CHAPTER 24
Activity-Based Costing (ABC)
Meaning
Activity-Based Costing (ABC) is that costing in which costs begin with tracing of activities and then
to producing the product. In other words, it is the process of costing system which focuses on activities
performed to produce products. This system assumes that activities are responsible for the incurrence of
costs and products creates the demand for activities. Costs are charged to products based on individual
product's use of each activity.
ABC aims at identifying as many costs as possible to be subsequently accounted as direct cost of
production. Any cost that is traced to a particular product via its consumption of activity becomes direct of
the product. For instance, in conventional costing system, cost of setup and adjustment time is considered
as factory overhead and subsequently assigned to different products on the basis of direct labour hours.
But in Activity-Based Costing, setup and adjustment time is determined for each product and its costs are
directly charged to each product. Thus. by emphasing activities, ABC tries to ascertain the factors that
cause each major activity, cost of such activities and the relationship between activities and products
produced.
According to professor Vipul "Activity-Based Costing had it genesis in the increasing importance of
indirect costs in the manufacturing operations. The direct processing costs which are easier to handle are
being relegated to the b\l<;;kgrouild with each passing day due to automation. In this changing scenario
where indirect costs
outweigh the direct processing costs in many a situation, one cannot be content
with rough and ready methods of yester years in dealing with indirect costs."
(ar
Different Stages in Activity-Based Costing
There are different activities in ABC costing. The following are the important stages of ActivityBased Costing :
(1)
Identify the different activities within the organisation.
(2)
Relate the overhead cost to the activities.
(3)
Support activities are then spread across the primary activities.
Activity-Based Costing (ABC)
5/3
(4)
Determine the activity cost drivers.
(5)
Calculate the activity cost drivers rate, i.e., the quantity of cost driver used by each product.
ABC and Cost Drivers
In Activity-Based Costing, activities are identified and classified into different categories that have
relationship with the different stages or parts of the production process. The factors that influence the cost
of a particular activity are known as "Cost Drivers." A Cost Driver is literally the factors, forces or events
that determine the cost of activities. The process of activity-based costing is based on the assumption that
cost behaviour is influenced by cost drives. It should be understood that direct costs do not need cost
drivers because direct costs are themselves cost drivers. They can be traced by direct relationship with the
different parts of product.
However, all other factory, office and administrative overheads need cost drives.
Examples of Cost Drivers
In order to trace overhead costs to manufacturing a product, suitable Cost Drivers should be
identified. The following are the few examples of Cost Drivers in Activity-Based Costing:
Cost Drivers
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(to)
(11)
Number of receiving order
Number of deliveries
Number of Purchase orders
Kilometres travelled per delivery
Number of customers' visits
Number placing orders for purchase
Number of returning or empty bottles
Number Material handling hours
Amount of labour cost incurred
Number of inspections
Number of physical delivery and}
receipt of goods
Activity
Ordering
Delivery
Order Taking
Deliveries
Customer Visit
Placing Orders
Bottles Returns
Product Handling
Labour Transactions
Inspection
Delivery
Classification of Activities
In the first stage of the Activity-Based Costing activities are identified and classified into different
categories or segments of the production process. The grouping of activities is preferably done using the
different levels at which activities are performed. Broadly, activities are classified into:
(1)
Unit Level Activities
(2)
Batch Level Activities
(3)
Product Level Activities
(4)
Facility Level Activities
(1) Unit Level Activities: Unit Level Activities are those activities which are performed each time a
single product or unit is produced. These activities are repetitive in nature. For example, direct labour hours,
machine hours, powers etc. are the activities used for each time for producing a single unit. Direct materials
and direct labour activities are also unit level activities, although they do not overhead costs. Cost of unit
level activity vary with the number of units produced.
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514
(2) Batch Level Activity: These activities which are performed each time a batch of products or group
of identical products are produced. All the units of a particular batch are uniform in nature and in size. The
cost of batch level activities vary with the number of batches are ascertained. Machine setups, inspections,
production scheduling, materials handling are examples of batch level activities which are related to batches.
(3) Product Level Activities: These activities which are performed to support the production of each
different type of product. Maintenance of equipment, engineering charges, testing routines, maintaining bills
of materials etc. are the few examples of product level activities.
