Activity Based Costing

ACTIVITY BASED ACTIVITY BASED COSTINGCOSTING

Activity based costing is a new and scientific approach developed by Cooper and Kalpan(1988) for assigning overhead to end product , jobs and processes. It aims to rectify the problem of inaccurate cost information due to selection of wrong bases of indirect cost apportionment. In the words of Cooper and Kalpan, “ABC systems calculate the cost of individual activities and assign costs to cost objects such as product and services on the basis of activities undertaken to produce each product or service.” In this system, overheads are assigned to activities are grouped in to cost pools before they are charged to cost objects i.e. jobs or products. According to C.I.M.A., London, activity based costing is cost attribution to cost units on the basis of benefits received from indirect activities, i.e. ordering, setting up, assuring quality etc. It is a modern tool of charging overhead cost in which cost are first traced to activities and then products or jobs.

The direct costs which mainly include material and labour , are chargeable to the end products without difficulty and are thus convenient the handle it is the indirectly costs also known as overhead ,which create problems for the cost accountant in determining the accurate product costs, the importance of indirect costs in the manufacturing operations is increasing and direct cost of an end product .Activity based costing is an upcoming more accurate product costs.

Basics of ABC; Cost of a product is the sum of the costs of all

Activities required to manufacture and deliver the product .

Product do not consume cost directly. Money is spent on activities. Activities are consumed by product . ABC assigns costs to products by tracing

expenses to activities . Each product is charged based on the which it used an activity .

TRADITIONAL APPROACHTRADITIONAL APPROACH

• Traditionally, indirect costs are distributed to end products Traditionally, indirect costs are distributed to end products on the assumption that products consume resources in on the assumption that products consume resources in proportion to the production volumes.proportion to the production volumes.

• Distribution of overhead cost by traditional approach .The Distribution of overhead cost by traditional approach .The main steps in this approach are :main steps in this approach are :

ABC APPROACHABC APPROACH• In the ABC approach companies identifiy the In the ABC approach companies identifiy the

major acitivities that couse overhead couse to be major acitivities that couse overhead couse to be incurred . the cost of the resources consumed incurred . the cost of the resources consumed performed these activities are grouped in to cost performed these activities are grouped in to cost pools . finally the cost are assigned to products pools . finally the cost are assigned to products using a measure of activity referred to as a cost using a measure of activity referred to as a cost driver . the steps involved in the ABC approach driver . the steps involved in the ABC approach then are then are

• step1: step1: identify major activities identify major activities

• step2: step2: Creation of Creation of cost pools cost pools

• step 3: step 3: identify measures of activities - the cost drivers identify measures of activities - the cost drivers

• step4: step4: calculating of the activity cost driver rate calculating of the activity cost driver rate Step5: charging the cost of activities to productsStep5: charging the cost of activities to products

TERMS USED IN ABCTERMS USED IN ABC• IN order to understand ABC, one should be familiar with the IN order to understand ABC, one should be familiar with the

meaning of the following terms . meaning of the following terms .

• ACTIVITYACTIVITY• AN activity may be defined as a particular task or unit of work with a AN activity may be defined as a particular task or unit of work with a

specific per purpose EX : Placing purchase order setting up of a specific per purpose EX : Placing purchase order setting up of a machine, after sales service, etc.machine, after sales service, etc.

• COST OBJECTCOST OBJECT• it is an item for which cost measurement is required . Ex ; a it is an item for which cost measurement is required . Ex ; a

product, a service a job or a customer etc.product, a service a job or a customer etc.

• COST DRIVERCOST DRIVER : It is a factor that causes a change in the : It is a factor that causes a change in the cost activity .cost activity .

• RESOURCE COST DRIVERRESOURCE COST DRIVER• It is a measure of the quantity of resource consumed by an It is a measure of the quantity of resource consumed by an

activity .Similarly, the number of times machines are setup will activity .Similarly, the number of times machines are setup will determine the cost of setting up of machinesdetermine the cost of setting up of machines

• ACTIVITY COST DRIVERACTIVITY COST DRIVER; It is a measure of frequency ; It is a measure of frequency and intensity of demand placed on the activity by cost objects .and intensity of demand placed on the activity by cost objects .

