Subject Name: Business Accounting and Finance

Code: ACC501
Credit Hours: 3

Activity-Based Costing:
A Tool to Aid Decision Making
 Activity-Based Costing: An Overview

• Activity Based Costing (ABC) is an accounting technique you can use to

determine the actual cost associated with each order your sales
representatives enter. To achieve your major business goals, you need to fully
understand the cost, time, and quality of the activities your employees or
machines perform. The more work a customer causes your sales
representative to perform, the less money you make. For example, if a
customer orders a product and then changes his mind, the time spent
entering that product on the sales order is wasted.
• Use the ABC system to designate specific, traceable activities that occur
during the customer order cycle. As your employees process the orders, the
system tracks each activity as it occurs and records it in a database. You can
then use the inquiry and reporting features to review the activities associated
with each customer's orders and compare the actual profit levels for each
customer. Based on this information, you may want to assign customers to
price classes that will keep your profit margins at acceptable levels.

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Activities
Many activities are associated with entering, shipping, and invoicing an order.
During a normal business day, your employees spend time performing these
activities, which translates into an expense that can be measured. Examples of
costed activities include:
Entering an order.
Making changes, such as quantity, shipping dates, or product, to an order.
Picking the line items on an order.
Scheduling an order.
Delivering and invoicing an order.
Handling cash receipts.
Your system is set up with a pre-defined set of activities, but you can add
additional activities, as needed.

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• Auto Group Codes
The system uses auto group codes—pre-defined triggers built into
programs—to log most activities. However, users can also enter log
entries, if needed. During system setup, each expense activity the
system tracks is assigned to an auto group code. Each activity code you
define must be assigned to an auto group code. You cannot define auto
group codes, as they are hard coded into the package.

• G/L Pools
The system uses G/L pools to link activities to the G/L accounts where the
associated expenses, such as employee salaries, paper, utilities, or
delivery expenses, are posted. When you assign a G/L pool to an
expense account, you can designate the percentage of the expense to
apply to the pool. The system uses this information to assign costs to
activities so that you can determine the cost of doing business with
your customers.
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• Reviewing Costs
• After determine the activities to track and the costs associated with each one,
the system calculates the activity-based costs.
• We can then use inquiries and reports to review activity and cost information
in a summary or detail format and identify the activities that make doing
business with a customer expensive. With accurate cost information, you can
adjust the way you do business with that customer and improve your
profitability.
• You need to collect ABC data for a year in order for the ABC cost calculation
program to produce accurate results. During that time, you use estimated
costs for each activity.

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• Setting Up Activity Codes
To generate the data required for the ABC inquiries and reports, you need to set
up the activity codes as follows:
• Assign ABC G/L pools to activity codes to calculate the cost per activity for
each activity code.
• Assign ABC expense categories to activity codes to summarize information
presented in the inquiries and report.
• Assign ABC extensions to activity codes to associate multiple activities with
the same auto group code.

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 Designing an Activity-Based Costing System
If activity-based accounting (ABC) system is well designed, you allocate costs more
precisely. You carefully separate costs between direct costs and indirect costs. You also
consider the specific activities that drive the indirect costs higher. Finally, the indirect costs
are allocated to the activities that cause those costs to be incurred.
Refining your approach
ABC is a refined costing system, or a more specific way to assign costs to cost objects. The
system avoids using big, generic categories, such as splitting a cost evenly between
divisions. Instead, it allocates indirect costs to the activities that generate those costs. The
result is likely to be more accurate costing and product pricing.
The refined costing system requires you to perform the following three tasks:
•Direct cost tracing: Review your direct costs and categorize more costs as direct costs, if
possible.
•Cost pools: Review cost pools and create more pools, if necessary.
•Cost-allocation bases: Decide on cost-allocation bases by using cause-and-effect criteria.

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Grouping costs by using a cost hierarchy
A cost hierarchy groups costs into cost pools based on cost drivers or cost allocation
bases. A cost hierarchy has levels, which explain how broadly you look at costs and
activities. Here are levels you may use in a cost hierarchy:
•Unit-level costs are cost activities performed on an individual unit, whether a product
or service. If you make blue jeans, your unit is one pair of jeans. An individual tax
return is a unit, if you prepare tax returns for clients.
•Batch-level costs are cost activities that generate costs at the batch level. For
example, when an automobile plant changes from one car model to another, it’s
changing batches and incurring setup costs. The plant is “retooling,” which may
include moving machinery, and certainly includes changing out the dies and
reprogramming the welding robots.
•Customer-level costs are cost activities generated for one customer. If you’re
remodelling a kitchen, your labor costs, materials used, and overhead costs incurred
for a specific customer are all customer-level costs. Customer-level costs may include
multiple orders from the same client.

