Meaning CHAPTER 24 Activity-Based Costing (ABC) Activity-Based Costing (ABC) is that costing in which

costs begin with tracing of activities and then to producing the product. In other words, it is the process
of costing system which focuses on activities performed to produce products. This system assumes that
activities are responsible for the incurrence of costs and products creates the demand for activities.
Costs are charged to products based on individual product's use of each activity. ABC aims at identifying
as many costs as possible to be subsequently accounted as direct cost of production. Any cost that is
traced to a particular product via its consumption of activity becomes direct of the product. For
instance, in conventional costing system, cost of setup and adjustment time is considered as factory
overhead and subsequently assigned to different products on the basis of direct labour hours. But in
Activity-Based Costing, setup and adjustment time is determined for each product and its costs are
directly charged to each product. Thus. by emphasing activities, ABC tries to ascertain the factors that
cause each major activity, cost of such activities and the relationship between activities and products
produced. According to professor Vipul "Activity-Based Costing had it genesis in the increasing
importance of indirect costs in the manufacturing operations. The direct processing costs which are
easier to handle are being relegated to the b\l<;;kgrouild with each passing day due to automation. In
this changing scenario where indirect costs (ar outweigh the direct processing costs in many a situation,
one cannot be content with rough and ready methods of yester years in dealing with indirect costs."
Different Stages in Activity-Based Costing There are different activities in ABC costing. The following are
the important stages of ActivityBased Costing : (1) Identify the different activities within the
organisation. (2) Relate the overhead cost to the activities. (3) Support activities are then spread across
the primary activities. Activity-Based Costing (ABC) 5/3 (4) Determine the activity cost drivers. (5)
Calculate the activity cost drivers rate, i.e., the quantity of cost driver used by each product. ABC and
Cost Drivers In Activity-Based Costing, activities are identified and classified into different categories that
have relationship with the different stages or parts of the production process. The factors that influence
the cost of a particular activity are known as "Cost Drivers." A Cost Driver is literally the factors, forces or
events that determine the cost of activities. The process of activity-based costing is based on the
assumption that cost behaviour is influenced by cost drives. It should be understood that direct costs do
not need cost drivers because direct costs are themselves cost drivers. They can be traced by direct
relationship with the different parts of product. However, all other factory, office and administrative
overheads need cost drives. Examples of Cost Drivers In order to trace overhead costs to manufacturing
a product, suitable Cost Drivers should be identified. The following are the few examples of Cost Drivers
in Activity-Based Costing: (1) (2) (3) (4) (5) (6) (7) (8) (9) (to) (11) Cost Drivers Number of receiving order
Number of deliveries Number of Purchase orders Kilometres travelled per delivery Number of
customers' visits Number placing orders for purchase Number of returning or empty bottles Number
Material handling hours Amount of labour cost incurred Number of inspections Number of physical
delivery and} receipt of goods Classification of Activities Activity Ordering Delivery Order Taking
Deliveries Customer Visit Placing Orders Bottles Returns Product Handling Labour Transactions
Inspection Delivery In the first stage of the Activity-Based Costing activities are identified and classified
into different categories or segments of the production process. The grouping of activities is preferably
done using the different levels at which activities are performed. Broadly, activities are classified into: (1)
Unit Level Activities (2) Batch Level Activities (3) Product Level Activities (4) Facility Level Activities (1)
Unit Level Activities: Unit Level Activities are those activities which are performed each time a single
product or unit is produced. These activities are repetitive in nature. For example, direct labour hours,
machine hours, powers etc. are the activities used for each time for producing a single unit. Direct
materials and direct labour activities are also unit level activities, although they do not overhead costs.