• Examples of cost drivers for various business function are as followsExamples of cost drivers for various business function are as follows

COST DRIVES FOR VARIOUS BUSINEES COST DRIVES FOR VARIOUS BUSINEES

FUNCTIONSFUNCTIONS

STEPS IN ACTIVITY BASED COSTINGSTEPS IN ACTIVITY BASED COSTING

• Steps in Activity Based Costing:Steps in Activity Based Costing:• The following are the steps in activity based cost allocation The following are the steps in activity based cost allocation • 1.Identification of main activities:1.Identification of main activities:

First of all, major activities in the organization are identified. The First of all, major activities in the organization are identified. The number of activities in an organization should neither be too large or number of activities in an organization should neither be too large or too small. Too large a number will be costly and will add to the too small. Too large a number will be costly and will add to the complexity of the system while a too smaller number of activities will complexity of the system while a too smaller number of activities will compromise with the accuracy of the cost. Total cost involved in the compromise with the accuracy of the cost. Total cost involved in the activity should be significant enough to justify to give an activity activity should be significant enough to justify to give an activity separate treatment.separate treatment.

• 2.Creation of cost pool:2.Creation of cost pool: Cost pool is grouping of individual cost items. A cost pool or cost Cost pool is grouping of individual cost items. A cost pool or cost bucket should be created for each activity. Cost pool is like a cost bucket should be created for each activity. Cost pool is like a cost centre around which costs are accumulated. For example, the total centre around which costs are accumulated. For example, the total cost of machines setup might constitute one cost pool for all setup cost of machines setup might constitute one cost pool for all setup related cost.related cost.

STEPES IN ABCSTEPES IN ABC• 4. 4. Calculation of activityCalculation of activity

cost driver rate: Just cost driver rate: Just as an overhead absorption rate is calculated as an overhead absorption rate is calculated in traditional costing system, in ABC a cost in traditional costing system, in ABC a cost driver rate is calculated as follows.driver rate is calculated as follows.

• Activity cost driver rate = Activity cost driver rate = Total cost of activityTotal cost of activity Cost driversCost drivers• 5. 5. Charging the cost of activities to Charging the cost of activities to

productsproducts The cost of activities The cost of activities are traced to products on the basis of are traced to products on the basis of demand by products. The cost drivers are demand by products. The cost drivers are used to measure product demand of activityused to measure product demand of activity

Charging the cost of Charging the cost of activities to products in this activities to products in this

wayway

Cost HierarchiesCost Hierarchies . ABC system commonly use a cost . ABC system commonly use a cost

hierarchy having four levelshierarchy having four levels

Output unit level costOutput unit level cost

Batch level costsBatch level costs

Product sustaining costProduct sustaining cost

Facility sustainingFacility sustaining

Out put unit level & Batch Out put unit level & Batch levellevel

• Output unit levelOutput unit level

costs are the activities performed on each costs are the activities performed on each individual unit of product or service. individual unit of product or service. Manufacturing operations cost related to the Manufacturing operations cost related to the activity of running the automated molding activity of running the automated molding machines are output unit level costs. They are machines are output unit level costs. They are output unit level cost because, overtime the cost output unit level cost because, overtime the cost of these activity increases with additional units of of these activity increases with additional units of output producedoutput produced..

• Batch levelBatch level

costs are the costs of activities related to a costs are the costs of activities related to a group of units of products or services rather than group of units of products or services rather than to each individual unit of product or service. In to each individual unit of product or service. In the plastim example, setup cost are batch level the plastim example, setup cost are batch level cost. They are batch level cost because, over cost. They are batch level cost because, over time , the cost of this setup activity increases time , the cost of this setup activity increases with setup hours needed to produce batches of with setup hours needed to produce batches of lenses lenses

