Title01 - ACTIVITY BASED COSTING (ABC)

ACTIVITY BASED COSTING (ABC)
Chp5
Objectives
• Understand about basic concepts of Activity
Based Costing (ABC) and its evolution and its
objectives.
• Know about difference between Traditional
Absorption Costing and Activity Based Costing.
• Understand about Cost drivers, its types.
• Understand about practical uses of Activity
Based costing.
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INTRODUCTION
• Activity based costing is a modern approach
which aims at rectifying the inaccurate cost
information.
MEANING OF ACTIVITY BASED COSTING
(ABC)
• CIMA defines Activity Based Costing as,
• ‘cost attribution to cost units on the basis of
benefit received from indirect activities e.g.
ordering, setting up, assuring quality.’
Features
• Activity-based costing (ABC) is a two-stage product
costing method.
• The cost pools in the two-stage
• An activity is any discrete task that an organization
undertakes.
• that products consume activities and activities
consume resources.
• a better understanding of the costs of the goods and
services it provides, including manufacturing,
service, and even nonprofit organizations
BASICS OF A B C
• ABC assigns costs to products by tracing
expenses to “activities”.
• Reflect/mirror the physical dynamics of the
business provides ways of assigning the costs
of indirect support resources to activities,
• It recognises that many organisational
resources are required not for physical
production of units of product but to provide a
broad array of support activities.
Relationship
EVOLUTION OF ACTIVITY BASED
COSTING SYSTEM
Evolution
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Deficiencies of Traditional Costing
convenient overhead recovery basis and blanket overhead recovery
inappropriate when used for decision-making and typical product strategy

decisions.
over the period many fixed costs become variable.
It’s easy to determine accurate costs of products or services
When companies expand their product offerings and these products use different
amount of resources
This situation is a main reason why companies use ABC.
Traditional costing fails to capture cause and effect relationships. If focused on the
cost incurred.
Traditional accounting was confined merely to furnish information at product level.
The new manufacturing technology demands the feedback of performance while

production is still in progress rather than history
DISTINCTION BETWEEN TRADITIONAL ABSORPTION COSTING
AND ACTIVIY BASED
COSTING
Traditional Absorption Costing Activity Based Costing
Overheads are first related to Overheads are first related to activities or
departments cost centres (Production and grouped into Cost Pools
Service Cost Centres)
Only two types of activities viz. Unit Level All levels of activities in the manufacturing
Activities and Facility Level Activities are cost hierarchy viz. Unit Level, Batch Level,
identified Product Level
and Facility Level are identified
This method relates overheads to cost This method relates overheads to the
centres i.e. locations. It is not realistic of causal factor
the behaviour of costs. i.e. driver. Thus, it is more realistic of cost
behaviour.
Overhead Rates can be used to ascertain Activity Cost Driver Rates can be used to
cost of ascertain cost of products and also cost of
products only. other cost objects such as customer
segments, distribution channels.
etc.
DISTINCTION BETWEEN TRADITIONAL
ABSORPTION COSTING AND ACTIVIY BASED
OBJECTIVES OF ACTIVITY BASED
COSTING
• To improve product costing
• To identify non-value adding activities in the
production process which might be a suitable focus for
attention or elimination
• To provide required information for decision making
• To reduce the frivolous (nonessential) use of common
resources
• To encourage managers to evaluate the efficiency of
internally provided services
• To calculate the full cost of products for financial
reporting purposes and for determining cost-
basedprices.
TERMINOLOGY OF ACTIVITY BASED
COSTING
Cost Object
It is an item for which cost measurement is
required e.g. Product, job or a customer
Cost Driver
• the allocation basis that
are used for applying
costs to services or
procedures are called
cost drivers
Unit level cost
• cost drivers were viewed only at the unit level.
Batch level cost
• Costs are caused by a group of things being
made, handled or processed at a single time
are referred to as batch level costs
Product-level cost
• A cost caused by the development, production
or acquisition of different items
Facility-level cost
• Some costs cannot be related to a particular
product line. These are instead related to
providing a facility.
Organizational-level cost:
• Certain costs are incurred at organizational
level for the single purpose of supporting
continuing facility operations.
Cost Pool
• Costs are grouped into pools according to the
activities, which drive them. In this all costs
associated with procurement i.e. ordering,
inspection, storing etc would be included in
this cost pool and cost driver identified
STAGES IN DEVELOPING ACTIVITY BASED
COSTING SYSTEM
IDENTIFY IDENT
RESOURCES ACTIVI
IDENTIFY
COST OBJECTS
IDENTIFY DETERMIN
COST OBJECTS (ACTIVITY) D
ASSIGN COSTS TO
DIFFERENT TYPES OF ACTIVITIES
• Activities comprise of units of work or tasks.
• .
Categories
Type of Activity Examples
Unit level activities: These are activities for which the Use of indirect
consumption of resources can be identified with the materials/consumables
number of units produced. It is performed each time a
unit is produced
Batch level activities: The costs of some activities are Material ordering, Inspection of
driven by the number of batches of units produced. Products
These are activities related to setting up of a batch or a
production run. It is performed each time a batch is
processed
Product level activities: The cost of some activiries are Designing the product, Producing
driven by the creation of a new product line and its parts specifications and keeping
maintenance. technical drawings of products.
Facility Level Activities: It must be carried out regardless Plant Security, Production
of which products are produced. These are activities Manager’s Salary and
necessary for sustaining the manufacturing process and Maintenance of buildings.
cannot be directly attributed to individual products
IMPORTANCE OF ACTIVITY BASED
COSTING (ABC)
To link the cost to its causal factor – i.e. the Cost Driver
To identify costs of activities rather than cost centres
To ascertain product costs with greater accuracy by relating overheads to activities
To overcome the inherent limitations of traditional absorption costing and use of blanket
overhead rates
To assist managers in budgeting and performance measurement
To provide the links between the activities, the organizational acts and the resources
consumed, and illustrate the differences between resource consumption and resource
provision
To help in cost control and cost reduction, as well as improved profitability.
To provide valuable economic information to support a company’s operational improvement and

