CHAPTER 3

Activity-Based Costing
After reading this chapter, you should be able to :

1. Explain traditional cost system — its concept, limitations, situations under which traditional
costing system can be used.

2. Define Activity — Based Costing (ABC).

3. Discuss stages and flow of costs in ABC.

4. Explain classification of activities in a manufacturing organization.

5. Compare traditional costing system and activity–based costing system.

6. Explain advantages and demerits of activity-based costing system.

7. Discuss activity-based costing in service industry.

8. Identify criteria for successful implementation of ABC system.

9. Explain situations under which ABC can be applied.

10. Define Attribute–Based Costing.

TRADITIONAL COSTING SYSTEM

Concept

Traditional product costing system is also referred to as functional-based cost accounting system or volume
based costing system. Traditional (or conventional) product costing system determines product cost by way of
allocating, in the first stage, direct costs to the products and then subsequently adding a proportion of
overheads deemed to be related to the units produced. In this costing system, overheads are charged to
products on a production volume related basis such as direct labour hours, direct labour cost and machine
hours. This costing system is based on the assumption that all overheads are related basically to production
volume.

Traditional product costing was developed when direct material costs and direct labor costs accounted for the
bulk of product costs incurred inside a firm or factory and manufacturing processes were labor intensive.
Factory overheads tend to serve all production and hence cannot be directly identified with or traced to
products or services.

In the past, labour activities were a major manufacturing activity. The other major manufacturing cost item,
direct materials costs, consists of payments to vendors rather than costs incurred inside the factory. With
labour costs being a primary manufacturing cost and labour activities being the major activity in the
manufacture of a product, volume-based costing systems focus on measuring and controlling direct labour
costs. Factory overheads were a small fraction of the labour costs and are deemed, as resources expended, to
support labour activities. Tying to direct labour costs, a traditional overhead costing system becomes a volume-
based costing system. As volumes (units) change, direct labour costs, as do overhead costs, vary in proportion
to changes in units of production.

Functional-based (Volume-based) costing system has the following features.

(i) It assumes simple labour based production and low level of mechanization,

(ii) Direct costs, i.e., direct material and direct labour, have larger proportion in the total costs of production.

(iii) Overhead costs are in small proportion because support or servicing functions such as planning,
purchasing, accounting, finance, administration, etc., are less.

(iv) Standardised products are generally assumed to be produced.

(v) This costing system is assumed not to be affected much by technology changes and production methods
and products are subject to slow rate of changes.

Volume-Based Overhead Rate

The factory overhead rate in a volume-based costing system is either a single over-head rate for the entire
operation (plantwide rate) or a set of overhead rates with various rates for different departments or divisions
(department rates). These overhead rates use an output-volume-based activity or activities to assign (or to
spread) factory overhead costs to products or services. An output-volume-based costing system spreads costs
evenly so that each cost object (product or service) receives the same amount.

Limitations of Volume-Based Costing System

Volume-based costing system have served well since the inception of cost accounting. However, remarkable
changes have taken place in production methods, organizational structure, cost behaviour and magnitudes.
Production is now automated and computerised. Overheads now-a-days constitute a very high proportion of
total costs as compared to direct labour. Support functions and their costs have shown increasing trends
continually. Thus, at present, overheads are less affected by production volume (as in conventional costing),
but more by range and complexity of products manufactured.
The following are the limitations of volume-based costing system.

1. Different products utilize different amount of resources, which is not recognized in traditional costing
system.

2. Overheads now constitute the largest share of cost, often greater than 50% and is typically applied to
products as percentage of the smallest cost (direct labour) leading to serious distortion of product cost.

3. By relying on volume-related measures to determine product costs, traditional costing system do poor job in
reflecting supporting costs for manufacturing and distribution of products or services. More and more factory
overheads, such as set-up cost, materials handling cost, and product design and research and development
costs, are unrelated to the number of units produced.

4. Traditional costing system tends to overcast standard, high volume products and under cost low-volume
products, leading to incorrect pricing and product-mix decisions.

5. It creates a bias toward direct labour reduction as a cost reduction rather than overall productivity
improvement.

6. It provides no information useful in either identifying productivity improvement opportunities or

determining if productivity improvement efforts have yielded significant results. Indeed, often
traditional costing system indicates higher cost in the presence of known productivity improvement or
vice versa.

Thus, companies that apply plant wide and departmental overhead rates to assign costs to products
often do not produce reliable cost data. Conventional product costing system follows a cost
smoothening or peanut-butter costing which describes a costing approach that uses broad averages for
distributing the costs of resources uniformly to cost objects (such as product or services) when the
individual products or services, in fact, use those resources in a non-uniform way. For some companies,
product cost distortions can be damaging, particularly for those characterized by intense or increasing
competitive pressures, continuous improvement, total quality management, total customer satisfaction
and sophisticated technology. As firms operating in this competitive environment adopt new strategies
to achieve competitive excellence, their cost accounting systems often must change to keep pace. Cost
accounting systems that worked reasonably well in the past may no longer be acceptable 1.

According to Brimson2, the traditional product cost model distorts product cost for several reasons:

1. Factory overhead costs are allocated rather than traced to products.

2. The total overhead component of product cost has historically grown faster than direct costs. As
overhead becomes a larger percentage of product cost, the distortion inherent in the allocation process
causes the total product cost to increase.
3. Generally accepted accounting principles often dictate or influence cost accounting practices. One of
these principles — the conservatism principle — is inconsistent with accurate product cost
determination in two important ways:

3a. The conservatism principle requires that reported cost be based on precise and easily verifiable data,
whereas management often needs costs that are based on forecasts and plans.

3b. The conservatism principle encourages expensing many costs in the current period that should be
capitalized. This practice distorts life-cycle costs.

4. Many activities included in selling, general and administration are traceable to specific products.

Blocher, Chen, Cokins and Lin3 Observe

“A volume-based overhead costing system, whether plant wide or departmental, often leads to
inaccurate product costs, especially for firms with complex manufacturing operations, firms with
varieties of products or heterogeneous production processes. As firms increase in variety of product,
volume, size, or complexity, resources used and costs spent on supporting activities, such as handling
and processing activities, increase. Distortions of volume-based overhead cost systems increase as
product diversity increases because the cost system — (1) is designed to cost products in the aggregate,
not to relate to unique manufacturing characteristics in different operations; (2) uses a common plant
wide or departmental cost driver and ignores differences in activities for different products or
production runs within the plant or department; (3) employs a common activity volume for all
operations such as direct labour-hours or cost as the base to distribute overhead costs to all products
while the selected activity is a small portion of the overall production activities; and (4) deemphasizes
long-term product analysis.

Users of traditional volume-based cost data, who are aware of likely distortions in cost data from a
volume-based costing system, often attempt to make intuitive, and likely, imprecise adjustments to the
volume-based cost information without understanding their complete effect and thereby, distort the
cost information further. Inaccurate cost information can lead to undesirable strategic results, such as
wrong product-line decisions, unrealistic pricing, and ineffective resource allocations.”

Situations under which Traditional Costing System Can Be Used

A volume-based costing system may provide reasonably accurate costs when a business firm possesses
the following characteristics:

1. Few and very similar product and service lines.

2. Low overhead expenses

3. Similar distribution channels, customer demands and customers.

4. Similar conversion process for all products or services.

5. High margins of products and services.

Example Illustrating Erroneous Costing with Traditional Costing System

● Four friends A, B, C, D go to a restaurant. Each one of them orders different item to eat and drink.
Obviously, each item’s price is different. So, at the end of the meal, the waiter brings a common bill
totaling all the items consumed by all the four. Say the bill is ` 1,080. What do they do? They divide `
l,080 by 4 and each one gives his share of the bill, i.e., ` 270.

The question to ask is: has each one really eaten worth ` 270? The answer is: “No”. Had you kept an
account of who ate what, you could have got the exact bill for the individual accurately. Suppose, one of
them kept an account of who ate what, he could calculate his share of total bill by looking at the prices
of the ordered items from the menu cards. So knowing this, one of them kept an account like this and he
found that the four friend ate like this: first one ate worth ` 150, the second one worth ` 420, third one `
270 and fourth one ` 240. The total is the same but each one costs differently than the earlier (average)
` 270 each.

Now replace the four friends by four products being manufactured in a company. With conventional
costing system the costs of each will be ` 270. Selling price of each would be decided by the market
trend. Therefore, we will calculate the profit or loss made by the sales of each item with reference to `
270 as the cost of each one of them. However, suppose we are in a position to keep a track of exact
costing of each product by using a costing system like and suppose that the exact cost found by ABC
happens to be ` 150 for first product. ` 420 for second product ` 270 for third product and ` 240 for
fourth product, your profit calculations now will give you an entirely different picture for each product.

