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Activity Based Costing

Introduction:
In the field of accounting, Conventional Costing (Absorption Costing/Traditional Costing) and
Activity-Based Costing (ABC) are two different methods for allocating indirect (overhead)
costs to products. Both methods estimate overhead costs to production and then assign these
costs to products on a basis.
Weakness of Conventional Costing System:
ABC System has developed basically on account of the limitations of the traditional absorption
costing system. They are:

1) The traditional basis of segregating costs into fixed and variable elements is
considered to be unrealistic. With the growth of business, the costs have become
more complex and complicated.
2) Conventional costing is useful when indirect costs are low compared to direct costs.
But today manufacturing overhead costs have increased significantly due to rapid
development of automated production.
3) Traditional cost systems allocate costs based on direct labour, material costs, revenue
or other simplistic methods. As a result, traditional systems tend to over-cost high
volume products, services and customers; and under-cost low volume.
4) The ever increasing and severe market competition due to globalisation has increased
the necessity of more accurate product costs in order to avoid the disadvantages of
under-costing and over-costing.
5) Traditional systems can measure only volume related costs. Non-volume related
activities like material handling, set-up etc. are important and their costs cannot be
apportioned on volume basis.
6) Traditional product costing systems were designed when most companies
manufactured a narrow range of products. Direct materials and direct labour were the
dominant factors of production then.

Activity Based Costing:

Activity Based Costing is an accounting methodology that assigns costs to activities
rather than products or services. ABC is a technique which involves the identification
of cost with each cost driving activity and making it the basis for the apportionment
of costs over different cost objects/jobs/products/customers or services.

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Concept of ABC:
The limitations of conventional costing, namely, unrealistic overhead allocation
methods, resulted in the development of Activity-Based Costing.
Under conventional costing system, overhead expense is allocated to a job or function
on the basis of direct labour costs, direct labour hours, machine hours, direct material
costs etc. These traditional methods of absorption of overhead costs were designed
when direct costs were a dominant part in the overall cost of production.

Activity based costing is a new system developed for determining the overhead cost.
It uses activities as the basis for determining the costs of products or services. It
focuses on activities performed to produce products. Costs are charged to the
products based on individual product’s use of each activity.
ABC system used a two-stage process for allocating resource costs, first allocating
resource costs to activities and then, in turn, allocating activity costs to products or
services. ABC is an accounting methodology which assigns costs to activities rather
than products or services.
Each overhead cost, whether variable or fixed, is assigned to a category of costs. These
cost categories are called activity cost pools. The actual activities that cause the total
cost in an activity cost pool to increase are called Cost Drivers. For example, the
number of times materials are ordered, and the number of shipments made to
customers.
Meaning: Activity Based Costing is also known as ABC Costing, ABC Method. ABC
refers to the allocation of costs to different activities according to their actual use. It
is a method of identifying a company’s indirect cost activities and assigning these
activity costs to the products or jobs that use these activities.
ABC based on simple concept that ‘resources are consumed by activities’ and
‘activities are assumed by the product (or cost object). In other words the cost objects
consume activities and activities consume resources.
Costs are charged to products or services based on individual products consumption
of each activity. It recognises that jobs, products, services etc, do not directly consume
resources but consume activities which consume resources. In brief, in Activity Based
Costing, overheads are first assigned to activities and then absorbed by cost objects
on the basis of activities consumed by these cost objects.

Definition: According to Cooper and Kalpan “ABC system calculates the cost of
individual activities and assigns cost to cost objects such as product and services on
the basis of activities undertaken to produce each product or services”.

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According to Horngren, “ABC is a system that focuses on activities and fundamental

cost objects and utilizes cost of these activities as building blocks or compiling the cost
of other cost objects”.

Characteristics of ABC System:

1. ABC system is based on the concept that products consume activities and activities
consume resources.
2. It is a two-stage product costing method that first assigns costs to activities and
then allocates them to products based on each product’s consumption of
activities.
3. The cost pools in the two-stage approach accumulate activity-related costs.
4. ABC focuses on activities as the fundamental cost objects. Costs are pooled not on
the basis of departments but according to the activities involved in production.
5. It increases the number of cost pools used to accumulate overhead costs.
6. It focuses on determination of cost drivers related to various organisational
functions.
7. It charges overhead costs to different products according to the cost driving
activities involved instead of a blanket rate based on direct labour cost or direct
labour hours or machine hours as in case of traditional method.