Product level & Faciltiy Product level & Faciltiy levellevel

• Product sustaining cost are the cost of activities undertaken to Product sustaining cost are the cost of activities undertaken to support individual products or services regardless of the number of support individual products or services regardless of the number of units or batches in which the units are produced. In the plastim units or batches in which the units are produced. In the plastim example, design cost or product sustaining cost. Plastim’s ABC Basics example, design cost or product sustaining cost. Plastim’s ABC Basics of ABC Cost of a product is the sum of the costs of all activities of ABC Cost of a product is the sum of the costs of all activities required to manufacture and deliver the product . product do not required to manufacture and deliver the product . product do not consume cost directly. Money is spent on activities. Activities are consume cost directly. Money is spent on activities. Activities are consumed by product . ABC assigns costs to products by tracing consumed by product . ABC assigns costs to products by tracing expenses to activities . Each product is charged based on the which expenses to activities . Each product is charged based on the which it used an activity system uses parts square feet a product sustaining it used an activity system uses parts square feet a product sustaining cost allocation base to allocate design cost to products. Another cost allocation base to allocate design cost to products. Another example of product sustaining cost is engineering costs incurred to example of product sustaining cost is engineering costs incurred to change product designs, although such changes are infrequent at change product designs, although such changes are infrequent at plastim. plastim.

• Facility sustaining costs are the cost of activities that cannot be Facility sustaining costs are the cost of activities that cannot be traced to individual products or services but support the organization traced to individual products or services but support the organization as a whole. In the plastim example, the general administration cost as a whole. In the plastim example, the general administration cost are facility sustaining costs. It is usually difficult to find good cause are facility sustaining costs. It is usually difficult to find good cause and effect relationship between these cost and cost allocation bases. and effect relationship between these cost and cost allocation bases. This lack of cause and effect relationship causes some companies not This lack of cause and effect relationship causes some companies not to allocate these costs to products and instead to deduct them from to allocate these costs to products and instead to deduct them from operating income.operating income.

Activity Based costing Activity Based costing systemssystems

• One of the best tools for refining a costing system is One of the best tools for refining a costing system is activity based costing. Activity Based costing refines a costing activity based costing. Activity Based costing refines a costing system by focusing on individual activities as the fundamental system by focusing on individual activities as the fundamental cost objects. An activity is an event, task, or unit of work with cost objects. An activity is an event, task, or unit of work with a specified purpose; for example, designing products, setting a specified purpose; for example, designing products, setting up machines, operating machines, and distributing products. up machines, operating machines, and distributing products. ABC systems calculate the costs of individual activities and ABC systems calculate the costs of individual activities and assign costs to cost objects such as products and services on assign costs to cost objects such as products and services on the basis of the activities needed to produce each product or the basis of the activities needed to produce each product or service.service.

Fundamental cost objects assignment to other Fundamental cost objects assignment to other

cost objectscost objects Activities cost of activities cost of Activities cost of activities cost of .products.products .service.service .customer .customer

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• Accurate and reliableAccurate and reliable:: ABC is more accurate and reliable determination of ABC is more accurate and reliable determination of products cost as it is based on cause and effect relationship is cost products cost as it is based on cause and effect relationship is cost incurrenceincurrence..

• Better pricing decisionsBetter pricing decisions: : It helps in overcoming the problem of over costing and It helps in overcoming the problem of over costing and under costing as a result of which management is able to make more under costing as a result of which management is able to make more judicious pricing decisions.judicious pricing decisions.

• Realistic:Realistic: The analyses of overhead cost with reference to activities is The analyses of overhead cost with reference to activities is considered to the more realistic because distribution of overhead based on considered to the more realistic because distribution of overhead based on activities is an objective approach activities is an objective approach

• Control of costControl of cost : ABC produces more meaningful information regarding cost : ABC produces more meaningful information regarding cost behaviour and enables management to control many fixed overheads behaviour and enables management to control many fixed overheads exercising more control over those activity which cause these fixed overhead.exercising more control over those activity which cause these fixed overhead.

• Greater cost efficiencyGreater cost efficiency : ABC helps to identify unnecessary activities so that these : ABC helps to identify unnecessary activities so that these may be weeded out and thus achieving greater cost efficiency. may be weeded out and thus achieving greater cost efficiency.

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Advantages of activity based Advantages of activity based costingcosting

Problems and SolutionsProblems and Solutions

Statement of Cost & ABC Statement of Cost & ABC MethodMethod

Calculation of Customer Level Activity Calculation of Customer Level Activity CostCost

Customer Level Activity Cost & Operating Customer Level Activity Cost & Operating IncomeIncome

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