Practicality of

Activity Based
Costing over
Conventional
Methods Project Report

Management Accounting II

Aakriti Kakkar
Group 1
91001
Aditi Bindlish 91003
Ankita Maheshwari 91007
Gourab Kundu 91020
H. Sanchay Grover 91021
Neha Kasturia 91037

FMG XVIII A
FORE School of Management
 Practicality of Activity Based Costing over Conventional Methods

PREFACE

A
ctivity Based Costing (ABC) is an alternative to the traditional way of
accounting. Traditionally it is believed that high volume customers
are profitable customers, a loyal customer is also a profitable one,
and profits will follow a happy customer. Studies on customer profitability
have unveiled that the above is not necessarily true.

ABC is a costing model that identifies the cost pool, or activity centers, in an
organization and assign costs to products and services (cost drivers) based on
the number of events or transactions involved in the process of providing a
product or a service.

As a result, Activity Based Costing can support managers to see how to

maximize shareholder value and improve corporate performance.

Typical Benefits of Activity Based Costing include:

 Identifying the most and least profitable customers, products and

channels.
 Determine the true contributors to and detractors from financial
performance.
 Accurately predict costs, profits and resource requirements associated
with changes in production volumes, organizational structure and
resource costs.
 Easily identifying the root causes of poor performance.
 Track costs of activities and work processes.
 Equip managers with cost intelligence to drive improvements.
 Facilitate a better marketing mix.
 Enhance the bargaining power with the customer.
 Achieving better positioning of products

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 Practicality of Activity Based Costing over Conventional Methods

TABLE OF CONTENTS

1. Determination of Cost of Object 4

2. Conventional Method of Costing (Or Traditional

Absorption Costing) and the Evolution of ABC System
of Costing 5

3. ABC System of Costing 5

Characteristics of Activity Based Costing System

Advantages of an Activity Based Costing System

Uses of Activity Based Costing Systems

The Activity Based Costing Procedures

4. Case Study: Major Ltd. 9

5. Case Study: Banking Institutions 12

6. When Is Activity-Based Costing Appropriate? 15

7. Activity Based Costing System, The Way Ahead. . . 15

8. Disadvantages of an Activity Based Costing System 16

9. Time Based Activity Based Costing System 16

10. Appendix 17

11. References 18

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1 DETERMINATION OF COST OF OBJECT

The cost of production of a product or batch or job, in simple terms may be
obtained in the following manner:

PARTICULARS AMOUNT (Rs)

Direct Material XXX
Direct Labour XXX
Overheads XXX
TOTAL COST XXX

Having listed the above costs, let us discuss them in detail:

(i) Direct costs:

Expenses that can be traced directly to (or identified with) a specific cost
center or cost object such as a department, process, or product are called
direct costs.

Direct costs (such as for labor, material, fuel or power) vary with the rate of
output but are uniform for each unit of production, and are usually under
the control and responsibility of the department manager.

(ii) Indirect Costs:

Expenses (such as for advertising, computing, maintenance, security,

supervision) incurred in joint usage and, therefore, difficult to assign to or
identify with a specific cost object or cost center (department, function,
program) are called indirect costs. Indirect costs are usually constant for a
wide range of output, and are grouped under fixed costs.

Based on their functions, they may be grouped as:

 Production or Works Overheads

 Administration Overheads
 Selling overheads
 Distribution Overheads

It is in reference to the apportionment and absorption of the overhead costs to

the type of products produced, that we have to discuss as to whether the ABC
system of costing is more practical than the conventional method or not.

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 Practicality of Activity Based Costing over Conventional Methods

2 CONVENTIONAL METHOD OF COSTING (OR

TRADITIONAL ABSORPTION COSTING) AND
THE EVOLUTION OF ABC SYSTEM OF
COSTING

Under the traditional absorption costing system, cost accountants had arbitrarily
charged a broad percentage of expenses into the direct costs (of the direct costs)
to allow for the indirect costs or overheads.

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 an 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.

As a result, these traditional costing systems were 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 were multiple products. Moreover where multiple products shared
common costs, there arose a danger of one product subsidizing another.

Keeping in view the limitations of the above method, 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.

3 ABC SYSTEM OF COSTING

Robin Cooper and Robert S. Kaplan described ABC as an approach to solve the
problems of traditional cost management systems.

Traditional costing systems have a tendency to assign indirect costs based on

something easy to identify (such as direct labor hours). This method of assigning
costs can be very inaccurate, as there is not necessarily a relationship between the
costs that are being assigned, and the activity they are being assigned to. This can
make evaluating costs tricky and inaccurate.

