ACTIVITY BASED COSTING

Cost Accounting includes collecting, classifying,

processing, analysing and reporting information to
managers in their planning and control activities
and information system to be developed to help in
decision making within the firm. Traditional cost
accounting focused on product costing by tracing
direct cost to the product and indirect costs are
allocated through cost centers.
In any system of costing direct costs are easier to
handle as these are directly charged to end products
but indirect costs are difficult to handle because
they need to be allocated to the end products by
following a suitable basis of allocation.
ABC is a recent development in cost accounting
which attempts to absorb overheads into product
cost on a more realistic basis. Many organizations
have now adopted Advanced Manufacturing
Technology with the result that overheads are
increasing and labour costs are becoming a smaller
portion of total costs. Costing systems which absorb
overheads on a direct labour basis are therefore not
relevant in an AMT Environment. The basic idea ABC
is that costs are grouped according to what drives
them or cause them to incurred. The cost drivers are
then used on an absorption base.
Concept of ABC

ABC is an accounting methodology that assigns costs to

activities rather than products and services. This
enables resources and overhead costs to be more
accurately assigned to products and services that
consume them. In order to correctly associate costs
with products and services, ABC assigns cost to
activities based on their resources. ABC is a term
developed for finding out the cost.
The basic feature of ABC is its focus on activities as the
fundamental cost objects. It uses activities as the basis
for calculating the cost of products and services. In
todays environment of globalization, when each
organization has to continuously its products and
benchmark its activities with the most efficient in the
world, a firm cannot do without activity based costing.
A firm can have a hold on the market only if it manages
properly the value chain at each stage. The value
added at each stage is to be compared with the costs
associated and on that basis decisions are taken about
cutting the unnecessary activities or adding the new
activities. In activity based costing the focus of
attention is on activity rather than a department. It is
modern approach of indirect cost allocation.

Kaplan and Coopers approach to ABC

Kaplan and Cooper of Harvard Business School, who

have developed this new approach in costing to
calculate product costs, claims that the cost 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 are known as fixed cost.) Short term variable
costs
are
volume
related
and
change
proportionately with the volume of production. Long
term variable costs vary in long term but not
instantaneously. Example Production scheduling
costs can be changed in the long term by changing
number of runs rather than changing number of
units produced.
They further claim that this approach relates
overhead costs to the forces behind them. The
forces behind overhead costs are named cost
drivers. Cost drivers can be defined as those
activities or transactions that are significant
determinants of costs. A cost driver is an activity
which generates cost. ABC system is based on the
belief that activities cause cost and that a link
should be made between activities and products by
assigning cost of activities to products based on an
individual products demand for each activity.
How to develop an ABC system?
The following are the three key areas of ABC
Product cost differentiation
Activities and their cost drivers
Identification of non- value added cost

Categories in activity based costing

Unit level activities The cost of some activities
mainly primary activities are strongly co-related to

the number of units produced. These activities are

known as unit level activities.
Batch level activities The cost 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 Material ordering, Machine setup cost,
inspection of products.
Product level activities The cost of some activities
are driven the creation of a new product line and
its maintenance. These activities are known as
product level activities.Example Designing the
product, advertising cost, if it is for individual
products.
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 Maintenance of
buildings, Plant security, Production managers
salary.
==============================
================
The philosophy of ABC is that costs can be
controlled more effectively by focusing directly on
managing the forces that causes the activities
the cost drivers rather than costs.
The following steps are involved in implementing
ABC to achieve the desired results;

1. Identifying the functional areas (like material

management, production, quality control etc.)
involved.
2. Identifying the key activities involved in each
functional area.
3. Allocating the common indirect costs to various
activities in each functional area.
4. Identifying the most suitable cost driver in each
activity under functional areas for better
allocation of indirect costs.
5. Preparing the statement of expenditure activity
wise and comparing it with the value addition
activity wise.
6.
Functional areas may be as follows
1. Material management
2. Stores management
3. Production management
4. Quality control management
5. Personnel management
6. Sales management
7. Repairs and maintenance
8. Administration
9. Public relations
ILLUSTRATION 1
XYZ manufactures four products, namely A,B,C and D
using the same plant and process. The following
information relates to a production period:

Product

Material Direct
Labour
Volume Cost per Labour

Machine
Time perCost

unit
unit
A
B
C
D
hours

per unit

per unit
Rs.
500 5
5,000 5
600 16
7,000
9

Rs.
hour hour
3
hour hour
3
2 hours 1 hour
12
7
1 hours
1

Total production overhead recovered by the cost

accounting system is analysed under the following
headings:
Rs.
Factory overhead applicable to machine-oriented activity

