CHAPTER 5

ACTIVITY BASED
COSTING
LEARNING OUTCOMES

After studying this chapter, you would be able to-

 Discuss problem of traditional costing system
 Discuss usefulness of Activity Based Costing(ABC)
 Discuss Cost Allocation under ABC
 Discuss Different level of activities under ABC
 Understand stages, advantages, and limitations of ABC
 Discuss various requirements in ABC implementation
 Explain the concept of Activity Based Management(ABM)
 Explain the concept of Activity Based Budgeting(ABB)

Activity Based Costing

Concept Usefullness Cost Hierarchy Steps

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 5.2 COST AND MANAGEMENT ACCOUNTING

5.1 INTRODUCTION
5
As discussed in chapter 4 i.e. