Activity-Based

Costing Systems
PREPARED FOR,

MD MOIN UDDIN
LECTURER, FBS, BUP

OUTLINE
WHAT IS ACTIVITY BASED COSTING?
WHY ABC IS NEEDED?
TWO STAGE ACTIVITY BASED COSTING METHOD
IMPLEMENTATION EXAMPLE
ADVANTAGES
DISADVANTAGES
IMPLEMENTATIUON CHALLENGES

WHAT IS ACTIVITY BASED

COSTING?
Activity-based costing(ABC) is a costing
methodology that identifies activities in an
organization and assigns the cost of each activity
with resources to all products and services
according to the actual consumption by each.
It enables a business to decide which products,
services, and resources are increasing their
profitability, and which are contributing to losses

Activity-based
Activity-based costing
costing (ABC)
(ABC) involves
involves
determining
determining the
the cost
cost of
of activities
activities and
and
tracing
tracing their
their costs
costs to
to cost
cost objectives
objectives on
on the
the
basis
basis of
of the
the cost
cost objectives
objectives utilization
utilization of
of
units
units of
of activity.
activity.

Part of ActivityBased Analysis

The Defect of Traditional

Costing System
Spreads overheads cost over entire product
range. A single overheads recovery rate (also
known as predetermined overheads rate or
overheads absorption rate) is used to absorb
total overheads cost to all production. For
instance,
For job order costing, overheads cost absorption rates
are normally based on direct labor cost or direct labor
hours
For process costing, overheads cost absorption rates
are normally based on machine hours worked
5

Results of the defect

Each product appeared to cost the same, as far as
overheads cost is concerned
Products with high profit margins subsidized
products with low profit margins
In-accurate cost accumulation led to inaccurate
profit planning of products
A product cannot compete in the market if its cost
is not accurately accumulated and reflected in

WHY ABC NEEDED?

Competitive demands for diverse
products/services
Increased significance of overhead costs
Growth of non unit-based overhead
Consumption ratios of unit-based and non unitbased overhead items differ

Improved information technology

Significance of strategic decisions

THE STEPS FOR IMPLEMENTING ABC SYSTEM

Step#1 Activity Identification

Activities must be identified and grouped

together in activity pools.
Activity pools are the supporting activities that
tie in to a product line or service.
These pools or buckets may include
fractionally assigned costs of supporting
activities to individual products as appropriate
during the second step.

Step #2: Activity Analysis

ABC continues with
activity analysis
identifying the processes which support a product
avoiding some of the systemic inaccuracies of
traditional costing.

This activity analysis identifies indirect cost relationships

and allows assignment of some percentage of that
activity to an end product directly.

Step #3: Assignment of Costs

Based on the findings of step #1 and #2, costs are
assigned to an activity pool.
For example, human resources costs would be assigned to
indirect administrative or indirect management costs.
These pools will each have some contribution to object
cost.

Step #4: Calculate Activity Rates

Initial analysis may include direct labor hours, or

indirect support labor. These activities must be

Step #5: Assign Costs to Cost Objects

Once activity costs, pools and rates are
identified and clearly defined, the next
step is to assign them to cost objects.
Objects are generally defined as the
results offered to a customer.
In both manufacturing and nonmanufacturing environments, this product
should have some saleable value to

Manufacturing Cost
Hierarchy
Unit level activities
Batch level activities
Product level activities
Facility level activities

Manufacturing Cost
Hierarchy
This
This activity
activity is
is
performed
performed for
for
each
each unit
unit of
of
product
product
produced
produced and
and
sold.
sold.

Unit Level
Examples
Cost of raw materials
Cost of inserting a
component
Utilities cost of
operating equipment
Some costs of
packaging

Manufacturing Cost
Hierarchy
Batch Level
Examples
Cost
Cost of
of processing
processing sales
sales
order
order
Cost
Cost of
of issuing
issuing and
and
tracking
tracking work
work order
order
Cost
Cost of
of equipment
equipment setup
setup
Cost
Cost of
of moving
moving batch
batch
between
between workstations
workstations
Cost
Cost of
of inspection
inspection

This
This activity
activity is
is
performed
performed for
for
each
each batch
batch of
of
product
product produced
produced
or
or sold.
sold.

Manufacturing Cost
Hierarchy
Product Level
Examples
Cost of product
development
Cost of product
marketing, such as
advertising
Cost of specialized
equipment
Cost of maintaining
specialized
equipment

This
This activity
activity is
is
performed
performed to
to support
support
each
each different
different product
product
that
that can
can be
be produced.
produced.

