Activity Based Costing (ABC) – Meaning | Features | Benefits

Table of Contents

1. Introduction
2. Features of ABC
3. Key Terms Used in Activity Based Costing
4. Steps Involved in the Process of Activity Based Costing (ABC)
5. Benefits and Weaknesses of ABC
6. Conclusion

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1. Introduction

Need for a more logical approach for assigning overhead costs

In the chapter on overheads, while going through the process of distribution of overheads, it was learnt that indirect costs (overheads) are assigned to final products through a series of steps that are:

• Allocation and apportionment of overheads to various cost centres (production and service departments)
• Re-apportionment of service department’s overheads to various production departments
• Absorption of overheads (which have been assigned to production departments) into final products, jobs or production orders.

This traditional approach of absorption of overheads emphasizes that products consume resources in proportion to production volumes.

In other words, traditional approach is popularly known as volume-based cost allocation and overheads are absorbed, on such bases as machine-hours, labour-hours, raw material content in the product or similar other volume measure that permeates all parts of the factory. Though multiple bases may be used, in traditional approach, for absorption of overheads of different cost centres (for example, labour hour rate for the departments utilizing manual labour and machine hour rate for the cost centres where work is done mainly by machines), little effort has been made to logically trace the incurrence of specific overhead cost to their causes. Consequently, a large amount of overhead costs is assigned to the cost objects rather arbitrarily. Product costs, therefore, are recognized as inaccurate universally and are not useful in bringing improvements in design, process or quality and do not provide information which may prove the best for various short term and long term decisions.

Moreover, the traditional methods or bases of absorption of overheads are no longer appropriate and suitable for the firms in modern environment which is representative of the following changes:

1. Growing overhead costs: Overhead costs were relatively small and the distortions in product costs arising due to inappropriate allocation or absorption of overheads was not significant. In today’s business world, direct labour represents a small proportion of total costs and proportion of overhead costs in total costs has increased to a great extent.
2. Increasing Product Diversity: Now a days, product life cycles are continually decreasing and most of the firms are recognising the need to differentiate products for segmented markets. Moreover, increasing product diversity, results to secure economies of scope and increased market share.
3. Increasing market competition: This has necessitated more accurate product cost so that right pricing decision can be taken. The intense global competition has made decision errors due to poor cost information more costly.
4. Information processing costs were too high in past years i.e. in eighties and it was, therefore, difficult to justify more sophisticated overhead allocation technique to bring accuracy in cost ascertainment. With the increase in data availability and more developed and sophisticated management information systems due to information technology
   revolution, the large application of newer approaches demanding large amount of information is within the reach of the firms. The above-mentioned changes have prompted various accounting researchers to think and explore about newer ways of absorption of overheads into final product. The newer or modern approach should enable the companies to measure more accurately how different products or services use company’s resources.

The recognition of this need has led to the emergence of a new approach of assigning overheads to cost objects, called Activity Based Costing (ABC). Robin Cooper and Robert Kaplan developed a more logical and refined solution to the problem of distribution of overheads in the form of ABC approach which involves the complete revision of the way, overheads are ultimately linked or attached to the end products or cost objects.

Before elaborating the meaning and features of ABC, however, the deficiencies of conventional approach of distribution of overheads are illustrated in the following points:

(a) Conventional approach is a peanut-butter costing approach which uses broad averages for charging overheads uniformly to products or services of a cost centre. This results into cost-smoothing, that is, undercosting of certain products and overcosting of some other products, simultaneously.

(b) This approach fails to provide useful information to the management for taking decisions about pricing, product- mix and capital investments based on inaccurate cost information especially in case of the firms selling multiple products or services. In a multi-product or multi-service firms, different products consume different activities which may
be disproportionate to volume of production.

(c) It does not satisfy the requirements of today’s manufacturing and competitive environment as products differ in terms of complexity and use of activities giving rise to overhead costs.

(d) Under conventional approach, high volume products receive large allocation of resources and conversely low volume products absorb small allocations as this method primarily relies upon volume related bases like direct labour hours and overhead costs change in direct relation to production volume. As a result, it under costs low volume products which may be complex or customised.

(e) Conventional approach fails to report on issues like quality, reliability, lead time, flexibility and customer satisfaction despite the fact that they represent the strategic goals of world class manufacturing companies. In other words, its entire emphasis is on internal activities and comparatively less attention is paid to the external environment in which the business operates.

Activity Based Costing: A modern approach to allocation and absorption of overheads:

1. Activity Based Costing (ABC) is more logical and Systematic approach developed by Cooper and Kaplan (1988) for assigning overhead costs to the final products, jobs or processes.
2. It aims to bring accuracy in the process of absorption of overheads by establishing a cause and effect relationship. ABC is a cost accumulation and allocation system that traces costs to products according to the activities performed on them.
3. It is a costing approach that assigns costs to products or services based on their consumption of resources caused by activities rather than on the basis of volume related measures such as direct labour hours, number of units produced or material cost of the product.

Thus, ABC approach recognizes that jobs, products, services etc. do not directly consume resources but consume activities which consume resources.

