Activity Based Costing:

A Basic Introduction
 Activity Based Costing: A Basic
Introduction

INTRODUCTION

Activity-based costing (ABC) is a costing model that identifies activities in an organization

and assigns the cost of each activity resource to all products and services according to the
actual consumption by each: it assigns more indirect costs (overhead) into direct costs.

In this way an organization can precisely estimate the cost of its individual products and
services for the purposes of identifying and eliminating those which are unprofitable and
lowering the prices of those which are overpriced.

In a business organization, the ABC methodology assigns an organization's resource costs

through activities to the products and services provided to its customers. It is generally used
as a tool for understanding product and customer cost and profitability. As such, ABC has
predominantly been used to support strategic decisions such as pricing, outsourcing and
identification and measurement of process improvement initiatives.

LITERATURE REVIEW

Traditionally cost accountants had arbitrarily added a broad percentage of expenses into the
indirect cost

However as the percentages of indirect or overhead costs had risen, this technique became
increasingly inaccurate because the indirect costs were not caused equally by all the
products. For example, one product might take more time in one expensive machine than
another product, but since the amount of direct labor and materials might be the same, the
additional cost for the use of the machine would not be recognized when the same broad
'on-cost' percentage is added to all products. Consequently, when multiple products share
common costs, there is a danger of one product subsidizing another.

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

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Md. Abul Hasnat
M.H. School of Business
Presidency University, Bangladesh
 Activity Based Costing: A Basic
Introduction
Robin Cooper and Robert S. Kaplan, proponents of the Balanced Scorecard, brought notice
to these concepts in a number of articles published in Harvard Business Review beginning in
1988. Cooper and Kaplan described ABC as an approach to solve the problems of traditional
cost management systems. These traditional costing systems are often unable to determine
accurately the actual costs of production and of the costs of related services. Consequently
managers were making decisions based on inaccurate data especially where there are
multiple products.

Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause
and affect relationships to objectively assign costs. Once costs of the activities have been
identified, the cost of each activity is attributed to each product to the extent that the
product uses the activity. In this way ABC often identifies areas of high overhead costs per
unit and so directs attention to finding ways to reduce the costs or to charge more for costly
products.

Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W. Burns as a
chapter in their book Accounting and Management: A Field Study Perspective.[2] They
initially focused on manufacturing industry where increasing technology and productivity
improvements have reduced the relative proportion of the direct costs of labor and
materials, but have increased relative proportion of indirect costs. For example, increased
automation has reduced labor, which is a direct cost, but has increased depreciation, which
is an indirect cost.

Like manufacturing industries, financial institutions also have diverse products and
customers which can cause cross-product cross-customer subsidies. Since personnel
expenses represent the largest single component of non-interest expense in financial
institutions, these costs must also be attributed more accurately to products and customers.
Activity based costing, even though originally developed for manufacturing, may even be a
more useful tool for doing this.

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M.H. School of Business
Presidency University, Bangladesh
 Activity Based Costing: A Basic
Introduction

METHODOLOGY

a. Cost allocation: Cost allocation is a process of attributing cost to particular cost

centers. For example the wage of the driver of the purchasing department can be
allocated to the purchasing department cost center. It is not necessary to share the
wage cost over several different cost centers. Cost and services are not
identical to each other.
b. Fixed cost: In economics, fixed costs are business expenses
that are not dependent on the activities of the business
they tend to be time-related, such as salaries or rents
being paid per month. This is in contrast to variable costs,
which are volume-related (and are paid per quantity).

In management accounting, fixed costs are defined as

expenses that do not change in proportion to the activity of a
business, within the relevant period. For example, a retailer must pay rent and utility
bills irrespective of sales.
c. Variable cost: Variable costs are expenses that change in proportion to the activity
of a business. In other words, variable cost is the sum of marginal costs. It can also
be considered normal costs. Along with fixed costs, variable costs make up the two
components of total cost. Direct Costs, however, are costs that can easily be
associated with a particular cost object. Not all variable costs are direct costs,
however; for example, variable manufacturing overhead costs are variable costs that
are not a direct costs, but indirect costs. Variable costs are sometimes called unit-
level costs as they vary with the number of units produced.

d. Cost driver: Cost Drivers are the structural causes of the cost of an activity
performed in the Value Chain. They determine the behavior of costs within an
activity.

A cost driver can be completely or partly or not at all under the control of a firm.

A firm's cost performance in all of its major discrete activities adds up to establish its
relative cost position.

