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INSPIRE Academy ( 888888 1719) Chapter 5 : ACTIVITY BASED COSTING .1

52 ACTIVITY
MATERIAL
BASED COSTING

1. MEANING

o Activity Based Costing is an accounting methodology that assigns costs to

activities rather than products or services.
o This enables resources and overhead Costs to be more accurately assigned to
products and services that consume them.
o ABC assigns cost to activities based on their use of resources and then
assign cost to the cost Objects.
o It can track the flow of activities in Organization by Creating a link between the
activity and the cost object.
o According to CIMA, it is defined as “Cost attribution to cost units on the basis of
benefits received form indirect activities ie ordering, Setting- up, assuring quality
etc,”

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2. DEFINITIONS

TERM MEANING

Cost o An item for which Cost measurement is required is called Cost object.
Object o e.g. Product, Customer, Job, Assignment, etc.

Cost Driver o A Factor that causes a change in the cost of an activity is called cost
driver
o It can be classified into two types;
1. Resource Cost Driver
2. Activity Cost Driver
e.g.

Business Functions Cost Driver

Research and i) Number of Research Products

Development or
ii) Personnel hours on a project or
iii) Technical complexities of
projects

Customer Service i) Number of service calls or

ii) Number of Products serviced or
iii) Hours spent on servicing
products

Designing i) Number of product designed

ii) Number of engineering hours

Distribution i) Number of items distributed

ii) Number of Customers

Marketing i) Number of advertisement run

ii) Number of sales personnel

Resource o It is a measure of the quantity of resources consumed by an activity.

Cost Driver o It is used to assign the cost of a resource to an activity or cost pool.

Activity o It is a measure of the frequency and intensity of demand, placed on

Cost Driver activities by cost objects.
o It is used to assign activity costs to cost objects.

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3. NEED FOR ABC

o Production Overheads are high in relation to direct costs .

o There is a great diversity in the product range.
o Products Used different amounts of overhead resources.
o Consumption of overhead resources is not primarily driven by volume or hours.

4. STEPS INVOLVED IN ACTIVITY BASED COSTING

1. Identification of various activities in the organization

• E.g purchasing, Production process set up, Material handling, Quality
Control, Maintenance etc.
2. Classification of activities into Primary activities and Supporting activities
3. Compute Cost Pool of each activity (cost pool = Total cost)
4. Transfer the Supporting activities cost to Primary activities on suitable basis
5. Determine Activity Cost Driver for each activity
6. Compute Activity Cost Driver Rate
Cost Pool
• Activity CostDriver Rate = Cost Driver

7. Assign costs to cost object Based on the cost driver rate (i.e.
Resources Consumed × Activity Cost Driver Rate )

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5. TRADITIONAL ABSORPTION COSTING VS. ABC

Traditional Absorption Costing Activity Based Costing

In this system, overheads are related to In this system, overheads are related to
cost center activities

Costs are assigned to Cost Units, ie. To Costs are assigned to Cost Objectives, ie
Products, or jobs customers,

Only two levels of activities are identified All four levels of activities are identified, Viz.
in this system: a) Unit Level Activities,
a) Unit Level Activities (Variable) b) Batch Level Activities,
and c) Product Level Activities and
b) Facility Level Activities (Fixed) d) Facility Level Activities.

Time is assumed as the only factor Activity wise Cost Drivers are identified.
governing cost in all cost centers. Time is one of Cost Driver.

Usage of Recovery rate may be either:- Specific Activity wise recovery rates are

1. Multiple rates (for each used. There is no “Single” or “overall” ABC

department) or Rate .
2. Single rate (for the entire factory).

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CONCEPT 1

Classify the following items under appropriate type of activities in Activity Based Costing;

a) Maintenance of Buildings
b) Use of indirect materials
c) Material ordering
d) Indirect Consumables
e) Inspection of products – like first item of every batch
f) Producing parts to a certain specification
g) Advertising costs, if advertisement is for individual products

Answer:
Item Types of Activity

a) Maintenance of buildings Facility level

b) Use of indirect Materials Unit level activities

a) Material ordering Batch level activities

b) Indirect consumables Unit level activities

c) Inspection of products – like first item of every Batch level activities

batch

d) Producing parts to a certain specification Product level

e) Advertising Costs, if advertisement is for Product level

individual Products

f) Production manager’s salaries Facility level

g) Advertising campaigns promoting the company Facility level

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CONCEPT 2

Indicate any two activity Cost drivers in respect of each of the following activity cost pools:

1) Manufacturing Cost
2) Human resources Cost
3) Marketing and Sales Costs
4) Accounting Costs

Activity Cost Pools Cost Driver

Manufacturing Cost • Number of machine hours

• Number of direct labour hours
• Number of machine setups
• Number of purchase orders

Human resources Cost • Number of employee

• Number of training Hours
• Number of recruiting contacts

Marketing and Sales Costs • Number of Customer Service

contacts
• Number of orders processed
• Number of advertisement
• Number of Sales Personnel

Accounting Costs • Number of billings

• Number of Cash receipts

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INSPIRE Academy ( 888888 1719) Chapter 5 : ACTIVITY BASED COSTING .7

ILLUSTRATION 1
1. A company produces three products A, B, and C, with standard costs and quantities per
unit are as follows :
Products A B C
Quantity produced 10,000 20,000 30,000
Direct material per unit (Rs.) 50 40 30
Direct labour per units (Rs.) 30 40 50
Labour hours required per unit 3 4 5
Machine hours required per unit 4 4 7
Number of purchase requisitions 1,200 1,800 2,000
Number of set ups 240 260 300

Production overhead split by departments : Department 1 = Rs. 11 lakhs and Department

2= Rs. 15 lakhs

Department 1 is labour intensive and Department 2 is machine intensive.

Total labour hours in department 1 = 1,83,333 while total machine hours in Department
2 = 5,00,000.

Production overhead split by activity: Receiving / inspecting = Rs. 14 lakhs

Production scheduling/ machine set up = Rs. 12 lakhs

Number of batches received / inspected = 5,000; Number of batches for scheduling and
set-up = 8000.

Required:

a) Prepare product cost statement under traditional absorption costing and activating
based costing method.
b) Compare the results under two methods.
SOLUTION

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1. Traditions Absorption costing

Statement of cost :

A(₹) B(₹) C(₹)

Direct Costs:
- Direct Labour

- Direct Material

- Production Overhead:

Total unit costs

Number of units

Total costs

A B C Total

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2. Activity Based Costing

A(₹) B(₹) C(₹)

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ILLUSTRATION 2
MST limited has collected the following data its two activities. It calculates activity cost rates
based on cost driver capacity.

Activity Cost Driver Capacity Cost

Power Kilowatt hours 50,000 kilowatt ₹2,00,000

hours

Quality inspections Number of 10,000 Inspections ₹3,00,000

inspections

The company makes three products M, S and T. for the year ended March 31, 2014. The
following consumption of cost drivers was reported:

Product Kilowatt hours Quality inspections

M 10,000 3,500

S 20,000 2,500

T 15,000 3,000

Required:

i. Compute the costs allocated to each product from each activity.

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SOLUTION
1. Statement of cost allocation to each product from each activity
Product

M(₹) S(₹) T(₹) Total

(₹)

Power (Refer to working

notes)

Quality inspections
(Refer to working note)

Working note:

Rate per unit of cost driver

Power

Quality inspection

Costing by Raj Awate – Amazing journey of logic and concept