37,425
Set-up costs
Cost of ordering materials
1,920
Handling materials
7,580
Administration for spare parts

4,355

8,600

These overhead costs are absorbed by products on a

machine hour rate of Rs.4.80 per hour giving an
overhead cost per product of
A = Rs.1.20; B = Rs.1.20; C = Rs.4.80; D = Rs.7.20
However, investigation into the production overhead
activities for the period reveals the following totals:
Number of
Number of
times
Number
Period Number of
material
material was
of

set-ups
spare parts
A
2
B
5
C
1
D
4

orders

handled

10

12

17

10

27

12
Your are required:
i)
To complete an overhead cost per product using
activity based costing, tracing overheads to
production units by means of cost drivers; and
ii) To comment briefly on the differences disclosed
between overheads traced by the present
system and those traced by activity based
costing.
SOLUTION
Factory overhead applicable to machine-oriented activity = Rs.37,424.
According to activity based costing (cost driver according to which these
overheads are to be applied is machine hours.)
Total machine hours = Volume x Machine hours required for each product
= 500 x

+ 5,000 x

+ 600 x 1 + 7,000 x 1

hours
= 12,475 hours
Machine hour rate for machine overhead charges =
= Rs.3 per
hour

Set-up costs to applied on the basis of number of set-ups

=

= Rs.256.18 per

set-up
(Cost driver is number of set ups)
Material ordering cost to be absorbed on the basis of number of material
orders
=

= Rs192 per order

(Cost driver is number of times material is ordered)

Material handling cost

= Rs.280.74 per time material handled

(Cost driver is number of times material handled)
Administration for Spare parts

= Rs.716.67
(Cost driver is number of spareparts)
i)

Computation of overhead cost per product using ABC

Overhead
Items

A (Rs)

B (Rs)

C (Rs)

D (Rs)

Machine
Overhead

Rs.0.75
For hr
@Rs.3/-

Rs.0.75
For hr
@Rs.3/-

Rs.3.00
For 1 hr
@Rs.3/-

Rs.4.50
For 1 hr
@Rs.3/-

Set up Cost

0.51
1x
Rs.256.18 /
500
1.12
2x
Rs.280.74 /
500
0.38
1 x Rs.192 /
500
2.87

0.31
6x
Rs.256.18 /
5000
0.56
10 x
Rs.280.74 /
5000
0.15
4 x Rs.192 /
5000
0.72

0.85
2x
Rs.256.18 /
600
1.40
3x
Rs.280.74 /
600
0.32
1 x Rs.192 /
600
1.19

0.29
8x
Rs.256.18 /
7000
0.48
12 x
Rs.280.74 /
7000
0.11
4 x Rs.192 /
7000
0.41

Material
Handling Cost
Material
Ordering Cost
Admn. for

Spare parts

2x
Rs.716.67 /
500

Total O/h per

unit according
to ABC
ii)

5x
Rs.716.67 /
5000

5.63

1x
Rs.716.67 /
600

2.49

4x
Rs.716.67 /
7000

6.76

5.79

OVERHEAD COST BASED ON TWO SYSTEMS AND THEIR

DIFFERENCES

Products

O/H cost per unit

based on ABC System
(Rs)

5.63

B
C
D

2.49
6.76
5.79

O/H cost per unit

based on present
System of
Difference(Rs)
Machine Hour
Rate of Rs.4.80
per hour (Rs)
1.20
+ 4.43
1.20
4.80
7.20

+ 1.29
+ 1.96
- 1.41

Break Even (or Cost Volume Profit)

Analysis
Break even analysis is a logical extension of
marginal costing. It
is based on the same
principles of classifying the operating expenses
into fixed and variable. Now-a-days it has
become a powerful instrument in the hands of
policy makers to maximise profits.

There may be change in the level of production

due to many reasons, such as competition,
introduction of a new product, trade depression
or boom, increased demand for the products,
scarce resources, change in the selling prices of
products etc. In such cases management must
study the effect on profit on account of the
changing levels of production. A number of
techniques can be used as an aid to
management in this respect. One such technique
is the break even analysis.
The term break even analysis is interpreted in
the narrower as well as broader sense. Used in its
narrower sense, it is concerned with finding out
the break even point, i.e. , level of activity where
the total cost equals total selling price. Used in
its broader sense, it means that system of
analysis which determines the probable profit at
any level of production. The break even analysis
establishes the relationship of costs, volume and
profit; so this analysis is also known as Cost
Volume Profit Analysis.
Objectives of Cost-Volume-Profit-Analysis
There exists close relationship between the cost,
volume and profit. If volume is increased the cost
per unit will decrease and the profit per unit will

