Activity Based Costing (ABC) – Definition | Steps | Applications

Activity Based Costing (ABC) is a method of accounting that identifies and assigns costs to overhead activities and then assigns those costs to products. The main goal of ABC is to provide a more accurate depiction of the cost of producing specific products and services by measuring the resources that are used during production and other activities. ABC is especially useful in complex environments where products use resources non-uniformly. By obtaining a more precise cost, businesses can better understand profitability, make more informed pricing decisions, and identify inefficiency areas in their operations.

Table of Content

1. Traditional Costing System
2. Activity Based Costing
3. Areas in which Activity Based Information is Used for Decision Making
4. Cost Pools
5. Cost Driver
6. Cost Object
7. Frequently Asked Questions

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1. Traditional Costing System

1.1 Introduction

The traditional cost accumulation system of absorption costing was developed at a time when most organisations produced only a narrow range of products (so that products underwent similar operations and consumed similar proportions of overheads).

The overhead costs were only a very small fraction of total costs.

The benefits of more accurate systems for overhead allocation would probably have been relatively small. In addition, information processing costs were high.

Traditional costing systems, which assume that all products consume all resources in proportion to their production volumes, tend to allocate too great a proportion of overheads to high volume products (which cause relatively little diversity and hence use fewer support services) and too small a proportion of overheads to low volume products (which cause greater diversity and therefore use more support services).

1.2 Drawbacks of Traditional Costing System

1. Different products utilize different amount of resources, which is not recognized in traditional costing system.
2. Overheads now constitute the largest share of cost, often greater than 50% and are typically applied to products as percentage of the smallest cost (direct labour) leading to serious distortion of product cost.
3. By relying on volume-related measures to determine product costs, traditional costing system do poor job in reflecting supporting costs for manufacturing and distribution of products or services. More and more factory overheads, such as set-up cost, materials handling cost, and product design and research and development costs, are unrelated to the number of units produced.
4. Traditional costing system tends to overcast standard, high volume products and under-cost low-volume products, leading to incorrect pricing and product-mix decisions.
5. It creates a bias toward direct labour reduction as a cost reduction rather than overall productivity improvement.
6. It provides no information useful in either identifying productivity improvement opportunities or determining if productivity improvement efforts have yielded significant results. Indeed, often traditional costing system indicates higher cost in the presence of known productivity improvement or vice versa.

2. Activity Based Costing

2.1 Definition

According to CIMA Official Terminology, Activity Based Costing is ‘An approach to the costing and monitoring of activities which involves 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 outputs.’

2.2 Meaning of Activities

Activities comprise of units of work or tasks. For example, purchase of materials is an activity consisting a series of tasks like purchase requisition, advertisement inviting quotations, identification of suppliers, placement of purchase order, follow-up, etc.

1. Value Added Activities (VA)

• These are activities necessary for the performance of the process.
• These represent work that is valued by the external or internal customer.
• They improve the quality or function of a product. Hence, the customers are usually willing to pay for the service.
• VA activities result in ‘Cost’ and not in losses.
• Example: Making product more versatile for certain other uses.

2. Non-Value Added Activities (NVA)

• These are additional and extraneous activities, not fully necessary for the performance of the process.
• These represent work that is not valued by the external or internal customer.
• NVA activities do not improve the quality or function of a product or service but they can adversely affect costs and prices.
• NVA activities create waste, result in delay of some sort, add cost to the products or services for which the customer is not willing to pay.
• Example: Moving materials and machine set up for a production run.

2.3 Steps in ABC System

1. To identify the different activities within the organisation: Usually, the number of cost centres that a traditional overhead system uses is quite small, say up to 15. In ABC the number of activities will be much more, say 200 the number will depend on how the management sub-divides the organisation’s activities. It is possible to break the organisation down into many very small activities, but if ABC is to be an acceptable and practical system it is necessary to use larger groupings, so that, say, 40 activities may be used in practice.
2. To determine what causes the cost of each activity: The cost driver (e.g. machine hours; number of dispatch orders).
3. To calculate the total cost for each activity: The cost pool (e.g. total machining costs; total costs of dispatch department).
4. To calculate an overhead absorption rate for each cost driver.
5. Activity Cost Driver Rate = Total Cost of an Activity/Cost Driver.
6. To calculate the total overhead cost for each product manufactured.
7. To calculate the overhead cost per unit for each product.

2.4 Applications of ABC

1. When an ABC analysis is combined with a review of investment costs for various tactical or strategic options, one can determine the return on investment to be expected for each of the investment options.
2. An ABC system can accumulate all of the costs associated with a particular distribution method, which allows managers to compare this cost to the profit margins earned on sales of products that are sold through it.
3. An ABC analysis will itemize the costs of each plant, and correctly allocate these costs to the activities conducted within them, which allows a company to determine which plants are more efficient than others.
4. An ABC analysis includes all activity costs associated with a manufactured item, which yields a comprehensive view of all costs associated with it, and which can then be more easily compared with the cost of a similar item that is purchased.
5. By using internal ABC analyses to determine the cost of various activities, a company can create a benchmark for what these costs should be in potential acquisition targets. If the targets have higher costs than the benchmark levels, then the acquiring company knows that it can strip out costs from the acquisition candidate by improving its processes, which may justify the cost of the acquisition.
6. An ABC analysis can reveal the cost of each activity within an organisation. The system is really designed to trace the costs of only the most significant activities, but its design can be altered to itemize the costs of many more activities. This information can then be used to determine which activities are so expensive that they will be the main focus of management attention, or which can be profitably combined with other activities through process centering. This is a primary cost-reduction activity.
7. An ABC analysis reveals all of the costs associated with a product, and so is useful for determining the minimum price that should be charged. However, the actual price charged may be much higher, since this may be driven by the ability of the market to absorb a higher price, rather than the underlying cost of a product.
8. An ABC analysis can be combined with product prices to yield a list of margins for each product sold. When sorted by market, product line, or customer, it is easy to see which products have low or negative returns, or which yield such low margin volume that they are not worth keeping.
9. An ABC analysis reveals the cost of anything that a management team needs to know about—activities, products, or customers—which can then be sorted to see where the highest-cost items are located. When combined with a value analysis, one can determine what costs return the lowest values, and structure a cost-reduction effort accordingly.
10. An ABC analysis can itemize the costs that are specific to each customer, such as special customer service or packaging issues, as well as increased levels of warranty claims or product returns. When added to the margins on products sold to customers, this reveals which customers are the most profitable after all costs are considered.

