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Management Accounting

Activity Based Costing
Kronecker Company, a growing mail order clothing and
accessory company, is concerned about its growing
marketing, distribution, selling and administration expenses. It
therefore examined its customer ordering patterns for the past
year and identified four different types of customers, as
illustrated in the following table. Kronecker sends catalogs
and flyers to all its customers several times a year. Orders are
taken by mail or over the phone by the toll free number.
Kronecker prides it self on the personal attention it provides
shoppers who order over the phone. All purchases are paid for
by check or credit card. It also maintains a very generous
return policy if customers are not satisfied with the product.
Customers must pay return shipping charges, but their
purchase price is then fully refunded.
Customer 1 Customer 2 Customer 3 Customer 4
Initial Sales Rs. 1000 Rs. 1000 Rs. 2,500 Rs. 3,000
Number of items returned 0 4 2 24
Dollar value of items returned 0 Rs. 200 Rs. 500 Rs. 1,500
Number of orders per year 1 6 4 12
Number of phone orders per year 1 0 0 12
Time spent on phone placing
orders
0.25 hour 0 0 1 hour
Number of overnight delivery 1 0 0 12
Number of regular delivery 0 6 4 0
Prices are set so that cost of goods sold is on
average about 75% of the sales price.
Customers pay actual shipping charges, but
extra processing is required for overnight
delivery. The company has developed the
following activity cost driver rates for its
support costs.

What advice will you give to the company.
Activity Activity Cost Driver
Rate (Rs.)
Process mail orders 5
Process phone orders 80
Process returns 5
Process over night delivery request 4
Maintain customer relations 50
200 500 1,500
Net sales
$1,000 $800 $2,000 $1,500
Cost of goods sold, 75%
of sales
750 600 1,500 1,125
Processing mail orders,
$5 per nonphone order
0 30 20 0
Process phone orders,
$80 per hour
20 0 0 80
Process returns,
$5 per item returned
0 20 10 120
Process overnight
delivery requests,
$4 per request
Maintain customer
relations
Customer 1 Customer 2 Customer 3 Customer-4
Sales
$1,000 $1,000 $2,500 $3,000
Less returns
0
Customer 4
is the most
expensive
Customer 1 is
fairly low-cost
to serve
Profit
$176 $100 $420 $77
Profit  Sales 0.18 0.10 0.17 0.03
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4 0 0 48
50 50 50 50
Class Assignment Contributions-Section A
G Findings Comments Suggestions
2 Loss for customer 4
Is -1944.
Company incurs a loss when transacting with
Customer 2 and Customer 4.
The cost of goods has been set to 75 percent to that of the sales. This is not
appropriate from a managerial point of view as it gives poor estimates
when calculating returns from a particular customer.
3 Profits for customer 3
Is 69.33. Profit to
sales ratio is 25%.
In absolute monetary terms, customer 4 is the most
profitable.
Customer Relations should be higher for customers placing fewer orders
and returning more number of units as compared to other customers.
4 Profitability
(Profit/Net Sales) for
customer 4 is 0.03%
And Customer 3 is
0.17%. C-1 is 18%
Although customer type 4 has the highest sales, it has
the highest monetary returns and the lowest profit.
Customer type 3 is by far the most profitable
To reduce the service activity usage or improve efficiency to reduce the
cost of providing services. The reason for returns, and follow up with
ways to reduce problems that caused the returns. To make phone ordering
more efficient, to reduce the time spent on the phone. Kronecker may also
charge fees to handle overnight delivery requests.
5 Customer type 1 is fairly low-cost to serve in spite of
ordering by phone and requesting overnight delivery
because this customer type orders only once a year.
The Company must spend resources and labour to advertise the advantages
of placing orders by mail instead of phones.
The company should introduce some cap on returning of the placed orders.
This will reduce the cost in process returns.
6 Profitability
(Profit/Net Sales) for
customer 4 is 0.05%
And Customer 3 is
0.21%.
Customer 3 is by far the most profitable in terms of
Gross Profit margin %, even though its sales are less
than customer 4’s. Customer 1 and 2 are more
profitable than customer type 4 in terms of profit
margin to sales %.
The company might also explore ways to make phone ordering more
efficient, to reduce the time spent on the phone.
Kronecker may also charge higher fees (than Rs. 4) to handle overnight
delivery requests.
7 Customer 2 most of the order are placed over mail but
since they have 20% of the sale items returned inwards
the net sale decrease.
Customer 3 and Customer 1 both of them has almost
similar profit to sales ratio i.e (17-18%) but the
differnce between the two is the sales ratio among
them themselves which is 1:2.5(Customer 1 to
Customer 3.
We would suggest company to increase business activities as like
Customer 3 where profit-sales margin is good for all the customer and
since the sales are larger they will retain larger profit.

