TABLE OF CONTENT

SR NO

TOPIC

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Introduction
Methodology
Steps in Developing Activity Based
Costing System
Levels of Activities
Benefits of Activity Based Costing
Advantages, Disadvantages and
Limitations
Steps to implement Activity-Based
costing
Activity
Activity based costing - a tool for
decision making
Activity Based Costing: A Decision
Making Tool
ABC Focus
Activity Based Costing with Two
Activities
Activity Based Costing with Four
Activities
REFERENCE

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Introduction
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. This model assigns more indirect
costs (overhead) into direct costs compared to conventional costing.
CIMA (Chartered Institute of Management Accountants) defines ABC as an approach to
the costing and monitoring of activities which involves tracing resource consumption and
costing final outputs. Resources are assigned to activities, and activities to cost objects based
on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs.
Aims of model
With ABC, a company can soundly estimate the cost elements of entire products, activities
and services. That may help inform a company's decision to either:

Identify and eliminate those products and services that are unprofitable and lower the
prices of those that are overpriced (product and service portfolio aim)

Or identify and eliminate production or service processes that are ineffective and
allocate processing concepts that lead to the very same product at a better yield (process
re-engineering aim).

In a business organization, the ABC methodology assigns an organization's

resource costs through activities to the products and services provided to its customers. ABC
is generally used as a tool for understanding product and customer cost and profitability
based on the production or performing processes. As such, ABC has predominantly been used
to support strategic decisions such as pricing, outsourcing, identification and measurement of
process improvement initiatives.
Prevalence
Following initial enthusiasm, ABC lost ground in the 1990s, to alternative metrics, such as
Kaplan's balanced scorecard and economic value added. An independent 2008 report
concluded that manually driven ABC was an inefficient use of resources: it was expensive
and difficult to implement for small gains, and a poor value, and that alternative methods
should be used. Other reports show the broad band covered with the ABC methodology.
However, application of an activity based recording may be applied as an addition to activity
based accounting, not as a replacement of any costing model, but to transform concurrent
process accounting into a more authentic approach.

Historical development
Traditionally, cost accountants had arbitrarily added a broad percentage of analysis into the
indirect cost. In addition, activities include actions that are performed both by people and
machine. However, as the percentages of indirect or overhead costs rose, this technique
became increasingly inaccurate, because indirect costs were not caused equally by all
products. For example, one product might take more time in one expensive machine than
another productbut since the amount of direct labor and materials might be the same,
additional cost for use of the machine is not being recognized when the same broad 'on-cost'
percentage is added to all products. Consequently, when multiple products share common
costs, there is a danger of one product subsidizing another.
ABC is based on George Staubus' Activity Costing and Input-Output Accounting. The
concepts of ABC were developed in the manufacturing sector of the United States during the
1970s and 1980s. During this time, the Consortium for Advanced Management-International,
now known simply as CAM-I, provided a formative role for studying and formalizing the
principles that have become more formally known as Activity-Based Costing.
Robin Cooper and Robert S. Kaplan, proponents of the Balanced Scorecard, brought notice to
these concepts in a number of articles published in Harvard Business Review beginning in
1988. Cooper and Kaplan described ABC as an approach to solve the problems of
traditional cost management systems. These traditional costing systems are often unable to
determine accurately the actual costs of production and of the costs of related services.
Consequently managers were making decisions based on inaccurate data especially where
there are multiple products.
Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause
and effect relationships to objectively assign costs. Once costs of the activities have been
identified, the cost of each activity is attributed to each product to the extent that the product
uses the activity. In this way ABC often identifies areas of high overhead costs per unit and so
directs attention to finding ways to reduce the costs or to charge more for costly products.
Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W. Burns as
a chapter in their book Accounting and Management: A Field Study Perspective. They
initially focused on manufacturing industry where increasing technology and productivity
improvements have reduced the relative proportion of the direct costs of labor and materials,
but have increased relative proportion of indirect costs. For example, increased automation
has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect
cost.
Like manufacturing industries, financial institutions have diverse products and customers,
which can cause cross-product, cross-customer subsidies. Since personnel expenses represent
the largest single component of non-interest expense in financial institutions, these costs must
also be attributed more accurately to products and customers. Activity based costing, even

though originally developed for manufacturing, may even be a more useful tool for doing
this.
Activity-based costing was later explained in 1999 by Peter F. Drucker in the
book Management Challenges of the 21st Century. He states that traditional cost accounting
focuses on what it costs to do something, for example, to cut a screw thread; activity-based
costing also records the cost of not doing, such as the cost of waiting for a needed part.
Activity-based costing records the costs that traditional cost accounting does not do.
The overhead costs assigned to each activity comprise an activity cost pool.

