Activity Based

Costing (ABC)
Dr. SujeewaDamayanthi
Department of Accounting
Faculty of Management & Finance
University of Colombo
Learning outcomes
• Explain why traditional costing system can provide
misleading information for decision making.
• Explain the ABC system and the need for modern
cost assigning system.
• Apply and evaluate traditional costing system and
ABC system.

2
Costing and pricing
products in the
traditional way
• Direct labour intensive production – Labour was at
the heart of production. To the extent that
machinery was used, it was to support the efforts
of direct labour.
• A low level of indirect cost relative to direct cost -
Little was spent on power, personnel services,
machinery.
3
Costing and pricing
products in the
traditional way
• A relatively uncompetitive market - Transport
difficulties, limited industrial production worldwide
and a lack of knowledge by customers of
competitors’ prices.
• Using simple costing systems to allocate costs
broadly was easy, inexpensive, and reasonably
accurate.
4
Costing and pricing
products in the new
environment
• Capital-intensive and machine-paced production.
Machines are at the heart of much production.
Most labour supports the efforts of machines
• A high level of indirect costs relative to direct costs.
Modern businesses tend to have very high
depreciation, servicing and power costs.

5
 Costing and pricing
products in the new
environment
• Highly competitive international market. Production,
much of it highly sophisticated, is carried out
worldwide. Potential customers can quickly and
cheaply find the prices of a range of suppliers and
markets now tend to be highly price competitive.
• Broad averaging has resulted in greater inaccuracy
of product costs.

6
Broad averaging and its
consequences
• Under-costing and over-costing products and services.
―Product under-costing – a product consumes a
high level of resources but is reported to have a low
cost per unit
―Product over-costing – a product consumes a low
level of resources but is reported to have a high
cost per unit
7
 Broad averaging and its
consequences
• Product-cost cross-subsidization – if a company under-costs
one of its products, it will over-cost at least one of its other
products. Similarly, if a company over-costs one of its
products, it will under-cost at least one of its other products.
• This is very common in situations in which a cost is
uniformly spread across multiple products without
recognizing the amount of resources consumed by each
product.
8
 Refining a costing
system
• A refined costing system reduces the use of broad
averages for cost assigning.
• Reasons that have accelerated the demand for such
refinements: increase in product diversity, increase in
indirect costs and competition in the market.
• Guidelines for refining a costing system includes:
classify more costs as direct costs, expand the number
of indirect cost pools and identify cost drivers.
9
 What is Activity based
costing?
• ABC system refines costing system by focusing on
individual activities as the fundamental cost object.
• An activity is an event, task, or unit of work with a
specified purpose (they are things that a firm does).
• ABC systems identify activities in all functions of the
value chain, calculate costs of individual activities, and
assign costs to cost objects.
10
 What is Activity based
costing?
• To implement a system of ABC, need to identify:
―Each of the various support activities involved in
the process of making products or providing
services
―The costs to be attributed to each support activity
―The factors that cause a change in the costs of
each support activity, that is, the cost drivers.
11
 How it works?
Step 1: Identify the cost objects and direct costs of the
products
Step 2: Identify the activities relating to indirect costs and
group indirect costs in activity cost pools
Step 3: Select appropriate cost driver for assigning the
cost of activities to cost objects
Step 4: Compute the cost driver rate
Step 5: Assign cost of the activities to products
Step 6: Compute the total cost of the products
12
 Cost/activity hierarchies
• Cost hierarchy categorizes various activity cost pools
on the basis of the different types of cost drivers, or
cost-allocation bases.
• Manufacturing activities can be classified into four
levels along the cost hierarchy:
―Unit-level activities
―Batch-level activities
―Production sustaining activities
―Facility-sustaining activities
13
 Cost/activity hierarchies
• Unit-level activities – activities performed on each
individual unit of a product or service.
• Batch-level activities – activities related to a group of units
of a product or service.
• Product-sustaining activities – activities undertaken to
support individual products or services.
• Facility-sustaining activities – activities that cannot be
traced to individual products or services.
14
 Example
• Sun Ltd is a multi-product company. It makes and sells
product A and product B. While product B is
technically sophisticated, product A’s manufacturing
process is quite simple.
• The direct costs and selling price related information
for product A and B are as follows:

15
Example
Product A Product B
Units produced 1000 1000
Labour hours 400hrs 600hrs
Selling price per unit Rs. 16 Rs. 28
Material cost per unit Rs. 5 Rs. 10
Labour cost per unit Rs. 1 Rs. 4

16
 Example
• Sun Ltd groups all indirect costs totaling Rs 20,000 into
a single overhead cost pool. Sun Ltd uses direct
manufacturing labour hours as the only allocation
base to allocate all indirect costs to products A and
products B.
• Compute the total cost per unit for Product A & B.

