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Limitations of Traditional Costing System:

1. In a traditional costing system, overheads i.e. indirect costs are allocated, apportioned and finally
absorbed in the cost units. There can be distortion in computing costs due to the basis selected for
absorption. The following example will clarify the situation.

A manufacturing company is producing two products, X and Y. The direct material cost for the
products is Rs.5,00,000 and Rs. 10,00,000 respectively. The total overheads are Rs.7,50,000 and the
company adopts direct material cost as the basis for absorption. The absorption percentage of
overheads will be 50% of the direct material for X. Thus the overheads absorbed on the product X will
be Rs. 2,50,000 and for Y, they will be Rs.5,00,000 Product Y has a larger share of the overhead costs
as the material costs are higher than that of X. However, actually product Y may be requiring lesser
efforts in the indirect activities than X, but only because it has a higher material costs, it will be
charged with larger amount of overheads. Thus there is a distortion in the total cost. This distortion in
costs may lead to wrong decisions in several areas like make or buy, pricing decisions, acceptance of
export offer etc.

2. Another limitation of traditional costing system is the division between fixed and variable may not
be realistic as there are many complications due to the complexity of the modern business.

Cost Object: It is an item for which cost measurement is required e.g. a product, a job or a customer.

Direct Costs: Those costs that can be specifically & exclusively identified with a particular cost
object. Direct costs can be accurately traced because they can be physically identified with a particular
object whereas indirect costs cannot. Prime cost refers to the direct costs of the product and consists of
direct material costs + Direct labour costs + Direct expenses. Direct costs are different from Variable
costs & may include fixed costs. Cost of hiring machine for producing a specific product is an example
of a direct expense although it fixed in nature.

Indirect Costs: They can’t be identified specifically and exclusively with a given cost object. The
salaries of factory supervisors can’t be specifically identified with a particular product hence these are
classified as indirect.
Definition:- CIMA defines Activity Based Costing as, ‘cost attribution to cost units on the basis of
benefit received from indirect activities e.g. ordering, setting up, assuring quality.’
Another definition of Activity Based Costing is, ‘the collection of financial and operational
performance information tracing the significant activities of the establishment to product costs.’
Objectives of Activity Based Costing
 To remove the distortions in computation of total costs as seen in the traditional costing
system and bring more accuracy in the computation of costs of products and services.
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 To help in decision making by accurately computing the costs of products and services.
 To identify various activities in the production process and further identify the value
adding activities.
 To distribute overheads on the basis of activities.
 To focus on high cost activities.
 To identify the opportunities for improvement and reduction of costs.
 To eliminate non value adding activities.
Activities: Any Event, Action, Transaction. Or work sequence that causes a Cost to be incurred in
producing a product or Activity providing a service. Activities comprise of units of work or tasks. For
example, purchase of materials is an activity consisting a series of tasks like purchase requisition,
advertisement inviting quotations, identification of suppliers, placement of purchase order, follow-up
etc.

Types of Activities: Activities basically fall into four different categories, known as the manufacturing
cost hierarchy. These categories were first identified by Cooper in 1990 and help to determine the type
of activity cost driver required. The categories are:
(i) Unit level activities (a.k.a. Volume related activities): These are activities for which the
consumption of resources can be identified with the number of units produced. E.g. Use of indirect
materials, Inspection or testing of every item produced or says every 100th item produced, indirect
consumables, etc. Performed each time a unit is produced.
(ii) Batch level activities: The costs of some activities (mainly manufacturing support activities) are
driven by the number of batches of units produced. These are activities related to setting up of a batch
or a production run. The costs of such activities vary with the number of batches made, but is fixed for
all units within that batch. E.g. Production scheduling, Material movement, Machine set up costs,
Inspection of products – like first item of every batch, etc. Performed each time a batch is produced
(iii) Product-sustaining activities or service sustaining activities: The costs of some activities (often
once only activities) are driven by the creation of a new product line and its maintenance. These are
activities performed to support different products in the product line. E.g. designing the product,
Producing parts to a certain specification, Advertising costs, if advertisement is for individual products,
etc. Performed to support production of different type of product
(iv) Facility-sustaining or business-sustaining activities: These are activities necessary for sustaining
the manufacturing process and cannot be directly attributed to individual products. E.g. Maintenance of
buildings, Plant security, Production manager’s salaries, Advertising campaigns promoting the co., etc.
Residuary head

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Cost Driver: It is the factor that causes a change in the cost of an activity. Instead of using the term
‘allocation bases’ or ‘overhead allocation rates’ the term cost driver is used in ABC system. They are
classified into:
Resource Cost Driver: It is a measure of the quantity of resource consumed by activity. It is used to
assign the cost of a resource to an activity or cost pool. An example of a resource cost driver is the
percentage of total square feet occupied by an activity. This factor is used to allocate a portion of the
cost of operating the facilities to the activity.
Activity Cost Driver: It is a measure of the frequency and intensity of demand, placed on activities by
cost objects. It is used to assign activity costs to cost objects. Activity cost drivers can be transaction
drivers (e.g. No. of purchase orders processed, no. of customer orders processed, etc.) as well as
duration drivers (it represent amount of time required to perform an activity e.g. Setup hours,
inspection hours, etc.).

Traditional Cost Accounting

It arbitrarily allocates overheads to the cost objects. Total Company’s overhead is allocated based on
volume based measure (taking time as base factor) i.e. labour hours or machine hours. Here the main
assumption is that there is a relationship between overhead & volume based measure.
Activity Based Costing
ABC is not a method of costing, but a technique for managing the organization better. It is a one-off
exercise which measures the cost and performance of activities, resources and the objects which
consume them in order to generate more accurate and meaningful information for decision-making.
ABM draws on ABC to provide management reporting and decision making. It is more accurate cost
management methodology. It focuses on indirect costs (overhead). It traces rather than allocates each
expense category to the particular cost object. It converts “indirect” expenses to “direct”.
ABC Basic Principle
o Cost objects consume activities.
o Activities consume resources.
o This consumption of resources is what derives costs.
o Understanding this relationship is critical to successfully managing overhead.
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When & Why to use ABC

1. Overhead is high-New production techniques have resulted in the increase of the proportion of
support service costs in the total cost of delivering value to customers. ABC improves the
accuracy of accounting for support service costs.
2. Products are diverse-There is product and customer proliferation. Demand on resources by
products / customers differ among product / customers. Therefore, product / customer
profitability can be measured reasonably accurately, only if consumption of resources can be
traced to each individual product / customer
3. Costs of errors are high-The costs associated with bad decisions have increased substantially.
4. Competition is stiff- Fierce competitive pressure has resulted in shrinking profit margin. ABC
helps to estimate cost of individual product or service more accurately. This helps to formulate
appropriate marketing / corporate strategy.

Steps involved in Activity Based Costing:

The steps in Activity Based Costing are explained below.
1. Understanding and analyzing manufacturing process:-
For installation of any costing system, study of manufacturing process is essential. For Activity Based
Costing system also, it is necessary to study the manufacturing process and ascertain various stages
involved in the product or service so that ‘activities’ involved in that can be identified.
2. Study of the Activities involved:-
The next step is to study the activities involved in the manufacturing process. In this step, the activities
involved in a process are identified. For example, in a bank, opening of an account is one of the
services offered to customers In this service, activities involved are studied. It may be revealed that
opening of a new account involves activities like issuing the application form, verification of the same
and accepting the initial amount required for opening of an account. Similarly in case of a
manufacturing company, purchase procedure may involve activities like receiving of purchase
requisition for concerned department or the stores department, inviting quotations from various
suppliers, placing of an order, follow up of the same and finally receiving and inspection of the goods.
In case of an educational institute, activities in a library may include activities like issue of books,
receipt of books, ordering new books, stock taking, removing obsolete and outdated books,
identification of slow moving and fast moving items etc. In this manner, whether in manufacturing or
in service sector, activities are identified and the next step is to divide the activities into value adding
and non value adding. The objective behind this is that attention can be focused on the value adding
activities while non value adding activities can be eliminated in the future.
3. Activity Cost Pool:-
Cost pool is defined by CIMA as, ‘the point of focus for the costs relating to a particular activity in an
activity based costing system.’ For example, in case of a manufacturing organisation, as regards to
stores, cost of classification, cost of issue of stores requisitions, inspection costs etc. can be pooled
under the heading ‘stores’. Thus cost pool concept is similar to the concept of cost center. The cost
pool is the point of focus or in other words, it is the total cost assigned to an activity. It is the sum of all
the cost elements assigned to an activity.
4. Cost Drivers:-
According to CIMA, ‘cost driver is any factor which causes a change in the cost of an activity, e.g. the
quality of parts received by an activity is a determining factor in the work required by that activity and
therefore affects the resources required. An activity may have multiple cost drivers associated with it.’
In other words, cost driver means the factors which determine the cost
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of an activity. For example, in stores, no. of stores requisitions will be cost drivers, in customer order
processing the no. of customers as well as no. of orders will be cost drivers Thus a cost driver is an
activity which generates cost. Activity Based Costing is based on the belief that activities cause costs
and therefore a link should be established between activities and product. The cost drivers thus are the
link between the activities and the cost.
5. Identification of costs with the products:-
The final step in Activity Based Costing is to identify the cost with the final products which can also be
called as cost objects. Cost objects include, products, services, customers, projects and contracts. As
mentioned earlier, direct costs can be identified easily with the products but the indirect costs can be
linked with the products by identifying activities and cost drivers. Thus Activity Based Costing is the
process of tracing costs first from resources to activities and then from activities to specific products.

