Activity Based Costing

(ABC)
Structure
1. Traditional Costing System
2. Need for Activity Based Costing System
3. History Behind Activity Based Costing System
4. ABC – What is it?
5. ABC – Who is involved in it?
6. ABC – When do we use it?
7. ABC – Objectives
8. Worked Example – Traditional Costing Vs ABC
9. ABC – Benefits and Limitations
Traditional Costing Systems
• Product Costs
Appear in the P&L when
– Direct labor goods are sold, prior to
that time they appear in
– Direct materials the balance sheet as
inventory.
– Factory Overhead
• Period Costs
– Administrative Appear in the P&L in the
period incurred.
expense
– Sales expense
Traditional Costing System
• Product Costs
– Direct labor Direct labor and direct
materials are easy to
– Direct materials trace to products.

– Factory Overhead The problem comes

with factory overhead.
• Period Costs
– Administrative
expense
– Sales expense
 Traditional Costing Systems

• Typically used one rate to allocate overhead to products.

• This rate was often based on direct labor cost or
direct labor hours.
• This made sense, as direct labor was a major cost driver in early
manufacturing plants.
• Manufacturing processes and the products they
produce are now more complex.
• This results in over-costing or under-costing.

– Complex products are not allocated an

adequate amount of overhead costs.
– Simple products get too much.
Need for ABC
Today’s businesses are working in an increasingly
complex environment.
Use of Advanced Technology

Product Life Cycle

Product Complexity

Channels of Distribution

Quality Requirements

Product Diversity
 Need for ABC
Composition of Cost

100

50

0
1 2 3
Direct Material 4Labour
Overheads
As the business grows overhead takes a larger pie in the total
cost of the product and hence it is important to charge it
accurately and more scientifically
History behind ABC
ABC became practiced in the early 1980’s but it has
really become a force in industry in the mid to late
1990’s
Most current approaches to ABC are based on
concepts developed by the Computer Aided
Manufacturing-International (CAM-I) Project
Since then ABC plans have been further
developed and diversified down to mid
and small size companies
ABC – What is it?
ABC is the Activity Based Cost
accounting method.
ABC focuses on identifying all
activities associated with making a
product or doing a process.
ABC – What is it? ….(contd.)
Activity = Cost

Identifying activities will yield a

total cost system.
 ABC – What is it?
ABC System is based on activities, linking spending on resources
to the products/services produced/delivered to customers. It uses
a two-stage overhead allocation:
(i) Tracing costs to activities
(ii) Tracing costs from activities to products/jobs

Conventional Activity Based

Costing Costing
Economi
Expenses Resources c
Element
Work
Activities
Performe
d
Product
Cost Objects Cost Objects
or
service
 Tracing Cost to Activities
Common Activities Associated Costs Cost Driver
Processing purchase Labour costs for workers determining order Number of purchase
order for materials quantities, contacting vendors, and orders processes
preparing purchase orders
Handling material Labour costs for workers handling material, Number of material
depreciation of equipment used to move requisitions
material
Inspecting incoming Labour costs for workers performing inspections, Number of receipts
material depreciation of equipment used to test strength
of materials, tolerances, etc.
Setting up equipment Labour costs for workers involved in setups, Number of setups
depreciation of equipment used to adjust
equipment
Producing goods using Depreciation on manufacturing equipment Number of machine-
manufacturing equip. hours
Supervising assembly Salary of assembly supervisors Number of assembly
workers labour-hours
Inspecting finished Labour cost for finished goods inspections, Number of
goods depreciation of equipment used to test whether inspections
finished goods meet customer specifications,
etc.
Packing customer Labour cost for packing workers, cost of Number of boxes
orders packing materials, etc. packed
 Tracing Costs from Activities to Products

The next step is to assign costs to products/jobs using cost drivers as a measure of
activity. Cost drivers represent the quantity of activities used to produce
individual products.
They identify the linkage between activities and cost objects and serve as
quantitative measures of the output of activities. In fact, they are the central
innovation of ABC system.Three types of cost drivers are:

(I) Transacti
(II) on
(III) Duration
Intensity
(Direct
Tracing Costs from Activities to Products

Transaction Drivers
Transaction drivers are used to count the frequency of an
activity/the number of times an activity is performed.

Duration Drivers
Duration drivers represents the amount of time
required to perform an activity.
Intensity Drivers
Intensity drivers are used to charge directly for
the resources used each time an activity is
performed.
Preparation of ABC product profitability report
Activity Cost Driver Rate
The next step is to compute the Activity Cost Driver
Rate (ACDR). The ACDR is the amount
determined dividing the activity expenses by
the total quantity of the activity cost driver.

Activity-Based Costing Products Profitability

Finally, ABC Products Profitability Report is prepared. It
combines activity expenses assigned to each product with their
direct (labour and material) costs.

The activity expenses assigned to a product is arrived at

multiplying the ACDR by the quantity of each activity cost driver
used by each product.
Who is involved in it?
Engineers
Accountants
Management
Factory workers
Supply Chain Management
personnel
Sales
……………….EVERYONE!
ABC
Terms
Activity • work performed within an
organization

Resource • financial input consumed by

activities
• any measure of the quantity of
Resource resources consumed by activities
• any measure of the frequency
Driver and intensity imposed by a
cost object
• any customer, service, process
Activity that requires a separate cost
measurement
Driver Cost
ABC
Costs
Business Produc
Process t

Cost Pool - Cost Pool - Cost Pool -

A B C

Cost Activity Cost Cost

Activity Activity Resource
Driver
Cost Cost
Element Element
 ABC – When do we use it?
When one or more of the following
conditions are present:
Product lines differ in volume and manufacturing
complexity.
Product lines are numerous and diverse, and they require
different degrees of support services.
Overhead costs constitute a significant portion of total
costs.
 ABC – When do we use it? …(contd.)
The manufacturing process or number of
products has changed significantly - for example, from
labour intensive to capital intensive automation.

Production or marketing managers are ignoring data

provided by the existing system and are instead using
“bootleg” costing data or other alternative data when
pricing or making other product decisions.
 ABC – Objectives
• The primary objective of ABC is to assign costs that
reflect / mirror the physical dynamics of the business
• Provides ways of assigning the costs of indirect support
resources to activities, business processes, customers,
products.
• 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.
 ABC– Benefits and Limitations
 More accurate and informative product
costs lead to better pricing decisions.
 The activities driving costs are
more accurately measured.
 Managers gain easier access to the
relevant costs.

An ABC system is very expensive

to develop and implement, and
very time-consuming to maintain.