Management Accounting

FINC001
ACTIVITY BASED COSTING
UNIT 9
 Concept & Importance
• Activity-based costing is a new scientific technique developed by
Cooper and Kaplan in 1988 for allocating overheads to final
products, processes and tasks.
• ABC helps managers make improved pricing decisions, inventory
estimations and profitability decisions.

Importance of ABC
• It helps in accurate cost and profit ascertainment with improved
allocation of overheads, cost control and its management.
• Due to increased competition, it becomes imperative to compute
the more accurate cost of each product and service because of the
varying demand for their resources.
• The ABC is closely associated to the concept of long run variable
costing.
 Check your progress
1. ABC by Cooper and Kaplan suggests the use of which of the following as the
denominator, while initially making activity cost pool rates for each activity.
a) Maximum capacity.
b) Practical capacity.
c) Budgeted capacity.
d) Normal capacity.

2. Which of the cost concept is most closely associated with activity-based costing?
a) Absorption costing.
b) Direct costing.
c) Short-run variable costing.
d) Long run variable costing.
Traditional Costing – Concept Limitations

• In Traditional costing, indirect costs are allocated to final

products on the basis that products consume resources in
proportion to the production volumes.
Traditional Costing system

Allocation,
Traditonal Costing Apportionment and Re- Absorption of
System apportionment of Overheads
overheads

Production Products
Overhead Rate A
Department A

Overhead Costs

Production Products
Overhead Rate B
Department B
Traditional Costing – Limitations

ABC was developed because of limitations in the traditional costing

system, which is as follows:
• Traditional costing system concentrates primarily on costs.
• Traditional costing system facilitates information display at the
product level.
• Traditional costing overheads were initially related to the
department's product and service cost centre. This type of
costing is beneficial for small units not for large units.
Difference between traditional costing
& ABC system
Check your progress
1.The main difference/ differences between how traditional costing and activity-
based costing account for indirect manufacturing costs is/ are:

a) Traditional costing uses only production volume based drivers while activity-
based costing uses only non-production volume-based drivers.
b) Traditional costing treats only unit-level costs as variable, while ABC
systems treat unit level, batch level and product-level costs as the variable.
c) Traditional cost allocations are usually based on a plant-wide overhead rate,
while ABC systems use departmental overhead rates.
d) Both a and b.
 Terms used in ABC
• Activity: An activity is referred to as a specific task or unit of work with a
specific objective. For example, placing a purchase order, after-sales services,
advertising for tender quotations, etc.
• Cost Object: Cost object is an item for which a cost measurement is required.
For example, a task, a service, a product etc.
• Cost Driver: Cost driver is a cause which leads to change in the cost of an
activity. There are two types of cost drivers- resource driver and activity cost
driver. For example,
Business Functions Cost Drivers
Material Purchase  Number of orders placed.
 Number of inspection.
 Number of purchasereceipts.
Advertising of product  Number of orders.
 Increase in sales.
Customer Service  Number of product returns from
customers.
Research & Development  Number of research ventures.
 Difficulties of ventures.
Terms used in ABC
• Resource cost driver: Resource cost driver is a measure for the
quantity of resource consumed by an activity. For example,
several purchase orders will decide the total cost of material
purchase.
• Activity cost driver: Activity cost driver is a measure of the
frequency and intensity of demand placed on activities of cost
objects.
Steps in Activity based Costing

Allocate costs to
Recognise the cost items based
Compute an
Recognize and Estimate the cost cost driver for on the level of
activity cost
categorise each of resources for each activity and activity required
charge for each
activity each activity the quantity of to make the
activity
each cost driver product or
provide a service
Step 1:Identify Activities

Activity Type with examples

Unit-level activities: Unit-level activities costs are allocated to activities that take action on each unit of product
or service. For example, supplies for material and depreciation of factory machine.

Batch level activities: Batch level activities costs are allocated to activities related to a batch of units of
products. For example, set-up costs, material arrangements or purchase orders etc.

Product level activities: Product level activities costs are allocated to activities which are undertaken to sustain
a specific product or service. For example, process engineering, product specifications, salaries of engineers and
products development costs etc.

Facility level activities: Facility level activities costs are those which cannot be traced to particular units,
batches, or products, are associated to sustain the buildings and facilities. This refers to the activities that are also
known as service and administrative activities. For example, security and safety, maintenance of general-purpose
machines and, plant management etc.
Step 2- Identify cost pool: Cost pool is referred to a grouping of
individual cost items. A cost pool is created for each activity and all
similar costs are collected. For example, the total cost of inspection
of products might constitute one cost pool for all inspection costs;
fabrication cost pool- the activity must be done based on each unit
produced.