Activity cost driver rate = Total Cost Activity

Activity Driver

To conclude that, the Activity Based Costing is a costing system, that tries to charge the indirect costs
to the products and services fairly and accurately. However for effective implementation there is a need
of involvement of the staff and their training on continuous basis. Similarly there is a need to review
the working of the system at periodic intervals and keep a follow up of the feedback received. These
actions will ensure effective implementation of the system. Support of top management is also required
for effective implementation of this system. Activity Based Costing system is definitely a better system
but much depends on the implementation of the same.

Let us take a small example to understand the steps stated above:

Assume that a company makes widgets and the management decides to install an ABC system. The
management decides that all overhead costs will have only three cost drivers viz. Direct labour hours,
Machine hours and number of purchase orders and the general ledger of the company shows the
following overhead costs –

General Ledger Amount Rs

Payroll taxes Machine 1,000
maintenance 500
Purchasing Dept. labour Fringe 4,000
benefits Purchasing Dept. 2,000
Supplies Equipment Depreciation 250
Electricity 750
Unemployment insurance 1,250
1,500
Total 11,250

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So, which overheads do you think are driven by direct labour hours?
The answer is — Payroll taxes 1,000
— Fringe benefits 2,000
— Unemployment insurance 1,500
— Total 4,500
Similarly, overheads driven by machine hours include Machine maintenance, depreciation and
Electricity totaling Rs. 2,500 and finally overheads driven by number of purchase orders
include purchasing department labour and purchasing department supplies totaling Rs.
4,250.
Now, overhead rate is calculated by the formula total cost in the activity pool / Base, base
being the total number of labour hours, machine hours and total number of purchase orders in
the given case.
Assume that the total number of labour hours be 1,000 hours, machine hours be 250 hours
and total purchase orders be 100 orders.
So, the ABC rates would be
4,500/1,000 = Rs. 4.50 per labour hour
2,500/250 = Rs. 10 per machine hour

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Rs. 4,250/ 100 = Rs. 42.50 per purchase order.
Now, let’s allocate the overheads between two widgets A and B the details of which are given
below
Particulars Widget A Widget B
Labour hours 400 600
Machine Hours 100 150
Purchase Orders 50 50
So, total overhead costs applied to widget A = (400x4.50) + (100x10) + (50x42.50) = Rs. 4,925
And total overheads applied to widget B = (600x4.50) + (150x10) + (50x42.50) = Rs. 6,325
So total overheads = Rs. 4,925 + Rs. 6,325 = Rs. 11,250.
Generally, in the traditional costing method, overheads are applied on the basis of direct
labour hours (total 1,000 labour hours in the given case). So, in that case the overhead
absorption rate would be – Rs. 11,250/1,000 = Rs. 11.25 per hour and the total
overheads applied to Widget A would have been = 400x11.25 = Rs. 4,500 and to Widget B =
600x11.25 = Rs. 6,750.
Hence Widget A would have been undervalued and Widget B overvalued by Rs. 425.

Example of cost drivers for different activity pools in a production department an be

explained below:
Activity Cost Pools Related Cost Drivers
Ordering and Receiving Materials cost Number of purchase orders
Setting up machines costs Number of set-ups
Machining costs Machine hours
Assembling costs Number of parts
Inspecting and testing costs Number of tests
Painting costs Number of parts
Supervising Costs Direct labour hours

Limitations of Activity Based Costing:

1. Activity Based Costing is a complex system and requires lot of records and tiresome calculations.
2. For small organisations, traditional cost accounting system may be more beneficial than Activity
Based Costing due to the simplicity of operation of the former.
3. Sometimes it is difficult to attribute costs to single activities as some costs support several activities.
4. There is a need of trained professionals who are limited in number.
5. This system will be successful if there is a total support from the top management.
6. Substantial investment of time and money is required for the implementation of this system.

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Activity Based Costing Traditional Absorption Costing

1. Overheads are related to activities and 1. Overheads are related to cost
grouped into activity cost pools. centers/departments.
2. Activities are classified as – (i) 2. Only (i) Unit Level (Variable) and (ii)
Unit Level, (ii) Batch Level, (iii) Facility Level (Fixed) activities are
Product Level and (iv) Facility Level identified.
3. activities.
Costs are related to activities and 3. Costs are related to cost centers and
hence are more realistic. hence not realistic of cost behaviour.
4. Activity–wise cost drivers are 4. Time (Hours) are assumed to be
determined. the only cost driver governing costs
in all departments.
5. Activity–wise recovery rates are 5. Either multiple overhead recovery
determined and there is no concept of a rate (for each department) or a single
single overhead recovery rate. overhead recovery rate may be
determined for absorbing overheads.

6. Cost are assigned to cost objects , 6. Costs are assigned to Cost Units i.e.
e.g. customers, products, services, to products, or jobs or hours.
departments, etc
7. Essential activities can be 7. Cost Centers/ departments cannot
simplified and unnecessary activities be eliminated. Hence not suitable for
can be eliminated. Thus the cost control.
corresponding costs are also

Activity Based Accounting: Activity Based Accounting is a broader term which involves in,
‘collection, recording, analysis, controlling and reporting of activity related costs rather than
departmental or cost centers related costs.’ It involves several activities like Activity Based Budgeting,
Cost management based on activities, performance measurement of activity, reducing the costs through
elimination of non value adding activities and also initiating innovative measure for reduction of costs.

Activity Based Cost Management (ABM): Empirical studies of ABC implementation have frequently
shown that the greater benefit derived from its adoption are in Cost Management rather in providing accurate
product cost. The term Activity based management (ABM) is used to describe the cost management
application of ABC. The use of ABC as a costing tool to manage costs at activity level is known as Activity Based
Cost Management (ABM). ABM is a discipline that focuses on the efficient and effective management of
activities as the route to continuously improving the value received by customers. ABM utilizes cost
information gathered through ABC. Through various different types of analysis, ABM manages activities rather
than resources. It determines what drives the activities of the organisation and how these activities can be
improved to increase the profitability.

Consortium for Advanced Management International (CAM) defines ABM as “adds a

dynamic, continuous improvement dimension to the more static ABC model”.
Interestingly, it has been observed that Japanese accountants began exploring activity-based techniques in the
early 1990s following movement in the United States toward the ABM model.

CAM defines ABM as: “A discipline that focuses on the management of activities as the
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route to improving the value received by the customer and the profit achieved by providing
this value. This discipline includes cost driver analysis, activity analysis, and
performance measurement. Activity-Based Management draws on Activity-Based Costing
as its major source of information.”
Activity-Based Management Model

In commenting on this model, one of its co-developers stated, “ABC supplies the information, and
ABM uses this information in various analysis designed to yield continuous improvement.”

Cost Driver Analysis: The factors that cause activities to be performed need to be identified in order
to manage activity costs. Cost driver analysis identifies these causal factors.

For example, a cost driver analysis study might determine that slow processing of customer invoices
results largely from lack of training of the customer invoice associates. This lack of training is thus a
cost driver of the customer invoice processing activity. It is one of the factors causing this activity to
take place (in this case, inefficiently). Managers have to address this cost driver to correct the root
cause of the slow processing problem. To accomplish this task, managers might decide that an internal
training program for customer invoice associates should be designed and implemented to increase the
speed of customer invoice processing.

The time saving from the improved training may lead to a reduction in the number of customer invoice
associated and, thus, to lower costs for the “customer invoice processing” activity. Of course, real
salary cost savings occur only if the number of jobs in the organisation actually decreases (e.g., through
attrition) or if displaced customer invoice associates are redeployed to VA activities, thus canceling the
need to hire new employees from outside. The tangible cost savings and intangible benefits from the
customer invoice processing improvements should be compared with both the tangible and intangible
costs of the new training program in a cost-benefit analysis.

The hypothetical customer invoice processing example shows that the identification and analysis of
cost drivers (causal factors) is a necessary first step toward improving the cost-effectiveness of
activities and cost management through ABM.

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Activity Analysis: Activity analysis, defined in section (a), identifies the activities of an organization
and the activity centers (or activity cost pools) that should be used in an ABC system. Activity analysis
also identifies Value Added (VA) and Non Value Added (NVA) activities. The degree to which
activities are grouped together into activity centers depends on the costs and benefits of the
alternatives. The number of activity centers is likely to change over time as organizational needs for
activity information evolve.

For example, only a few activity centers may be used in an initial ABC pilot study. As managers
become more accustomed to the initial ABC system and find the output useful, they may request a
more detailed and refined ABC model.

Performance Analysis: Performance analysis involves the identification of appropriate measures to

report the performance of activity centers or other organizational units, consistent with each unit’s
goals and objectives. Performance analysis aims to identify the best ways to measure the performance
of factors that are important to organizations in order to stimulate continuous improvement.

Business application of ABM: ABM views the business as a set of linked activities that ultimately
add value to the customer. ABM is based on the premise that activities consume costs. Therefore, by
managing activities costs will be managed in long term. Activities may be grouped in such a way as to
describe the total process. For example, serving a particular customer involves a number of discrete
activities, but the sum total of these activities represents the process by which the client is serviced.
ABM classifies each activity within a process as value-added activities or non-value added activities.

