Activity Based Costing

1. Introduction
2. Meaning and definition
3. Meaning of terms used in Activity Based Costing
4. Cost allocation under Activity Based Costing
5. Traditional absorption costing vs Activity Based Costing
6. Level of activities under Activity Based Costing methodology/cost hierarchy
7. Stages in Activity Based Costing
8. Advantages of Activity Based Costing
9. Limitations of Activity Based Costing
10. Requirements in Activity Based Costing implementation
11. Practical applications of Activity Based Costing
    
    

Overhead, in traditional costing system, overhead costs are grouped together under cost center and then absorbed into product costs on either of the basis such as direct labour hours, machine hours, volume etc. In certain cases, this traditional costing system gives inaccurate cost information. Though, it should not be assumed that all traditional absorption costing systems are not accurate enough to give adequate information for pricing purposes or other long-run management decision purposes. Some traditional systems treat overheads in a detailed way and relate them to service cost centres as well as production cost centres. The service centre overheads are then spread over the production cost centres before absorption rates are calculated.

The main cause of inaccuracy is in the calculation of the overhead rate itself, which is usually based on direct labour hours or machine hours. These rates assume that products that take longer to make, generate more overheads and so on.

Organisations, who do not wish to know how much it costs to make a product with precise accuracy, may be happy with traditional costing system. Others, however, fix their price on cost basis and need to determine it with reasonable accuracy. The latter organisations have been greatly benefitted from the development of activity based costing (ABC), which is considered as a modern absorption costing method, and was evolved to give more accurate product costs.

Various factors lead to the development of Activity Based Costing include:

1. Growing overhead costs because of increasingly automated production
2. Increasing market competition, which necessitated more accurate product costs.
3. Increasing product diversity to secure economies of scope & increased market share.
4. Decreasing costs of information processing because of continual improvements and increasing application of information technology.

Activity Based Costing is particularly needed by organisations for product costing in the following situations:

1. High amount of overhead: When production overheads are high and form significant costs, ABC is more useful than traditional costing system.
2. Wide range of products: ABC is most suitable, when, there is diversity in the product range or there are multiple products.
3. Presence of non-volume related activities: When non-volume related activities e.g. material handling, inspection set-up, are present significantly and traditional system cannot be applied, ABC is a superior and better option. ABC will identify non-value-adding activities in the production process that might be a suitable focus for attention or elimination.
4. Stiff competition: When the organisation is facing stiff competition and there is an urgent requirement to compute cost accurately and to fix the selling price according to the market situation, ABC is very useful. ABC can also facilitate in reducing cost by identifying non-value-adding activities in the production process that might be a suitable focus for attention or elimination.

Activity Based Costing is an accounting methodology that assigns costs to activities rather than products or services. This enables resources & overhead costs to be more accurately assigned to products & services that consume them. ABC is a technique which involves identification of cost with each cost driving activity and making it as the basis for apportionment of costs over different cost objects/ jobs/ products/ customers or services.

Activity Based Costing assigns cost to activities based on their use of resources. It then assigns cost to cost objects, such as products or customers, based on their use of activities. ABC can track the flow of activities in organization by creating a link between the activity (resource consumption) and the cost object.

CIMA defines ‘Activity Based Costing’ as “An approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs.”

(i) Activity – Activity, here, refers to an event that incurs cost.

(ii) Cost Object–It is an item for which cost measurement is required e.g. a product or a customer.

(iii) Cost Driver–It is a factor that causes a change in the cost of an activity. There are two categories of cost driver.

• Resource Cost Driver– It is a measure of the quantity of resources consumed by an activity. It is used to assign the cost of a resource to an activity or cost pool.
• Activity Cost Driver–It is a measure of the frequency and intensity of demand, placed on activities by cost objects. It is used to assign activity costs to cost objects.

(iv) Cost Pool-It represents a group of various individual cost items. It consists of costs that have same cause and effect relationship. Example machine set-up.

