, insurance, credit cards, mortgage financing, depository services etc. The role of banking is redefined from a mere intermediary to service provider of various financial services under one roof acting like a financial supermarket.

Important events in evolution of Information Technology:-

• Introduction of MICR based cheque processing
• Arrival of card based payments
• Introduction of Electronic Clearing Services
• Introduction of RTGS/NEFT
• Introduction of Cheque Truncation System (CTS) or Image-based Clearing System (ICS)
• Introduction of Core Banking Solutions (CBS)
• Introduction of Automated Teller Machine (ATMs)
• Introduction of Phone and Tele Banking
• Introduction of Internet and Mobile Banking

Recent IT Trends of Indian banks

The banking industry is going through a period of rapid change to meet competition, challenges of technology and the demand of end user. Clearly technology is a key differentiator in the performance of banks. Banks need to look at innovation not just for product but for process also.

Today, technology is not only changing the environment but also the relationship with customers. Technology has not broken barriers but has also brought about superior products and channels. This has brought customer relationship into greater focus. It is also viewed as an instrument of cost reduction and effective communication with people and institutions associated with the banking business. The RBI has assigned priority to the up gradation of technological infrastructure in financial system. Technology has opened new products and services, new market and efficient delivery channels for banking industry. IT also provides the framework for banking industry to meet challenges in the present competitive environment. IT enables to cut the cost of global fund transfer.

Some of the recent IT devices described as below:

1. Electronic Payment and Settlement System

The most common media of receipts and payment through banks are negotiable instruments like cheques. These instruments could be used in place of cash. The inter bank cheques could be realized through clearing house systems. Initially there was a manual system of clearing but the growing volume of banking transaction emerged into the necessity of automating the clearing process.

2. Use of MICR Technology

MICR overcomes the limitation of clearing the cheques within banking hours and thus enables the customer to get the credit quickly. These are machine – readable codes added at the bottom of every cheque leaf which helped in bank and branch-wise sorting of cheques for smooth delivery to the respective banks on whom they are drawn. This no doubt helped in speeding up the clearing process, but physical delivery of cheques continued even under this partial automation.

3. CTS (Cheque Truncation System)

Truncation means stopping the flow of the physical cheques issued by a drawer to the drawee branch. The physical instrument is truncated at some point on route to the drawee branch and an electronic image of the cheque is sent to the drawee branch along with the relevant information like the MICR fields, date of presentation, presenting banks etc. This would eliminate the need to move the physical instruments across branches, except in exceptional circumstances, resulting in an effective reduction in the time required for payment of cheques, the associated cost of transit and delays in processing etc., thus speeding up the process of collection or realization of cheques.

4. Electronic Clearing Services (ECS)

The ECS was the first version of “Electronic Payments” in India. It is a mode of electronic funds transfer from one bank account to another bank account using the mechanism of clearing house. It is very useful in case of bulk transfers from one account to many accounts or vice-versa. The beneficiary has to maintain an account with the one of the bank at ECS Centre.

There are two types of ECS (Electronic Clearing Service)

• ECS Credit: ECS Credit clearing operates on the principle of ‘single debit multiple credits’ and is used for transactions like payment of salary, dividend, pension, interest etc.
• ECS Debit: ECS Debit clearing service operates on the principle of ‘single credit multiple debits’ and is used by utility service providers for collection of electricity bills, telephone bills and other charges and also by banks for collections of principle and interest repayments.

5. Electronic Fund Transfer (EFT)

EFT was a nationwide retail electronic funds transfer mechanism between the networked branches of banks. NEFT provided for integration with the Structured Financial Messaging Solution (SFMS) of the Indian Financial Network (INFINET). The NEFT uses SFMS for EFT message creation and transmission from the branch to the bank’s gateway and to the NEFT Centre, thereby considerably enhancing the security in the transfer of funds.

6. Real Time Gross Settlement (RTGS)

RTGS system is a funds transfer mechanism where transfer of money takes place from one bank to another on a ‘real time’ and on ‘gross basis’. This is the fastest possible money transfer system through the banking channel. Settlement in ‘real time’ means payment transaction is not subjected to any waiting period. The transactions are settled as soon as they are processed. “Gross settlement” means the transaction is settled on one to one basis without bunching with any other transaction.