9 Customer 3 has the highest profitability while the
customer 4 has the lowest.
Customer 4 places orders in a costlier manner as it
spends 1 hour on phone and it has the requests of more
overnight deliveries.
Company can impose charge for the overnight delivery requests.
Company can change their way to increase efficiency for phone orders.
Company can reduce the servicing cost for the customers.
11 Profitability
(Profit/Net Sales) for
customer 4 is 0.05%
And Customer 3 is
0.21%.
Profitability ratio is highest for the customer 3 while it
is lowest for the customer 4.
Customer 2 and 3 are easy to serve since they do not
use phone to order
 Company can reduce the servicing cost for the customers.
 Company can ask the customer for the return of goods.
 Company can change their way to increase efficiency for phone orders.
Group-5
KRONECKER COMPANY
Customer 1 Customer 2 Customer 3 Customer 4
Sales 1000 1000 2500 3000
Return Inwards 200 500 1500
Net Sales 1000 800 2000 1500
Cost of Goods Sold 750 600 1500 1125
Gross Margin 250 200 500 375
Add Selling Overheads 74 100 80 1178
Profit Margin 176 100 420 -803
Overheads
Customer 1 Customer 2 Customer 3 Customer 4
Rate Orders Total Orders Total Orders Total Orders Total

Process Mail Orders 5 0 0 6 30 4 20 0 0
Process Phone Orders 80 1 20 0 0 0 0 12 960
Process Returns 5 0 0 4 20 2 10 24 120
Process Over-night Delivery Request 4 1 4 0 0 0 0 12 48
Maintain Customer Relation 50 1 50 1 50 1 50 1 50
Total 74 100 80 1178
Activity-Based Costing
 Traditional allocation method
 Activity-based allocation method
Costs
Products
Costs
Products
Activities
First stage
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Second stage
Conventional Costing
Expenses
Cost Objects
AB Costing
Resources
Activities
Cost Objects
Economic
Element
Work
Performed
Product or
service
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Traditional Costing Systems
 Product Costs
 Direct labor
 Direct materials
 Factory Overhead
 Period Costs
 Administrative expense
 Sales expense
Direct labor and direct
materials are easy to trace to
products.