Value-Added Activities (VA): The value-added activities are those activities which are indispensible
in order to complete the process. The customers are usually willing to pay (in some way) for these
services. For example polishing furniture by a manufacturer dealing in furniture is a value added
activity.

Non-Value-Added Activities (NVA): The NVA activity represents work that is not valued by the
external or internal customer. NVA activities do not improve the quality or function of a product or
service, but they can adversely affect costs and prices. Non-value added activities create waste, result
in delay of some sort, add costs to the products or services and for which the customer is not willing to
pay. Moving materials and machine set up for a production run are examples of NVA activities. The
preparation of tax returns and other compliance work by organizations do not directly benefit the
customers of their products and services, but because they are required by law. They are not considered
NVA activities.

By measuring activities rather than traditional departmental costs, business can focus on cross
functional processes in order to identify non-value adding activities and pinpoint the time drives of cost
at each stage. The goal of the ABCM is to make customer needs to be satisfied while making fewer
demands for resources. Current research suggests that customers have perceived needs in four areas, all
of which must be satisfied simultaneously.

The customers require- Lower costs, higher quality, faster response time & Greater innovation.

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To satisfy these needs ABM currently being used for a variety of business applications. Such as:

Cost Reduction: ABCM helps the organization to identify costs against activities and to find
opportunities to streamline or reduce the costs or eliminate the entire activity, especially if there is no
value added. It is particularly useful in identifying and quantifying process waste and providing vehicle
for continuous process improvement through continuous cost reduction.

Activity Based Budgeting: Activity based budgeting analyze the resource input or cost for each
activity. It provides a framework for estimating the amount of resources required in accordance with
the budgeted level of activity. Actual results can be compared with budgeted results to highlight both
in financial and non-financial terms those activities with major discrepancies from budget for potential
reduction in supply of resources. It is a planning and control system which seeks to support the
objectives of continuous improvement. It means planning and controlling the expected activities of the
organization to derive a cost-effective budget that meet forecast workload and agreed strategic goals.
The three key elements of activity based budgeting are as follows:-

— Type of work to be done

— Quantity of work to be done

— Cost of work to be done

Business Process Re-engineering: Business process re-engineering involves examining business

processes and making substantial changes to how organisation currently operates. ABCM is a powerful
tool for measuring business performance, determining the cost of business output and is used as a
means of identifying opportunities to improve process efficiency and effectiveness. A business process
consists of linked set of activities. For example purchasing of materials might be considered as
business process consist of activities such as receiving a purchase request, identifying supplies,
preparing purchase orders, mailing purchase orders and performing follow up. One way the process
might be reengineered by sending the production schedule direct to the suppliers and to enter into a
contractual agreement to deliver materials according to the production schedule. The end result might
be permanent reduction or elimination of some activities like raising a requisition every time there is a
need for materials, identifying potential suppliers each time, waiting for their bid which may result in a
delay of the production process and thereby hamper the organisation’s goals

Benchmarking: Benchmarking is a process of comparing of ABC-derived activity costs of one

segment of company with those of other segments. It requires uniformity in the definition of activities
and measurement of their costs.

Performance Measurement: Many organisations are now focusing on activity performance as a

means of facing competitors and managing costs by monitoring the efficiency and effectiveness of
activities. Activity performance measures consist of measures relating to costs, time, quality and
innovation. For instance, in the current era of globalisation, the overall goal for any company is to
produce a quality product at a competitive price. But the quality is not something which one can apply
somewhere in the production process or assume will happen automatically. Product quality starts with
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the correct design. The next stages are high quality raw material inputs, quality processing and work,
and proper handling and packaging etc. The various performance measures of quality are:

Area Measures

Quality of purchased component → zero defects

Quality of output → % yield

Customer awareness → orders; number of complaints

Benefits of Activity Based Cost Management

• Provision of excellent basis and focus for cost reduction.

• Provides operational management with a clear view of HOW to implement an Activity
based budget.
• Provision of clear understanding of the underlying causes of business processing costs.
• Provision of excellent basis for effectiveness of management decision making.
• Identification of key process waste elements, permit management prioritization and
leverage of key resources.

Activity Based Budgeting (ABB)

Activity-based budgeting is a process of planning and controlling the expected activities for the
organisation to derive a cost-effective budget that meets forecast workload and agreed strategic goals.
An activity-based budget is a quantitative expression of the expected activities of the firm, reflecting
management’s forecast of workload and financial and non-financial requirements to meet agreed
strategic goals and planned changes to improve performance.

Thus, the key elements of ABB are:

• Type of work/activity to be performed;
• Quantity of work/activity to be performed; and
• Cost of work/activity to be performed.

ABB focuses on the activity/business processes. Resources required are determined on the expected
activities and workload. The objective is to bring in efficiency into the system. So, in the process of
budget preparation, many key questions need to be addressed and properly answered
Activity Based Budgeting (ABB) is a technique for enhancing the accuracy of financial forecasts and
increasing management understanding. When automated, ABB can rapidly and accurately produce
financial plans and models based on varying levels of volume assumptions. Also, ABB eliminates
much of the needless rework created by traditional budgeting techniques. ABB analyzes the products
or services to be produced, what activities are required to produce those products or services, and
finally what resources need to be budgeted to perform those activities. Simply said, ABB is the
reversing of the ABC process to produce financial plans and budgets.

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Difference Between Activity Based Costing And Activity Based Management:

Activity Based Costing is logical distribution of overheads, i.e. overheads are distributed on the basis
of the consumption of resources. It helps to avoid distortion of costs of products/services. On the other
hand, Activity Based Management, on the other hand, is a discipline that focuses on efficient
management so as to value of services rendered to customers This focus on activities is being used
effectively for cost reduction, business process re-engineering, and benchmarking and performance
measurement. Activity Based Management brings about a change in viewing at the objective by
incorporation of financial perspective, internal business perspective, innovation and learning
perspective.

ABC systems address the following Questions:

• What activities are being performed by the organizational resources?
• How much does it cost to perform activities?
• Why does the organization need to perform those activities?
• How much of each activity is required for the organization’s products, services, and customers?

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Activity Based Cost system installation and operation

The motives for pursuing an ABC implementation, or at least of investigating its feasibility, must be established
at the outset. Most commonly these will be:

To improve product costing especially in those situations where existing methods under cost some products
and over cost others; or

To identify non-value-adding activities in the production process that might be a suitable focus for attention or
elimination.

In practice, the former is the most quoted goal, even though the latter may be more appropriate. This is
especially so for firms which are highly labour intensive and which do not have a great diversity of products in
their range, and where allocation of overhead based on direct labour hours may already function efficiently.

Direct costs, like materials and direct labour, are easily assigned directly to products. Some indirect costs,
particularly those selling costs which are product specific (e.g., advertising), may be directly assigned to the
product too. The remaining indirect costs are those which are problematical and provide the focus for ABC,
with resource costs indirectly assigned to the cost object via cost pools and activity drivers.

A number of distinct practical stages in the ABC implementation are as follows:

Staff Training: The co-operation of the workforce is critical to the successful implementation of ABC. They are
closest to the process and most aware of the problems. Staff training should be, as far as possible, jargon-free,
and create an awareness of the purpose of ABC. It should be non-threatening in nature, stressing that
increased efficiencies resulting from a successful implementation will mean rewards not redundancies. The
need for the co-operation of staff in the concerted team effort, for mutual benefit, must be emphasised
throughout the training activity.

Process Specification: Informal, but structured, interviews with key members of personnel will identify the
different stages of the production process, the commitment of resources to each, processing times and
bottlenecks. The interviews will yield a list of transactions which may, or may not, be defined as ‘activities ‘at a
subsequent stage, but in any case provide a feel for the scope of the process in the entirety.

Activity Definition: The problem must be kept manageable at this stage, despite the possibility of information
overload from new data, much of which is in need of codification. The listed transactions must be rationalized
in order to aggregate those in similar categories and eliminate those deemed immaterial. The resultant cost
pools will likely have a number of different events, or drivers, associated with their incurrence.

Activity Driver Selection: A single driver covering all of the transactions grouped together in an ‘activity’
probably does not exist. Multiple driver models could be developed if the data were available, but cost-benefit
analysis has rarely shown these to be desirable. The inter-correlation of potential activity drivers will probably
be so strong as to suggest that it really does not matter which one is selected. This argument might be
employed to avoid the costly collection of data items otherwise not monitored, nor easily accessible.

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Costing: A single representative activity driver can be used to assign costs from the activity pools to the cost
objects. If, for example, the number of engineering set-ups has been identified as a driver of process costs and
the total set-up cost is Rs. 40,000 for a company producing four products (A, B, C, D) then the number of set-
ups per product can be used to assign these costs. If product A requires 2 set-ups; B 4 set-ups ; C 24 and D 10,
then the average cost per set-up of Rs. 40,000/40 set ups = Rs. 1,000, a misleading figure taken at face value,
which does not imply the different demands of the set up resource made by the different products. However,
total set-up costs can be distributed to product groups in proportion to use, i.e., A: Rs. 2,000, B: Rs. 4,000, C:
Rs. 24,000 and D: Rs. 10,000 and then assigned to individual units of product in proportion to the total level of
output.