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Grouping costs by using a cost hierarchy contd..
•Product-sustaining costs are cost activities that support a particular product or service
line, regardless of the number of units produced. A product-sustaining cost extends the
life of a product; technology products are good examples. To stay relevant with
customers, software companies come out with endless new versions of software.
•Extending a product’s life is supposed to keep customers buying it. Design costs can be
product-sustaining costs. To keep the technology product current, you change the
design. You can allocate product-sustaining costs to a product or to an entire product
line (sometime called a “product family” in high tech).
•Facility-sustaining costs are cost activities that support the overall company, such as
legal and accounting activities. The rent, insurance, and maintenance on the company’s
building are facility-sustaining costs, because the building is essential to keeping the
entire company running. The costs should be allocated over the entire company.
Companies with multiple buildings sometimes cost allocate for each building to see
whether a building is too expensive to occupy.

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 The Mechanics of Activity-Based Costing
Activity based costing (ABC) assigns manufacturing overhead costs to products in a more
logical manner than the traditional approach of simply allocating costs based on machine
hours. Activity based costing first assigns costs to the activities that are the real cause of the
overhead. It then assigns the cost of those activities only to the products that are demanding
the activities.
•Developing Activity-Based Costing (ABC) | Cost Accounting
The following points highlight the top ten factors for developing Activity-Based Costing
(ABC).
1. Traditional product costing systems cannot report accurate product or service cost.
2. Traditional costing methods of overhead absorption use volume-related measures, such as
direct labour hours, or machine hours etc. But there are many overhead expenses which are
not related to physical volume.
These are related to support activities such as material handling, material procurement,
setting-up of machines etc. These activities and their cost should not be allocated to
products based on production volumes.

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3. Traditional product costing systems assume that products or services produced consume all
resources in proportion to their production volumes. Thus, products or services which take
more time to manufacture, generate more overheads. This assumption leads to under-costing
of low volume products or over-costing of high volume products or services.
4. Traditional costing system distorts products or service cost when the firm produces different
products or services which make diverse demand on resources. Products or services make
diverse demand on resources because of volume, process set-up, batch size or complexity.
5. This system fails to reflect the cause and effect relationship between activity consumption
and cost incurrence.
6. The need drives Traditional cost accounting systems to value stock rather than to provide
meaningful information for managing activities and controlling the causes of cost (i.e., cost
driver).
7. Overhead expenses are not a mere burden to be maintained. Overhead costs for support
functions, such as, product design, quality control, customer service, production planning and
sales order processing are as important to the customer as physical process on the shop floor.
8. This system fails to highlight inter-relationship among the various activities of production
departments.

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• Illustration:
• A company manufacturing two products, furnishes the following data for a year

• You are required to calculate the cost per unit of each product A and B based on:
• Activity-based Costing Method:

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 Comparison of Traditional and ABC Product Costs
• The difference between ABC or Activity Based Costing and TCA or Traditional Cost
Accounting is that ABC is complex whereas TCA is simple.
• The ABC system began in 1981 whereas TCA methods were designed and developed
between 1870 to 1920. In the TCA system, the cost objects and used up resources are
required to evaluate the cost whereas in the ABC system the cost is dependent upon
the activities used up by the cost objects.
• Activity Based Costing is accurate and preferred over the TCA cost management
system. The ABC method of cost management system is adopted when the overheads
of the company are high and there are large numbers of miscellaneous products.
Inaccuracy or errors are most unwanted and undesirable because of the competitive
rates set by the competitors in the market. Due to this heavy and stiff competition, a
highly reliable and accurate method is required for the cost management.
• TCA or Traditional Cost Accounting uses a single overhead pool and is not able to
calculate the true cost. The costs of the objects are allocated randomly based upon the
labour or machine hours etc. ABC costing includes identifiable products parts or labor
whereas TCA arbitrarily accumulates expenses, salaries, depreciations etc.

