CHAPTER VI

ACTIVITY BASED COSTING SYSTEM

Activity-Based vs. Traditional Costing

Costing is used in business accounting strategies as a way of determining the
cost of manufacturing a product in relation to the revenue generated by that
product. Costing systems determine the overhead of production and then
allocate those overhead costs to a business’ products.

There are two common methods for allocating these indirect costs to products.
Both of these methods assess overhead costs and then attach these costs to
products based on certain cost drivers. A cost driver is any component that
costs money or any factor that is related to a cost occurring, such as the
volume produced or the number of labor hours.

The first of these methods is activity-based costing, which is sometimes

referred to as “ABC.” Activity-based costing determines all activities associated
with production, assigns a cost to those activities and then determines the cost
of the product.

The other method is traditional costing, which assigns costs to products

based on an average overhead rate. This method pools all indirect costs in
production and applies those costs equally across the board using one
appropriate cost driver, such as machine hours.

Activity-based costing is more accurate because it takes important factors into

account before assigning a cost to a product. However, for this same reason, it
is a bit more complicated and time-consuming. It’s also more thorough and
considers nonmanufacturing expenses as well, such as administrative and
managerial costs.

Traditional costing is a much easier way of determining the cost of a product,

since it relies solely on assigning average overhead rates. This also means it

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won’t always be as accurate, because it doesn’t factor in nonmanufacturing
expenses or determine which overhead costs actually affect specific products.

Product cost determination under activity-based costing is made on the basis

of cost driver required for producing goods or delivering services. Activity-based
costing is becoming more effective in costing of multi-products produced by
industries and executing customers' orders.

Activity-based costing (ABC) is an effective management approach for

distributing and controlling the overhead costs. Overhead analysis can be
made more accurate by using ABC techniques for a wide range of products, for
product costing and profitability analysis and for distribution and control of the
overheads appropriately.

The following chart explains the general structure of activity based (ABC)
costing model.

The Activity Based Costing Model

Cost Objects
(e.g., products and customers)

Activities

Consumption of Resources

Cost

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Advantages of Activity-Based Costing (ABC)

1. Product cost determination under activity-based costing is more accurate

and reliable because it focuses on the cause and effect linkage of costs
and activities in the context of producing goods.
2. Fixation of selling price for multi-products under activity-based costing is
fair and correct because overheads are allocated on the basis of relevant
cost drivers.
3. Control of overheads consisting of fixed and variable becomes possible by
controlling and monitoring activities. Linkage between cost and activities
are clearly identified in activity-based costing and thus
provides opportunities to control overhead costs.
4. Sufficient information can be obtained to make decisions about the
profitability of different product lines.
5. Fair allocation of overheads occupy a considerable portion in the total
cost components.

Disadvantages or Limitations of Activity Based Costing System

1. Implementing an ABC system is a major project that requires substantial
resources. Once implemented   an activity based costing system is costly
to maintain. Data concerning numerous activity measures must be
collected, checked and entered into the system.

2. ABC produces numbers such as product margin, that are odds with the
numbers produced by traditional costing systems. But managers are
accustomed to using traditional costing systems to run theirs operations
and traditional costing systems are often used in performance
evaluation.

3.  Activity based costing data can be easily misinterpreted and must be

used with care when used in making decisions. Costs assigned to
products, customers and other cost objects are only potentially relevant.

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 Before making any significant decision using activity based costing data,
managers must identify which costs are really relevant for the decisions
at hand.

4. Reports generated by these systems do not conform to generally accepted

accounting principles (GAAP). Consequently, an organization involved in
activity based costing should have two cost systems - one for internal use
and one for preparing external reports.

Developing Activity-Based Costs

Activity-based costing involves the following four steps:

1. Identify the activities—such as processing orders—that consume

resources and assign costs to them.

2. Identify the cost driver(s) associated with each activity. A cost driver
causes, or “drives,” an activity’s costs. For the order-processing activity, the
cost driver could be the number of orders.

3. Compute a cost rate per cost driver unit or transaction. The cost driver
rate could be the cost per order, for example.