ABC: A Decision Making Tool

It is a useful tool for many of the management decisions facing companies today. It can bring a picture of the
operation to light that may not be obvious through other analysis tools. Specifically, ABC is useful in analyzing
specific segments of an organization. This might include a market line, a group of products (even a single
product), a customer, or an employee. The ABC is implemented in following decisions:

• ABC is a complement to total quality management (TQM). It provides quantitative data that can track
the financial impact of improvements implemented as part of the TQM initiative. Some have even suggested
that ABC is the most important concept introduced since TQM. Amoco Performance Products, Transparent
Container Co. and Fellowes Manufacturing Co. are a few companies that have utilized the ABC/TQM modeling
concept to improve performance and profitability.

• Wholesale distributors can gain significant advantage in the decision-making process through
implementation of ABC concepts. The expansion of line offerings has brought about difficult decisions for the
distributor. Using traditional financial data, overhead burden is distributed equally across the product line.
Introduction of new products or vendors might also introduce variance to the overhead. For instance, the need
to support a special storage area for control or environmental reasons, or the need of new handling equipment
will increase overall operational costs. These costs will be spread over the product line, reducing margin on
existing products and reducing the cost impact of the new items. ABC models the costs back to the activity. The
burden created by the new product is correctly reflected. This allows the existing merits while leaving the new
line to justify itself.

• Other decisions that can be assisted by ABC include facility and resource expansion. Often the basis for
relocation or opening of a new distribution center is based on cost associations. Reduction in freight or other
logistics costs can offset the expense of the new facility, staff or equipment. When the numbers used are
enterprise-based, the return might not develop as expected. The ABC model can identify the specific cost
elements being targeted, providing a much clearer picture from which management can act.

• Decision support for human resources can be augmented by ABC. Where activity, and therefore cost,
can be associated to an individual, new levels of financial performance can be determined. This might be
appropriate in cases of branch management or sales. Adding or deleting resource slots can be determined
based on costs of activities as well. The added data provided through ABC can present a number of options,
including outsourcing, productivity improvements through automation, and a determination of
employee/revenue ratios.
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• Companies who wish to determine price based on cost plus markup basis find ABC method of costing
very relevant and are able to determine competitive prices for their products.

• Using Traditional absorption costing, overheads may get distributed equally across all product lines.
ABC traces costs back to the activity and the consumption of resources by each product. Thus, product line
profitability can be determined in more realistic terms.

• Other areas where ABC system can be relevant include market, make or buy decisions, transfer pricing,
plant close – down decisions, evaluation of offshore production or outsourcing a process, capital investment
decisions, etc.

In summary, activity-based costing is a management decision-making tool. It provides financial support data
structured in a fashion fundamentally different from accounting data provided in the general ledger. By
associating cost to the activity, a clear relationship can be established between sources of activity demand and
the related costs. This association can benefit the distributor in determining where costs are being incurred,
what is initiating the costs and where to apply efforts to curb inflationary costs. This can be of particular value
in tracking new products or customers. It can also provide tracking of logistics costs, one of the fastest growing
areas of expense to the distribution operation.

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Concept of ‘ABC’ followed by ‘Coca Cola Enterprises Belgium’

Coca Cola Enterprises Belgium (CCEB) produces, distributes and sells the different brands of
‘The Coca-Cola Company’. In the field of distribution, it is also CCEB who services the entire
Belgian and Luxembourg market. CCEB is present in more than 85,000 points of sale
(supermarkets, grocery stores, companies, hospitals, cinemas, amusement parks, sport center).
By the end of 2009, CCEB employed more than 2,500 employees in Belgium and Luxembourg
with revenue of €1.1 billion.
Like many other companies, Coca-Cola Enterprises Belgium was confronted with an
increasing Cost to Serve (CTS) due to a changing customer landscape. This created a challenge
to which CCEB needed to formulate decisive answers to stay on track towards achieving their
growth path and their company objectives.
When companies are confronted with increasing CTS, it is essential to analyse the
organisation, its revenues & costs and its processes down to the most detailed level of
information. It is this data that give the true reasons behind certain evolutions so that
management can take fact-based decisions. When having such a challenge at hand, Activity
Based Costing is the most advanced and complete method to gain this information. Thus, CCEB
wanted to use the information from ABC analysis to formulate:
— Cost/Profit modeling
— Performance Modeling and
— Set-up an internal recharge mechanism to sales
By implementing Activity-Based Costing, CCEB obtained the right information that
enabled them to harmonise and streamline the processes of their different distribution centers.
This made it possible for CCEB to calculate the costs in a fair and transparent way, so that
the sales force is charged correctly according to the complexity that Supply Chain had to deal
with. From the capacity insights that CCEB got from Activity-Based Costing, multiple initiatives
were derived that ultimately led to the redesign of the regional distribution strategy, including:
— Optimizing efficiency and capacity within the logistic department
— Designing the most efficient processes, based on the time equations from ABC Analysis
— Implementing "best practice" processes in the CCEB distribution centers
These actions successfully reduce their Cost to Serve and still be in line with the new corporate
S&M-strategy.

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Q#01: Give two examples for each of the following categories in activity based costing:
(i) Unit Level activities Energy, Machine depreciation, Repairs
(ii) Batch Level activities Setup-hours , Procurement costs
(iii) Product Level activities Design costs, Engineering costs
(iv) Facility Level activities Rent, Building security

Q#02: Explain the concept of activity based costing. How ABC system supports corporate strategy?
Ans: “ABC is an accounting methodology that assigns costs to activities rather than products
and services. This enables resources and overhead costs to be more accurately assigned to
products and services that consume them when compared to traditional methods where either
labor or machine hrs are considered as absorption basis over cost centers.”
In order to correctly associate costs with products and services, ABC assigns cost to activities
based on their resources . It then assigns cost to ‘Cost objects’, such as products and
customers, based on their use of activities. ABC can track the flow of activities in organization by
creating a link between the activity and the cost objects. ABC supports corporate strategy in
many ways such as:
(i) ABC system can effectively support the management by furnishing data, at the
operational level and strategic level. Accurate product costing will help the management to
compare the profits of various customers, product lines and to decide on price
strategy etc.
(ii) Information generated by ABC system can also encourage management to redesign the
products.
(iii) ABC system can change the method of evaluation of new process technologies, to
reduce setup times, rationalization of plant lay out in order to reduce or lower material
handling cost, improve quality etc.
(iv) ABC system will report on the resource spending.
(v) ABC analysis helps managers focus their attention and energy on improving activities and
the actions allow the insights from ABC to be translated into increased profits.
(vi) Performance base accurate feedback can be provided to cost centre managers.
(vii) Accurate information on product costs enables better decisions to be made on pricing,
marketing, product design and product mix.

Q#03: 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?

ANS: The conventional product cost system was in vogue when companies manufactured
narrow range of products, overhead costs were relatively small and distortions arising
from inappropriate overhead allocations were not significant. It used volume measures like direct
labour hours or machine hours for charging overhead costs to products. In the case of a
company using highly automated plant, direct labour is a small fraction of cost when compared with
overheads (because of higher amount of depreciation). In case where such a company is multi
product, overheads which are large in proportion to direct labour are influenced by number of
set up, inspection, number of purchases etc. In these circumstances, the volume based method
of recovery of overheads is no longer appropriate and such a measure will report inaccurate
product costs. Hence, the traditional system of costing was found to over cost high volume

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products and under cost low volume products. Activity Based Costing (ABC) system aims at
refining the costing system used in automated plants in the following manner:
(i) ABC systems trace more costs as direct costs.
(ii) ABC systems create homogeneous cost pools linked to different activities.
(iii) For each activity cost pool, ABC systems seek a cost allocation base that has a
cause and- effect relationship with costs in the cost pool.

Q#04: Write the factors prompting the development of ABC system.

Ans: Factors prompting the development of ABC system include:

(i) Growing overhead costs because of increasingly automated production.
(ii) Increasing market competition which necessitated more accurate product costs.
(iii) Increasing product diversity to secure economies of scope & increased market share.
(iv) Decreasing costs of information processing because of continual improvements and
increasing application of information technology.

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Q#01:
A company produces three products A, B and C for which the standard costs and quantities
per unit are as follows:
Products A B C
Quantity produced 10,000 20,000 30,000
Direct material/p.u. 5 4 30
( Rs ) Direct labour/p.u. 0 0 50
(Rs ) Labour hours/p.u. 3 4 5
Machine hours/p.u. 0 0 7
No. of purchase requisitions 3 4 2,000
No. of set ups 4 4 300
Production overhead split by departments — Department 1 = Rs

11,00,000
— Department 2 = Rs. 15,00,000
Department 1 is labour intensive and Department 2 is machine intensive

Total labour hours in Department 1 = 1,83,333

Total machine hours in Department 2 = 5,00,000
Production overhead split by activity — Receiving/inspecting Rs.

14,00,000
— Production scheduling/machine setup
Rs.12, 0 0 ,0 0 0

Rs. 26,00,000
Number of batches received/inspected = 5,000
Number of batches for scheduling and set-up = 800
You are required to:
(i) Prepare Product Cost Statement under traditional absorption costing and Activity Based
Costing method.
(ii) Compare the results under two methods.

