5.

1 INTRODUCTION
Overhead, in traditional costing system, overhead costs are grouped together under
cost center and then absorbed into product costs on either of the basis such as direct
labour hours, machine hours, volume etc. In certain cases, this traditional costing
system gives inaccurate cost information. Though, it should not be assumed that all
traditional absorption costing systems are not accurate enough to give adequate
information for pricing purposes or other long-run management decision purposes.
Some traditional systems treat overheads in a detailed way and relate them to service
cost centres as well as production cost centres. The service centre overheads are then
spread over the production cost centres before absorption rates are calculated. The
main cause of inaccuracy is in the calculation of the overhead rate itself, which is
usually based on direct labour hours or machine hours. These rates assume that products
that take longer to make, generate more overheads and so on.

Organisations, who do not wish to know how much it costs to make a product with
precise accuracy, may be happy with traditional costing system. Others, however,
fix their price on cost basis and need to determine it with reasonable accuracy. The
latter organisations have been greatly benefitted from the development of activity
based costing (ABC), which is considered as a modern absorption costing method,
and was evolved to give more accurate product costs.

Absorption Costing:
Absorption costing, also known as full costing, includes all manufacturing costs
(direct materials, direct labor, and both variable and fixed manufacturing overhead)
as part of the product cost.

Overhead Allocation:

It allocates overhead costs to products based on a predetermined overhead rate,

often using a volume-based driver like direct labor hours or machine hours.
Example:

A company manufactures two products, A and B. Under absorption costing, all

manufacturing overhead costs (e.g., rent, utilities, depreciation) are allocated to both
products based on the total production units or direct labor hours.

5.1.1 Factors prompting the development of ABC

Various factors lead to the development of ABC include:

1. Growing overhead costs because of increasingly automated production

2. Increasing market competition, which necessitated more accurate product

costs.

3. Increasing product diversity to secure economies of scope & increased market share.

4. Decreasing costs of information processing because of continual

improvements and increasing application of information technology.

5.1.2 Usefulness/Suitability of ABC

ABC is particularly needed by organisations for product costing in the following
situations:

1. High amount of overhead: When production overheads are high and form
significant costs, ABC is more useful than traditional costing system.
2. Wide range of products: ABC is most suitable, when, there is diversity in the
product range or there are multiple products.

3. Presence of non-volume related activities: When non-volume related

activities e.g. material handling, inspection set-up, are present significantly
and traditional system cannot be applied, ABC is a superior and better option.
ABC will identify non-value-adding activities in the production process that
might be a suitable focus for attention or elimination.
4. Stiff competition: When the organisation is facing stiff competition and
there is an urgent requirement to compute cost accurately and to fix the
selling price according to the market situation, ABC is very useful. ABC can
also facilitate in reducing cost by identifying non-value-adding activities in the
production process that might be a suitable focus for attention or elimination.

5.2 MEANING AND DEFINITION

Activity Based Costing is an accounting methodology that assigns costs to
activities rather than products or services. This enables resources & overhead
costs to be more accurately assigned to products & services that consume them.
ABC is a technique which involves identification of cost with each cost driving
activity and making it as the basis for apportionment of costs over different
cost objects/ jobs/ products/ customers or services.

ABC assigns cost to activities based on their use of resources. It then assigns cost
to cost objects, such as products or customers, based on their use of activities. ABC
can track the flow of activities in organization by creating a link between the activity
(resource consumption) and the cost object.

CIMA defines ‘Activity Based Costing’ as “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 utilise cost drivers to attach activity costs to
outputs.”

5.3 MEANING OF TERMS USED IN ABC

(i) Activity – Activity, here, refers to an event that incurs cost.

(ii) Cost Object–It is an item for which cost measurement is required e.g.
a product or a customer.
(iii) Cost Driver–It is a factor that causes a change in the cost of an activity. There
are two categories of cost driver.

 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.

 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.

(iv) Cost Pool-It represents a group of various individual cost items. It consists of
costs that have same cause and effect relationship. Example machine set-up.

