ACTIVITY BASED COSTING .

Introduction of Activity Based Costing

Activity-based costing is a costing method 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. Therefore, this model assigns more
indirect costs into direct costs compared to conventional
costing.

Activity Based Costing – Meaning

Activity-Based Costing (ABC) is one in which costs are first
identified to activities and then to the products. It is a system
which focuses on activities performed to produce products. ABC
system assumes that activities that are responsible for the
incurrence of costs and products create the demand for
activities. Costs are charged to the products based on individual
product’s use of each activity.

Activity Based Costing – Objectives

1. To bring more accuracy in calculation of cost of products and
services as compared with traditional costing system, since all
products are not produced equally,
i. As some products are produced in large batches and some in
small batches.
ii. As manufacturing overhead costs have increased significantly
and they no longer correlate with the productive machine hours
or direct labour hours.
2. To understand product and customer cost
3. To understand profitability based on the production or
performing processes
4. To have a structured analysis in respect of complex processes
5. To provide wealth of information to the management in
order to help in decision making
6. To eliminate non-value adding activities due to diversity of
products
7. To increase value adding activities since diversity of customer
demands are growing rapidly
Activity Based Costing – Need of ABC System by an
Organisation

(i) Production overhead costs are high in comparison to the

various direct costs;
(ii) Product range of the organisation is highly diverse;
(iii) Overhead resources used by various products are very
different in amounts;
(iv) Volume or quantity of production is not primary driving
force for the consumption of overhead resources.

Activity Based Costing – Features of ABC Method

(a) Cost are pooled not on the basis of departments but

according to the activities involved in the production.
(b) It charges overhead cost to product according to activities
involved in the product instead of using average overhead
distribution rate as in case of traditional method.
(c) It leads to more accurate cost information because of easy
traceability of cost according to activities cost driver.
(d) It helps in eliminating non-value added activities thereby
reducing the per unit cost of product. Thus, it helps in cost
control.

Activity Based Costing - Characteristics

1. It increases the number of cost pools used to accumulate
overhead costs. The number of pools depends upon the cost
driving activities. Thus, instead of accumulating overhead
costs-in a single company- wise pool or departmental pools, the
costs are accumulated by activities.
2. It charges overhead costs to different jobs or products in
proportion to the cost driving activities in place of a blanket
rate based on direct labour cost or direct hours or machine
hours.
3. It improves the traceability of the overhead costs which
results in more accurate unit cost data for management.
4. Identification of cost during activities and their causes not
only help in computation of more accurate cost of a product or
a job but also eliminate non-value added activities. The
elimination of non-value added activities would drive down the
cost of the product. This, in fact, is the essence of activity based
costing.

Activity Based Costing – Requirements of ABC System

1. Setting-up of an information system which could help trace
all the costs to cost objects.
2. Support from top to bottom because the system involves
people at all levels.
3. Integration of system into financial system. For it,
computerization may be required.

Activity Based Costing Terms – Cost Objects,

Activities, Cost Pool and Cost Drivers
1. Cost Objects:
Generally, the products are cost objects, but the customers,
services or locations can also be the cost objects.
2. Activities:
These consist of the aggregate of different tasks and are
concerned with functions associated with cost objects. There
are two types of activities-
(A) support activities,
(B) Production process activities.
Support activities are, for example, schedule production, set up
machine, purchase materials, inspect items, customer orders,
supplier records etc. Under the production process activity,
machine products and assembled products are included within
this production process.
Activity cost centres are, sometimes, similar to cost centres
used under traditional costing system. In case the purchase
department and purchasing activity both are treated as cost
centres, the support activity cost centre also becomes identical
to cost centre taken under traditional costing system.
3. Cost Pool:
It is another name given to a cost centre and, therefore, an
activity cost centre may also be termed as an activity cost pool.
4. Cost Drivers:
The causes for incurrence of overhead costs are known as cost
drivers. A cost driver is a factor the change of which results in a
consequential change in the total cost of a related object. If its
level changes, it brings a corresponding change in the level of
total cost of the related cost object.
Following are some of the examples of cost drivers:
i. Machine setups
ii. Purchase orders
iii. Quality inspections
iv. Production orders (Scheduling)
v. Engineering change orders
vi. Shipments
vii. Material receipts
viii. Inventory movement
ix. Maintenance reports
x. Scrap/rework orders
xi. Machine time
xii. Power consumed
xiii. Kilometres driven
xiv. Computer-hours logged
xv. Beds occupied
xvi. Flight-hours logged.
The activity cost drivers can broadly be classified into
following three categories:
A. Transaction drivers
B. Duration drivers
C. Intensity drivers.
A. Transaction drivers –
These Include types of transactions which result in overhead
costs e.g., purchase orders processed, customer orders
processed, inspections performed and the set-ups undertaken,
all count the number of times an activity is performed.
B. Duration drivers –
Mean the amount of time required to perform an activity.
Examples of duration drivers are set-up hours and inspection
hours.
C. Intensity drivers –
Refer to drivers which directly charge for the resources used
each time as activity is performed. Duration drivers establish an
average hourly rate of performing an activity while intensity
drivers involve direct charging based on the actual activity
resources relevant to a product.

