Activity Based Costing (ABC) System

About Traditional Costing System (TCS)

• Traditional Absorption Costing Systems used by manufacturing companies to

calculate unit product costs for the purpose of valuing inventories and
determining cost of goods sold for external financial reports.

• It is generally accepted that a time-based method is used wherever possible, i.e.

the machine hour rate or the labour hour rate. This is because many overhead
costs increase with time, for example, indirect wages, rent and rates.
 Issue with Absorption Costing System
• A manufacturing firm produces two identical products: Product L is a low volume item which
requires certain activities such as special engineering, additional testing, and many machine setups
because it is ordered in small quantities.
• A similar product, Product H, is a high volume product—running continuously—and requires
little attention and no special activities.
• If this company uses traditional costing, it needs to allocate all of its overhead to products based
on the number of machine hours.
• This will result in little overhead cost allocated to Product L, because it does not have many
machine hours. However, it demands lots of engineering, testing, and setup activities.
• In contrast, Product H will be allocated an enormous amount of overhead (due to all those
machine hours), but it actual demands little overhead activity.
• The result will be a miscalculation of each product's true cost of manufacturing overhead. As a
result, simple high-volume products would be over-costed (i.e. receive a larger allocation of
overheads) and low-volume complex products would be under-costed (i.e. receive a smaller
allocation of overheads).
 Illustration
(Managerial Accounting (5th Edition) By Weygandt ,Kimmel & Kieso; Illustration – Chapter 4)
• Assume that the Company produces 25,000 units of H & 5,000 units per year.
Each product requires one hour of direct labor for completion.
• The direct materials cost per unit is $40 for H and $30 for L. The direct labor
cost is $12 per unit for each product.
• Further the company reveals that Company’s expected annual overhead costs relate
to three activities viz. machine setups, machining, and inspections and accordingly,
the expected overhead costs are $3,00,000, $5,00,000 and $ 1,00,000 respectively.
• The number of machine set-ups required for L is 1,000, and for H is 500; the
machine hours required for H is 30,000 and for L is 20,000; and number of
inspections required for H is 500 and for L is 1,500.
• What would be the unit cost under both the systems?
 Solution
Unit cost as per Absorption Costing

• Each product requires one hour of direct labour for completion. Therefore,
total annual direct labour hours are 30,000 (25,000 + 5,000).
• Expected annual manufacturing overhead costs are $900,000 [i.e.
$(3,00,000+5,00,000 + 1,00,000)]. The predetermined overhead rate is $30
($900,000 / 30,000) per direct labour hour.
• For H = DM + DL + Mfg. overhead = $ (40+12+30) = $82
• For L = DM + DL + Mfg. overhead = $ (30+12+30) = $72
 Solution
Unit cost as per Activity Based Costing
a) Determination of Overhead cost:
• Machine set-up cost per unit = $ 3,00,000/1,500 = $200
• Machine hour rate = $5,00,000 /50,000 = $10
• Cost of inspection per unit = $1,00,000 / 2,000 = $ 50
• For H = [($200 x 500) + ($10 x 30,000) + ($ 50 x 500)] = $ 4,25,000
• Overhead cost per unit of H = $4,25,000 / 25,000 = $ 17
• For L = [($200 x 1,000) + ($10 x 20,000) + ($ 50 x 1,500)] = $ 4,75,000
• Overhead cost per unit of L = $4,75,000 / 5,000 = $ 95
b) Unit cost as per ABC
• For H = DM + DL + Mfg. overhead = $ (40+12+17) = $69; For L = $ (30+12+95) = $137
• So, L is understated by $ (137 – 72) = $ 65 & H is overstated by = $ (82 – 69) = $13 as per
Absorption costing
 Problems of Under & Over Costing
• TCS Using Broad averages for charging overheads uniformly to product/
service is known as ‘Cost smoothing’ or ‘peanut butter costing’ – leading to
under-costing of some products & over-costing of others.
• When one product is under-costed, it results in other products being over-
costed as total amount of overheads remain unchanged – known as ‘product
cost cross-subsidization’.
• The use of volume-related allocation base of TCS for allocating overheads
would be result in product cost distortion in an environment of complex and
high product variety.
• The ABC system eliminates this source of cost distortion.
 The ABC system
• 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.
1. Study of the Activities involved :- Identifying all activities involved - divide the activities into
value adding and non value adding - non value adding activities can be eliminated in the
future.
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.
2. Activity Cost Pool :- the point of focus for the costs or the total cost assigned to a particular
activity in ABC system.
In case of a manufacturing organization, as regards to stores, cost of classification, cost of issue of stores requisitions,
inspection costs etc. can be pooled under the heading ‘stores’. - the sum of all the cost elements assigned to an
activity.
3. Cost Drivers - activities which generates cost - the factors which determine the cost of an
activity.
For example, in a 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.
4. Identification of costs with the products :- The final stage - to identify the cost with the cost
objects - which include, products, services, customers, projects and contracts.
TCS(ACS) vs. ABC
 A hypothetical situation
• Sunlight company manufacturing two products A and B, using the same equipment and similar
processes. An extract of the production for these products in one period is shown below:
• Particulars Product A Product B
• Quantity produced(units) 5,000 7,000
• Direct labour hours per unit 1 2
• Machine hours per unit 3 1
• Set ups in the period 10 40
• Orders handled in the period 15 60
• Overhead costs Rs.
• Relating to machine activity 2,20,000
• Relating to production run set-ups 20,000
• Relating to handling of orders 45,000
• Calculate production overheads to be absorbed by one unit of each of the products considering the
Traditional costing approach using direct labour hour rate to absorb overheads.
 Traditional Costing Approach
• Computation of Direct Labour Hours:
• Product A 5,000 units X 1= 5,000 hours
• Product B 7,000 units X 2= 14,000 hours Total = 19,000 hours
• Overhead Absorption Rate = Total Overheads ÷ Total Direct Labour Hours
= Rs.2,85,000 ÷ 19,000 = Rs.15
• Overhead to be absorbed are:
• For Product A = 1 X Rs. 15 = Rs.15
• For Product B = 2 X Rs.15 = Rs.30
 Activity Based Costing Approach