You will now be able to find as to which product is really making the profit or loss and exactly how
much?

Now, based on this information of exact profitability and cost of each product by using ABC,
management decisions on product-mix, cost reduction, product design modifications, marketing/ sales
strategies can be taken more correctly. In absence of this information, by using the information given
earlier by the conventional costing system, all these decision were being taken as “shot in the dark” —
literally blindly. They were misleading.

ACTIVITY-BASED COSTING (ABC)

The 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 products create
the demands for activities. Costs are charged to products based on individual product’s use of each
activity. In traditional product costing system, costs are, first, traced not to activities but to an
organizational unit, such as department or plant and then to products. ABC, as compared to traditional
cost system, is based on one fundamental difference. Under ABC, activity and product/service costs are
determined based on the primary principle that activities consume resources (costs). Products and
services (cost objects), in turn, consume the activities. This principle is fundamentally different from
traditional costing systems whose premise is that product/services consume resources directly and
activity costs are not calculated at all.

Stages And Flow of Costs in ABC

There are two primary stages in ABC — first, tracing costs to activities; second, tracing activities to
products. The different steps in the two stages of ABC are explained below:

Step 1. Identify the main activities in the organization. Examples include: material handling, purchasing,
receipt, dispatch, machining, assembly and so on.

Step 2. Identify the factors which determine the costs of an activity. These are known as cost drivers.
Examples include: number of purchase orders, number of orders delivered, number of set-ups and so
on.

Step 3. Collect the costs of each activity. These are known as cost pools and are directly equivalent to
conventional cost centres.

Step 4. Charge support overheads to products on the basis of their usage of the activity, expressed in
terms of the chosen cost driver(s). For example, if the total costs of purchasing were ` 2,00,000 and
there were 1,000 purchase orders (the chosen cost driver), products would be charged ` 200 per
purchase order. Thus, a batch generating 3 purchase orders would be charged 3 × ` 200 = ` 600 for
purchasing overheads.

ABC follows a two-stage cost assignment procedure and assigns resource costs such as factory overhead
costs to activity cost centres or cost pools and then to cost objects to determine the amount of resource
costs for each of the cost objects. That is, resources (costs) are assigned to activities. Activity cost is then
assigned to cost objects.

There are five basic components to the activity-based cost assignment.

1. Resources, 2. Resource Drivers, 3. Activities, 4. Activity Cost drivers, and 5. Cost objects.

1. Resources. Resources are what organizations spend their money on — the categories of costs that
are recorded. Resource is defined as an economic or money element that is applied or used in the
performance of activities. Salaries and materials, for example, are resources used in the performance of
activities. Additional examples of resources include repair, inspection, rent, depreciation, utilities,
insurance, and supplies. Most ABC systems currently exclude costs like income taxes and interest
expense that are not used in the performance of activities.
2. Resource Drivers. Resource drivers are the basis for tracing resources to activities. Resource driver
is defined as a measure of the quantity of resources consumed by an activity. An example of a resource
driver is the percentage of total square feet of space occupied by an activity. This factor is used to trace
a portion of the cost of operating the facilities to the activity.

Examples of common resource drivers for salaries/wages, rent, equipment, depreciation, and utilities
include the following:

Resource Resource Driver

Salaries Percentage of people’s time spent on each activity

Headcount assignment.

Hours spent on each activity.

Rent/facility costs Square feet of facility consumed by each activity.

Cubic feet of facility consumed by each activity.

Equipment depreciation Specific analysis to associate equipment use to each activity.

Machine time by activity

Utilities (electric) Kilowatt hours consumption by activity

Square feet of facility

3. Activities. An activity is a unit of work. If you go to a restaurant for luch/dinner, a waiter or waiters
might perform the following units of work:

• Seat customer and offer menu • Take you order • Send orders to kitchen • Bring food • Replenish
beverages • Determine and bring bill • Collect money and give change • Clear table

Each of these is an activity and the performance of each activity consumes resources that cost money.

Activities, represent work performed in an organization. The cost of activities is determined by tracing
resources to activities using the resource drivers. An example of how the salaries of a receiving
department of a manufacturing company might be traced to receiving department activities. In this
example, the resource is receiving department salaries. The activities are as follows: receive materials,
unload trucks, move material, schedule receipts, expedite material, and resolve vendor errors. The
resource driver is a percentage of people’s time devoted to each receiving department activity.
While percentage of people’s time was selected as the resource driver in this example, as an alternative,
the head count of people assigned to each activity or the hours devoted to each activity could have been
used as the resource driver.

Assuming that salaries were the only resource of the receiving department, calculating the cost of
receiving department activities would be quite simple. All that is required is to multiply the percentage
of people’s time (resource driver) by the salary amount.

In practice, a single resource and resource driver would be rare. The receiving department of a large
organization is likely to have multiple resource and resource drivers. Total activity cost would be
determined by tracing each resource (using an appropriate resource driver) to the receiving department
activities. Once determined, activity costs can be traced to cost objects using activity drivers.

4. Activity Cost Drivers. Like a resource driver that is used to trace resources to activities, an activity
cost driver is used to trace activity costs to cost objects. An activity cost pool is a ‘container’ in which
costs are accumulated that relate to a single activity in the ABC system. Activity driver is defined as a
measure of the frequency and intensity of the demands placed on activities by cost objects. An activity
driver is used to assign costs to cost objects.

A cost driver is an activity which generates cost. A cost driver is a factor, such as the level of activity or
volume, that causally affects costs (over a given time span). That is, a cause-and-effect relationship exists
between a change in the level of activity or volume and a change in the level of the total costs of that
cost object. Thus, cost drivers signify factors, forces or events that determine the costs of activities.
Based on activity usage (consumption), activity costs are traced to cost objects.

Cost Driver Rate = Activity Cost Activity Volume

In a manufacturing organization, the following are examples of some cost drives.

Some Examples of Activity Cost Drivers

Activity or Activity Center Activity Cost Drivers

1. Accounting personnel 1. Reports requested; Amount expended, Job change actions; hiring actions;
training hours; counseling hours

2. Data processing 2. Reports requested; transactions processed; programming hours; programme change
requests

3. Production engineering 3. Hours spent in each shop; job specification changes requested; product change
notices processed.

4. Quality control 4. Hours spent in each shop; defects discovered; samples analyzed.

5. Plant services 5. Preventive maintenance cycles; hours spent in each shop; repair and maintenance actions
6. Material services 6. Money value of requisitions; number of transactions processed; number of personnel in
direct support.

7. Utilities 7. Direct usage (Metered to shop); space occupied.

8. Production shops 8. Fixed per-job change; set-up made; direct labour; machine hours; number of moves;
material applied.

9. Run machines 9. Machine hours

10. Setup machines 10. Set-up or set-up hours

11. Schedule production jobs 11. Production runs

12. Receive materials 12. Material receipts

13. Support existing products 13. Number of products

14. Introduce new products 14. Number of new products introduced.

15. Maintain machines 15. Maintenance hours

16. Modify product characteristics 16. Engineering change notices

It should be understood that direct costs do not need cost drivers as they can be traced directly to a
product. Direct costs are themselves cost drivers. However, all other factory or manufacturing costs
need cost drivers. The cost driver of variable costs is the level of activity or volume whose change causes
the variable costs to change proportionately.

Costs that are fixed in the short-run have no cost drivers in the short-run but may have cost drivers in
the long run. For instance, costs of testing personal computers (which comprise costs of testing
department equipment and staff costs) may not change with changes in the volume of production.
Therefore, these costs would be fixed in the short run. In the long run, however, an organization may
need to increase/decrease testing department’s equipment and staff to the levels needed to support
future production volumes. So, in the long run, volume of production or activity becomes cost drivers of
these testing and staff costs.

Short-Term and Long-Term Variable Costs

Short-term variable costs increase or decrease corresponding with changes in the volume of activity.
Costs that do not move in relation to volume have conventionally been accepted as fixed. “Generally
[however], as a business expands, costs tend to be far more variable than they should be and when it
contracts, they are far more fixed than they should be.” 4 Professor Robert Kaplan of Harvard University
considers the ability of “fixed” costs to change under the “Rule of One.” which means that possessing or
using more than one unit of a resource is evidence that the resource is variable. 5 Because of this logic,
many people have come to view fixed costs as long-term variable costs, for which suitable (usually non
volume-related) cost drivers simply need to be identified.