7. Core Banking Solutions (CBS)

Computerization of bank branches had started with installation of simple computers to automate the functioning of branches, especially at high traffic branches. Core Banking Solutions is the networking of the branches of a bank, so as to enable the customers to operate their accounts from any bank branch, regardless of which branch he opened the account with. The networking of branches under CBS enables centralized data management and aids in the implementation of internet and mobile banking. Besides, CBS helps in bringing the complete operations of banks under a single technological platform.

8. Development of Distribution Channels

The major and upcoming channels of distribution in the banking industry, besides branches are ATMs, internet banking, mobile and telephone banking and card based delivery systems.

9. Automated Teller Machine (ATM)

ATMs are perhaps most revolutionary aspect of virtual banking. The facility to use ATM is provided through plastic cards with magnetic strip containing information about the customer as well as the bank. In today’s world ATM are the most useful tool to ensure the concept of “Any Time Banking” and “Any Where Banking”.

10. Phone Banking

Customers can now dial up the banks designed telephone number and he by dialling his ID number will be able to get connectivity to bank’s designated computer. By using Automatic voice recorder (AVR) for simple queries and transactions and manned phone terminals for complicated queries and transactions, the customer can actually do entire non-cash relating banking on telephone: Anywhere, Anytime.

11. Tele Banking

It is another innovation, which provided the facility of 24 hour banking to the customer. Tele-banking is based on the voice processing facility available on bank computers. The caller usually a customer calls the bank anytime and can enquire balance in his account or other transaction history.

12. Internet Banking

Internet banking enables a customer to do banking transactions through the bank’s website on the internet. It is system of accessing accounts and general information on bank products and services through a computer while sitting in its office or home. This is also called virtual banking.

13. Mobile Banking

Mobile banking facility is an extension of internet banking. Mobile banking is a service provided by a bank or other financial institution that allows its customers to conduct financial transactions remotely using a mobile device. Unlike the related internet banking it uses software, usually called an App, provided by the financial institution for the purpose. Mobile banking is usually available on a 24 hour basis. Some financial institutions have restrictions on which accounts may be accessed through mobile banking, as well as a limit on the amount that can be transacted. Transactions through mobile banking may include obtaining account balances and lists of latest transactions, electronic bill payments, and fund transfers between a customer’s or another’s accounts.

Conclusion

Information Technology offers enormous potential and various opportunities to the Indian Banking sector. It provides cost-effective, rapid and systematic provision of services to the customer. The efficient use of technology has facilitated accurate and timely management of the increased transaction volumes of banks which comes with larger customer base. Indian banking industry is greatly benefiting from IT revolution all over the world.

Another concept i.e Virtual Banking or Direct Banking is now gaining importance all over the world. According to this concept Banks offer products, services and financial transaction only through electronic delivery channels generally without any physical branch. Owing to lower branch maintenance and manpower cost such banks are able to offer competitive pricing for their product and services as compared to traditional banks.

The Indian banks lag far behind the international banks in providing online banking. In fact, this is not possible without creating sufficient infrastructure or presence of sufficient number of users. Technology is going to hold the keys to future of banking. So banks should try to find out the trigger of change. Indian Banks need to focus on swift and continued infusion of technology.

The need for computerization was felt in the Indian banking sector in late 1980s, in order to improve the customer service, book-keeping and MIS reporting. In 1988, Reserve Bank of India set up a Committee on computerization in banks headed by Dr. C. Rangarajan.

Banks began using Information Technology initially with the introduction of standalone PCs and migrated to Local Area Network (LAN) connectivity. With further advancement, banks adopted the Core Banking platform. Thus branch banking changed to bank banking. Core Banking Solution (CBS) enabled banks to increase the comfort feature to the customers as a promising step towards enhancing customer convenience through anywhere and anytime banking. Different Core banking platforms such as Finacle designed by Infosys, BaNCS by TCS, FLEXCUBE by i-flex, gained popularity.

The process of Computerization gained pace with the opening of the economy in 1991-92. A major driver for this change was propelled by rising competition from private and foreign banks. Several commercial banks started moving towards digital customer services to remain competitive and relevant in the race.

