Basic Concepts of Costing

Cost
Cost as the amount of expenditure (actual or notional) incurred on or attributable to a given
thing.

Costing
According to the CIMA of London Costing as the techniques and processes of ascertaining
costs.

Cost Accounting
According to the CIMA of London Cost Accountancy as the application of costing and cost
accounting principles, methods and techniques to the science, art and practice of cost control
and the ascertainment of profitability.
Cost accounting has broader scope than the costing.

Cost Centre
A cost centre is a sub-unit of the organisation for which costs may be collected separately
and used for cost ascertainment and control.
According to the CIMA of London Cost centre as a location, person or item of equipment or
group of these for which cost may be ascertained and used for the purposes of cost control.
Ex: a Department, a Machine, a salesman, etc.

Cost Unit
According to the CIMA of London Cost unit as a unit of quantity of product, service or time
or a combination of these in relation to which costs may be ascertained or expressed.
Ex: per tonne, per quintal, numbers, each job, each article, per litre, per kg, etc.

Methods of Costing
1. Job Costing
2. Contract Costing
3. Batch Costing
4. Process Costing
5. Operation Costing
6. Single or Output Costing
7. Operating Costing
8. Other methods of costing-Multiple Costing
Cost Management
Cost management identifies, collects, measures, classifies and reports information that
useful to managers for determining the cost of products, customers and suppliers and other
relevant objects and for planning, controlling, making continuous improvements and decision
making.

Cost Management System is defined as a set of cost management techniques that function
together to support the organisational goals and activities.

Tools and Techniques of Cost Management

1. Activity Based Costing
2. Activity Based Management
3. Target Costing
4. Life Cycle Costing
5. Total Quality Management
6. Balanced Scorecard
7. Bench Marking
8. Just-in Time Policy
9. Theory of Constraints
10. Learning Curve Theory
11. Product Design
12. Business Process Re-engineering
13. Value Chain Analysis and Value Engineering
 Activity Based Costing
Under conventional or Traditional costing indirect costs (i.e. overhead expenses) are initially
identified with and accumulated by cost centres and finally to the products through process
called allocation, apportionment, re-apportionment and absorption. But under Activity Based
costing (ABC), indirect costs are initially traced to activities and then to the products. That
means, under both the systems (viz., Conventional Costing and Activity Based costing), the
final stage pertains to the same of charging costs to the product/s. But both the systems differ
in the first stage, indirect costs are traced with the departments under Traditional Costing and
with the activities under Activity Based costing. Hence, the activities are placed at the centre
of accounting mechanism in the first stage under Activity Based Costing.
Some Definitions of Activity Based Costing

Activity Based Costing can be defined as a costing methodology that identifies activities in
an organisation and assigns the cost of each activity with resources to all products and
services according to actual consumption by each.

According to CIMA “Activity Based Costing as cost attribution to cost units on the basis of
benefit received form indirect activities e.g., ordering, setting-up, assuring quality”.

According to Horngreen “Activity Based Costing as a system that focuses on activities as

fundamental cost objects and utilises cost of these activities as building blocks or compiling
cost of other objects”.

Characteristics of Activity Based Costing

1. Activity Based Costing is basically concerned with charging indirect costs to goods and
services. However, it is not to mean that it does not consider the indirect costs. It is only
mean that there is no difference between Traditional Costing and Activity Based Costing
with respect to the accounting treatment of direct or prime costs.

2. Activity Based Costing method was developed by an alternative approach to address

certain problems associated with Traditional Costing with regard to overhead accounting.

3. Activity Based Costing cannot be regarded as a substitute for any of the costing methods
such as Job Costing, Process Costing, etc. It is only a generic approach and it should be as
a part of Job Costing, Process Costing, etc.
4. Activity Based Costing is based on the premise that the activities cause the enterprises to
incur overhead expenses. Hence, it requires to identify their activities and then to charge
the costs of these activities to the products, services, etc., which required the activities.

5. Activity Based Costing also recognises the fact that it is the activities (but not the
products) which consume resources and the products demand these activities and consume
the benefits of these activities.

6. Hence, it is necessary initially, to identify all the acivities and to categorise them into a
few major activity groups wherein each activity group comprises a number of
homogeneous activities and the costs are collected and accumulated by these activity
groups.

7. The costs of these activity groups are apportioned to products on the basis of benefits
received by the products from the activity groups.

