Unit 5: Activity Based Costing (ABC)

• Concept,
• Significance and salient features;
• Stages and flow of costs in ABC;
• Basic components of ABC - resource drivers and cost drivers;
• Application of ABC in a manufacturing organization and service industry.
Concept
Activity Based Costing is an accounting methodology that assigns costs to activities rather than
products or services. This enables resources & overhead costs to be more accurately assigned
to products & services that consume them. ABC is a technique which involves identification
of cost with each cost driving activity and making it as the basis for apportionment of costs
over different cost objects/ jobs/ products/customers or services.
ABC assigns cost to activities based on their use of resources. It then assigns cost to cost
objects, such as products or customers, based on their use of activities. ABC can track the flow
of activities in organization by creating a link between the activity (resource consumption) and
the cost object.
CIMA defines ‘Activity Based Costing’ as “An approach to the costing and monitoring of
activities which involves tracing resource consumption and costing final outputs. Resources
are assigned to activities, and activities to cost objects based on consumption estimates. The
latter utilize cost drivers to attach activity costs to outputs.”

Significance and salient features

ABC is particularly needed by organizations for product costing in the following situations:
1) High amount of overhead: When production overheads are high and form
significant costs, ABC is more useful than traditional costing system.
2) Wide range of products: ABC is most suitable, when, there is diversity in the
product range or there are multiple products.
3) Presence of non-volume related activities: When non-volume related activities e.g.
material handling, inspection set-up, are present significantly and traditional system
cannot be applied, ABC is a superior and better option. ABC will identify non-
value-adding activities in the production process that might be a suitable focus for
attention or elimination.
4) Stiff competition: When the organisation is facing stiff competition and there is an
urgent requirement to compute cost accurately and to fix the selling price according
to the market situation, ABC is very useful. ABC can also facilitate in reducing cost
by identifying non-value-adding activities in the production process that might be a
suitable focus for attention or elimination.

Advantages of Activity Based Costing

The main advantages of using Activity Based Costing are:
 • More accurate costing of products/services.
• Overhead allocation is done on logical basis.
• It enables better pricing policies by supplying accurate cost information.
• Utilizes unit cost rather than just total cost
• Help to identify non-value-added activities which facilitates cost reduction.
• It is helpful to the organizations with multiple products.
• It highlights problem areas which require attention of the management.

Limitations of Activity Based Costing

The main limitations using Activity Based Costing are:
• It is more expensive, particularly in comparison with traditional costing system.
• It is not helpful to the small organizations.
• It may not be applied to organizations with limited products.
• Selection of the most suitable cost driver may not be easy/ may be difficult or
complicated.

Requirements in ABC Implementation

A number of distinct practical stages are required in the ABC implementation which are given
as below:
1. Staff Training: The co-operation of the workforce is critical to the successful
implementation of ABC. Staff training should be done to create an awareness on the
purpose of ABC.
2. 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.
3. Activity Definition: The activities must be defined clearly in the early stage in order to
manage the problems, if any, effectively. There might be overloading of information
from the new data, but the same is needed in codification.
4. Activity Driver Selection: Cost driver for each activity shall be selected.
5. Assigning Cost: A single representative activity driver can be used to assign costs from
the activity pools to the cost objects.

Difference between Activity Based Costing and

Traditional Absorption Costing

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. Costs are related to activitiesand hence 2 Costs are related to cost centers and
are more realistic. hence not realistic of cost behaviour.

3 Activity–wise cost drivers are 3. Time (Hours) are assumed to be the

determined. only cost driver governing costs in
all departments.

4. Activity–wise recovery rates are determined 4. Either multiple overhead recovery

and there is no concept of a single overhead rates (for each department) or a
recovery rate. single overhead recovery rate may
be determined for absorbing
overheads.

5. Cost are assigned to cost objects, e.g. 5. Costs are assigned to Cost Units
customers, products, services, departments, i.e. to products, or jobs or hours.
etc.

6. Essential activities can be simplified and 6. Cost Centers/ departments cannotbe

unnecessaryactivities can be eliminated. eliminated. Hence, not suitable for
Thus, the corresponding costs are also cost control.
reduced/ minimized. Hence ABC aids cost
control.