Step 3- Recognize resource drivers: Recognizing the resource

drivers helps to establish a link between expenditure and activities
carried out in a firm.
Step 4: Recognize activity cost
drivers
Activity cost pools Cost Drivers

Material handling Number of parts

Production scheduling Number of batches

Quality inspections Number of inspections

Photocopying Number of pages

Warranty service Number of service calls

Step 5: Allocate cost to cost objects

• The costs of activities are recognised to products based on

demand by-products.
• Cost drivers determine the product demand for activities.

For example, the total cost for inspection of products is ₹2,000

and there are 20 inspections during the period. Thus, the rate
per inspection is ₹100 (₹2,000/20). If a specific cost centre
requires 5 inspections, the expense to that cost centre will be
₹100*5= ₹500. If 10 units of the product are manufactured in
the cost centre, the cost per unit will be ₹500/10 = ₹50.
Product profitability under
Activity based Costing

Let's discuss an example of ABW construction firm, a modular

residence designer using both traditional costing system and ABC.
Presently; the firm constructs two basic models—a 1,500 square foot
(1 Bedroom unit) and a 2,000 square foot (2 Bedroom units). The
cost of direct material for 1bedroom and 2bedroom unit is
₹12,00,000 and ₹16,00,000 respectively. The cost of direct labour is
₹8,00,000 and ₹10,00,000 respectively.
Estimated Overheads costs
Overhead Item Estimated Cost (₹)

Indirect Material 7,00,00,000

Indirect Labour
2,00,00,000
- Construction supervisors
50,00,000
- Part-Time workers

Other Overhead
3,00,00,000
-Allocated service department cost
60,00,000
- Instruments
1,00,00,000
-Truck and other equipment

Total 14,10,00,000
Overhead cost calculation as per
traditional costing system
• Overhead cost allocation as per the traditional costing system for two
products is as follows:

Total floor space = [(100 *1,500) + (100*2,000)] = 3, 50,000 square foot

Overhead Allocation Rate 14,10,00,000 ÷ 3, 50,000 = ₹402.86/ square foot
So, overhead cost/ unit for 1,500 square foot model is 1,500*₹402.86 = ₹6, 04,290
Overhead cost/ unit for 2,000 square foot model is 2,000*₹402.86 = ₹8, 05,720

• Overhead cost allocation as per the traditional costing system for three
products is as follows:
Total floor space = [(100 *1,500) + (100 *2,000) + (1,000 *300] = 6,50, 000 square foot
Overhead Allocation Rate Rs.42, 00, 00,000 ÷ 6, 50,000 = ₹646.15/ square foot
So, overhead cost/ unit for 1,500 square foot model is1,500* ₹646.15 = ₹9, 69,225
Overhead cost/ unit for 2,000 square foot model is 2,000* ₹646.15 = ₹12, 92,300
Overhead cost/ unit for 300 square foot model is 300* ₹646.15= ₹1, 93,845
 Total Costs / Unit Using Volume-Based
Overhead Allocation (Traditional Costing
System)

Items Basic Model 1 Basic Model 2 Modular House

(1 Bedroom Unit) (2 Bedroom Unit) (Small house)
Number of Units 100 100 1000
Direct Material (₹) 12,00,000 16,00,000 8,25,000
Direct Labour(₹) 8,00,000 10,00,000 4,85,000
Overheads (₹) 9,69,225 12,92,300 1,93,845
Total cost/ unit 29,69,225 38,92,300 15,03,845

By using Volume-Based Overhead Allocation, the small house costs exceed the desired costs by
₹1,03,845 (15,03,845- 14,00,000).
 Overhead costs calculation as per Activity
based Costing

Step 1: Identify Activities

Activity Estimated Costs

(₹)

Inspections 5,00,00,000
Supervisions 2,50,00,000
Purchasing 9,00,00,000
Delivery and Set up 25,50,00,000
Total 42,00,00,000
Step 2: Recognize activity cost
drivers

Activity Cost Drivers

Inspections Number of inspections

Supervisions Hours of supervision time

Purchasing Number of purchase order

Delivery and Set-Up Set-Up time(in days)

Step 3: Estimated activity Cost Driver

Cost Driver Basic Model 1 Basic Model 2 Modular Total

(1Bedroom (2 Bedroom House
Unit) Unit) (Small
house)

Number of (25*100)=2,500 (35*100)=3,500 (15*1,000)=15,0 21,000

00
inspections
Hours of (30*100)=3,000 (40*100)=4,000 (5*1,000)=5,000 12,000

supervision time
Number of (70*100)=7,000 (80*100)=8,000 (6*1,000)=6,000 21,000

purchase
order
Set Up time(in (12*100)=1,200 (15*100)=1,500 (1*1,000)=1,000 3,700

days)
Step 4: Predetermined Activity Rates

Activity Total Estimated Cost Driver Predetermined

Cost estimated amount overhead rate (₹)