Two significant cost drivers that cause long-term variable costs to change, but which traditionally have
been disregarded, are product variety and product complexity. Product variety refers to the number of
different types of products made: product complexity refers to the number of components included in a
product; process complexity refers to the number of processes through which a product flows.

These items create additional overhead (such as warehousing, purchasing, set-ups, and inspections), so
long-term variable costs tend to increase as the number and types of products increase. Therefore,
managers should use these cost drivers in applying ABC.

Selection of Activity Cost Drivers

In traditional product costing, the number of cost drivers used are few such as direct labour hours,
machine hours, direct labour costs, units produced. But ABC may use multiple cost drivers that relate
costs more closely to the resources consumed and activities occurring. There are difficulties in choosing
realistic cost drivers. There are no simple rules that pertain to the selection of cost drivers. The best
approach is to identify the resources that constitute a significant proportion of the product costs and
determine their cost behaviour. When identifying and selecting activity drivers, match the activity to the
activity level, which is defined as a description of how an activity is used by a cost object
(product/service) or activity. Some activity levels describe the cost object that uses the activity and
nature of its use.

According to Hilton6, the following three factors are important in selecting appropriate cost drivers.

(i) Degree of Correlation: The central concept of an activity-based costing system is to assign the costs of
each activity to product lines on the basis of how each product line consumes the cost driver identified
for the activity. The idea is to infer how each product line consumes the activity by observing how each
product line consumes the cost driver. Therefore, the accuracy of the resulting cost assignments
depends on the degree of correlation between consumption of the activity and consumption of the cost
driver,

(ii) Cost of Measurement: Designing any information system entails cost-benefit trade-offs. More the
activity cost pools in an activity-based costing system, the greater will be the accuracy of the cost
assignments. However, more activity cost pools also entail more cost drivers, which result in greater
costs of implementing and maintaining the system.

Similarly, the higher the correlation between a cost driver and the actual consumption of the associated
activity, the greater the accuracy of the cost assignments. However, it may also be more costly to
measure the more highly correlated cost driver.

(iii) Behavioural Effects: Information systems have the potential not only to facilitate decisions but also
to influence the behaviour of decision-makers. This can be good or bad, depending on the behavioural
effects. In identifying cost drivers, an ABC analyst should consider the possible behavioural
consequence. For example, in a JIT production environment, a key goal is to reduce inventories and
material handling activities to the absolute minimum level possible. The number of material moves may
be the most accurate measure of the consumption of the material handling activity for cost assignment
purposes. It may also have a desirable behavioural affect of inducing managers to reduce the number of
times materials are moved, thereby reducing material.

Dysfunctional behavioural effects are also possible. For example, the number of vendor contacts may be
a cost driver for the purchasing activity of vendor selection. This could induce purchasing managers to
contact fewer vendors, which could result in the failure to identify the lowest-cost or highest-quality
vender.

ABC focuses on the drivers which cause overheads and traces overheads to products in terms of usage
of costs drivers. Therefore, under ABC, a large proportion of overheads are product related. In
traditional costing systems, however, most support overheads are assigned to products in general
arbitrary manner and therefore cannot be related to products. ABC by identifying appropriate cost
drivers and cost pools makes the product costs more accurate and reliable. Further, ABC, in this way,
helps in better cost management and cost control by managing the activities which causes costs.

Miller7 observes that tips for identifying activity drivers include the following:

• Pick activity drivers that correlate with the actual consumption of the activity.

• Minimize the number of unique drivers. Cost and complexity are directly correlated with the number
of drivers.

• Pick activity drivers that encourage improved performance.

• Pick activity drivers that are already available and/or have a low cost of collection.

5. Cost Object .Cost object can be any customer, product, service, contract, project, or other work unit
for which a separate cost measurement is desired. The most common cost object is product or service.
Activity drivers are used to trace activity costs to cost objects. An example of how an activity of a sales
department might be traced to customer segments (cost object).

In this example, the activity of the sales department is “make” sales call. The activity driver is the
number of sales calls. If the objective was to determine the selling cost associated with customer
segment, then the cost objects might be large customers, medium-sized customers, and small
customers. Assume that the make sales calls activity costs ` 5,00,000 and was the only activity of the
department. If the total sales calls made were 5,000, of which 1,000 were made on large customers, 500
on medium customers, and 3,500 on small customers, the cost of each customer segment would be as
follows:
Again, like the Resource Driver Example, as displayed earlier, single activities and activity drivers do not
exist. It is only by tracing other sales department activities like prepare proposals, answer inquires, and
take orders that the total cost for each of the customer segments identified as cost objects could be
determined.

The foregoing examples were intended to be simple and to demonstrate the basic concepts of ABC.
Applications of these concepts in practice can be quite complex. Even the simplest of ABC applications
could involve 5 to 10 resources, 25 or more activites, and 10 to 25 cost objects. That is why it is
important to resist the urge for perfection by defining activities and drivers at too detailed a level,
especially in the early stages of implementation. The goal of ABC is to provide relevant information
useful for decision making, measuring performance, and effecting improvement. Do not give up
relevance for precision.

COST HIERARCHY IN ABC

Accountants often use a cost hierarchy to help them identify activities and then assign costs to these
activities. ABC developers and practitioners have identified a number of general categories for the cost
hierarchy based on different levels of operation.

Accountants are not restricted to these categories; others can also be used to analyze costs when
organizations want to focus on different facets of their operations. For example, costs could be
categorized by business segment or by strategic emphasis, such as quality or protection of the
environment.

General Hierarchy of ABC Costs and Cost Drivers

Level of Activities

Organization-Sustaining

Activities are related to the overall organization and unaffected by number or types of facilities and customers
or by volumes of products, batches, or units.

Facility-Sustaining

Activities are related to the overall operations of a facility and unaffected by number of customers served or by
quantities of products, batches, or units.

Customer-Sustaining

Activities are related to individual or groups of past, current, and future customers and are not driven by total
sales volumes and mix.

Product-Sustaining

Activities support the production and distribution of a single product or line of products.
Batch-Level

Activities performed for each batch of product and not related to the number of units in the batch.

Unit-Level

Activities to produce individual units of goods or services; resource cost is proportional to production volumes
or sales volumes.

Examples of Costs

• Administrative salaries

• Headquarters housekeeping

• Information system salaries

• Accountant salaries and equipment

• Facility janitorial service

• Retail store insurance and heating

• Manufacturing plant manager’s salary

• Depreciation and liability insurance for individual hospitals in a hospital system

• Customer sales representative salaries

• Technical support salaries and supplies

• Customer market research

• Special tools for a customer’s order

• Production line supervisor salary

• Product advertising

• Product design engineer salaries

• Depreciation of equipment used to manufacture one type of product

• Labor cost for new set-up at the beginning of a batch

• Utility costs for heating a kiln for batches of pottery

• Shipping costs for batches

• Material handling wages

• Production workers paid based on quantity produced

• Supplies used to provide services

Examples of Cost Drivers

These costs are typically not allocated because they do not vary with activity volumes. These costs are typically
not allocated except when the organization needs to allocate all product costs for a particular purpose.

• Number of sales calls

• Hours of technical support (not tied to a specific product)

• Number of customers

• Number of engineering change orders

• Number of advertisements

• Machine hours

• Setup hours

• Number of batches

• Weight of orders shipped

• Machine hours

• Units processed

• Materials quantity processed

Source: Leslie G. Eldenburg and Susan K. Wolcott, Cost Management, John wiley and Sons, 2005, p. 262.

The discussion of different activities in ABC cost hierarchy are as follows:

1. Organization-Sustaining Activities

Organization-sustaining activities are tasks or functions undertaken to oversee the entire entity. These
activities occur no matter how many facilities are operated, customers are served, products are sold,
batches are processed, or units are produced. Headquarters office activities and costs, the salaries and
office costs of the chief executive officer and chief financial officer are considered organizationsustaining
because they occur regardless of customer, product-line, batch, or unit volumes. Because many of these
costs are fixed, such as administrative salaries, depreciation, and rent or lease costs, usually no cause-
and-effect relationships exist between organization-sustaining costs and the activities performed at this
level. Therefore, these activity costs are typically assigned to the entire organization and not allocated to
specific product lines, batches, or units.

2. Facility-Sustaining Activities

Facility-sustaining activities are activities undertaken to provide and manage an area, location, or
property. These activities occur no matter how many customers are served, products are sold, batches
are processed, or units are produced. Therefore, they are assigned to the facility and not allocated to
product lines, batches, or units. A company may have manufacturing facilities and/or research centres in
different countries or areas. Each of the manufacturing and researeh facilities may incur costs that do
not vary with levels of activity in the facility, such as facility manager salary, building depreciation,
insurance, and telephone services. These costs would be considered facility-sustaining costs.