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M.H. School of Business
Presidency University, Bangladesh
 Activity Based Costing: A Basic
Introduction
According to Michael Porter, there are 10 major cost drivers:

1. Economies or Diseconomies of Scale.

2. Learning and Spillovers. The cost of a value activity often declines over time due to
learning or improvements that increase its efficiency. Or due to knowledge acquired
from suppliers, consultants, former employees or reverse engineering.

3. Pattern of Capacity Utilization. Different ways of configuring a value activity will

affect its sensitivity for capacity (under)utilization.

4. Linkages. The cost of many value activities is affected by how other activities are
performed within the firm's own value chain or with the value chain of a supplier or
a channel ("Vertical Linkages"). Through combining these activities and their
linkages, their total cost can be reduced.

5. Interrelationships between business units within a firm in the form of shared

activities.

6. Vertical Integration. Doing more activities within the firm.

7. Timing, such as First Mover Advantage or Second Mover Advantage.

8. Discretionary Policies. The strategic choices a firm make, for example being a self-
service internet bank or being the fastest courier company.

9. Location. Geographic location where an activity is conducted and the prevailing costs
of personnel, materials, energy, etc.

10. Institutional Factors. Government regulation, tax regimes, financial incentives,

unionization, tariffs and levies, local content rules also affect the costs of a value
activity.

e. Cost driver rate: cost driver in a system of activity-based costing, any factor such as
number of units, number of transactions, or duration of transactions that drives the
costs arising from a particular activity. When such factors can be clearly identified
and measured.

Direct labor and materials are relatively easy to trace directly to products, but it is more
difficult to directly allocate indirect costs to products. Where products use common
resources differently, some sort of weighting is needed in the cost allocation process. The
measure of the use of a shared activity by each of the products is known as the cost driver.
For example, the cost of the activity of bank tellers can be ascribed to each product by

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M.H. School of Business
Presidency University, Bangladesh
 Activity Based Costing: A Basic
Introduction
measuring how long each product's transactions takes at the counter and then by
measuring the number of each type of transaction.

DIFFERENCE BETWEEN ABC AND TRADITIONAL COST ACCOUNTING

METHODS

So what is really the difference between ABC and traditional cost accounting methods?
Despite the enormous difference in performance, there are three major differences:

 In traditional cost accounting it is assumed that cost objects consume resources

whereas in ABC it is assumed that cost objects consume activities.
 Traditional cost accounting mostly utilizes volume related allocation bases while ABC
uses drivers at various levels.
 Traditional cost accounting is structure-oriented whereas ABC is process-oriented.
 Activity-based costing is a more accurate cost management system than TCA. One
would use the ABC method when overhead is high, products are diverse, cost of
errors high and competition is stiff.
 Traditional Cost Accounting is unable to calculate the 'true' cost of the product. TCA
arbitrarily allocates overhead to the costs of objects.
This is discussed in more detail in the subsequent sections and illustrated below. 

But first, the direction of the arrows are different because ABC brings detailed information
from the processes up to assess costs and manage capacity on many levels whereas
traditional cost accounting methods simply allocate costs, or capacity to be correct, down
onto the cost objects without considering any 'cause and effect' relations.

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M.H. School of Business
Presidency University, Bangladesh
 Activity Based Costing: A Basic
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Figure: Difference between ABC & Traditional Costing

Hence, we see that the traditional usage of fixed and variable costs is totally meaningless. In
ABC, all costs are included. However, ABC employs a different usage and definition of fixed
and variable costs.  A fixed activity cost is a cost that exists due to the very existence of the
activity whereas a variable activity cost changes as the output of the activity changes.  This
distinction is very helpful in various improvement efforts. 

Therefore, in Activity-Based Management (ABM)a third type of drivers is employed in

addition to the two aforementioned drivers. This type of drivers is called cost drivers and
they are the underlying causes of costs of activities and measured by non-financial
performance measures. Today, the most important of these measures can be presented in a
balanced scorecard and they represent the process view in ABM.  These are possibly the
most difficult drivers to identify. 

ACTIVITY-BASED MANAGEMENT
Activity-based management and activity-based costing (ABM/ABC) have brought about
radical change in cost management systems. ABM has grown largely out of the work of the
Texas-based Consortium for Advanced Manufacturing-International (CAM-I). The principles
and philosophies of activity-based thinking apply equally to service companies, government
agencies and process industries. Activity-based costing and activity-based management
have been around for more than fifteen years.

It is a one-off exercise which measures the cost and performance of activities, resources and
the objects which consume them in order to generate more accurate and meaningful
information for decision-making. ABM draws on ABC to provide management reporting and
decision making. ABM supports business excellence by providing information to facilitate
long-term strategic decisions about such things as product mix and sourcing. It allows
product designers to understand the impact of different designs on cost and flexibility and
then to modify their designs accordingly.