Manufacturing Cost
Hierarchy
Facility Level
This
This activity
activity is
is
performed
performed to
to
maintain
maintain general
general
manufacturing
manufacturing
capabilities.
capabilities.

Examples
Cost of maintaining general
facilities
Cost of non-specialized
equipment
Cost of maintaining nonspecialized equipment
Cost of real property taxes
Cost of general advertising
Cost of general administration

Changing Composition of Total

Manufacturing Costs
Volume-Based Unit
Level Analysis

Activity-Based MultipleLevel Analysis

Variable: Only one

Variable: Many types of

type of variable
cost is considered:
Unit level

variable cost drivers are

considered, including:
Unit level
Batch level
Product level

Changing Composition of Total

Manufacturing Costs

Volume-Based Unit
Level Analysis
Fixed: Costs that do not
vary with the number of
units

Activity-Based MultipleLevel Analysis

Fixed: Costs that do not

respond to change in variable

cost drivers are considered:

Facility level

Customer Cost Hierarchy

A merchandising organization or the sales division of a
manufacturing organization might use the following
hierarchy:

Unit level activities

Order level activities
Customer level

activities
Facilities level

Customer Cost Hierarchy

An organization that sells to distinct market
segments might have the following cost hierarchy:
Unit level activities
Order level activities
Customer level activities
Market segment level

activities

1.

Practical
Practical Advice
Advice for
for Implementing
Implementing
ABC
ABC
Capture the attention of top management
.

2.

Dont shoot the customer.

3. Decide the form ABC will take.

4. Supplement the ABC measures creativity where appropriate.
5. Be careful in costing bottlenecks that create excess capacity.
6.

Challenge managers who believe their costs are fixed.

7. Calculate costs top-down and bottom-up.

8. Account for cost of capital.
9.

Use multi-functional teams.

10.

Dont underestimate the need for managing change.

Usefulness for ABC

Implementation
ABC helps to identify inefficient products, departments and activities.
ABC helps to allocate more resources on profitable products, departments and
activities.
ABC helps to control the costs at any per-product-level level and on a
departmental level.
ABC helps to find unnecessary costs that may be eliminated.
ABC helps fixing the price of a product or service with any desired analytical
resolution

REASONS FOR ABC IMPLEMENTATIONS

Better Management
Budgeting, performance measurement
Calculating costs more accurately
Ensuring product /customer profitability
Evaluating and justifying investments in new technologies
Improving product quality via better product and process design
Increasing competitiveness or coping with more competition
Management
Managing costs
Providing behavioral incentives by creating cost consciousness among
employees

Implementation of
Activity Based Costing (ABC)
and
Traditional
Cost Accounting (TCA) Methods
in an
Automobile Parts Manufacturing
Company:
A Case Study

Current status:

Current prices, direct labour hour to produce each of the

items, their material costs, and annual production
quantities are as under and are shown
Sr. No.

Object

Part A

Part B

Part C

Material cost

400

250

300

Direct labour hours

3.7

4.5

Annual quantity

18000

16000

18500

Selling Price/each

1200 each

850 each

1150 each

The company has recorded following expenses last

year on its General Ledger Statement and it is
shown
(a)

Direct labour

1,67,50,000.00

(b)

Direct material

24,58,000.00

(c)

All other indirect expenses

Salaries & wages

35,43,650

Fringe benefits

9,48,328

Utilities

5,17,837

Income tax

1,58,121

Equipment rental

4,30,491

Postage

31,195

Depreciation

2,93,233

Property tax

74,868

Maintenance

1,18,541

Property insurance

56,151

Tools

93,585

In Traditional costing method

Total Labour hours required
Part A

= (18,000 5)

= 90,000 hrs

Part B

= (16,000 3.7)

= 59,200 hrs

Part C

= (18,500 4.5)

= 83,250 hrs

Total labour hours

= 2, 32,450 hrs

Direct labour hour cost

Direct labour hour cost

= (1,67,50,000/2,32,450)

= 72.05 /hr

Total/overall indirect cost

Total indirect cost

= 62,66,000

Over cost/labour hour

Over cost/labour hour

= (62,66,000.00/2,32,450)

=26.95 /hr

Part Cost Calculation in traditional costing

S.N
O.

Expenses

Part A

Part B

Part C

Direct material

400

250

300

Direct labour

(72.054.5) = 324.23

Overhead

Total cost

(72.053.7) =
266.59
(26.953.7) =
99.72
616.31

Price

850

1150

Margin

305

Margin %

25.41

(72.055) =
360.25
(26.955) =
134.75
895

1200

233.69
27.50

(26.954.5) =
121.28
745.51

404.49
35.18

Thus, Part C has the best margin % i.e.