According to Cooper and Kaplan, ABC approach calculates the cost of individual activities and assigns costs to cost objects such as products and services on the basis of activities undertaken to produce products and to render the services.

CIMA, London defines, Activity Based costing as the

“cost attribution to cost units on the basis of benefits received from indirect activities i.e. ordering, setting up, assuring quality etc.”.

These definitions of ABC indicate that ABC is not a distinct method of costing like, job costing or process costing. It is rather a new approach of assigning overheads to final products and services. The allocation or assignment of overhead costs under ABC approach is done on the basis of benefits received by the products, services or cost object from indirect activities. It aims to provide a more detailed tracking of costs incurred on the basis of activities. This implies that incurrence of many of the overhead costs (representing firm’s resources) is explained not by the amount of output produced but by the complexity and diversity of the company’s products, its product lines, distribution channels and customers etc.

As organizations try to expand, they do not increase the sales of a single product to a single customer, rather they expand turnover by introducing new varieties or lines of product, new distribution channels and new customers. Consequent to the increase in complexity and diversity of production process, overhead costs (costs of organizational infrastructure) increase to meet the demands created by new variety of product, new customers etc. Assignment and allocation of such costs, according to Cooper & Kaplan should be based on transaction-based cost drivers e.g. the number of purchase orders for purchase activity, the number of inspection hours for total costs of inspection etc.

ABC approach has received greater attention since mid 80’s and has provided a leading solution to the weaknesses of cost and managerial data. The technique first makes a detailed record of specific activities within a firm. These form the cost pools. Then it improves the accuracy of cost ascertainment by directly tracing the costs to cost objects. ABC approach, further, attempts to show that most of the overhead costs incurred to perform various activities vary in accordance with the change of a factor called cost driver and therefore, cost should be absorbed into products or services or cost objects based on
a cost driver rate. A cost driver is any factor that has the effect of changing the level of costs for a cost object.

2. Features of ABC

• ABC is a two-stage product costing method that assigns cost to activities undertaken to manufacture products, at the first stage and then charges the cost of activities to various cost objects based on their consumption of activities as reflected through number of activity cost drivers.
• Its principal emphasis has been on improved assignment of overheads to cost objects. Instead of allocating overheads in terms of unit-based or volume-related measures such as, direct labour hours, machine hours, or material cost etc. ABC uses non-volume related measures which are much larger in number than the bases adopted in conventional costing and more logical in linking the overheads to the end-products.
• ABC approach helps an organisation in bringing accuracy in distributing overhead costs to final product or cost units and avoids product-cost cross subsidization i.e. overcosting of some products at the cost of undercosting of some other products. More accuracy in determining product costs is brought about by enhancing the understanding of cost behaviour.
• Identification of cost to various activities and their causes not only helps in computation of more accurate cost of a product or a job but also eliminates non value-added activities. The elimination of non-value added activities would help in bringing down the cost of the product.
• ABC approach has provided a methodology for costing product lines and for directing managerial attention to areas where action may result in cost benefit to the organisation concerned. It is intended to provide cost information for strategic design and operational control decisions.

3. Key Terms Used in Activity Based Costing

Cost object: It is an item for which cost measurement is required e.g. a product, a job, a process, a service etc.

Activity: An activity is unit of work with a specific purpose. Activities are actions, movements or work sequences. In other words, activity represents any discrete task that an organisation undertakes to make products or deliver services. Activities consume resources. It is in the activities that costs are accumulated and hence, appropriately referred to as cost-pools or cost- buckets.

The activities can be classified as follows:

(a) Unit Level – This type of activity must be performed for each unit of production. Costs which vary with the units are related to such activities.

(b) Batch Level – These activities must be performed for each batch of products rather than each unit. Such activities include, machine-setup, quality assurance, packing activity, material handling etc.

(c) Product sustaining level – This type of activity includes activities that are required to support an entire product line, but are not performed every time a new unit or batch of products is produced. For example engineering design costs, Advertising, R&D costs, customer satisfaction etc.

(d) Facility (or general operations) level – Such activities are required for the entire production process to occur. For example, plant management salaries, plant depreciation, Rent and Insurance etc.

This classification is called a cost hierarchy

Cost Pool – As mentioned while describing activity, costs are grouped into pools according to the activities which cause them. For instance, all the costs associated with the procurement of materials such as, ordering, receiving and inspection costs would be included in the cost pool of procurement activity.

Cost driver – In an ABC system, the bases of applying or linking costs of cost pool to the products, services job or processes are called cost drivers. It is a factor that causes a change in the activity and is to be identified for each activity. For example, R&D cost will be influenced either by number of research projects or personnel hours on a project. A list of cost drivers for specified activities is given in the following table:

Cost drivers may be mainly of two types i.e.

(a) Resource cost driver

(b) Activity cost driver

Resource cost driver – It is a measure of quantity of resources consumed by an activity. Resource cost driver is used to relate the overhead costs to an activity and thus creating a cost pool.

Activity cost driver – It is a measure of the frequency and intensity of demand placed on the activities by the cost object. Higher is the frequency and more intensity of demand placed by the cost object for an activity, higher will be the share of overhead costs to be assigned to the cost object. Thus an activity cost driver is used to apply the cost of a cost pool (activity cost) to the cost object.