Activity Based Costing – 5 Essential Steps Involved in

ABC

Step # 1. Identifying the Activities:

The first step in ABC is to identify the major activities which
take place in an organisation. The number of activities in
production may differ from product to product and
organisation to organisation.
The number of activities in the organisation should neither be
too large or too small. An activity may be a very small activity
but it should justify the cost incurred for it. An activity may be a
single activity or combination of several activities. Cost-benefit
analysis of each and every activity may be undertaken to judge
the worthiness of activity.
Step # 2. Determining Cost Pool/Cost Centres for Each
Major Activity:
Cost pool means grouping of total cost for each major activity.
It simply means allocation and apportionment of various costs
to a particular activity or group of activities. For example, total
cost of placing orders may be grouped under ordering cost.
Step # 3. Determining Cost Driver for Each Major
Activity:
Cost drivers are that activities which determine the cost. These
activities result in occurrence of Overhead cost. Thus, cost
driver is a factor or an event which results in consequential
change in the total cost of the object.
Step # 4. Calculation of Activity Cost Driver Rate:
Next step would be to obtain activity cost driver rate by dividing
the total cost of an activity by cost driver as shown below –
Activity driver rate = Total cost of an activity/Cost driver
Step # 5. Charging Activity Cost to the Product Cost:
Cost of activity will be charged to the product using cost driver
rate according to the requirement of activities of each product.
For instance, a product may require 10 machine setups and 1
inspection related activity. Thus, product will be charged for
both machine related set up activity cost and inspection activity
cost.

Activity Based Costing – Important Uses

(a) Focus on where the cost originates, i.e., the causes of the
cost.
(b) Accurate product cost due to understanding of the cost
behaviour.
(c) Identifies source of non-value added activity or wasted
efforts.
(d) Strategic cost information of which long-term profitability
decision for a product can be taken.
(e) Non-financial information regarding quality flexibility and
value to the customer can be received.
(f) Improved cost-basis available both at head office and plant
level for better decision making.

Activity Based Management (ABM) can be classified

into two categories as under:
(i) Operational ABM:
It means using Activity Based Cost information (ABC) for
“doing things right”. This improves overall efficiency through
identification of activities which add value to the product and
those which do not add value to the product. Activities which do
not add value to the product are to be eliminated or
significantly reduced while activities which add value to the
product are to be continued and improved.
(ii) Strategic ABM:
This refers to “doing the things right”. The activity based cost
information can be used to identify the products or activities
which are useful for the organization. It can also be used for
customers’ profitability analysis which can help in identifying
the customers who are more profitable and hence to be focused
more.
It may be noted that the technique of Activity Based
Management should be used by management keeping in mind
the fact that decision made should in the benefit of the whole
organization and not only for a particular department or
division. This is because some activities may have an implicit
value but may not be reflected in the financial value added to
the product.

Objectives of Activity Based Management (ABM) can

be stated as under:

(i) Reducing Costs –

Managers can set cost reduction targets in terms of reducing
the cost per unit in relation to cost allocation base in different
activities areas. For instance, a manager may aim at reducing
cost of transporting the product from Rs. 5 per unit to Rs. 4.50
per unit.
(ii) Creating Performance Measures –
The Activity Based Management (ABM) system provides
information and data on activity performance. The performance
measures may relate to quality of the product, production cycle
time, productivity of workers or satisfaction of customers etc.
(iii) Improving Cash Flow –
Targets can be set and accordingly measures can be taken for
improving the liquidity of the business.
(iv) Producing Enhanced Value Product –
This is possible by eliminating or minimizing a non-value
added activity i.e., an activity which neither contributes to the
customer’s value nor to the organization’s need. It is a total
waste.
The main advantages of ABC system are as under:

(i) Focus on Cost – ABC system focuses attention, when the

cost originates or when it is the cause of the cost.
(ii) Identification of Source – It identifies sources of non-
value added activity which might be a suitable force for
attention.
(iii) Improved Cost Basis – It provides a better and
improved cost basis both at head office level as well as at plant
level, so that better decision may be taken.
(iv) Better Reporting – ABC system provides better
reporting of cost of activities and their performance which will
help in taking suitable decision and in improving efficiency.
(v) Accuracy in Product Cost – ABC system ascertains
accurate product cost due to better understanding of the cost
behaviour. Of course the apportionment of indirect cost to cost
objectives is required

Activity Based Costing – Limitations of Activity Based

Costing

1. Activity-Based Costing system is time consuming and

expensive to develop and implement. It is not suitable for small
organisations.
2. Determination of most appropriate cost drivers is difficult.
3. In some cases finding the activity that causes the cost is
impractical. For example, factory insurances, factory manager’s
salary, rent, rates and taxes of the factory premises. In these
cases, it is better to allocate costs on the basis of arbitrary
volume. Here, ABC is not suitable.
4. A limited number of cost drivers may not fully explain the
cost behavior of different items in the cost pool.
5. Implementation of ABC in service industry is difficult as the
tracing of costs to service delivery may result in too many cost
drivers.

Activity Based Costing – Major Problems of Activity

Based Costing
Problems with the ABC Approach:
(a) Cost of change will be high as everything will have to be
worked out from scratch.
(b) It would be difficult to correlate the marginal increase in
cost with a particular cost driver.
(c) Over a period of time, the ABC will tend to standardise the
cost of activities related to a particular product or process.
(d) The ABC system will require a change due to changes
associated with new products and new technology. This will put
strain on the costing system and resources due to certain degree
of inbuilt standardisation.
(e) The ABC is at the stage of evolution. Literature on the ABC
concept at present is primarily restricted to the manufacturing
environment.