3. Customer-Sustaining Activities

Customer-sustaining activities are tasks or functions undertaken to service past, current, and future
customers. These costs tend to vary with the needs of individual customers or groups of customers. The
sales representatives most likely require technical training about possible uses for the company’s
products and their applications in various industries. Training aimed at particular customers would
probably be considered customer-sustaining costs. Similarly, the commissions and fees paid to sales
representatives and agents would be classified as customer-sustaining.

4. Product-Sustaining Activities

Product-sustaining activities are activities undertaken to support the production and distribution of a
single product or line of products. These activities are not related to units or batches, but to individual
products or product lines. Some costs, such as division headquarters, research and development, and
some types of marketing, are incurred exclusively for each product line and do not vary with levels of
production or other activities. These costs are classified as product-sustaining. Some of the product
sustaining costs apply to all of the products within a particular division, while other product-sustaining
costs relate to only a single product.

5. Batch-Level Activities

Batch-level activities are activities undertaken for a group of goods or services that are processed as a
group. Batch-level costs do not relate to the number of units in the batch, but instead to the number of
batches processed. Thus, batch costs increase as the number of batches increases.

6. Unit-Level Activities
Unit-level activities are undertaken to produce individual units manufactured or services produced.
Unit-level activities need to be performed for every unit of good or service, and therefore the cost
should be proportional to the number of units produced.

COMPARISON BETWEEN TRADITIONAL COSTING AND ACTIVITY BASED COSTING

SYSTEM

The following are the differences between the two costing systems:

1. Cost Assignment: Both the costing systems do the costing of a cost object which may be a finished or
semifinished product, a component, an activity, a process consisting of series of activity, a customer, asupplier,
etc., However, the methodology of costing in the two costing systems is different.

Let us take the example of a component as a cost object for doing its costing. The component consumes certain
amount of certain material and labour and that can be exactly measured. So, the costing of direct material and
direct labour can be done in ABC exactly in the same manner as is done in conventional costing system, i.e.,
by multiplying total material consumed by the component by material’s unit price and by multiplying total
labour hours used by the component by the per hour labour rate. To this will be added, the portion of
overheads of the organization that actually got consumed by this component. In conventional costing system, it
is done by loading a percentage of the total overhead cost of the organization to the component. Generally, this
percentage is either the percentage of the labour cost or as the percentage of the material cost of the component
or labour or machine hours as compared to the overall labour cost or overall material cost or total labour or
machine hours of the entire organization. In fact, there is no rationale to it since the component may not have
actually attracted the overheads to it in this manner of percentages.

In ABC, there is a need to find out the actual overhead activities performed on the component. Each overhead
activity is measured in terms of its cost driver, i.e., how many units of that cost driver were actually used by
the component. On each overhead activity, the total cost of that overhead activity is collected at the
organizational level. This is called the overhead cost pool of that activity. Also unit cost of each activity driver
is worked out by dividing the total overhead cost pool of that activity by the total units of the cost driver used
at the organizational level. This gives the actual cost of per unit of the cost driver of that activity. Now, by
multiplying the units of cost driver actually used by the component by this cost driver rate, one can get the
actual cost of that overhead activity performed on the component. The overhead cost is allocated, in this
manner, to the component for all the overhead activities the component used.

In summary, in ABC, each overhead activity has a overhead cost pool at the organizational level, each
overhead activity has a cost driver with its unit of measurement and each cost driver has its unit cost, i.e., the
cost driver cost. In this way, ABC improves product costing procedure (as compared to traditional costing)
because it recognizes that many so-called fixed overhead costs vary in proportion to changes other than
production units. By establishing the link between these cost drivers and fixed overhead costs, they are finally
traced to individual products. Exhibit 3.6 presents an overview of product cost determination under traditional
costing and ABC system.

2. Two-stage Allocation: It can be observed that both the costing systems follow a two stage allocation
procedure. In traditional costing, in the first stage, overhead costs are allocated to production departments. But,
in ABC, in the first stage, overhead costs are assigned to each major activity and not to departments. In
traditional costing, overheads are pooled/collected department-wise. But in ABC, many activity-based cost
pools or cost centres are created. In traditional costing, overhead costs of service departments are
allocated/reapportioned to production departments and therefore in this costing system finally only fewer cost
pools exist. But ABC creates separate cost pools for service activities as well and overhead costs of these
service activities (service department) are assigned directly to specific products through applying cost driver
rates. Thus, in ABC, there is no need to allocate/reapportion overheads of service department.

Comparison of Traditional and Activity-Based Costing System

(a) Traditional product costing system

Stage 1: Overheads assigned to Stage 2: Overheads allocated to products production departments

(b) Activity-based product costing system

Stage 1: Overheads assigned to Cost Stage 2: Overheads assigned to products centres/cost pools using cost
driver rates

3. Use of Historical Costs : Another difference between traditional and activity-based costing is the historical
orientation. It is not unusual for an organization to use actual historical cost as the basis for developing
manufacturing cost standards. These historical costs often include rework, duplication, waste, redundancy, and
inefficiency, Accepting historical costs as given and reflecting these costs in standards does not support
continuous improvement. In a competitive situation, where competitors have been proactive in eliminating
waste and improving activities, an organization can go out of business while meeting its standards. While
activity-based costs are also calculated using historical resource costs, the orientation is different. Proponents
of ABC are concerned about future competitive positions and use historical cost only as a baseline for
improvement. Exhibit 3.7 summarizes the major differences between the two costing systems.

Traditional ABC System

Traditional ABC

1. Cost pools 1. One or limited number 1. Many, to reflect different activities

2. Applied rate 2. Volume-based cost drivers 2. Activity-based, nonfinancial

3. Suited for 3. Labour-intensive, low-overhead 3. Capital-intensive, product-diverse, widely companies

diverse set of operating activities, variation in number of production runs, highoverhead companies.

4. Benefits 4. Simple, inexpensive 4. Accurate product costing, possible elimination of non-value added
activities.

5. Cost assignment 5. Allocates overhead costs first products or services

5. Assigns overhead costs first to activity cost to departments and second to pools and second to products or
services.
6. Focus 6. Focuses on managing costs of responsibility centres. 6. Focuses on managing processes and
activities functional departments or and solutions of cross-functional problems.

ADVANTAGE OF ABC

The following are the advantages of ABC.

1. Accurate Product Cost : ABC brings accuracy and reliability in product cost determination by focusing on
cause and effect relationship in the cost incurrence. It recognizes that it is activities which cause costs, not
products and it is product which consumes activities. This way, ABC does activity accounting.

The primary benefits of activity accounting are that it provides a company with (1) an accurate product cost
and (2) visibility of cost reduction and performance improvement opportunities. Competition increases the
need for an accurate product cost because a company can’t pass on inefficiencies through higher prices.
Perhaps even more important than knowing product cost is having visibility of waste and cost reduction and
performance improvement opportunities to enable management to increase competitiveness.

Uses of Product Cost. Product cost information is required in various forms and at different levels to meet
objectives such as the following:

• Establishing selling prices

• Estimating product cost for new products and special one-time orders

• Determining the profitability for expansion or abandonment of different business segments, such as product
lines, market segments, distribution channels, or customers

• Calculating the gross margins associated with individual products

• Facilitating make/buy decisions on whether to manufacture a part internally or purchase it from an outside
vendor

• Assisting in the investment analysis process

• Valuing inventory and calculating cost of goods sold for external financial reporting purposes

• Assisting in off-shore sourcing decisions.

2. Focus on Non-value Added Costs: ABC systems enable managers to focus on measurement at the activity
level. Once activities are identified and cost drivers are chosen, employees are more aware of cause-and-ellect
relationships. This awareness prompts employees to search for ways to improve performance simply because
they have more information about the cost effects of an activity. By more carefully analyzing activity costs, the
importance and materiality of some non-value-added costs becomemore apparent, and motivation to reduce
those costs increases. In an ABC system, activities that do not add value to customers are more likely to be
identified and eliminated from operations. Examples include holding excess levels of inventories, unnecessary
motion and transportation, waste in the set-up process, and inspection inefficiencies
3. 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.

4. 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. ABC supports many other new management philosophies, including
Total Quality Management (TQM) and continuous improvement. ABC is invaluable in identifying costs that
are related to quality. By developing cost pools driven by efforts to increase quality, or by failure to achieve
acceptable quality (including warranty costs, and perhaps even estimates of customer illwill), ABC provides a
starting point for managers to select areas where improvements are most likely to have significant economic
effects. ABC also helps managers set goals for improvement, such as reducing the costs of inspection by a
given percentage or so that companies can see tangible progress toward TQM10

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

6. Use of Excess Capacity and Cost Reduction: ABC, through the processes of pooling of activity costs and the
identification of cost divers, 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.

