Chapter Three PDF

Activity Based Costing
1. Problems of Traditional Costing
Traditional costing allocates overheads only

on volume basis like labour / machine hour.
This results in under or over costing as

resources consumed by a service or a product
and costs allocated to it do not match.
The assumption that higher the volume,

greater the share of indirect costs to that
product or service line is too simplistic to
be true.
1. Problems of Traditional Costing
In a multi product or multi-service

firm, different products consume
different activities, hence resources
used do not bear proportionate
relation to the volumes.
Activity based costing focuses on

activities as the fundamental cost
objects.
2. Activity Based Costing (ABC)
Cost of Activities Cost allocated to

Activities Cost Pools
Cost Drivers Product/Service
An activity is a process that causes

work. Activities drive costs.
Cost drivers are allocation basis for the

activity. [ Purchase order is a driver in
a Purchasing Dept.]
some more cost drivers:-
activity driver
Machine set up number of production runs

Inspection inspection per item
Receiving / Packing number of orders
Stores number of deliveries
Warehousing items in stock
Material Handling number of parts
Determination of direct cost is common

for traditional & ABC costing.
In ABC overheads are allocated based

on appropriated cost drivers unlike in
traditional costing, where they are
allocated on volumes( labour / machine
hours) using indiscriminate averages.
3. Transaction-based cost drivers

Transactions undertaken by the support
departments consume resources of the
firm. e.g.
☻ Goods received orders drive the cost
of the receiving dept.
☻ Dispatch orders drive cost of dispatch
department.
☻ Production runs undertaken drive the
costs of scheduling, inspection or
setup costs.
3. Transaction-based cost drivers
In ABC, a cost pool is established for

each cost driver.
The costs of this pool are divided by
number of transactions or activities
that generated these costs to arrive
at a charging out rate
ABC system thus uses rates, that
understand cost behaviour, for
allocating costs to products.
4. Cost analysis under ABC
Company’s resources represented by so

called fixed costs, increase not
because of increase in volume of a
single product but because of
☻ diversity of company products

☻ new customers
☻ distribution channels
☻ product lines.
ABC attempts to show that a

major part of these (so called
fixed costs) are based on
activities & are in reality
variable (and, therefore,
controllable).
There are three major kinds of

activities in the organizations :
☻ Unit level activities.

☻ Batch level activities.
☻ Product sustaining activities.
These activities drive following

types of costs or expenses
☻ Costs at Unit level

☻ Costs at Batch or production run
level
☻ Product sustaining costs.
These are depicted in the next diagram.

Product Line
Materials
Machine Hours
Unit Level
Cost varying Activities Energy
with Units Labour Hours
Set Ups
Cost Varying with Batch Level Inspection
Number of Batches Activities Purchase Orders
Materials Movements
Product Specification
Cost Varying with Product Product enhancement
Product Line Sustaining Process Engineering
Activities Customer Satisfaction
This diagram shows that by deducting all

cost at unit level from the revenues the
firm arrive at contribution margin for
individual products.
From this margin reduce batch level costs
& product sustenance costs and firm gets
product level margins.
Superiority of ABC lies in providing
batch level, product sustaining, product
lines and customer level costs not
available in traditional costing.
5. Full costs as product costs under ABC
Classification of costs
based on activities allows
assignment of costs to
individual products without
trouble and arbitrariness.
So common in traditional costing.
5. Full costs as product costs under ABC

The steps involved to determine cost are :
• Identify activities.
• Identify cost of each activity.
• Identify primary cost driver of each
activity
• And treat it as a cost pool.
• Calculate allocation rate per
transaction.
• Allocate costs to products by multiplying
the above rate by cost drivers for the
product / service.
6. Benefits and weakness of ABC

Benefits:
ABC is more expensive than the traditional
costing system. Hence benefits need to be
properly weighed.
1. Total company costs for each activity can

be obtained, analyzed, planned &
controlled.
2. More accurate costs are available as
costs are identified with activities &
then applied to products based on cost
drivers.

Benefits: contd.
3. Managers manage activities well with
knowledge of costs resulting into
competitive products.
4. ABC focuses on cause and effect
relationship of activities allowing
managers to manage them effectively.
5. ABC highlights process technology,
product design, product mix, operational
movements that are break even or
unprofitable. This is of great help in
management decisions and action.

Weaknesses :
1. ABC fails to encourage managers to think

about changing work processes to make
business competitive.
2. ABC does not confirm to GAAP. Hence it is
more used for internal analysis.
3. Using ABC for short term decisions can
harm long term interests.
4. ABC does not help in removing constraints
that cause delays or excesses.
7. Factors influencing application of ABC
1. High incidence of overhead cost caused by

automation, complexity of production
calls for correct allocation of overheads
to products.
2. Product complexity or diversity is
recognized in allocating costs under ABC.
3. Volume diversity say caused by
production of two similar products in
different batch sizes.
8. ABC as resources usage model
1. The periodic financial statements provide

information on the cost of activities
supplied in each period.
2. ABC provides information on quantity &
cost of activities actually used.
3. The difference provides critical data on
cost of resources not used.
4. This data can also be used by Managers to
modify their use of resources in the
short run to provide immediate results.
9. Installation of ABC
Factors justifying the implementation.
1. The firms are facing greater competition.