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Q#02
You have been appointed as a management consultant by XYZ ltd – a key manufacturer of
machining tools. You need to analyse how application of activity-based costing (ABC) to
costing of the company’s product lines would improve product costing and help it price its
product offerings in a more efficient manner.
Details of the four products and relevant information are given below for one period:
Product P Q R S
Output in units 150 120 60 90
Costs per unit R.S R.S Rs. Rs.
Direct material 50 60 40 80
Direct labour 32 24 18 20
Machine hours (per unit) 5 4 3 2
The four products are similar and are usually produced in production runs of 15 units and sold
in batches of 10 units.
The production overhead is currently absorbed by using a machine hour rate, and the total of
the production over head has been analysed as follows:
Rs.

Machine department costs (rent, Business, rates, depreciation and Supervision) 18,960
Set-up costs 5,600
Stores receiving 4,000
Inspection/quality control 1,620
Material handling and dispatch 7,980
You have identified ‘cost drivers’to be used are as listed below for the overhead costs shown:
Cost Cost Driver
Set-up costs Number of production runs
Stores receiving Requisitions raised
Inspection/quality control Number of production runs
Materials handling and dispatch Orders executed
The number of requisitions raised on the stores was 20 for each product and the number of
orders executed was 42, each order being for a batch of 10 of a product.
Requirements
(a) Calculate the total costs for each product if all overhead costs are absorbed on a
machine hour basis.
(b) Calculate the total cost of each product, using activity-based costing.
(c) Compare the two costs under the two scenarios and identify the implications this could
have on pricing and profit.

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Q#03
A manufacturing company produces Bail Pens that are printed with the logos of various
companies. Each Pen is priced at Rs. 5. Costs are as follows:
Cost Driver Unit Variable Cost Level of Cost Driver
Units Sold 2.5 —
Setups 225 40
Engineering hours 10 250
Other Data:
Total Fixed Costs (conventional) 48,000
36,500
Total Fixed Costs (ABC)
Required:
1. Compte the break-even point in units using activity-based analysis.
2. Suppose that company could reduce the setup cost by 75 per setup and could reduce
the number of engineering hours needed to 215. How many units must be sold to break
even in this cost.

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Q#04
The following information provides details of costs, volume & cost drivers for a particular
period in respect of ABC Ltd. for product X, Y and Z
Product X Product Y Product Z Total
1. Production and sales (units) 30,000 20,000 8,000
2. Raw material usage (units) 5 5 11
3. Direct material cost 25 20 11 12,38,000
4 Direct labour hours 1.33… 2 1 88,000
. Machine hours 1.33… 1 2 76,000
5 Direct labour cost 8 12 6
. Number of production runs 3 7 20 30
6 Number of deliveries 9 3 20 32
. Number of receipts (2 × 7)* 15 35 220 270
7 Number of production orders 15 10 25 50
. company operates a just-in-time inventory policy, and receives each component once per production run.
*The

Overhead costs:
Set-up 30,000
Machines 7,60,000
Receiving 4,35,000
Packing 2,50,000
Engineering 3,73,000
Rs.18,48,000

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In the past the company has allocated overheads to products on the basis of direct
labour hours. However, the majority of overheads are related to machine hours rather
than direct labour hours.
The company has recently redesigned its cost system by recovering overheads using
two volume related bases: machine hours and a materials handling overhead rate for
recovering overheads of the receiving department. Both the current and the
previous cost system reported low profit margins for product X, which is the company’ s
highest-selling product. The management accountant has recently attended a
conference on activity-based costing, and the overhead costs for the last period have
been analysed by the major activities in order to compute activity-based costs.
From the above information you are required to:
(a) Compute the product costs using a traditional volume-related costing system
based on the assumption that:
(i) All overheads are recovered on the basis of direct labour hours (i.e.
the company’s past product costing system);
(ii) The overheads of the receiving department are recovered by a materials
handling overhead rate and the remaining overheads are recovered using a
machine hour rate (i.e. the company current costing system).
(b) Compute product costs using an activity-based costing system.

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Chicago Manufacturing Co. (CMC) manufactures several product of varying levels of designs and models. It
uses a single overhead recovery rate based on direct labour hours. The overheads incurred by the CMC in the
half of the year are as under:
Rs.
Machine operation expenses 1,012,500
Machine maintenance expenses 187,500
Salaries of technical staff 637,500
Wages and salaries of stores staff 262,500
During this period, CMC introduced activity based costing system and the following significant
activities were identified:
— Receiving materials and components
— Set up of machines for production runs
— Quality inspection
It is determined that:
— The machine operation and machine maintenance expenses should be apportioned between
stores
and production activity in 20:80 ratio.
— The technical staff salaries should be apportioned between machine maintenance, set up and
quality
inspection in 30:40:30 ratio.
The consumption of activities during the period under review are as under:
— Direct labour hours worked 40,000
— Direct wage rate Rs. 6 per hour
— Production set-ups 2,040
— Material and component consignments from received from suppliers 1,960
— Number of quality inspections carried out 1,280
The data relating to two products manufactured by the CMC during the period are as under:
Product A Product B
Direct material costs (Rs.) 6,000 4,000
Direct labour hours 960 100
Direct material consignments received 48 52
Production runs 36 24
Number of quality inspections done 30 10
Quantity produced (units) 15,000 5,000
A potential customer has approached CMC for the supply of 24,000 units of a component K to be
delivered in lots of 3,000 units per quarter. The job will involve an initial design cost of Rs. 60,000
and the manufacture will involve the following per quarter:
Direct material costs Rs. 12,000
Direct labour hours 300
Production runs 6
Inspections 24
Number of consignments of Direct materials to be received 20
CMC desires a markup of 25% on cost.
Required:
(i) Calculate the cost of product P and Q based on the existing system of single overhead
recovery rate.
(ii) Determine the cost of product P and Q using activity based costing system.
(iii) Compute the sales value per quarter of component K using activity based costing
system.

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Question-4
During the last 20 years, JPY Ltd’s manufacturing operation has become increasingly automated
with Computer-controlled robots replacing operators. JPY currently manufactures over 100
products of varying levels of design complexity. A single plant wise overhead absorption rate,
based on direct labour hours, is used to absorb overhead costs In the quarter ended March, JPY’s
manufacturing overhead costs were:
(Rs.‘000)
Equipment Operation Expenses 125
Equipment Maintenance Expense 25
Wages Paid to Technicians 85
Wages Paid to Store Men 35
Wages Paid to Dispatch Staff 40
During the quarter, the company reviewed the Cost Accounting System and concluded that
absorbing overhead costs to individual products on a labour hour absorption basis is meaningless.
Overhead costs should be attributed to products using an Activity Based Costing (ABC) system
and the following was identified as the most significant activities:
(i) Receiving component consignments from suppliers
(ii) Setting up equipment for production runs
(iii) Quality inspections
(iv) Dispatching goods as per customer’s orders.
It was further observed that in the short-term JPY’s overheads are 40% fixed and 60% variable.
Approximately, half the variable overheads vary in relating to direct labour hours worked and half
vary in relation to the number of quality inspections.
Equipment operation and maintenance expenses are apportioned as:
− Component stores 15% , manufacturing 70% and goods dispatch 15%
Technician’s wages are apportioned as:
− Equipment maintenance 30% , set up equipment for production runs 40% and quality
inspections
30%
During the quarter:
(i) A total of 2,000 direct labour hours were worked (paid at Rs. 12 per hr.)
(ii) 980 components consignments were received from suppliers
(iii) 1020 production runs were set up
(iv) 640 quality inspections were carried out
(v) 420 orders were dispatched to customers.
JPY’s production during the quarter included components R, S and T. The following information is
available:
Component Component Component
R S T
Direct Material Rs. 1,200 Rs. 2,900 Rs. 1,800
Direct Labour Hrs worked 25 480 50
Component Consignments Recd. 42 24 28
Production Runs 16 18 12
Quality Inspections 10 8 18
Orders (goods) Despatched 22 85 46
Quantity Produced 560 12,800 2,400
Required:
(i) Calculate the unit cost of R, S and T components, using JPY’s existing cost accounting system.
(ii) Explain how an ABC system would be developed using the information given.
(iii)Calculate the unit cost of components R, S and T using ABC system.

