ACTIVITY  BASED  COSTING

Activity based costing is a new and scientific approach

developed by Cooper and Kalpan(1988) for assigning
overhead to end product , jobs and processes. It aims to
rectify the problem of inaccurate cost information due to
selection of wrong bases of indirect cost apportionment. In the
words of Cooper and Kalpan, “ABC systems calculate the cost
of individual activities and assign costs to cost objects such as
product and services on the basis of activities undertaken to
produce each product or service.” In this system, overheads
are assigned to activities are grouped in to cost pools before
they are charged to cost objects i.e. jobs or products.
According to C.I.M.A., London, activity based costing is cost
attribution to cost units on the basis of benefits received from
indirect activities, i.e. ordering, setting up, assuring quality
etc. It is a modern tool of charging overhead cost in which
cost are first traced to activities and then products or jobs.
 The direct costs which mainly include material and labour , are
chargeable to the end products without difficulty and are thus
convenient the handle it is the indirectly costs also known as
overhead ,which create problems for the cost accountant in
determining the accurate product costs, the importance of indirect
costs in the manufacturing operations is increasing and direct cost
of an end product .Activity based costing is an upcoming more
accurate product costs.

Basics of ABC;                                       
 Cost of a product is the sum of the costs of all
Activities required to manufacture and deliver the
product .
 Product do not consume cost directly.
 Money is spent on activities.
 Activities are consumed by product .
 ABC assigns costs to products by tracing
expenses to activities . Each product is charged
based on the which it used an activity .
 TRADITIONAL APPROACH
• Traditionally, indirect costs are distributed to end products
on the assumption that products consume resources in
proportion to the production volumes.
• Distribution of overhead cost by traditional approach .The
main steps in this approach are :
 ABC APPROACH
• In the ABC approach companies identifiy the major
acitivities that couse overhead couse to be incurred .
the cost of the resources consumed performed these
activities are grouped in to cost pools . finally the cost
are assigned to products using a measure of activity
referred to as a cost driver . the steps involved in the
ABC approach then are
• step1: identify major activities
• step2: Creation of cost pools
• step 3: identify measures of activities - the cost
drivers
• step4: calculating of the activity cost driver rate
Step5: charging the cost of activities to products
TERMS USED IN ABC
• IN order to understand ABC, one should be familiar with the
meaning of the following terms .
• ACTIVITY
• AN activity may be defined as a particular task or unit of work with
a specific per purpose EX : Placing purchase order setting up of a
machine, after sales service, etc.
• COST OBJECT
• it is an item for which cost measurement is required . Ex ; a
product, a service a job or a customer etc.
• COST DRIVER : It is a factor that causes a change in the
cost activity .
• RESOURCE COST DRIVER
• It is a measure of the quantity of resource consumed by an
activity .Similarly, the number of times machines are setup will
determine the cost of setting up of machines
• ACTIVITY COST DRIVER; It is a measure of frequency
and intensity of demand placed on the activity by cost objects .
• Examples of cost drivers for various business function are as follows
COST DRIVES FOR VARIOUS BUSINEES
FUNCTIONS
 STEPS IN ACTIVITY BASED COSTING
• Steps in Activity Based Costing:
• The following are the steps in activity based cost allocation
• 1.Identification of main activities:
First of all, major activities in the organization are identified. The number
of activities in an organization should neither be too large or too small.
Too large a number will be costly and will add to the complexity of the
system while a too smaller number of activities will compromise with the
accuracy of the cost. Total cost involved in the activity should be
significant enough to justify to give an activity separate treatment.
• 2.Creation of cost pool:
Cost pool is grouping of individual cost items. A cost pool or cost bucket
should be created for each activity. Cost pool is like a cost centre around
which costs are accumulated. For example, the total cost of machines
setup might constitute one cost pool for all setup related cost.
 STEPES IN ABC
• 4. Calculation of activity
cost driver rate: Just
as an overhead absorption rate is calculated
in traditional costing system, in ABC a cost
driver rate is calculated as follows.
• Activity cost driver rate =
Total cost of activity
Cost drivers
• 5. Charging the cost of activities to
products The cost of activities
are traced to products on the basis of
demand by products. The cost drivers are
used to measure product demand of activity
 Charging the cost of
activities to products in
this way
 Cost Hierarchies
 . ABC system commonly use a cost
hierarchy having four levels

 Output unit level cost

 Batch level costs

 Product sustaining cost

 Facility sustaining
 Out put unit level & Batch
level
• Output unit level
costs are the activities performed on each individual
unit of product or service. Manufacturing operations
cost related to the activity of running the automated
molding machines are output unit level costs. They
are output unit level cost because, overtime the cost
of these activity increases with additional units of
output produced.
• Batch level
costs are the costs of activities related to a group
of units of products or services rather than to each
individual unit of product or service. In the plastim
example, setup cost are batch level cost. They are
batch level cost because, over time , the cost of this
setup activity increases with setup hours needed to
produce batches of lenses
 Product level & Faciltiy
level
• Product sustaining cost are the cost of activities undertaken to support
individual products or services regardless of the number of units or
batches in which the units are produced. In the plastim example,
design cost or product sustaining cost. Plastim’s ABC Basics of ABC
Cost of a product is the sum of the costs of all activities required to
manufacture and deliver the product . product do not consume cost
directly. Money is spent on activities. Activities are consumed by
product . ABC assigns costs to products by tracing expenses to
activities . Each product is charged based on the which it used an
activity system uses parts square feet a product sustaining cost
allocation base to allocate design cost to products. Another example of
product sustaining cost is engineering costs incurred to change
product designs, although such changes are infrequent at plastim.
• Facility sustaining costs are the cost of activities that cannot be
traced to individual products or services but support the organization
as a whole. In the plastim example, the general administration cost are
facility sustaining costs. It is usually difficult to find good cause and
effect relationship between these cost and cost allocation bases. This
lack of cause and effect relationship causes some companies not to
allocate these costs to products and instead to deduct them from
operating income.
 Activity Based costing
systems
• One of the best tools for refining a costing system is activity based
costing. Activity Based costing refines a costing system by focusing on
individual activities as the fundamental cost objects. An activity is an event,
task, or unit of work with a specified purpose; for example, designing
products, setting up machines, operating machines, and distributing
products. ABC systems calculate the costs of individual activities and assign
costs to cost objects such as products and services on the basis of the
activities needed to produce each product or service.

Fundamental cost objects assignment to other cost objects

Activities cost of activities cost of
.products
.service
.customer
 Advantages of activity based
costing
:
• Accurate and reliable:
ABC is more accurate and reliable determination of products cost as it
is based on cause and effect relationship is cost incurrence.
• Better pricing decisions:
It helps in overcoming the problem of over costing and under costing as a
result of which management is able to make more judicious pricing decisions.
• Realistic:
The analyses of overhead cost with reference to activities is considered to the
more realistic because distribution of overhead based on activities is an objective
approach
• Control of cost
: ABC produces more meaningful information regarding cost behaviour and
enables management to control many fixed overheads exercising more control over
those activity which cause these fixed overhead.
• Greater cost efficiency
: ABC helps to identify unnecessary activities so that these may be weeded
out and thus achieving greater cost efficiency.
•
Problems and Solutions
Statement of Cost & ABC
Method
Calculation of Customer Level Activity
Cost
Customer Level Activity Cost & Operating
Income
• P. Banu Prakash
• B. Com
• M.B.A 1st Year
• KBN PG Centre