ACTIVITY BASED COSTING

INTRODUCTION

Imagine, in a Bakery 100 unit of Standard Pineapple Cake is produced and 100 units of different varieties
of customized cakes are produced. The Cost of labour is AED 200. Now, if you want to calculate the
labour cost per unit according to traditional costing, itll come out to be 1 AED per unit. But, it takes
twice as much labour to produce customized cake than standard ones, this makes the calculation of per
unit labour cost of AED 1 wrong and which, in turn, affects the pricing of products, expansion or
reduction in output strategies. To overcome this drawback of traditional costing, a new technique of
calculating costs was introduced in late 80s known as Activity Based Costing.

An Approach to the costing and monitoring of activities which involve tracing resource
consumption and costing final outputs. Resources are assigned to activities, and activities to cost
objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to
output.

CIMA

Activity based Costing(ABC), is a method of assigning costs to a companys products and services on the
basis of resources that they consume. It identifies different transactions, duration and intensity that has
been put in production, which are then used to determine the cost of products and services. Following are
some of the features of Activity based costing and how it differs from the tradition costing method: -

Links resource expenses to the variety and complexity of products produced, not only the
physical volumes produced as was the case in traditional costing
Explains why different products having the same physical units of production have drastic
differences in their fixed costs, unlike in traditional costing.
Drives operating expenses to the activities that are indirectly involved in converting raw materials
into finished goods in addition to the traditional method of driving operating expenses to
activities that are directly involved in production.
Goal is to be approximately correct, rather than being precisely wrong, as are virtually all
traditional product costing systems.

ACTIVITY BASED COST IMPLEMENTATION

We combine all the costs, direct or indirect, incurred during production process, considering costs per
activity to calculate the total production cost of the product & service. There are basically five steps in
calculation of the total production cost as per ABC: -

Step 1: Activity Identification: The first step in ABC is to identify and group all activities in production
process together in activity pools. Activity pool are the supporting activities that tie into a product line or
service. These pools include fractionally assigned costs of supporting activities to individual products
during the 2nd step.

Step 2: Activity Analysis: In this step we continue with activity analysis i.e. identifying the processes
which support a product and excluding the inaccuracies of traditional costing.
Step 3: Assignment of costs: Bases on the findings of step 1 & 2, costs are assigned to an activity pool.
For example, machine setup costs would be assigned to indirect production costs or factory overheads.
These pools will each have some contribution to object costs.

Step 4: Calculate activity rates: Initial analysis may include direct labour hours, or machine setup time,
these activities must be assigned a value in real currency. All values and rates must be added in this step.
For example, Indirect labour hours should be in terms of wage rate.

Step 5: Assign costs to cost objects: Next step is to assign them to cost objects based on the activity
costs, pools and rates identified in the previous steps. Cost object is often a product for which the costs
are measured.

Where will activity based cost systems have the greatest impacts?

There are two most basic rules that help to guide the search for high potential ABC applications:

1) The Willie Sutton rule: This rules stresses on the need for a firm to look for areas with large
expenses in indirect and support resources, especially when these resources are growing
continuously. Operations where expenses are more than just direct labour and direct materials and
if they vary much with the changes in output, ABC costing would be the perfect fit for cost
measurement.
2) High Diversity: ABC would be essential in situations in which large variety exists in products,
customers, or processes.

ADDING VALUE WITH ACTIVITY BASED COSTING

Finance and operations managers can use Activity Based costing to support process improvement
initiatives in support of mission goals and objectives by enhancing their ability to perform the following:

1) Strategic Decision-Making: ABC helps manager to develop strategies and take effective
decisions. The decisions can be:
a) Setting objectives and mission based on process costs
b) Which product to focus more on, based on different costs incurred to produce them.
c) Changing process or methods of particular products that is incurring huge inappropriate costs

Some examples of strategies a manager can take on the based-on ABC: Cost reduction,
Product/Service pricing, Cost modelling, etc.

2) Operational Decision-Making: ABC helps managers to take important decision regarding

operations and production process. For example:
a) Identifying opportunities for process improvement
b) Measuring the cost and the performance Impact of process changes
c) Determining resources needed for business processes

Some examples of decisions a manager can take relating to operations: Output decisions, Stock
Valuation, etc.
 3) Planning and Budgeting: ABC helps manager to identify trends in activity costs over the years
which would help him in planning and making effective budgets. Planning and Budgeting
includes the following:
a) Identifying how changes to budget affects the costs of products and services
b) Forecasting resources needed for changes in program requirements
c) Improving reporting to stakeholders.

Some examples of plans that a manager can make based on ABC data: Customer profitability
analysis, New product/service design, etc.

ABC as cost control technique

Company-Pratt & Whitney

Year-2000

Annual Revenue-$602 million

Industry-Aircraft Manufacturing

Problem-Very high cost

P&W designs and produces small and medium gas turbine engines for business aircraft, helicopters,
regional transportation, military trainers, utility aircraft, auxiliary power units, and industrial and marine
applications. In five manufacturing plants they relied on traditional costing methods.

Implemented ABC

P&W costing team studied the routing of each parts as it passed through production cycle and assign the
costing according to the behavior of process-direct and indirect. Calculated individual cost for different
activities- sandblasting, drilling, deburring etc.

Overhead applied to sandblasting was based on number on hours of operation. Usage of sandblasting beads
to form grains of sand to almost BB size contributed far more to the cost than the operational hours. The
specific part being processed like pin, blade or washer strongly influenced bead usage. Overhead was
reapplied according to bead usage, and costs changed significantly.

In traditional costing, if a small part (Washer) and very large part (engine case) had same machine hours,
they would get same overhead. Here it was incorrectly burdening the washer with the same overhead as the
engine. Now, each part carries just the direct costs and overhead that are expended in making that part.

Development and depreciation costs are included in final costs.

To date, the costing team has completed the lowest costing level, the two parts plants in Halifax and
Montreal. ABC showed which machine are busy and underutilized.

http://www.3csoftware.com/clients/success-stories/success-story-pratt-whitney/