Activity-Based Costing Explained: Diving Deeper into Costs

Activity-based costing (ABC) is a method of assigning overhead and indirect costs to

products and services in a more accurate and nuanced way compared to traditional
methods. Instead of relying on a single factor like direct labour hours, ABC identifies
and analyses activities that drive these costs and then allocates them based on how
much each product or service consumes those activities.
Here's a breakdown of the key concepts:
Why ABC?
Traditional costing methods often struggle to accurately capture the true cost of
complex products and services, especially when they involve diverse production
processes and varying resource needs. By focusing on activities, ABC provides a
more realistic picture of cost drivers and helps businesses make better decisions.
How does it work?
The ABC process involves several steps:
1. Identifying Activities: Break down your operations into discrete activities,
such as design, setup, inspection, order processing, etc.
2. Costing Activities: Estimate the cost of each activity, considering resources
consumed (e.g., personnel time, materials, utilities).
3. Choosing Cost Drivers: Identify what triggers each activity (e.g., number of
setups, machine hours, inspection points).
4. Calculating Cost Driver Rates: Divide the cost of each activity by its chosen
cost driver to get a unit rate.
5. Assigning Costs to Products/Services: Track how much each
product/service consumes each activity (e.g., number of setups required,
inspection time) and multiply by the relevant cost driver rate to get its share of
the activity cost.
Benefits of ABC:
• Improved Cost Accuracy: More precise cost insights for better pricing,
product mix optimization, and profitability analysis.
• Strategic Decision Making: Identify cost-intensive activities for improvement
and cost reduction opportunities.
 • Customer Profitability Analysis: Understand the true profitability of different
customer segments.
• Process Improvement: Identify and target non-value-adding activities for
streamlining.
Challenges of ABC:
• Implementation Complexity: Requires careful activity identification, cost
estimation, and data tracking.
• Subjectivity: Choosing cost drivers and activity costing methods can involve
judgment calls.
• Cost-benefit Analysis: Implementation costs need to be weighed against the
potential benefits.
Is ABC right for you?
ABC is particularly valuable for businesses with:
• Diverse product or service offerings with varying complexity.
• Significant overhead costs.
• A need for accurate cost information for strategic decisions.
If you're unsure, consider a pilot project to evaluate the potential benefits and assess
the implementation effort before committing to a full-blown ABC system.

Illustration
M/s SPU is following Activity Based Costing. The budgeted overheads and cost driver
volumes are as under:
Cost Pool Budgeted Overheads
Material Procurement 1160000
Material Handling 500000
Maintenance 1940000
Set-up 830000
Quality Control 352000
Machinery 1440000
Cost Driver Budgeted Volume
No. of orders 2200
No. of movement 1360
 Maintenance Hours 16800
No. of Setups 1040
No of Inspection 1800
No of Machine Hours 48000

The company has produced a batch of 5200 units. Its material cost was Rs.260000 and labour cost
Rs.490000. Usage activities of the said batch are as follows:

Material Orders 52
Material movement 36
Maintenance Hours 1380
Set-ups 50
Quality Control inspections 56
Machine Hours 3600

Calculate:

1. Cost Driver Rate that are used for tracing appropriate amount of overheads to the said
batch.
2. The cost for the batch of output.