Unit 5 - Activity-Based Costing (ABC)

Activity-Based Costing (ABC) is a system of costing, where costs are first traced to activities
and then to products. This costing system works with an assumption that activities are
responsible for the costs that are incurred. As stated earlier, costs are charged to products based
on the individual product's use for each activity.

The Chartered Institute of Management Accountants, UK (CIMA) defines1 ABC 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 utilise cost drivers to attach activity costs to
outputs”.

Features of Activity Based Costing (ABC)

Features of Activity Based Costing are as follows:

 ABC is a modern approach to the allocation of indirect costs. Costs allocated to each
activity symbolise the resources consumed by the activity.
 As done in conventional costing, ABC is not restricted to the allocation of indirect costs
to departments. It moves further to identify the individual activity for indirect cost
allocation as the lowest unit.
 Based on consumption, resources are allotted to each activity and then to cost objects.
 ABC identifies the activities using the activity cost drivers and results in a more accurate
cost calculation.
 This approach facilitates easy identification of cost according to activities cost driver.
 This costing method is suitable if there is more than one product in the manufacturing line
and overheads have a high share in total cost.
 This approach creates a straight cause and effect association with various resources.

Activity Based Costing Vs Traditional Costing System

No. Activity Based Costing Traditional Costing System

1 Allots overheads on the basis of Assigns overhead based on a single
various cost pools and activities. overhead rate
2 Favourable for technology- driven Favourable for labour driven
manufacturing process manufacturing process
3 Favourable when the overhead increase is Favourable when the overhead increases
based on various are based on traditional components like
activities that different for various labour hours
product

IMPORTANCE OF ACTIVITY BASED COSTING (ABC)

1. Decision making is one of the significant functions performed by managers. They may
adapt the traditional costing system, which may contain errors in costing due to apportionment
and absorption techniques. Here, ABC improves the decision-making process by providing
correct and relevant product cost data.
2. Multiple cost drivers are used in ABC that are transaction-based than product-based. Cost
drivers and rates may also help in the scheming of new products or existing products.
3. ABC follows all activities even outside the factory premises to calculate more overheads.
For example, besides the product costs, it touches costs to managerial activities, processes etc.
4. ABC focuses on the cause and effect relationship in costing. This is to bring accuracy and
reliability in cost determination. These are the products that are said to have consumed activities.
5. Due to ABC, costs as per activities become visible and more apparent. It can identify
actions not adding value to the product. Managers may put more control over the activities and
can control fixed overhead costs created by those activities.

OBJECTIVES OF ACTIVITY BASED COSTING (ABC)

Some objectives of ABC are listed as under:
• To recognise several activities in the process of production, including the activities
that add value.
• To eliminate the non value-adding activities.
• To put emphasis on the high-cost activities
• To incorporate activities based on distribution overheads.
• To help in decision-making process in the identification of a suitable price of product
and services.
• To ensure accurate and precise cost determination of products and services.
• To find options to improve the process and reduction of costs.

MERITS AND DEMERITS OF ACTIVITY BASED COSTING (ABC)

• Removes Cross Subsidization Issues
Products may be subject to over-costing, which may result in under costing of other products.
ABC may take care of this issue. ABC put the role of activities between costs and products and
makes the relationship more explicit.
• Deals with Complicated Processes
There have been growth and development in all walks of life, including production of product
and services. Due to this, complications in various processes have risen in the industries too.
Now, there are cross-linkages in the production process and costing of products. The number of
processes and activities involved in production has increased. ABC deals with these
complications in costing that emerged due to processes.
• Product Customisations
Nowadays, production is being done with many variations, in terms of sizes, design etc. If the
production takes place on one premise, the costing process will need refinement to price the
products suitably. ABC helps here.
• Identification of Cost Saving Chances
In ABC, it is easier to identify cost saving opportunities. It considers costs to all areas, including
various processes, products, managerial responsibility, customers, departments etc. It removes
the issues related to the error of estimation.
Demerits
• A Complex System
ABC works with various cost pools and drivers. It is assumed to be more complex than the
traditional system of product costing. This is one of the demerits. In fact, selection of drivers,
common costs, driver rates etc., put forward a complex system.
• Product and Process should be Fully Known
One of the significant demerits is that the people who are employing ABC usually require
significant experience in the products and processes of the industry.
ABC is preferred if the firm uses cost-plus pricing, whereas market- based prices may not favour
it.
• Rely on a sophisticated system
ABC requires a minimum level of information technology in the
organisation. Much data is needed and processed for implementing a particular decision. Small
and new organisations may not take full advantage of ABC, due to poor information technology
systems.
• Consumes a lot of Time and efforts
ABC is a time-consuming process. It comprises a number of steps and a lot of groundwork to
start and complete the process.
Organisations may put time and effort if they get utility out of the process. As mentioned earlier
also, large manufacturing firms can utilise it better than small firms.
• Increase in Indirect Costs
Due to the high involvement of technology in ABC, indirect costs rise significantly.

