COLLEGE OF BUSINESS AND MANAGEMENT SCIENCES (COBAMS)

SCHOOL OF BUSINESS

MASTER OF BUSINESS ADMINISTRATION (MBAM)

MBS 8101 COST AND MANAGEMENT ACCOUNTING

YEAR II / SEMESTER 1 / ACADEMIC YEAR 2021/2022

ACTIVITY-BASED COSTING (ABC)

SUBMITTED TO

Festo Tusubira, PhD

BY

No STUDENT NAME REGISTRATION NUMBER

1. ASIIMIRE ISABEL 2021/HD06/20401U

2. KATOOKO CATE CHEDE 2021/HD06/20442U

3. KAWAIDA DAVID 2021/HD06/20445U

4. KAYIWA PHILLIP 2020/HD06/20424U

5. KWIKIRIZA IVAS 2021/HD06/20463U

6. KIMBUGWE HERBERT OSCAR 2019/HD06/28544U

7. MUHAMIRIZA LOUIS 2021/HD06/23290U

8. NALUGEMWA JOAN 2021/HD06/20515U

9. KISAKYE IVAN 2021/HD06/20456U

10. KIGOZI ISAAC 2021/HD06/20453U

NOVEMBER, 2022
TABLE OF CONTENTS

1.0 Introduction...........................................................................................................................1

1.1 Definition of ABC.............................................................................................................2

1.2 ABC Terminology.............................................................................................................2

2.0 Comparison of traditional and ABC.....................................................................................4

3.0 The emergence of ABC systems...........................................................................................5

4.0 Volume-based and non-volume-based Cost Drivers............................................................5

4.1 Volume-based cost drivers................................................................................................5

4.2 Non-volume-based cost drivers........................................................................................6

5.0 Designing ABC Systems......................................................................................................7

Step 1: Identifying activities....................................................................................................7

Step 2: Assignment of costs to activity cost centres................................................................8

Step 3: Selecting appropriate cost drivers for assigning the cost of activities to cost objects.8

Step 4: Assigning the cost of the activities to products...........................................................9

6.0 ABC profit analysis..............................................................................................................9

Example:...............................................................................................................................12

Cost driver data:.....................................................................................................................12

Required:................................................................................................................................12

Solution:.................................................................................................................................12

7.0 ABC cost management applications...................................................................................15

8.0 Limitations of ABC............................................................................................................16

9.0 References...........................................................................................................................17
1.0 INTRODUCTION

Activity Based Costing (ABC) is a costing system, which focuses on activities performed to
produce products. ABC is that costing in which costs are first traced to activities and then to
products. This costing system assumes that activities are responsible for the incurrence of costs
and create the demands for activities e.g. an accounting firm prepares tax returns, a University
teaches students. Costs are charged to products based on individual products’ use of each
activity.

In traditional absorption costing system, costs are first traced not to activities but to an
organizational unit, such as a department or plant and then to products. It means under both,
ABC and traditional absorption costing systems the second and final stage consists of tracing
costs to the product.

ABC aims at identifying as many costs possible to be subsequently accounted as direct costs of
production. Any cost that is traced to a particular product via its consumption of activity
becomes the direct cost of the product. For instance, in a conventional costing system, cost of
setup and adjustment time is considered as factory overhead and subsequently assigned to
different products on the basis.

As global competition intensifies, companies are producing an increasing variety of products and
services. They are finding that producing different products and services places varying demands
on their resources. The need to measure more accurately how different products and services use
resources has led companies such as American Express, Boeing, General Motors, and Exxon
Mobil to refine their costing systems. One of the main ways companies around the globe have
refined their costing systems is through activity-based costing.

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1.1 Definition of ABC

ABC was first defined in the late 1980s by Kaplan and Bruns. It can be considered as the
modern alternative for costing.

CIMA defines ABC as “cost attribution to cost units on the basis of benefit received from
indirect activities e.g. ordering, setting up, assuring quality”. ABC has also been defined by
CAM-1 organisation of Arlinton Texas as “the collection of financial and operational
performance information tracing the significant activities of the firm to product Costs”.