Banks have benefitted in several ways by adopting newer technologies. E-banking has resulted in reducing costs drastically and has helped generate revenue through various channels. As per last available information, the cost of a bank transaction on Branch Banking is estimated to be in a range of Rs.70 to Rs.75 while it is around Rs.15 to Rs.16 on ATM, Rs.2 or less on Online Banking and Rs.1 or less on Mobile Banking.  The number of customer base has also increased because of the convenience in ‘Anywhere Banking’. Digitization has reduced human error. It is possible to access and analyze the data anytime enabling a strong reporting system.

RBI has been a guiding force for the banks in forming regulations and giving recommendations to achieve various objectives. Commercial Banks in India have moved towards technology by way of Bank Mechanization and Automation with the introduction to MICR based cheque processing, Electronic Funds transfer, Inter-connectivity among bank Branches and implementation of ATM (Automated Teller Machine) Channel have resulted in the convenience of Anytime banking. Strong initiatives have been taken by the Reserve Bank of India in strengthening the Payment and Settlement systems in banks.

Technological Milestones in Indian Banks:

According to the RBI Report in 2016-17 there are 2,22,475 Automated Teller Machines (ATMs) and 25,29,141 Point of Sale devices (POS).  Implementation of electronic payment system such as NEFT (National Electronic Fund Transfer), ECS (Electronic Clearing Service), RTGS (Real Time Gross Settlement), Cheque Truncation System, Mobile banking system, Debit cards, Credit Cards, Prepaid cards have all gained wide acceptance in Indian banks. These are all remarkable landmarks in the digital revolution in the banking sector. Online banking has changed the face of banking and brought about a noteworthy transformation in the banking operations.

National Electronic Funds Transfer (NEFT) is the most commonly used electronic payment method for transferring money from any bank branch to another bank in India. It operates in half hourly batches. At present there are 23 settlements.

Real Time Gross Settlement (RTGS) is primarily used for high-value transactions which are based on ‘real time’. The minimum amount to be remitted through RTGS is Rupees Two Lakhs. There is no upper limit.

Immediate Payment Service (IMPS) is an instant electronic funds transfer facility offered by National Payments Corporation of India (NPCI) which is available 24 x7.

The usage of Prepaid payment instruments (PPIs) for purchase of goods & services and funds transfers has increased considerably in recent years. The value of transactions through PPI Cards (which include mobile prepaid instruments, gift cards, foreign travel cards & corporate cards) & mobile wallets have jumped drastically from Rs.105 billion and Rs. 82 billion respectively in 2014-15 to Rs. 277 billion and Rs. 532 billion respectively in 2016-17.

Challenges

1. Security Risks

External threats such as hacking, sniffing and spoofing expose banks to security risks. Banks are also exposed to internal risks especially frauds by employees / employees in collusion with customers

2. Financial Literacy / Customer Awareness

Lack of knowledge amongst people to use e-banking facilities is the major constraint in India.

3. Fear factor

One of the biggest hurdle in online banking is preference to conventional banking method by older generation and mostly people from the rural areas. The fear of losing money in the online transaction is a barrier to usage of e-banking.

4. Training

Lack of adequate knowledge and skills is a major deterrent for employees to deal with the innovative and changing technologies in banks. Training at all levels on the changing trends in IT is the requirement of the day for the banks.

Today banking is amongst the top paying fields in the area of commerce and accounts. With a net worth over INR 64 trillion, the banking industry is growing at a steady rate of 8%. This exponential growth of the banking sector will not only ensure a stronger economy but will continue to open lucrative career avenues for job seekers.

Opportunities in banking sector in India are enormous. It is estimated that in the coming few years over 5 lakh fresh jobs will be up for grabs. Also with the new banking license regime coming into play, the job scenario is expected to become more lucrative in the times to come.

It is not only the private sector that will have vacancies on offer, but the public sector banks will also not be far behind. With an expected deficit of 50% employees in the coming years due to retirement, the public sector banking scenario will also witness huge recruitment drives. 