4. Assign costs to products by multiplying the cost driver rate by the volume
of cost driver units consumed by the product.

A few examples of the activities and appropriate cost drivers are stated below:

Activities or transactions................................Cost drivers

Material procurement.................................Number of materials procured

Material handling.........................................Quantity of input material
Customers' order execution........................Number of orders executed

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Dispatch of goods..........................................Number of dispatches
Inspections.....................................................Number of inspections
Machine operation.........................................Machine hours
Production scheduling...................................Number of production scheduling
Production runs..............................................Number of production run
Employees' related activity...........................Number of employees
Set-ups.............................................................Number of set-ups

Illustration:
If inspection cost is $ 140,000 for assembling 100 ordinary and 100 automatic
cameras. If one ordinary camera needs 2 inspections and one automatic
camera needs 5 inspection, then find the inspection cost per inspection.

Solution,
Calculation of number of inspection:

Number of inspections of ordinary cameras = 100 cameras x 2 = 200

Number of inspections of automatic camera = 100 cameras x 5 = 500
Therefore, total number of inspections = 200+500 = 700

Now, inspection cost per inspection = total inspection costs/No. of inspections

= $ 140000/700 inspections = $ 200 per inspection.

Step 4: Trace or allocate the cost of the activities or operations to the

final products.

Trace refers to the distribution of overheads to different product lines produced

by using a cost driver rate. Overheads are recovered by different product lines
based on the number of the activities required by each product by using
a driver rate. Tracing refers to the recovery of inspection cost by the product
lines by using relevant cost driver.

In the above illustration, $ 100000 and $ 40000 shared by automatic and

ordinary cameras respectively i.e the ordinary camera required

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200 inspection at the rate of $ 200 per inspection and automatic cameras
required 500 inspection at the rate of $200 per inspection.
Thus, overheads are assigned to prevailing products lines by recognizing the
relevant cost drivers for ascertaining product cost under activity-based costing.

Illustration

Ferris Corporation makes a single product - a fire resistant commercial filing

cabinet - that it sells to office furniture distributors. The company has a simple
ABC system that it uses for internal decision making. The company has two
overhead departments whose costs are listed below:

Manufacturing overhead $5,00,000

Selling and administrative overhead $300,000

Total overhead costs $8,00,000

 The company's activity based costing system has the following activity cost
pools and activity measures:
 

Activity Cost Pool Activity Measures

Assembling units Number of units

Processing orders Number of orders

Supporting customers Number of customers

Other Not applicable

Costs assigned to the "other" activity cost pool have no activity measure; they
consist of the costs of unused capacity and organization-sustaining costs -
neither of which are assigned to products, orders or customers.

Ferris Corporation distributes the costs of manufacturing overhead and of

selling and administrative overhead to the activity cost pools based on
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employee interviews, the results of which are reported below:
 

Distribution of Resource Consumption Across Activity Cost Pools

Assembling Processing Supporting
  Other Total
Units Orders Customers

Manufacturing overhead 50% 35% 5% 10% 100%

Selling and administrative overhead 10% 45% 25% 20% 100%

Total activity 1,000 units 250 orders 100 customers -- --

Required:

1. Perform the first stage allocation of overhead costs to the activity cost
pools.
2. Compute activity rates for the activity cost pools.
3. Office Mart is one of the Ferris Corporation's customers. Last year Office
Mart ordered filing cabinet four different times. Office Mart ordered a
total of 80 cabinets during the year. Construct a table showing the
overhead costs of these 80 units and four orders.