(Horngren, Datar, & Rajan, 2015) referred to ABC as a means of refining a costing system by
identifying individual activities as the fundamental cost objects. ABC is a means of tracing
all support activities directly to particular goods or services (Atrill & McLaney, 2009). ABC
improves the accuracy of cost estimation by using multiple cost drivers to trace the cost of
activities to the products associated with the resources consumed by those activities (Babad
& Balachandran, 1993).

1.2 ABC Terminology

Term Definition
Activity Activities comprise units of work or tasks. For example, the purchase of
materials is an activity consisting of a series of tasks like purchase
requisition, advertisement inviting quotations, identification of suppliers,
placement of purchase order, follow-up etc. Activities can fall into 4
categories i.e., unit-level, batch-level, product-level and facility-level
Cost object An item for which cost measurement is required e.g. Product, job or
customer

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Cost driver The allocation bases are used for applying costs to services or
procedures. It is a factor that causes a change in the cost of an activity.
Few examples of cost drivers as under:
Function Cost drivers
R&D Number of research projects
Personal hours on a project
Technical complexities of projects
Customer service Number of service calls
Number of products serviced
Hours spent on servicing products

Unit level cost Traditionally, cost drivers were viewed only at the unit level. These
drivers create unit-level costs meaning that they are caused by the
production or acquisition of a single unit of product or the delivery of a
single unit or service.
Batch-level Costs caused by a group of things being made, handled or processed at a
costs single time are referred to as batch-level costs.
Product-level A cost caused by the development, production or acquisition of different
costs items is called a product-level or process-level cost. These include
engineering change orders, equipment maintenance, product development
and scrap if related to product design.
Facility-level Some costs cannot be related to a particular product line. These are
costs instead related to providing a facility. E.g. Cost of maintaining a building
or plant security or advertisement promoting the organization.
Organisational- Certain costs are incurred at the organizational level for the single
level costs purpose of supporting continuing facility operations. These
organizational-level costs are common to many different activities and
products and services can be prorated among services and products on an
arbitrary basis only. These costs are not product related, thus they should
be subtracted from net product revenues instead of an arbitrary and
illogical apportionment.
Cost pool Costs are grouped into pools according to the activities, which drive
them. For instance, all costs associated with Procurement i.e., ordering,
inspection, storing etc would be included in this cost pool and the cost

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 driver identified.

2.0 COMPARISON OF TRADITIONAL AND ABC

There is a basic philosophical difference between traditional and activity-based costing

systems wherein the traditional view considers overheads as a service rendered to cost units,
the cost of which must be charged to those units whereas, activity-based costing views
overheads as being caused by activities and therefore the cost units that cause these activities
and their related costs must be charged for the same (Atrill & McLaney, 2009).

Traditional Absorption Costing Activity Based Costing

Overheads are first related to department Overheads are first related to activities or
cost centres (production and service cost grouped into cost pools
centres)
Only two types of activities i.e. Unit Level All levels of activities in the manufacturing
Activities and Facility Level Activities are cost hierarchy i.e. Unit Level, Batch Level,
identified Product Level and Facility Level are
identified.
Relates overheads to cost centres i.e. Relates overheads to the causal factor
locations. It is not realistic for the behaviour i.e. driver. Thus, it is more realistic of cost
of costs. behaviour.
Overhead rates can be used to ascertain the Activity Cost Driver Rates can be used to
cost of products only. ascertain cost of products and cost of other
cost objects such as customer segments,
distribution channels.
etc.

Products Costs Activities Products

Costs

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3.0 THE EMERGENCE OF ABC SYSTEMS

Traditional costing systems were designed decades ago when most companies manufactured
a narrow range of products, and direct labour and materials were the dominant factory costs.
Overhead costs were relatively small, and the distortions arising from inappropriate overhead
allocations were not significant. Information processing costs were high, and it was therefore
difficult to justify more sophisticated overhead allocation methods. The cost information
requirements of service businesses were not fully appreciated (Drury & Tayles, 2020).