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 Practicality of Activity Based Costing over Conventional Methods

The Chartered Institute of Management Accountants (CIMA) London, defines it

as “a technique of cost attribution to cost units on the basis of benefits received
from indirect activities, e.g., ordering, setting up, assuring quality.”

Activity-based costing, simply put, is a process where costs are assigned due to the
cause and effect relationship between costs and the activities that drive 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. ABC is a method that measures cost of a Product/Service, based on the
activities performed to produce the product / service. An Activity is an event, task
or unit of work with a specified purpose.

For example:
 Designing products
 Setting up machines
 Operating machines
 Distributing products
 Administer Processes

Characteristics of Activity Based Costing System

 It increases the number of cost pools used to accumulate overhead costs.
The number of pools depends upon the cost driving activities. Thus, instead
of accumulating overhead costs-in a single company-wise pool or
departmental pool, the costs are accumulated by activities.

 It charges overhead costs to different jobs or products in proportion to the

cost riving activities in place of a blanket rate based on direct labour cost or
direct labour hors or machine hours.

 It improves the traceability of the overhead costs which results in more

accurate unit cost data for management.

 Identification of cost during activities and their causes not only help in
computation of more accurate cost of a product or a job but also eliminate
non value added activities. The elimination of non value added activities
would drive down the cost of the product.

Advantages of an Activity Based Costing System

 The first and most important advantage is the accuracy in the process of
costing with regards to the product line, the end-users of the product, the
stock-keeping units employed by the management and the channel and

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 Practicality of Activity Based Costing over Conventional Methods

category which streamline the flow of the product from the producer to the
end user.

 This system better assists in the process of understanding the concept of

overhead costs i.e. the allocation of common business resources as they are
used by specific product lines and their relation to specific cost driver.

 The system is easy to understand and interpret is it is accessible, useable

and practically implement able across all norms of business set-ups.

 This process uses unitary cost, or marginal cost as the computation base in
contrast to the traditional cost accounting methods which employ total
cost.

 The system works exceptionally well will quality improvement and up

gradation programs e.g. Six Sigma

 This system is particularly helpful in identifying and ear-marking some of

the matters business activities which are a burden or stress on the business
i.e. wasteful or non value adding services.

 The system also works exceptionally with performance management systems

which are employed by most human resource departments in contemporary
businesses.

 This process allows companies to implement costing strategies across

another diagonal of the firm as business processes, supply chains and value
addition channels are ably and optimally analyzed in this process.

 This system mimics the actual business process as the appropriation of

common pool resources takes place in the same way as common resources
are used in the business.

 This system aids in the process of benchmarking which is an integral part of

he quality control system.

Uses of Activity Based Costing Systems

 It helps to identify inefficient product, department and activity

 It helps to allocate more resources on profitable product, department and

activity

 It helps to control the cost at individual level and on departmental level

 It helps to find unnecessary costs

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 Practicality of Activity Based Costing over Conventional Methods

The Activity Based Costing Procedures

Activity-based costing can be more complicated to set up and operate than
other costing systems. Generally, the process is devised somewhat in the
following manner:

 All activities that use resources are identified

 Cost pools are set up for each of the activities identified
 Overhead costs are assigned to the cost pools based on a cost driver
 A cost driver is an activity that has a proven cause and effect relationship
with the costs associated with the cost pool.
 Cost drivers can be based off of resources or activities
 Only if a cost driver cannot be recognized will a cost be assigned on an
allocation basis
 Related cost pools are assigned an overhead rate based on cost drivers
 Cost pools are used to assign costs; the basis depends on the company and
industry
 Costs can then be assigned to units, batches, or products
 These pools can be combined to look at facility, division, or other levels of
cost categories
 Costs can then be evaluated to see where and how costs are occurring, from
that point management can discern what costs are controllable and how
they arise.

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 Practicality of Activity Based Costing over Conventional Methods

4 CASE STUDY: MAJOR LTD.

Major Ltd. manufactures two products A and B. The product A is a
low volume item and its sales are only 5, 000 units per annum. The
product B is a high-volume item and sales are 20, 000 units per
annum. Both products require two direct labour hours for
completion.

The company works 50, 000 direct labour hours each year as given below:

PRODUCT PARTICULARTS HOURS

PRODUCT A 5, 000 units x 2 hours 10, 000
PRODUCT B 20, 000 units x 2 hours 40, 000
TOTAL 50, 000

Material and labour costs for each product (per unit) are given below:

DESCRIPTION PRODUCT A PRODUCT B

DIRECT MATERIALS 25 15
DIRECT LABOUR (at Rs 5
10 10
per hour)

The company’s total manufacturing overhead costs are Rs 8,75, 000 per annum.
The company has analysed its operations and has determined that five activities
act as cost drivers in the incurrence of overhead costs.