Cost of unit level activity vary with the number of units produced. 514 A Textbook of Financial Cost and
Management Accounting (2) Batch Level Activity: These activities which are performed each time a
batch of products or group of identical products are produced. All the units of a particular batch are
uniform in nature and in size. The cost of batch level activities vary with the number of batches are
ascertained. Machine setups, inspections, production scheduling, materials handling are examples of
batch level activities which are related to batches. (3) Product Level Activities: These activities which are
performed to support the production of each different type of product. Maintenance of equipment,
engineering charges, testing routines, maintaining bills of materials etc. are the few examples of product
level activities. (4) Facility Level Activities: Facility Level Activities are those which are needed to sustain
a factory's general manufacturing process. These activities are common to a variety of products and are
most difficult to link to product specific activities. Factory management, maintenance, security, plant
depreciation are the few examples of facility level activities. Difference Between Activity-Based Costing
and Conventional Costing Activity-Based Costing (I) It begins with identifying activities and then to
producing the products (2) It mainly focuses on activities performed to produce products (3) Cost
Drivers used for identifying the factors that influence the cost of particular activity (4) Overhead costs
are assigned to Cost Centre or Cost Pools (5) Overhead costs are assigned to products using Cost Drivers
Rates (6) Variable overhead is appropriately identified to individual products (7) In ABC many activity
based on Cost Pools or Cost Centres are created (8) There is no need to allocate and redistribution of
overhead of service departments to production departments (9) It assumes that fixed overhead costs
vary in proportion to changes in the volume of output. Conventional Costing (or) Traditional Costing (1)
It begins with identifying cost and then to producing the products (2) It emphasises mainly on
ascertainment of costs after they have been incurred (3) Cost unit is used for allocation and
accumulation of costs (4) Overhead costs are assigned to production departments or service
departments (5) Overheads allocated on the basis of departmental overhead allocation rate (6) Costs
may be allocated or assigned either on actual cost incurred or on standard cost basis (7) Overheads are
pooled and collected department wise (8) The process of allocation and re-distribution of the costs of
the service departments to production department is essential to find out total cost of production (9) It
assumes that fixed overheads do not vary with changes in the volume of output. Activity-Based Costing
(ABC) 515 Advantages of Activity-Based Costing ABC system is a very valuable tool of control. It offers a
number of advantages to the management and the following are the main advantages : (I) It brings
accuracy and reliability of the costing data in determination of the cost of the products_ (2) It facilitates
cause and effect relationship to exercise effective cost control. (3) It provides necessary cost information
to the management to take decisions on any matter, relating to the business_ (4) It is much helpful in
fixing the cost and selling price of a product. (5) It facilitates overhead costs allocate directly to the
specific product. (6) It enables to manage the activities rather than costs. (7) It helps to remove all types
of wastages and inefficiencies. (8) It provides valuable information to evaluate on the relative
efficiencies of various plants and machinery. (9) Cost Driver Rates will help in significant impact on the
development of new products or modification of existing products. Essentials Factors of a Good Activity-
Based Costing System The success of the Activity-Based Costing system depends on the following
factors: (1) Objectives of costing system and level of competition. (2) Number of products
manufactured. (3) Product diversity and the business_ (4) Adaptation of cost management measures,
standardization and technical aspects. (5) Degree of sophistication and suitability to the firm. (6)
Determination of single or combined Cost Driver. (7) Determination number of Activity Centre, Cost
Pools and Cost Drivers. (8) Determin.ation of total overhead costs and economy. (9) Evaluation of trade
off between measurement of costs and cost of errors. (10) Elasticity and adoptive to the changing
circumstances. Illustration: 1 Indian pottery company is noted for a full line of quality products. The
company operates one of the plants in Mumbai. That plant produces two types of products: Indian
design A, and contemporary B, Rajan the president of the company, recently decided to change from a
volume-based costing system to an activity-based costing system. Before making the change company
wide he wanted to assess the effect on the product cost of the Mumbai plant. This plant was chosen
because it produces only two types of products, most other plants produced at least a dozen. To assess
the effect of the change, the following data have been gathered : 516 A Textbook of Financial Cost and
Managemelit Accounting Products Quantity Prime Cost Machine Hours Material Moves Setups Indian A
2,00,000 7,00,000 50,000 7,00,000 100 Contemporary B 50,000 1,50,000 12,500 1,00,000 50 Total Value
(Rs.) 8,50,000 2,50,000 3,00,000 15,000 Rs. 2,50,000 is the cost of maintenance of machine. Under the
current system, the cost of maintenance, material handling and setups are assigned to the products on
the basis of machine hours. Required (1) Compute the unit cost of each product using the current unit-
based approach. (2) Compute the unit cost of each product using an activity-based costing approach.