Job Prospects

An aspirant who wishes to make a career in the banking industry has quite a lot of options to choose from. It is not only the conventional fields like marketing, sales, financial analysts, human resource, client servicing, insurance etc in banking sector that are in vogue, but upcoming areas such as investment banking, internet banking etc. are also to look out for.

Educational Requirements

An aspirant can get into the banking industry after completing his/her graduation. Profile and pay package of the job depends on the aspirant’s educational qualification and experience. Higher one’s qualifications and more the experience, the better will be the salary.  The starting salary could range between Rs. 10,000 – 15,000.

Banking Scene

FICCI and a few other reputed financial institutions have said that the Indian banking sector is set to become the third largest by the year 2025. The public sector banks alone are giving away more than 7 lakh jobs every year. Moreover, since there is a huge population in the banks waiting for retirement, around 40,000 additional jobs get created automatically annually. Imagine the opportunities you have to get a career that is not only promising but also offers a better lifestyle and perks.

Admit it. Nothing makes you look smarter than a white-collar job in a bank. But that’s just the cosmetic part of it. Banking careers include relationship managers, personal banking and loan officers, wealth advisory, book keeping professionals, auditing clerks, finance service representatives to name a few. Indian banking is now on a competitive mode, so you will land faster growth opportunities in your career. Since India still does not have formal schools and institutions offering specific courses in banking, there is always a dearth for competitive personnel. Even SBI- one of the oldest banks- is now opening opportunities to the younger executives who work with better efficiency.

Banking career has always been respectable but now it has also become challenging. In addition, Indian banks follow employee-benefit norms and have great promotion opportunities. Private banks such as ICICI, HDFC, HSBC, Yes Bank, etc. are known to possess great learning and growing environment for young professionals.

Banks in India recruit through common and specific exams, interviews, aptitude test and GDPI. Only last month, the government has relaxed the 60% marks in graduation criterion for the common entrance exam for public sector banks, scrapped the computer literacy requirement and raised the maximum age to 30 from 28.

Most people think Finance sector jobs are rather boring. Another popular myth is that most of these careers are meant for people with Math and/or Commerce background.

First of all, understand that Finance sector is a very vast field that includes financial analysis, finance management, chartered accountancy, company secretaryship, management accountancy, equity sales and share trading, share consultancy, insurance and the likes. The public sector alone offers a variety of options in organizations such as FICCI, NABARD, UTI, SEBI and the likes.

And no if you choose the area of your interest, it cannot be boring. The best thing about this sector is the scope of becoming consultants, so in the long run you don’t really work under anyone but create your own niche. Every CA intern starts off with a firm and eventually opens his own. Similarly, an equity sales is an area where you can become your own boss if you excel in it. In addition, a Company Secretary job is one that is both exciting and respectable. Then there is a whole array of insurance sector jobs.

Another good thing about this sector is you can always keep upgrading yourself. So even if you are an MBA in Finance, you can do a certificate programme in Financial Analysis.

There are three big Indian professional bodies that are offering certifications in chartered accountancy (CA), management accountancy (ICWA) and company secretary (CS). Many universities and colleges in India offer MBA in Finance. There are short-term certifications available through correspondence and online.

The short-term variable costs should be identified to products using volume related cost drivers such as direct labour hour, direct material cost, machine hours etc. Kalpan and Cooper claimed that volume related cost drivers are inappropriate for tracing long-term variable costs to products because they are driven by complexity and variety and not by volume and the key to understanding what causes (drivers) overhead costs in transactions undertaken by support departments costs and factory overheads to product lines under ABC system is shown in the following figure:

Steps to Develop ABC System:

1. Identify the main activities performed in the organization, such as manufacturing, assembly etc., as well as support activities, including purchasing, packing and dispatching.
2. Identify the factors which influence the cost of each activity- the cost drivers.
3. Collect accurate data on direct labour, material and overhead costs.
4. Establishing the demands made by particular products on activities, using the cost drivers as a measure of demand.
5. Trace the cost of activities to products according to a product’s demand for each activity.

The rules developed by Kaplan and Cooper for this process is:

1. Focus on expensive resources, thus directing attention to resource categories where the new costing process has the potential to make big differences on product cost.
2. Emphasis on resources whose consumption varies significantly by product and product type-look for diversity.
3. Focus on resources whose demand patterns are un-correlated with traditional allocation measures.