Data relating to the five activities are given below:

TRACEABLE NUMBER OF EVENTS OR TRANSACTIONS

ACTIVITY
COSTS TOTAL PRODUCT A PRODUCT B
Machine
2,30,000 5,000 3,000 2, 000
setups
Quality
1,60, 000 8,0000 5, 000 3, 000
inspections
Production
81,000 600 200 400
orders
Machine-hours
3,14,000 40,000 12,000 28, 000
worked
Material
90,000 750 150 600
receipts

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 Practicality of Activity Based Costing over Conventional Methods

Total 875,000
COMPUTATION OF PER UNIT COST

I. Computation of product cost using Direct Labour Hour rate method

for absorption of overhead costs

Manufactring Overhead costs = 8,75,000

Direct Labour Hours 50,000

= Rs 17.50 per hour

Using this rate, the cost to manufacture each of the products is given below:

PRODUCT A (Rs.) PRODUCT B (Rs.)

Direct materials 25 15
Direct Labour 10 10

Manufacturing Overheads
35 35
(2 x Rs.17.50)

Total cost to manufacture 70 60

II. Computation of product cost using Activity Based Costing

(A) OVERHEAD RATES BY ACTIVITY

NUMBER OF
TRACEABLE COSTS RATE PER EVENT
ACTIVITY EVENTS OR
(Rs) OR TRANSACTION
TRANSACTIONS
Machine setups 2,30,000 5,000 Rs 46 per set up
Rs 20 per
Quality inspections 1,60, 000 8,0000
inspection
Production orders 81,000 600 Rs 135 per order

Machine-hours
3,14,000 40,000 Rs 7.85 per hour
worked

Material receipts 90,000 750 Rs 120 per receipt

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 Practicality of Activity Based Costing over Conventional Methods

(B) OVERHEAD COST PER UNIT OF PRODUCT

PRODUCT A PRODUCT B
PARTICULARS Events or Events or
Amount (Rs) Amount (Rs)
transactions transactions
Machine setups (at
3,000 1,38,000 2, 000 92,000
Rs 46 per setup)
Quality inspections
(at Rs 20 per 5, 000 1,00,000 3, 000 60,000
inspection)
Production orders
200 27,000 400 54,000
(at Rs 135 per order)
Machine-hours
worked (at Rs 7.85 12,000 94,200 28, 000 2,19,800
per hour)
Material receipts (at
150 18,000 600 72,000
Rs 120 per receipt)
Total overhead cost
3,77,200 4,97,800
assigned (a)
Number of units
5,000 20,000
produced (b)
Overhead cost per
75.44 24.89
unit (a)/(b)

(C) COMPUTATION OF TOTAL COSTS OF PRODUCTS

ACTIVITY BASE DIRECT LABOUR BASE

PARTICULARS
Product A Product B Product A Product B
Direct Material 25 15 25 15
Direct Labour 10 10 10 10
Manufacturing
75.44 24.89 35 35
Overheads (Rs.)
Total cost of
110.44 49.89 70 60
manufacture (Rs.)

The analysis shows that in case a company adopts direct labour rate method for
absorption of overhead costs, the amount of overheads charged would be Rs 35 per
unit for each product. In other words, the overhead cost is the same for both the
products in spite of the fact that they have widely different cost driving activities.

For instance the company recorded 5,000 machine setups during the year of which
3000 setups were traceable to product A and 2,000 to product B. It is therefore
appropriate to use activity based costing for charging overhead costs to prevent
any distortions in assigning costs to products.

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 Practicality of Activity Based Costing over Conventional Methods

The statement for product shows that product A is undercharged

5
and product B is overcharged as per traditional costing systems.
CASE STUDY: BANKING INSTITUTIONS

Like manufacturing industries, financial institutions also have

diverse products and customers which can cause cross-product
cross-customer subsidies. Activity based costing, even though
originally developed for manufacturing, may even be a more useful
tool by which costs can be attributed more accurately to products
and customers.

Suppose a small bank has an Administration Department which serves two main
departments i.e. Investment Department and Loan Department. Traditionally,
all costs incurred in Administration Department are distributed between the
beneficiaries according to number of employees.

COST INCURRED ACTIVITIES NUMBER Amount (Rs)

PERFORMED

STAFF SALARIES RECRUITMENTS 12 60,000

COMPUTER HANDLING COURT 4 50,000

CASES

BUILDING RENT EMPLOYMENT 500 45,000

RECORDS

MISCELLANEOUS 15,000

TOTAL 170,000

Now we need to find out cost of each activity. This would be ascertained on the
following basis:

A study was conducted to find out cost per job. It was observed that, in terms of
rupees, staff and computer time was Rs. 2,000 and Rs. 1,500 respectively per job.