Activity-based costing (ABC) is a costing approach that assigns resource costs to cost
objects such as products, services, or customers based on activities performed for the cost
objects. The premise of this costing approach is that a firms products or services are the
results of activities and activities use resources which incur costs. Costs of resources are
assigned to activities based on the activities that use or consume resources (resource
consumption drivers), and costs of activities are assigned to cost objects based on activities
performed for the cost objects (activity consumption drivers). ABC recognizes the causal or
direct relationships between resource costs, cost drivers, activities, and cost objects in
assigning costs to activities and then to cost objects.
ABC assigns factory overhead costs to cost objects such as products or services by
identifying the resources and activities as well as their costs and amounts needed to produce
output. Using resource consumption cost drivers, a firm determines the resource costs
consumed by activities or activity centers (activity cost pools) and calculates the cost of a unit
of activity. The firm then assigns the cost of an activity to products or services by multiplying
the cost of each activity by the amount of the activity consumed by each of the cost objects.
Traditionally cost accountants had arbitrarily added a broad percentage of expenses into the
indirect cost. In addition, activities include actions that are performed both by people and
machine. However, as the percentages of indirect or overhead cots rose, this technique
became increasingly inaccurate, because indirect costs were not caused equally by all
products. Consequently, when multiple products share common costs, there is a danger of one
product subsidizing another.
Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause
and effect relationships to objectively assign costs. Once costs of the activities have been
identified, the cost of each activity is attributed to each product to the extent that the product
uses the activity. In this way ABC often identifies areas of high overhead costs per unit and so
directs attention to finding ways to reduce the costs or to charge more for costly products.

Methodology

Methodology of ABC focuses on cost allocation in operational management. ABC helps to

segregate

Fixed cost

Variable cost

Overhead cost

The split of cost helps to identify cost drivers, if achieved. Direct labour and materials are
relatively easy to trace directly to products, but it is more difficult to directly allocate indirect
costs to products. Where products use common resources differently, some sort of weighting
is needed in the cost allocation process. The cost driver is a factor that creates or drives the
cost of the activity. For example, the cost of the activity of bank tellers can be ascribed to
each product by measuring how long each product's transactions (cost driver) takes at the
counter and then by measuring the number of each type of transaction. For the activity of
running machinery, the driver is likely to be machine operating hours. That is, machine
operating hours drive labor, maintenance, and power cost during the running machinery
activity.
Application in routine business
ABC has proven its applicability beyond academic discussion. ABC is applicable throughout
company financing, costing and accounting:

ABC is a modeling process applicable for full scope as well as for partial views.

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.

A report summarizes reasons for implementing ABC as mere unspecific and mainly for case
study purposes (in alphabetical order):

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 behavioural incentives by creating cost consciousness among employees

Responding to an increase in overheads

Responding to increased pressure from regulators

Supporting other management innovations such as TQM and JIT systems

Beyond such selective application of the concept, ABC may be extended to accounting, hence
proliferating a full scope of cost generation in departments or along product manufacturing.
Such extension, however requires a degree of automatic data capture that prevents from cost
increase in administering costs.

Steps in Developing Activity Based Costing System:

Developing an activity-based costing system entails three steps: (1) identifying resource costs
and activities, (2) assigning resource costs to activities, and (3) assigning activity costs to cost
objects.
Step 1: Identify Resource Costs and Activities
The first step in designing an ABC system is to conduct an activity analysis to identify the
resource costs and activities of the firm. Most firms record resource costs in specific accounts
in the accounting system. Examples of these accounts include supplies, purchasing, materials
handling, warehousing, office expenses, furniture and fixtures, buildings, equipment, utilities,
and salaries and benefits. However, special effort most likely will be needed to determine
appropriate resource costs for activity-based costing because generally several different
resource costs may be recorded in a single account or the costs for an activity may be
recorded in several accounts.
6

For example, a firm may use a single factory supplies account for all supplies in its
operations that include several manufacturing operations. Costs to complete a purchasing
order may be spread over several accounts including accounts for warehousing, purchasing,
and receiving. Through activity analyses a firm identifies the work it performs to carry out its
operations. Activity analyses include gathering data from existing documents and records, as
well as collecting additional data using questionnaires, observations, or interviews of key
personnel.
Levels of Activities
To identify resource costs for various activities, a firm classifies all activities according to the
way in which the activities consume resources.

A unit-level activity is performed on each individual unit of product or service of the

firm.
Examples of unit-level activities include direct materials, direct labor-hours, inserting a
component, and inspecting every unit. A unit-level activity is volume-based. The required
activity varies in proportion with the quantity of the cost object.

A batch-level activity is performed for each batch or group of units of products or

services.
A firm incurs a batch-level activity for each batch or group of units of products or services
scheduled to be processed together, rather than for each individual unit of the cost object.
Examples are setting up machines, placing purchase orders, scheduling production,
conducting inspections by batch etc.
A product-level activity supports the production of a specific product or services.
Examples of product-sustaining activities include designing products, administering parts
required for products, and engaging in engineering changes to modify products.

A facility-level activity supports operations in general. These activities are not caused
by products or customer service needs and cannot be traced to individual units,
batches, or products.