Thus, ABC is the process of tracing costs first from resources to activities and then from activities to specific products. The technique of ABC lays the importance of different costs for different purposes and the identification of just those costs, which are relevant to a particular decision. However, it does not challenge the conventional accounting methods and theory; instead, it refines the ideas and concepts of conventional methods.

Traditional Versus ABC Approach to Designing a Costing System:

In traditional approach, there is lack of cause and effect relationship between the cost allocation bases and indirect cost pools because one or a few cost pools for each department or entire plant having little homogeneity are used. In ABC approach, many homogeneous indirect cost pools for various activity areas rather than a department or entire plant are used. There is a cause and effect relationship between the cost allocation bases and the indirect cost pools.

The traditional approach usually uses a few pools of indirect costs, so cost allocations are of intently based on broad averages. The costs of products thus, ascertained may be either over-costed or undercoated which may lead managers to make wrong pricing decisions resulting in loss of market share by fixing higher selling prices or selling prices for some products may be below the costs incurred to produce them. Activity based costing is a rational way of assigning indirect costs to various activities and pricing decisions taken by managers will be rational.

The activity based job costing method or process costing method is helpful in ascertaining areas where cost reductions are possible. Activity based costing can lead to improved decision making such as fixing selling price and pinpointing the area where cost reduction is possible because it provides more detailed information about various activities involved in a product or service.

Activity based principles can be successfully applied to the art of budgeting. Activity based budgeting is an approach to budgeting that lays emphasis on budgeting the costs of activities necessary to produce and sell products and services. Activity based budgeting is especially useful in case of budgeting of indirect costs.

Important steps in activity based budgeting are as follows:

1. Determining the demand for each individual activity on the basis of budgeted production.
2. Determining the budgeted cost of performing each activity.
3. Ascertaining the actual cost of each activity.
4. Comparing the actual cost with the budgeted cost of each activity, noting down the difference and taking corrective action, wherever necessary.

1. Simple traditional distinction made between fixed cost and variable cost is not enough guide to provide quality information to design a cost system.
2. The more appropriate distinction between cost behaviour patterns are volume (scale) related, diversity (scope) related, events (decisions) related and time related.
3. Cost drivers need to be identified. A cost driver is a structural determinant of cost related activity. The logic behind is that cost drivers dictate the cost behaviour pattern. In tracing overhead cost to product, a cost behaviour pattern must be understood so that appropriate cost driver could be identified.

Key Areas of ABC:

Following are the three key areas of ABC:

1. Product cost differentiation.
2. Activities and their cost drivers.
3. Identification of non-value added cost.

In ABC system a cost center is established for each cost driver and identification, measurement and control of cost drivers is essential in ABC. ABC is the planned and systematic study and determination of cost of each of the branches of business activities that add to the value of product and services.

Benefits of ABC:

Accurate Product Cost:

ABC brings accuracy and reliability in product cost determination by focusing on cause and effect relationship in the cost incurrence. It recognises that it is activities which cause costs, not products and it is product which consume activities. In advanced manufacturing environment and technology where support functions overheads constitute a large share of total costs, ABC provides more realistic product costs.

ABC produces reliable and correct product cost data in case of greater diversity among the products manufactured such as low-volume products, high-volume products. Traditional costing system is likely to bring errors and approximation in product cost determination due to using arbitrary apportionment and absorption methods.

Information about Cost Behaviour:

ABC identifies the real nature of cost behaviour and helps in reducing costs and identifying activities which do not add value to the product. With ABC, managers are able to control many fixed overhead costs by exercising more control over the activities which have caused these fixed overhead costs. This is possible since behaviour of many fixed overhead costs in relation to activities now become more visible and clear.

Tracing of Activities for the Cost Object:

ABC uses multiple cost drivers, many of which are transaction based rather than product volume. Further, ABC is concerned with all activities within and beyond the factory to trace more overheads to the products.

Tracing of Overhead Costs:

ABC traces costs to areas of managerial responsibility, processes, customers, departments besides the product costs.