ABM also supports the quest for continuous improvement by allowing management to gain
new insights into activity performance by focusing attention on the sources of demand for
activities and by permitting management to create behavioral incentives to improve one or
more aspects of the business.

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M.H. School of Business
Presidency University, Bangladesh
 Activity Based Costing: A Basic
Introduction
 ABM is a fundamental shift in emphasis from traditional costing and performance
measurement. People undertake activities which consume resources – so controlling
activities allows you to control costs at their source.
 The real value and power of ABM comes from the knowledge and information that
leads to better decisions and the leverage it provides to measure improvement.
 ABM enables management to make informed decisions about lines of business,
product mix, process and product design, what services should be offered, capital
investments, and pricing.
 ABM is more than an accounting tool; it's a system for continuous improvements. It
is not a single answer but merely one of the many tools that can be used to enhance
organizational performance management.
 ABM will not reduce costs, it will only help you understand costs better to know
what to correct.
 The process of ABM does consume resources, and the manpower costs can be
significant.
 _ Other priorities, top management commitment,
 IT capabilities and integration with financial and budgeting systems should be
considered before implementation.
 Organizations have begun to look at ABM for a variety of reasons. Among the most
commonly cited are:
o top-down pressure to reduce costs;
o Competitive pressure/market conditions;
o organization-wide programmed;
o The introduction of benchmarking;
o Regulatory issues;
o Seeking world-class status through process management.

 ABC and ABM are a continuum of value. ABM is the application of ABC data to
manage product portfolios and business processes better.

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M.H. School of Business
Presidency University, Bangladesh
 Activity Based Costing: A Basic
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BENEFITS OF ACTIVITY-BASED COSTING

Typical benefits of Activity-Based Costing:

 Identify the most profitable customers, products and channels.

 Identify the least profitable customers, products and channels.

 Determine the true contributors to- and detractors from- financial performance.

 Accurately predict costs, profits and resources requirements associated with changes
in production volumes, organizational structure and costs of resources.

 Easily identify the root causes of poor financial performance.

 Track costs of activities and work processes.

 Equip managers with cost intelligence to stimulate improvements.

 Facilitate a better Marketing Mix

 Enhance the bargaining power with the customer.

 Achieve better Positioning of products

With the costing now based on activities, the cost of serving a customer can be ascertained
individually. Deducting the product cost and the cost to serve each customer, one can arrive
at customer's profitability. This method of dealing separately with the customer costs and
the product costs enables the identification of the profitability of each customer and
Positioning the products and services accordingly.

USES OF ACTIVITY BASED COSTING

It helps to identify inefficient products, departments and activities

It helps to allocate more resources on profitable products, departments and activities

It helps to control the costs at an individual level and on a departmental level

It helps to find unnecessary costs

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M.H. School of Business
Presidency University, Bangladesh
 Activity Based Costing: A Basic
Introduction

ACTIVITY BASED COSTING PRACTICE- BE CAUTIOUS

Even in activity-based costing, some overhead costs are difficult to assign to products and
customers, such as the chief executive's salary. These costs are termed 'business sustaining'
and are not assigned to products and customers because there is no meaningful method.
This lump of unallocated overhead costs must nevertheless be met by contributions from
each of the products, but it is not as large as the overhead costs before ABC is employed.

Although some may argue that costs untraceable to activities should be "arbitrarily
allocated" to products, it is important to realize that the only purpose of ABC is to provide
information to management. Therefore, there is no reason to assign any cost in an arbitrary
manner.

STEPS OF ACTIVITY BASED COSTING

Following an Example of Activity Based Costing Estimate

To get a better understanding of how an ABC estimate is developed, assume that it has been
asked to prepare a cost estimate for a site evaluation. To verify that there is no
contamination at the site, subsurface soil samples will have to be collected. The area of the
site is known, and the guideline for the number of samples per unit area has also been
given.