(4) Facility Level Activities: Facility Level Activities are those which are needed to sustain a factory's
general manufacturing process. These activities are common to a variety of products and are most difficult to
link to product specific activities. Factory management, maintenance, security, plant depreciation are the few
examples of facility level activities.
Difference Between Activity-Based Costing and Conventional Costing
Conventional Costing (or)
Traditional Costing
Activity-Based Costing
(I)
It begins with identifying activities and
then to producing the products
(1)
It begins with identifying cost and then to
producing the products
(2)
It mainly focuses on activities performed
to produce products
(2)
It emphasises mainly on ascertainment of
costs after they have been incurred
(3)
Cost Drivers used for identifying the
factors that influence the cost of
particular activity
(3)
Cost unit is used for allocation and
accumulation of costs
(4)
Overhead costs are assigned to Cost
Centre or Cost Pools
(4)
Overhead costs are assigned to production
departments or service departments
(5)
Overhead costs are assigned to products
using Cost Drivers Rates
(5)
Overheads allocated on the basis of
departmental overhead allocation rate
(6)
Variable overhead is appropriately
identified to individual products
(6)
Costs may be allocated or assigned either
on actual cost incurred or on standard cost
basis
(7)
In ABC many activity based on Cost
Pools or Cost Centres are created
(7)
Overheads are pooled and collected
department wise
(8)
There is no need to allocate and redistribution of overhead of service
departments to production departments
(8)
The process of allocation and re-distribution
of the costs of the service departments to
production department is essential to find
out total cost of production
(9)
It assumes that fixed overhead costs
vary in proportion to changes in the
volume of output.
(9)
It assumes that fixed overheads do not vary
with changes in the volume of output.
Activity-Based Costing (ABC)
515
Advantages of Activity-Based Costing
ABC system is a very valuable tool of control. It offers a number of advantages to the management
and the following are the main advantages :
(I)
It brings accuracy and reliability of the costing data in determination of the cost of the products_
(2)
It facilitates cause and effect relationship to exercise effective cost control.
(3)
It provides necessary cost information to the management to take decisions on any matter,
relating to the business_
(4)
It is much helpful in fixing the cost and selling price of a product.
(5)
It facilitates overhead costs allocate directly to the specific product.
(6)
It enables to manage the activities rather than costs.
(7)
It helps to remove all types of wastages and inefficiencies.
(8)
It provides valuable information to evaluate on the relative efficiencies of various plants and
machinery.
(9)
Cost Driver Rates will help in significant impact on the development of new products or
modification of existing products.
Essentials Factors of a Good Activity-Based Costing System
The success of the Activity-Based Costing system depends on the following factors:
(1)
Objectives of costing system and level of competition.
(2)
Number of products manufactured.
(3)
Product diversity and the business_
(4)
Adaptation of cost management measures, standardization and technical aspects.
(5)
Degree of sophistication and suitability to the firm.
(6)
Determination of single or combined Cost Driver.
(7)
Determination number of Activity Centre, Cost Pools and Cost Drivers.
(8)
Determin.ation of total overhead costs and economy.
(9)
Evaluation of trade off between measurement of costs and cost of errors.
(10)
Elasticity and adoptive to the changing circumstances.
Illustration: 1
Indian pottery company is noted for a full line of quality products. The company operates one of the
plants in Mumbai. That plant produces two types of products: Indian design A, and contemporary B, Rajan
the president of the company, recently decided to change from a volume-based costing system to an
activity-based costing system. Before making the change company wide he wanted to assess the effect on
the product cost of the Mumbai plant. This plant was chosen because it produces only two types of
products, most other plants produced at least a dozen. To assess the effect of the change, the following data
have been gathered :
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516
Products
Quantity
Prime Cost
Machine Hours
Material Moves
Setups
Indian A
Contemporary B
2,00,000
50,000
7,00,000
1,50,000
50,000
12,500
7,00,000
1,00,000
100
50
8,50,000
2,50,000
3,00,000
15,000
Total Value (Rs.)
Rs. 2,50,000 is the cost of maintenance of machine.
Under the current system, the cost of maintenance, material handling and setups are assigned to the products on
the basis of machine hours.