7. Benefit to Service Industry: Service organizations, such as banks, hospitals and government departments,
have very different characteristics than manufacturing firm. 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. Absorption costing has generally been considered inappropriate for these organizations, whereas
ABC offers the potential benefits from improved decision making and cost management.

8. Control Over Fixed Cost: ABC attacks the shapeless mass of common costs, decomposing them into
smaller, more homogeneous cost pools related to specific activities. ABC also takes a long-term view of fixed
costs, and in the long run all costs are variable—that is, fixed costs (such as depreciation) merely represent
costs incurred for larger chunks of activity than those paid for on a per unit or per batch basis; when one of
these large chunks of activity is completed, another chunk will have to be purchased. Hence, management must
control fixed costs and take action to reduce them when normal periodic activity levels decline. Certainly,
there are difficult problems in determining how to treat fixed costs in either an OBC or ABC system, since
fixed costs usually represent some amount of capacity of activity that may or may not ultimately be used.

Some argue that activity-based costs would be more useful for short-range decision making if separate rates
were developed for variable costs that changed with the volume of activity, and for fixed costs that do not
change with the volume of activity. Others respond that activity-based costing is intended to assist in making
long-term structural and organizational decisions rather than day-to-day short-range decisions and that all costs
are variable in the long-run. One danger of separating fixed and variable costs in a model for strategic planning
is that decision makers may be left feeling that variable costs are more important than fixed costs because fixed
costs cannot be controlled in the near-term.

Such an attitude leads to continual growth of fixed costs and a feeling of helplessness on the part of managers.
ABC is intended to help reassert control over so-called “fixed” costs (often known as common costs) which
increased dramatically recently.

9. ABC and Strategic Cost Management: Activity-based costing facilitates strategic cost management. ABC
not only shows how activities consume resources and how products or customers trigger activities but also
assigns costs to products or customers according to the resources they consume. ABC describes a firm as a
series of activities whose performance is designed to satisfy customers’ needs. It provides information for
managers to manage activities to improve competitiveness, and achieve strategic goals.

Strategic choices determine activities. Successful firms use their resources on activities that lead to the greatest
strategic benefit. Through measurement of costs of activities and identification of activities in manufacturing
products or providing services, ABC/M helps managers to understand the relationship between the firm’s
strategy and the activities and resources needed to implement the strategy.

10. Managing Constrained Resources: If an organization faces capacity constraints, ABC can help identify
each product’s use of constrained resources. By analyzing the activities within the constraints, efficiency
improvements can be proposed and tested. Thus, ABC information can help managers identify the best way to
relax constraints. ABC information can also be used in designing products and manufacturing or service
delivery processes that minimize use of constrained resources. In addition, by developing an ABC system that
separates committed from flexible costs, managers would have more accurate information to determine the
contribution margin per constrained resource. When products with the highest contribution margin per
constrained resource are emphasized, profits are maximized.

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 ABC

The following are the demerits of ABC:

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

Many costs are associated with designing and using an ABC system. including the following:
• System design costs such as employee time and consulting fees

• Accounting and information system modifications needed to gather and report activity and cost driver
information.

• Employee training to use the ABC system effectively.

Sometimes the cost of developing ABC information is low, especially in cases where the activity cost is
readily available and the number of times the activity is performed can easily be tracked.

2. 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.

3. Disadvantages to Smaller Firms: ABC has different levels of utility for different organization 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.

4. Measurement Difficulties: The main limitations of an ABC system are the measurements necessary to
implement it. ABC system requires management to estimate costs of activity pools and to identify and measure
cost drivers for these people 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. As ABC systems get very detailed and more cost pools
are created, more allocations are necessary to calculate activity costs for each cost pool. This increases the
chances of misidentifying the costs of different activity-cost pools. For example, supervisors are more prone to
incorrectly identify the time they spent on different activities if they have to allocate their time over five
activities rather than only two activities.

According to Shank and Govindarajan at least three major problems with ABC as a formal cost accounting
system deserve careful consideration before deciding where the ABC concept should fit into the broader
context of strategically relevant cost management systems. These problems are as follows :

Problem 1: A static Versus Dynamic View of Cost

ABC assigns all of the current manufacturing costs to products without carying as to whether or not the cost is
legitimate in a strategic sense or adding any value in the value chain. For example, receiving cost would be
assigned to products in proportion to the share of receiving activity each generates. This evaluation is correct
in a static sense, but it may be dangerous in a dynamic sense.

Receiving, as a step in the value chain, does not add much value, if any, to the end product. A dynamic view of
strategically relevant product cost focuses on reducing or even eliminating all costs that are not value added,
such as receiving. In a JIT environment, the receiving cost category is essentially eliminated as components are
received directly at the relevant manufacturing work station only as needed; inbound storage and inspection
and warehouse handling no longer exist.
Focusing on product costs that incorporate all current expenditure levels can be disadvantageous as using
inaccurate cost data. In addition to assigning current activities to the products that currently consume them, a
strategic product costing system must formally acknowledge the need to continually rethink which activities
really add value to the customer and how to perform those activities in the most efficient manner. As indicated
in Exhibit 3.8, only activities in box A should be assigned to products.

Activities in box D need to be examined for ways to improve their efficiency and, ultimately, those activities
should be moved to box A. Activities in box C should be eliminated. One needs to examine whether the
resources devoted to activities in box B can be redeployed in value-adding activities. The ideas contained in
Exhibit 3.8 give rise to the idea that firms need activity-based management (ABM) rather than activity-based
costing systems.

Problem 2: Adherence to an Obsolete Distinction Between Product and Period Costs

ABC is caught up in the distinction between costs that will be inventoried and those that will be expensed.
From the standpoint of financial statement preparation it is, of course, absolutely necessary to worry about
what is accumulated in the balance sheet in inventory accounts and what is expensed directly. But whatever
relevance, if any, this distinction had for managerial purposes has long since gone. In most firms today,
strategically relevant portions of product costs are incurred long before the product even reaches the
manufacturing stage (e.g., research and development costs) and/or long after it leaves the factory (e.g.,
marketing and distribution costs). The costs incurred for design, development, selling, distribution, and
customer service are very relevant components of product cost for strategic analysis.

Problem 3: Costing Products Through Today’s Activity Chain Assumes Today’s Strategy

Even when the focus is on full cost versus only manufacturing cost and when the emphasis is on only the
value-adding activities versus all current activities, ABC still involves accounting for today’s strategy. This
assumption is dangerous when extended into tomorrow. This observation is not a criticism as much as it is a
recognition of a limitation of any formal accounting system. Such systems necessarily account for today, not
tomorrow. Much of strategic analysis and thus strategic cost management involves constantly reevaluating
today’s competitive positioning in favor of alternatives that would be better adapted to current perceptions of
tomorrow’s competitive environment.

EXHIBIT 3.8: Value Engineering the Cost Structure

ABC IN THE SERVICE INDUSTRY

ABC has the same objectives in service firms as in manufacturing organizations. ABC can prove very useful to
many service organizations such as airlines, insurance companies, banks, hospitals, hotels, railways, financial
service firms. In these service organization, managers need accurate information about the cost of services
being provided by them. Further, such service firms require to use this information to improve their operations
and to fulfill the needs of their customers in a more cost effective manner.

Large-scale service organizations have a number of features that have been identified as being necessary to
derive significant benefits from the introduction of ABC:

(i) They operate in a highly competitive environment;

(ii) They incur a large proportion of indirect costs that cannot be directly assigned to specific cost objects;

(iii) Products and customers differ significantly in terms of consuming overhead resources;

(iv) They market many different products and services.

Furthermore, many of the constraints imposed on manufacturing organizations, such as having to meet
financial accounting stock valuation requirements, or a reduction to change or scrap existing systems, do not
apply.

The general approach of identifying activities, activity cost pools, and cost drivers may be used in the service
industry as well as in manufacturing. The classification of activities into unit-level, batchlevel, product-
sustaining level and facility-level activities also applies in service industry settings.

Kaplan and Cooper suggest that service companies are ideal candidates for ABC, even more than
manufacturing companies. Earlier, service organizations were government-owned or operated in highly
regulated, protected and non-competitive environment. Thus, service organizations were not under any
pressure to improve profitability by eliminating non-value added or non-profit activities. The prices of services
were simply increased to cover cost increases. No efforts was made to design a cost system that accurately
measures the costs and profitability of individual services.