2.5 Merits of ABC

1. ABC recognizes the increased complexity of modern businesses with its multiple cost drivers, many of which are transaction based rather than volume based.
2. ABC is concerned with all overhead costs, including such ‘non-factory floor’ costs as quality control and customer service, and so it takes cost accounting beyond its ‘traditional’ factory floor boundaries.
3. ABC gives a meaningful analysis of costs which should provide a suitable basis for decisions about pricing, product mix, design and production.
4. ABC helps with cost reduction because it provides an insight into causal activities and allows organisations to consider the possibility of outsourcing particular activities, or even of moving to different areas in the industry value chain.
5. ABC can be used in conjunction with Customer Profitability Analysis (CPA) to determine more accurately the profit earned by serving particular customers.
6. ABC can be used by service and retail organisations. Many service and retail businesses have characteristics very similar to those required for the successful application of ABC in modern manufacturing industry.

2.6 Demerits of ABC

1. The cost of obtaining and interpreting the new information may be considerable. ABC should not be introduced unless it can provide additional information for management to use in planning or control decisions.
2. Some arbitrary cost apportionment may still be required at the cost pooling stage for items like rent, rates and building depreciation. If an ABC system has many cost pools, the amount of apportionment needed may be greater than ever.
3. Many overheads relate neither to volume nor to complexity. The ability of a single cost driver to fully explain the cost behaviour of all items in its associated pool is questionable.
4. There will have to be a trade-off between accuracy, the number of cost drivers and complexity.
5. ABC tends to burden low-volume (new) products with a punitive level of overhead costs and hence threatens opportunities for successful innovation if it is used without due care.
6. Some people have questioned the fundamental assumption that activities cause cost; they suggest that decisions cause cost or the passage of time causes cost or that there may be no clear cause of cost.

2.7 Use of ABC in Decision Making

1. For decisions like relocation or opening of a new distribution center, reduction in freight or other logistics costs can offset the expense of a new facility, staff or equipment. ABC system can identify the specific cost elements being targeted, providing a much clearer picture according to which management can decide and act accordingly.
2. ABC is a complement to Total Quality Management (TQM) and it provides quantitative data that can track the financial impact of improvements implemented as part of the TQM initiative.
3. Using traditional absorption system, overheads may get distributed equally across all product lines. ABC system traces the costs back to the activity and the consumption of resources by each product. This helps in analysing the costs and profits of existing and new products in a more realistic manner.
4. ABC can augment decision support for human resources. ABC can present a number of options, including outsourcing, productivity improvements through automation and determination of employee/revenue ratios.

3. Areas in which Activity Based Information is Used for Decision Making

• Product line profitability
• Capital Investment decisions
• Transfer Pricing
• Pricing of products
• Market Segmentation and Distribution Channels
• Make-or-Buy decisions and outsourcing
• Plant shut-down decisions
• Evaluation of off-shore production, etc.

4. Cost Pools

Cost pools are commonly used for the allocation of factory overhead to units of production, as required by several accounting frameworks. They are also used in activity-based costing to allocate costs to activities. A business that wants to allocate costs at a highly-refined level may choose to do so using a number of cost pools.

The various Cost Pools may be as under in a manufacturing company:

• Purchasing Department
• Receiving Department
• Material Handling
• Set-up of Machines
• Inspection and Quality Control
• Research and Developments
• Customer Service
• Production Control

5. Cost Driver

It is a factor that causes a change in the cost of an activity.

5.1 Categories of cost driver

1. Resource Cost Driver: It is a measure of the quantity of resources consumed by an activity. It is used to assign the cost of a resource to an activity or cost pool. For example, number of purchase orders placed will influence the cost of materials to be purchased.
2. Activity Cost Driver: It is a measure of the frequency and intensity of demand, placed on activities by cost objects. It is used to assign activity costs to cost objects. Activity cost drivers can be transaction drivers (e.g. No. of purchase orders processed, no. of customer orders processed, etc.) as well as duration drivers (it represent amount of time required to perform an activity e.g. Setup hours, inspection hours, etc.)
3. Volume Based Cost Drivers: They assume that a product’s consumption of overhead is directly related to units produced i.e. in case of Machine hours, if volume is increased by 10%, machine hours will increase by 10% hence energy cost will increase by 10%.
4. Non-volume Based Cost Drivers: They are in contrast of volume based cost drivers. Non-volume-based activities are not performed each time a unit of the product or service is produced e.g. number of production runs for production scheduling & the number of purchase orders for the purchasing activity.

5.2 Some Cost Drivers that are used in the context of Activity Based Costing

• Number of requisitions rose
• Number of machine set-up
• Number of machine hours
• Number of production runs
• Number of processed orders
• Number of purchase orders
• Number of orders completed
• Number of labour hours
• Number of orders packed and delivered
• Number of inspections
• Number of customers visit, etc.

6. Cost Object

It is an item for which cost ascertainment is required. For example, a product, a service, a job, a work order No. or a customer, etc.

7. Frequently Asked Questions