Business functions	Cost Driver
Research and Development	Number of research projects Personnel hours on a project
Design of products, services and procedures	Number of products in design Number of parts per product Number of engineering hours
Customer Service	Number of service calls Number of products serviced Hours spent on servicing products
Marketing	Number of advertisements Number of sales personnel Sales revenue
Distribution	Number of units distributed Number of customers

Under activity based cost allocation overheads are attributed to products on the activity base. Traditionally, overhead costs are grouped together under cost centre and then absorbed into product costs on some basis such as direct labour hours. Activity based costing identifies the activities which cause cost to be incurred and searches for fundamental cost drivers of these activities. Once the activities and there cost drivers have been identified this information can be used to assign overheads to cost objects (e.g. products) which have actually caused cost to be incurred.

 

In traditional absorption costing overheads are first related to cost centres (Production & Service Centres) and then to cost objects, i.e., products. In ABC overheads are related to activities or grouped into cost pools. Then they are related to the cost objects, e.g., products. The two processes are, therefore, very similar, but the first stage is different, as ABC uses activities instead of functional departments (cost centres). The problem with functional departments is that they tend to include a series of different activities, which incur a number of different costs that behave in different ways. Activities also tend to run across functions; for instance, procurement of materials often includes raising a requisition note in a manufacturing department or stores. It is not raised in the purchasing department where most procurement costs are incurred. Activity costs tend to behave in a similar way to each other i.e., they have the same cost driver. Therefore, ABC gives a more realistic picture of the way in which costs behave.

 

Activity Based Costing	Traditional Absorption Costing
Overheads are related to activities and grouped into activity cost pools.	Overheads are related to cost centers/departments.
Costs are related to activities and hence are more realistic.	Costs are related to cost centers and hence not realistic of cost behaviour.
Activity-wise cost drivers are determined.	Time (Hours) are assumed to be the only cost driver governing costs in all departments.
Activity-wise recovery rates are determined and there is no concept of a single overhead recovery rate.	Either multiple overhead recovery rates (for each department) or a single overhead recovery rate amy be determined for absorbing overheads.
Cost are assigned to cost objects, e.g. customers, products, services, departments, etc.	Costs are assigned to Cost Units i.e. to products or jobs or hours.
Essential activities can be simplified and unnecessary activities can be eliminated. Thus, the corresponding cost are also reduced/minimized. Hence Activity Based Costing aids cost control.	Cost centers/departments cannot be eliminated. Hence, not suitable for cost control.

 

The categories of activities are:

Level of Activities	Meaning	Example
Unit level activities	These are those activities for which the consumption of resources can be identified with the number of units produced.	The use of indirect materials/consumables tends to increase in proportion to the number of units produced. The inspection or testing of every item produced, if this was deemed necessary or, perhaps more likely, every 100th item produced.
Batch level activities	The activities such as setting up of a machine or processing a purchase order are performed each time a batch of goods is produced. The cost of batch related activities varies with number batches made, but is common (or fixed) for all units within the batch.	Material ordering -  where an order is placed for every batch of production Machine set-up costs-where machines need resetting between each different batch of production. Inspection of products where the first item in every batch is inspected rather than every 100th item quoted above.
Product level activities	These are the activities which are performed to support different products in product line.	Designing the product Producing parts specifications Keeping technical drawings of products up to date
Facilities level activities	These are the activities which cannot be directly attributed to individual products. These activities are necessary to sustain the manufacturing process and are common and joint to all products manufactured.	Maintenance of buildings Plant security

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The different stages in ABC calculations are listed below:

(1) Identify the different activities within the organisation: Usually the number of cost centres that a traditional overhead system uses is quite small, say up to fifteen. In ABC, the number of activities will be much more, say 200; the exact number will depend on how the management subdivides the organisation’s activities. It is possible to break the organisation down into many very small activities. But if ABC is to be acceptable as practical system it is necessary to use larger groupings, say, 40 activities may be used in practice. The additional number of activities over cost centres means that ABC should be more accurate than the traditional method regardless of anything else. Some activities may be listed as follows:-

• Production schedule changes
• Customer liaison
• Purchasing
• Production process set up
• Quality control
• Material handling
• Maintenance

(2) Relate the overheads to the activities, both support and primary, that caused them. This creates ‘cost pools’ or ‘cost buckets’. This will be done using resource cost drivers that reflect causality.

(3) Support activities are then spread across the primary activities on some suitable base, which reflects the use of the support activity. The base is the cost driver that is the measure of how the support activities are used.