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M.H. School of Business
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 Activity Based Costing: A Basic
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Figure: Overhead Cost Analysis

Define activities, activity cost pools, and activity measures

Assume that the cost of supplying resources – personnel, supervision, information
technology, telecommunications, and occupancy − to perform these activities is
$500,000 per quarter. In building an ABC model for the customer service department,
the system designer asks employees to estimate the percentage of their time spent (or
that they expect to spend) on the three principal activities they perform. Suppose they
estimate these percentages as 80%, 5% and 15%, respectively. The ABC system designer
also learns that the actual (or estimated) quantities of work for the quarter in these
three activities are:

• 8,000 customer orders

• 250 customer complaints
• 550 credit checks

1. Assign overhead costs to activity cost pools

The system assigns the $500,000 resource cost to activities, based on the time
percentage, and calculates activity cost driver rates as shown below:

Overhead % Total
Customer
80% $ 400000
Orders
Customer
5% 25000
Complaints
Credit Checks 15% 75000
Total $ 500000

Table: Overhead Cost

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 Activity Based Costing: A Basic
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Figure: ABC System

2. Calculate activity rates

Activity Cost Activity Cost

Activity % Assigned Cost
Driver Quantity Driver Rate
Handle orders 80% $400,000 8,000 $ 50/order
Process
5% 25,000 250 $100/complaint
complaints
$136.36/credit
Check credit 15% 75,000 550
check
Total 100% $ 500,000

Table: Calculated Activity Rates

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M.H. School of Business
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 Activity Based Costing: A Basic
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The project team then uses the calculated activity cost driver rates to assign the expenses of
the three activities to individual customers based on the number of orders handled,
complaints processed, and credit checks performed for each customer.

MATHEMATICAL ILLUSTRATION

Returning to the numerical example, suppose that the analyst obtains estimates of the
following average unit times for the three customer-related activities:

Handle customer orders40 minutes

Process customer complaints110 minutes
Perform credit check 150 minutes

We can now simply calculate the activity cost driver rate for the three activities:

Activity Cost Driver Rate @

Activity
Unit Time (minutes) $0.80/minute

$ 32
Handle customer order 40

$88
Process customer complaint 110

$120
Perform credit check 150

Table: Calculate Activity Cost Driver Rates

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M.H. School of Business
Presidency University, Bangladesh
 Activity Based Costing: A Basic
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These rates are lower than those estimated before. The reason for this discrepancy
becomes obvious when we calculate the cost of performing these activities during the
recent quarter.

Activity Unit Time Quantity Total Minutes Total Cost

Handle
40 8000 320000 $ 256000
customer order
Process
customer 110 250 27500 22000
complaint
Perform credit
150 550 82500 66000
check
Total 430000 $ 344000
Table: Calculated Overhead Cost
The analysis reveals that only 78% of the practical capacity (430000/550,000) of the
resources supplied during the period was used for productive work (and hence only 78% of
the total expenses of $500,000 are assigned to customers during this period). The traditional
ABC system over-estimates the costs of performing activities because its distribution of
effort survey, while quite accurate − 80%, 5% and 15% of the productive work is the
approximate distribution across the three activities − incorporates both the costs of
resource capacity used and the costs of unused resources. By specifying the unit times to
14
perform each instance of the activity the organization gets both a more valid signal about
the cost and the underlying efficiency of each activity as well as the quantity (121,400 hours)
and cost ($97,120) of the unused capacity in the resources supplied to perform the activity.
With estimates of the cost of resource supply, the practical capacity of the resources
supplied, and the unit times for each activity performed by the resources, the reporting
system becomes quite simple for each period. Suppose the quantity of activities shifts, in
the subsequent period, to 10,200 orders handled, 230 customer complaints, and 540 credit
checks performed. During the period, the costs of each of the three activities are assigned
based on the standard rates, calculated at practical capacity: $32 per order, $88 per
complaint, and $120 per credit check. This calculation can be performed in real time to
assign customer administration costs to individual customers, as transactions from
customers occur.

The report at the end of the period is both simple and informative:

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M.H. School of Business
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 Activity Based Costing: A Basic
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Unit Total Total Cost

Activity Quantity Unit Cost
Time Time Assigned
Handle Customer 40 $ 32
10,200 408,000 $ 326,400
Orders
110 $88
Process Complaints 230 25300 20240

Perform Credit 150 $120

540 81,000 64800
Checks
TotalUsed 514300 $ 411440
Total Supplied 550,000 $500,000
Unused Capacity 35700 $ 88560
Table: Analysis Report

The report reveals the estimated time spent on the three activities, as well as the
resource costs required to handle the activity demands. It also highlights the difference
between capacity supplied (both quantity and cost) and the capacity used. Managers can
review the $88,560cost of the 35700minutes (595 hours) of unused capacity and
contemplate actions to reduce the supply of resources and the associated expense.
Rather than reduce currently unused capacity, managers may choose to reserve that
capacity for future growth. As managers contemplate new product introductions, expansion
into new markets, or just increases in product and customer demand, they can forecast how
much of the increased business can be handled by existing capacity, and where capacity
shortages are likely to arise that will require additional spending to handle the increased
demands. For example, the vice president of operations at Lewis-Goetz, a hose and belt
fabricator based in Pittsburgh, saw that one of his plants was operating at only 27% of
capacity. Rather than attempt to downsize the plant, he decided to maintain the capacity for
a large contract he expected to win later that year.

