Unit - 3

Activity Based Costing

 Activity Based Costing – Introduction
1.Cost Accountancy is the application of Costing and Cost
Accounting principles, methods and techniques to the
science, art and practice of cost control and the
ascertainment of profitability. It includes the
presentation of information derived therefrom for the
purpose of managerial decision-making.
2.Traditional Cost Accounting is Product-oriented
Costing wherein Direct Costs are charged directly to
the cost units and the Indirect Costs are charged
through Allocation, Apportionment and Absorption
3.Traditionally, Absorption Costing is used
 Cost Composition and Treatment
– Traditional Cost Accounting
Total Cost:
1.Direct Costs identified and charged to Cost Units – no
difference between Conventional Costing and ABC
2.Indirect Costs (Overhead Expenses)
• Allocated to Production and Service Departments
• Apportioned to Production and Service Departments on some
basis
• Service Department Costs are re-apportioned to Production
Departments on some basis
• Production Department Costs are absorbed by Products on
some basis (usually, production)
3. Distorts cost of the product as the base is not
objective.
Cost Composition and Treatment
– Traditional Cost Accounting
Traditional Absorption Costing was
Suitable when ……
1.Direct Labour Costs and Direct Material Costs
were dominant factory costs, and Overhead
Expenses were relatively small
2.Information Processing Costs were high
3.Absence of intense global competition
4.Low levels of automation
5.Limited Product Range
 But Now,
The above factors have changed –
1.Substantial improvement in the use of automation
and mechanization
2.Mechanization leading to increase in overhead
expenses and reduction in the relative share of
labour costs
3.Presence of global competition and wide range of
product lines, etc
The above changes have necessitated the change the
method of accounting for costs.
But Now, today’s businesses are
working in an increasingly complex
environment,
1.Use of Advanced Technology
2.Product Life Cycle
3.Product Complexity
4.Channels of Distribution
5.Quality Requirements
6.Product Diversity
 Composition of Cost