Examples of Cost Drivers:

Business functions Cost Driver

Research and Development  Number of research projects

 Personnel hours on a project

Design of products, services  Number of products in design

and procedures  Number of parts per product
 Number of engineering hours

Customer Service  Number of service calls

 Number of products serviced
 Hours spent on servicing products
 Marketing  Number of advertisements
 Number of sales personnel
 Sales revenue

Distribution  Number of units distributed

 Number of customers

5.4 COST ALLOCATION UNDER ABC

Under activity based cost allocation overheads are attributed to products on the
activity base. Traditionally, overhead costs are grouped together under cost centre
and then absorbed into product costs on some basis such as direct labour hours.
Activity based costing identifies the activities which cause cost to be incurred and
searches for fundamental cost drivers of these activities. Once the activities and
there cost drivers have been identified this information can be used to assign
overheads to cost objects (e.g. products) which have actually caused cost to be
incurred.
 5.5 TRADITIONAL ABSORPTION COSTING VS ABC
Cost Allocation under Traditional and Activity Based Costing system

Direct Cost
Tracing of Product/
Cost Ascertainment Service
Cost
Indirect Cost
Cost
Allocation

Traditional Costing Activity based Costing

Based on Machine
hours, labour Hours, Based on Cost Driver
Volume etc.

Cost Allocation under Traditional and Activity Based Costing System

In traditional absorption costing overheads are first related to cost centres
(Production & Service Centres) and then to cost objects, i.e., products. In ABC
overheads are related to activities or grouped into cost pools. Then they are related
to the cost objects, e.g., products. The two processes are, therefore, very similar,
but the first stage is different, as ABC uses activities instead of functional
departments (cost centres). The problem with functional departments is that they
tend to include a series of different activities, which incur a number of different
costs that behave in different ways. Activities also tend to run across functions; for
instance, procurement of materials often includes raising a requisition note in a
manufacturing department or stores. It is not raised in the purchasing department
where most procurement costs are incurred. Activity costs tend to behave in a
similar way to each other i.e., they have the same cost driver. Therefore, ABC gives
a more realistic picture of the way in which costs behave.
 Activity Based Costing Traditional Absorption Costing
1. Overheads are related to 1. Overheads are related to cost
activities and grouped into centers/departments.
activity cost pools.
2. Costs are related to activities and 2 Costs are related to cost centers
hence are more realistic. and hence not realistic of cost
behaviour.
3 Activity–wise cost drivers are 3. Time (Hours) are assumed to be
determined. the only cost driver governing
costs in all departments.
4. Activity–wise recovery rates are 4. Either multiple overhead recovery
determined and there is no rates (for each department) or a
concept of a single overhead single overhead recovery rate may
recovery rate. be determined for absorbing
overheads.
5. Cost are assigned to cost 5. Costs are assigned to Cost Units
objects, e.g. customers, i.e. to products, or jobs or hours.
products, services, departments,
etc.
6. Essential activities can be 6. Cost Centers/ departments cannot
simplified and unnecessary be eliminated. Hence, not suitable
activities can be eliminated. Thus, for cost control.
the corresponding costs are also
reduced/ minimized. Hence ABC
aids cost control.

5.6 LEVEL OF ACTIVITIES UNDER ABC METHO-

DOLOGY/COST HIERARCHY
These categories are generally accepted today, but were first identified by Cooper
(1990). The categories of activities help to determine the type of activity cost driver
required.
The categories of activities are:

Level of Meaning Example

Activities
1.Unit level These are those activities  The use of indirect
activities for which the consumption materials/consumables tends to
of resources can be increase in proportion to the
identified with the number number of units produced.
of units produced.  The inspection or testing of every
item produced, if this was deemed
necessary or, perhaps more likely,
every 100th item produced.
2.Batch level The activities such as  Material ordering–where an order
activities setting up of a machine or is placed for every batch of
processing a purchase production
order are performed each  Machine set-up costs–where
time a batch of goods is machines need resetting between
produced. The cost of each different batch of production.
batch related activities  Inspection of products where the
varies with number of first item in every batch is
batches made, but is inspected rather than every 100th
common (or fixed) for all item quoted above.
units within the batch.
3. Product These are the activities  Designing the product,
level which are performed to  Producing parts specifications
activities support different  Keeping technical drawings of
products in product line products up to date.
4.Facilities These are the activities  Maintenance of buildings
level which cannot be directly  Plant security
activities attributed to individual
products. These activities
are necessary to sustain
the manufacturing
process and are common
and joint to all products
manufactured
5.7 STAGES IN ACTIVITY BASED COSTING (ABC)
The different stages in ABC calculations are listed below:

(1) 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 fifteen. In ABC, the number of activities will be much more, say 200;
the exact number will depend on how the management subdivides the
organisation’s activities. It is possible to break the organisation down into
many very small activities. But if ABC is to be acceptable as practical system
it is necessary to use larger groupings, say, 40 activities may be used in
practice. The additional number of activities over cost centres means that ABC
should be more accurate than the traditional method regardless of anything
else. Some activities may be listed as follows:-

 Production schedule changes

 Customer liaison

 Purchasing

 Production process set up

 Quality control

 Material handling

 Maintenance

(2) Relate the overheads to the activities, both support and primary, that
caused them. This creates ‘cost pools’ or ‘cost buckets’. This will be done
using resource cost drivers that reflect causality.

(3) Support activities are then spread across the primary activities on some
suitable base, which reflects the use of the support activity. The base is the
 cost driver that is the measure of how the support activities are used.

(4) Determine the activity cost drivers that will be used to relate the overheads
collected in the cost pools to the cost objects/products. This is based on the
factor that drives the consumption of the activity. The question to ask is –
what causes the activity to incur costs? In production scheduling, for example,
the driver will probably be the number of batches ordered.

(5) Calculate activity cost driver rates for each activity, just as an overhead
absorption rate would be calculated in the traditional system.
 The activity driver rate can be used not only to identify cost of products, as
in traditional absorption costing, but it can also be used for costing other cost
objects such as customers/customer segments and distribution channels. The
possibility of costing objects other than products is part of the benefit of ABC.
The activity cost driver rates will be multiplied by the different amounts of
each activity that each product/other cost object consumes.

Cost allocation under ABC

Let us take a small example to understand the steps stated above:
Assume that a company makes widgets and the management decides to install an
ABC system. The management decides that all overhead costs will have only three
cost drivers viz. direct labour hours, machine hours and number of purchase orders.
The general ledger of the company shows the following overhead costs –

General Ledger Amount (`)

Payroll taxes 1,000
Machine maintenance 500
Purchasing Dept. labour 4,000
Fringe benefits 2,000
Purchasing Dept. Supplies 250
Equipment depreciation 750
Electricity 1,250
Unemployment insurance 1,500
Total 11,250
So, which overheads do you think are driven by direct labour hours?
The answer is
Payroll taxes ` 1,000
Fringe benefits ` 2,000
Unemployment insurance ` 1,500
Total ` 4,500

Similarly, overheads driven by machine hours include Machine maintenance,

depreciation and Electricity totaling ` 2,500 and finally overheads driven by number
of purchase orders include purchasing department labour and purchasing
department supplies totaling ` 4,250.

Now, overhead rate is calculated by the formula

Total cost in the activity pool ÷ Base,
base being the total number of labour hours, machine hours and total number of
purchase orders in the given case.

Assume that the total number of labour hours be 1,000 hours, machine hours be
250 hours and total purchase orders be 100 orders.

So, Cost driver rate would be

Cost Driver Rate (`)
` 4,500/ 1,000 ` 4.50 per labour hour
` 2,500/ 250 ` 10 per machine hour
` 4,250/ 100 ` 42.50 per purchase order

Now, let’s allocate the overheads between two widgets A and B the details of which
are given below:

Particulars Widget A Widget B

Labour hours 400 600
Machine Hours 100 150
Purchase Orders 50 50

So, total overhead costs applied to widget A = (400×4.50) + (100×10) + (50×42.50)

= 4,925
And total overheads applied to widget B = (600×4.50) + (150×10) + (50×42.50) =
` 6,325

So total overheads = ` 4,925 + ` 6,325 = ` 11,250.

Generally, in the traditional costing method, overheads are applied on the basis of
direct labour hours (total 1,000 labour hours in the given case). So, in that case the
overhead absorption rate would be – ` 11,250/ 1000 = ` 11.25 per hour and the
total overheads applied to Widget A would have been = 400 × 11.25 =
` 4,500 and to Widget B = 600 ×11.25 = ` 6,750.

Hence Widget A would have been undervalued and Widget B overvalued by ` 425.