However, due to privatization, deregulation and increasing competition, the service organizations need to have
cost and management accounting systems which can help them to accurately measure cost and resulting
profitability for their services, customers and markets. Therefore, ABC would prove advantageous to service
organizations to understand their cost base and to make decisions on valueadded/non-value added activities.

The uses for ABC information for service industries are similar to those for manufacturing organizations:

(i) It leads to more accurate product costs as a basis for pricing decisions when cost-plus pricing methods are
used;

(ii) It results in more accurate product and customer profitability analysis statements that provide a more
appropriate basis for decision-making;

(iii) ABC attaches costs to activities and identifies the cost drivers that cause the costs. Thus ABC provides a
better understanding of what causes costs and highlights ways of performing activities more effectively by
reducing cost driver transactions. Costs can therefore be managed more effectively in the long term. Activities
can also be analysed into value added and nonvalue added activities and by highlighting the costs of non-value
added activities attention is drawn to areas where there is a potential for cost reduction without reducing the
products’ service potentials to customers.

Kaplan and Cooper illustrate the use of ABC in banks for product and customer profitability analysis. The
following are some of the activities and cost drivers in bank as identified by Kaplan and Cooper18.
Drury and Tayler 19 after making survey of UK Companies have concluded that service organization are more
likely to implement ABC systems. They found that 51% of the financial and service organization surveyed,
compared with 15% of manufacturing organizations, had implemented ABC.

Difficulties in Implementing ABC in Service Industry

The following are the difficulties for the application of ABC:

(i) Facility sustaining costs (such as property rents, etc.,) represent a significant proportion of total costs and
may only be avoidable if the organization ceases business. It may be impossible to establish appropriate cost
drivers;

(ii) It is often difficult to define products where they are of an intangible nature. Cost objects can therefore be
difficult to specify;

(iii) Many service organizations have not previously had a costing system and much of the information
required to set up an ABC system will be non-existent. Therefore, introducing

ABC is likely to be expensive.

CRITERIA FOR SUCCESSFUL IMPLEMENTATION OF ABC SYSTEM

For an ABC system to be successful, a business organization must embrace this system and use it for all
management decision-making. According to Guin20 the success of ABC system depends on the four key
factors.

1. The system has top management support.

2. The ABC methods are understandable and explainable.

3. The system is accessible

4. Internal people take ownership of the system.

1. Top management support is critical. An ABC system changes a company’s perspective of its business. As
such, the organization has winners and losers. The losers are likely to fight the system unless senior
management voice confidence in it. Senior executives should provide briefings and training about ABC to their
employees. In addition, most people are resistant to change, and unless change is forced, a new idea can
whither away.

2. For the ABC system to be successful, the company’s employees must understand it and its results. The ABC
system must represent how the company’s activities consume resources and how its products or customers
trigger those activities. Simplifying assumptions are not only allowable but necessary; the system cannot
become too complex. If a system is not understandable, it is not credible.
At the same time the system must accurately report product costs. The results must appear intuitively correct.
Assignment schemes should not be arbitrary. If one part is more expensive than another, and the difference
cannot be explained, the system will not have credibility. Without credibility, the system will fail.

3. The ABC system must be accessible by all potential users. All potential users of an ABC system must have
timely, convenient access to the cost system. This is one important reason an integrated cost system is superior
to a stand-alone system. Integrated cost systems are accessible from any information system terminal in the
company. No non-integrated system can match this availability.

Restricting access to the system also breeds distrust. Users are naturally skeptical of new systems. Many users
only feel comfortable with the system after prolonged experimentation.

4. The implementation site’s personnel must gain ownership to the system. This holds true for all new systems.
Unless someone is committed to the new idea and champions it, overcoming all obstacles to its
implementation, the idea bogs down and withers away. A cost system is no exception. In addition, only with
in-house expertise will the system become an evolving entity, growing and responding to new company needs.

Bahnub advises practioners and managers to learn a few lessons for implementing ABC successfully.

ABC Lessons Learned

• Begin with the end in mind

• Obtain “correct” alignment

• Is the climb worth the view ?

• Transparency, accuracy, automation, and precision

• Focus on the process, not the people

• Leverage and improve systems and processes

• Leverage and reinforce quality improvement initiatives.

Source: Brent Bahnub, Activity-Based Management for Financial Institutions, John Wiley and Sons, 2010, p.
161.

These implementational guidelines have been discussed below.

1. Begin with the End in Mind

One prerequisite in ABC is “Begin with the end in mind.’’ Who will be accountable for changing processes,
products, and customer behaviours based on the ABC information? How will they be held accountable? What
types of information will they need? How will the data be delivered? Is there an opportunity to make this an
iterative development process to generate quick wins?
As ABC leader, one needs to know the answers to these questions in order to describe the future state and
inspire others to reach this objective.

2. Obtain “Correct” Alignment

ABC/M should not be viewed as only an accounting project, or IT project. This is a narrow view of ABC/M.
ABC/M is a business project which requires IT enablement. Overall, project management and sponsorship
need to reside in the area accountable for improving the bottom line using ABC data.

3. Is the Climb Worth the View?

ABC should focus on myriad of detailed data, analyis and thereby pinpoint a method of quantitatively and
qualitatively estimating the costs and benefits of these alternatives. Additionally, business firms need a steering
committee (or ABM Board) to help resolve these choices. As ABC/M effort evolves, one need to modify the
approach: “If the map differs from the terrain, follow the terrain,”

4. Transparency, Accuracy, Automation and Precision

Two common pitfalls in ABC implementations are a lack of transparency (sometimes it even becomes
downright secrecy) and a premature drive to automation. The order of transparency, accuracy, automation, and
precision is important. A lack of transparency leads to distrust in the data and a plethora of questions regarding
the ABC calculations and drivers. This results in more investigative work by the ABC implementation team.
On the other hand, transparency allows users to kick the tires, validate the results, and point out opportunities
for improvements. Similarly, attempts to prematurely automate the system can be a waste of project resources.
In the beginning, use “good” existing automated sources (including proxy drivers) in lieu of “better” manual
sources that require significant automation effort. After the ABC data has been validated and it is clear the data
will be used, prioritize the automation of drivers. It makes no sense to automate a data source that is not used
or is marginally useful. If there are ways to improve the model accuracy with little increased effort, make the
changes. However, if users maintain the ABC model is not “right” but have no helpful improvement
suggestions, be very cautious.

5. Focus on the Process, Not the People

Even though most people recognize that logically the process is responsible for the results, in many cases
people are rewarded or punished as if they were the majority contributors of the outcome. Sales personnel are
commonly both beneficiaries and victims of this misguided thinking. The quality field understands that most
results are process-driven, including sales The ABC team needs to follow this philosophy, as well, for two very
important reasons. First only by changing the process one can materially and permanently change the results.
Second, focusing on the process takes a lot of the emotion associated with personal pride out of the equation.
People want to perform meaningful and quality work. Any implication to the contrary is an attack on their
value and sense of worth.

6. Leverage and Improve Systems and Processes

The ABC system needs data. It is a classic GIGO (garbage in, garbage out) system. If the driver input is
accurate and timely, the ABC output will be more accurate and timely. Therefore, business firms should use
every opportunity to use and improve existing resource and activity driver sources.
7. Leverage and Reinforce Quality Improvement Initiatives

Just as existing systems and processes can be utilized and reinforced by the ABC system, quality improvement
initiatives should have a mutually beneficial relationship with ABC. Further, ABC can be beneficial to the
balanced scorecard as well. Specifically, activity costs and drivers can be used as metrics within the balanced
scorecard. For example, through the use of ABC, error-related activity costs can be viewed on a monthly basis
and included as a tracking metric for the

Internal Business Process perspective. Additionally, customer and product profitability may be key metrics in
the Financial perspective.

SITUATIONS UNDER WHICH ABC CAN BE APPLIED

Activity-based costing is useful in companies having the following characteristics:

1. the production or performance of a wide variety of products or services;

2. high overhead costs that are not proportional to the unit volume of individual products;

3. significant automation that has made it increasingly more difficult to assign overhead to products using the
traditional direct labour or machine hour bases;

4. profit margins that are difficult to explain; and

5. hard-to-make products that show big profits and easy-to-make products that show losses22.

1. Product Variety and Product Complexity

Product variety is commonly associated with a need to consider activity-based costing. Products may be
variations of the same product line (such as Archies’s different types of greeting cards), or they may be in
numerous product families (such as Hindustan unilever’s detergents, diapers, fabric softeners, and shampoos).
In either case, product additions cause numerous overhead costs to increase.

Companies with complex products, services, or processes may want to investigate ways to reduce that
complexity. Management may want to review the design of the company’s products and processes to
standardize them and reduce the number of different components, tools, and processes required.