Examples include providing security and safety, performing maintenance of general purpose
machines, managing the plant, incurring factory property taxes etc. These activities are also
called as business or infrastructure sustaining activities.
Step 2: Assign Resource Costs to Activities
Activity-based costing uses resource consumption cost drivers to assign resource costs to
activities. Because activities drive the cost of resources used in operations, a firm should
choose resource consumption cost drivers based on cause-and-effect relationships. Typical
resource consumption cost drivers include the number of (1) labor hours for labor intensive
activities; (2) employees for payroll-related activities; (3) setups for batch-related activities;
(4) moves for materials-handling activities; (5) machine-hours for machine repair and
maintenance; and (6) square feet for general maintenance and cleaning activities.
7

The cost of the resources can be assigned to activities by direct tracing or estimation. Direct
tracing requires measuring the actual usage of resources by activities. When direct tracing is
not available, department managers and supervisors need to estimate the amount or
percentage of time (or effort) employees spend on each identified activity.
Step 3: Assign Activity Costs to Cost Objects
The final step is to assign costs of activities or activity cost pools to cost objects based on the
appropriate activity consumption cost drivers. Outputs are the cost objects for which firms or
organizations perform activities. Typical outputs for a cost system are products and services;
however, outputs also can include customers, projects, or business units. Firms use activity
consumption cost drivers to assign activity costs to cost objects. Activity cost drivers should
explain why the cost of a cost object goes up or down. Typical activity consumption cost
drivers are purchase orders, receiving reports, inspection reports or hours, parts stored,
payments, direct labor-hours, machine-hours, and setups and manufacturing cycle time.

Benefits of Activity Based Costing:

Since the 1980s an increasing number of firms have adopted the activity-based costing
system. These firms adopt ABC because of the benefits it offers.
Benefits
Initially, many firms adopt activity-based costing to reduce distortions in product costs often
found in their volume-based costing systems. Volume-based costing systems, generate
product or service costs bearing little or no relationship to activities and resources consumed
in operations. ABC clearly shows the effect of differences in activities and changes in
products or services on costs. Among the major benefits of activity-based costing that many
firms have experienced are:
Better profitability measures: ABC provides more accurate and informative product costs,
leading to more accurate product and customer profitability measurements and to betterinformed strategic decisions about pricing, product lines, and market segments.
Better decision making: ABC provides more accurate measurements of activity-driving
costs, helping managers to improve product and process value by making better product
design decisions, better customer support decisions, and fostering value enhancement
projects.
Process improvement: The ABC system provides the information to identify areas where
process improvement is needed.

From the above discussion it should be evident that not only is ABC useful and powerful to
any organization, but a need for companies that want to excel, and efficiently and effectively
increase their Sustainable Competitive Advantage (SCA).
Alternatives
Lean accounting methods have been developed in recent years to provide relevant and
thorough accounting, control, and measurement systems without the complex and costly
methods of manually driven ABC. However lean accounting is a snapshot concept for
capturing just partial derivatives or differentials of selected cost functions. Lean accounting
takes an opposite direction from ABC by working to eliminate peculiar cost allocations rather
than apply complex methods of resource allocation.
Lean accounting is primarily used within lean manufacturing. The approach has proven
useful in many service industry areas including healthcare, construction, financial services,
governments, and other industries.
Application of Theory of constraints (TOC) is analysed in a study[11] showing interesting
aspects of productive coexistence of TOC and ABC application. Identifying cost drivers in
ABC is described as somewhat equivalent to identifying bottlenecks in TOC. However the
more thorough insight into cost composition for the inspected processes justifies the study
result: ABC may deliver a better structured analysis in respect to complex processes, and this
is no surprise regarding the necessarily spent effort for detailed ABC reporting.
For a complete listing of alternatives, please refer to:

Advantages
The major advantage of activity based costing is the ability to estimate the cost of individual
products and services precisely. By transferring overhead costs to individual units of products
or services, ABC helps identify inefficient or non-profitable products or activities that eat into
the profitability of efficient processes or highly profitable products.
The advantages of ABC extend to:
1. Making possible equitable and scientific pricing by reducing prices of products that
use less activity resources and increase prices of products that consume more of the
firms activity resources
2. Helping organizations provide value added services or top-ups to existing products
on actual cost incurred basis.
3. Eliminating unprofitable items from the product line, thereby increasing profitability
without increasing prices, a valuable option in recessionary times

4. Eliminating the cost of maintaining or running non-remunerative activities, increasing

overall profitability
5. Allowing allocation of resources to profitable items or items that use less resources.
6. Ensuring compatibility with performance management scorecards by revealing per
person contribution to the product cost, and hence, profits.
7. Exposing waste and inefficiency that contributes to boosting productivity
8. Identifying and eliminating non-value adding activities, or activities that do not
contribute to the final value of the product or process. Examples of non-value adding
activities include needless inspections and duplicate processes.
Providing quantifiable figures for planning and estimates
ABC mirrors the functioning of an organization and contributes to strategic decision-making
processes. It identifies the relation of the product within the business activity and the
resources it requires.
ABC identifies activities that consume too much of the organization's time or resources, or
that contribute little to profitability. This helps in deciding on whether to outsource such
processes or whether to implement processes improvement methodologies.
ABC highlights non-remunerative distribution channels allowing the management to adopt
alternative marketing strategies or close down the channel for a more profitable one.
ABC exposes wastes in the process and integrates well with overall quality management
initiatives such as Six Sigma, Total Quality Management, and Kaizen.