100

0
1 2 3 4
Direct Material Labour Overheads
 Inadequacies of Traditional Methods
of Overhead Absorption
Product cost under Traditional Absorption Costing
System is not so accurate due to many reasons.
1.There has been a systematic distortion of product costs due
to the use of inappropriate volume-based methods for
production overhead apportionment
2.Convenient overhead recovery basis and blanket overhead
recovery are acceptable when valuing stocks for financial
reporting, but not for decision making and typical product
strategy decisions.
3.Lack of visibility and transparency in the case of
increasingly important areas of overhead expenses.
 Inadequacies … (contd)
4. The traditional fixed versus variable split is often
unrealistic. because, as business grows they often
become more complex – variable???
5. Non-factory overheads have been neglected even
though these comprise of significant elements of
overhead expense – they are essential not unproductive
or waste
6. The multi-product companies usually make decisions
on pricing, product mix, process technology, etc
based on distorted cost information due to difficulties in
Traditional Costing System
7. The cost structure is changing reducing direct labour
component to small proportion – mechanization and
automation
 Inadequacies … (contd)
8. Traditional Costing System is often unable to
determine accurately the actual costs of
production and of the related services
9. Traditional Accounting was confined merely to
furnishing information at product level. The new
manufacturing technology demands the feedback
on performance while production is still in
progress rather than history
10. There is also an urgent need to integrate the
activity measurement and financial measurement
Hence, the need for a new mechanism - ABC
ABC - Concept, Meaning and Definition
1.ABC emphasizes on the need to obtain a better
understanding of the behaviour of overhead costs and
ascertains what causes overhead costs and how they relate to
product.
2.It assumes that activities cause costs and that products create
the demand for activities. Costs are assigned to products on
the demand for activities.
 Concept …. (contd)
3. Activity is an aggregate of closely related tasks [eg.,
Customer Processing Activity = (1) Receiving orders from
the customers, (2) Interacting with the Production
Department regarding capacity to produce, (3) Giving
commitment to consumer regarding delivery time, (4) Actual
delivery, etc].
4. ABC is the cost attribution to cost units on the basis of
benefit received from indirect activities e.g., ordering,
setting up, assuring quality, etc.
5. ABC is a system of costing which assigns costs first to the
activities that are the real cause of the overhead. It then
assigns the cost of these activities only to the products
that are actually demanding and using the activities.
 Concept … (contd)
6. ABC is a system that first accumulates overhead
costs for each of the activities of the area being
costed, and then, assigns the costs to the products,
services or other cost objects that require that
activity.
7. ABC is a system based on activities linking
organizational spending on resources, on products
and services produced and delivered to customers.
8. ABC is the collection of financial and operation
performance information tracing the significant
activities of the firm to product costs.
 Basics of ABC
1.Cost of a product is the sum of the costs of all
activities required to manufacture and deliver
the product.
2.Products do not consume costs directly.
3.Activities are consumed by product/services
4.Money is spent on activities.
5.ABC assigns Costs to Products by tracing
expenses to “activities”. Each Product is
charged based on the extent to which it used an
activity.
 Basics (contd)
6. The primary objective of ABC is to assign
costs that reflect the physical dynamics of the
business.
7. Provides ways of assigning the costs of
indirect support resources to activities,
business processes, customers, products.
8. It recognizes that many organizational
resources are required not for physical
production of units of product but to provide a
broad array of support activities.
 Kaplan and Cooper’s Approach to
ABC
1.Kaplan and Cooper of Harvard Business School
developed this new system for the ascertainment of
product costs.
2.Initially, they focussed on manufacturing industry
where increasing technology and productivity
improvements have reduced the relative proportion
of the direct costs of labour and materials, but have
increased relative proportion of indirect costs.
3.Later, this system has been extended to other sectors
of the economy as the developments in other sectors
resemble that of manufacturing sector.
 Kaplan (contd)
4. They suggest to classify the costs into two broad
categories viz., (a) Short-term Variable Costs
(popularly called, Variable Costs), and (b) Long-
term Variable Costs (popularly called, Fixed Costs)
 Kaplan (contd)
5.Short-term Variable Costs are volume
related and change proportionately with
the volume of production, and the Long-
term Variable Costs vary in long-term but
not instantaneously.

6.They argue that the overhead costs are

influenced by the forces behind them viz.,
Cost Drivers.
 Cost Drivers
1.Cost Drivers are those activities or transactions that
are significant determinants of costs.
2.Cost Driver is an activity which generates costs.
3. Kaplan and Cooper’s approach to ABC is based on the
belief that, “activities cause costs and a link should,
therefore, be made between the activities and products
by assigning costs of activities to products based on an
individual product’s demand for each activity.”
4. Cost Drivers are used to describe the events or forces that
are the significant determinants of the cost activities.
 Cost Drivers (contd)
1. An activity driver is a quantitative measure of the output
of an activity. In other words, a change in the level of cost
driver will cause a change in the level of the total cost of a
related cost object.
2. The linkage between activities and cost objects such as
products, customers, etc is accomplished by using activity
drivers.
3. Cost Driver is any output measure that causes costs (i.e.,
causes the use of costly resources)
4. The selection of an activity driver reflects a subjective
trade-off between accuracy and cost of measurement
5. For example, Production Scheduling Cost is generated
by the number of production runs that each product
generates. Then the number of set ups would
represent the cost driver for production scheduling.
 Cost Pools
1.Costs are grouped into Pools according to the
activities which drive them. As ABC system
gets very detailed and more cost pools are
created, allocations are necessary to calculate
activity costs for each cost pool.
2.For example, a cost pool may be of
procurement of goods. In this case, all costs
associated with procurement (ordering,
inspection, storing, etc) are included in this
cost pool and cost driver identified.
 Main Activities and their Cost
Drivers
Sl.
Main Activity Cost Drivers
No
01 Machine Set-up Number of Production Runs