Some expenses were directly traced as under:

 Staff salaries included a sum of Rs.30, 000 for court cases.

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 Practicality of Activity Based Costing over Conventional Methods

 Time Sheet shows that a sum of Rs.10, 000 was due to computer time spent
in record keeping.
 The building area occupied by the staff in various activities was estimated
as under:
o Recruitment 25%
o Court Cases 15%
o Record Keeping 60%

 The misc. expanses can be distributed equally among these three activities.
Given below are the details for the same:
(the figures mentioned are in Rs.)

NO COURT NO RECORD NO
PARTICULARS RECRUITMENT TOTAL
. CASES . KEEPING .

STAFF SALARIES 24,000 A 30,000 E 6,000 I 60,000

COMPUTER 18,000 B 22,000 F 10,000 J 50,000

BUILDING RENT 11,250 C 6,750 G 27,000 K 45,000

MISCELLANEOUS 5,000 D 5,000 H 5,000 L 15,000

TOTAL 58250 63,750 48,000 1,70,000

The descriptions of the indicators A-L are as below:

A. Number of jobs * Cost per job = 2000*12 = Rs 24,000

B. Number of jobs * Cost per job = 1500*12 = Rs 18,000
C. 25% of total rent
D. 1/3 rd of total miscellaneous cost
E. Directly traced
F. Residual figure: 50,000 – (18,000 + 10,000)
G. 15 % of total rent
H. 1/3 rd of total miscellaneous cost
I. Residual figure: 60,000 – (24,000 + 30,000)
J. Directly traced
K. 60 % of total rent
L. 1/3 rd of total miscellaneous cost

Since we have Department-wise data on all activities, we can now distribute

the cost on the basis activities consumed by each Department.  This would
show that Loan Department was charged 90% of total costs where as its true
share was only 28%. When performance awards are distributed, staff of Loan

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 Practicality of Activity Based Costing over Conventional Methods

Department may suffer only because of unjustified cost-allocation by the

Accounts Department.

This shown below: 

Table 1: Personnel schedule for the Investment and Loan Departments

ACTIVITIES INVESTMENT
LOAN DEPARTMENT TOTAL
PERFORMED DEPARTMENT
RECRUITMENT 11 1 12
HANDLING COURT
4 0 4
CASES
EMPLOYMENT
50 450 500
RECORDS
TOTAL 65 451 516

Table 2: The total costs associated with the Investment and the Loan
Department.
(Figures in Rs.)

ACTIVITIES INVESTMENT
LOAN DEPARTMENT TOTAL
PERFORMED DEPARTMENT
RECRUITMENT 53,396 4,854 58,250
HANDLING COURT
63,750 - 63,750
CASES
EMPLOYMENT
4,800 43,200 48,000
RECORDS
TOTAL 121,946 48,054 1,70,000

Table 3: The Loan Department was charged 90% of total costs where as its true
share was only 28% as per ABC Costing.
(Figures in Rs.)

COST ALLOCATION INVESTMENT

LOAN DEPARTMENT TOTAL
UNDER: DEPARTMENT
ABC 121,946 48,054 1,70,000

Traditional Cost
17,000 1,53,000 1,70,000
Accounting

DISTORTIONS (104,946) 104,946 -

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6 WHEN IS ACTIVITY-BASED COSTING

APPROPRIATE?
Activity-based costing can theoretically be used in almost any industry, because it
can be adapted to determine costs at so many different levels. However, ABC is
used most effectively in complex companies that are not entirely service-based.
Complex companies may see the most benefit from this type of costing because it
is most helpful when the costing information is difficult to understand or evaluate.
Service industries may not benefit as much from activity-based costing as other
industries because their costs can be difficult to assign as they may not have an
identifiable cause and effect relationship.
Companies considering using ABC should also keep in mind that while it can be a
very powerful management tool, it can be very expensive to start and it does not
always conform to generally accepted accounting principles (GAAP) so if using an
ABC system a company may have to keep a separate system to track costs in a
manner that does conform to GAAP.

7 ACTIVITY BASED COSTING SYSTEM,

THE WAY AHEAD. . .
In recent years, companies have reduced their dependency on traditional
accounting systems by developing activity-based cost management systems.
Initially, managers viewed the ABC approach as a more accurate way of calculating
product costs. But ABC has emerged as a tremendously useful guide to
management action that can translate directly into higher profits. Moreover,
the ABC approach is broadly applicable across the spectrum of company
functions and not just in the factory.