Disadvantages and Limitations

The major disadvantage of activity based costing is that although activity based costing is a
scientific approach, the method of implementation is complex, time consuming, and costly.
The process of data collection and data entry requires substantial resources, and remains
costly to maintain.
ABC reports do not conform to generally accepted accounting principles (GAAP), and as
such, firms following ABC need to maintain two cost systems and accounting books, one for
internal use and another for external reports, filings, and statutory compliance. This is a
cumbersome duplication of efforts.
A primary disadvantage of ABC is that it is not possible to divide some overhead costs such
as the chief executive's salary on a per-product usage basis. Similarly, employees rarely
devote 100% of their working hours to productive activities, and not all productive activities
add value to the product or process of the firm. For instance, the ABC method fails to account
10

for the time employee takes part in a first aid awareness campaign, leading to substantial
cost leaks. There is no meaningful way to assign such 'business sustaining' costs to products
on a proportionate basis, and products and services share such costs equally.
Finally, too much attention to detail and control might obscure the bigger picture or make the
firm lose sight of strategic objectives in a quest for small savings, making the firm penny
wise and pound foolish. For instance, ABC might identify one distribution channel as nonremunerative, or an inspection as non-value adding. Such channeling or processes might be
non-profitable, but placed in the first place to achieve some other strategic objectives.

Steps to implement Activity-Based costing

1. Identify and assess ABC needs - Determine viability of ABC method within an
organization.

2. Training requirements - Basic training for all employees and workshop sessions for
senior managers.

3. Define the project scope - Evaluate mission and objectives for the project.

4. Identify activities and drivers - Determine what drives what activity.

5. Create a cost and operational flow diagram How resources and activities are related
to products and services.

6. Collect data Collecting data where the diagram shows operational relationship.

7. Build a software model, validate and reconcile.

8. Interpret results and prepare management reports.

9. Integrate data collection and reporting

11

Integrating EVA and PBC

Recently, Mocciaro Li Destri, Picone & Min (2012) proposed a performance and cost
measurement system that integrates the EVA criteria with Process Based Costing (PBC).
Authors note that activity-based costing system is introspective and focuses on a level of
analysis which is too low. On the other hand, they undescore the importance to consider the
cost of capital in order to bring strategy back into performance measures.
Limitations
Applicability of ABC is bound to cost of required data capture. That drives the prevalence to
slow processes in services and administrations, where staff time consumed per task defines a
dominant portion of cost. Hence the reported application for production tasks do not appear
as a favorized scenario.
Tracing Costs
Even in ABC, some overhead costs are difficult to assign to products and customers, such as
the chief executive's salary. These costs are termed 'business sustaining' and are not assigned
to products and customers because there is no meaningful method. This lump of unallocated
overhead costs must nevertheless be met by contributions from each of the products, but it is
not as large as the overhead costs before ABC is employed.
Although some may argue that costs untraceable to activities should be "arbitrarily allocated"
to products, it is important to realize that the only purpose of ABC is to provide information
to management. Therefore, there is no reason to assign any cost in an arbitrary manner.
Transition to automated ABC accounting
The prerequisite for lesser cost in performing ABC is automating the data capture with an
accounting extension that leads to the desired ABC model. Known approaches for event
based accounting simply show the method for automation. Any transition of a current process
from one stage to the next may be detected as a relevant event. Paired events easily form the
respective activity.
The state of the art approach with authentication and authorization
in IETF standard RADIUS gives an easy solution for accounting all work position based
activities. That simply defines the extension of the Authentication and Authorization (AA)
concept to a more advanced AA and Accounting (AAA) concept. Respective approaches for
AAA get defined and staffed in the context of mobile services, when using smart phones as
e.a. intelligent agents or smart agents for automated capture of accounting data.
Public sector usage of ABC
When ABC is reportedly used in the public administration sector, the reported studies do not
provide evidence about the success of methodology beyond justification of budgeting practise
and existing service management and strategies.
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Usage in the US Marine Corps started in 1999. Its use by the UK Police has been mandated
since the 2003-04 UK tax year as part of England and Wales National Policing Plan,
specifically the Policing Performance Assessment Framework.
Activity
Activity-Based Costing
The concepts of ABC were developed in the manufacturing sector of the United States during
the 1970s and 1980s.It is a practice in which activities are identified and all related costs of
performing them are calculated, providing actual costs chargeable. The focus of activity
based costing is activities. Thus identifying activities is a logical first step in designing an
activity based costing. An activity is an event, task or unit of work with a specified purpose.
For example; designing products, setting up machines, operating machines and distributing
products

13

Activity based costing - a tool for decision making

By : Dr. P. Chellasamy, Ligy V. K. (Sr. Elaiza Chf)