Better Decision Making:

ABC improves greatly the manager’s decision making as they can use more reliable product cost data. ABC helps usefully in fixing selling prices of products as more correct data of product cost is now readily available.

Cost Management:

ABC provides cost driver rates and information on transaction volumes which are very useful to management for cost management and performance appraisal of responsibility centres. Cost driver rates can be used advantageously for the design of new products or existing products as they indicate overhead costs that are likely to be applied in costing the product.

Use of Excess Capacity and Cost Reduction:

ABC, through the processes of pooling of activity costs and the identification of cost drivers, can lead to a range of applications. These include the identification of spare capacity and the fostering of cost reduction by comparing the resources required under ABC with the resources that are currently provided. This provides a platform for the development of activity-based budgeting in which the resource relationships identified by ABC are used to project future resource requirements.

Benefit to Service Industry:

Service organizations, such as banks, hospitals and government departments, have very different characteristics than manufacturing firms. Service organizations have almost no direct costs, most of the costs are overheads and they do not hold stocks of service as the service is consumed when it is produced. Traditional costing has generally been considered inappropriate for these organizations, whereas ABC offers the potential of benefits from improved decision making and cost management.

An ABC system can provide better costing information and help management manage ef­ficiently and gain a better under-standing of the firm’s competitive advantages, strengths and weak­nesses. Often, managers recognize needs for a better costing system such as ABC when they are experiencing increased lost sales due to erroneous pricing that resulted from inaccurate costing data.

An ABC system has the most impact on firms that have areas with large, increasing expenses or have numerous products, services, customers, processes, or a combination of these. Example are plants that produce standard and custom products, high-volume and low-volume products, or mature and new products.

Firms that accept small and large orders, offer standard and customized deliveries, or satisfy all customers including those who demand frequent changes and services either before or after the delivery, and customers who hardly ever request special services can benefit substantially from activity-based costing systems.

Colin Drury observes:

“ABC provides not only a base for calculating more accurate product costs but also a mechanism for managing costs. An ABC system focuses management attention on the underlying causes of costs. It assumes that resource-consuming activities cause costs and that products incur costs through the activities they require for designing, engineering, manufacturing, marketing, delivery, invoicing and servicing. By collecting and reporting on the significant activities in which a business engages, it is possible to understand and manage costs more effectively.

With an ABC system, costs are managed in the long run by controlling the activities that drive them. In other words, the aim is to manage the activities rather than costs. By managing the forces that cause the activities (i.e., cost drivers), costs will be managed in the long-term. The applica­tion of activity-based systems may have the greatest potential for contributing to cost management, budgeting, and control and performance evaluation.”

According to Weil and Maher:

“Activity-based costing plays an important role in companies’ strategies and long-range plans to develop a competitive cost advantage. While activity-based costing focuses attention on activities in allocating overhead costs to products, activity-based management focuses on managing activities to reduce costs. Cost reduction generally requires a change in activities. Top management can send notices to company employees to reduce costs, but the implementation requires a change in activi­ties. If you have lived in a city that has had to reduce costs, you know that achieving the reduction required a change in activities such as fewer police patrols, a cut in library hours, and reduced social services. An entity cannot know the effect of a change in activities on costs without the type of cost information provided by activity-based costing.”

Demerits of Activity Based Costing (ABC):

Expensive and Complex:

ABC has numerous cost pools and multiple cost drivers and therefore can-be more complex than traditional product costing systems. It can prove costly to manage ABC system.

Selection of Drivers:

Some difficulties emerge in the implementation of ABC system, such as selection of cost drivers, assignment of common costs, varying cost driver rates etc.

Disadvantages to Smaller Firms:

ABC has different levels of utility for different organisation such as large manufacturing firm can use it more usefully than the smaller firms. Also, it is likely that firms depending on cost-plus pricing can take advantages from ABC as it gives accurate product cost. But those firms who use market based prices may not favour ABC. The level of technology and manufacturing environment prevailing in different firms also affect the application of ABC.

Measurement Difficulties:

The main costs and limitations of an ABC system are the measurements necessary to implement it. ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers to serve as cost allocation bases. Even basic ABC systems require many calculations to determine costs of products and services. These measurements are costly. Activity cost rates also need to be updated regularly.