(4) Determine the activity cost drivers that will be used to relate the overheads collected in the cost pools to the cost objects/products. This is based on the factor that drives the consumption of the activity. The question to ask is – what causes the activity to incur costs? In production scheduling, for example, the driver will probably be the number of batches ordered.

(5) Calculate activity cost driver rates for each activity, just as an overhead absorption rate would be calculated in the traditional system.

 

 

 

The activity driver rate can be used not only to identify cost of products, as in traditional absorption costing, but it can also be used for costing other cost objects such as customers/customer segments and distribution channels. The possibility of costing objects other than products is part of the benefit of ABC. The activity cost driver rates will be multiplied by the different amounts of each activity that each product/other cost object consumes.

 

Assume that a company makes widgets and the management decides to install an ABC system. The management decides that all overhead costs will have only three cost drivers viz. direct labour hours, machine hours and number of purchase orders. The general ledger of the company shows the following overhead costs –

General Ledger	Amount
Payroll taxes	1,000
Machine maintenance	500
Purchasing Dept. labour	4,000
Fringe Benefits	2,000
Purchasing Dept. Supplies	250
Equipment depreciation	750
Electricity	1,250
Unemployement insurance	1,500
Total	11,250

So, which overheads do you think are driven by direct labour hours?

 

The answer is

Payroll taxes	1,000
Fringe benefits	2,000
Unemployement insurance	1,500
Total	4,500

Similarly, overheads driven by machine hours include Machine maintenance, depreciation and Electricity totaling ` 2,500 and finally overheads driven by number of purchase orders include purchasing department labour and purchasing department supplies totaling ` 4,250.

Now, overhead rate is calculated by the formula

Total cost in the activity pool ÷ Base,

base being the total number of labour hours, machine hours and total number of purchase orders in the given case.

Assume that the total number of labour hours be 1,000 hours, machine hours be 250 hours and total purchase orders be 100 orders.

So, Cost driver rate would be

Cost Driver Rate	Amount
4,500/1,000	4.50 per labour hour
2,500/250	10 per machine hour
4,250/100	42.50 per purchase order

Now, let’s allocate the overheads between two widgets A and B the details of which are given below:

Particulars	Widget A	Widget B
Labour hours	400	600
Machine hours	100	150
Purchase orders	50	50

So, total overhead costs applied to widget A = (400×4.50) + (100×10) + (50×42.50) = ` 4,925

 

And total overheads applied to widget B = (600×4.50) + (150×10) + (50×42.50) = `6,325

So total overheads = ` 4,925 + ` 6,325 = ` 11,250.

Generally, in the traditional costing method, overheads are applied on the basis of direct labour hours (total 1,000 labour hours in the given case). So, in that case the overhead absorption rate would be – ` 11,250/ 1000 = ` 11.25 per hour and the total overheads applied to Widget A would have been = 400 × 11.25 = ` 4,500 and to Widget B = 600 ×11.25 = ` 6,750.

Hence Widget A would have been undervalued and Widget B overvalued by

` 425.

Some of the examples of cost drivers for different activity pools in a production department are stated below:

Activity Cost Pools	Related Cost Drivers
Ordering and Receiving Materials cost	Number of purchase orders
Setting up machines	Number of set ups
Machining costs	Machine hours
Assembling costs	Number of parts
Inspecting and testing costs	Number of tests
Painting costs	Number of parts
Supervising Costs	Direct labour hours

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8. ADVANTAGES OF ACTIVITY BASED COSTING

The main advantages of using Activity Based Costing are:

1. More accurate costing of products/services.
2. Overhead allocation is done on logical basis.
3. It enables better pricing policies by supplying accurate cost information.
4. Utilizes unit cost rather than just total cost
5. Help to identify non-value added activities which facilitates cost reduction.
6. It is helpful to the organizations with multiple products.
7. It highlights problem areas which require attention of the management.

The main limitations using Activity Based Costing are:

1. It is more expensive, particularly in comparison with traditional costing system.
2. It is not helpful to the small organizations.
3. It may not be applied to organizations with limited products.
4. Selection of the most suitable cost driver may not be easy/ may be difficult or complicated.