02 Purchase of Materials Number of Orders placed

03 Warehousing Items in Stock

04 Quality Testing Hours of Test Time

05 Material Handling Number of Parts

 Activities, Cost Drivers (contd)
Sl.
Main Activity Cost Drivers
No
06 Inspection • Inspection Time per Item
•Number of Items Inspected
• Inspection Plans
• Number of Inspections Carried out

07 Stores Delivery Number of Store Deliveries

08 Packing Number of Packing Orders

09 Receiving Material Number of Consignments Received

 Activities, Cost Drivers (contd)
Sl.
Main Activity Cost Drivers
No
10 Customer Order •Order Value
Processing •Order Source (Customer Location)
•Order Source (New/Old Customer)
11 Production •Number to be Supplied
•Shift Pattern and Number
•Industrial Relation Issues
12 Maintenance •Number of Machine Breakdowns
•Maintenance Schedule
•Capital Expenditure
13 Material •Number of Material Transactions
Planning/ •Volume of Material Receipts
Acquisition •Volume of Material Orders
 Allocation of Overhead under ABC
Steps:

1.Identify and define the major activities (cost pools)

which cause the indirect costs
2.Accumulate the costs with the activities
3.Define the Cost Drivers
4.Compute Cost Driver Rate or Cost Recovery Rate or
Overhead Absorption Rate = (Overhead Expenses of
the Activity ÷ Size of Cost Driver)
5.Apply the Cost Driver Rate to the actual size of cost
driver used by a product, and charge the product of
these two to the Product as its share
 Characteristics of ABC
1. Simple traditional distinction made between
fixed and variable costs is not enough guide
to provide quality of information to design a
cost system. The more appropriate distinction
between cost behaviour patterns are volume
(scale) related, diversity (scope) related,
events (decisions) related and time related.

2. Costs drivers need to be identified. A cost

driver is a structural determinant, of cost
related activity.
 Characteristics of ABC (contd)
3. ABC traces costs first from
resources to activities and then from
activities to specific products.
4. It lays emphasis on different activities
(causing costs) for different purposes
5. Charging of indirect costs is based on
the quantity of service of activities
demanded and used by the products
 Steps in the Introduction of ABC
Step
No Description of the Step
I Identify the chosen Cost Objects (Product, Service, Customer, etc)
II Identify the Direct Costs (i.e., Prime Cost of the product, service
or customer)
III Select the major activities and the Cost Drivers
IV Identify the costs associated with each Activity (apply allocation
and apportionment techniques wherever necessary)
V Computer the Cost Driver Rate
VI Compute the indirect costs of the products = (Activity for the
product × Cost Driver Rate)

VII Compute the Total Cost = (Direct Costs + Indirect Costs)

 Implementation of ABC
1. In ABC, the hidden weaknesses and high cost segments are
identified for maximum effectiveness of Cost Accounting
system.

2. The process of designing and implementing an ABC system for

support departments - interview the concerned departmental
heads to have an insight into the departmental operations and
into the factors that trigger departmental activities. After the
interview, the system designer can use the number of appropriate
Cost Drivers for each activity to allocate the departmental costs.

3. Subsequent analysis traces these activities to specific products.

4. ABC calls for high level costing policy for effectiveness of

activities in a competitive economy for survival and prosperity.
 Benefits of ABC
1. In ABC, managers focus attention on activities
rather than products. Because, activities in various
departments may be combined and costs of similar
activities ascertained. e.g., Quality Control,
Material Handling, Repairs to Machines, etc
2. Costs are identified with activities and then
allocated to products or services based on
appropriate cost drivers.
3. Managers manage activities and not products.
Change in activities lead to changes in costs.
 Benefits of ABC (contd)
4. To manage the activities better and to make wiser
economic decisions, managers need to identify the
relationship of causes (activities) and effects
(costs) in a more detailed and accurate manner.
ABC focuses on this aspect.
5. ABC highlights problem areas that deserve
management’s attention and more detailed
analysis.
6. It is useful in setting priorities for managerial
attention and action.