The CIMA technology defines ABC as a cost attribution to cost units on the basis of benefit
received from indirect activities. Peter B. B. Turney defines ABC as "a method of
measuring the cost and performance of activities and cost objects. Assigns cost to activities
based on their use of resources and assigns cost to cost objects based on their use of
activities. ABC recognizes the causal relationship of cost drivers to activities." ABC can be
defined by the following equation:
C/A = HD + M + E + S
Where C/A = Estimated cost per activity
H = Number of labor hours required to perform the activity one time
D = Wages per labor hour
M = Material costs required to perform the activity one time
E = Equipment costs to perform the activity one time
S = Subcontracting costs to perform the activity one time
The total cost for performing the activity will be based on the number of times the
activity is performed during a specific time frame. An activity based costing system first
traces costs to activities and then to products and other cost objects. The following figure
diagrammatically explains the basic flow of Activity-Based Costing.
Important Terms in Activity Based Costing
The operation of the ABC system involves the use of the following terms:
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Cost object: It refers to an item for which cost measurement is required.e.g. a product, a
service, or a customer.
Cost pool: A cost pool is a term used to indicate grouping of costs incurred on a particular
activity which drives them.
Cost driver: A cost driver is any factor or force that causes a change in the cost of activity.
Cost driver may be involved two parts:
1. Resource cost driver 2. Activity cost driver
A resource cost driver is a measure of the quantity of resources consumed by an activity. An
activity cost driver is a measure of the frequency and intensity of demand, placed on
activities by cost objects. The cost drivers for various functions i.e., production, marketing,
research, and developments are given below.
Activity based costing - a tool for decision making
By : Dr. P. Chellasamy, Ligy V. K. (Sr. Elaiza Chf)
Production

Number of units
Number of set-ups

Marketing

Number of sales personnel

Number of sales orders

Research& development

Number of research projects

Personnel hours spend on projects
Technical complexities of the
projects

Customer service

Number of service calls

Number of products serviced
Hours spend on servicing products

Stages of Activity Based Costing

The different steps or stages in ABC system can be given as follows:
Identify the chosen cost objects
The cost objects of any organization are the products or services and the goal is to first
15

calculate the total cost of manufacturing and distributing these products and their unit cost.
2. Identify the different activities within the organization
After the identification of cost objects, the main activities, which are being performed in the
organization, have to be identified. Usually the number of activities over cost centers in ABC
will be much more as compared to traditional overhead system. The exact number will
depend on how the management subdivides the organizations activities.
3. Identifying the direct cost of products
The direct cost of products or objects may comprise direct material cost, direct labor cost and
direct expenses. Classification of as many of the total costs as direct costs as is economically
feasible should be made. It reduces the amount of costs classified as indirect.
4. Relating the overhead to the activities
After identifying the organizations activities, the various items of overhead are related to
activities both support and primary, that caused them. As a result of relating the items of
overhead to various activities, cost pool or cost buckets are created.
5. Spreading the support activities across the primary activities
The spreading of support activities (i.e., activities which support or assist manufacturing)
across the primary activities (correlated to the number of units produced) is done on some
suitable base which reflects the use of support activity. The base is the cost driver and is
measured of how the support activities are used.
6. Determining the activity cost drivers
The determination of the activity cost drivers is done in order to relate the overhead collected
in cost pools to the cost objects of products. It is done on the basis of the factor that drives the
consumption of the activities.
7. Calculating the activity cost driver rates
The activity cost rates for each activity are calculated in the way in which overhead
absorption rates would be calculated under the traditional system. It can be presented as
follows:
Activity cost driver rate =

Total cost of activity

Activity driver
These activity cost driver rates are to be used for ascertaining the amount of overhead
chargeable to various cost objects or products.

By : Dr. P. Chellasamy, Ligy V. K. (Sr. Elaiza Chf)

16

8. Computing the total cost of products or cost objects

The total costs of the products shall be computed by adding all direct and indirect costs
assigned to them. The amount of overhead chargeable to a product or cost object shall be
calculated by multiplying the activity cost drivers rates by different amounts of each activity
that each product or other cost object consumes.
Traditional Costing and Activity Based Costing
Traditional costing can lead to undercosting or overcosting of products or services. Over or
under costing of products distorts cost information. A poor quality of cost information causes
management to make poor decisions for pricing, product emphasis, make or buy etc. ABC
differs from the traditional system only in respect of allocations of overheads or indirect
costs. Direct costs are identified with, or assigned to, the cost object, in the same manner as is
done in case of traditional costing system. Overhead costs are linked to the cost objects based
on activities. This is shown in the following figure:

Activity Based Costing In 1980s And 1990s

The activity based costing systems, described by Robin Cooper and Robert Kaplan in the
1980's and 1990's, has attracted much attention. These systems identify the major activities of
a facilitys production process and then classify these activities into one of the following

17

categories:
unit-level activities;
batch-level activities;
product-sustaining level activities and;
facility-sustaining level activities.
In the example below, described by Robin Cooper,
the number of direct labor hours a product consumes is the cost driver for unit-level
activities;
the number of setups a product consumes is the cost driver of batch-level activities;
and the number of parts a product consumes is the cost driver of product-sustaining level
activities.
By : Dr. P. Chellasamy, Ligy V. K. (Sr. Elaiza Chf)
Consumption Patterns by product