Today, companies produce a wide range of products, direct labour often represents only a
small fraction of total costs, and overhead costs are of considerable importance. Service
businesses form a larger part of the economy of most countries. Simplistic overhead
allocations cannot be justified, particularly when information processing costs are no longer a
barrier to introducing more sophisticated cost systems. Furthermore, today’s intense global
competition has made decision errors due to poor cost information more probable and costlier
(Drury & Tayles, 2020).

In a series of articles based on observations of innovative ABC-type systems, (Cooper &

Kaplan, 1988) conceptualized the ideas underpinning these systems and coined the term
ABC. The articles generated considerable publicity and consultants began to market and
implement ABC systems. ABC was therefore developed due to many deficiencies of
traditional cost systems.

4.0 VOLUME-BASED AND NON-VOLUME-BASED COST DRIVERS

In comparison with traditional systems, ABC systems rely on a greater number and variety of
second-stage cost drivers. The term ‘variety of cost drivers’ refers to the fact that ABC
systems use both volume-based and non-volume-based cost drivers. In contrast, traditional
systems use only volume-based cost drivers (Drury & Tayles, 2020).

4.1 Volume-based cost drivers

Volume-based cost drivers assume that a product’s consumption of overhead resources is

directly related to units produced. In other words, they assume that the overhead consumed
by products is highly correlated with the number of units produced (Drury & Tayles, 2020).

Typical volume-based cost drivers used by traditional systems are units of output, direct
labour hours and machine hours. These cost drivers are appropriate for measuring the

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consumption of expenses such as machine energy costs, depreciation related to machine
usage, indirect labour employed in production centres and inspection costs where each item
produced is subject to final inspection. Volume-based drivers are appropriate in the above
circumstances because activities are performed each time a unit of the product or service is
produced

4.2 Non-volume-based cost drivers

In contrast, non-volume-related activities are not performed each time a unit of the product or
service is produced (Drury & Tayles, 2020).

Consider, for example, 2 activities - setting up a machine and re-engineering products.

1. Setup resources are consumed each time a machine is changed from one product to
another. It costs the same to set up a machine for 10 or 5,000 items. As more setups
are done more setup resources are consumed. It is the number of setups, rather than
the number of units produced, that is a more appropriate measure of the resources
consumed by the setup activity.
2. Similarly, product re-engineering costs may depend on the number of different
engineering works orders and not the number of units produced. For both activities,
non-volume-based costing is appropriate

Drivers such as the number of setups and engineering orders needed for the accurate
assignment of the costs of these activities.

Using only volume-based cost drivers to assign non-volume-related overhead costs can result
in the reporting of distorted product costs. The extent of distortion depends on what
proportion of total overhead costs the non-volume-based overheads represent and the level of
product diversity. If a large proportion of an organization’s costs are unrelated to volume,
there is a danger that inaccurate product costs will be reported with a traditional costing
system. Conversely, if non-volume-related overhead costs are only a small proportion of total
overhead costs, the distortion of product costs will not be significant.

In these circumstances, traditional product costing systems are likely to be acceptable.

In fact, where the following two conditions exist, traditional product costing systems can
result in the over-costing of high-volume products and under-costing of low-volume
products:

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  non-volume-related overhead costs are a large proportion of total overhead costs; and
 there is product diversity

5.0 DESIGNING ABC SYSTEMS

Towards designing and refining costing systems, there are three broader guidelines to
consider, namely; direct-cost tracing, indirect-cost pools and cost-allocation bases
(Horngren, Datar, & Rajan, 2015). Direct-cost tracing involves quantifying as many direct
costs as possible with the aim of reducing the costs being considered as indirect costs.
Indirect-cost pools allow for all costs in a homogenous cost pool to have a cause-and-effect
with a single cost driver that is used as a cost allocation base. Cost-allocation bases are
derived from cost drivers for each individual cost-allocation pool.

(Drury & Tayles, 2020) quantified four key steps in designing activity-based costing systems
i.e.: i) identifying the major activities that take place in an organization, ii) assigning costs to
cost pools for each activity, iii) determining the cost driver for each activity, iv) assigning the
cost activities to products according to their utilization or demand for the activities (as
summarized in the diagram below)

Assigning the
Identifying cost of
Assigning Determining
the major activities to
costs to cost the cost
activities that products
pools/cost driver for
take place in according to
centres for each major
an the product’s
each activity; activity;
organization; demand for
activities.