Advantages/ Benefits of Activity Based Costing

1. It is more precise, accurate and reliable in comparison to traditional costing systems.
2. It provides analytical information for the purpose of strategic decision making.
3. It helps in achieving the objectives of cost-effectiveness as many as fixed and variable
overheads become controllable in ABC.
4. In ABC costs/ overheads are charged specifically and relevantly to the products.
5. It attempts to segregate allocable and non-allocable overhead costs and also segregates the
costs on the basis of level of operations.
6. It increases the efficiency of cost control system. On the basis of information provided by
ABC, effective measures can be adopted for cost cutting.
7. It helps in performance evaluation, through the comparison of budgeted and actual
performance.
8. It helps in revision of standard performance and aids in identification of forthcoming
profitable opportunities.
9. ABC facilitates in recognising and redefining of allocation of costs to activities, which
ultimately enhances profitability.
10. ABC needs detailed analysis of costs which helps in the process of fixation of selling
price and the bottom line to which selling price can be lowered in competitive situation.
11. Analysis of Break Even Point (BEP), Margin of Safety, etc., through ABC helps in
decision making.
Limitations of Activity Based Costing
1. ABC is a system designed to provide information to management and it does not provide
decisions.
2. ABC is a complex system which consists of various cost pools and cost driver rates.
3. Cost estimation, ascertainment, allocation and apportioning, along with deciding on cost
groups and drivers can become difficult in the absence of adequate knowledge.
4. ABC requires segregation of activities up to the root level, specialisation as involvement
and commitment. It sometimes becomes difficult to break all the tasks into clearly
identified activities.
5. ABC is beneficial to complex and large organisations. For small organisations, traditional
system is more economical and simple.
6. Sometimes, the use of multiple cost drivers is necessary. Often it is difficult to attribute
costs to single activities, some cost support several activities.
7. Some costs like production-sustaining costs are highly difficult to trace even in ABC.

Activities
An activity is an event, task or unit of work with a well defined purpose such as setting-up of
machines, testing quality of units of output, etc. An activity also represents an aggregate of
closely related tasks. In other words it consists of tasks having common characteristics.
Categories of Activities
1. Unit Level Activities: The costs of some activities (mainly primary activities) are strongly
co-related to the number of units produced. These activities are called as Unit Level
Activities. Example:
a. The use of indirect materials
b. Inspection or testing of every item produced
c. Indirect consumables

2. Batch Level Activities: The costs of some activities (mainly manufacturing support
activities) are driven by the number of batches of units produced. These activities are known
as Batch Level Activities. Example:
a. Material ordering
b. Machine set-up cost
c. Inspection of products-like first item of every batch
3. Product Level Activities: The costs of some activities are driven by the creation of new
product line and its maintenance. These are called as Product Level Activities. Example:
a. Designing the product
b. Producing parts to a certain specified limit
c. Advertising cost, if advertisement for individual products

4. Facility Level Activities: The cost of some activities cannot be related to a particular
product line, instead they are related to maintaining the building and facilities. These
activities are known as Facility Level Activities. Example:
a. Maintenance of buildings
b. Plant security
c. Production manager’s salary
d. Advertising campaigns promoting the company

Cost Pools
Cost pools are similar to cost centres in traditional costing systems. Costs are pooled or
collected on the basis of activity that drives the costs regardless of conventional departmental
boundaries.
The activity cost pool is the total cost assigned to an activity. It is the sum total of all cost
elements assigned to an activity. Under ABC, costs are grouped into pools, according to the
activities which drive them.
Example:
a. Customer order processing b. Material Planning/ acquisition
c. Inspection and quality control d. Production control
e. Maintenance f. Research and development
g. Customer Service h. Customer Accounting

Cost Drivers
In ABC system, it is necessary to identify the factors which determine the costs of an activity.
These are called as cost drivers. A cost driver is an activity which generates cost.
Cost drivers are used to trace costs to products by using a measure of resources consumed by
each activity. An activity may have multiple cost drivers associated with it. Cost driver
explains why an activity is performed and how much effort is extended to carry out the work.

Example:
a. Number of purchase orders drives cost of the purchasing activity
b. Number of goods received notes drives the costs of material receiving activity
c. Number of items in stock drives the costs of storekeeping
d. Number of sales invoices drives the costs of the sales, dispatch and sales ledger activities

Cost Object
It is the final point to which costs are traced. These are linked to the objective of the
organisation. It is the reason for performing an activity. These include products, services,
customers, projects, contracts, etc. It enables to identify the activities required to produce
products etc.
Direct costs like materials and labour are easily assigned direct to cost objects. Indirect costs
are indirectly assigned to cost object via cost pools and cost drivers. It involves the tracing of
cost of activities to products according to a product’s demand for each activity.

Important Cost Pools and its Cost Drivers

Cost Pools Cost Drivers
No. of customers
No. of order source (customer location)
Customer Order Processing No. of orders by Quantity
No. of orders by value
No. of customer visits

No. of items/ parts/components

No. of deliveries
No. of material receipts
Material Planning/ Acquisition No. of material orders
No. of material movements
No. of stock shortages/discrepancies
No. of material transactions
Weight/volume of materials

No. of Inspections
No. of rejects
No. of receipts
No. of parts/volume
No. of customers
Batch sizes
Inspection and Quality Control
No. of product changes
No. of setups
No. of suppliers

No. of product changes

Production Control
No. of parts operational
No. of production hours
 No. of machine changes
No. of order board changes
No. of personnel supervised
No. of schedule changes
No. of machine layout changes
No. of production batches
No. of setups
No. of orders

