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Ans.1)
  
  () is a costing model that identifies activities in an
organization and assigns the cost of each activity resource to all products and services
according to the actual consumption by each: it assigns more indirect costs (overhead) into
direct costs. In this way, an organization can precisely estimate the cost of individual products
and services so they can identify and eliminate those that are unprofitable and lower the prices
of those that are overpriced. In a business organization, the ABC methodology assigns an
organization's resource costs through activities to the products and services provided to its
customers. It is generally used as a tool for understanding product and customer cost and
profitability. As such, ABC has predominantly been used to support strategic decisions such as
pricing, outsourcing, identification and measurement of process improvement initiatives.

  

   

à It helps to identify inefficient products, departments and activities

à It helps to allocate more resources on profitable products, departments and activities
à It helps to control the costs at an individual level and on a departmental level
à It helps to find unnecessary costs
à It helps fixing price of product or service scientifically


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Discussion of activity based costing by looking at two products manufactured by the same
company. Product 124 is a low volume item which requires certain activities such as special
engineering, additional testing, and many machine setups because it is ordered in small
quantities. A similar product, Product 366, is a high volume productͶrunning continuouslyͶ
and requires little attention and no special activities. If this company used traditional costing, it
might allocate or "spread" all of its overhead to products based on the number of machine
hours. This will result in little overhead cost allocated to Product 124, because it did not have
many machine hours. However, it did demand lots of engineering, testing, and setup activities.
In contrast, Product 366 will be allocated an enormous amount of overhead (due to all those
machine hours), but it demanded little overhead activity. The result will be a miscalculation of
each product's true cost of manufacturing overhead. Activity based costing will overcome this
shortcoming by assigning overhead on more than the one activity, running the machine.
Activity based costing recognizes that the special engineering, special testing, machine setups,
and others are activities that cause costsͶthey cause the company to consume resources.
Under ABC, the company will calculate the cost of the resources used in each of these activities.
Next, the cost of each of these activities will be assigned only to the products that demanded
the activities. In this example, Product 124 will be assigned some of the company's costs of
special engineering, special testing, and machine setup. Other products that use any of these
activities will also be assigned some of their costs. Product 366 will not be assigned any cost of
special engineering or special testing, and it will be assigned only a small amount of machine
setup.


  
  


  
 
  
(1) Manufacturing overhead costs have increased significantly

(2) The manufacturing overhead costs no longer correlate with the productive machine hours
or direct labor hours

(3) The diversity of products and the diversity in customers' demands have grown, and

(4) Some products are produced in large batches, while others are produced in small batches.

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Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W. Bruns as a
chapter in their book Accounting and Management: A Field Study Perspective.[3] 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 don͛t.

- 
   

1) Define activities, activity cost pools, and activity measures.

2) Assign overhead costs to activity cost pools.

3) Calculate activity rates.

4) Assign overhead costs to cost objects using the activity rates and activity measures.

5) Prepare management reports.


 
   

 $
 Unit level drivers are triggered for every unit that is being produced. For
example, for a man and a machine that produces one unit at a time, the associated direct labor
will be a unit level cost driver. This is therefore a volume related driver similar to the traditional
allocation bases.

% 

 Batch level drivers are triggered for every batch produced. A good
example of that is production planning, because the planning is done for each and every batch
regardless of the size of the batch. Here, number of batches can be a good driver.

&

 Product level drivers are triggered for every product regardless of the
number of units and batches produced. These drivers occur by the sole existence of a product.
A good example of a driver is the number of product development hours per product so that
the more product development hours a product triggers the more product development costs
should be assigned to that product.

'
 
 relate to specific customers and include activities such as sales calls,
catalog mailings, and general technical support that are not tied to any specific product.

()  
 Activities that are carried out regardless of which customers
are served, which products are produced, how many batches are run, or how many units are
made.

  
   

*+
   These costs vary based on the number of parts handled.
%*
-   These costs vary based on the time required to setup the machines
for a particular board. This occurs only once per batch of boards.

&,     These costs vary based on the number of boards processed.
Machine Insertion Costs - These costs vary based on the number of parts to be inserted.

'*,    These costs vary based on the number of parts to be inserted.

(-   These costs vary based on the time required to solder a particular board
and the number of boards soldered.

-c.    These costs vary based on the time required to test the PC board, and the
number of boards tested.