Kaplan and Cooper’s Approach:

The concept of Activity Based Costing was developed in the manufacturing sector of the
United States during the 1970’s and 1980’s, by Kaplan and Cooper of Harvard Business School.
Kaplan and Cooper described Activity Based Costing as an approach to solve the problems of
traditional cost management systems.
Kaplan and Cooper claim that the costs should be classified as long-term variable costs and
short-term variable costs. Traditionally short-term variable costs are known as variable costs
and long term variable costs are known as fixed costs.
Under ABC system, product cost is determined by obtaining a greater understanding of cost
behaviour and using new measures of quantity of resources consumed by each product.ABC
system is based on the belief that activities cause costs and that a link should therefore be
made between activities and products by assigning cost of activities to products based on an
individual product’s demand for each activity.
COST OBJECTS, COST DRIVERS AND COST POOLS:

1. Cost Objects: Cost object is an item for which cost measurement is required. For
instance, if the objective is to select the most profitable customer, an individual
customer is the cost object. Cost object is the final point to which costs are traced. It
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is the reason for performing an activity. Cost objects include products, services,
customers, projects and contracts. Generally, the products are cost objects, but the
customers, services or locations can also be the cost objects.
2. Cost Driver: Cost driver refers to a factor that creates or drives the cost of an activity.
It is the force behind overhead costs. Cost driver can be defined as those activities or
transactions that are significant determinant of costs. 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.
Types of Cost Drivers:
i) Transaction Drivers: These include the number of transactions which result
in overhead cost e.g., purchase orders processed, customer orders processed,
inspection performed and the set-ups undertaken, all count the number of
times an activity is performed.
ii) Duration Drivers: Duration drivers mean the amount of time required to
perform an activity. These drivers establish an average hourly rate of
performing an activity. Examples, of duration drivers are set-up hours and
inspection hours.
iii) Intensity Drivers: Intensity drivers refer to drivers which directly charge for
the resources used each time as activity is performed. They involve direct
charging based on the actual activity resources relevant to a product.
Activity cost drivers may also be classified as
a) Resource Cost Driver: It is a measure of the quantity of resource consumed by an
activity. For example, number of orders placed will determine the cost of
purchasing the materials, the number of times the machines are set up will
determine the cost of setting up of machines.
b) Activity Cost Driver: It is a measure of the frequency and intensity of demand
placed on the activities by cost objects. It is used for assigning activity costs to cost
objects consuming the activity.

3. Cost Pool: ‘Cost Pool’ or ‘Activity Pool’ is another name given to a cost centre in
traditional cost systems. An activity cost pool is grouping of individual costs items
associated with an activity such as making a particular product. In other words, an
activity cost pool is an aggregate of all the costs associated with performing a
particular activity.
Cost pool is like a cost centre around which costs are accumulated. For example,
the total cost of machine set ups might constitute one pool, total cost of placing
orders may be grouped under ordering cost. Costs are pooled or collected on the
basis of activity that drives the costs regardless of conventional departmental
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boundaries. Cost pool means allocation and apportionment of various costs to a

particular activity or group of activities.
CIMA Official Terminology defines Cost Pool as “the point of focus for the costs
relating to a particular activity in an Activity Based Costing System”.

Allocation of Overheads Under ABC System/ Steps in the Implementation of ABC:

1. Process Specification: The first step in ABC is to identify different stages of
production process, the commitment of resources to each processing times and
bottlenecks. This will provide a list of transactions, which may or may not be
defined as ‘activities’ at a subsequent state.
2. Identify main activities: The next step in implementation of ABC system is to
identify the major activities which take place in an organisation. The number of
activities in an organisation should neither be too large or too small. Too large a
number will be costly and will add to the complexity of the system while too small
number of activities will compromise with the accuracy of the cost. Total cost in
the activity should be significant enough to justify giving an activity a separate
treatment.
3. Determining Activity Cost Pool: An activity cost pool is grouping of individual
costs items associated with an activity. Cost pools created for costs of activities
undertaken to support individual products or services regardless of the number
of units or batches produced are called Product (or service) sustaining cost
pools. Example, Design costs. Cost pools created for costs of activities that cannot
be traced to individual products or services but support the organisation as a
whole are known as facility sustaining costs pools or secondary costs pools.
Examples are computer services, rent, building security etc.
4. Determination of Activity Cost Driver for each major activity: Cost driver is a
factor which determines the costs of an activity. They are the activities or
transactions which result in the occurrence of overhead cost. Examples: number
of machine setups, number of purchase orders, number of customer order
placed etc.
Activity cost driver rate is computed as follows:
Activity cost driver rate= Total cost of activity ÷ Activity cost driver
5. Tracing of cost with cost with Cost Objects: The cost objects are linked to the
objective of the organisation. The cost object enables to activities required to
produce products etc. Direct costs like materials and labour are easily assigned
directly to cost objects. The indirect costs are indirectly assigned to the cost
object via cost pools and cost drivers.

