ACTIVITY BASED COSTING

Activity Based Costing (ABC) is a modern absorption costing method, which focuses on
individual activities instead of cost centers. In the past, it was reasonable to categorize costs as
either fixed or variable with sales. However, some costs do not vary with sales but do vary with
some other activity. For example, some costs of the purchasing department vary with the number
of vendors the company uses and the number of parts and components the company buys.

Managing costs has two basic aspects:

1. Managing the cost itself. For example, buying materials, parts and components at
better prices

2. Managing the activity that causes the costs. For example, reducing the material content
of a product without sacrificing quality

To manage costs effectively, managers associate costs with activities.

An activity is an event, task or unit of work with a specified purpose, such as designing of
products, setting up of machines, operating machines, cleaning and maintenance of machines and
distribution of products.

Under traditional absorption costing systems, overhead costs are first related to cost centers
(production and service centers) and then to cost objects i.e. products and services. For many
years, labor time was used to assign manufacturing overhead costs to products. As manufacturing
became more sophisticated, machines and computers took over many of the tasks that people had
performed, and labor requirements declined. Now many activities drive costs. Volume is one
major driver measured either in output (units produced) or input (labor hours, machine hours
etc.) Accountants today recognize two other major influences on cost: complexity and diversity
of operations. As a company’s products become more complicated, having more parts and
requiring more operations, costs will increase even though total output does not increase.
Similarly, if a company increases the variety of its product offerings, costs will increase even if
total output remains constant.

ABC seeks to estimate the costs of products (and other cost objects) by estimating the cost of
many activities and in turn using these estimates to estimate the cost of products by reference to
how much of the activity each product uses. ABC is concerned with resource consumption. It
provides a way to trace resource consumption to products and other cost objects.

In ABC systems, overheads are related to activities or grouped into cost pools. A cost pool is a
grouping of individual indirect cost items driven by the same activity. A cost pool may consist of
all the costs incurred by a department such as assembly department in a factory. A cost pool
could also consist of only some of the costs of a department. For example, the number of
purchase orders drives some of the costs of the purchasing department and number of vendors
drives others, while four or five other drivers might drive other costs. A pool could also consist
of costs from more than one department. For example, the number of employees drives some
costs of both the payroll and personnel departments.

ABC does not use departments (cost centers), because functional departments tend to include a
series of different activities, which incur a number of different costs that behave in different
ways. Also some activities run across different functions. For example, all material procurement
costs are not incurred in the purchasing department. A part of it is also incurred in manufacturing
or stores department where material requisition is raised.

Activity costs tend to behave in a similar way to each other i.e. they have the same cost driver. A
cost driver is a factor such as level of activity or volume that causes a change in the cost over a
period of time. For example, number of parts is a cost driver for product design costs, miles
driven is a cost driver of distribution costs. Cost drivers are of two types, resource cost drivers
and activity cost drivers.

Resource cost drivers measure the quantity of resources (people, machinery, space and utilities)
consumed by an activity. It is used to assign the cost of resources to an activity or cost pool. For
example, processing of customer returns will require people to receive, inspect and rework the
returned goods. This will also require space and equipment (computers). The resources required
by this activity will depend on the number of returns or the rupee value of returns. Resource cost
drivers for research and development activity include number of research projects and for
customer service activity, the number of products serviced, number of service calls.

Activity cost drivers measure the frequency and intensity of demand placed on activities by cost
objects. It is used to assign activity costs to cost objects. Examples of activity cost drivers for
research and development activity include personnel hours on a project and technical
complexities of a project. Activity cost drivers for customer service activity include hours spent
on servicing products.

Stages in Activity Based Costing

1. Activity Identification, definition and classification

Activities represent actions taken or work performed by equipment or people for other people,
for example, treating patients and monitoring patients in a hospital. Similarly, purchasing
material and receiving material are activities in any organization. A simple list of activities
identified is called an activity inventory.