Step 1: Identifying activities

Activities are the aggregation of many different tasks, events or units of work that cause the
consumption of resources. For example, purchasing materials might be identified as a
separate activity which consists of the aggregation of many different tasks, such as the ones
depicted in the graphic below:

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Step 2: Assignment of costs to activity cost centres

The cost of resources consumed over a specified period are now assigned to each activity.
The aim is to determine how much the organization is spending on each of its activities.

Many of the resources will be directly attributable to specific activity centres, but others
(such as labour, lighting, and heating costs) may be indirect and jointly shared by several
activities.

These costs should be assigned to activities based on cause-and-effect cost drivers or

interviews with staff who can provide reasonable estimates of the resources consumed by
different activities. Staff can, for example, be asked to maintain a diary of the time they spend
on various activities over a certain period. Arbitrary allocations should be minimized.

Cause-and-effect cost drivers used at this stage to allocate shared resources to individual
activities are called resource cost drivers

Step 3: Selecting appropriate cost drivers for assigning the cost of activities to cost objects

(Atrill & McLaney, 2009) emphasized identifying cost drivers as vital to a successful ABC
system, given that they have a cause-and-effect relationship with activity costs and therefore
serve as a basis for attaching activity costs to a given product or service

To assign the costs attached to each activity cost centre to products, a cost driver must be
selected for each activity centre. The cost drivers used at this stage are called activity cost
drivers.

 Several factors must be borne in mind when selecting a suitable cost driver:
 It should provide a good explanation of costs in each activity cost pool
 Should be easily measurable
 The data should be relatively easy to obtain and be identifiable with products. The
costs of measurement should therefore be considered

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Activity cost drivers consist of transaction and duration drivers.

 Transaction cost drivers such as the number of purchase orders processed, number
of customer orders processed, number of inspections performed and the number of
setups undertaken, all count the number of times an activity is performed. Transaction
drivers are the least expensive type of cost driver to measure, but they are also likely
to be the least accurate because they assume that the same quantity of resources is
required every time an activity is performed.
However, if the variation in the amount of resources required by individual cost
objects is not great, transaction drivers will provide a reasonably accurate
measurement of activity resources consumed. If this condition does not apply, then
duration cost drivers should be used.
 Duration cost drivers represent the amount of time required to perform an activity.
Examples of duration drivers include setup hours and inspection hours. Examples of
duration drivers include setup hours and inspection hours. For example, if one product
requires a short setup time and another requires a long time then using setup hours as
the cost driver will more accurately measure activity resource consumption than the
transaction driver (number of setups) which assumes that an equal amount of activity
resources is consumed by both products.

Step 4: Assigning the cost of the activities to products

The final step involves applying the cost driver rates to products. This means that the cost
driver must be measurable in a way that enables it to be identified with individual products.
The ease and cost of obtaining data on cost driver consumption by products is therefore a
factor that must be considered during the third step when an appropriate cost driver is being
selected (Drury & Tayles, 2020).

6.0 ABC PROFIT ANALYSIS

Whereas traditional models rely on a hierarchical approach to profitability analysis, (Cooper

& Kaplan, 1988) applied the hierarchical activity classification specified by the ABC system
to conduct profitability analysis

(Drury & Tayles, 2020) The general principles of activity profitability analysis applied to
different cost objects classifies costs according to the causes of their variability at different
hierarchical levels, with the lower hierarchies representing costs which can be meaningfully
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assigned without relying on arbitrary allocations, moving further up into complexity and
arbitrariness of allocation, as illustrated in the figure below:

Figure 1: An illustration of hierarchical ABC profitability analysis. Adopted from Drury C, Cost & Management Accounting
11th Edition

This approach categorizes costs according to the causes of their variability at different
hierarchical levels.

Hierarchies identify the lowest level to which cost can meaningfully be assigned without
relying on arbitrary allocations.

