Activity Based Costing (ABC)

https://www.youtube.com/watch?v=ivlI0HvUPQo

Meaning of ABC:

The activity-based costing (ABC) system is a method of accounting you can use
to find the total cost of activities necessary to make a product. The ABC system
assigns costs to each activity that goes into production, such as workers
testing a product, setting up of machines, orders passed for purchase of raw
materials etc.

Activity based costing (ABC) is an accounting methodology that assigns costs to

activities rather than products or services. This enables resources and
overhead costs to be more accurately assigned to the products and the
services that consume them. ABC is a systematic, cause-and-effect method of
assigning the cost of activities of products, services, customers, or any cost
object. ABC is based on the principle that ‘products consume activities.’
Traditional cost systems allocate costs based on direct labour, material costs,
revenue or other simplistic methods. As a result, traditional systems tend to
over-cost high volume products, services, and customers; and under-cost low
volume.

KEY TAKEAWAYS

 Activity-based costing (ABC) is a method of assigning overhead and

indirect costs—such as salaries and utilities—to products and services.
 The ABC system of cost accounting is based on activities, which are
considered any event, unit of work, or task with a specific goal.
 An activity is a cost driver, such as purchase orders or machine setups.
 The cost driver rate, which is the cost pool total divided by cost driver, is
used to calculate the amount of overhead and indirect costs related to a
particular activity.

ABC is used to get a better grasp on costs, allowing companies to form a more
appropriate pricing strategy.
Definition of Cost Pool and Cost Driver

Cost pool: It is an aggregate of all the costs associated with performing a

particular business activity.

Cost driver: It is an activity that is the root cause of why a cost occurs. It must
be applicable and relevant to the event that is incurring a cost. A cost driver
assists with allocation expenses in a systematic manner that results in more
accurate calculations of the true costs of producing specific products.

Steps in ABC

• Identify which activities are necessary to create a product

• Separate each activity into its own cost pool
• Assign activity cost drivers to each cost pool
• Divide the total overhead in each cost pool by the total cost drivers to get
your cost driver rate
• Compute how many hours, parts, units, etc. that the activity used and
multiply it by the cost driver rate to find total cost
• Calculate Cost per Unit by dividing the Total Cost by Total Units produced.

Uses of ABC
• Identification of necessary activities: The ABC system shows how overhead is
used, which helps to determine whether certain activities are necessary for
production.
• Focus on Value adding activities: The Activity Based Costing helps the
management on focusing the forces on value adding activities and eliminate
non-value adding activities.
• Ensuring profit margin: The specific allocation of costs also helps to set prices
that produce a healthy small business profit margin.
• Product pricing: With an ABC system, the business can assign costs to each
activity in the production process, allowing it to more accurately set a price
that accounts for how much it costs to create a product.
• Measures to improve productivity: The accurate cost information helps the
management to adopt productivity improvement approaches like Total Quality
Management (TQM), Business Process Re-engineering (BPR) etc.
• Help in deciding Make or Buy: The management can take make or buy
decisions by considering the cost of manufacture of a product or sub contract
the same with an outside agency through Activity Based Costing analysis.
Distinguish between Traditional costing and ABC:

Activity-based costing is used in external finance, while traditional costing is

used in external reporting statements. Activity-based costing uses multiple
drivers for its operational requirements, while traditional costing uses an
identical cost driver for its operational requirements.

BASIS OF TRADITIONAL COSTING ACTIVITY BASED COSTING

DIFFERENCE
MEANING Traditional costing is the The Activity-Based Costing (ABC)
allocation of factory overhead tois a costing system, which
products based on the volume focuses on activities performed
of production resources to produce Products. ABC is that
consumed. costing in which costs are first
traced to activities and then to
products.
COST POOLS Traditional costing system ABC system accumulates costs
accumulates costs into facility- into activity cost pools. These are
wise or departmental cost pools. designed to correspond to major
The costs in each cost pool are activities or business processes.
heterogeneous- they are costs By design, the costs in each cost
of many major processes and pool are largely caused by single
generally are not caused by a factor- the cost driver.
single factor.
ALLOCATION Traditional systems allocate ABC system allocates costs to
BASES costs to products using volume- products, services and other cost
based allocation bases: units, objects from the activity cost
direct labor input, machine pools using allocation bases
hours, revenue etc. corresponding to the cost drivers
of activity costs.
HIERARCHY OF This costing generally estimates ABC allows for non- linearity of
COSTS all the costs of an organization costs within the organization by
as being driven by the volume of explicitly recognizing that some
product or service delivered. costs is not caused by the
number of units produced.
COST OBJECTS Traditional Costing focuses on ABC focuses on estimating the
estimating the cost of a single costs of many cost objects of
cost object i.e. unit of product or interest: units, batches, product
service. lines, business processes,
customers and suppliers.
DECISION Because of the inability to align Because of the ability to align
SUPPORT allocation bases with cost allocation bases with cost
drivers, leads to the problems of drivers, provides more accurate
 over casting and under casting
of costs.
COST Cost control is viewed as a
CONTROL departmental exercise rather
than a cross functional effort.
COSTING Traditional costing system is
SYSTEM relatively less expensive to
implement and maintain.
SUITABILITY Traditional costing is suitable for Activity based costing system is
labour intensive and low
overhead companies.
TYPES OF Only two types of activities viz.
ACTIVITIES Unit Level Activities and Facility manufacturing cost hierarchy viz.
Level Activities are identified.
OVERHEAD Overhead Rates can be used to
RATES ascertain cost of products only.
information to support
managerial decisions.
By providing summary costs of
the organizational activities, ABC
allows for prioritization of cost
management efforts.
ABC system is expensive to
implement and maintain.
suitable for capital-intensive,
product-diverse, widely diverse
set of operating activities,
variation in numbers of
production runs, high-overhead
companies.
All levels of activities in the
Unit Level, Batch Level, Product
Level and Facility Level are
identified.
Activity Cost Driver Rates can be
used to ascertain cost of
products and also cost of other
cost objects such as customer
segments, distribution channels.
etc.