No. of setups
No. of machine breakdowns
Capital expenditures
No. of defects
Maintenance No. of tool changes
Activity levels
No. of product changes
No. of production hours
No. of engineering changes
Maintenance schedule

No. of research projects

Research and Development
Personnel hours on a project
Technical complexities of projects

No. of products/services/processes
No. of technical experts hours spent
Design of Products, Services and Processes
Amount spent on each product/process
No. of design changes
Activity levels

No. of sales visits

No. of quotations submitted
No. of invoices raised
Marketing No. of customers
Sales value of each product
Estimated time devoted to different products
Average quantities delivered
Amount incurred for each product

Average quantities delivered

No. of kilometres to customer point
Distribution No. of orders delivered
Capital cost of vehicles, buildings, stock
Amount incurred for each product
Actual sales value

Customer Service No. of service calls

No. of products serviced
 No. of hours spent on servicing products

No. of dispatches
No. of deliveries
No. of invoices
Customers Accounting
No. of accounting reports
No. of sales orders
No. of payroll
No. of accounting changes

Assignment/ Allocation of Overhead Expenses under Activity Based

Costing
The following steps involved in assignment/allocation of Overhead Expenses under Activity
Based Costing
1. Identify the cost objects such as products, services, etc., with respect to which costs
should be ascertained after assigning indirect costs to products.
2. Identify the items of direct or prime costs and charge them to the products (this step is
same under both traditional costing and Activity Based Costing).
3. Identify different activities (relating supporting services) and classify them into few
major categories on the basis of nature of activities. For Example:, all machine related
activities may be categorised into one category. In the same way, other activities should
be classified.
4. Determine the amount of overhead expenses associated with each of the major activity
groups (also called, cost pools or activity cost pools).
5. Identify the cost drivers which are in the form of factors which influence the cost of an
activity.
6. Compute the cost pool rate. The cost pool or driver rate represents the cost per unit of the
cost driver for a pool. The pool rate which is similar to the overhead absorption rate
under conventional costing may be computed either on the basis of actual activities or
planned activities.
7. On the basis of the cost pool rate, cost drivers and the use of activity resources by the
products, the cost of each activity cost pool is traced and assigned to the products.
Therefore,
Indirect Cost assigned to Product= Activity demanded by the product X Cost Pool/ Driver Rate

8. Compute the total cost of the product by determining the sum of direct costs and indirect
costs.
Problem No.:1
Solution:
Particulars A B
Machine Hours 6X1000=6000 Hours 1.5X2000=3000 Hours
Setups 15 50
Orders 18 70

Overhead Absorption Rates:

Relating to Machines Rs. 3,00,000/ 9000 Hours Rs. 34 per hour
Relating to Setups Rs. 30,000/ 65 Rs. 462 per setup
Relating to Orders Rs. 35,000/ 88 Rs. 398 per order

Overhead Absorbed:
A= (6000 X 34) + (15 X 462) + (398 X 18) = Rs. 2,18,094
B= (3000 X 34) + (50 X 462) + (398 X 70) = Rs. 1,52,960

Problem No.:2
Solution:

(i) Calculation of Cost Driver Rates

Material Procurement Rs. 2,90,000/ 550 Rs. 527

Material Handling Rs. 1,25,000/,340 Rs. 368
Setup Rs. 2,07,500/ 260 Rs. 798
Maintenance Rs. 4,85,000/ 200 Rs. 115
Quality Control Rs. 88,000/ 450 Rs. 195
Machinery Rs. 3,60,000/ 12000 Rs. 30

(ii) Statement Showing Ascertainment of Cost of Batch of Components using ABC (Rs.)

Direct Materials 1,30,000

Direct Labour 2,45,000
Overheads:
Material Procurement (Rs. 527 X 26) 13,702
Material Handling (Rs. 368 X 18) 6,624
Setup (Rs. 798 X 25) 19,950
Maintenance (Rs. 115 X 690) 79,350
Quality Control (Rs. 195 X 28) 5,460
Machinery (Rs. 30 X 1,800) 54,000 1,79,086
Total Cost of Batch of 2,600 Components 5,54,086

Problem No.:3
Solution:

Problem No.:4
Problem No.:5
Family store wants information about the profitability of individual product lines-Soft Drinks, Fresh
Produce and packaged food. Family store provides the following data for the year 2012-13 for each
product line.
Problem No.:6
Problem No.:7
Problem No.:8
 Product-wise Production Cost per Unit under Activity Based Costing
Amount in Rs.
Particulars
P Q R
Prime Cost per Unit (a) 66.00 64.00 34.00

Set-up Costs1 0.100 0.350 2.500

Receiving Costs2 0.806 2.819 44.306
Engineering Costs3 3.730 3.730 23.313
Machine Expenses4 12.925 10.340 20.680
Packing Costs5 2.344 1.172 19.531
Total Overhead Expenses (b) 19.905 18.411 110.330
Production Cost per Unit (a+b) 85.905 82.411 144.330