Activity Based Costing (ABC)

AIM 4343 02/16/2004

Activity Based Costing
 View the manufacturing organization as a
collection of distinct activities.
 These activities are the fundamental building
blocks of the cost system.
 The focus is not on departments but on
distinct activities that are carried out in
departments.
 Ultimate objective is accurate product
costing.
Operational Steps in ABC
 Set up a two-stage system with
minimum top-layer pools and maximum
intermediate-layer pools.
 Choose activities not departments as
your intermediate cost objects.
 Allocate costs from top-layer pools to
activities and also trace costs by
activities.
 Identify a cost driver in each activity
area.
 Allocate a particular activity cost to all
the products (using that activity) through
the chosen driver.
 Make sure that excess capacity costs
are not allocated.
Different types of activities
 Unit level activities: This type of activity
must be carried out on each unit of
production. A machine-related activity
cost pool represents a unit level activity
since every product unit may require
machining time.
 Batch-related activities: Performed each
time a batch of goods is produced.
These are independent of number of
units in the batch. E.g., set-up,
purchase orders processing, production
scheduling, first-item inspection etc.,
 Product-sustaining activities: Performed
to enable individual products to be
produced and sold. The resources
consumed by activities are independent
of units or batches of product. E.g.,
process engineering, product design,
product enhancement etc.,
 Facility-sustaining activities: Not related
to volume and mix of individual
products. E.g., plant management,
building maintenance, security etc.,
Differences between traditional
costing systems and ABC
 Traditional costing systems: Intermediate cost
objects are typically departments - indirect
costs are generally allocated through volume-
based drivers (number of units, direct labor
hours etc.,) to products.
 ABC: Intermediate cost objects are activities
- allocation through cost drivers (number of
set-ups, number of parts etc., need not be
volume-based) to products.
Firms for which ABC is
especially useful
 Firms that have,
• High overhead costs.
• Diverse set of operating activities.
• Diverse range of products.
• Wide variation in number of production
runs and costly setups.
Activity Based Management (ABM)
 ABC is only one component of a total
cost management system.
 It should be followed by ABM.
 ABM involves using knowledge gained
in the design of ABC for continuous
improvement activities.
Indicators for implementation of ABC
 Complex products that are difficult to manufacture
are reported to be very profitable although they are
not priced at a premium.
 Line managers do not believe product costs reported
by accounting department.
 Company is losing bids it is supposed to win.
 Company is outsourcing products in which it has
expertise in manufacturing.
 Competitors’ high volume products are priced
unrealistically low.