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• Smaller targeted costs that are built upon activities are calculated with the
help of the ABC system. The ABC system is advantageous since it helps in
simplifying the decision-making process and it makes management concepts
become clear and target -oriented. It also helps in evaluating performances
and sets standards which can help the manager to use this information for
comparison purposes.
• In the Traditional Cost Accounting System, the company determines the cost
of production after the products have been produced whereas in the target
or Activity Based Accounting System, the value or cost of the product is
determined on the basis of customer feedback and pocket range. The ABC
system helps the company to determine whether to lower or raise the
activities cost to grab the consumers. The ABC system also helps in keeping
up with the competitors without sacrificing the quality and the quantity of
the products.

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• Summary:
• 1. Traditional cost accounting is obsolete whereas various target-oriented
companies more use Activity Based Accounting.
• 2. ABC methods help the company to identify the needs of keeping or
eliminating certain activities to add value to the products. 
• 3. TCA methods focus on the structure rather than on processes whereas
ABC methods focus on the activities or processes rather than on the
structure.
• 4. ABC provides accurate costs whereas TCA accumulates values arbitrarily.
• 5. A TCA is almost obsolete whereas A ABC method are largely in use since
1981.

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 Targeting Process Improvements
• Activity-based management (ABM) is used in conjunction with activity-based costing to
improve processes and reduce costs. Activity-based management is used in
organizations as diverse as manufacturing companies, hospitals, and the Canadian Coast
Guard.
• The first step in any improvement program is to decide what to improve. The theory of
constraints approach, which is a powerful tool for targeting the area in an organization
where improvement will yield the greatest benefit. Activity- based management
provides another approach. The activity rates computed in activity- based costing can
provide valuable clues concerning where there is waste and scope for improvement in
an organization.
• Targets are frequently used as a motivational technique. Founded on well-established
theories of achievement motivation, targets that are specific and perceived achievable
can help to focus managerial action, encourage people to succeed and drive superior
performance.
• But setting the right targets is tricky and has become a real issue for many organisations.

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Common target setting issues
There are three common issues that undermine the effectiveness of targets. These are:

The forecast was mainly based on past performance, so people do not over achieve as
over achievement will make the next year’s target much harder
Some targets are based on the wrong performance measures which is often referred to
as ‘hitting the target and missing the point’
Targets were ‘given’ to the sales people and no ownership was created.

10 step target-setting tool to improving process: -

This target-setting tool will help you better understand and implement sales targets. It is
divided into 10 steps and presented in the form of a wheel to illustrate its cyclical nature.

1.Review stakeholder expectations: You need to ask, “who are our stakeholders?” and “what
do they expect from us?” This will determine the critical areas your organisation needs to
address in order to be perceived as successful.
 

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2.Strategic objectives clarification/ selection: Once the stakeholders’ expectations are
identified, you need to express these as strategic objectives. Strategic objectives are clear
statements of what the organisation needs to achieve. They must be few and should address
the different stakeholders’ requirements.
3. Success map: A success map is a visual tool that shows how lower level objectives link to
higher level strategic objectives. It is a powerful communication tool that explains “what” is
to be achieved and “why”. It also shows where each part of the organisation contributes to
achieving these goals.
4. Objectives prioritisation: Most companies try to achieve too much. It is much better to
prioritise and deliver fewer objectives than fail to deliver on too wide a range of goals. The
focus will help employees too as they will be very clear about what is important in the coming
period.
5. Operationalisation: This means designing appropriate performance measures. How you
define the measure will drive behaviour. So KPIs must reflect the organisation’s goals and
encourage the right behaviour from those responsible for delivering the goals.
6. Data collection: This step is often overlooked. You need to collect timely and relatively
accurate information as a basis for setting your targets. Data is never perfect, but it does have
to be consistent and reliable enough to be fit for purpose.

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• 7. Data analysis: This is fundamental. You must draw on your knowledge of the
past and of the future to project what is going to happen. You also must analyse
the capability of your processes. Are the processes capable of delivering the
forecast? Most companies forecast, but fewer reassess their capabilities.
• 8. Set targets: Based on the previous steps, this is the point you set the target.
Judgement is required, and you need to assess the risk of getting the target wrong.
This is also where most organisations stop, but this is not the end of the process.
• 9. Action plan design: An action plan is required covering all the projects and
changes to the organisation that are needed to ensure the target is reached. This
may include training, new processes, new IT systems or ways of working with your
customers.
• 10. Action plan discussion and agreement: The plan must be communicated to
staff. The communication must be two ways and done regularly. Regular staff
meetings where the objectives are restated, goals outlined, and progress discussed
is a good format. Sending out the annual targets by email is not!