It is more necessary to get rid of
arbitrary allocation of overheads to
arrive at realistic costs for competitive
pricing & eliminate inefficiency.
2. Overheads are assuming relatively high
proportion.
3. Products becoming more complex.
4. And volumes getting more diverse.
Steps in the implementation.
1. Primary Steps :
♠ Feasibility Study.
♠ Create IT infra-structure.
♠ Convincing line employees.
♠ Value-chain analysis.
2. Operational Steps :
♠ Identification of activities, costs,
cost drivers.
♠ Computation of absorption rates.
♠ Cost allocation based on transactions.
1. Primary Steps : Feasibility Study.
♠ Determine a] cost of development of the
system & b] cost of running it.
♠ Compare with benefits accruing from a] more
accurate cost information for product
pricing, b] more accurate profit analysis by
product, customer, process or department, c]
improved performance measures and d] improved
insight into what causes the cost.
Expected benefits should outweigh the costs.
1. Primary Steps : ♠ Create IT infra-
structure.
Large amount of information is to be

generated regarding cost pools, cost
drivers, transactions etc. for effective
implementation & operation of ABC.
This calls for suitable IT infra-

structure to support ABC.
1. Primary Steps : ♠ Convincing line
Employees.
To overcome resistance from line
employees & to gain their cooperation, it
is necessary that the concept of ABC is
sold to them.
the techniques to be used include group
discussions, training programs, case
study, live demonstration etc.
Employees must be assured that ABC
retains their job security.
1. Primary Steps : ♠ Value-chain analysis.
The ABC system should provide information

and analytical support and impetus for
development of new and revised strategy.
The purpose of this value chain analysis
is to determine where managers can lower
costs from design to distribution in the
company’s segment of the chain.

2. Operational Steps : ♠ Inventorization and
screening of activities.
Activities are cost objects under ABC.

Resources are employed or costs incurred
to carry out these activities.
Hence success of ABC depends on their

proper inventorization to ensure no
activity is missed

2. Operational Steps : ♠ Inventorization and
screening of activities.
Screening of these activities is

required to confirm is the
activity necessary? and is it
possible to club activities?

2. Operational Steps : ♠ Identification of
costs & cost drivers.
Is achieved through three approaches –

a] personal observation and measurement
by each manager for activities under his
control, b] analysis of cost and
operation records and c] feedback about
the experience from other firms.

2. Operational Steps : ♠ Identification of
costs & cost drivers.
The objective of this exercise is to have
☻ indirect cost pools
☻ indirect cost allocation bases.
Indirect cost pools comprise costs that have
similar cause effect relationship.
Cost allocation base is a factor that drives
or determines cost.

2. Operational Steps : ♠ Computation of
absorption rates
The objective of this exercise is to arrive
at rates for allocation of costs to
products.
The rate is calculated by dividing the cost
in the cost pool by number of transactions
that cause the pool.

2. Operational Steps : ♠ Allocation of over
head based on transactions.
The objective of this exercise is to apply

the absorption rate arrived earlier to the
cost drivers / transactions of the product
or service.
All operational steps are once again shown

in the next diagram.

2. Operational Steps :
Cost of Activities Cost allocated to

Activities Cost Pools
Cost Drivers Product/Service
All operational steps are once again shown in

the above diagram.
Next Chapter “ Budgetary Control”
Bye !!!

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Activity Based Costing

1. Problems of Traditional Costing

Traditional costing allocates overheads only

This results in under or over costing as

The assumption that higher the volume,

1. Problems of Traditional Costing

In a multi product or multi-service

Activity based costing focuses on

2. Activity Based Costing (ABC)

Cost of Activities Cost allocated to

An activity is a process that causes

Cost drivers are allocation basis for the

2. Activity Based Costing (ABC)

some more cost drivers:-

Machine set up number of production runs

2. Activity Based Costing (ABC)

Determination of direct cost is common

In ABC overheads are allocated based

3. Transaction-based cost drivers

3. Transaction-based cost drivers

In ABC, a cost pool is established for

4. Cost analysis under ABC

Company’s resources represented by so

☻ diversity of company products

4. Cost analysis under ABC

ABC attempts to show that a

4. Cost analysis under ABC

There are three major kinds of

☻ Unit level activities.

4. Cost analysis under ABC

These activities drive following

☻ Costs at Unit level

These are depicted in the next diagram.

4. Cost analysis under ABC

This diagram shows that by deducting all

5. Full costs as product costs under ABC

5. Full costs as product costs under ABC

6. Benefits and weakness of ABC

1. Total company costs for each activity can

6. Benefits and weakness of ABC

6. Benefits and weakness of ABC

1. ABC fails to encourage managers to think

7. Factors influencing application of ABC

1. High incidence of overhead cost caused by

8. ABC as resources usage model

1. The periodic financial statements provide

1. The firms are facing greater competition.

Large amount of information is to be

This calls for suitable IT infra-

The ABC system should provide information

Steps in the implementation.

Activities are cost objects under ABC.

Hence success of ABC depends on their

Steps in the implementation.

Screening of these activities is

Steps in the implementation.

Is achieved through three approaches –

Steps in the implementation.

Steps in the implementation.