Produc
t

Unit
level
activiti
es

Batch
level
activiti
es

Size

Volum Materi Direct Machi No. of No. of Times No. of

e
al
labor ne
setups orders Handle parts
costs hours hours
d

P1

Small Low

P2

Sma High
ll

Produc Total overhead costs

tsustain
ing
activiti
es

$60
$600

5
50

50

1
3

1
3

Amou $660
nts
consu
med

55

55

Activit $66
y

$550

$825

$480

$500

$100

$1000

18

1
1

cost(ov
er
head)
Aggregated activity cost

$1441

$1080

$1000

$3521

Overhead costs reported by an ABC system

Unit level
activities

Batch level
activities

Product-sustaining
activities

Total overhead
costs

$1441.00

$1080.00

$1000.00

$3521.00

Total cost driver 55

units

Consumption
intensity

$270.00

$500.00

Total overhead
costs

$26.20

Unit level activities

Batch level activities

Product-sustaining
activities

Produ Direc Consumpti Cost setup Consumpti Cost Part

Consumpti Cost
ct
t
on intensity traced s
on intensity traced Numbe on intensity traced
labor
rs
hours
P1

$26.20

$131.0 1
0

$270.00

$270.0 1
0

$500.00

$500.0
0

P2

50

$26.20

$131.0 3
0

$270.00

$810.0 1
0

$500.00

$500.0
0

According to Robin Cooper activity based costing systems can be used to monitor how an
organization's resources are consumed and help to manage consumption and spending in a
company. With activity based costing systems managers can attempt to perform its activities
more efficiently, reprice products or alter the company's product mix.
Activity Based Costing Methodology
The insight brought in by ABC methodology can be broadly categorized as:

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Customer Profitability
Product Profitability
Process Efficiency
Customer Profitability
Traditionally it is believed that:
High volume customers are profitable customers
Loyal customer is also a profitable one
Profits will follow a happy customer.
By : Dr. P. Chellasamy, Ligy V. K. (Sr. Elaiza Chf)
The ABC studies on customer profitability have unveiled that the above are often exceptions.
With the costing based on activities, the cost of serving a customer can be ascertained
individually. Deducting the product cost and the cost to serve each customer one can arrive at
customers profitability. This method of dealing customer cost and product cost separately has
lead to identifying the profitability of each customer and to position their products or services
accordingly.
Product Profitability
ABC costs the products based on the activities that goes into it. This facilitates arriving at the
accurate cost of the products and enhances effective strategic decisions to:
Position their products better
Facilitate better Product mix for the market
Enhance the bargaining power with the customer
Process Efficiency
ABC implementation will make the employees, across functions, to understand the various
costs involved, which will in turn enable them to
Analyze the Cost.
Identify the Value Added and Non Value Added Activities.
Implement the improvements and realize the benefit.
This is a continuous improvement process in terms of analyzing the cost, to reduce or
eliminate the Non Value Added activities and to achieve an over all efficiency.
ABC and Healthcare
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More and more, healthcare enterprises are finding that their accounting systems do not
provide useful operations management information. In their quest to reduce costs and develop
an advantaged marketplace position, healthcare providers are discovering ABC. It offers an
approach and the type of information required to realize performance breakthroughs:
It recognizes that cost and quality are the direct result of the activities providers undertake to
deliver services to their patients.
It is business-process and end-product focused, and invites cooperation, rather than
competition, between functional departments.
It is developed based on the process knowledge and insight of those directly involved in the
delivery of the service. In the case of patient care, physicians, nurses, therapists, et al,
participate and contribute to its development.
As a result, activity-based cost information is both intuitive and logical. In short, it makes
sense to those charged with the responsibility for improving performance and provides them
with transparent information on the cost ramifications of their decisions. Example
applications include:
Evaluating the cost implications of alternative clinical pathways
Streamlining care delivery practices across the care continuum
Decision-making regarding management levels and spans of control
Enhancing staff utilization by time of day
Resourcing consolidated departments/deployed functions
A report by the US-aided Quality Assurance Project on Can ABC work in developing
countries? with Peruvian Healthcare System as the case, says: Traditional cost accounting
methods pool all indirect costs and then allocate them to the various services in proportion to
service direct costs. This approach tends to overestimate the unit cost of high volume services
and underestimate low-volume services. When indirect costs are large, often the case in
healthcare, the cost of services may be misinterpreted. ABC solves this problem by
estimating the cost of the work activity that consume resources and by linking these costs to
the services that are provided. And even though the authors say that ABC may be difficult to
implement, even in the US, it is still feasible in a developing country.
Activity Based Costing: A Decision Making Tool
Prior to the emergence of ABC, companies typically calculated profitability using the
allocation method. This allocation method involves allocating costs to a product or customer
using metrics such as the total number of accounts, customers, products produced, or
transactions. Table 1 gives a hypothetical example of how this method calculates the
profitability of three customer channels: store, catalog, and internet. In this example, the
company allocates overhead costsincluding accounting, IT, marketing, and call-center coststo
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customer channels, based on the number of customers per channel.

