Activity Based Costing

Introduction
■ Activity Based Costing (ABC) is one of the mostly accepted
techniques that is used to allocate these overhead costs accurately
introduced by Robert S. Kaplan.
■ Many leading companies who has applied ABC system has created
more accurate ABC information leads to better strategic decisions
about products, services and customers.
■ This chapter involve discussion on how ABC system works, its
benefits over the traditional costing systems and implications in
adopting an ABC system.
A comparison of Traditional and ABC
systems
■ Both systems use the two-stage allocation process.
■ In the first stage traditional systems tend to allocate costs to departments whereas
ABC systems allocate costs to activities: (ABC systems tend to have more cost
centers/cost pools)
■ In the second stage traditional systems rely on a small number of volume-based cost
drivers (typically direct labor or machine hours) whereas ABC systems use many
second stage cost drivers.
■ ABC systems seek to use only cause-and-effect cost drivers whereas traditional systems
often rely on arbitrary allocation bases.
■ ABC systems tend to establish separate cost driver rates for support departments
whereas traditional systems merge support and production center costs.
A two-stage allocation process
Traditional costing system
The two-stage allocation process - ABC
system
Basic Concepts involved in ABC
■ Costs related to a cost object can be divided in to two categories as direct and indirect costs. The direct costs can
be directly observable and can be accurately traced to the cost objects identified. Such direct identification of
costs in to the cost objects is known as cost tracking.
■ Indirect costs cannot be identified directly in to the cost objects as they are common to several cost objects and
such indirect costs should be assigned to cost objects using cost allocations.
■ The cost allocation can be defined as the process of assigning costs when a direct measure does not exist for the
quantity of resources consumed by a particular object. The Cost allocations involve the use of surrogate rather
than direct measures. The basis that is used to allocate the costs to cost objects is known as allocation base or the
cost driver.
■ Cost driver can be defined as any factor that causes a change in the cost of an activity. There are two categories
of cost drivers;
I. A resource cost driver: is a measure of the quantity of resources consumed by an activity. It is used to assign
the cost of a resource to an activity or cost pool.
II. An activity cost driver: is a measure of the frequency and intensity of demand placed on activities by cost
objects. It is used to assign activity costs to cost objects.
The two stage allocation of Overheads
Overheads in any organization should be allocated in two stages, no matter the system used is traditional or
ABC. The two stages are;
1. Overheads are assigned to cost centers/ cost pools.
2. Cost accumulated in cost centers/ cost pools are allocated to costs objects using selected allocation bases.

Designing of ABC system

A key assumption in ABC is that overhead costs are caused by a variety of activities and the different
products and services utilize these activities in a non-homogeneous fashions when producing and providing
them.

An adoption of ABC system involved four steps

1. Identifying the major activities that take place in an
organization
These major activities are composed of the aggregation of units of work or tasks described by verbs
associated with the tasks.
Examples of Cost Drivers

In order to trace overhead costs to manufacturing a product, suitable Cost Drivers should be identified.
The following are the few examples of Cost Drivers in Activity-Based Costing:

Cost Drivers Activity

(1) Number of receiving order Ordering

(2) Number of deliveries Delivery
(3) Number of Purchase orders Order Taking
(4) Kilometres travelled per delivery Deliveries
(5) Number of customers' visits Customer Visit
(6) Number placing orders for purchase Placing Orders
(7) Number of returning or empty bottles Bottles Returns

(8) Number Material handling hours Product Handling

(9) Amount of labour cost incurred Labour Transactions
(10) Number of inspections Inspection
(11) Number of physical delivery and receipt of goods Delivery
Classification of Activities
In the first stage of the Activity-Based Costing activities are identified and classified into
different categories or segments of the production process. The grouping of activities is
preferably done using the different levels at which activities are performed. Broadly,
activities are classified into:
■ Unit Level Activities
■ Batch Level Activities
■ Product Level Activities
■ Facility Level Activities
2. Assigning costs to cost pools/ cost
centers for each activity
■ After identification of major activities, the cost of resources consumed
over a specific period must be assigned to each activity. The aim is to
identify how much the organization is spending on each of identified
major activity.
■ While some of the resources are directly attributable to the specific
activity centers such as labor and heating costs, the indirect costs which
are shared by several activities should be assigned to activities on the
basis of cause and effect using the resource cost drivers and arbitrary
allocation of such costs should be avoided.
3. Determining the cost driver for each
major activity
In order to assign the costs attached to each activity cost center to products or to the cost
objects, a cost driver must be selected for each activity center and such cost drivers are
called activity cost drivers as described earlier.
Following factors must be kept in mind when selecting a suitable cost driver.
■ The cost driver selected should provide a good explanation of costs in each activity
pool.
■ The selected cost driver should be easily measurable; and
■ Data should be relatively easy to obtain and be identifiable with products.
4. Assigning the cost of activities to
products according to the product’s demand
for activities
The final stage involves applying the cost driver rates to products.
Therefore the cost driver must be measurable in a way that enables it to be
identified with individual products.
For instance, if set-up hours are selected as a cost driver, there must be a
mechanism for measuring the set-up hours consumed by each product.
The calculation of activity cost driver rate is done as follows:

