ACTIVITY BASED COSTING

In traditional costing system below are the steps

- Total factory overheads are first allocated/apportioned to department/ cost
centers.
- Overheads of service cost centers / departments are reapportioned to
production cost centers
- Finally department wise absorption rates are derived to absorb overheads
to the job, units etc. on the basic of direct labour hours, machine hours etc.
Limitations
- Pooling of cost into functional department is not always logical.
- Absorption rates here assume that products that take longer to make
generate more overheads and so on.
- This approach do not distribute overheads with detailed accuracy.
Factors prompting the development of ABC
1. Growing overhead costs because of increasingly automated production
2. Increasing market competition which necessitated more accurate product costs.
3. Increasing product diversity to secure economies of scope & increased market
share.
4. Decreasing costs of information processing because of continual improvements
and increasing application of information technology.

Usefulness/Suitability of ABC
1. High amount of Overhead: When Production overheads are high and
significant cost, ABC will be very much useful instead of traditional costing
system
2. Wide range of products: ABC is most suitable, when, there is a diversity in the
product range or there are multiple products.
3. Presence of Non-volume related activities: When non-volume related activities
e.g. material handling, inspection set-up, are present significantly and
 traditional system cannot be applied, ABC is a superior and better option. ABC
will identify non-value-adding activities in the production process that might
be a suitable focus for attention or elimination.
4. Stiff competition: When the organisation is facing stiff competition and there is
an urgent requirement to compute cost accurately and to fix the selling price
according to the market situation, ABC is very useful. ABC also can facilitate in
reducing cost by identifying non-value-adding activities in the production
process that might be a suitable focus for attention or elimination.

MEANING AND DEFINITION

Activity Based Costing is an accounting methodology that assigns costs to

activities rather than products or services. This enables resources & overhead
costs to be more accurately assigned to products & services that consume
them. ABC is a technique which involves identification of cost with each cost
driving activity and making it as the basis for apportionment of costs over
different cost objects/ jobs/ products/ customers or services.

MEANING OF TERMS USED IN ABC

(i) Activity – Activity, here, refers to an event that incurs cost.

(ii) A Cost Object–It is an item for which cost measurement is required e.g.
a product or a customer
(iii) A Cost Driver–It is a factor that causes a change in the cost of an
activity.
There are two categories of cost driver. Example Production runs
• A Resource Cost Driver– It is a measure of the quantity of resources
consumed by an activity. It is used to assign the cost of a resource to an
activity or cost pool.
• An Activity Cost Driver–It is a measure of the frequency and intensity
of demand, placed on activities by cost objects. It is used to assign
activity costs to cost objects.
 (iv) Cost Pool-It represents a group of various individual cost items. It
consists of costs that have same cause effect relationship. Example
Machine set-up.

Examples of Cost Drivers:

Business functions Cost Driver
Research and Development • Number of research projects
• Personnel hours on a project
Design of products, services and • Number of products in design
procedures • Number of parts per product
• Number of engineering hours
Customer Service • Number of service calls
• Number of products serviced
• Hours spent on servicing products
Marketing • Number of advertisements
• Number of sales personnel
• Sales revenue
Distribution • Number of units distributed
• Number of customers

Cost Allocation under Traditional and Activity Based Costing system

Activity Based Costing Traditional Absorption Costing

1. Overheads are related to activities

1. Overheads are related to cost
and grouped into activity cost pools.
centers/departments.
2. Costs are related to activities and
2 Costs are related to cost centers
hence are more realistic. and hence not realistic of cost
behaviour.
3 .Activity–wise cost drivers are 3. Time (Hours) are assumed to be
determined. the only cost driver governing costs in
all departments.
 4. Activity–wise recovery rates are 4. Either multiple overhead recovery
determined and there is no concept rate (for each department) or a single
of a single overhead recovery rate. overhead recovery rate may be
determined for absorbing overheads.
5.Cost are assigned to cost objects, 5.Cost are assigned to cost objects,
e.g. customers, products, services, e.g. customers, products, services,
departments, etc. departments, etc.
6.Essential activities can be 6. Cost Centers/ departments cannot
simplified and unnecessary activities be eliminated. Hence not suitable for
can be eliminated. Thus the cost control.
corresponding costs are also
reduced/ minimized. Hence ABC aids
cost control.