The problem comes with
factory overhead.
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Today’s businesses are working in an
increasingly complex environment.
Use of Advanced Technology
Product Life Cycle
Product Complexity
Channels of Distribution
Quality Requirements
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Product Diversity
ABC systems addresses the
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following Questions:
 What activities are being performed by the
organisational resources?
 How much does it cost to perform activities?
 Why does the oranisation need to perform those
activities?
 How much of each activity is required for the
organisation’s products, services, and customers?
Basics of A B C : How?
Steps:
1. Form cost pools
2. Identify activities
3. Map resource costs to activities
4. Define activity cost drivers
5. Calculate cost
Cost pools are groups or
categories of individual
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expense items
Levels of Cost Incurrence
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 Not all costs are volume-related
 Unit level
 Batch level
 Product level
 Facility level
Activities: Types
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• Unit level: Performed each time a unit is
produced
• Batch level: Performed each time a batch is
produced
• Product level: Performed to support production of different type
of product
• Customer Level: Performed to support servicing customers
• Facility level:Residuary head
Map resource costs to activities
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 Financial accounting categorises expenses by
spending code; salaries, fringe benefits,
utilities, travel, communication, computing,
depreciation etc.
•ABC collects expenses from this financial
system and drive them to the activities
performed.
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Mapping
Accounting Records
Salaries 313,000
Depreciation 155,000
Electricity 132,000
Supplies 25,000
Travel 100,000
Total 725,000
ABC Records
Activities Salaries Depreciati Electricity Supplies Travel Total
Business
Development
20,000 25000 5000 5000 55,000
Maintianing
Present Business
80,000 60000 50000 5000 10000 205,000
Purhcasing
Material
125,000 50000 20000 20000 60000 275,000
Set up Machines 25,000 10000 2000 37,000
Running Machines 50,000 10000 50000 110,000
Resolve Quality
Problems
13,000 5000 25000 43,000
Total 313,000 155000 132000 25000 100000 725,000
Define activity drivers
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 The linkage between activities and cost objects, such
as products, customers,, is accomplished by using
activity drivers.
 An activity driver is a quantitative measure of the
output of an activity.
 The selection of an activity driver reflects a
subjective trade-off between accuracy and cost of
measurement.
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d
n
Activities Drivers
Unit Level
Acquire and Use material for containers No. of Containers
Acquire and Use material for baby-care p No. of products
Batch Level
Set up manually controlled machines No. of batches of con
Set up computer controlled machines No. of batches of B.
Product Level
Design and manufacture moulds No.of moulds require
Use manually controlled machines Product type (contai
Use conputer controlled machines Product type (B.Prod
Custome r Level
Consult customers No. of consultations
Provide warehousing for customers No. of cubit feet
Faciltiy Level
Manage workers Salaries
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Activities Drivers Activity Cost
Activity Volum
Activity R
Unit Level
Acquire and Use material for containers No. of Containers 40,000 1,000,000 0.04
Acquire and Use material for baby-care products No. of products 80,000 8,000 10
Batch Level
Set up manually controlled machines No. of batches of containers 3,000 10 300
Set up computer controlled machines No. of batches of B.
Produst
12,000 20 600
Product Level
Design and manufacture moulds No.of moulds required 5,000 5 1000
Use manually controlled machines Product type (containers) 15,000 1 15000
Use conputer controlled machines Product type (B.Products) 40,000 1 40000
Customer Level
Consult customers No. of consultations 4,000 40 100
Provide warehousing for customers No. of cubit feet 2,000 10,000 0.2
Faciltiy Level
Manage workers Salaries 3,000 15,000 0.2
Use main building Square feet 48,000 16,000 3
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Ascertaining Cost
Activities A. Rate A.Volume Containers Baby Product
Unit Level
Acquire and Use material for containers 0.04 1,200,000 48,000
Acquire and Use material for baby-care products 10 7,000 70000
Batch Level
Set up manually controlled machines 300 12 3,600
Set up computer controlled machines 600 16 9600
Product Level
Design and manufacture moulds 1000
1 1,000
4 4000
Use manually controlled machines 15000 1 15,000
Use conputer controlled machines 40000 1 40000
Customer Level
Consult customers 100
Containers 2 200
B.products 40 4000
Provide warehousing for customers 0.2
Containers 8,000 1,600
B.products 2,000 400
Faciltiy Level
Manage workers 0.2
Containers 4,000 800
B.products 10,000 2000
Use main building 3
Containers 5,000 15,000
B.products 7,000 21000
Total Cost 85,200 151,000
Let’s work an example . . .
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 Assume that a company makes widgets
 Management decides to install an ABC system
Remember ABC Steps
• Overhead cost drivers are determined.
• Activity cost pools are created.
• A activity cost pool is a pool of individual costs that all have the
same cost driver.
• All overhead costs are then allocated to one of the activity cost pools.

• An overhead rate is then calculated for each cost pool using the following formula:
• Costs in activity cost pool/base
• The base is, of course, the cost driver
• Overhead costs are then allocated to each product according to how
much of each base the product uses.
Overhead Cost Drivers are
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Determined:
 Management decides that all overhead costs only have
three cost drivers—sometimes called activities (obviously a
simplification of the real world)
 Direct labor hours
 Machine hours
 Number of purchase orders
All overhead costs are then allocated to one of
the activity cost pools.
Direct Labor
Machine Hours
# of Purchase Orders
Which overhead costs do you
think are driven by direct labor
25
hours?
General Ledger
Payroll taxes $1,000
Machine maintenance $500
Purchasing Dept. labor $4,000
Fringe benefits $2,000
Purchasing Dept.
Supplies
$250
Equipment
depreciation
$750
Electricity $1,250
Unemployment
insurance
$1,500
All overhead costs are then allocated to one of the activity cost pools.
Direct Labor

$1,000
2,000
1,500
$4,500
Machine Hours
# of Purchase Orders
Overhead driver by direct labor
hours 35
General Ledger
Payroll taxes $1,000
Machine maintenance $500
Purchasing Dept. labor $4,000
Fringe benefits $2,000
Purchasing Dept.
Supplies
$250
Equipment
depreciation
$750
Electricity $1,250
Unemployment
insurance
$1,500
All overhead costs are then allocated to one of the activity
cost pools.
Direct Labor