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 Activity –Based Costing and External Reports
• Since activity-based costing (ABC) system generally provides more accurate product
costs than traditional costing methods, why isn't it used for external reports?
• Some companies do use activity-based costing in their external reports, but most do
not. There are many reasons for this. First, external reports are less detailed than
internal reports prepared for decision making. On the external reports, Individual
product costs are not reported. Cost of goods sold, and inventory valuations are
disclosed, but there is no breakdown of these accounts by product. If some products
are under-costed and some are over-costed, the errors tend to cancel each other
when the product costs are added together.
• Second, it is often very difficult to make changes in a company's accounting system.
The official cost accounting system in most large companies are usually embedded in
complex computer programs that have been modified in-house over the course of
many years. It is extremely difficult to make changes in such computer programs
without causing numerous bugs.

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• Third, an ABC costing system does not conform to generally accepted accounting principles
(GAAP). Product cost computed for external reports purposes must include all the manufacturing
costs and only manufacturing costs; but in ABC system products costs exclude some
manufacturing costs and include some non-manufacturing costs. It is possible to adjust the ABC
data at the end of the period to conform to GAAP, but it requires more work.
• Fourth, the auditors are likely to be uncomfortable with allocation that are based on interviews
with the company's personnel. Such objective data can be easily manipulated by management to
make earnings and other key variables look more favourable.
• Most companies use activity-based costing for management reporting, to make better product
pricing, make vs. buy, product roll-out, and other strategic decisions. Frequently, activity-based
costing allocates expenses that are not normally included in your inventory balances, such as
general, administrative, and selling expenses.
• Using General Ledger and the budget process, you can create resources and activities, perform
allocations from general ledger actual balances to resources, and then perform secondary
allocations to activities. Since you may have multiple budgets, General Ledger supports multiple
sets of activity-based costs.
• For all these reasons, most companies confine their ABC efforts to special studies for
management, and they do not attempt to integrate activity-based costing into their formal cost
accounting system.

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 The Limitations of Activity-Based Costing
• Activity-based costing provides many benefits such as accurate pricing, better
allocation of resources, elimination of non-value adding activities, and the like. The
method however has many disadvantages and limitations as well. Read on to find
out the major activity-based costing limitations.
• Complexity
• The most prominent of activity-based costing limitations is its complex nature that
prevents its widespread application. Activity based costing systems usually remain
difficult to comprehend and costly to operate.
• Activity based costing requires management to not only estimate the costs of each
activities and identify and measure the cost drivers for such activities, but also
update the same on a regular basis. Traditional management accounting uses a
single cost-center approach, and implantation of activity-based costing might
require division of costs into multiple pools to represent the many activities. This
takes away much of the organization’s resources such as management time and
cost.

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• Assumptions
• A major limitation of activity-based costing is that while it institutes a complex methodology
to assign costs to activities, the system remains far from perfect. The major shortcomings
include:
• Some overhead costs such as the chief executive's salary remains impossible to divide and
allocate on a per-product usage basis.
• Not all productive activities need to add value to products. For instance, an employee taking
part in a first aid awareness campaign or a fire safety drill indulges in a productive activity,
but such activities do not add any value to the product or service.
• Most activity-based costing methods assign such 'business sustaining' costs to products on a
proportionate basis or based on assumptions, and this makes the system far from perfect.
• The Big Picture 
• A major ABC limitation is that activity-based costing places too much attention to detail and
control on processes. This causes a severe limitation in that it obscures the bigger picture by
causing the organization to lose sight of strategic long-term objectives in a quest for small or
short-term savings. For instance, activity-based costing might identify one distribution
channel as non-remunerative when such channelling might be placed to achieve strategic
depth rather than profits in the first place.

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• Confirmation to Standards
• Activity based costing, while providing for better management control over the
business process, does not conform to generally accepted accounting
principles (GAAP). This means that firms following activity-based costing need
to duplicate their efforts by maintaining two cost systems and separate
accounting books for internal use and external reports, filings, and statutory
compliance. 
• Finally, activity-based costing does not replace an existing job order or process
cost system, but rather supplement the same.
• The are many activity based costing limitations that lead to further research
and result in the development of lean accounting methods such as Balanced
Scorecards and Economic Value Added (EVA). Such methods take a new
approach by eliminating cost allocations and focusing on thorough accounting,
controls, and measurement systems, without the complex and costly methods
of activity-based costing, thereby doing away with the limitations.

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Thank You

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