increase. Thus there is direct relation between

volume and profit but inverse relation between
volume and cost. Analysis of this relationship has
become interesting and useful for the cost and
management accountant. This analysis may be
applied
for
profit-planning,
cost
control,
evaluation of performance and decision making.
The main objectives of such analysis are given
below:
i) This analysis helps to forecast profit fairly
accurately as it is essential to know the
relationship between profits and costs on
one hand and volume on the other.
ii) This analysis is useful in setting up flexible
budgets which indicates costs at various
levels of activity. We know that sales and
variable costs tend to vary with the volume
of output. It is necessary to budget the
volume first for establishing budgets for
sales and variable costs.
iii) This analysis assists in evaluation of
performance for the purpose of control. In
order to review profits achieved and costs
incurred, it is necessary to evaluate the
effects on costs of changes in volume.
iv) This analysis also assists in formulating
price policies by showing the effect of
different price structures on costs and

v)

profits. We are aware that pricing plays an

important part in stabilizing and fixing up
volumes especially in depression period.
This analysis helps to know the amount of
overhead costs to be charged to the
products cost at various levels of operation
as we know that pre-determined overhead
rates are related to a selected volume of
production.

The study of cost volume profit relationship can

be made by
i) Mathematical relationship between cost,
volume and profit and
ii) ii) by preparing break even charts.
In order to understand mathematical relationship
between cost, volume and profit, it is desirable to
understand the following four concepts, their
calculations and applications.
i)
ii)

Contribution
Contribution/Sales (C/S) or Profit Volume (P/V)
ratio.
iii) Break Even point
iv) Margin of safety

Contribution

Contribution is the difference between the

sales and the marginal cost of sales and it
contributes towards fixed expenses and profit.
Eg.,Suppose selling price per unit Rs.15,
variable cost per unit is Rs.10, fixed cost
Rs.1,50,000 then contribution per unit will be
Rs.5.
Contribution for 30,000 units @ Rs.5 is
Rs.1,50,000 which is sufficient only to meet
the fixed cost of Rs.1,50,000 and no amount is
left for profit. If output is 20,000 units,
contribution is Rs.1,00,000which is not
sufficient to meet the fixed expenses of
Rs.1,50,000 and the result is a loss of
Rs.50,000. An output of 40,000 units will give
a contribution of Rs.2,00,000 which will be
sufficient to meet the fixed costs of
Rs.1,50,000 and leave a profit of Rs.50,000.
Thus contribution will go to meet fixed
expenses and then to earn profit. Contribution
can be represented as:
Contribution = Selling Price
Marginal Cost

OR
Profit
OR
Profit

Contribution = Fixed Expenses +

Contribution Fixed Expenses =

Contribution/Sales (C/S) or Profit/Volume (P/V) Ratio

The profit/volume ratio is one of the most

important ratios for studying the profitability of
operations of a business and establishes the
relationship between contribution and sales. This
ratio is calculated as under:
P/V Ratio =

( i.e.,

Or

Or

Or

(i.e.,

(i.e.,

The ratio can also be shown in the form of

percentage if the formula is multiplied by 100.

Thus, if selling price is Rs.15 and marginal cost is

Rs.10 then P/V ratio
=

or

= 33 %

In the above example, for every Rs.100 of sales,

contribution is 33 %. A sale of every Rs.100 will bring a
profit of Rs.33 after expenses are met.
Comparison of P/V ratios for different products can be
made to find out which product is more profitable.
Higher the P/V ratio, more will be the profit and lower
the P/V ratio lesser will be the profit.
The P/V ratio is very useful and is used for the
calculation of:

i)

Break Even Point =

ii)

Value of sales to earn a desired amount of profit:

iii) Variable Costs = Sales ( 1 P/V Ratio)

iv) Profit = Sales x P/V Ratio) Fixed Cost
v) Fixed Cost = (Sales x P/V Ratio) Profit
vi) Margin of Safety =

Eg.,Calculate P/V Ratio from the following

information:
a) Given: Selling price - /Rs.10 per unit, Variable
cost per unit Rs.6.
b)Given the profit and sales of two periods as
under:
Sales (Rs)
Profits (Rs)
2012
1,50,000
20,000
2013
1,70,000
25,000
Soln:
1. P/V Ratio = Contribution / Sales x 100
= 4/10x100 = 40%
(Contribution = SP VC, Rs. 10-Rs.6 = 4)
2. Change in profit / change in sales x 100
= Rs.5000 / Rs.20000 x 100 = 25%

BREAK EVEN POINT

A business is said to break even when its total sales

are equal to its total costs. It is a point of no profit
no loss.
Break Even Point (in units) =
Or

Break Even Point (in amount) =