Activity cost driver rate = Total cost of activity

Activity driver
 Benefits of ABC system
■ Greater costing accuracy is the primary benefit achieved using ABC.
■ ABC method assigns costs only to the products that require the activity for
production and eliminates allocating irrelevant costs to a product.
■ ABC costing method provide an easy interpretation of cost for internal
management
■ ABC costing system enables benchmarking and a greater understanding of
overhead costs.
■ An application of ABC system benefits most to the organizations which has the
following characteristics;
– Intensive competition;
– Non-volume related indirect costs that are a high proportion of total indirect costs; and
– A diverse range of products all-consuming organizational resources in significantly
different proportions (High product diversity).
Limitations of ABC system
ABC will be of limited benefit if the overhead costs are primarily volume related or if the overhead is a
small proportion of the overall cost. It is impossible to allocate all overhead costs to specific activities. The
choice of both activities and cost drivers might be inappropriate. Other Limitations are as follows,

 Collection and preparation of data is time-consuming

 Costs more to accumulate and analyze information
 Source data is not always readily available from normal accounting reports
 Reports from ABC do not always conform to generally accepted accounting principles and
cannot be used for external reporting
 Data produced by ABC may conflict with managerial performance standards previously
established from traditional costing methods
Example 01
You are the new chief accountant of Alpha Ltd, a furniture manufacturer located in Chicago. You
have given following information.
Table 1: Costs incurred

Cost Division Amount budgeted ($)

Wood to produce tables Tables 540,000
Leather to produce sofas Sofas 850,000
Direct Labor Tables 50,000
Direct Labor Sofas 200,000
Factory utilities Both 200,000
Property taxes for
Both 50,000
factory

Note: The direct labor is split because each division has its own team (i.e., one division's labor does not work for
the other).
Table 2: Other information

Data Sofa Table Total

Direct labor hours
20,000 5,000 25,000
budgeted
Square feet used in
6,000 4,000 10,000
factory

Required:
1.Determine which of the costs provided are indirect and thus can benefit from Activity-Based Costing.
2.Determine the appropriate cost drivers for the cost pools identified in # 01.
3.Calculate the cost activity rates for each pool identified in #1 using the cost drivers in # 02.
Solution
1. The answer is factory utilities and property taxes for the factory since they cannot be traced to
a single division.
2. Factory utilities:
Although we can argue that square footage is a good cost driver, the rationale for selecting direct
labor hours as a cost driver is that the factory utilities (e.g., lighting, electricity, etc.) will increase in
cost based on the amount of hours worked.
Therefore, the answer is Direct Labor Hours.
Property taxes:
The square footage occupied by each division should be used.
3. Cost pool Total driver Cost rate (Pool $/Total
Cost pool Cost Driver
Amount base base)
Direct labor
Factory utilities 200,000 25,000 $8 per direct labor hour
hours
Property taxes for Square feet used
50,000 10,000 $5 per square foot
factory in factory
Example 02
The following details pertain to different activities and their costs for Gamma Ltd. You are
required to calculate the overhead rate for each activity with the use of ABC Costing.

We are here given five activities hence, we need to allocate those costs based upon their cost
drivers.
Using the ABC formula: Cost Pool total / Cost driver
Each activity pool’s total cost is divided by its cost driver to arrive at different rates.
Overhead Rate for the Purchasing Activity is as follows
Overhead Rate for the Purchasing Activity = 1,20,000 / 200 = 600.00
Similarly, do the calculation of ABC Cost Formula for all the cost pool activities.
Example 03
Beta is a manufacturing company of drugs is considering switching from their traditional method
of cost to a newly implemented system by their production head which is activity-based costing so
that the two products Z serum and W serum can be sold at their proper cost and make them price
competitive in the market.
Below are the production details that have been derived from the production sheet.
You are required to arrive at product-based total cost using ABC formula.
Answer
The total estimated overhead is 506250.00
After arriving at different rates, we now have to arrive at product level total cost which
would be nothing but multiplying different overhead rates as arrived above with their
individual actual cost drivers.
Thank you