Process complexity reflects numerous non-value-added activities and thus causes time delays and costs
increases.

Many traditional cost systems are not designed to account for information such as how many different parts are
used in a product, so management cannot identify products made with low-volume or unique components.
Activity-based costing systems are flexible and can gather such details so that persons involved in
reengineering efforts have information about relationships among activities and cost drivers. Armed with these
data, reengineering efforts can be focused on the primary causes of process complexity and on the causes that
create the highest levels of waste.
2. Lack of Commonality in Overhead Costs

Certain products and services create substantially more overhead costs than others. Although some of these
additional overhead costs may be caused by product variety or product/process complexity, others may be
related to support services. For example, some products require significant levels of advertising; some use high
cost distribution channels; and some necessitate the use of hightechnology machinery. If only one or two
overhead pools are used, overhead related to specific products will be spread over all products. The result will
be increased costs for products that are not responsible for the increased overhead.

3. Problems in Current Cost Allocations

If a company has undergone one or more significant changes in its products or processes (such as increased
product variety or business process re-engineering), managers and accountants need to investigate whether the
existing cost system still provides a reasonable estimate of product or service’ cost. Many companies that have
automated their production processes have experienced large reductions in labour and large increases in
overhead costs. In such companies, using direct labour as an overhead allocation base produces extraordinarily
high application rates.

Products made using automated equipment tend to be charged an insufficient amount of overhead, whereas
products made using high proportions of direct labour tend to be overcharged Traditional cost allocations also
generally emphasize the assignment of product costs to products, at the same time the majority of period costs
are expensed as incurred. Activity-based costing recognizes that some period costs (such as R&D and
distribution) may be distinctly and reasonably associated with specific products and thus should be traced and
allocated to those products. This recognition changes the traditional view of product versus period cost.

4. Changes in Business Environment

A change in a company’s competitive environment may also require better cost information. Increased
competition may occur for several reasons: (1) other companies have recognized the profit potential of a
particular product or service, (2) the product or service has become cost-feasible to make or perform, or (3) an
industry has been deregulated. If many new companies are competing for old business, the best estimate of
product or service cost must be available to management so that profit margins and prices can be reasonably
set.

Changes in management strategy can also signal a need for a new cost system, for example, if management
wants to begin new operations, the cost system must be capable of providing information on how costs will
change. Confirming management’s view of costs to the traditional variable versus fixed classifications may not
allow such information to be effectively developed.

ILLUSTRATIVE PROBLEMS

Problem 1

Surya Hotel uses activity-based costing to determine the cost of servicing customers. There are three activity
pools: guest check-in, room cleaning, and meal service. The activity rates associated with each activity pool
are ` 6.90 per guest check-in, ` 16.40 per room cleaning, and ` 3.10 per served meal (not including food).
Sonali visited the hotel for a 4-night stay. Sonali had three meals in the hotel during her visit. Determine the
total activity-based cost for servicing Sonali for this visit.

Solution:

Guest check-in ` 6.90 (1 check-in × ` 6.90)

Room cleaning 65.60 (4 nights × ` 16.40)

Meal service ` 9.30 (3 meal × ` 3.10)

Total activity cost ` 81.80

Problem 2

The total factory overhead for Continental Styles, is budgeted for the year at ` 3,60,000. Continental
manufactures two types of men’s pants: Jeans and khakis. The jeans and khakis each require 0.15 direct labour
hour for manufacture. Each product is budgeted for 20,000 units of production for the year.

Determine (a) the total number of budgeted direct labour hours for the year, (b) the single plant factory
overhead rate, and (c) the factory overhead allocated per unit for each product using the single plant wide
factory overhead rate.

Solution:

(a) Jeans: 20,000 units × 0.15 direct labour hour = 3,000 direct labour hours

Khakis: 20,000 units × 0.15 direct labour hour = 3,000 direct labour hours 6,000 direct labour hours.

(b) Single plantwide factory overhead rate: ` 3,60,000/6,000 dlh = ` 60 per dlh

(c) Jeans : ` 60 per direct labour hour × 0.15 dlh per unit = ` 9/unit Khakis: ` 60 per direct labour hour × 0.15
dlh per unit = ` 9/unit.

Problem 3

Ratna Food Company manufactures three types of snack foods; tortilla chips, potato chips, and pretzels. The
company has budgeted the following costs for the upcoming period:

` Factory depreciation 12,900

Indirect labour 30,200

Factory electricity 3,500

Indirect materials 6,650

Selling expenses 17,025

Administrative expenses 9,600

Total costs 79,875

Factory overhead is allocated to the three products on the basis of processing hours. The products had the
following production budget and processing hours per case:

Budgeted Production

Processing Hours

volume (cases) per Case

Tortilla chips 3,000 0.12

Potato chips 4,800 0.10

Pretzels 1,500 0.15

Total 9,300

Required:

(a) Determine the single plant wide factory overhead rate:

(b) Use the factory overhead rate in (a) to determine the amount of total and per-case factory overhead
allocated to each of the three products under generally accepted accounting principles.

Solution:

(a)Single Plant wide Factory Overhead Rate =

` 53 250 1 065 , * , sin per proces g

= ` 50 per processing hour

*` 79,875 – ` 9,600 – ` 17,025

The selling and administrative expenses are not factory overhead.

*Total processing hours:

Budgeted Production × Processing Processing Volume(cases) Hours per Case = Hours

Tortilla chips 3,000 × 0.12 = 360

Potato chips 4,800 × 0.10 = 480

Pretzels 1,500 × 0.15 = 225

Total 9,300 1,065

(b) Single Plantwide Factory Overhead per Case

Factory Over-head Factory (Factory Overhead

Processing × Rate per = Overhead Budgeted Volume)

Hours Processing Hour

Totilla chips 1,360 × 50 = 18,000 ` 18,000  3,000 cases = ` 6.00

Potato chips 1,480 × 50 = ` 24,000 ` 24,000  4,800 cases = ` 5.00

Pretzels ,225 × 50 = 11,250 ` 11,250  1,500 cases = ` 7.50

Total 1,065 ` 53,250

REVIEW QUESTIONS
1. What is Activity-Based Costing? Why is it needed?

2. What is a cost driver? What is the role of cost driver in tracing costs to products?

3. Explain the steps in applying Activity-Based Costing (ABC) in a manufacturing company.

4. How are activities grouped in a manufacturing company?

5. Distinguish between activity-based costing and traditional costing system.

6. What are the benefits of activity-based costing?

7. Define unit level activities, batch level activities, product level activities and facility level activities.

8. “Overhead costs are source of product cost distortion.” Do you agree? Explain.

9. What are the four basic steps required for activity-based costing?

10. Give the criterion for choosing cost drivers for allocating costs to products.

11. Why are conventional product-costing systems more likely to distort product costs in highly automated plants? How
do activity-based costing systems deal with such a situation?

12. “Activity-based costing systems yield more accurate product costs than conventional systems because they
use more cost drivers to assign support costs to products.” Do you agree with this statement? Explain.

13. What are unit level activities? Batch level activities? Product-level activities? Facility-level activities?
14. “Attributing direct costs and absorbing overhead costs to the product/service through an activity-based
costing approach will result in a better understanding of the true cost of final output.” You are required to
explain and comment on the above statement.

15. What is an activity-based approach to designing a costing system?

16. Describe four levels of cose hierarchy.

17. What are the key reasons for product cost differences between traditional costing systems and ABC systems.

18. “ABC systems only apply to manufacturing companies.” Do you agree? Explain.

19. “Activity-based costing is the wave of the present and the future. All companies should adopt it.” Do you agree?
Explain.

20. What is volume-based overhead rate?

21. Explain the limitations of volume-based costing system.

22. Why is product cost distorted in traditional costing system?

23. Under what situations traditional costing can be applied?

24. Explain the following:

(i) Resource Drivers, (ii) Activities, (iii) Activity Cost Drivers.

25. Discuss the flow of costs in ABC.

26. Discuss activity cost drivers.

27. What are short-term and long-term variable cost in ABC?

28. What are the factors in selecting cost drivers?

29. What are different types of cost drivers?

30. What is cost object?

31. Explain the following:

(i) Unit level activities

(ii) Batch level activities

(iii) Product level activities

(iv) Facility level activities.

32. Distinguish between traditional costing and activity-based costing.

33. In what way accurate product costs are useful to management?

34. How are fixed costs controlled better in ABC than in traditional costing system?

35. What are the problems associated with ABC?

36. Discuss the use of ABC in service industry.

37. Discuss the situations under which ABC can be used most appropriately.

38. How do the product complexity and process complexity make costing system more complex?

39. The following are six cost pools established for a company using activity-based costing. The pools are related to the
company’s products using cost drivers:

Cost Pools:

(a) Inspection of raw materials.