After identifying activities, activity attributes are used to define activities. These attributes
include the tasks involved in the activity, types of resources used, amount (percentage) of time
spent, cost objects that consume the activities and a measure of activity consumption (activity
driver). This information is given in an activity dictionary.

To facilitate achievement of such managerial objectives as product or customer costing,

continuous improvement, TQM, activities are classified into primary and secondary, value-added
and non-value-added, quality related, and environmental etc.
A primary activity is an activity that is consumed by a final cost object such as a product or a
customer. A secondary activity is one that is consumed by intermediate cost objects such as
primary activities, materials or other secondary activities. Before assigning the costs of primary
activities to products, the cost of secondary activities consumed by primary activities are
assigned to primary activities.

Example:

Activity Name Activity Description Activity Type Cost Object Activity

Driver

Treating Patients Administering medicine Primary Patient Type Number of

And changing dressings (normal, treatments

intermediate
Or intensive

Under the traditional overhead accounting system, the number of cost centers used is quite small
say up to 15. But the number of activities could be much more even going up to 200. But the
number should be restricted to a reasonable level, say 40.

2. Create cost pools for primary and secondary activities

Activities consume resources such as material, labour, energy and capital. Resources consumed
by different activities are assigned using direct and driver tracing. The drivers used for assigning
resource costs are called resource drivers (e.g. time spent by a labour resource on different
activities). Costs of computer resources used can be assigned using hours of use.

Under this stage, cost pools are created using resource cost drivers. The traditional absorption
system uses a single indirect cost pool. This single cost pool is not homogeneous because cost of
some of some of the activities like designing of products, setting up of machines, distribution of
output are lumped into a single cost pool. These activities have a weak cause and effect
relationship with the direct manufacturing labour hours or machine hours. ABC systems create
smaller cost pools linked to different activities. These activity related cost pools are
homogeneous.

3. Assigning secondary activity costs to primary activities

Supervising nurses is a secondary activity. This needs to be assigned to other primary activities
such as treating patients, monitoring patients, providing hygienic care, and responding to
requests. This is done using some suitable base, which reflects the use of this activity. In this
case, it could be the labour time spent by nurses on each of the primary activities.

4. Determine the Activity Cost Drivers

Activity cost drivers are used to relate the overheads collected in the cost pools to the cost
objects. Activity cost drivers are identified on the basis of that factor that drives the consumption
of that activity. Two types of activity drivers, transaction drivers and duration drivers, may be
used.

Transaction drivers measure the number of times an activity is performed (number of treatments,
number of requests, and number of batches)

Duration drivers measure the demand in terms of time it takes to perform an activity (set up
hours, monitoring hours). Duration drivers should be used when the time it takes to perform an
activity varies from transaction to transaction (treatment for a normal patient may take 10
minutes and for an intensive care patient, 45 minutes).

After defining the activity drivers, a bill of activities can be prepared showing the product,
expected product quantity, activities and the amount of each activity to be consumed by each
product.

Bill of Activities
Activity Activity Normal Intermediate Intensive Total
Driver

Output Patient days 10000 5000 3000

Treating patients Treatments 5000 10000 15000 30000
Providing hygienic care Hygienic care hours
Responding to requests No. of requests

5. Calculate the Activity Cost Driver Rates for each Activity

Primary activity rates are computed by dividing the budgeted activity costs by practical activity
capacity (activity output that can be produced if the activity is performed efficiently).

The following formula is used for this purpose:

Budgeted cost of activity

Activity Cost Driver Rate = ---------------------------------
Practical activity capacity
6. Assigning Activity Costs to Cost Objects

Cost of primary activities is assigned to cost objects in proportion to their usage of the activity.
The activity cost driver rate is multiplied by the amount of an activity consumed by a cost object.
Many different cost objects are possible (products, materials, customers, suppliers, distribution
channels, geographical regions).

Purposes and Benefits of ABC:

Traditional absorption costing tends to over cost high volume, long production run products and
under cost low volume short production run products. It averages batch costs such as set-up costs
over all the products rather than relating them to each batch.