Stages and flow of costs in ABC

The different stages in ABC calculations are listed below:
1. Identify the different activities within the organization: Usually the number of cost
centers that a traditional overhead system uses is quite small, say up to fifteen. In ABC,
the number of activities will be much more, say 200; the exact number will depend on
how the management subdivides the organization’s activities. It is possible to break the
organization down into many very small activities. But if ABC is to be acceptable as
practical system it is necessary to use larger groupings, say, 40 activities may be used
in practice. The additional number of activities over cost centers means that ABC
should be more accurate than the traditional method regardless of anything else. Some
activities may be listed as follows: -
• Production schedule changes
• Customer liaison
• Purchasing
• Production process set up
• Quality control
• Material handling
 • Maintenance
2. Relate the overheads to the activities, both support and primary, that caused them. This
creates ‘cost pools’ or ‘cost buckets. This will be done using resource cost drivers that reflect
causality.
3. Support activities are then spread across the primary activities on some suitable base,
which reflects the use of the support activity. The base is the cost driver that is the measure of
how the support activities are used.
4. Determine the activity cost drivers that will be used to relate the overheads collected in
the cost pools to the cost objects/products. This is based on the factor that drives the
consumption of the activity. The question to ask is – what causes the activity to incur costs? In
production scheduling, for example, the driver will probably be the number of batches ordered.
5. Calculate activity cost driver rates for each activity, just as an overhead absorption rate
would be calculated in the traditional system.
The activity driver rate can be used not only to identify cost of products, as in traditional
absorption costing, but it can also be used for costing other cost objects such as
customers/customer segments and distribution channels. The possibility of costing objects
other than products is part of the benefit of ABC. The activity cost driver rates will be multiplied
by the different amounts of each activity that each product/other cost object consumes.

Basic components of ABC - resource drivers and cost drivers

a) Activity: Activity, here, refers to an event that incurs cost.
b) Cost Object: It is an item for which cost measurement is required e.g. a product or a
customer.
c) Cost Driver: It is a factor that causes a change in the cost of an activity.
d) There are two categories of cost driver.
 (i) Resource Cost Driver: It is a measure of the quantity of resources consumed by an
activity. It is used to assign the cost of a resource to an activity or cost pool.
(ii) 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.
e) Cost Pool: It represents a group of various individual cost items. It consists of costs
that have same cause and effect relationship. Example machine set-up.
Examples of Cost Drivers:
Business Functions Cost Driver
Research and Development • Number of research projects
• Personnel hours on a project
Design of products, services and • Number of products in design
procedures
• Number of parts per product
• Number of engineering hours
Customer Service • Number of service calls
• Number of products serviced
• Hours spent on servicing products
Marketing • Number of advertisements
• Number of sales personnel
• Sales revenue
Distribution • Number of units distributed
• Number of customers