(b) Production equipment repairs and maintenance.

(c) Raw materials storage.

(d) Plant heat, light, water and power.

(e) Finished product quality control.

(f) Production line set-ups.

Required: For each of the preceding cost pools, identify a possible cost driver.

40. Explain why overcosting and undercosting products occur with traditional costing systems.

41. What is activity-based costing ? Distinguish between ABC and traditional costing system. Explain
advantages of activity-based costing.

42. Why might ABC be useful in a company with only one product?

43. Explain why a costing system that uses either a plant wide or a departmental overhead rate is likely to
produce distorted product costs.

44. Explain how a traditional, Volume-based product costing system operates. What are cost drivers? What is
their role in an activity based costing systems?

45. What is the role of an activity dictionary in an ABC project?

46. Explain why a manufacturer with diverse product lines may benefit from an ABC system?

47. Are ABC systems appropriate for the service industry?

48. Why would management be concerned about the accuracy of product costs?

49. Under what conditions would the multiple production department factory overhead rate method provide
more accurate product costs than the single plantwide factory overhead rate method?

50. How can activity based costing be used in service companies?

51. “Activity-based costing is great for manufacturing companies but it does not really address the needs of the
service sector.” Do you agree? Explain.

52. “One of the lessons learned from activity-based costing is that all costs are really a function of volume.”
True, False, Uncertain? Explain.

53. Would you expect companies that adopt ABC to add value to shareholders? How would you measure such
added value?

54. “Activity-based costing is for accountants and production managers. I plan to be a marketing manager, so
ABC would not help me.” Do you agree with this statement? Explain.

55. In a televised cricket game, what activities are value added? What activities are non-value added? Would
everyone agree with your choices? Why or why not?

56. “Are all companies likely to benefit to an equal extent from adopting ABC.” Discuss.

57. “It is often claimed that ABC provides better information concerning product costs than traditional
accounting techniques. It is also sometimes claimed that ABC provides better information as a guide to
decision-making. However, one should treat these claims with caution. ABC may give a different impression
of product costs but it is not necessarily a better impression. It may be wiser to try improving the use of
traditional techniques before moving to ABC.”

Requirements:

(a) Explain the ideas concerning cost behaviour which underpin ABC. Explain why ABC may be better
attuned to the modern manufacturing environment than traditional techniques. Explain why a company might
or might not obtain a more meaningful impression of product costs through the use of ABC.

(b) Explain how the traditional cost accounting system being used by a company might be improved to provide
more meaningful product costs.

(c) Critically appraise the reported claim that ABC gives better information as a guide to decision-making than
do traditional product costing techniques.
58. “The traditional methods of cost allocation, cost apportionment and absorption into products are being
challenged by some writers who claim that much information given to management is misleading when these
methods of dealing with fixed overheads are used to determine product costs.”

You are required to explain what is meant by cost allocation, cost apportionment and absorption and to
describe briefly the alternative approach of activity-based costing in order to ascertain total product costs.

59. “It is now fairly widely accepted that conventional cost accounting distorts management’s view of business
through unrepresentative overhead allocation and inappropriate product costing. This is because the traditional
approach usually absorbs overhead costs across products and orders solely on the basis of the direct labour
involved in their manufacture. And as direct labour as a proportion of total manufacturing cost continues to
fall, this leads to more and more distortion and misrepresentation of the impact of particular products on total
overhead costs.” You are required to discuss the above and to suggest what approaches are being adopted by
management accountants to overcome such criticism.

60. ‘Attributing direct costs and absorbing overhead costs to the product/service through an activity-based
costing approach will result in a better understanding of the true cost of the final output.’ You are required to
explain and comment on the above statement.

61. “The basic idea justifying the use of Activity-Based Costing (ABC) and Activity-Based Budgeting (ABB)
are well publicised, and the number of applications has increased. However, there are apparently still
significant problems in changing from existing systems”.

Requirements:

(a) Explain which characteristics of an organization, such as its structure, product range, or environment, may
make the use of activity based techniques particularly useful.

(b) Explain the problems that may cause an organization to decide not to use, or to abandon use of, activity
based techniques.

(c) Some categorisations of cost drivers provide hierarchical models:

(i) unit-level activities, (ii) batch activities, (iii) product sustaining activities, (iv) facility sustaining activities.

Other analyses focus on ‘value adding’ and ‘non-value adding’ activities.

Explain what is meant by ‘non-value adding activities’, and discuss the usefulness of this form of analysis.

62. “Large service organizations, such as banks and hospitals, used to be noted for their lack of standard
costing systems, and their relatively unsophisticated budgeting and control systems compared with large
manufacturing organizations. But this is changing and many large service organizations are now revising their
use of management accounting techniques.’’

Requirements:
(a) Explain which features of large-scale service organizations encourage the application of activity-based
approaches to the analysis of cost information.

(b) Explain which features of service organizations may create problems for the application of activitybased
costing.

(c) Explain the uses for activity-based cost information in service industries.

(d) Many large service organizations were at one time state-owned, but have been privatised Examples in some
countries include electricity supply and telecommunications. They are often regulated. Similar systems of
regulation of prices by an independent authority exist in many countries, and are designed to act as a surrogate
for market competition in industries where it is difficult to ensure a genuinely competitive market.

Explain which aspects of cost information and systems in service organizations would particularly interest a
regulator, and why these features would be of interest.

EXERCISES

1. The Commissioner of Municipal Corporation, Delhi is dissatisfied with rising costs and deteriorating quality
of the services provided by the municipal workers, particularly in the Public Works Department; paving

roads, repairing potholes, and cleaning the streets. He is contemplating privatizing these services by
outsourcing the business to independent, private contractors. The Commissioner has demanded that his staff
develop an activity-based cost system for municipal services. However, before proceeding with his
privatization initiative, he declared, “Introducing competition and privatization to government services requires
real cost information.

You can’t compete out if you are using fake cost.” Currently, the accounting and financial systems of Delhi
City report shows only how much is being spent in each department, by type of expenditure, payroll, benefits,
materials, vehicles, equipment (including computers and telephones) and supplies.

Required:

(a) Before outsourcing to the private sector, why does the Commissioner want to develop activity-based cost
estimates of the current cost of performing these municipal services?

(b) After building activity-based cost models, should this information be shared with the municipal workers?
Why or why not? How might the workers use the ABC information?

2. Banks have a variety of products, such as savings accounts, cheque facility accounts, Term Deposits (TDs),
and loans. Assume that you were assigned the task of determining the administrative costs of “savings
accounts” as a complete product line. What are some of the activities associated with savings accounts? In
answering this question, consider the activities that you might perform with your savings account. For each
activity, what would be an activity base that could be used to allocate the activity cost to the savings account
product line?
3. The controller of Apollo System Co. devised a new costing system based on tracing the cost of activities to
products. The controller was able to measure post-manufacturing activities, such as selling, promotional, and
distribution activities, and to allocate these activities to products in order to have a more complete view of the
company’s product cost. This effort produced better strategic information about the relative profitability of
product lines. In addition, the controller used the same product cost information for inventory valuation on the
financial statements. Surprisingly, the controller discovered that the company’s reported net income was larger
under this scheme than under the traditional costing approach. Why was the net income larger, and how would
you react to the controller’s action?

4. Classify the following cost drivers as structural, executional, or operational: (a) Number of plants (b)
Number ol moves (c) Degree of employee involvement (d) Capacity utilization (e) Number of product lines (f)
Number of distribution channels (g) Engineering hours (h) Direct labour hours (i) Scope (j) Product
configuration (k) Quality management approach (l) Number ot receiving orders (m) Number of defective units
(n) Employee experience (o) Types of process technologies (p) Number ol purchase orders (q) Types and
efficiency of layout (r) Scale (s) Number ol functional departments (t) Number of planning

5. Match each of the following activities to the most likely activity level for a bank. Suggest a feasible cost
driver base for each, and explain why you think that your chosen cost-driver bases are feasible.

Activity Activity Level

1. Sales calls—existing commercial customers (a) Unit

2. Sales calls—new commercial customers (b) Batch

3. Commercial loan negotiation (c) Product

4. Commercial loan review (d) Customer

5. Customer file maintenance (e) Facility

6. Community involvement

7. Employee relations

8. Commercial loan customer service

9. Consumer loan customer service

10. Consumer loan review

11. Consumer deposit/withdrawal processing

12. Commercial deposit/withdrawal processing

13. Advertising particular products.