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
Appear in the P&L in the
– Administrative expense period incurred.
– Sales expense
Traditional Costing Systems
• Product Costs
Direct labor and direct
– Direct labor materials are easy to
trace to products.
– Direct materials
The problem comes
– Factory Overhead 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 ofCost

100

50

0
1 2 3 4
Direct Material Labour 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 Costing Activity Based Costing
Expenses Resources Economic
Element

Work
Activities
Performed

Product or
Cost Objects Cost Objects
service
Tracing Cost to Activities
This step is to identify major activities that
cause/drive overhead costs to be incurred. Some
of the activities are related to production volume
(such asproduction runs, salary of supervisors and
so on) but others are not (such as
inspection /handling of materials, setting up
equipment and so on). The cost of resources
consumed in performing these activities are
grouped into cost pools.
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 preparing orders processes
purchase orders
Handling material Labour costs for workers handling material, Number of material
depreciation of equipment used to move material requisitions
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 packing Number of boxes
orders 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
ABCsystem.Three types of cost drivers are:
(I) Transaction
(II) Duration
(III) Intensity (Direct charging)
Tracing Costs from Activities to Products
Transaction Drivers
Transaction drivers are used to count the frequency ofan
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 Report
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 byeachproduct.
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

Resource Driver • any measure of the quantity of resources

consumed by activities

Activity Driver • any measure of the frequency and

intensity imposed by a cost object

Cost object • any customer, service, process that

requires a separate cost measurement
ABC Costs

Business Product
Process

CostPool-A CostPool-B CostPool-C

CostActivity CostActivity CostActivity

Resource
Driver
CostElement CostElement
ABC – When do we use it?
When one or more of the following conditions are
present:
Product lines differ in volume and
manufacturingcomplexity.
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 labor 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 ABCis 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.
Illustration – Traditional Costing System
Montex PenTotal and Product Profitability (Amt. in Rs.)
Blue Black Red Purple
Total
Particulars Pens Pens Pens Pens
(1) (2) (3) (4) (5)
Production/Sales volume 25,000 20,000 4,500 500 50,000

Unit sale price 45 45 46.5 49.5

Sales (a) 11,25,000 9,00,000 2,09,250 24,750 22,59,000

Material costs 3,75,000 3,00,000 70,200 8,250 7,53,450

Direct labour costs 1,50,000 1,20,000 27,000 3,000 3,00,000

Overheads (300% of Direct
4,50,000 3,60,000 81,000 9,000 9,00,000
Labour)
Total costs (b) 9,75,000 7,80,000 1,78,200 20,250 19,53,450
Total operating income
1,50,000 1,20,000 31,050 4,500 3,05,550
[(a) – (b)]
Return on sales (%) 13.3 13.3 14.8 18.2 13.5
Illustration – Activity Based Costing
Let us now do a step-wise cost allocation of overhead costs and prepare
ABC Products Profitability Report for the Montex Pen Manufacturing
Company as per data provided in previous example
(A) The total overheads (aggregating Rs 9,00,000) were comprised of the
following:
Expense category Expenses (Rs)
Indirect labour 3,00,000
Fringe benefits 2,40,000
Computer system expenses 1,50,000
Machinery 1,20,000
Maintenance 60,000
Energy 30,000
Total 9,00,000
Illustration – Activity Based Costing
Step 1
The activities and activity expenses of the Company are summarised below:

Cost driver Total

Overhead
Handle
Support
Run expenses
cost items production Set up machine (Rs.)
machines
runs products
Indirect labour and
50% 40% 10% — 4,20,000
1/2 fringe benefits
Computer expenses 80% — 20% — 1,50,000
Machine depreciation — — — 100% 1,20,000
Maintenance — — — 100% 60,000
Energy Activity — — — 100% 30,000
Expenses (Rs.) 3,30,0001 1,68,0002 72,0003 2,10,0004 7,80,000

1 (Rs 4,20,000 × 0.50) + (Rs 1,50,000 × 0.80) = Rs 2,10,000 + Rs 1,20,000 = Rs

3,30,000
2 (Rs 4,20,000 × 0.40) = Rs 1,68,000
3 (Rs 4,20,000 × 0.10) + (Rs 1,50,000 × 0.20) = Rs 42,000 + Rs 30,000 = Rs 72,000
4 (Rs 1,20,000 + Rs 60,000 + Rs 30,000) × 1.00 = Rs 2,10,000
Illustration – Activity Based Costing
Step 2
Products
Activity Cost Driver Blue Black Red Purple
Total@
Pens Pens Pens Pens
Direct labour-hour/unit 0.02 0.02 0.02 0.02 1,000

Machine-hour/unit 0.20 0.20 0.20 0.20 10,000

Production runs 70.00 65.00 50.00 15.00 200

Setup time/run 4.00 2.40 5.60 5.60 —

Total setup time (hour) 280.00 156.00 280.00 84.00 800

Number of products 1.00 1.00 1.00 1.00 4
@Total labour and machine-hours are obtained by multiplying the unit amounts
by the quantity of each type of pen sold, that is, 25,000 blue, 20,000 black, 4,500
red and 500 purple pens.
Illustration – Activity Based Costing
Step 3

The activity cost driver rates and the activity expenses assigned to products are
shown below:
Activity
Activity Activity cost cost Activity cost
Activity
expenses driver driver driver rate
quantity
Handle 3,30,000 Number of 200 Rs 1,650 per run
Production production
runs runs
Set up machines 1,68,000 Number of 800 Rs. 210 per setup
setup hours Hour
Support products 72,000 Number of 4 Rs. 18,000 per
products Product
Run machines 2,10,000 Number of 10,000 Rs. 21 per
machine-hours machine-hour
Total 7,80,000
Illustration – Activity Based Costing
Step 4
Activity Expenses Assigned to Products
Activity ACDR ACDQ Activity ACDQ Activity ACDQ Activity ACDQ Activity
for Exp.: for Exp.: for exp.: for Exp.:
Blue Blue Black Black Red Red purple Purple

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Handle
Production 1,650 70 1,15,500 65 1,07,250 50 82,500 15 24,750
Run

Setup
210 280 58,800 156 32,760 280 58,800 84 17,640
Machines

Support
18,000 1 18,000 1 18,000 1 18,000 1 18,000
Products

Run
2.10 5,000 1,05,000 4,000 84,000 900 18,900 100 210
Machines

Note: ACDR = Activity Cost Driver Rate; ACDQ = Activity Cost Driver Quantity
Illustration – Activity Based Costing
Exhibit 3 Activity-Based Costing Products Profitability Report
Black Purple
Particulars Blue Pens Red Pens Total
Pens Pens
Sales revenues 11,25,000 9,00,000 2,09,250 24,750 22,59,000
Material cost 3,75,000 3,00,000 70,200 8,250 7,53,450
Direct labour cost 1,50,000 1,20,000 27,000 3,000 3,00,000
Overheads:
50% fringe benefit on direct
60,000 48,000 10,800 1,200 1,20,000
labour
Handle production runs 1,15,500 1,07,250 82,500 24,750 3,30,000
Setup machines 58,800 32,760 58,800 17.640 1,68,000
Support products 18,000 18,000 18,000 18,000 72,000
Run machines 1,05,000 84,000 18,900 2,100 2,10,000
Total 3,57,300 2,90,010 1,89,000 63,690 9,00,000
Operating income 2,42,700 1,89,990 (76,950) (50,190) 3,05,500
Return on sales(%) 21.7 21.1 (36.8) (202.8) 13.5
QUESTIONS?