Examples of Cost Drivers

Some of the examples of cost drivers for different activity pools in a production department are
stated 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
Application of ABC in a manufacturing organization and service industry
Activity-Based Costing (ABC) is a costing methodology that identifies activities in an
organization and assigns the cost of each activity to all products and services according to the
actual consumption by each. It's a useful tool in both manufacturing and service industries for
more accurately allocating costs and understanding profitability. Here's how it can be applied
in each:
Manufacturing Organization:
1. Product Costing Accuracy: ABC helps in accurately determining the cost of products
by tracing the actual consumption of resources. Traditional costing methods might
allocate overhead costs based on direct labor hours or machine hours, which may not
reflect the true cost drivers. ABC identifies activities such as setup, material handling,
and quality control, allowing for a more precise allocation of costs.
2. Cost Reduction: By understanding the activities that consume resources, management
can identify areas where costs can be reduced or eliminated. For example, if setup times
are a significant cost driver, efforts can be made to streamline the setup process, leading
to cost savings.
3. Product Mix Decisions: With a better understanding of the costs associated with each
product, management can make more informed decisions about which products to focus
on or discontinue. Products that appear profitable under traditional costing methods
may turn out to be less profitable when their true costs are considered under ABC.
4. Process Improvement: ABC highlights inefficiencies in the production process by
identifying activities that are not value-added. This insight can drive process
improvement initiatives to increase efficiency and reduce costs.
Service Industry:
1. Service Costing: In the service industry, where there are no tangible products, ABC
can help in accurately determining the cost of providing various services. For example,
in a healthcare organization, ABC can identify the activities involved in providing
different medical procedures and allocate costs accordingly.
2. Customer Profitability Analysis: ABC can help in analysing the profitability of
different customer segments by identifying the resources consumed in serving each
segment. This information can be used to focus resources on high-profit customers or
to renegotiate contracts with low-profit customers.
3. Service Improvement: By understanding the activities that drive costs, service
organizations can identify areas for improvement. For example, if customer support
calls are a significant cost driver, measures can be taken to reduce the number of calls
by improving product quality or providing better documentation.
4. Service Pricing: ABC provides insights into the cost structure of services, allowing
organizations to set prices that accurately reflect the cost of providing those services.
This can help in avoiding under-pricing that leads to losses or overpricing that drives
away customers.
In both manufacturing and service industries, ABC provides a more accurate picture of costs
and profitability, enabling better decision-making and resource allocation. However,
implementing ABC can be resource-intensive and requires commitment from management to
gather data and maintain the system.
ILLUSTRATION 1
ABC Ltd. is a multiproduct company, manufacturing three products A, B and C. The budgeted
costs and production for the year ending 31st March are as follows:
A B C
Production quantity (Units) 4,000 3,000 1,600
Resources per Unit:
-Direct Materials (Kg.) 4 6 3
-Direct Labour (Minutes) 30 45 60
The budgeted direct labour rate was ` 10 per hour, and the budgeted material cost was ` 2 per
kg. Production overheads were budgeted at ` 99,450 and were absorbed to products using the
direct labour hour rate. ABC Ltd. followed the Absorption Costing System.
ABC Ltd. is now considering to adopt an Activity Based Costing system. The following
additional information is made available for this purpose.
1. Budgeted overheads were analysed into the following:
(`)
Material handling 29,100
Storage costs 31,200
Electricity 39,150
2. The cost drivers identified were as follows:
Material handling Weight of material handled
Storage costs Number of batches of material
Electricity Number of Machine operations
3. Data on Cost Drivers was as follows:
A B C
For complete production:
Batches of material 10 5 15
Per unit of production:
Number of Machine operations 6 3 2
You are requested to:
1. PREPARE a statement for management showing the unit costs and total
costs of each product using the absorption costing method.
2. PREPARE a statement for management showing the product costs of
each product using the ABC approach.
3. STATE what are the reasons for the different product costs under the two
approaches?
SOLUTION
1. Traditional Absorption Costing
A B C Total
(a) Quantity (units) 4,000 3,000 1,600 8,600
(b) Direct labour (minutes) 30 45 60 -
(c) Direct labour hours (a × b)/60 minutes 2,000 2,250 1,600 5,850
Overhead rate per direct labour hour:
= Budgeted overheads /Budgeted labour hours
= ` 99,450 / 5,850 hours
= ` 17 per direct labour hour
Unit Costs:

A (`) B (`) C (`)

Direct Costs:

- Direct Labour 5.00 7.50 10.00

- Direct Material 8.00 12.00 6.00

Production Overhead: 8.50 12.75 17.00

 `17×30   `17×45   `17×60 
 60   60   60 
     

Total unit costs 21.50 32.25 33.00

Number of units 4,000 3,000 1,600

Total costs 86,000 96,750 52,800

1. Activity Based Costing

A B C Total

Quantity (units) 4,000 3,000 1,600 -

 Material Weight per unit (Kg.) 4 6 3 -

Total material weight 16,000 18,000 4,800 38,800

Machine operations per unit 6 3 2 -

Total operations 24,000 9,000 3,200 36,200

Total batches of Material 10 5 15 30

Material handling rate per kg. = ` 29,100  38,800 kg.

= ` 0.75 per kg.

Electricity rate per machine operations = ` 39,150  36,200

= ` 1.081 per machine

operations

Storage rate per batch = ` 31,200  30 batches

= ` 1,040 per batch

Unit Costs:

A (`) B (`) C (`)

Direct Costs:

Direct Labour 5.00 7.50 10.00

Direct material 8.00 12.00 6.00

Production Overheads:

Material Handling 3.00 4.50 2.25

(`0.75  4) (`0.75  6) (`0.75  3)

Electricity 6.49 3.24 2.16

(`1.081  6) (`1.081  3) (`1.081  2)

Storage 2.60 1.73 9.75

 `10 `1,040   `5× `1,040  `15× `1,040 
     
4,000 3,000 1,600
     
Total unit costs 25.09 28.97 30.16

Number of units 4,000 3,000 1,600

Total costs ` 1,00,360 ` 86,910 ` 48,256

Comments: The difference in the total costs under the two systems is due
to the differences in the overheads borne by each of the products. The Activity
Based Costs appear to be more precise.