$1,000
2,000
1,500
$4,500
Machine Hours

$ 500
750
1,250
$2,500
# of Purchase Orders
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General Ledger
Payroll taxes $1,000
Machine maintenance $500
Purchasing Dept. labor $4,000
Fringe benefits $2,000
Purchasing Dept.
Supplies
$250
Equipment
depreciation
$750
Electricity $1,250
U
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o
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v
m
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1,500
ours?
All overhead costs are then allocated to one of the activity
cost pools.
Direct Labor

$1,000
2,000
1,500
$4,500
Machine Hours

$ 500
750
1,250
$2,500
# of Purchase Orders

$4,000
250
$4,250
And finally, which overhead costs are
driven by # of purchase orders?
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General Ledger
Payroll taxes $1,000
Machine maintenance $500
Purchasing Dept. labor $4,000
Fringe benefits $2,000
Purchasing Dept.
Supplies
$250
Equipment
depreciation
$750
Electricity $1,250
Unemployment
insurance
$1,500
An overhead rate is then calculated for each cost pool:
Direct Labor
Again the formulas is:
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Machine Hours
# of Purchase Orders
$1,000
2,000
1,500
$4,500
$ 500
750
1,250
$2,500
$4,000
250
$4,250
Costs in Activity Cost Pool/Base = rate
Assume the following bases:
Direct labor hours = 1,000
Machine hours = 250 Purchase
orders = 100
The ABC rates are:
$4,500/1,000 = $4.50 per direct labor hour
$2,500/250 = $10 per machine hour
$4,250/100 = $42.50 per purchase order
Overhead costs are then allocated to each
product according to how much of each base
uses.

$4,500/1,000 = $4.50 per direct labor hour
$2,500/250 = $10 per machine hour
$4,250/100 = $42.50 per purchase order

Lets assume the company makes two products, Widget A and Widget B:

Let’s also assume that each product uses the following activity
of overhead cost drivers:

Notice that all base units are
accounted for.
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Base Widget A Widget B Total
Direct labor hours 400 600 1,000
Machine hours 100 150 250
Purchase orders 50 50 100
Now let’s allocate overhead to
Widget A:
In this case, 400 hours used to make Widget A is multiplied by the rate of
$4.50. This gives total overhead applied for this activity cost pool of $1,800
to Widget A.
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Base A Rate Allocated
Direct labor hours 400 $ 4.5
0
$ 1,800.00
Continuing the calculation:
Let’s do the saŵe thiŶg foƌ the otheƌtwo ƌates, to get the total aŵouŶt
of overhead applied to Widget A:
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Widget A Base Rate Allocated
Direct labor hours 400 $ 4.50 $ 1,800.00
Machine hours 100 $ 10.00 $ 1,000.00
Purchase orders 50 $ 42.50 $ 2,125.00
Total $ 4,925.00
Now let’s allocate overhead to
Widget B:
Let’s do the same thing for the other two rates, to get the total
of overhead applied.
The original overhead to be applied was $4,500 of direct labor
driven overhead + $2,500 of machine hour driven overhead + $4,250 of
purchase order driven overhead = $11,250 total overhead to apply.