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NEC Ltd. manufactures two parts ‘P’ and ‘Q’ for Computer Industry.
P : Annual production and sales of 1,00,000 units at a selling price of Rs. 100.05 per unit.
Q : Annual production and sales of 50,000 units at a selling price of Rs. 150 per unit.
Direct and Indirect costs incurred on these two parts are as follows:
Rs.in’000
Particulars of Costs P Q Total
Direct Material Cost (Variable) 4,200 3,000 7,200
Labour Cost (Variable) 1,500 1,000 2,500
Direct Machining Cost (See 700 550 1,250
Note)*
Indirect Costs
Machine Setup Cost 462
Testing Cost 2,375
Engineering Cost 2,250
Note: Direct machining costs represents the cost of machine capacity dedicated to the production of
each product. These costs are fixed and are not expected to vary over the long run horizon.
Additional information is as follows:
P Q
Production Batch Size 1,000 units 500 units
Set-up Time per batch 30 hours 36 hours
Testing Time per unit 5 hours 9 hours
Engineering Cost incurred on each product 8.40 lakhs 14.10 lakhs
A foreign competitor has introduced product very similar to ‘P’. To maintain the company’s share
and profit, NEC Ltd. has to reduce the price to Rs. 86.25. The company calls for a meeting and
comes up with a proposal to change design of product ‘P’. The expected effect of new design is as
follows:
— Direct Material cost is expected to decrease by Rs. 5 per unit.
— Labour cost is expected to decrease by Rs. 2 per unit.
— Machine time is expected to decrease by 15 minutes, previously it took 3 hours to produce 1 unit
of
‘P’. The machine will be dedicated to the production of new design.
— Set up time will be 28 hours for each set up.
— Time required for testing each unit will be reduced by 1 hour.
— Engineering cost and batch size will be unchanged.
Required:
(a) Company management identifies that cost driver for Machine set-up costs is ‘Set up hours used
in batch setting’ and for testing costs is ‘testing time’. Engineering costs are
assigned to products by special study. Calculate the full cost per unit for ‘P’ and ‘Q’
using Activity-Based Costing.
(b) What is the Mark-up on full cost per unit of P?
(c) What is the Target Cost per unit for new design to maintain the same mark up percentage on full
cost per unit as it had earlier? Assume cost per unit of cost drives for the new design remains
unchanged.
(d) Will the new design achieve the cost reduction target?
(e) List four possible management actions that the NEC Ltd. should take regarding new design.

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Super Food Ltd. Manufactures 3 types of biscuits, A, B and C, in a fully mechanized factory. The
company has been following conventional method of costing and wishes to shift to Activity Based
Costing System and therefore wishes to have the following data presented under both the systems
for the month.
Inspection Cost Rs. p.m. 73,000
Machine – Repairs & Maintenance Rs. p.m. 142,000
Dye Cost Rs. p.m. 10,250
Selling Overheads Rs. p.m. 162,000

Particulars Product A Product B Product C

Prime Cost (Rs. per unit) 12 9 8
Selling Price (Rs. per unit) 18 14 12
Gross Production (units / production run) 2,520 2,810 3,010
No. of Defective (units / production run) 20 10 10
Inspection:
3 4 4
No. of Hours / Production Run
Dye Cost / Production Run (Rs. ) 200 300 250
No. of Machine Hours / Production Run 20 12 30
Sales – No. of Units / Month 25,000 56,000 27,000

The following additional information is given:

(i) No accumulation of inventory is considered. All good units produced are sold.
(ii) All manufacturing and selling overheads are conventionally allocated on the basis of units sold.
(iii) Product A needs no advertisement. Due to its nutritive value, it is readily consumed by diabetic
patients of a hospital. Advertisement costs included in the total selling overhead is Rs. 83,000.
(iv) Product B needs to be specially packed before being sold, so that it meets competition. Rs.
54,000
was the amount spent for the month in specially packing B, and this has been included in the
total
selling overhead cost given.

You are required to present product wise profitability of statements under the conventional
system and the ABC system and accordingly rank the products.

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‘Humara - Apna’ bank offers three products, viz., deposits, Loans and Credit Cards. The bank
has selected 4 activities for a detailed budgeting exercise, following activity based costing
methods.
The bank wants to know the product wise total cost per unit for the selected activities, so that
prices may be fixed accordingly.
The following information is made available to formulate the budget:

Activity Present Cost Estimation for the budget period

(Rs.)
ATM Services:
(a) Machine Maintenance 4,00,000 All fixed, no change.
(b) Rents 2,00,000 Fully fixed, no change.
(c) Currency 1,00,000 Expected to double during budget period.
Replenishment Cost
Total 7,00,000 (This activity is driven by no. of ATM
transactions)
Computer Processing 5,00,000 Half this amount is fixed and no change is
expected.
The variable portion is expected to increase to
three times the current level.
(This activity is driven by the number of
computer transactions)
Issuing Statements 18,00,000 Presently, 3 lac statements are made. In the
budget period, 5 lac statements are expected.
For every increase of one lac statement, one
lac rupees is the budgeted increase.
(This activity is driven by the number of
statements)
Computer Inquiries 2,00,000 Estimated to increase by 80% during the
budget period.
(This activity is driven by telephone minutes)

The activity drivers and their budgeted quantifies are given below:
Activity Drivers Deposits Loans Credit Cards
No. of ATM Transactions 1,50,000 --- 50,000
No. of Computer Processing 15,00,000 2,00,000 3,00,000
Transactions
No. of Statements to be issued 3,50,000 50,000 1,00,000
Telephone Minutes 3,60,000 1,80,000 1,80,000

The bank budgets a volume of 58,600 deposit accounts, 13,000 loan accounts, and 14,000 Credit
Card Accounts.
You are required to:
(i) Calculate the budgeted rate for each activity.
(ii) Prepare the budgeted cost statement activity wise.
(iii) Find the budgeted product cost per account for each product using (i) and (ii) above.

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DEO Limited sells two versions: Deluxe and Premium of its only product GoGo Juicer. The GoGo
Juicer uses patented technology to extract the last drop of juice from most fruits. The 'Premium'
version can handle larger fruit and has more options relative to the 'Deluxe' version. The following
table provides the financial results of the most recent year of operations:

Particulars Deluxe Premium Total

90,000 10,000 1,00,000
units units units

Revenue (Rs.) 63,00,000 9,00,000 72,00,000

Material cost (Rs.) 10,80,000 2,50,000 13,30,000
Direct labour cost (Rs.) 14,40,000 1,60,000 16,00,000
Contribution margin (Rs.) 37,80,000 4,90,000 42,70,000
Allocated fixed manufacturing overhead (Rs.) 34,20,000 3,80,000 38,00,000
Allocated fixed selling and administrative overheads (Rs.)
2,51,563 35,937 2,87,500

Profit margin (Rs. ) 1,08,437 74,063 1,82,500

Profit margin per unit (Rs.) 1.2048 7.4063

Labour cost is Rs. 16 per hour and each product requires one hour of labour. The company
currently allocates all fixed manufacturing overheads, using labour hours as the allocation basis. It
allocates fixed selling and administrative overheads, using revenue as the allocation base.
Although the profit margin per unit of 'Deluxe' juicer is rather low, DEO Limited believes that it is
important to keep this model in the product mix. However, DEO can tailor its promotion and sales
strategies to improve the sales mix to 16:4 ratio from the current 9:1 ratio of 'Deluxe' to 'Premium'
juicers, with total volume staying at 1,00,000 units.
DEO Limited finds that Rs. 1.1 million of the Rs. 3.8 million of fixed manufacturing overheads
pertains to batch related activities such as scheduling production runs. Similarly, Rs. 115,000 is the
amount of administrative overheads out of the Rs. 287,500 of selling and administrative overheads.
It is found that the 'premium' juicer is produced in smaller batches (250 units per batch) than that of
'Deluxe' juicer (500 units per batch). Similarly, it takes 10 sales visits to sell 1,000 units of the
'Deluxe' juicer, while it takes 25 visits to sell 1,000 units of 'Premium' juicer.
Required:
(i) Prepare a profitability statement based on the proposed sales mix, using the most
appropriate basis of allocating fixed overheads. (In absence of an appropriate basis, do
not allocate overheads to products)
(ii) Advise the company on whether it should go ahead with the propose change in sales mix.

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Bank of HK operated for years under the assumption that profitability can be increased by
increasing Rupee volumes. But that has not been the case. Cost analysis has revealed the following:

Activity Activity Cost Activity Activity

(Rs.) Driver Capacit
y
Providing ATM Service 100,000 No. of Transactions 200,000
Computer Processing 1,000,000 No. of Transactions 2,500,000
Issuing Statements 800,000 No. of Statements 500,000
Customer Inquiries 360,000 Telephone Minutes 600,000

The following annual information on three products was also made available:

Activity Driver Checking Personal Gold

Accounts Loans Visa
Units of Product 30,000 5,000 10,000
ATM Transactions 1,80,000 0 20,000
Computer Transactions 20,00,000 2,00,000 3,00,000
Number of Statements 3,00,000 50,000 1,50,000
Telephone Minutes 3,50,000 90,000 1,60,000

Required:
(i) Calculate rates for each activity.
(ii) Using the rates computed in requirement (i), calculate the cost of each product.

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G-2020 Ltd. is a manufacturer of a range of goods. The cost structure of its different products is as
follows:

Product Product Product

Particulars
A B C
Direct Materials 50 40 40 Rs./u
Direct Labour @ 10 Rs. / hour 30 40 50 Rs./u
Production Overheads 30 40 50 Rs./u
Total Cost 110 120 140 Rs./u
Quantity Produced 10,000 20,000 30,000 Units

G-2020 Ltd. was absorbing overheads on the basis of direct labour hours. A newly appointed
management accountant has suggested that the company should introduce ABC system and has
identified cost drivers and cost pools as follows:

Activity Cost Pool Cost Driver Associated Cost

Stores Receiving Purchase Requisitions 296,000
Inspection Number of Production Runs 894,000
Dispatch Orders Executed 210,000
Machine Setup Number of Setups 1,200,000

The following information is also supplied:

Details Product A Product B Product C

No. of Setups 360 390 450
No. of Orders Executed 180 270 300
No. of Production Runs 750 1,050 1,200
No. of Purchase Requisitions 300 450 500

You are required to calculate activity based production cost of all the three products.