Solution:

1. The first stage allocation of costs to the activity cost pools appears below:

                                         Activity Cost Pools

Assembling Processing Supporting

  Other Total
Units Orders Customers

Manufacturing overhead $250,000 $175,000 $25,000 $50,000 $500,000

Selling and administrative

30,000 135,000 75,000 60,000 300,000
overhead

Total activity $280,000 $310,000  $100,000 $110,000 $800,000

2. The activity rates for the activity cost pools are:

 

Activity Cost Pools Total Cost Total Activity Activity Rate

Assembling units $280,000 1,000 units $280 per unit

Processing orders $310,000 250 units $1,240 per order

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Supporting customers $100,000 100 customers $1,000 per customer

3. The overhead cost for the four orders of a total of 80 filing cabinets would be
computed as follows:
 

Activity Cost Pools Total Cost Total Activity Activity Rate

Assembling units $280 per unit 80 units $22,400

Processing orders $1,240 per order 4 units $4,960

Supporting customers $1000 per customer Not applicable  

4. The product and customer margin can be computed as follows: 

Filing Cabinet Product Margin:    

Sales ($595 per unit × 80 units)   $47,600

Cost:    

     Direct materials ($180 per unit × 80 units) $14,400  

     Direct materials ($50 per unit × 80 units) 4,000  

     Volume related overhead (above) 22,400  

     Order related overhead (above) 4,960 45,760

    $1,840

    ==========

Customer profitability Analysis – Office Mart    

Product margin (above) $1,840  

Less: Customer support overhead (above) 1,000  

   

  $840  

Value added and Non-value added activities

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The value you add to your products is what convinces your customers to buy
them. Non-value-added activities add costs to your product without enhancing
the value. Cost accounting is a managerial accounting division that tracks
production costs. As your items move through production, cost accounting
identifies which activities add value to your products and which ones do not.
Keeping your non-value-added activities to a minimum improves your profit
margin by cutting unnecessary expenses.

Warehouse Delivery

Raw materials are the direct materials you use to produce your products.
However, raw materials in and of themselves do not add value to your
products. The costs of purchasing, transporting and storing your raw materials
are non-value-added activities. In addition, the time your employees spend
moving the raw materials into your warehouse and entering each item into the
inventory accounting program are non-value-added activities. Returning
damaged or defective raw materials are additional non-value-added activities.

Work in Process

Taking raw materials out of storage and placing them on the production line is
a value-added activity. Your employee’s direct labor on the production line is
another value-added activity. However, inspection and quality control are non-
valued-added activities. Inspecting the work in process or finished items do not
add value to them. Reworking defective items are non-value-added activities.
Moving defective items from the production line to the reworking station and
back to the production line are non-value-added activities.

Inventory Storage

Transporting your finished goods from the production area into storage is a
non-value-added activity, as are the costs of storing and warehousing your
finished goods. Having too much inventory on hand may indicate a problem
with estimating customer demand, and keeping inventory in storage for too

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long may reduce its value through obsolescence. Your customers may view
your older inventory as inferior compared to what your competitor offers.

Sold Merchandise

Selling your merchandise is a value-added activity. You recoup your

investment and make a profit on the sale. If customers can order your
merchandise by mail, the costs of preparing the merchandise for shipment and
sending the items are value-added activities. However, if you accept returns,
returning the merchandise back into storage is a non-value added activity. If
your customer returns a defective item, the time spent repairing or reworking
the unit doesn't add value to it

Classification of Activity levels

While using cost drivers to assign overhead costs to individual units works well
for some activities, for some activities such as setup costs, the costs are not
incurred to produce an individual unit but rather to produce a batch of the
same units. For other costs, the costs incurred might be based on the number
of product lines or simply because there is a manufacturing facility. To assign
overhead costs more accurately, activity‐based costing assigns activities to one
of four categories:

 Unit‐level activities occur every time a service is performed or a product

is made. The costs of direct materials, direct labor, and machine
maintenance are examples of unit‐level activities.

 Batch‐level activities are costs incurred every time a group (batch) of

units is produced or a series of steps is performed. Purchase orders,
machine setup, and quality tests are examples of batch‐level activities.

 Product‐line activities are those activities that support an entire

product line but not necessarily each individual unit. Examples of
product‐line activities are engineering changes made in the assembly

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 line, product design changes, and warehousing and storage costs for
each product line.

 Facility support activities are necessary for development and

production to take place. These costs are administrative in nature and
include building depreciation, property taxes, plant security, insurance,
accounting, outside landscape and maintenance, and plant
management's and support staff's salaries.