The actual overhead allocated was $4,925 for Widget A + $6,350 =
$11,250 overhead applied.
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Widget B Base Rate Allocated
Direct labor hours 600 $ 4.50 $ 2,700.00
Machine hours 150 $ 10.00 $ 1,500.00
Purchase orders 50 $ 42.50 $ 2,125.00
Total $ 6,325.00
Same Problems Traditional
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Method
 Okay, so what if we had allocated the overhead in this company using
traditional cost accounting allocation.
 Let’s assume the base is direct labor hours.
 What would be the amount allocated to each product?
Calculation
General Ledger
This the total overhead we
were given, the total
amount is $11,250 as
explained on the previous
slide.
Base Widget A Widget B Tota
Direct labor hours 400 600 1,000
Machine hours 100 150 250
Purchase orders 40 60 100
Total direct labor hours
are 1,000, also given
earlier.
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Payroll taxes $1,000
Machine maintenance $500
Purchasing Dept. labor $4,000
Fringe benefits $2,000
Purchasing Dept.
Supplies
$250
Equipment
depreciation
$750
Electricity $1,250
Unemployment
insurance
$1,500
Calculation
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 The rate would be:
 OH Rate = Overhead/Direct Labor Hours
 $11,250/1,000 = $11.25 per hour.
 Applying overhead using this rate:
 Widget A: 400 hours x $11.25 = $4,500
 Widget B: 600 hours x $11.25 = $6,750
 Total overhead applied = $11,250
Comparison
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Which is more accurate?
ABC Costing!
Note these are total costs. To get per-unit costs we would divide by the number of units
produced.
Widget A Widget B Total
Traditional
Method
$4,500 $6,750 $11,250
Activity Based
Costing
$4,925 $6,325 $11,250
Difference -$425 $425 -0-
Production Department Indirect
factory wages
Factory equipment depreciation Factory
utilities
Factory building lease
$ 500,000
300,000
120,000
80,000 $ 1,000,000
40,000 Shipping costs traced to customer orders General
Administrative Department
Administrative wages and salaries Office
equipment depreciation
400,000
50,000
Administrative building lease Marketing
Department
60,000 510,000
Overhead Costs at Classic Brass (Manufacturing
and NonManufacturing)
Marketing wages and salaries 250,000
Selling expenses 50,000 300,000
Total overhead costs $ 1,850,000
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
Traced $/DLH Traced
Products or Customers
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Customer
Orders
(# of Orders)
Order
Size
(Mach Hrs)
Product
Design
Customer
Relations
(# of Customers)
Other
Overhead Costs
First-Stage Allocation
Products or Customers
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Customer
Orders
Product
Design
Order
Size
Customer
Relations
Other
Overhead Costs
First-Stage Allocation
Second-Stage Allocations
$/MH $/Order $/Design $/Customer
Products or Customers Unallocated
Indirect Costs
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 Not easily and conveniently traceable to cost
objects
 Cost element is shared among cost objects
 Physically impossible to trace
 Not cost effective to trace
Indirect Costs
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 Need for allocation
 Estimate product or activity cost
 What does it really cost?
 Increase awareness of indirect costs
 Activities are not free
 Plan more cost efficient operations
 Now that we know what it costs, what should we do?
Allocation of Indirect Costs
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 Typical allocation methods
 Ability to bear
 Fairness or equity
 Benefits received
 Cause and effect
Traditional Allocation Method
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 Indirect costs allocated to cost object based on the
cost object’s consumption of some measure of
activity, usually labor hours
$10,000,000 total indirect cost 400,000
total labor hours
= $25 per hour rate
A product consuming 6 labor hours would be charged
$150 ($25 x 6) of indirect costs
Criticisms of Traditional Overhead
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Allocation

 Assumes all overhead is volume-related
 Factory-wide or departmental rates
 All related to single activity measure
 Departmental focus, not process focus
 Focus on costs incurred, not cause of costs
Conventional Costing
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• Total Cost = Material + Labour+ Overheads
• Overheads are allocated to the products on volume based measures
e.g. labour hours, machine hours, units produced

Will this not distort the costing in the new
environment?

ABC provides an Alternative.
Activity-Based Costing (ABC)
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 Purpose
 Allocation of indirect costs based on causal activities
 Attempts to identify “direct” link between cost and cost
object
 Results in better allocation
 Does not provide “true” cost
ABC Definitions
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 Activity based costing is an approach for
allocating overhead costs.
 An activity is an event that incurs costs.
 A cost driver is any factor or activity that has a direct cause
and effect relationship with the resources consumed.
Overview of ABC
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 Identifies activities required to produce the
product or service
 Determines the cost of the activities
 Allocates costs to the cost object based on
the object’s consumption of activities
Basics of A B C
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• Cost of a product is the sum of the costs of all activities
required to manufacture and deliver the product.
• Products do not consume costs directly
• Money is spent on activities
• Activities are consumed by
product/services
Basics of A B C (contd.)
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• ABC assigns Costs to Products by tracing expenses to
“activities”. Each Product is charged based on the
extent to which it used an activity

• The primary objective of ABC is to assign costs that
reflect/mirror the physical dynamics of the business
Basics of A B C (contd.)
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• Provides ways of assigning the costs of indirect support
resources to activities, business processes, customers,
products.
• It recognises that many organisational resources are
required not for physical production of units of product but
to provide a broad array of support activities.
Building an ABC Model
Identify
Resources
Identify
Activities
Identify Cost
Objects
Define
Resource
Drivers
Define
Activity
Drivers
Enter
Resource
Costs
Enter
Resource
Driver Qty.
Enter Activity
Driver Qty.
Calculate
Costs
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Thank you.