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Ice-Cream Ltd. is engaged in production of three types of ice-cream products: Coco, Strawberry
and Vanilla. The company presently sells 50,000 units of Coco @ Rs. 25 per unit, Strawberry
20,000 @ Rs. 20 per unit and Vanilla 60,000 units @ Rs. 15 per unit. The demand is sensitive to
selling price and it has been observed that every reduction of Rs. 1 per unit in selling price,
increases the demand for each product by 10% to the previous level. The company has the
production capacity of 60,500 units of Coco, 24,200 units of Strawberry and 72,600 units of
Vanilla. The company marks up 25% on cost of the product.
The Company management decides to apply ABC analysis. For this purpose it identifies four
activities and the rates as follows:
Activity Cost Rate
Ordering Rs. 800 per purchase order
Delivery Rs. 700 per delivery
Shelf stocking Rs. 199 per hour
Customer support and assistance Rs. 1.10 p.u. sold
The other relevant information for the products is as follows:

Particulars Coco Strawberry Vanilla

Direct Material p.u. (Rs.) 8 6 5
Direct Labour p.u. (Rs.) 5 4 3
No. of Purchase Orders 35 30 15
No. of Deliveries 112 66 48
Shelf Stocking Hours 130 150 160

Under the traditional costing system, store support costs are charged @ 30% of prime cost. In ABC
these costs are coming under customer support and assistance.
Required:
i. Calculate target cost for each product after a reduction of selling price required to achieve
the sales equal to the production capacity.
ii. Calculate the total cost and unit cost of each product at the maximum level using traditional
costing.
iii. Calculate the total cost and unit cost of each product at the maximum level using activity
based costing.
iv. Compare the cost of each product calculated in (i) and (ii) with (iii) and comment on it.

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Asian Mfg. Co. had decided to increase the size of the store. It wants the information about the
probability of the individual product lines: Lemon, Grapes and Papaya. It provides the following
data for the 2013 for each product line:

Particulars Lemon Grapes Papaya

Revenues (Rs.) 79,350 210,060 120,990
Cost of goods sold (Rs.) 60,000 150,000 90,000
Cost of bottles returned (Rs.) 1,200 0 0
Number of purchase orders placed 36 84 36
Number of deliveries received 30 219 66
Hours of shelf stocking time 54 540 270
Items sold 12,600 110,400 30,600

Asian Mfg. Co. also provides the following information for the year 2013:
Activity Description of Activity Total Costs Cost Allocation
(Rs.) Basis
Bottle returns Returning of empty bottles to the 1,200 Direct tracing to
store product line
Ordering Placing of orders of purchases 15,600 156 purchase
orders
Delivery Physical delivery and the receipts 25,200 315 deliveries
of merchandise
Self stocking Stocking of merchandise on store 17,280 864 hours of time
shelves and ongoing restocking
Customer Assistance provided to customers 30,720 1,53,600 items sold
support including bagging and checkout

Required:
I. Asian Mfg. Co. currently allocates store support costs (all costs other than the cost of goods
sold) to the product line on the basis of the cost of goods sold of each product line.
Calculate the operating income and operating income as the percentage of revenue of each
product line.
II. If Asian Mfg. Co. allocates store support costs (all costs other than the cost of goods sold) to
the product lines on the basis of ABC system, calculate the operating income and operating
income as the percentage of revenue of each product line.
III. Compare both the systems.

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Golden North Ltd. manufactures four products, namely A, B, C and D using the same plant and
process. The following information relates to a production period:

Product A Product B Product C Product D

Output in units 720 600 480 504
Cost per unit: Rs. Rs. Rs. Rs.
Direct Material 42 45 40 48
Direct Labour 10 9 7 8
Machine hours per unit 4 hrs. 3 hrs. 2 hrs. 1 hr.

The four products are similar and are usually produced in production runs of 24 units and sold in
batches of 12 units. Using machine hour rate currently absorbs the production overheads. The total
overheads incurred by the company for the period is as follows:

Machine operation and maintenance cost (Rs.) 63,000

Setup costs (Rs. ) 20,000
Store receiving (Rs. ) 15,000
Inspection (Rs.) 10,000
Material handling and dispatch(Rs. ) 2,592

During the period the following cost drivers are to be used for the overhead cost:
Activity Cost Driver
Setup cost No. of production runs
Store receiving Requisition raised
Inspection No. of production runs
Material handling and dispatch Orders executed

It is also determined that:

— Machine operation and maintenance cost should be apportioned between setup cost, store
receiving
and inspection activity in 4:3:2.
— Number of requisition raised on store is 50 for each product and the no. of order executed is 192,
each order being for a batch of 12 of a product.
Required:
i. Calculate the total cost of each product, if all overhead costs are absorbed on machine hour
rate basis.
ii. Calculate the total cost of each product using activity base costing.
iii. Comment briefly on differences disclosed between overhead traced by present system and
those traced by activity based costing.

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Wool Mark Ltd. manufactures three types of products namely P, Q and R. The data relating to
a period are as under:

Particulars P Q R
Machine hours per unit 10 18 14
Direct Labour hours per unit @ Rs. 20 4 12 8
Direct Material per unit (Rs.) 90 80 120
Production (units) 3,000 5,000 20,000

Currently the company uses traditional costing method and absorbs all production overheads
on the basis of machine hours. The machine hour rate of overheads is Rs. 6 per hour.
The company proposes to use activity based costing system and the activity analysis is as
under:
Particulars P Q R
Batch size (units) 150 500 1,000
Number of purchase orders per batch 3 10 8
Number of inspections per batch 5 4 3

The total production overheads are analyzed as under:

Machine set up costs 20%
Machine operation costs 30%
Inspection costs 40%
Material procurement related costs 10%
Required:
i. Calculate the cost per unit of each product using traditional method of absorbing all
production overheads on the basis of machine hours.
ii. Calculate the cost per unit of each product using activity based costing principles.

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The following are Product Alpha's data for next year budget:

Activity Cost Driver Cost Driver Cost Pool

Volume / Year (Rs.)
Purchasing Purchase orders 1,500 75,000
Setting Batches produced 2,800 1,12,000
Materials handling Materials movements 8,000 96,000
Inspection Batches produced 2,800 70,000
Machining costs Machine hours 50,000 150,000

Purchase orders 25
Output 15,000 units
Production batch size 100 units
Materials movements per batch 6
Machine hours per unit 0.1

Required:
(i) Calculate the budgeted overhead costs using activity based costing principles.
(ii) Calculate the budgeted overhead costs using absorption costing (absorb overhead using machine
hours).
(iii) How can the company reduce the ABC for Product Alpha?

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Transnet Ltd. is engaged in the production of four products: A, B, C and D. The price charged for
the four products are Rs. 180, Rs. 175, Rs. 130 and Rs. 180 respectively, Market research has
indicated that if Transnet Ltd can reduce the selling prices of its products by Rs. 5, it will be
successful in getting bulk orders and gain a significant share of market of those products. The
company’s profit markup is 25 per cent on cost of the product. The relevant information of products
are as follows:

Products A B C D
Output in units 600 500 400 600
Cost per unit -
Direct material (in Rs.) 40 50 30 60
Direct labour (in Rs. ) 28 21 14 21
Machine hours (per unit) 4 3 2 3

The four products are usually produced in production runs of 20 units and sold in batches of 10
units. The production overhead is currently absorbed by using a machine hour rate, and the total of
the production overheads for the period has been analysed as follows:

(Rs.)
Machine department costs 52,130
Setup costs 26,250
Stores receiving 18,000
Inspection / Quality control 10,500
Material handling and dispatch 23,100
The cost drivers to be used for the overhead costs are as follows:
Cost Cost drivers
Setup costs Number of production runs
Store receiving Requisitions Raised
Inspection / Quality control Number of production runs
Materials handling and dispatch Order executed
The number of requisitions raised in the stores was 100 for each product and the number of orders
executed was 210, each order being for a batch of 10 units of a product.
You are required:
(i) To compute the target cost for each product.
(ii) To compute total cost of each product using activity based costing.
(iii) Compare target cost and activity based cost of each product and comment whether the price
reduction is profitable or not.

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Question-Explain the concept of activity based costing. How ABC system supports corporate strategy?
Solution:
“ABC is an accounting methodology that assigns costs to activities rather than products and
services. This enables resources and overhead costs to be more accurately assigned to
products and services that consume them when compared to traditional methods where either
labour or machine hrs are considered as absorption basis over cost centres.”
In order to correctly associate costs with products and services, ABC assigns cost to activities
based on their resources . It then assigns cost to ‘Cost objects’, such as products and
customers, based on their use of activities. ABC can track the flow of activities in organization
by creating a link between the activity and the cost objects. ABC supports corporate strategy
in many ways such as:
(i) ABC system can effectively support the management by furnishing data, at the
operational level and strategic level. Accurate product costing will help the management
to compare the profits of various customers, product lines and to decide on price
strategy etc.
(ii) Information generated by ABC system can also encourage management to redesign the
products.
(iii) ABC system can change the method of evaluation of new process technologies, to
reduce setup times, rationalization of plant lay out in order to reduce or lower material
handling cost, improve quality etc.
(iv) ABC system will report on the resource spending.
(v) ABC analysis helps managers focus their attention and energy on improving activities
and the actions allow the insights from ABC to be translated into increased profits.
(vi) Performance base accurate feedback can be provided to cost centre managers.
(vii) Accurate information on product costs enables better decisions to be made on pricing,
marketing, product design and product mix.