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ABC is the process of tracing costs first from resources to activities and then
from activities to specific products. The cost of activities are traced on the basis
of a product’s demand for each activity. The cost drivers are used to measure a
products demand for each activity.
6. Staff training: The cooperation of the work force is critical to the successful
implementation of ABC. Staff training should be oriented to create an awareness
of the purpose of the ABC
7. Review and follow-up: The actual operation of the ABC system should be closely
monitored. Periodic review and follow-up action is necessary for successful
implementation of the system.

Benefits from Adaptation of ABC System:

1. Realistic basis for overhead absorption: ABC attempts to absorb overheads into
product costs on a more realistic basis.
2. Accurate product cost: Traditional costing system is likely to bring errors and
approximation in product cost determination due to using arbitrary methods of
overhead costs apportionment and absorption. ABC brings accuracy and
reliability in product cost determination by focusing on cause and effect
relationship in the cost incurrence.
3. Information about Cost behaviour: ABC identifies the real nature of cost
behaviour and helps in reducing costs and identifying activities which do not add
value to the product. With ABC managers are able to control many fixed
overhead costs.
4. Tracing of activities for the Cost Object: ABC uses multiple cost drivers, many of
which are transaction based rather than product volume. ABC is concerned with
all activities within and beyond the factory to trace more overheads to the
products.
5. Tracing of overhead costs: ABC traces costs to areas of managerial responsibility,
processes, customers, departments besides the product costs.
6. Better Decision making: ABC improves greatly the manager’s decision making as
they can use more reliable product cost data.
7. Cost management: ABC provides cost driver rates and information on
transaction volumes which are very useful to management for cost management
and performance appraisal of responsibility centres.
8. Use of excess capacity and cost reduction: ABC, through the processes of pooling
of activity costs and the identification of cost drivers, can lead to the
identification of spare capacity and the fostering of cost reduction.

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9. Activity-based budgeting: Comparing the resources required under ABC with the
resources that are currently available provides a platform for the development
of activity-based budgeting to project future resource requirements.
10. Benefit to service industry: Traditional costing has generally been considered
inappropriate for these organisations whereas ABC offers the potential of
benefits from improved decision making and cost management.

DIFFICULTIES FACED BY THE INDUSTRIES IN THE SUCCESSFUL

IMPLEMENTATION OF ABC:
1. Required adequate cost knowledge: Cost estimation, ascertainment,
allocation and apportioning, along with deciding on the cost groups and
drivers can become difficult in the absence of adequate knowledge.
2. Cost activities and drivers: It is difficult to break all the tasks into clearly
identified activities. Identification of suitable and appropriate cost drivers
becomes difficult for certain activity costs. A limited number of cost drivers
may not fully explain the cost behaviour of different items in the cost pool.
3. Treating fixed costs as variable: ABC essentially treats fixed costs as if they
were variable. This can, without proper understanding, give some people an
inaccurate understanding which can then lead to poor decision making.
4. Tracing costs: 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. They are not assigned to products
and customers because there is no meaningful method.
5. Cost allocation: The allocation of indirect costs does not truly reflect the
resources consumed by the end products.
6. Complex cost calculation: In manufacturing industries the calculation of costs
according to activity cost pools may be difficult and complex exercise.
7. Inaccurate costing information: Short run decision making may suffer
because of inadequate cost information. Providing inaccurate costing
information leads to taking of wrong decisions by the top management.
8. Time consuming: There are multiple overhead cost pools, and each has its
own unique measure of activity. Collection, analysis and preparation of data
is time-consuming and expensive. It is not suitable for small organisations.
9. Expensive: ABC system is more expensive, as there is a cost to collect and
analyse cost driver information as well as to allocate overhead on the basis
of multiple cost drivers.

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10. Volume based cost: Using an ABC method of costs can increase the per-unit
costs of the low-volume products and decrease the per-unit cost of high-
volume products.
11. High cost of change: Cost of change will be high as everything will have to be
worked out from scratch. This will put strain on the costing system and
resources due to certain degree of inbuilt standardisation.
12. Not suitable of service industry: The ABC is at the stage of evolution.
Literature on the ABC concept at present is primarily restricted to the
manufacturing environment.
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Problems:
1. MNP Ltd. has electricity bill of Rs. 50000 per year. The number of labour hours has
a direct impact on the electricity bill. For the year, there were 2500 labour hours
worked, which is the cost driver. The company uses electricity for 10 hrs per unit
of the product ‘PRID’. Calculate the cost driver rate and overhead costs per unit of
‘PRID’.
2. Santro Pvt. Ltd produces two products, S and T for which the standard cost and
output for January, 2023 are as follows:
Products S T

Output(Units) 5000 7000

Direct labour hours per unit 1 2

Machine hour per unit 3 1

Machine setups for the month 10 40

Orders handled for the month 15 60

Overhead costs for the month of January, 2023 Rs.