 The lowest hierarchical levels (shown at the top of the diagram) are product, customer
and branch contributions after deducting unit-level costs and, ignoring the business
unit level

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  The highest hierarchical levels (shown in the penultimate row prior to the overall
business unit) are product lines, distribution channels and country profits.

From the figure, we can see that:

 A unit-level contribution margin is calculated for each individual product. This is

derived by deducting the cost of unit-level activities from sales revenues
 From the above, unit-level contribution expenses relating to batch-related activities
are deducted
 Next the cost of product-sustaining activities are deducted. Thus, three different
contribution levels are reported at the individual product level.

Differentiating contributions at these levels provides a better understanding of the

implications of product mix and discontinuation decisions in terms of cost and profit
behaviour.

There are 2 further levels in the product hierarchy i.e., product brand and product line level,
although the former may be rare in some organisations. A product line consists of a group of
similar products. For example, banks have product lines such as savings accounts, lending
services, currency services, insurance services and brokering services. he lending services
product line would include personal loans, house mortgage loans, business loans, etc (Drury
& Tayles, 2020)

Some expenses such as marketing, research and development, and distribution expenses
might be incurred for the benefit of the whole product line and not for any products within
the line. Therefore these product line-sustaining expenses should be attributed to the product
line but no attempt should be made to allocate them to individual products.

Finally, the profit for the organizational unit as a whole can be determined by deducting
facility-sustaining expenses from the sum of the individual product line contributions.

The aim of ABC hierarchical profitability analysis is to assign all organizational expenses to
a particular hierarchical or organizational level where cause-and-effect cost assignments can
be established so that arbitrary allocations are non-existent. Compared to the profitability
analysis in traditional costing, the ABC analysis provides greater detail in the analysis of
indirect costs.

We elaborate on profit analysis using ABC system with the example below.

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Example:

Una manufactures 3 products: A, B, and C. Data for the period just ended is as follows:

A B C
Production (units) 20,000 25,000 2,000
Sales price (per unit) $20 $20 $20
Material cost (per unit) $5 $10 $10
Labour hours (per unit) 2 hours 1 hour 1 hour
(Labour is paid at the rate of $5 per hour)

Overheads for the period were as follows:

Set-up costs 90,000

Receiving 30,000
Despatch 15,000
Matching 55,000

Cost driver data:

A B C
Machine hours per unit 2 2 2
Number of set-ups 10 13 2
Number of deliveries received 10 10 2
Number of orders despatched 20 20 20

Required:

a) Calculate the cost (and hence profit) per unit, absorbing all the overheads based on
labour hours.
b) Calculate the cost (and hence profit) per unit absorbing the overheads using an
Activity Based Costing approach.

Solution:

a) Traditional costing cost card

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 A B C
Materials 5 10 10
Labour 10 5 5
Overheads 2x2.84 = $5.68 $2.84 $2.84
Total cost $20.68 $17.84 $17.84
Selling price $20 $20 $20
Profit $(0.68) $2.16 $2.16

Workings

Product Details Working Total

20,000 units of product A 20,000x2 40,000
are made each taking 2
hours
25,000 units of product B 25,000x1 25,000
are made each taking 1 hour
20,000 units of product C 2,000x1 2,000
are made each taking 1 hour:
Total 67,000
Overhead absorption rate 190,000/67,000 $2.84/hour

b) ABC system cost card

A B C
Materials 5 10 10
Labour 10 5 5
Overheads $3.9 $3.69 $8.63
Total cost $18.90 $18.79 $23.63
Selling price $20 $20 $20
Profit $1.10 $1.21 $(3.63)

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Workings

Activity Total A B C
Set-up costs: $90,000 36,000 46,800 7,200
Cost per setup =
90,000/(10+13+12) = $3600

Receiving costs: $30,000 13640 13640 2728

Cost per reception =
30,000/(10+10+2) = $1364

Despatch costs: $15,000 5,000 5,000 5,000

Cost per despatch =
15,000/(20+20+20) = $250
Machining costs: $55,000 23,400 29,250 2,340
Note that each product has
different machine hours, so we
must determine them first
A: 20,000x2 = 60,000
B: 25,000x2 = 50,000
C: 20,000x2 = 40,000
Total = $94,000
Cost per machine hour =
55,000/94,000 = $0.585
Total 190,000 78,040 94,690 17,268
Units 20,000 25,000 2,000
Overhead cost per unit $3.9 $3.69 $8.63