• Calculation of Machine hours:

• For Product A = 5,000 X 3 hours = 15,000 hours
• For Product B = 7,000 X 1 hour = 7,000 hours Total = 22,000 hours
• Machine Hour Driver Cost = (Rs.2,20,000/ 22,000) = Rs.10 per hour
• Set Up Driver Cost = [Rs.20,000 / (10 + 40 set ups)] = Rs.400 per setup
• Order Handling cost = [Rs.45,000 / (15 + 60 orders)] = Rs.600 per order

Allocation of Overheads for Products

Product A Product B
Machine Hour Driver Cost 15,000 x 10 1,50,000 7,000 X 10 70,000
Set Up Driver Cost 10 X 400 4,000 40 X 400 16,000
Order Handling cost 15 X 600 9,000 60 X 600 36,000
Overhead Rate per unit (1,63,000/5,000) = (1,22,000/7,000)=Rs17.43
Rs32.60
 Benefits of ABC
1. ABC leads to more cost pools being used to assign overhead costs to products:
Instead of one plantwide pool and a single cost driver, companies use numerous
activity cost pools with more relevant cost drivers - Costs are assigned more directly
on the basis of the cost drivers.
2. ABC leads to enhanced control over overhead costs: Companies can trace many
overhead costs directly to activities—allowing some indirect costs to be identified as
direct costs.
3. ABC leads to better management decisions: More accurate product costing should
contribute to setting selling prices that can help achieve desired product profitability
levels - Can be helpful in deciding whether to make or buy a product part or
component.
• ABC does not change the amount of overhead costs - It allocates those overhead costs
in a more accurate manner - to better understand cost behavior and overall
profitability.
 Test your understanding
Product - A Product - B Product - C
Output (Units) 10,000 20,000 30,000
Direct Material per unit (Rs.) 50 40 32
Direct Labour per unit (Rs.) 30 40 48
Labour Hours per unit 3 4 5
Machine Hours per unit 4 4 7
No. of purchase requisitions 600 900 1000
No. of Machine set-ups 120 130 150
Production Overhead split by Departments: Department X – Rs.12,00,000 & Department Y -
Rs.15,00,000. Department X is labour intensive and Y is machine incentive. Total labour hours in
Department X = 2,00,000 hours and Total machine hours in Department Y = 5,00,000 hours.
Production overhead split by activity: Receiving & Inspection – Rs.14,00,000 and Production scheduling
/set up – Rs. 13,00,000; No. of batch received/ inspected – 2,500 & No. of batches for scheduling/ set
up – 400. Prepare cost statements under TCS & ABC methods & compare them.
Activity-Based Management (ABM)
• The activity-based management (ABM) refers to a set of actions that
management can take, based on information from an ABC study, to
increase/improve profitability.
• These include a combination of:
(i) repricing of unprofitable products,
(ii) increasing sales volume of highly profitable products,
(iii) process improvement (e.g. how to reduce setup times in contrast to faster run of production,
equipment; &
(iv) engineering and design improvements.
• Their combined effect would be production of the same volume and mix of
products with fewer resources.
Applicability & limitations
• The ABC system is a much applicable to both manufacturing & service companies.
• Service companies have a unique cost structure - Virtually all their costs are indirect/fixed.
• In contrast to manufacturing companies, customer behaviour determines the basic operating costs of
products/services of service companies.
• They should, therefore, identify the differential profitability of individual customers as they determine
the quantity of demands for their operating activities.
• Moreover, service companies should act on total relationship profitability of a customer and not on the
profitability of just a single customer.
• The structure/construction of the ABC system of a service company is identical to that of a
manufacturing company.
• The major benefits of ABC system are:
(i) it does not under-cost complex low-volume products and over-cost high-volume simple products &
(ii) it may result in improved cost control.
• The limitations of ABC system are:
(a) it is costly to develop and maintain &
(b) it is used to develop full costs and does not measure the incremental costs needed to produce an item.