Solution: (1) Total overhead is Rs. 10,00,000. The plant wide rate is Rs. 16 per machine hour (Rs.
10,00,000 '"' 6,25,000) Overhead is assigned as follows : Indian A = Rs. 16 x 50,000 = Rs. 8,00,000
Contemporary B = Rs. 16 x 12,500 = Rs. 2,00,000 The unit costs for the two products are as follows :
Indian = Rs. 8,00,000 + 7,00,000 = Rs. 7.50 2,00,000 Rs. 2,00,000 + 1,50,000 Contemporary = = Rs. 7.00
50,000 (2) In the activity-based approach, the consumption ratios are different for all three overhead
activities, so overhead pools are formed for each activity. The overhead rates for each of these pools are
as follows : Rs. 2,50,000 Maintenance = :;: R3. 4 per hour 62,500 Rs. 3,00,000 Material handling = = Rs.
0.375 per move 8,00,000 Rs. 4,50,000 Setup = = Rs. 3,000 per setup 150 Overhead is assigned as follows.
: Indian A: Maintenance Material handling Setup Cost = Rs. 4 x 50,000 = Rs. 0.375 x 7,00,000 = Rs. 3000 x
100 Total Overhead = = = = Rs. 2,00,000 2,62,500 3,00,000 7,62,500 Activity-Based Costing (ABC)
Contemporary B : Maintenance Material handling Setup Costs = Rs. 4 x 12,500 = Rs. 0.375 x 1,00,000 =
Rs. 3000 x 50 Total Overhead This produces the following unit costs Indian A: Prime Cost Add : Total
Overhead Costs Total Costs Units Produced Rs. = 50,000 = 37,500 = 1,50,000 = 2,37,500 Rs. = 7,00,000 =
7,62,500 = 14,62,500 = 2,00,000 units Unit Cost = Rs. 14,62,500 2,00,000 = Rs. 7.31 per unit
Contemporary B : Prime Cost Add : Total Overhead Costs Total Costs Units Produced Unit Cost
Illustration: 2 = Rs. 3,87,500 50,000 Rs. = 1,50,000 = 2,37,500 = 3,87,500 = 50,000 units = Rs. 7.75 per
unit 5/7 Family store wants information about the profitability of individual product lines: Soft drinks,
Fresh Produce and Packaged food. Family store provides the following data for the year 2002-03 for
each product line : Particulars Soft Drinks Fresh Produce Packaged Food Revenues Rs. 7,93,500
Rs.21,00,600 Rs. 12,09,900 Cost of goods sold Rs. 6,00,000 Rs. 15,00,000 Rs. 9,00,000 Cost of bottles
returned Rs. 10,000 Rs. ° Rs.O Number of purchase orders placed 360 840 360 Number of deliveries
Received 300 2,190 660 Hours of shelf-stocking Time 540 5,400 2,700 Items sold 1,26,000 11,04,000
3,06,000 518 A Textbook of Financial Cost and Management Accounting Family store also provides the
following information for the year 2002-2003 Activity Description of Activity Total Cost Cost - allocation
Base Bottles returns Returning of empty-bottles to store Rs.12,ooO . Direct tracing to soft-drink line
Ordering Placing of orders for purchases Rs. 1.56,000 1,560 purchase orders Delivery Physical delivery
and receipt of goods Rs. 2,52,000 3,150 deliveries Shelf stocking Stocking of goods on store shelves } Rs.