Because ABC reveals the links between performing particular activities and the
demands those activities make on the organization’s resources, it can give
managers a clear picture of how products, brands, customers, facilities, regions, or
distribution channels both generate revenues and consume resources. The
profitability picture that emerges from the ABC analysis helps managers focus their
attention and energy on improving activities that will have the biggest impact on
the bottom line.

Fully exploiting ABC as a guide to profitability, however, requires a conceptual

break from traditional cost accounting systems and a willingness to act on the

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 Practicality of Activity Based Costing over Conventional Methods

insights ABC analysis provides. Managers must refrain from allocating all expenses
to individual units and instead separate the expenses and match them to the level
of activity that consumes the resources. Very simply, managers should separate
the expenses incurred to produce individual units of a particular product from the
expenses needed to produce different products or to serve different customers,
independent of how many units are produced or sold. Then managers must be
prepared to act. First, they should explore ways to reduce the resources required
to perform various activities. Then to transform those reductions into profits, they
must either reduce spending on those resources or increase the output those
resources produce. The actions allow the insights from ABC to be translated into
increased profits at the bottom line.

8 DISADVANTAGES OF AN ACTIVITY BASED

COSTING SYSTEM
 Data collection process for this system is very time consuming.

 The capital expenditure on the activity based system and its subsequent
running costs can be a road block for firms.

 The system is very transparent which some managers would not approve
of as they would like to keep some things out of the view of the owners
of the company

9 TIME BASED ACTIVITY BASED COSTING

SYSTEM
This is a new approach to sidestep the difficulties associated with large-scale ABC
implementation. Here, managers estimate the resource demands imposed by
each transaction, product, or customer, rather than relying on time- consuming
and costly employee surveys.

The Time-Driven Activity-Based Costing method is simpler since it requires, for

each group of resources, estimates of only two parameters:
 How much it costs per time unit of capacity to supply resources to the
business activities (the total overhead expenditure of a department divided
by the total number of minutes of employee time available) and,
 Estimation of the unit times of activities: how much time it takes to carry
out one unit of each kind of activity - (as estimated or observed by the
manager).
This Time-Driven ABC approach also overcomes a serious technical problem
associated with employee surveys: the fact that, when asked to estimate time
spent on activities, employees invariably report percentages that add up to 100.
Managers should take into account time that is idle or unused. The method also

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supports time equations, a feature that enables the ABC model to reflect the
complexity of real- world operations by showing how specific order, customer, and
activity characteristics cause processing times to vary.

10 APPENDIX

Terminology

1. Cost Object: Generally, the products are cost objects, but the customers,
services or locations can also be the cost objects.

2. Activities: An Activity is an event, task or unit of work with a specified

purpose. These consist of the aggregate of different tasks and are
concerned with functions associated with cost objects.

3. Cost pool: It is another name given to a cost centre.

4. Cost Centre: Distinctly identifiable department, division, or unit of firm

whose managers are responsible for its all associated costs and for ensuring
adherence to its cost-budgets.

5. Cost driver: The causes for incurrence of overhead costs are known as cost
drivers.

Example:
a) Machine setups
b) Purchase orders
c) Quality inspections
d) Production orders.

6. Activity hierarchies:

a) Unit level activities: These are activities which are performed each time
a unit of product or service is produced.

b) Batch-level activities: These are performed each time a batch operation

is carried out.

c) Product sustaining activities: These are performed to support diversity

of products.

d) Facility-sustaining activities: These are performed to support the

manufacturing process. Such costs are common to all the products
manufactured. These are not assigned to products individually.

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11 REFERENCES

RESOURCES FROM THE INTERNET

 hbr.harvardbusiness.org/1991/05/profit-priorities-from-activity-based-
costing/ar/1
 accounting.suite101.com/article.cfm/activitybased_costing_abc
 en.wikipedia.org/wiki/Activity-based_costing
 www.businessdictionary.com/definition/direct-cost.html
 www.scribd.com/doc/3163579/Activity-Based-Costing
 www.scribd.com/doc/14751986/Advantages-and-disadvantages-of-activity-
based-costing-with-reference-to-economic-value-addition
 hubpages.com/hub/CASE-STUDY-ACTIVITY-BASED-COSTING

BOOKS REFERRED

1. Maheshwari S.N., and S.N Mittal, ‘Cost Accounting- Principles and

Practice’:Mahavir Publication,New Delhi, 2007, pp 289-296
2. Horgrn C.t., and others, ‘Cost accounting-A managerial emphasis’:Pearson
Education Inc., New Delhi, 2009, pp 152-206

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