A number of distinct practical stages are required in the ABC implementation which are given as below:

1. Staff Training: The co-operation of the workforce is critical to the successful implementation of ABC. Staff training should be done to create an awareness on the purpose of ABC.
2. Process Specification: Informal, but structured interviews with key members of personnel will identify the different stages of the production process, the commitment of resources to each, processing times and bottlenecks.
3. Activity Definition: The activities must be defined clearly in the early stage in order to manage the problems, if any, effectively. There might be overloading of information from the new data, but the same is needed in codification.
4. Activity Driver Selection: Cost driver for each activity shall be selected.
5. Assigning Cost: A single representative activity driver can be used to assign costs from the activity pools to the cost objects.

 

ABC can act as a decision making tool in the following ways:

1. ABC along with some other cost management technique can be utilized to improve performance and profitability of an organization.
2. Wholesale distributors can gain significant advantage in the decision-making process through implementation of ABC concepts by correlating costs to various activities. Introduction of new product or vendor can be better decided through ABC.
3. ABC can assist in decisions related to facility and resource expansion. Often the basis for relocation or opening of a new distribution center is based on cost associations. Reduction in freight or other logistic costs can offset the expense of the new facility, staff or equipment. The ABC model can identify the specific cost elements being targeted, providing a much clearer picture which aids in management actions.
4. ABC augments decision support for human resources.. Since the activity (and therefore costs) can be associated to an individual, new levels of financial performance can be determined. This might be evident in the case of branch management or sales.
5. Companies who wish to determine price based on cost plus markup basis find ABC method of costing very relevant and are able to determine competitive prices for their products.

Meaning of Activity Based Management

The term Activity based management (ABM) is used to describe the cost management application of ABC. The use of ABC as a costing tool to manage costs at activity level is known as Activity Based  Cost  Management  (ABM). ABM is a discipline that focuses on the efficient and effective management of activities as the route to continuously improving the value received by customers. ABM utilizes cost information gathered through ABC.

 

The various types of analysis involved in ABM are as follows:

(1) Cost Driver Analysis: The factors that cause activities to be performed need to be identified in order to manage activity costs. Cost driver analysis identifies the causal factors.

1. Value-Added Activities (VA): The value-added activities are those activities which are indispensable in order to complete the process. The customers are usually willing to pay (in some way) for these services. For example, polishing furniture by a manufacturer dealing in furniture is a value added activity.
2. Non-Value-Added Activities (NVA): The NVA activity represents work that is not valued by the external or internal customer. NVA activities do not improve the quality or function of a product or service, but they can adversely affect costs and prices. Moving materials and machine set up for a production run are examples of NVA activities.

(3) Performance Analysis: Performance analysis involves the identification of appropriate measures to report the performance of activity centres or other organisational units, consistent with each unit’s goals and objectives.

Activity based management can be used in the following ways

1. Cost Reduction: ABM helps the organisation to identify costs against activities and to find opportunities to streamline or reduce the costs or eliminate the entire activity, especially if there is no value added.
2. Business Process Re-engineering: Business process re-engineering involves examining business processes and making substantial changes to how organisation currently operates. ABM is a powerful tool for measuring business performance, determining the cost of business output and is used as a means of identifying opportunities to improve process efficiency and effectiveness.
3. Benchmarking: Benchmarking is a process of comparing of ABC-derived activity costs of one segment of company with those of other segments. It requires uniformity in the definition of activities and measurement of their costs.
4. Performance Measurement: Many organisations are now focusing on activity performance as a means of facing competitors and managing costs by monitoring the efficiency and effectiveness of activities.

Activity based budgeting analyse the resource input or cost for each activity. It provides a framework for estimating the amount of resources required in accordance with the budgeted level of activity. Actual results can be compared with budgeted results to highlight both , in financial and non-financial terms, those activities with major discrepancies from budget for potential reduction in supply of resources. It is a planning and control system which seeks to support the objectives of continuous improvement. It means planning and controlling the expected activities of the organization to derive a cost-effective budget that meet forecast workload and agreed strategic goals. ABB is the reversing of the ABC process to

produce financial plans and budgets.

The three key elements of activity based budgeting are as follows:-

• Type of work to be done
• Quantity of work to be done
• Cost of work to be done

Few benefits of activity based budgeting are as follows:-