35.18%.

Now, True Cost calculation of parts by

Activity Based Costing (ABC) Method :
Flashback
.
1

Machine hours/unit

3.7

4.5

Material cost/unit

400

350

200

Labour hours/unit

3.7

4.5

Total labour hours

18,000

16,000

18,500

Selling price/part

1,200

850

1,150

After interviewing the staff of company;

some of the information was received
from the Companys records

Sr.
No.

Object

Part A

Part B

Part C

Total

Customer orders

1,800

2,000

2,500

63,00

Parts manufactured

18,000

16,000

18,500

52,500

Work orders

110

100

120

330

Set-ups

110

100

120

330

Calculation of unit activity costs :

S.N
O.

Activities

Activity
cost

Activity driver

Quantity

Processing orders

15,03,840

No. of orders

6,300

Scheduling orders

12,53,200

No. of work orders 330

Set-up machines

17,54,480

No. of set-ups

330

Inspection lots

10,02,560

No. of lots

330

Shipping part

7,51,920

No. of shipments

6,300

Activities
Processing
orders
Scheduling
orders
Set-up machines
Inspection lots

Cost/unit
238.70
3,797.57
5,316.60
3,038.06
119.35

% of Activity
cost

24%
20%
28%
16%

Note : Activity Costs Calculation

Total indirect cost from general ledger % activity
e.g., Processing orders = 62, 66,000 0.24
= 15, 03,840

Activity Costs :
Part A

Part B

Part C

Sr. Activity
No

Cost

Vol.

Total
Cost

Unit
Cost

Vol.

Total
Cost

Unit
Cost

Vol.

Total
Cost

Unit
Cost

Processing
Orders

238.70

1,80
0

4,29,66
0

23.87

2,00
0

4,77,4
00

29.83

2,50
0

5,96,75
0

32.25

Scheduling
Orders

3,797.5
7

110

4,17,73
2.7

23.20

100

3,79,7
57

23.73

120

4,55,70
8.4

24.63

Set-up
machines

5,316.6
0

110

5,84,82
6

32.49

100

5,31,6
60

33.22

120

6,37,99
2

34.48

Inspection
lots

3,038.0
6

110

3,34,18
6.6

18.56

100

3,03,8
06

18.98

120

36,45,6
7.2

19.70

Shipping
parts

119.35

1,80
0

2,14,83
0

11.93

2,00
0

2,38,7
00

14.91

2,50
0

2,98,37
5

16.12

Calculation of true costs of all

three parts :
Sr.N
o.

Expenses

Part A

Part B

Part C

(1)

Direct material

400

250

300.00

(2)

Direct labour

360.25

266.59

324.23

(3)

Overhead distribution (activity cost

basis )

110.05

119.67

127.18

(4)

Total cost {=(1)+(2)+(3)}

870.03

636.26

751.41

(5)

Selling price

1200

850

1150

(6)

Margin{=(5)-(4)}

329.97

213.74

398.59

(7)

Margin %

27.49%

25.14%

34.66%

COMPARISON
PART

Selling
price

TCA
cost

TCA
margin

TCA
margin%

ABC
cost

ABC cost
margin

ABC cost
margin%

Part
A

1,200

895

305

25.41%

870.03

329.97

27.49%

Part
B

850

616.31

233.69

27.50%

636.26

213.74

25.14%

Part
C

1,150

745.51

404.49

35.18%

751.41

398.59

34.66%

ADVANTAGES
Accurate costing.
Better understanding.
Utilizes unit cost.
Integrates with Six Sigma.
Better control
Supports performance management
Helps in benchmarking

DISADVANTAGES
Big Budget.
Maintenance Cost
Creates confusion
Misinterpretation
Do not conform to GAAP

IMPLEMENTATION CHALLANGES
The initiative to implement ABC system must be strongly
supported by the management. The workings involve a
tremendous job of making inquiries from employees.
The design and implementation of ABC system should be the
responsibility of a cross functional team of technicians. Normally,
the team would include representatives from accounting,
finance, IT, marketing, production and engineering departments.
Services of an ABC system consultant must be hired in order to
prevent the wastage of resources and time.
Selection of ABC software that could implement and automate
the processing of the system should be made upon expert
advice.

REFERENCES
Cost & Management Accounting by Colin Drury, 5/e
Cost Accounting by Horngren /Datar /Foster, 11/e
Managerial Accounting by Hilton and Platt
Managerial Accounting by Weygandt / Kieso / Kimmel,
2/e
Cima Official Terminology

THANK