Module 11

ACTIVITY BASED COSTING

Dr. Varadraj Bapat

Activity Based Costing
(ABC)
2

•Concept of ABC
•Traditional Costing V/s ABC
•Treatment of cost under ABC
•Steps of ABC
•Benefits
•Limitations
•Activity Based Management: ABM
•Relation between ABC & ABM
Dr. Varadraj Bapat
Reasons to choose the
right way of costing
3

In business, arriving at the

correct cost is very important,
because it:
• identifies money-makers and
money losers;
• finds an economic break-even
point;
Dr. Varadraj Bapat
4

• facilitates opportunities for cost

control.
• permits comparison of different
options; and
• enables strategic decision
making.

Dr. Varadraj Bapat

The Concept of ABC
5

Activity-Based
Costing
Departmental
Overhead i ty
Rates ex
p l
o m
Plant-wide f C
Overhead lo e
v
Rate Le
Overhead Absorption
Dr. Varadraj Bapat
The Concept of ABC
6

Overhead Absorption
Departmental Department D1 OH
Overhead Rate = Overheads
Rates Apportioned /
Machine Hours

Plant-wide Plant OH Rate =

Overhead Overhead Cost /
Rate Machine Hours
Dr. Varadraj Bapat
 Introduction
7

 ABC is a costing system,

which focuses on activities
performed to produce
products.
 ABC relates cost (resources
consumed) to work
accomplished (outputs
produced).
Dr. Varadraj Bapat
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 ABC is a management tool that

provides better allocation of
resources.
 The ABC or unit cost goal is a
benchmark that represents an
expectation of the cost
incurred for the production of
an output.
Dr. Varadraj Bapat
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 ABC aligns costs to outputs

thereby increasing cost
visibility, and is useful in
forecasting financial
baselines.
Dr. Varadraj Bapat
 Traditional
Costing V/s ABC
10

ABC Traditional

Resources Everything in Resources

Organization

Consume Traced by Resource Allocate

Drivers
What is actually
Activities being done Cost Centre

Consume Traced by Activity

Drivers
-Products/Services - Products
Objects Objects
- Customers - Services
- Etc
 ABC’s Basic Premise
11

 Cost objects consume activities.

 Activities consume resources.

 This consumption of resources is

what drives costs.

 Understanding this relationship is

critical to successful budget

management.
Dr. Varadraj Bapat
 Treatment of
Costs under ABC
12

In ABC, products are assigned the

overhead costs that are supposed to
be related to the allocation base.
 Non-manufacturing costs

 Manufacturing costs

 Plant wide Overhead Rate

 Departmental Overhead Rates

 Costs of idle capacity

Dr. Varadraj Bapat

 ABC’s Basic Steps
13

1 . Analyze activities.
2 . Gather cost data.
3 . Trace costs to activities.
4 . Establish output measures.
5 . Analyze costs.

Dr. Varadraj Bapat

 ABC’s Basic Benefits
14

 Makes it possible to determine

production cost traced to
outputs.
 Targets areas needing
management attention.
 Encourages the consideration of
alternative methods of
production.
 Highlights operational efficiency.
Dr. Varadraj Bapat
15

 Identifies financial benchmarks

for activity performance.
 Generates more information to
measure and reward
performance, and prioritizes
activities for cost reductions.
 Provides a common managerial
framework among support
activities.
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 Limitations of ABC
16

 Trade-off between expense and

accuracy.
 Need for more precise data

 Need of full support of top level

management, and support of

ABC based performance review.
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 Cases of overstated costs and

under-stated margins and
mistakes in pricing and other
critical decisions.

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 18

Activity Based
Management
18

Activity based management involves

any use of ABC information to support
the organization’s strategy, improve
operations, or manage activities and
their resulting costs.

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 19

19

Activity Based Costing

establishes relationships between
overhead costs and activities so that
we can better allocate overhead
costs.
Activity-based management
focuses on managing activities to
reduce costs.
Dr. Varadraj Bapat
 20

Relation ABC and ABM

20

Cost Assignment View

Resource costs ABM

Process View
Activity Analysis Activity Evaluation

Root Activity Performance

Causes Triggers Measures
Activities

Cost Objects
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Eliminating non-
21
value added costs
using ABM

•Identifying Activities
•Identifying non-value added activities
•Understanding activity linkage, root
causes and triggers
•Establishing performance measures
•Reporting non value added costs
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 22

22

ABM seeks to satisfy

following customers needs
•Lower costs
•Higher quality
•Faster response time
•Greater innovation

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 23

23

Customer
Profitability Analysis

Customer profitability analysis

uses activity-based costing to
determine the activities, costs and,
profit associated with serving
particular customers.
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Customer Profitability
Analysis
24

A costly customer is one:

Demands
Orders faster
small service
quantities
Requires
special
packaging

Often
changes Orders
orders frequently

Dr. Varadraj Bapat