ACTIVITY BASED

COSTING
INTRODUCTION
 One of the best tools for refining a costing system is
Activity Based Costing.
 ABC is that costing in which costs are first traced to
activities and then the products.
 It is costing system which focuses on activities performed
to produce products.
 This system calculates the cost of individual activities and
assign cost to cost objects such as products and services on
the basis of the activities needed to produce each product
or service.
Steps in Activity Based Costing
 Identifying major activities
 Identifying the supplier
 Purchase requisition

 Preparing purchase order

 Mailing the purchase order

 Follow up etc…..

Perform an in-depth analysis of the operating processes

of each responsibility segment, each process may consist
of one or more activities required by outputs.
Con..
 Assign resources costs to activities:
This is some times called ‘Tracing’. Trace ability refers to tracing
costs to cost objects to determine why costs were incurred. DOD
categories costs in three ways
 Direct
 Indirect.
 General and Administrative:
Costs that cannot responsibly the activity produced be associated
with any particular product or service produced. There costs
would remains the same no matter what out put the activity
produced.
Cont…
 Identify outputs: Identify all of the outputs for which
an activity segment performs activities and consumes
resources . Outputs can be products ,services or
customers.
 Assign activity costs to out put: Assign activity
costs to outputs using activity drivers . Activity drivers
assign activity costs to outputs based on individual outputs
consumption or demand for activities. For example, a
driver may be the number of times an activity is performed
or length of time an activity is performed.
Stages And Flow Of Costs In ABC
 As stated earlier there are two primary stages in ABC

First tracing cost to activities

Second tracing activities to product.
The different steps in the two stages of ABC
are explained below:

Firstly activities are identified and then classified into different
categories that have relation with different parts of the
production process.
 Secondly factory overhead costs of the activities are
determined and classified into homogeneous cost pools.

Thirdly the factors that influence the cost of a particular
activity should be identified they are knows as ‘cost drivers’.
Activities And Relevant Cost drivers
 Activities drive costs .Costs are allocated based on appropriate cost
drivers. ABC is based on the assumptions that cost behaviour is
influenced by cost drivers. Given below are few examples of activities
and the relevant cost drivers.
Activities Cost drivers
 Machine set-up Number of production runs
 Purchasing materials Numbered of orders placed
 Ware housing Items in stock
 Packing Number of packing orders
 Quality testing Hours of test time
 Stores delivery Number of stores delivery
Classification of Activities
 The grouping of activities is preferably done using different levels at
which activities at which activities are performed. Broadly activities
are classified in to four. They are
 Unit level activities :These are the activities which are performed each
time a unit is produced.
 Batch level activities: These are the activities which are performed
each time a batch of goods or products are produced.
 Product level activities: These are the activities which are performed
to support the production of each different type of production.
 Facility level activities: These are those which are needed to certain a
factories general manufacturing process.
 Activity Related Product Costs
Product Line

material
Costs varying with Unit level activities Machine hours
units energy
Labour hours
Cost varying setups
with number Inspection
of batches Batch level activities Purchase Order
Materials
movement
Product specification
Costs varying with
product line Product substaining Productenhancement
activities Process engineering
customersatisfaction
Benefits of ABC
 Activity based costing brings accuracy and reliability in
product cost determination by focusing on cause and effect
relationship in the cost incurrence.
 Managers manage activities and not products. The changes
in activities leads to changes in costs. Therefore if the
activities are managed well ,costs will fall and resulting
product will be more competitive.
 ABC highlights the problem areas that deserves the
managements attentions and more detailed analysis.
 ABC system is used in setting priorities for action.
 Makes “Indirect” expenses “Direct”.
DRAWBACKS OF “ABC”
 ABC fails to encourage managers to think about changing
work processes to make business more competition.
 ABC is not conformed to generally accepted accounting
principles in same area.
 Using ABC for short run decisions may sometimes prove
costly in the long run.
 ABC does not encourage the identification and removal of
constraints creating delays and excesses.
 An over emphasis on cost reduction with out regard to the
constraints does not create an environment for learning
about the problems and management.
Factors influencing application of ABC

 High incidence of over head cost: If the proportion of

over head cost to total cost is relatively high, it is
necessary that over head cost is applied to products fairly
and accurately in order to prevent over costing of some
products and under costing of others .The extent of
automation ,complexity of production ,etc generally
increases the over head cost today .In such a situation cost
assignment should be based on the suitable cost drivers .As
result product cost are distorted. Actions taken on the basis
of disorted product cost cannot give good result in the long
run.
Cont…..
 Product complexity or diversity: when products consume
activities and inputs in different proportions product
diversity occurs. In such a situation, there is a difference in
the size, complexity, materials, components or other
characteristics and demands made on a firms resources by
product lines. The complex products may consume more
non-unit level inputs such as machine setups than less
complex products. Therefore unless the complexity or
diversity of product is given due weightage in absorption
of costs, product costs are likely to be distorted.
 Volume diversity occurs when there is a difference in the
number of units manufactured by product lines.
Growing Interest In Activity Based
Costing
 Activity Based Costing is being implemented by a growing
number of companies around the globe.
 Few organizations use ABC as their basic on going cost
accounting system.
 Many ABC applications are selective -special studies with
in sub parts of the organization such as business divisions
or particular functions .
 DIAGRAMATIC REPRESENTATION OF ABC
Indirectlabour
Indirect labour

Prepare tooling
Inspect incoming materials

Move materials Maintain machines Setup machines

No of receipts
No of moves Maintainance No of steps
Setup hours
hours

$/receipts
$/moves $/setup
$/Maintainance hours $/Setup hours

Product services/customers
Installation of ABC
The macro economic factors which justify the implementation of ABC are
 Relatively high proportion of overhead costs.
 Product complexity.
 Volume diversity
Steps involved in installation of ABC
Primary Steps:
 Feasibility study.
 IT support.
 Selling the concept to the line employees.
 Strategy and value change analysis.
 Inventorization and screening of activities.
 Identification of cost and cost drivers.
Operational step:
They represent the identification of activities, cost and cost drivers, computation of
absorption rates and allocation of overhead costs based on the activities.
 Presented by

Sujatha .Bhupathi(7843)

MBA 1st year.

KBN college