Type B problems:

Problem 1: Following are the information available from Arun Ltd.

Total Overheads 100,000

Costs relating to set ups 50%
Costs relating to inspections 50%
Number of Set ups 100
Number of Inspections 50
Calculate the Cost per Driver.

Solution
Step 1 - Pool the costs
Category Working Pool
Set up costs (100,000 x 50%) 50,000
Inspection costs (100,000 x 50%) 50,000
Total Overheads (Check) 100,000

Step 2 - Divide by Number of Drivers

Category Number of Cost Pool Working Cost per
drivers Driver
Set up costs 100 50,000 (50,000 / 100) 500
Inspection costs 50 50,000 (50,000 / 50) 1000

Problem 2:
To produce product A takes the following:
Number of set ups 20
Number of inspections 2
Using the cost per driver in the previous example, what are the total overheads applicable to
product A?
Solution

Driver Number Cost Per Driver Total Cost

Set ups 20 500 10,000
Inspections 2 1000 2,000
Total Overheads Per Unit of A 12,000

Problem 3:

Activity Annual cost driver Cost Cost driver

Machine 40,000 hours 10,00,000 600 hours
Labour Rs.6,00,000 60,000 Rs.14,000
Setup 20,000 hours 2,00,000 150 hours
Production order 4000 orders 4,00,000 10 orders
Material handling 2000 requisitions 40,000 6 requisitions
Parts administration 24,000 parts 9,60,000 40 parts
All factory overhead costs to products are based on 300% of direct labour cost.

Compare the total annual costs of the product using both the traditional and ABC system.
Solution

Cost driver Cost Assignment

Cost system Pool rate
Consumption (Rs)
Traditional cost system 300% Rs.14,000 42,000
ABC System:
(i) Labour 10% Rs.14,000 1,400
(ii) Machine Rs.25 per hour 600 hours 15,000
(iii) Setup Rs.10 per hour 150 hours 1,500
(iv) Production order Rs.100 per order 10 orders 1,000
(v) Material handling Rs.20 per 6 requisitions 120
(vi) Parts Rs.40 per part 40 parts 1600
Rs 20,620

The total cost of the product under ABC is Rs 24,620, whereas under the traditional cost
system, it is Rs. 42,000.
Problem 1: Company A has the following information applicable to its products:

Total Overheads = 100,000

Total machine Hours 50,000
Product A B
Units of Production 2,500 5,000
Material Cost p/unit 30 50
Labour Cost per unit 20 16
Machine Hrs P/unit 10 5

% Overheads
Set up Costs 35
Inspections 45
Materials Handling 20

A B Total
Set ups 300 50 350
Inspections 500 250 750
Goods Movements 300 700 1000

What is the Cost per unit of A and B

(1) Under Traditional Absorption Costing.
(2) Under ABC.

Problem 2: The budgeted overheads and cost driver volumes of DSS Ltd are as follows.
Cost Pool Budgeted Overheads Cost Driver Budgeted
(Rs) Volume
Material procurement 10,80,000 No. of orders 1,300
Material handling 3,50,000 No. of movements 780
Machinery 8,40,000 No.of machine hours 34,000
Maintenance 10,70,000 Maintenance hours 8,900
Quality control 2,66,000 No. of inspection 700
Set-up 4,80,000 No. of setups 620

The company produces 2,450 components of A-1. Its material cost was Rs 1,50,000 and the
labour cost Rs2,55,000. The usage activities are:

Material orders are 29. Maintenance hours are 680. Material handling is 21, Quality control
inspection are 31, setups are 22, and machine hours are 1,950
Calculate cost driver rates and ascertain the cost of a batch of components using ABC.