01 ACTIVITY BASED COSTING

INTRODUCTION

Today the business world has become more competitive and face with
challenges in the decision making process for survival and sustainable in the
business world. Pricing is main decision of businesses which require the cost
structure of a product or service. It is important allocation of overhead costs in
determining the cost of a product or service. This is because overhead cost is
significant percentage of cost structure in current business organizations. The
main reason behind this is the shift of business organizations from labor
oriented techniques to the technology oriented product and process techniques
such as flexible manufacturing systems, computer integrated manufacturing
systems (CAM) etc.
Inaccurate allocation of overheads will lead to flawed strategic decisions which
will result uncertainties and instability over the survival of the organizations.
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 involved discussion on how
ABC system works, its benefits over the traditional costing systems and
implications in adopting an ABC system.

Importance of ABC as a cost allocation system

The traditional product costing systems were designed decades ago when most
companies manufactured a narrow range of products where the direct labor
and direct materials were concerned to be dominant factory costs. The
overhead costs relevant to such productions were relatively small and thus
distortions arising from inappropriate overhead allocations were not regarded
as significant.

In todays business environment, companies have wide range of products

where the overhead costs are considered to represent a significant portion and
as a result, a simple overhead allocation done using direct labor or machine
hours will not be sufficient, since most of the major overheads do not vary with
the direct labor or machine hours. Due to the traditional allocation methods
used, many distortions in overhead allocations were observed and this lead to
misleading information to the users of the information.
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ABC emerged as a result of the background described above. ABC analyses all
activities to identify what drives the costs incurred, what causes the costs to
increase. These cost drivers may be labor hours or machine hours but they
could also be a variety of other factors as well such as number of set ups,
Number of units produced etc.

Traditional Systems Distort Product and Customer Costs

High Overcosted

Traditional
Volume
Costs

Low Undercosted

Product Complexity Customer Complexity

Small batch sizes Customized products
Long set-up times Short lead times
Unique components Unpredictable orders
Special inspection and tests Extensive technical support
Extensive material handling Extensive post-sales support
Special vendors Special tests and requirements

Source: Robert S.Kaplan(2001)

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 centres/cost pools)
In the second stage traditional systems rely on a small number of volume-
based cost drivers (typically direct labour 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
centre costs.

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A two-stage allocation process
(traditional costing system)

The two-stage allocation process

(ABC system)

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Example:
Production Scheduling of an organization can be identify with the number of
production runs, That is higher the number of production runs performed
higher will be the Production Scheduling to perform. Thus it is appropriate to
absorb Production Scheduling costs according to the production runs
performed rather than direct materials consumed.
Discuss the reasons that lead ABC costing to emerge.
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.

Activity 4.2
Identify the below given costs in to cost tracking or cost allocation in a
Cosmetics manufacturing company.
Raw materials for cream production
Quality inspection cost

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 Electricity cost
Plastic tubs for cream packaging
Wages for machine operators
Machine maintenance expenses

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;
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.
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 indirect cost allocation can be done using either the cause and effect
allocation method or arbitrary method. The cause and effect allocation of
overheads is where the allocation base is assumed to be a significant
determinant of cost allocation whereas arbitrary allocation is used when the
allocation base is not significant determinant of the cost allocated. Under the
ABC method, cause and effect allocation method must be used.

4.2.2 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.

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An adoption of ABC system involved four steps;

I. 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
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 Delivery
receipt of goods

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:

(1) Unit Level Activities

(2) Batch Level Activities

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 (3) Product Level Activities

(4) Facility Level Activities

(1) Unit Level Activities:

Unit Level Activities are those activities which are performed each time a single
product or unit is produced. These activities are repetitive in nature.
For example, direct labour hours, machine hours, powers etc. are the activities
used for each time for producing a single unit. Direct materials and direct
labour activities are also unit level activities, although they do not overhead
costs.
Cost of unit level activity vary with the number of units produced.

(2) Batch Level Activity:

These activities which are performed each time a batch of products or group of
identical products are produced. All the units of a particular batch are uniform
in nature and in size. The cost of batch level activities vary with the number of
batches are ascertained.
Machine setups, inspections, production scheduling, materials handling are
examples of batch level activities which are related to batches.

(3) Product Level Activities:

These activities which are performed to support the production of each
different type of product.
Maintenance of equipment, engineering charges, testing routines, maintaining
bills of materials etc. are the few examples of product level activities.

(4) Facility Level Activities

Facility Level Activities are those which are needed to sustain a factory's
general manufacturing process. These activities are common to a variety of
products and are most difficult to link to product specific activities. Factory
management, maintenance, security, plant depreciation are the few examples
of facility level activities.

II. 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

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 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.

III. Determining the cost driver for each major activity;

In order to assign the costs attached to each activity cost centre to products or
to the cost objects, a cost driver must be selected for each activity centre 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.

IV. Assigning the cost of activities to products according to the products

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:

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 Activity cost driver rate = Total cost of activity

Activity driver

4.4 Benefits and Limitations of an 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;

o Intensive competition;

o Non-volume related indirect costs that are a high proportion of

total indirect costs; and

o A diverse range of products all consuming organizational

resources in significantly different proportions (High product
diversity).

The organizations do not implement ABC system due to the question of

its cost effectiveness.

That is, for ABC to be effective as an accurate system it is required to have

as many as fifty different activities identified and costs attribute to them,
such process requires lot of time and effort.

References
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 Cooper, R. and Kaplan, R.S., (1988), Measure costs right: make the right
decision, Harvard Business Review.

Cooper, R. and Kaplan, R.S., (1988), How cost accounting distorts product
cost, Management Accounting.

Drury, C (2007), Cost and Management accounting, Thomson Learning, India.

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 Question 1

Triple Limited makes three types of gold watches the Diva (D), the Classic (C) and
the Poser (P). A traditional product costing system is used at present; although an
Activity Based Costing (ABC) system is being considered. Details of the three products
for a typical period are:
Hours per unit Materials

Production Units
Labour hours Machine hours Cost per unit (Rs.)

Product D - 750 0.5 1.5 20

Product C - 1250 1.5 1.0 12

Product P - 7,000 01 03 25

Direct labor costs Rs.6 per hour and production overheads are absorbed on a machine
hour basis. The overhead absorption rate for the period is Rs.28 per machine hour.

Required:

(a) Calculate the cost per unit for each product using traditional methods, absorbing
overheads on the basis of machine hours.

Total production overheads are Rs.654,500 and further analysis shows that the total
production overheads can be divided as follows:

%
Costs relating to set-ups 35
Costs relating to machinery 20
Costs relating to materials handling 15
Costs relating to inspection 30

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Total production overhead 100

The following total activity volumes are associated with each product line for the period
as a whole:
Number of Set Number of Number o
ups movements of finspections
materials
Product D 75 12 150

Product C 115 21 180

Product P 480 87 670

670 120 1000

Required:

(b) Calculate the cost per unit for each product using ABC principles (work to two
decimal places).

(c) Explain why costs per unit calculated under ABC are often very different to costs per
unit calculated under more traditional methods. Use the information from Triple
Limited to illustrate.

(d) Discuss the implications of a switch to ABC on pricing and profitability.

Pilot paper of ACCA, Performance Management, 2006 December, Question 1

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