Table 1. Simple Allocation of Call-Center Overhead

Total

Store

Catalog

Internet

Revenue

$3,500,000 $2,000,000 $1,000,000

$500,000

Number of
Customers

50,000

35,000

10,000

5,000

Cost per Customer

$10

$10

$10

$10

Call-Center Costs

$500,000

$350,000

$100,000

$50,000

Net Revenue

$3,000,000 $1,650,000 $900,000

$450,000

Margin

85.7%

90.0%

82.5%

90.0%

From the example above, management might conclude that all channels are performing
relatively well, but the big opportunity lies in growing the catalog and internet channels
through additional investments. These two channelsthough smaller in overall revenueappear
more attractive after cost allocations and could realize explosive, profitable growthgiven
management attention and aggressive investments.
Table 2 shows the more realistic outcome when an organization applies ABC and apportions
call center expenses to each customer channel, based on the number of incoming calls each
channel generates. Since catalog customers create 80% of the incoming call-center volume,
this channel should incur a greater proportion of the total cost.
Table 2. ABC Allocation of Call-Center Overhead

Total

Store

Catalog

Internet

Revenue

$3,500,000

$2,000,000

$1,000,000

$500,000

Number of Calls

100,000

80,000

20,000

Cost Per Call

Call-Center Costs

$500,000

$0

$400,000

$100,000

Net Revenue

$3,000,000

$2,000,000

$600,000

$400,000

Margin

85.7%

100%

60.0%

80%

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The insight from this analysis is far different. After allocating costs based on the consumption
of resources, management can see that the catalog channel uses far more resources and is
actually less profitable than other channels. Rather than throwing away additional investment
to grow this channel, management should take corrective action to bring this segment up to
acceptable profitability levels.
Software Packages for ABC
ABC Focus
It is tool for costing products and services and improving efficiencies. "ABC Focus is a tool
which makes ABC concepts simple to understand and use. It is a very attractive package
because its flexible costing model, consolidated reporting and a very competitive pricing
regime make it suitable for large and small business in virtually any industry." ABC Focus
provides a structured approach to cost products, services, processes, activities and unused
capacity. It provides a platform on which to confidently adjust pricing and activities for
competitive advantage.
QPR Cost Control
The user-friendly QPR Cost Control system helps to understand the real cost structure of the
company and identify how the business really works. Using the proven approach Activity
Based Costing / Management, the software identifies exactly what costs are linked to each
individual customer, product, service or activity. QPR Cost Control gives the information to
make decisions about the most profitable path for the business. QPR Cost Control is used
successfully by all types of organizations, from large international corporations to
universities, hospitals and government agencies.
Growing Interest in Activity Based Costing
Activity based costing is being implemented by a growing number of companies around the
globe. Specific ABC applications vary from organization to organization. A few organizations
use ABC as their basic, ongoing cost accounting system. But many ABC applications are
selective- special studies within subparts of the organization, such as business divisions or
particular functions.
A survey of US companies in the food and beverage industry found 18% of the respondents
implementing ABC and 58% considering it. A survey of Dutch companies in the food and
beverage industry found 12% currently using ABC and another 25% are considering it.
Among Canadian companies one survey indicates that 14% of the interviewed businesses
have implemented ABC and another 15% are considering using ABC it. The ABC system has
replaced existing system for 24% of the Canadian respondents and it is a supplementary (offline) system for 76%. A United Kingdom survey found that just under 20% of 251
respondents had used ABC. An Australian survey found that 43% of the respondents were
either using ABC or implementing it. A survey of Irish manufacturing companies that have
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implemented ABC reported the following percentages for the actual benefits experienced:

More accurate cost

information for product
costing and pricing

71%

Improved cost control and management

66%

Improved insight into cost drivers

58%

Better performance measures

46%

More accurate customer profitability analysis

25%

survey of Irish service-sector companies reports similar percentages for the benefits
experienced .Results from similar studies in developed economies around the world indicate
that ABC is not a passing fad. A majority of companies still use traditional costing methods,
but the use of ABC appears to be increasing.
Significance of Activity Based Costing
The following list reflects the results of several surveys of practice in the United States, the
United Kingdom, and Canada to determine why companies choose ABC.
Cost Reduction: - ABC measures how much activities that are costly and then take steps to
reduce their costs by changing the productions process or outsourcing those activities.
Product pricing and decisions of whether to continue producing a product or keeping a
particular customer. ABC implementers generally believe that that ABC provides more
accurate cost information than conventional costing does. Management can use this
information to negotiate price increases with customers or to drop unprofitable products.
Budgeting and performance measurement: - Management can use more accurate cost
information to improve budgets and measures of department and division performance.
Limitations of Activity Based Costing
More time consuming to collect data
Cost of buying, implementing and maintaining activity based system
In some cases, the establishment of cause and effect relationship between cost driver and
costs not be a simple affair.
ABC does not conform to generally accepted accounting principles in some areas.
By : Dr. P. Chellasamy, Ligy V. K. (Sr. Elaiza Chf)

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Activity Based Costing with Two Activities