4. Steps Involved in the Process of Activity Based Costing (ABC)

The steps involved in the process of ABC are discussed below:

(1) Inventorisation and screening of various activities within the organisation – Focus on activities is the distinctive feature of ABC. This is because the root cause of cost incurrence is activities being undertaken. The first step in ABC, therefore, is comprehensive inventorisation of all the activities for the entire process of a firm’s operations from product development to marketing. For this purpose, many companies rely upon grass-root level employees as they may provide more accurate information than senior managers, who are away from daily operations. After identification of activities, a final list should be prepared after going through the screening process based on the following questions:

(a) Is the activity must or is it possible to discontinue or outsource the activity?

(b) Is it creating any value or not?

(c) Is it possible to club the activities?

The final list of activities, however, should be limited to a reasonable figure, at least in the beginning. Presence of too many activities will give rise to the problems during implementation. However, more activities can be added later.

(2) Creating cost pools or cost buckets that means relating the overheads to the activities using resource cost drivers. For creating cost pools, activities are classified in such a way that they correspond to manageable segments of the production process. Costs are associated with each of these segments and homogeneous cost pools are created. A homogeneous cost pool is a collection of overhead costs that are logically related to the activities undertaken and for which cost variations can be explained by a single cost driver.

(3) Apportioning the costs of support activities over the primary activities on Sustainable basis.

(4) Determining the activity cost driver for each activity and computing activity cost driver rate: As cost driver is the factor that causes or drives the incurrence of specific costs, it is the causal factor that explains the consumption of resources and affects a change in the cost of an activity. To find a cost driver for a particular cost pool, it is ensured that overhead activities must be logically related and have the same consumption ratio for all products.

Activity cost driver rates are computed for each activity just like overhead absorption rates in traditional approach

Activity cost driver rate = Total cost of Activity/Total Number of activity cost drivers

Thus, cost per unit of the cost driver is computed for each cost pool.

(5) Tracing the overheads of each pool to products or cost objects by means of activity cost drivers’ rate: Once an activity cost driver rate or pool rate is obtained, costs of a particular cost pool is charged to cost objects as follows:

Applied or absorbed overheads = cost driver rate × number of cost drivers in cost objects

Thus how much cost of a cost pool is recovered from a particular cost object depends on the quantity of cost driver used by each cost object or end product.

5. Benefits and Weaknesses of ABC

Benefits: The benefits of ABC approach are outlined below:

1. This approach has been introduced to overcome the limitations of traditional method of absorption of overheads based on departmental overhead rates. ABC aims to ascertain product costs with greater accuracy by relating overheads to activities rather than cost centres.
2. In this approach, costs are absorbed into end-products based on a cost driver rate. Thus, ABC focuses on linking the cost of cost object to the real causal factor through cost driver. Consequently, determination of product cost is based on cause and effect relationship.
3. Managers manage activities and not products. Changes in activities lead to changes in costs. Therefore, if activities are managed well, costs will fall and resulting products will be more competitive.
4. It helps in identifying the source of non value added activities or wasted efforts and eliminating them.
5. ABC produces more meaningful information regarding cost behaviour and enables management to control many fixed overheads by exercising more control over those activities which cause these fixed overheads.
6. ABC highlights problem areas that deserve the management’s attention and more detailed analysis. Right decisions can be made on pricing, process technology, product design and product-mix etc. with more accuracy in ascertaining cost.

Weaknesses: ABC also brings the weaknesses along with the advantages. Various limitations as pointed out by the critics are mentioned below:

1. Implementing an ABC approach requires substantial resources which may involve high costs. Therefore, it is not useful for small organizations.
2. ABC is a complex system which needs creation of lots of records and information and putting in large amount of clerical efforts. A trained cost accounting staff to create and manage the database is required for adopting this approach.
3. Usefulness of the data of ABC approach for efficient decision-making depends on the skills of the management as the data can be misinter-preted and may lead to erroneous decisions if not used with due and proper care.
4. ABC does not encourage the identification and removal of constraints creating delays and excess. An overemphasis on cost reduction without regard to constraints does not create an environment for learning about the problems and their management.
5. Reports generated by this system do not conform to GAAP. So, an organisation adopting ABC approach should have two cost systems – One for internal analysis and another for external reporting.
6. Identification of suitable cost driver becomes difficult for certain activities.
7. It may not prove useful in determining true costs in short-run especially when fixed costs have to be incurred in short-run even if there is no activity.

6. Conclusion

The Activity Based – costing system was developed more than two decades ago. Many firms in the USA, the UK, Canada and Japan have been increasingly switching over to ABC from conventional approach of assignment of overheads. In India, implementation of ABC approach is comparatively limited.

In a global Scenario, Indian firms have to operate in a competitive environment because of changes in economic policies and many other consequential changes. There is no scope for inefficiency and inaccuracy now. So, many large Indian companies need to switch-over to ABC System from conventional costing approach which leads to arbitrary allocation of overheads.