CONTINUOUS IMPROVEMENT
The implementation of ABC can make the employees understand the various costs involved.
This will then enable them to analyze the cost, and to identify the activities that add value
and those that do not add value. Finally, based on this, improvements can be implemented
and the benefits can be realized. This is a continuous improvement process in terms of
analyzing the cost, to reduce or eliminate the non-value added activities and to achieve an
overall efficiency.

ABC has helped enterprises in answering the market need for better quality products at
competitive prices. Analyzing the product profitability and customer profitability, the ABC
method has contributed effectively for the top management's decision making process.
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M.H. School of Business
Presidency University, Bangladesh
 Activity Based Costing: A Basic
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With ABC, enterprises are able to improve their efficiency and reduce the cost without
sacrificing the value for the customer. Many companies also use ABC as a basis for a
balanced scorecard.

This has also enabled enterprises to model the impact of cost reduction and subsequently
confirm the savings achieved. Overall, Activity Based Costing (ABC) is a dynamic method for
continuous improvement. With Activity Based Costing any enterprise can have a built-in
competitive cost advantage, so it can continuously add value to both its stakeholders and
customers.

The implementation of Activity Based Costing is not easy - not an ABC. Special activity based
costing software can be helpful.

CONCLUSION

Over the past 15 years, activity-based costing has enabled managers to see that not all
revenue is good revenue, and not all customers are profitable customers. Unfortunately, the
difficulties of implementing and maintaining traditional ABC systems have prevented
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Presidency University, Bangladesh
 Activity Based Costing: A Basic
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activity-based cost systems from being an effective, timely, and up-to-date management
tool. The time-driven ABC approach has overcome these difficulties. It offers managers a
methodology that has the following positive features:

 Easy and fast to implement

 Integrates well with data now available from recently installed ERP and CRM systems
 Inexpensive and fast to maintain and update
 Ability to scale to enterprise-wide models
 Easy to incorporates specific features for particular orders, processes, suppliers, and
customers
 More visibility to process efficiencies and capacity utilization
 Ability to forecast future resource demands based on predicted order quantities and
complexity

These characteristics enable activity-based costing to move from a complex, expensive

financial systems implementation to becoming a tool that provides meaningful and
actionable data, quickly and inexpensively, to managers.

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M.H. School of Business
Presidency University, Bangladesh
 Activity Based Costing: A Basic
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BIBLIOGRAPHY

Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study Perspective

(Harvard Business School Press, 1987).

Sapp, Richard, David Crawford and Steven Rebishcke, Journal of Bank Cost and Management
Accounting (Volume 3, Number 2), 1990, Journal of Bank Cost and Management
Accounting (Volume 4, Number 1), 1991.

David M. Katz, Activity-Based Costing (ABC).

Police Service National ABC Model Manual of Guidance Version 2.3 June 2007.

Sir Ronnie Flanagan, The Review of Policing Final Report, February 2008.

Tiffany Bradford, Types of Accounting Costing Systems, 2008

Weygandt / Kieso / Kimmel, Managerial Accounting (Second Edition)

jan@emblemsvag.com with questions or comments about this web site.

Copyright © 2000 Jan Emblemsvag

DR jake, mitchell; alan price (2003). Economics: Principles in action. Upper Saddle River,
New Jersey 07458: Pearson Prentice Hall.

DR Alex, Suleman. "A controversial-issues approach to enhance management accounting

education.".Journal of Accounting Education 1994.

Ali, H. F. "A multi-contribution activity-based income statement.”Journal of Cost

Management 1994.

Innes, J and Mitchell, F (1995), Activity-based costing in the UK's largest companies: a
survey, CIMA.
Innes J, and Norris, G (1997), The use of activity-based information: a managerial
perspective, CIMA.
‘Activity-based management’, Management Accounting Issues Paper 10, SMAC, 1995.

Statement of Management Accounting, NAA/IMA, 1998.

http://www.pitt.edu/~roztocki/abc/abc.htm ABM Internet website guide, by NarcyzRoztocki
of the Pittsburgh University. Comprehensive internet web links covering all areas of
ABM
http://www.pitt.edu/~roztocki/abc/abctutor/ Introduction to Activity-based Costing (ABC)
Internet ABC online presentation. University of Pittsburgh

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M.H. School of Business
Presidency University, Bangladesh