customer satisfaction programs.
To furnish many significant benefits over traditional costing techniques
USES OF ACTIVITY BASED COSTING
Activity Customer Distributio
costs profitability n cost
Make or Minimum
buy
Margins price
Production
facility cost
LIMITATIONS OF ACTIVITY BASED
COSTING
Implementing an ABC system requires substantial resources, which is costly to maintain.
Activity Based Costing is a complex system which need lot of record for calculations.
traditional costing systems are often used in performance evaluations.
Activity based costing data can be easily misinterpreted
Reports generated by this systems do not conform to generally accepted accounting principles
(GAAP).
Illustration
Solution
Solution
Summary
• The Activity-Based Costing (ABC) is a costing system, which focuses on activities performed to produce
products. ABC is that costing in which costs are first traced to activities and then to products.
• ABC is developed due to many deficiencies of Traditional Cost systems.
• In traditional product costing system, costs are first traced not to activities but to an organizational unit,
such as
• department or plant and then to products.
• Cost driver is an activity which generate cost. Costs are grouped according to what drives them or causes
them to
• be incurred.
• A Cost Object: It is an item for which cost measurement is required e.g. Product , job or a customer.
• Cost drivers type of Pure Volume, Weighted Volume, Situational, Motivational.
• Cost pool is created for each activity and such activities are related with each type of product to determine
the cost of such product.
• Stages in developed ABC system as under:
• Identify resources
• Identify activities
• Identify cost objects
• Determine resource drivers
• Determine cost (activity) drivers
• Assign costs to the cost objects
References
• Cost and Management Accounting byRavi
Kishore,Taxmann’s 4th Edition.
• Cost Accounting by Dr. S.N Maheshwari,
Sultan.

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ACTIVITY BASED COSTING (ABC)

inappropriate when used for decision-making and typical product strategy

over the period many fixed costs become variable.

It’s easy to determine accurate costs of products or services

Traditional accounting was confined merely to furnish information at product level.

The new manufacturing technology demands the feedback of performance while

To identify costs of activities rather than cost centres

To ascertain product costs with greater accuracy by relating overheads to activities

To assist managers in budgeting and performance measurement

To provide valuable economic information to support a company’s operational improvement and

To furnish many significant benefits over traditional costing techniques

traditional costing systems are often used in performance evaluations.

Activity based costing data can be easily misinterpreted

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