Required
(1)
(2)
Compute the unit cost of each product using the current unit-based approach.
Compute the unit cost of each product using an activity-based costing approach.
Solution:
(1)
Total overhead is Rs. 10,00,000. The plant wide rate is Rs. 16 per machine hour (Rs. 10,00,000 '"'
6,25,000)
Overhead is assigned as follows :
Indian A
Contemporary B
= Rs. 16
=Rs. 8,00,000
x 50,000
= Rs. 16 x 12,500
= Rs. 2,00,000
The unit costs for the two products are as follows :
Indian
=
Rs. 8,00,000 + 7,00,000
= Rs. 7.50
2,00,000
Contemporary
(2)
=
Rs. 2,00,000 + 1,50,000
= Rs. 7.00
50,000
In the activity-based approach, the consumption ratios are different for all three overhead activities, so
overhead pools are formed for each activity. The overhead rates for each of these pools are as follows :
Maintenance
=
Material handling
=
Setup
=
Rs. 2,50,000
:;: R3. 4 per hour
62,500
Rs. 3,00,000
8,00,000
Rs. 4,50,000
150
=Rs. 0.375 per move
=Rs. 3,000 per setup
Overhead is assigned as follows. :
Rs.
Indian A:
Maintenance
Material handling
Setup Cost
=
=
=
Rs. 4 x 50,000
Rs. 0.375 x 7,00,000
Rs. 3000 x 100
Total Overhead
=
=
=
=
2,00,000
2,62,500
3,00,000
7,62,500
Activity-Based Costing (ABC)
5/7
Contemporary B :
Rs.
Maintenance
Material handling
Setup Costs
=
=
=
Rs. 4 x 12,500
Rs. 0.375 x 1,00,000
Rs. 3000 x 50
Total Overhead
=
=
=
=
50,000
37,500
1,50,000
2,37,500
This produces the following unit costs
Indian A:
Rs.
Prime Cost
Add : Total Overhead Costs
Total Costs
Units Produced
Unit Cost
Rs. 14,62,500
=
2,00,000
=
=
=
=
14,62,500
2,00,000 units
= Rs. 7.31 per unit
Contemporary B :
Rs.
=
=
=
=
Prime Cost
Add : Total Overhead Costs
Total Costs
Units Produced
=
Unit Cost
7,00,000
7,62,500
Rs. 3,87,500
50,000
1,50,000
2,37,500
3,87,500
50,000 units
=Rs. 7.75 per unit
Illustration: 2
Family store wants information about the profitability of individual product lines: Soft drinks, Fresh
Produce and Packaged food. Family store provides the following data for the year 2002-03 for each
product line :
Particulars
Revenues
Cost of goods sold
Cost of bottles returned
Number of purchase orders placed
Number of deliveries Received
Hours of shelf-stocking Time
Items sold
Soft Drinks
Fresh Produce
Packaged Food
Rs. 7,93,500
Rs. 6,00,000
Rs. 10,000
360
300
540
1,26,000
Rs.21,00,600
Rs. 15,00,000
Rs. 12,09,900
Rs. 9,00,000
Rs.O
360
660
2,700
3,06,000
°
Rs.
840
2,190
5,400
11,04,000
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A Textbook of Financial Cost and Management Accounting
Family store also provides the following information for the year 2002-2003
Activity
Description of Activity
Total Cost
Bottles returns
Returning of empty-bottles to store
Ordering
Delivery
Placing of orders for purchases
Physical delivery and
receipt of goods
Stocking of goods on store shelves }
and On-going restocking
}
Assistance provided to
customers including check-out
Shelf stocking
Customer support
Cost - allocation Base
Rs.12,ooO
. Direct tracing to
soft-drink line
1,560 purchase orders
Rs. 1.56,000
Rs. 2,52,000
Rs. 1,72,800
3,150 deliveries
8,640 hours of
}
shelf-stocking time
Rs. 3,07,200
15,36,000 items sold
Required
(l)"
(2)
(3)
Family store currently allocates support cost (all costs other than cost of goods sold) to product lines on
the basis of cost of goods sold of each product line. Calculate the operating income and operating income
as a % of revenues for each product line.