Machine activity costs 220000

Machine setup costs 20000

Orders handling costs 45000

Total overheads 285000

Calculate the production overheads per units of each of the products under:
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1) Traditional Absorption Costing using direct labour hour method and

2) Activity Based Costing Method.

3. XYZ manufactures storage discs model S and model M. The records of the company
show the following overheads and other data for December, 2022. Machine
maintenance Rs. 2500, Purchase Overhead Rs. 4250 and Indirect labour cost Rs.
4500.
Particulars MODEL ‘S’ MODEL ‘M’ TOTAL

Labour hours 400 600 1000

Machine hours 100 150 250

Purchase orders 50 50 100

Compute the overhead cost allocated to each product from each activity.

4. Budget overheads and cost driver volumes of S Ltd are as follows:

Cost Pools Budget Cost Driver Budget
Overhead Volumes
(Rs.)
1. Material 900000 No of orders 3000
purchases
2. Material handling 400000 No of movements 1000

3. Setup 300000 No of set-ups 600

4. Maintenance 1000000 Maintenance hours 10000

5. Quality Control 200000 No of inspection 1000

6. Machinery 1000000 No of Machine hours 20000

The company has produced a batch of 3000 components of AB-30. Its material cost is
Rs. 150000 and direct labour cost Rs. 300000.
The usage activities of said batch are as follows:
Machine hours 2500 Set up 30

Material orders 30 Maintenance hours 500

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Material movements 15 No. Of inspections 30

a) Calculate cost driver rates that are used for treating appropriate amount of
overheads to the said batch.
b) Ascertain the cost of batch of components using Activity Based Costing.

5. Monak Ltd. has collected the following data for its two activities. It calculates cost
rates based on cost driver capacity.
Activity Cost driver Capacity Cost

Power Kilowatt hours 60000 kwh Rs. 300000

Inspection No. of inspections 25000 inspection Rs. 500000

The company makes three products A,B and C. For the year ended 31 st March
2022, the following consumption of cost drivers was reported.
Product Kilowatt hours Quantity of inspection

A 10000 10000

B 25000 8000

C 20000 5000

You are required to:

i) Compute the cost allocated to each product from each activity.
ii) Calculate the cost of unused capacity for each activity.
6. Mahan Ltd. has the following data relating to three products A,B and C. Budgeted
overheads and production for the year ending 31 December, 2022 are as follows:
Budgeted overheads and production data relating to three products A,B and C
for the year ending 31 December, 2022:
Particulars A B C

Production units 4000 3000 1600

Direct material per unit (kg) 4 6 3

Direct labour (hours) 0.5 0.75 1

The budgeted direct labour rate was Rs. 100 per hour and budgeted material cost
was Rs. 2 per kg. Production overheads were budgeted at Rs. 99450 and were
absorbed to products using the direct labour hour rate.

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Additional information:
i) Cost drivers and budgeted overheads:
Activity Cost Driver Budgeted
Overheads(Rs.)

Material handling Weight of material handled 29100

Storage costs Number of batches of material 31200

Electricity Number of Machine operations 39150

ii) Data on Cost Drivers:

Particulars A B C

For Complete Production Batches of material 10 5 15

Per unit of production Number of machine 6 3 2

operations
Prepare a statement of total and unit costs using:
a) Traditional absorption costing method and
b) ABC System.
7. Following details have been recorded for 4 batches made in a period.
Batch A B C D

Output in units 250 60 200 120

Cost per batch

Direct material(Rs.) 1650 750 2100 900
Direct labour(Rs.) 9200 1520 6880 2400

Labour hours per batch 1150 190 860 300

Total production overhead for the period has been analyzed as follows:
(Rs.) (Rs.)

Machine related costs 14600 Material handling &

despatch 6800

Stores 8250 Inspection/Quality Control 5850

Setup 6200 Engineering support 8300

Cost drivers have been identified for the cost pools as follows:
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Cost Pool Cost Driver

Machine costs Machine hours

Material handling Material movements

Stores Requisitions raised

Inspection No. of inspections

Set up No of setups

Engineering support Engineering hours

The following Cost Driver (CD) volumes were recorded for the batches:
Batch A B C D TOTAL

Machine hours per batch 520 255 610 325 1710

Material movements 180 70 205 40 495

Requisitions 40 21 43 26 130

Inspections 18 8 13 8 47

Setups 12 7 16 8 43

Engineering hours 65 38 52 35 190

Required:
a) Batch and unit costs using traditional costing methods based on a labour
hour overhead absorption rate
b) Batch and unit cost using ABC
c) Compare the cost in a) and b)

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