1,72,800 8,640 hours of } and On-going restocking shelf-stocking time Customer support Assistance
provided to } customers including check-out Rs. 3,07,200 15,36,000 items sold Required (l)" Family store
currently allocates support cost (all costs other than cost of goods sold) to product lines on the basis of
cost of goods sold of each product line. Calculate the operating income and operating income as a % of
revenues for each product line. (2) If family store allocate support costs (all costs other than cost of
goods sold) to product lines using an Activity-Based Costing System, calculate the operating income as a
% of revenues for each product line. (3) Comment on your answers in requirement (1) and (2) rCA, May,
2003 J Solution: (i) Calculation of Operating Income and Operating Income as a % of revenues for each
product line : Particulars Soft Drinks Fresh Produce Packaged Foods Total Rs. Rs. Rs. Rs. Revenues
7,93,500 21,00,000 12,09,900 41,04,000 Cost of Goods Sold 6,00,000 15,00,000 9,00,000 30,00,000
Store Support Cost (30%) 1,80,000 4,50,000 2,70,000 9,00,000 Total Cost 7,80,000 19,50,000 11,70,000
39,00,000 Operating Income 13,500 1,50,600 39,900 2,04,000 Operating Income} as % of revenue 1.70%
7.17% 3.30% 4.97% (ii) The activity rates are as follows : Activity Cost Hierarchy Total Cost Qty. of Cost
Overhead Rs. Allocation Base Allocation Rate Ordering Batch Level 1,56,000 + 1,560 Purchase Orders =
Rs. 100 per order Delivery Batch Level 2,52,000 + 3,150 delivers = Rs. 80 per delivery Shelf Stocking
Output Unit Level 1,72,800 + 8,640 hours = Rs. 20 per hour Customer Support Output Unit Level
3,07,200 + 15,36,000 items sold = Rs. 0.20 per items sold Activity-Based Costing (ABC) 519 Cost
Allocation Statement Under Activity-Based Costing System Particulars Soft Drinks Fresh Produce
Packaged Foods Total Rs. Rs. Rs. Rs. Revenues (1) 7,93,500 21,00,000 12,09,900 41,04,000 Cost of goods
sold 6,00,000 15,00,000 9,00,000 30,00,000 Bottle - Return cost 12,000 - - 12,000 Ordering cost } 36,000
84,000 36,000 1,56,000 @ Rs. 100 (360 x 100) (840 x 1(0) (360 x 100) Delivery cost } 24,000 1,75,000
52,800 2,52,000 @ Rs. 80 (300 x 80) (2,190 x 80) (660 x 80) Shelf stock cost } 10,800 1,08,000 54,000
1,72,800 @ Rs. 20 (540 x 20) (5,400 x 80) (2700 x 20) Customer support cost } 25,200 2,20,800 61,200
3,07,200 @ Rs. 0.20 (1,26,000 x 0.20) (ll,04,OOO x 0.20) (3,06,000 x 0.20) Total Cost (2) 7,08,000
20,88,000 11,04,000 39,00,000 Operating Income } (1) - (2) 85,500 12,600 1,05,900 2,04,000 Operating
Income as % } of Revenue 10.78% 0.60% 8.75% 4.97% (iii) Managers believe the Activity-Based Cost
(ABC) system is more credible than the previous costing system. The ABC system distinguishes the
different type of activities at Family store more precisely. It also tracks more precisely how individual
product lines use resources. Soft drink consume less resources than either fresh produce or packaged
food. Soft drinks have fewer deliveries and require less Shelf-Stocking time. Managers of Family Stores
can use ABC information to guide their decisions, such as how to allocate a planned increase in floor
space. Pricing decisions can also be made in a more informed way with ABC information. Illustration: 3
Alpha Limited has decided to analyse the profitability of its few new customers. It buys bottled water at
Rs.90 per case and sells to retail customers at a list price of Rs.108 per case. The data pertaining to five
customers are : Particulars A B C D E Case Sold 4,680 19,688 1,36,800 71,550 8,775 List selling price
Rs.108 Rs.108 Rs.108 Rs.108 Rs.108 Actual selling price Rs.108 Rs.106.20 Rs.99 Rs.I04.4O Rs.97.20
Number of purchase Orders 15 25 30 25 30 Number of customer Visits 2 3 6 2 3 Number of Deliveries 10
30 60 40 20 Kilometers traveled Per delivery 20 6 5 10 30 Number of expedited Deliveries 0 0 0 0 1 520
Its five activities and their cost drivers are : Activity Order taking Customer visits Deliveries Product
handling Expedited deliveries A Textbook of Financial Cost and Management Accounting Cost Driver
Rate Rs. 750 per purchase order Rs. 600 per customer visit Rs. 5.75 per delivery k.m. travelled Rs. 3.75
per case sold Rs. 2,250 per expedited delivery Required (i) Compute the customer level operating
income of each of five retail customers now being examined (A,B,C,D, and E); comment on the results.