ABC systems reveal information, which enables managers to adjust price policies and develop
different product strategies in an effective manner. ABC systems are, thus, primarily needed for
product costing by those organizations where:

- production overheads are high in relation to direct costs.

- there is a great diversity of product range.
- products use very different amounts of overhead resources.
- consumption of overhead resources is not primarily driven by volume.

Intermediate Cost Objects

Cost objects consume activities as well as other resources (such as materials). Materials place
demands on other activities such as purchasing and inspection. These material related activities
are not directly consumed by final cost objects and are, therefore, secondary activities. These
secondary activities are consumed by materials and the materials are then consumed by final cost
objects. These costs are first assigned to materials and the materials costs are then assigned to
cost objects.

Categories of Activity Costs Based on Cost Drivers ( Cost Hierarchies)

Grouping activities reduces the number of activity rates needed, simplifies the task of product
costing and reporting and decreases the overall complexities of product costing model.

Homogeneous sets of activities are collection of activities that have the same process
classification, the same level classification and the same activity driver classification.

A process is a series of activities that are linked to perform a specific objective, for example,
product development, fabrication, assembly, procurement, order fulfillment, customer servicing.
The procurement process includes such activities as purchasing, receiving and paying suppliers.
The process classified activities are then classified into one of the following four general activity
categories.

1. Unit Level Activities

These activities are performed each time a unit is produced (for example, grinding, polishing and
assembly). The costs relating to unit level activities increase with additional units of output
produced. For example, manufacturing operation costs such as cost of energy, machine
depreciation and repair.

2. Batch Level Activities

Batch level activities are those that are performed each time a batch is produced. The costs of
these activities vary with each batch of products rather than individual unit or product, for
example, set up costs. Cost of set up activity will vary with the number of set up hours needed to
produce batches of products over time and not with the number of units of product produced.
Procurement costs are also batch-level costs because they are related to number of purchase
orders rather than to the quantity or value of materials purchased.

3. Product Level Activities

Product level activities are those activities that are performed to support individual products or
services regardless of the number of units or batches in which units are produced. Examples
include designing and modifying the product, the mould and the process, engineering activity to
change product designs, developing product testing procedures, introducing new products. The
costs of such activities tend to increase with the number of different products.

The procurement process involves both batch level activities (purchasing materials, receiving
materials) and product level activities (paying suppliers).

4. Facility Level Activities

Some activities are performed to support the organization as a whole, e.g. general administration,
provision of manufacturing facilities, providing plant security. It is usually very difficult to find a
good cause-and-effect relationship between the costs of such activities and a cost allocation base.
Some companies treat these costs as period costs while others allocate these costs to products on
the basis of DLH or some other basis. Allocating these costs to products become important when
management wants to set selling prices on the basis of an amount of cost that includes all costs.

Knowing the activity level is important because it helps management identify the activity drivers
and also provides insights concerning the root causes of activities and thus can help managers in
their efforts to improve activity performance.

Activity Driver/Consumption Ratio Classification

Activities within unit-level, batch-level and product-level activities can be further sub-divided on
the basis of consumption ratios. Activities with the same consumption ratios can use the same
activity driver to assign costs.

This final grouping creates homogeneous set of activities; a collection of activities that share a
common objective (from the same process), are at the same level and use the same activity
driver. For example, we can have a single activity driver rate for purchasing and receiving
materials as these belong to the same process (procurement) and are at the same level (batch).
Example: Activity Based Costing

Coffee Bean Inc. (CBI) is a distributor and processor of different blends of coffee. The company
buys coffee beans from around the world and roasts, blends and packages them for resale. CBI
currently has 15 different coffees that it offers to gourmet shops in one-pound bags. The major
cost is raw materials; however there is a substantial amount of manufacturing overhead in the
predominantly automated roasting and packing process. The company uses relatively little direct
labour.

Some of the coffees are very popular and sell in large volumes, while a few of the newer blends
have very low volumes. CBI prices its coffee at full product cost, including allocated overheads,
plus a markup of 30 percent. If prices for certain coffees are significantly higher than market,
adjustments are made. The company competes primarily on the quality of its products, but
customers are price conscious as well.