Question-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?
Solution:
The conventional product cost system was in vogue when companies manufactured narrow
range of products, overhead costs were relatively small and distortions arising from
inappropriate overhead allocations were not significant. It used volume measures like direct
labour hours or machine hours for charging overhead costs to products. In the case of a
company using highly automated plant, direct labour is a small fraction of cost when compared
with overheads (because of higher amount of depreciation). In case where such a company is
multi product, overheads which are large in proportion to direct labour are influenced by
number of set up, inspection, number of purchases etc. In these circumstances, the volume
based method of recovery of overheads is no longer appropriate and such a measure will
report inaccurate product costs. Hence, the traditional system of costing was found to over
cost high volume products and under cost low volume products. Activity Based Costing (ABC)
system aims at refining the costing system used in automated plants in the following manner:
(i) ABC systems trace more costs as direct costs.
(ii) ABC systems create homogeneous cost pools linked to different activities.
(iii) For each activity cost pool, ABC systems seek a cost allocation base that has a
causeand- effect relationship with costs in the cost pool.

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Question-Write the factors prompting the development of ABC system.

Solution:
Factors prompting the development of ABC system include:
(i) Growing overhead costs because of increasingly automated production.
(ii) Increasing market competition which necessitated more accurate product costs.
(iii) Increasing product diversity to secure economies of scope & increased market share.
(iv) Decreasing costs of information processing because of continual improvements and
increasing application of information technology.
Question-State main advantages of Activity Based Costing.
Solution:
The main advantages of using Activity Based Costing are:
(i) More accurate costing of products/services, customers, SKUs, distribution channels.
(ii) Better understanding overhead.
(iii) Utilizes unit cost rather than just total cost.
(iv) Integrates well with Six Sigma and other continuous improvement programs.
(v) Makes visible waste and non-value added.
(vi) Supports performance management and scorecards.
(vii) Enables costing of processes, supply chains, and value streams.
(viii) Activity Based Costing mirrors way work is done.
(ix) Facilitates benchmarking.

Question-Explain which features of the Service organisations may create problems for the application of activity-
based costing.
Solution:
The following may create problem for adoption of ABC system in service organisation –
(i) Facility sustaining costs (such as property, rents etc.) represent a significant portion of
total costs and may only be avoidable if the organisation ceases business. It may be
impossible to establish appropriate cost drivers.
(ii) It is often difficult to define products where they are of intangible nature. Cost objects
can therefore be difficult to specify.
(iii) Many service organisations have not previously had a costing system and much of the
information required to set up a ABC system will be non-existent. Therefore
introduction of ABC may be expensive.
Question-What is the fundamental difference between Activity Based Costing System (ABC) and
Traditional Costing System? Why more and more organisations in both the manufacturing and non-manufacturing
industries are adopting ABC?
Solution:
In the traditional system of assigning manufacturing overheads, overheads are first allocated
and apportioned to cost centres (production and support service cost centres) and then
absorbed to cost objects (e.g. products). Under ABC, overheads are first assigned to activities
or activity pools (group of activities) and then they are assigned to cost objects. Thus, ABC is
a refinement over the traditional costing system. Usually cost centres include a series of

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different activities. If different products create different demands on those activities, the
traditional costing system fails to determine the product cost accurately. In that situation, it
becomes necessary to use different rates for different activities or activity pools.
The following are the reasons for adoption of ABC by manufacturing and non-manufacturing
industries:
(i) Fierce competitive pressure has resulted in shrinking profit margin. ABC helps to
estimate cost of individual product or service more accurately. This helps to formulate
appropriate marketing / corporate strategy.
(ii) There is product and customer proliferation. Demand on resources by products /
customers differ among product / customers. Therefore, product / customer profitability
can be measured reasonably accurately, only if consumption of resources can be traced
to each individual product / customer.
(iii) New production techniques have resulted in the increase of the proportion of support
service costs in the total cost of delivering value to customers. ABC improves the
accuracy of accounting for support service costs.
(iv) The costs associated with bad decisions have increased substantially.
(v) Reduction in the cost of data processing has reduced the cost of tracking resources
consumption to large number of activities.

Question-Point out the differences between activity based costing and traditional absorption costing.
Solution:
The points of differences between activity based costing and traditional absorption costing can
be enumerated below:

Activity Based Costing Traditional Absorption Costing

(i) Overheads are related to activities and (i) Overheads are related to cost
grouped into activity cost pools. centers / departments.
(ii) Activities are classified as – (i) Unit (ii) Only (i) Unit Level (Variable) and
Level, (ii) Batch Level, (iii) Product (ii) Facility Level (Fixed) activities
Level and (iv) Facility Level activities. are identified.
(iii) Costs are related to activities and (iii) Costs are related to cost centers and
hence are more realistic. hence not realistic of cost behaviour.
(iv) Activity–wise cost drivers are (iv) Time (Hours) are assumed to be the
determined. only cost driver governing costs in all
departments.
(v) Activity–wise recovery rates are (v) Either multiple overhead recovery
determined and there is no concept of a rate (for each department) or a single
single overhead recovery rate. overhead recovery rate may be
determined for absorbing overheads.
(vi) Cost are assigned to cost objects, e.g. (vi) Costs are assigned to Cost Units i.e.
customers, products, services, to products, or jobs or hours.
departments, etc.
(vii) Essential activities can be simplified (vii) Cost Centers / departments cannot
and unnecessary activities can be be eliminated. Hence not suitable for
eliminated. Thus the corresponding cost control.
costs are also reduced / minimized.
Hence ABC aids cost control.

Question-State Benefits of Activity Based Cost Management.

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Solution:
Benefits of Activity Based Cost Management
(i) Provision of excellent basis and focus for cost reduction.
(ii) Provides operational management with a clear view of HOW to implement an Activity
Based budget.
(iii) Provision of clear understanding of the underlying causes of business processing costs.
(iv) Provision of excellent basis for effectiveness of management decision making.

(v) Identification of key process waste elements, permit management prioritisation and
leverage of key resources.
Question-What are the key elements of Activity Based Budgeting (ABB)?
Solution:
The key elements of ABB are:
(i) Type of work/activity to be performed;
(ii) Quantity of work/activity to be performed; and
(iii) Cost of work/activity to be performed.

Question-Give two examples for each of the following categories in activity based costing:
(i) Unit level activities
(ii) Batch level activities
(iii) Product level activities
(iv) Facility level activities
Solution:
Examples:

(i) Unit Level Activities ---- (i) Use of indirect materials

(ii) Inspection or testing of every item produced
(iii) Indirect consumables
(ii) Batch Level Activities ---- (i) Material ordering
(ii) Machine set up costs
(iii) Inspection of products–like first item of every
batch
(iii) Product Level ---- (i) Designing the product
(ii) Producing parts to a certain specification
(iii) Advertising costs, if advertisement is for individual
products

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Question-State with a brief reason whether you would recommend an activity based system of costing in each
of the following independent situations:
(i) Company K produces one product. The overhead costs mainly consist of
depreciation. (ii) Company L produces 5 different products using different production
facilities.
(iii) A consultancy firm consisting of lawyers, accountants and computer engineers
provides management consultancy services to clients.
(iv) Company S produces two different labour intensive products. The contribution per
unit in both products is very high. The BEP is very low. All the work is carried on
efficiently to meet the target costs.
Solution:
Sl. Description Recommend Reasons
No ABC (Yes / No)
(i) K produces one No  One product situation. For allocation
product. Overhead is of overhead, ABC is not required.
mainly depreciation.  ABC for cost reduction not beneficial
since most of the overhead is
depreciation.
(ii) L produces 5 different Yes  Multi product situation. ABC is
products with required for allocation of overhead.
different facilities.  ABC is necessary for pricing.
 Cost drivers are likely to be
different.
 Cost reduction may be possible.
 Production facilities are different.
(iii) Professional services Yes  Variety of services. Hence ABC is
– lawyers / required for cost allocation.
/ accountants /  Services are very different.
computer engineers.  ABC is necessary for pricing.
 Cost reduction possible.

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(iv) S produces 2 No  Different products, but labour

different intensive. Hence,
labour intensive overhead allocation based on readily
products. High traceable direct labour cost will be
unit contribution and accurate. Hence, ABC not required
efficient operations. for cost allocation.
 Low BEP level implies low level
of fixed cost as a % of sale price or
as a % of total cost.
 Many fixed cost activity drivers are
likely to align with the direct labour
costs. Hence not required for cost
allocation.
 Efficient operation. Hence ABC
not required even for cost
reduction or ABC management.

Question-State whether each of the following independent activities is value-added or non-value-added: (i)
Polishing of furniture used by a systems engineer in a software firm.
(ii) Maintenance by a software company of receivables management software for a
banking company.
(iii) Painting of pencils manufactured by a pencil factory.
(iv) Cleaning of customers' computer key boards by a computer repair centre.
(v) Providing, brake adjustments in cars received for service by a car service station.

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