STAGES IN ACTIVITY BASED COSTING (ABC)

The different stages in ABC calculations are listed below:
1. Identify the different activities within the organisation: Usually the number
of cost centres that a traditional overhead system uses are quite small, say
up to fifteen. In ABC the number of activities will be much more, say 200;
the exact number will depend on how the management subdivides the
organisation’s activities. It is possible to break the organisation down into
many very small activities. But if ABC is to be acceptable as practical system
it is necessary to use larger groupings, so that, say, 40 activities may be used
in practice. The additional number of activities over cost centres means that
ABC should be more accurate than the traditional method regardless of
anything else. Some activities may be listed as follows:-
• Production schedule changes
• Customer liaison
• Purchasing
• Production process set up
• Quality control
• Material handling
• Maintenance
 2. Relate the overheads to the activities, both support and primary, that
caused them. This creates ‘cost pools’ or ‘cost buckets’. This will be done
using resource cost drivers that reflect causality.
3. Support activities are then spread across the primary activities on some
suitable base, which reflects the use of the support activity. The base is the
cost driver that is the measure of how the support activities are used.
4. Determine the activity cost drivers that will be used to relate the overheads
collected in the cost pools to the cost objects/products. This is based on the
factor that drives the consumption of the activity. The question to ask is –
what causes the activity to incur costs? In production scheduling, for
example, the driver will probably be the number of batches ordered
5. Calculate activity cost driver rates for each activity, just as an overhead
absorption rate would be calculated in the traditional system.

Activity cost driver rate = Total cost of activity /Activity driver

ADVANTAGES OF ACTIVITY BASED COSTING
The main advantages of using Activity Based Costing are:
1. More accurate costing of products/services.
2. Overhead allocation is done on logical basis.
3. It enables better pricing policies by supplying accurate cost information.
4. Utilizes unit cost rather than just total cost
5. Help to identify non-value added activities which facilitates cost
reduction.
6. It is very much helpful to organization with multiple product.
7. It highlights problem areas which require attention of the management.

LIMITATIONS OF ACTIVITY BASED COSTING

The main limitations using Activity Based Costing are:
1. It is more expensive particularly in comparison with Traditional costing
system.
2. It is not helpful to small Organization.
3. It may not be applied to organization with very limited products.
 4. Selection of most suitable cost driver may not be useful

REQUIRMENTS IN ABC IMPLEMENTATION

A number of distinct practical stages are required in the ABC implementation
which are given as below:
Staff Training: The co-operation of the workforce is critical to the
successful implementation of ABC. Staff training should be done to create an
awareness of the purpose of ABC.

Process Specification: Informal, but structured, interviews with key members

of personnel will identify the different stages of the production process, the
commitment of resources to each, processing times and bottlenecks.

Activity Definition: Early activity should be clearly defined the problem must
be kept manageable at this stage, despite the possibility of information
overload
from new data, much of which is in need of codification.

Activity Driver Selection: Cost driver for each activity shall be selected.

Assigning Cost: A single representative activity driver can be used to assign

costs from the activity pools to the cost objects.ost suitable cost driver may not
be useful.

LEVEL OF ACTIVITIES UNDER ABC METHODOLOGY

These categories are generally accepted today but were first identified by
Cooper (1990). The categories of activities help to determine the type of
activity cost driver required
1.Unit level activities These are those activities for which the consumption of
resources can be identified with the number of units produced.
Example • The use of indirect materials/consumables tends to increase in
proportion to the number of units produced.
• The inspection or testing of every item produced, if this was deemed
necessary or, perhaps more likely, every 100th item produced.
2.Batch level activities The activities such as setting up of a machine or
processing a purchase order are performed each time a batch of goods is
produced. The cost of batch related activities varies with number of batches
made, but is common (or fixed) for all units within the batch.
Example • Material ordering–where an order is placed for every batch of
production
• Machine set-up costs–where machines need resetting between each
different batch of production.
• Inspection of products where the first item in every batch is inspected rather
than every 100th item quoted above.
3. Product level activities These are the activities which are performed to
support different products in product line
Example • Designing the product, • Producing parts specifications
• keeping technical drawings of products up to date.
4.Facilities level activities These are the activities which cannot be directly
attributed to individual products. These activities are necessary to sustain the
manufacturing process and are common and joint to all products
manufactured
Example • Maintenance of buildings • Plant security