Activity Based Costing

Dr. M.V.S. Kameshwar Rao

Associate Professor, IBS, Hyderabad
Activity Based Costing – ABC – What is it?
• A method of costing where the overhead costs are allocated to the
product or service based on the activities involved in producing the
product or service
• Need for this technique arised when
• Companies started manufacturing more than 1 product
• The Overhead Costs started occupying the major share of the cost of a product
• The products or services are not similar and there is customisation
• Overheads become a function of the complexity and uniqueness of the product
• It is the Cause and Effect principle that is used to cost a product or
service.
• The cost of a product or services is function of all the various activities
that go in to produce it
Merits and Limitations
• Merits:
• A more reliable basis for cost plus pricing
• Helps identify over priced and under priced products and services
• Helps Identify hidden cross subsidisation of products and services
• Does not load unutilised capacity costs onto the product or service
• Provides visibility to managers to manage and control costs
• Limitations:
• Time Consuming and expensive to lay down Activity Based Costing
• Identifying Cost Drivers for some costs like Insurance, Supervisor Salary,
Depreciation of Buildings etc
Steps in Establishing Activity Based Costing
• Identify the various activities undertaken in an organisation
• An activity is an event or unit or work with a purpose
• Create “Cost Pool” for each major Activity
• Allocate and Apportion all Indirect Expenses (Overhead Expenses) to
these Cost Pools and also direct costs attributable to the activity
• Determine “Cost Drivers” for each Activity
• Compute the Activity Cost Rate as “Activity Cost / The Intensity of the
Activity Cost Driver” Eg: Inspection Cost / No. of Inspections done
• Identify the activities required to product each product or service
• Identify the intensity of consumption of the activity by each product
• Absorb the cost of an activity into the final cost of the product or service
Traditional Costing (TC) Vs ABC
• TC – Aggregate Indirect Costs or Overheads are allocated to products or
services based on Volume production or number of service instances
• ABC – Computes costs of product or services by cumulating the cost of
activities that are consumed by each product or service
• TC - To a large extent all the products and services are treated
homogeneous for allocation of overheads.
• ABC – Each product or service is treated unique to absorb the overheads
• TC – Service Centre costs are allocated to production centres and finally
these costs are absorbed as production overheads
• ABC – Each product or service is mapped to the kind of service centre
tasks it consumes and the cost of service centre are directly assigned to
the cost of product without re-routing
Illustration Traditional Costing
• A company manufactures and sells two products A (25000 units) and B
(5000 units)
• Time required to produce each unit of A or B is 1 Hour
• Labour Cost for each unit of A or B is Rs.12 per unit. So Rs. 12 per hour
• Material Cost for A Rs.40 per unit and B is Rs.30 per unit
• Overheads total to Rs.9,00,000 for the entire year of operations.
• Overheads need to be absorbed based on the Direct Labour Cost i.e.
Rs.25,000 and Rs.5,000 = Rs.30,000
• Each unit of product produced will absorb Rs.30 as overheads
• So product A would Cost Rs.40 + Rs.12 + Rs.30 = Rs.82
• And product B would Cost Rs.30 + Rs.12 + Rs.30 = Rs.72
Illustration Contd....A B Costing
• Rs.9,00,000 of overheads are actuall incurred due to three activities
• Setting up Machines - Rs.3,00,000 – with 1500 set ups
• Machining – Rs. 5,00,000 – with 50,000 machine hours
• Inspecting – Rs.1,00,000 – with 2000 inspections
• Therefore the cost rate for each unit of activity can be arrived at as
• Setting Up = 3,00,000 / 1500 = Rs.200 per set up
• Machining = 5,00,000 / 50,000 = Rs.10 per machine hour
• Inspecting = 1,00,000 / 2000 = Rs.50 per inspection
• Product A requires 500 setups, 30,000 machine hours, and 500
inspections to produce 25,000 units
• Product B requires 1000 setups, 20,000 machine hours, and 1500
inspections to produce 5000 units
 Illustration Contd....A B Costing
Cost of Product A Activity Activity Total Annual Cost of Product B Activity Activity Total Annual
Consumed Cost Cost Consumed Cost Cost
Setting Up Machines 500 200 1,00,000 Setting Up Machines 1000 200 2,00,000
Machining 30000 10 3,00,000 Machining 20000 10 2,00,000
Inspection 500 50 25,000 Inspection 1500 50 75,000
Total Overhead 4,25,000 Total Overhead 4,75,000
Units Produced 25,000 Units Produced 5,000
Overhead Per Unit 17 Overhead Per Unit 95

Cost Component Product A Product B Product A Product B

ABC ABC TC TC
Raw Material per Unit 40 30 40 30
Labour per Unit 12 12 12 12
Overheads per Unit 17 95 30 30
Total Cost per Unit 69 137 82 72