Let's illustrate the concept of activity based costing by looking at two common manufacturing
activities: (1) the setting up of a production machine for running batches of products, and (2)
the actual production of the units of product.
We will assume that a company has annual manufacturing overhead costs of $2,000,000of
which $200,000 is directly involved in setting up the production machines. During the year
the company expects to perform 400 machine setups. Let's also assume that the batch
sizes vary considerably, but the setup efforts for each machine are similar.
The cost per setup is calculated to be $500 ($200,000 of cost per year divided by 400 setups
per year). Under activity based costing, $200,000 of the overhead will be viewed as a batchlevel cost. This means that $200,000 will first be allocated to batches of products to be
manufactured (referred to as a Stage 1 allocation), and then be assigned to the units of
product in each batch (referred to as Stage 2 allocation). For example, if Batch X consists of
5,000 units of product, the setup cost per unit is $0.10 ($500 divided by 5,000 units). If Batch
Y is 50,000 units, the cost per unit for setup will be $0.01 ($500 divided by 50,000 units). For
simplicity, let's assume that the remaining $1,800,000 of manufacturing overhead is caused
by the production activities that correlate with the company's 100,000 machine hours.
For our simple two-activity example, let's see how the rates for allocating the manufacturing
overhead would lookwith activity based costing and without activity based costing:

Next, let's see what impact these different allocation techniques and overhead rates would
have on the per unit cost of a specific unit of output. Assume that a company manufactures a
batch of 5,000 units and it produces 50 units per machine hour, here is how the cost assigned
to the units with activity based costing and without activity based costing compares:

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If a company manufactures a batch of 50,000 units and produces 50 units per machine hour,
here is how the cost assigned to the units with ABC and without ABC compares:

As the tables above illustrate, with activity based costing the cost per unit decreases from
$0.46 to $0.37 because the cost of the setup activity is spread over 50,000 units instead of
5,000 units. Without ABC, the cost per unit is $0.40 regardless of the number of units in each
batch. If companies base their selling prices on costs, a company not using an ABC approach
might lose the large batch work to a competitor who bids a lower price based on the
lower, more accurate overhead cost of $0.37. It's also possible that a company not using ABC
may find itself being the low bidder for manufacturing small batches of product, since its
$0.40 is lower than the ABC model of $0.46 for a batch size of 5,000 units. With its bid price
based on manufacturing overhead of $0.40but a true cost of $0.46the company may end
up doing lots of production for little or no profit.
Our example with just two activities (production and setup) illustrates how the cost per unit
using the activity based costing method is more accurate in reflecting the actual efforts
associated with production. As companies began measuring the costs of activities (instead of
focusing on the accountant's departmental classifications), they began using ABC cost

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information to practice activity based management. For example, with the cost of setting up a
machine now being measured and discussed, managers began to ask questions such as:

Activity Based Costing with Four Activities

Let's add two more activities to our example: procurement and material handling. The costs
of these two activities are not caused bynor do they correlate withmachine hours. Rather,
we will assume that both of these activities are related to the physical weight of the direct
material used in making the product.
The company determines that $300,000 of its annual manufacturing overhead is associated
with procurement and material handling. As a result, the company removes $300,000 from
the manufacturing overhead that will be allocated via machine hours, and instead plans to
allocate the $300,000 to the products based on the weight of the materials used. The company
expects that during the year it will procure and handle 3,000,000 pounds of material. Under
activity based costing, the company will assign $0.10 ($300,000 divided by 3,000,000
pounds) per pound of product weight to each unit manufactured. The end result is that the
heavier parts will not only have more direct material cost, they will also be assigned more
factory overhead than the lighter parts. By assigning some manufacturing overhead to a
product based on the product's weight, the remaining manufacturing overhead assigned via
machine hours will be reduced. These points are illustrated in the following table:

In the table below we can see how ABC would assign costs to the following:

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A product that weighs 0.5 pound and is produced in a batch of 50,000 units at a rate of 50 per
hour
A product that weighs 1.5 pounds and is produced in a batch of 50,000 units at a rate of 50
per hour
No activity based costing allocationsall manufacturing overhead costs are allocated entirely
via machine hours.

If the manufacturing overhead costs are caused by a number of activities such as setup,
procurement, handling, and production, then using the activity based costing method of
determining costs will give you a result that is closer to the true costs. As you can see, the
product that weighs 0.5 pound is assigned $0.36 of manufacturing overhead, while the
product weighing 1.5 pounds is assigned $0.46 of manufacturing overhead. Under the
traditional costing allocations the procurement and handling costs would be assigned on
production hours. Keep in mind that whenever manufacturers have a diverse lineup of
products, allocating costs on a single basis (such as machine hours) will result in inaccurate
per-unit manufacturing overhead costs.
Additional Information and Resources
Because the material covered here is considered an introduction to this topic, many
complexities have been omitted. You should always consult with an accounting professional
for assistance with your own specific circumstances.

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REFERENCE
www.google.com
http://en.wikipedia.org/wiki/Activity-based_costing
http://www.accountingcoach.com/activity-based-costing/explanation
https://www.scribd.com/search-documents?query=abc+costing

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