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7.0 ABC COST MANAGEMENT APPLICATIONS

1. Activity Costs: ABC is designed to track the cost of activities, so we can use it to see
if activity costs are in line with industry standards. If not, ABC is an excellent
feedback tool for measuring the ongoing cost of specific services as management
focuses on cost reduction.
2. Customer profitability: Although most of the costs incurred for individual customers
are simply product costs, there is also an overhead component, such as unusually high
customer service levels, product return handling, and cooperative marketing
agreements. An ABC system can sort through these additional overhead costs and
determine which customers are providing a reasonable profit. This analysis may result
in some unprofitable customers being turned away, or more emphasis being placed on
those customers who are contributing more to profits.
3. Distribution cost: Organisation uses a variety of distribution channels to sell its
products, such as retail, Internet, distributors, and mail order catalogues. Most of the
structural cost of maintaining a distribution channel is overhead, so if we can make a
reasonable determination of which distribution channels are using overhead, we can
make decisions to alter how distribution channels are used, or even to drop
unprofitable channels.
4. Make or buy: ABC enables the manager to decide whether he should get the activity
done within the firm or outsource the same. Outsourcing may be done if the firm is
incurring higher overhead costs as compared to the outsourcer or vice-versa.
5. Margins: With proper overhead allocation from an ABC system, we can determine
the margins of various products, product lines, and entire subsidiaries. This can be
quite useful for determining where to position company resources to earn the largest
margins.
6. Minimum price: Product pricing is really based on the price that the market will
bear, but the marketing manager should know what the cost of the product is, to avoid
selling a product that will lose the company money on every sale. ABC is very good
for determining which overhead costs should be included in this minimum cost,
depending upon the circumstances under which products are being sold.
7. Production facility cost: It is usually quite easy to segregate overhead costs at the
plant-wide level, so we can compare the costs of production between different
facilities.

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8.0 LIMITATIONS OF ABC

Activity-based costing helps managers in decision-making. However, it has certain

limitations or disadvantages:

1. Implementing an ABC system requires substantial resources, which is costly to

maintain. (Atrill & McLaney, 2009) setup costs and costs of running, maintaining and
updating the system must be incurred, and only increase as the complexity of business
operations increases.
2. ABC is a complex system which needs a lot of records/information for calculations.
Furthermore, (Atrill & McLaney, 2009) point to the consideration where should
managers find it difficult to interpret ABC reports, then the potential benefits of
running the system may be foregone.
3. ABC may not be justified in smaller organisations due to the limited capacity and
complexity of information gathering and calculation.
4. ABC data can be easily misinterpreted and must be used with care when used in
decision-making. Managers must identify which costs are relevant for the decisions at
hand. (Atrill & McLaney, 2009) add that not all costs can easily be identified with a
certain activity and some may have to be allocated to cost pools, as well as
mentioning cases where relationships between activity costs and their cost drivers
may be difficult to determine.
5. Reports generated by these systems do not conform to generally accepted accounting
principles (GAAP). Consequently, an organization involved in ABC costing should
have two cost systems - one for internal use and one for preparing external reports.

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9.0 REFERENCES

Atrill, P., & McLaney, E. (2009). Management Accounting for Decision Makers (6th ed.).
Prentice Hall.

Babad, Y. M., & Balachandran, B. V. (1993). Cost Driver Optimization in Activity-Based

Costing. The Accounting Review, 563.

Cooper, R., & Kaplan, R. S. (1988). Measure Costs Right: Make the Right Decisions.
Harvard Business Review, 69(10), 20.

Drury, C., & Tayles, M. (2020). Management and Cost Accounting (11th ed.). Annabel
Ainscow. Retrieved from https://books.google.co.ug/books?id=1ii-zQEACAAJ

Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost Accounting - A Managerial
Emphasis (15th ed.). Pearson.

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