Data for the 2006 budget include manufacturing overhead of Rs.30, 00,000 which has been
allocated on the basis of each product’s direct labour cost. The budgeted direct labour cost for
2006 totals Rs.6, 00,000. Based on the sales budget and raw material budget, purchases and use
of raw materials (mostly coffee beans) will total Rs.60, 00,000.

The expected prime costs of one kg bags of the two of the company’s products are as follows:
Mona Loa Malaysian
Direct Material Rs. 84 Rs. 64
Direct Labour Rs 6 Rs. 6

CBI’s controller believes the traditional product-costing system may be providing misleading
cost information. She has developed an analysis of the 2006 budgeted manufacturing-overhead
costs shown in the following chart.

Activity Cost Driver Budgeted Activity Budgeted Cost

Purchasing Purchase orders 1158 Rs. 5,79,000

Material Handling Setups 1800 7,20,000
Quality Control Batches 720 1,44,000
Roasting Roasting hours 96100 9,61,000
Blending Blending hours 33600 3,36,000
Packaging Packaging hours 26000 2,60,000

Total Manufacturing -------------------

Overhead cost 30,00,000
--------------------
Data regarding the 2006 production of Mona Loa and Malaysian Coffee are shown in the
following table. There will be no raw-material inventory for either of these coffees at the
beginning of the year.

Mona Loa Malaysian

Budgeted sales 10,000 kg. 200 kg.
Batch size 1,000 kg. 50 kg.
Setups 3 per batch 3 per batch
Purchase order size 2,500 kg. 50 kg.
Roasting time 1 hr. per 10 kg. 1 hr. per 10 kg.
Blending time 5 hr. per 10 kg. 0.5 hr. per 10 kg.
Packaging time 1 hr. per 10 kg. 0.1 hr per 10 kg.

Required:

(a) Using Cofee Bean Inc’s current product costing system:

(i) Determine the company’s predetermined overhead rate using direct labour cost as the
single cost driver.

(ii) Determine the full product costs and selling price of one kg of Mona Loa Coffee and one
kg of Malaysian coffee.

(b) Develop a new product cost, using an activity-based costing approach for one kg of Mona
Loa coffee and one kg of Malaysian coffee.
Solution
a) (i)
Predetermined Overhead Rate using Direct Labour Cost as single Cost Driver
Rs.
Budgeted direct labour cost for 2006 6,00,000
Budgeted manufacturing overhead cost for 2006 30,00,000
Predetermined overhead rate (30,00,000 x 100)/6,00,000 500% of direct
labour cost
(ii) Full Production Costs and Selling Prices per Kg.
Mona Loa Malaysian
Rs. Rs.
Direct material 84 64
Direct labour 6 6
Manufacturing overhead 30 30
----- ------
120 100
Markup (30%) 36 30
---- ------
Selling Price 156 130
----- ------
(b) Activity Cost Driver Rates
Activity Activity Cost Driver Rate
Purchasing Rs. 5,79,000/ 1158 Rs. 500 per purchase order
Material handling Rs. 7,20,000/1800 Rs. 400 per setup
Quality control Rs.1,44,000/720 Rs. 200 per batch
Roasting Rs. 9,61,000/96,100 Rs. 10 per roasting hour
Blending Rs.3,36,000/33,600 Rs. 10 per blending hour
Packaging Rs. 2,60,000/26,000 Rs. 10 per packaging hour

Product Costs using ABC

Mona Loa Malaysian
Rs. Rs.
Direct material 8,40,000 12,800
Direct labour 60,000 1,200
Manufacturing overhead:
Purchasing 2,000 2,000
Material handling 12,000 4,800
Quality control 2,000 800
Roasting 10,000 200
Blending 50,000 100
Packaging 10,000 20
----------- ---------
Total cost 9,86,000 21,920
---------- ---------
Budgeted production (Kgs.) 10,000 200
Cost per Kg.(Rs.) 98.6 109.6