(ii) What insights are gained by reporting both the list selling price and the actual selling price for each
customer? (iii) What factors Alpha Ltd. should consider in deciding whether to drop one or more of five
customers? [CA, Nov. 2003J Solution: Particulars A B C D E Revenues at List Price 5,05,440 21,26,304
1,47,74,000 77,27,400 9,47,700 Less: Discount Nil 35,438 12,.31,200 2,57,580 94,770 Revenues at Actual
Price 5,05,440 20,90,866 1,35,43,200 74,69,820 8,52,930 Less : Cost of Goods sold at 4,21,200 17,71,920
1,23,12,000 64,39,500 7,89,750 Rs. 90 per unit Gross Margin (A) 84,240 3,18,946 12,31,200 10,30,320
63,180 Customer Level Operating Cost Order taking 11,250 18,750 22,500 18,750 22,500 @ Rs. 750 (750
x 15) (750 x 25) (750 x 30) (750 x 25) (750 x 30) Customer Visits @ Rs. 600 1,200 1,800 3,600 1,200 1,800
Delivery Vehicles (Rs. 5.75 per Km) 1,150 1,035 1,725 2,300 3,450 Product handling Rs. 3.75 per case
17,550 73,830 5,l3,ooo 2,68,3l3 32,906 Expected runs (Rs. 2250 per run) - - - - - Total Costs (B) 31,150
95,415 5,40,825 2,90,563 62,906 Customer Level Operating Income (A) - (B) 53,090 2,23,531 6,90,375
7,39,757 274 (i) Customer D is the most profitable customer, despite having only 52.30% of the unit
volume of customer C. A major exploitation is that customer C receives at Rs.9 discount per case while
customer D receives only at Rs.3.60 discount per case. Customer E is less profitable, in comparison with
the small customer A being profitable. Customer E received a discount of Rs.1D.80 per case, make more
frequent orders, requires more customer visits and requires more delivery kms, in comparison with
customer A. (ii) Separate reporting of both the listed selling price and the actual selling price enables
Alpha Ltd. to examine which customer receives different discount documents and how sales people may
differ in the discounts they grant. There is a size pattern in the discount across the 5 customers, except
for customer E. Activity-Based Costing (ABC) 52! Sales Volume Discount Per Case C 0,36,800 Cases)
12,31,200 1,36,800 = Rs.9 D (71,550 Cases) 2,57,580 71,550 = Rs.3.60 B (19,688 Cases) 35,438 19,688 =
Rs. 1.80 E (8,775 Cases) 94,770 8,775 = Rs.IO.80 A (4,680 Cases) 4,680 4,680 = Rs.O The reasons for the
Rs. 10.80 discount for customer E should be explored. (iii) Dropping customers should be the last resort
taken by Alpha Ltd. Factors to be considered include: What is the expected future profitability of each
customer? Are the currently unprofitable (E) or low profitable (A) customers likely to be highly profitable
in the future? What costs are avoidable if one or more customers are dropped? Can the relationship
with "problem" customers be restructured so that there is a 'win win' situation? QUESTIONS 1. What do
you understand by Activity-Based Costing? 2. What is meant by Cost Driver? Explain role of Cost Driver
in tracing costs to products. 3. Explain the stages in applying ABC in manufacturing company. 4. Explain
the difference between Activity-Based Costing and Traditional Costing System? 5. What are the
advantages of Activity-Based Costing? 6. What are the classification of activities? Explain it briefly. 7.
What are the factors to be considered while adopting ABC? DOD