Activity Based Costing

In costing finding cost per unit is not the only objective but the way you calculate it matters the most. In order to calculate correct cost for a product or service we incur two costs direct & indirect. Direct cost can be easily identified with respective product or service but indirect cost have to be apportioned in some logical manner. For apportioning overheads we have two systems

1. Traditional Costing (Learnt in Overheads chapter)
2. Activity Based costing

In Overheads chapter i.e. traditional costing system, overhead costs are grouped together on the basis of cost center and then absorbed into product costs on the basis of direct labour hours, machine hours, volume etc. In majority cases this traditional costing system gives inaccurate cost information.

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.

The concepts of ABC were developed in the manufacturing sector of the United States during the 1970’s and 1980’s. During this time, the consortium for advanced manufacturing – International, now known as CAM-I, provided a formative role for studying and formalizing the principles that have become more formally known as Activity Based Costing.

ABC is developed due to many deficiencies of Traditional Cost systems which are as under:

• The Traditional costing system has developed convenient overhead recovery basis and blanket overhead recovery are acceptable when valuing stocks for financial reporting, but they are inappropriate when used for decision-making and typical product strategy decisions.
• It’s easy to determine accurate costs of products or services when a company has only a few products. When companies expand their product offerings and these products use different amount of resources such as supervision, quality control, etc. it is more difficult to determine accurate costs of products. This situation is a main reason why companies use ABC.
• Traditional costing fails to capture cause and effect relationships. If focused on the cost which is already 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.

Therefore, in order to overcome the inadequacies of traditional methods of overhead absorption, Activity Based Costing has been devised.

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.

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.’

“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.”

ABC has also been defined by CAM-1 organisation as,

“the collection of financial and operation performance information tracing the significant activities of the firm to product Costs”.

• Activity-based costing (ABC) is a two-stage product costing method that first assigns costs to activities and then allocates them to products based on the each product’s consumption of activities.
• The cost pools in the two-stage approach now accumulate activity-related costs.
• An activity is any discrete task that an organization undertakes to make or deliver a product or service.
• Activity-based costing is based on the concept that products consume activities and activities consume resources.
• Activity-based costing can be used by any organization that wants a better understanding of the costs of the goods and services it provides, including manufacturing, service, and even nonprofit organizations.

(i)      Activity – Activity means any event that incurs cost.

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

(iii)    A Cost Driver – It is a factor that causes a change in the cost of an activity. Example Production runs.

          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 effect relationship. Example Machine set-up.

Examples of Cost Drivers:

Cost Allocation under Traditional and Activity Based Costing system

Cost Allocation under Traditional and Activity Based Costing system

• 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 giving a more realistic picture of the way in which costs behave.

Activities basically fall into four different categories, known as the manufacturing cost hierarchy. These categories were first identified by Cooper in 1990 and help to determine the type of activity cost driver required. The categories are:

Activities basically fall into four different categories, known as the manufacturing cost hierarchy. These categories were first identified by Cooper in 1990 and help to determine the type of activity cost driver required. The categories are:

(1)     Identify the different activities within the organisation: In ABC the number of activities will depend on how the management subdivides the organization’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. 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 to cost products, as in traditional absorption costing, but it can also cost 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 diff amounts of each activity that each product/other cost object consumes.

(1)     Staff Training: Proper training of the workforce is critical to the successful implementation 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: Activity should be clearly defined. The problem must be kept manageable at early stage, despite the possibility of information overload from new data, much of which is in need of 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

The objectives of Activity Based Costing are as under:

1. To improve product costing and provide required information for decision making
2. To identify non-value adding activities in the production process which might be a suitable factor for attention or elimination?
3. To reduce the frivolous (nonessential) use of common resources
4. To encourage managers to evaluate the efficiency of internally provided services
5. To calculate the full cost of products for financial reporting purposes and for determining cost-based prices.

1. To link the cost to Cost Driver.
2. To identify costs of activities rather than cost centres.
3. To ascertain product costs with greater accuracy by relating overheads to activities.
4. To overcome the inherent limitations of traditional absorption costing and use of blanket overhead rates.
5. To assist managers in budgeting and performance measurement.
6. To provide the links between the activities, the organizational acts and the resources consumed and illustrate the differences between resource consumption and resource provision.
7. To help in cost control and cost reduction, as well as improved profitability.
8. To provide valuable economic information to support a company’s operational improvement and customer satisfaction programs.
9. To furnish many significant benefits over traditional costing techniques

(a) More potential for sensitivity analysis;

(b) Providing a model prospect on value-adding organizational transactions and activities.

The main limitations using Activity Based Costing are:

(i)      It is more expensive particularly in comparison with Traditional costing system.

(ii)     It is not helpful to small Organization.

(iii)    It may not be applied to organization with very limited products.

(iv)    Selection of most suitable cost driver may not be useful.

The need to measure more accurately how different products and services use resources has led companies such as American Express, Boeing, General Motors, and Exxon Mobil to refine their costing systems. One of the main ways companies around the globe have refined their costing systems is through activity based costing.