The costs of unit‐level, batch‐level, and product‐line activities are easily

allocated to a specific product, either directly as a unit‐level activity or through
allocation of a pooled cost for batch‐level and product‐line activities. In
contrast, the facility‐level costs are kept separate from product costs and are
not allocated to individual units because the allocation would have to be made
on an arbitrary basis such as square feet, number of divisions or products, and
so on.

ABC in service organization

Service companies have had problems coming up with decent cost accounting
systems because they have been modeling them after systems found in
manufacturing firms. The problems with this are that manufacturing firms
place emphasis on valuing inventory, which service firms do not have, and use
standard costs calculated for direct materials and labor. Direct materials and
direct labor are not major cost categories in service firms and it is hard to
calculate standard costs in a service setting. Nonetheless, service firms do need
to know accurate costs for product profitability analysis. They need to find out:

 Which products are profitable.

 Which products should be emphasized.

 Trends in product profitability over time.

 Product costs as a basis for setting prices.

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This means that costing in the service sector needs to be forward-looking, and
ABC is a tool for such analysis. There are several service industries where ABC
has started to emerge, and will continue to prove useful.

Financial Services

As the regulation ended in the banking industry, costing became more

important as banks competed with one another. Banking costs are not driven
by the volume of customers, but rather the number of transactions processed.
Traditional volume based costing is obviously inappropriate in this case. Banks
are moving to the concept where the user pays for the cost of the services they
use, so that all users do not share the bill evenly. To do so they must have an
accurate reflection of the cost of services.

Sharma (1992) described step-by-step how banks should implement ABC:

 Split the bank into profit centers.

 Prepare a list of products associated with each profit center and a list
of product related and non-product related activities.

 Divide non-product related activities into activities with unit-specific

significance and activities with organization-wide significance. 

The former activities are spread across all products produced by the
unit. The latter category should include as few things as possible.

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Many banks have already had success applying such division principles.

Healthcare

Healthcare providers used to be able to increase their prices or service to

increase revenues and profitability. Today Medicare or managed care firms
essentially set revenues with their prospective payment system (PPS). All
healthcare providers can do to improve profitability is make good decisions
with accurate cost information. PPS improved the sophistication of cost
accounting systems in healthcare.

In a survey of hospital administrators about what information they needed to

manage effectively, they said:

 The cost of an episode of care.

 Accurate allocation of administrative costs to products.

 A comparison of costs and their causes over time.

 Information regarding the cost of various activities.

All of this information is available from an ABC system. There are examples of
hospitals successfully implementing ABC systems in the article.

Young and Pearlman (1993) believed that hospital’s cost accounting systems
evolve in a four-step process:

 The hospital improves the overall cost accounting systems.

 The system separates variable and fixed costs. 

 The system identifies factors that drive costs, the ways these factors
can be controlled, and redefines departments as profit or cost centers.

 The accounting system supports the reconfiguration of administrative

systems that cut across traditional functional lines.

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Another viewpoint on hospital cost accounting systems is provided by Ramsey
(1994). He believes that it should serve three purposes:

 It should promote cost efficiency without sacrificing product and

service quality.

 It should allow the organization to maximize its resources through

product and service line management. 

 It should highlight areas for continual improvement.

Insurance

This industry is also making the move toward better management of costs due
to increased competition. Here workers may spend a long time working on one
task and the time on each task varies greatly depending on the case. The
discussion in this section is mainly about ABC concepts and hospital
malpractice insurance. A study found that a variety of factors drove
malpractice costs and that the risk of malpractice was also tied to geographical
locations. With these facts a malpractice insurance cost per medical procedure
was calculated and divided by the number of that type of procedure for
accurate costing.

Conclusion

ABC can be applied in service industries other than those described here. It
has become increasingly important for companies whose markets are becoming
more competitive. Since ABC is really about cost management, using it allows
service companies to reduce and control their costs in order to make correct
pricing and other decisions, and to increase their profitability. It is likely to
continue to become more prevalent in the service industry in the future.

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