Inspections 5,00,00,000 21,000 2,380.95/ inspection

Supervisions 2,50,00,000 12,000 2,083.33/

supervision
Purchasing 9,00,00,000 21,000 4,285.71/ purchase

Delivery and 25,50,00,000 3,700 68,918.92/ day

Set Up
 Let’s see the Activity-Based Cost/ Unit for
ABW Construction Firm for all three models.
Activity Cost Driver Cost Basic Model 1 Basic Model 2 Modular House Total cost /
(1 Bedroom unit) (2 Bedroom unit) (Small House) activity
Inspections Number of inspections 2,380.95/ 25 35 15 1,78,571.25
inspection

Supervisions Hours of supervision time 2,083.33/ 30 40 5 1,56,249.75

supervision

Purchasing Number of purchase 4,285.71/ 70 80 6 6,68,570.76

order purchase

Delivery and Set- Set-Up time(in days) 68,918.92/ day 12 15 1 19,29,729.76

Up

Total cost/ activity 1249050.39 1543307.18 1,40,764.08

for each house
Observe that the four activities here formulate
the overhead constituent in computing the total
cost.

Cost Basic Model 1 Basic Model 2 Modular House

(1 Bedroom unit) (2 Bedroom unit) (Small House)
Direct Material (₹) 12,00,000 16,00,000 8,25,000
Direct Labour (₹) 8,00,000 10,00,000 4,85,000

Inspections 59,523.75 83,333.25 35,714.25

Supervisions 62,499.90 83,333.20 10,416.65
Purchases 2,99,999.70 3,42,856.80 25,714.26
Delivery and Setup 8,27,027.04 10,33,783.80 68,918.92
Total cost/ unit 3249050.39 4143307.05 14,50,764.08
 Comparing the total cost and price for both
costing methods
Cost Basic Model 1 Basic Model 2 Modular House
Comparison 1500 sq. ft. 2000 sq. ft. 300 sq. ft.

Traditional 29,69,225 38,92,300 15,03,845

costing (₹)

Activity-based 3249050.39 4143307.05 14,50,764.08

costing (₹)

Difference in 279825.39 2510007.05 53,080.92

cost(₹) (higher in ABC) (higher in ABC) (lower in ABC)

Price 120% of Cost

Comparison
Sales price 35,63,070 46,70,760 18,04,614
based on
traditional
costing
Sales price 38,98,860.468 49,71,968.46 17,40,916.90
based on
Activity Based
Costing
Difference in 3,35,790.468 3,01,208.46 63,697.10
price (₹) (higher in ABC) (higher in ABC) (lower in ABC)

So, it can be concluded that the sales price and the cost is lower for modular house with Activity-
based Costing and higher for 1 & 2 Bedroom units. This is justified too, because the large size
houses actually consume more overheads as they require more precession and therefore utilizes
more proportion of all the activities.
Activity based costing- Application

• Activity-based costing is widely used in manufacturing firms as

well as service industry firms.
• Every small decision has a huge impact on the cost function.
• Firms like Nike, Ford Motors, UPS, Safety- Kleen Corporation,
Raiffeisen Bank of Luxembourg, etc have successfully
implemented ABC.
• Some of the Indian firms like Castor India, TCS, Bharat Forge,
Bharat Earth Movers, Air Asia and many other firms from
banking, insurance and healthcare sector have also successfully
implemented ABC.
• Establishing an ABC system is a precondition for getting better
business processes and re-engineering cost utilities in the long
run.
 Uses of ABC
• To estimate a more precise cost per unit.
• To facilitate much-improved insight about tracing the overhead
costs drivers.
• To identify that overhead costs are not all associated with
production and sales volume.
• Overhead costs constitute a significant ratio of total costs.
• To derive practical costs in a multifaceted business scenario.
• To estimate all overhead costs, not just factory overheads.
• To estimate costs in service costing as in product costing.
Limitations of ABC

• It will be of limited benefit if the overhead costs are primarily

volume related or if the overhead is a small proportion of the
overall cost.
• It is impossible to allocate all overhead costs to precise activities.
• The choice of both activities and cost drivers might be
inappropriate.
• ABC can be more difficult to explain to the stakeholders of the
costing exercise.
• The benefits obtained from ABC might not justify the costs.
 ABC in service industry
• Activity-based costing is equally important for service providers as
it is for manufacturing firms.
• It has achieved acceptance in the service industry, the U.S. Postal
Service Office used activity-based costing to assist in deciding the
costs and benefits of permitting customers to reimburse with debit
and credit cards.
• One of the major limitations is the nature of the type of work done
by service industry firms is non-repetitive.
• So, for using ABC in service industry firms need to find out:
 Profitable services.
 Which services should be emphasized?
 The tendency in service profitability over time.
 Service costs as a basis for deciding prices.
Check your progress

1. What is an activity measurement in activity-based costing?

a) A primary cost driver.
b) The volume of work associated with the activity.
c) A secondary cost driver.
d) Both b and c.