If family store allocate support costs (all costs other than cost of goods sold) to product lines using an
Activity-Based Costing System, calculate the operating income as a % of revenues for each product line.
Comment on your answers in requirement (1) and (2)
rCA, May, 2003 J
Solution:
(i)
Calculation of Operating Income and Operating Income as a % of revenues for each
product line :
Particulars
Soft Drinks
Rs.
Fresh Produce
Rs.
Packaged Foods
Rs.
Revenues
7,93,500
21,00,000
12,09,900
41,04,000
Cost of Goods Sold
Store Support Cost (30%)
6,00,000
1,80,000
15,00,000
4,50,000
9,00,000
2,70,000
30,00,000
9,00,000
Total Cost
7,80,000
19,50,000
11,70,000
39,00,000
13,500
1,50,600
39,900
2,04,000
1.70%
7.17%
3.30%
4.97%
Operating Income
Operating Income}
as % of revenue
(ii)
Total
Rs.
The activity rates are as follows :
Activity
Ordering
Delivery
Shelf Stocking
Customer Support
Cost Hierarchy
Batch Level
Batch Level
Output Unit Level
Output Unit Level
Total Cost
Rs.
1,56,000
2,52,000
1,72,800
3,07,200
Qty. of Cost
Allocation Base
+ 1,560 Purchase Orders
+ 3,150 delivers
+ 8,640 hours
+ 15,36,000 items sold
Overhead
Allocation Rate
=Rs. 100 per order
=Rs. 80 per delivery
=Rs. 20 per hour
=Rs. 0.20 per items sold
519
Activity-Based Costing (ABC)
Cost Allocation Statement Under Activity-Based Costing System
Particulars
Revenues (1)
Cost of goods sold
Bottle - Return cost
Ordering cost }
@ Rs. 100
Delivery cost }
@ Rs. 80
Shelf stock cost }
@ Rs. 20
Customer support cost }
@ Rs. 0.20
Total Cost (2)
Soft Drinks
Rs.
Packaged Foods
Rs.
Total
Rs.
7,93,500
21,00,000
12,09,900
41,04,000
6,00,000
12,000
36,000
(360 x 100)
24,000
(300 x 80)
10,800
(540 x 20)
25,200
(1,26,000 x 0.20)
15,00,000
9,00,000
84,000
(840 x 1(0)
1,75,000
(2,190 x 80)
1,08,000
(5,400 x 80)
2,20,800
(ll,04,OOO x 0.20)
36,000
(360 x 100)
52,800
(660 x 80)
54,000
(2700 x 20)
61,200
(3,06,000 x 0.20)
30,00,000
12,000
1,56,000
7,08,000
20,88,000
11,04,000
39,00,000
85,500
12,600
1,05,900
2,04,000
10.78%
0.60%
8.75%
4.97%
Operating Income }
(1) - (2)
Operating Income as % }
of Revenue
(iii)
Fresh Produce
Rs.
-
-
2,52,000
1,72,800
3,07,200
Managers believe the Activity-Based Cost (ABC) system is more credible than the previous
costing system. The ABC system distinguishes the different type of activities at Family store
more precisely. It also tracks more precisely how individual product lines use resources.
Soft drink consume less resources than either fresh produce or packaged food. Soft drinks have
fewer deliveries and require less Shelf-Stocking time.
Managers of Family Stores can use ABC information to guide their decisions, such as how to allocate
a planned increase in floor space. Pricing decisions can also be made in a more informed way with ABC
information.
Illustration: 3
Alpha Limited has decided to analyse the profitability of its few new customers. It buys bottled
water at Rs.90 per case and sells to retail customers at a list price of Rs.108 per case. The data pertaining
to five customers are :
Particulars
Case Sold
List selling price
Actual selling price
Number of purchase Orders
Number of customer Visits
Number of Deliveries
Kilometers traveled Per delivery
Number of expedited Deliveries
A
B
C
D
E
4,680
Rs.108
Rs.108
15
2
10
20
0
19,688
Rs.108
Rs.106.20
25
3
30
6
0
1,36,800
Rs.108
Rs.99
30
6
60
5
0
71,550
Rs.108
Rs.I04.4O
25
2
40
10
0
8,775
Rs.108
Rs.97.20
30
3
20
30
1
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520
Its five activities and their cost drivers are :
Activity
Cost Driver Rate
Order taking
Customer visits
Deliveries
Product handling
Expedited deliveries
Rs.