17
Example – Calculating
cost per unit
Product A Product B
Rs. Rs.
Material cost per unit 5 10
Labour cost per unit 1 4
Overhead cost per unit 8 12
(Rs 20*0.4hr) (Rs 20*0.6hr)
Cost per unit 14 26

18
 Example
• After conducting a market survey managing director of
Sun Ltd got to know that a competitor of Sun Ltd put
on the market a product identical to model A at a price
of Rs 12 instead Rs 16. After a careful study of the
current overhead cost Sun Ltd identifies following
activities and costs pools relating to overhead;

19
Example
Activities Rs.

Setting up machine 10,000

Maintain and clean machine 6,000

Products delivery 4,000

Total overheads 20,000

20
 Example
Product Product Total
A B
Machine setup hours 100 400 500 hours

Cleaning and maintenance 50 150 200

interventions interventions
Number of deliveries 20 380 400
deliveries

21
 Example
Requirement:
• Compute the total cost of the product using Activity
based costing method.
• Compare the unit cost of products with the unit cost
of traditional approach, comment on the result.

22
 Example – Calculating
cost driver rate
Activity Activity Activity cost Activity cost
Cost (Rs) driver driver rate
Setting up 10,000 Machine Rs. 20 per setup
machine setup hours hour
Maintain and 6,000 Cleaning and Rs. 30 per
clean machine maintenance intervention
interventions
Products 4,000 Number of Rs. 10 per
delivery deliveries delivery

23
 Example – Allocating
indirect costs to each
prduct
Activity Activity cost assigned Activity cost assigned
to Product A to Product B
Setting up Rs 2,000 Rs 8,000
machine Rs 20*100 setup hrs Rs 20*400 setup hrs
Maintain and Rs 1,500 Rs 4,500
clean machine Rs 30*50 Rs 30*150
interventions interventions
Products Rs 200 Rs 3,800
delivery Rs 10*20 deliveries Rs 10*380 deliveries

24
 Example – Calculating
cost per unit
Product A Product B

Total overhead cost Rs 3,700 Rs 16,300

Units Produced 1,000 units 1,000 units
Overhead cost per unit Rs 3.70 Rs 16.30
(3,700/1,000) (16,300/1,000)
Direct costs per unit Rs 6.00 Rs 14.00
Total cost per unit Rs 9.70 Rs 30.30

25
 Comparison of unit cost
under traditional and
ABC systems
Product A Product B
Unit cost under traditional Rs 14.00 Rs 26.00
method
Units cost under ABC Rs 9.70 Rs 30.30
method
Selling price per unit Rs 16.00 Rs 28.00
Undercosting/overcosting Rs 4.30 (Rs 4.30)

26
 Comparison of unit cost
under traditional and
ABC systems
• Volume based cost drivers assume that a product’s
consumption of overhead resources is directly related
to units produced.
• At Sun Ltd activities identified are not relating to
volume based cost drivers.
• All three are non-volume elated activities which are not
performed each time a unit of the product is produced.
27
Comparison of unit cost
under traditional and
ABC systems
• Therefore, using only volume-based cost drivers to
allocate non-volume related overhead costs can
result in the reporting of distorted product costs.
• At Sun Ltd Product A is overcosted and Product B is
undercosted under the traditional method.

28
 Cost versus benefit
considerations
• The optimal costing system is different for different
organizations. A simplistic traditional costing system
may report reasonably accurate product costs in
organizations that have following characteristics:
―Low level competition

―Non-volume related indirect costs proportion is low

―Standardized product range

29
 Cost versus benefit
considerations
• In contrast, a sophisticated ABC system may be
optimal for organizations having following
characteristics:
―Intensive competition

―Non-volume related indirect costs proportion is high

―A diverse range of products

30
Activity based costing
system - benefits
• Supposed to provide a more accurate cost structure
for product.
• Eliminate non- value added activities.

• Helps with decision on product mix, customer mix.

31
Activity based costing
system - limitations
• Companies with homogeneous production and
labour intensive operations gain little from ABC.
• If you select the wrong cost driver, your costs will
be inaccurate.
• Data availability matter.
• ABC alone will not tell if a customer is satisfied or if
a process is in control.

32
 ABC in service
organizations
• Service organizations are ideal candidates for ABC
more than manufacturing organizations (Kaplan &
Cooper, 1998). Since, most of the costs in serice
organizations are indirect.
• According to Kaplan and Cooper (1998) activities and
cost drivers relating to a UK bank are as follows:

33
 ABC in service
organizations
Activity Cost driver
Provide ATM services Number of ATM transactions
Clear debit items Number of debits processed
Clear credit items Number of credits processed
Issue cheque books Number of cheque books
issued
Computer processing Number of computer
transactions
Prepare statements of accounts Number of statements issued
transactions

34
 Using ABC for improving cost
management and profitability
• Activity-based management (ABM) is a method of
management decision making that uses activity-based
costing information to improve customer satisfaction
and profitability.
• Include decisions about pricing and product mix, cost
reduction, process improvement, and product and
process design.
35