Question: Amrit Company produces 3 products A, B and C. The company follows Activity Based
Costing system. Information related to various costs of these products for the last year:

Particulars A B C
Production and Sales (Units) 15000 12000 18000
Selling Price per unit (Rs.) 7.5 12 13
Raw material usage (Kg) p.u. 2 3 4
Direct Labour hours p.u. 0.1 0.15 0.2
Machine hours p.u. 0.5 0.7 0.9
No. of production runs p.a. 16 12 8
No. of purchase orders p.a. 24 28 42
No. of deliveries to retailers p.a. 48 60 32

The price of Raw materials remained constant through out the year at Rs.1.2 per kg and the labour
cost was Rs.14.8 per hour. The annual Overhead costs are as follows:
 Overheads Rs.
Machine set up costs 26550
Machine Running costs 66400
Procurement costs 48000
Delivery costs 54320

Solution:

Traditional method

a. Calculation of Total overhead

Overheads Rs.
Machine set up costs 26550
Machine Running costs 66400
Procurement costs 48000
Delivery costs 54320
Total 195270

b) Calculation of Overhead Absorption rate

Particulars A B C Total
Production volumes 15000 12000 18000
Labour hours p.u. 0.1 0.15 0.2
Total Labour hours 1500 1800 3600 6900

Overhead absorption rate = 195270/6900 = Rs.28.30 per hour.

c) Calculation of Cost p.u.

Particulars A B C
Raw Material Cost (Usage * Rs.1.20) 2.4 3.6 4.8
Direct Labour Cost (Labour hours * Rs. 14.80) 1.48 2.22 2.96
Overhead (Labour hours * 28.30) 2.83 4.25 5.66
CPU 6.71 10.07 13.42
ABC Method

a) Calculation of Overhead Absorption rate:

Cost Pool Rs. Cost Driver Rate of OH per

activity
Machine set up No of production 26550/36 =
costs 26550 runs p.a (16+12+18) = 36 runs 737.50 per run
Machine running No. of Machine (7500+8400+16200) 66400/32100 =
costs 66400 hours p.a = 32100 hours 2.0685 per hour
48000/94
Procurement No. of purchase (24+48+42)=94 =510.6383 per
costs 48000 orders p.a. orders order
No. of deliveries per (48+30+62) = 140 54320/140 = 388
Delivery costs 54320 retailers p.a. deliveries per delivery

# Total Machine hours p.a = Machine hours p.u * Total units produced
A = 0.5 * 15000 = 7500
B = 0.7 * 12000 = 8400
C = 0.9 * 18000 = 16200

b) Calculation of Cost p.u.

Particulars A B C
Material Cost 2.4 3.6 4.8
Labour cost 1.48 2.22 1.96
Overhead ##
Machine set up (737.50 * 16)/15000 (737.50 * 12)/12000 = (737.50 * 8)/18000 =
costs =0.7867 0.7375 0.3278
(2.0685 *
Machine running (2.0685 * 7500)/15000 (2.0685 * 8400)/12000 16200)/18000 =
costs = 1.034 = 1.4479 1.8616
Procurement (510.6383 * 24)/15000 (510.6383*28)/12000 = (510.6383*42)/18000
costs = 0.817 1.1915 = 1.1915
(388 * 48)/15000 = (388 * 30)/12000 = (388*62)/18000 =
Delivery costs 1.2416 0.97 1.3364
Total CPU 7.7593 10.1669 11.4773

## Overheads p.u. for products A, B and C

= (Overhead absorption rate* No. of cost drivers used by the individual products p.a.)/ No. of units
produced