Rs.
Rs.
Rs.
Rs.
750 per purchase order
600 per customer visit
5.75 per delivery k.m. travelled
3.75 per case sold
2,250 per expedited delivery
Required
(i)
(ii)
(iii)
Compute the customer level operating income of each of five retail customers now being examined
(A,B,C,D, and E); comment on the results.
What insights are gained by reporting both the list selling price and the actual selling price for each
customer?
What factors Alpha Ltd. should consider in deciding whether to drop one or more of five customers?
[CA, Nov. 2003J
Solution:
A
B
C
D
Revenues at List Price
Less: Discount
5,05,440
Nil
21,26,304
35,438
1,47,74,000
12,.31,200
77,27,400
2,57,580
9,47,700
94,770
Revenues at Actual Price
Less : Cost of Goods sold at
Rs. 90 per unit
5,05,440
4,21,200
20,90,866
17,71,920
1,35,43,200
1,23,12,000
74,69,820
64,39,500
8,52,930
7,89,750
84,240
3,18,946
12,31,200
10,30,320
63,180
11,250
(750 x 15)
18,750
(750 x 25)
22,500
(750 x 30)
18,750
(750 x 25)
22,500
(750 x 30)
1,200
1,800
3,600
1,200
1,800
1,150
1,035
1,725
2,300
3,450
17,550
73,830
5,l3,ooo
2,68,3l3
32,906
Particulars
Gross Margin (A)
Customer Level Operating Cost
Order taking
@ Rs. 750
Customer Visits
@ Rs. 600
Delivery Vehicles
(Rs. 5.75 per Km)
Product handling
Rs. 3.75 per case
Expected runs
(Rs. 2250 per run)
-
-
-
E
-
-
Total Costs (B)
31,150
95,415
5,40,825
2,90,563
62,906
Customer Level
Operating Income (A) - (B)
53,090
2,23,531
6,90,375
7,39,757
274
(i) Customer D is the most profitable customer, despite having only 52.30% of the unit volume of
customer C. A major exploitation is that customer C receives at Rs.9 discount per case while
customer D receives only at Rs.3.60 discount per case.
Customer E is less profitable, in comparison with the small customer A being profitable. Customer E received a
discount of Rs.1D.80 per case, make more frequent orders, requires more customer visits and requires more delivery
kms, in comparison with customer A.
(ii) Separate reporting of both the listed selling price and the actual selling price enables Alpha Ltd. to examine
which customer receives different discount documents and how sales people may differ in the discounts
they grant. There is a size pattern in the discount across the 5 customers, except for customer E.
52!
Activity-Based Costing (ABC)
Discount Per Case
Sales Volume
C 0,36,800 Cases)
D (71,550 Cases)
B (19,688 Cases)
E (8,775 Cases)
A (4,680 Cases)
12,31,200
2,57,580
35,438
94,770
4,680
1,36,800
71,550
19,688
8,775
4,680
=
=
=
=
=
Rs.9
Rs.3.60
Rs. 1.80
Rs.IO.80
Rs.O
The reasons for the Rs. 10.80 discount for customer E should be explored.
(iii)
Dropping customers should be the last resort taken by Alpha Ltd. Factors to be considered include:
What is the expected future profitability of each customer? Are the currently unprofitable (E) or low profitable
(A) customers likely to be highly profitable in the future?
What costs are avoidable if one or more customers are dropped?
Can the relationship with "problem" customers be restructured so that there is a 'win win' situation?
QUESTIONS
1.
2.
3.
4.
5.
6.
7.
What do you understand by Activity-Based Costing?
What is meant by Cost Driver? Explain role of Cost Driver in tracing costs to products.
Explain the stages in applying ABC in manufacturing company.
Explain the difference between Activity-Based Costing and Traditional Costing System?
What are the advantages of Activity-Based Costing?
What are the classification of activities? Explain it briefly.
What are the factors to be considered while adopting ABC?
DOD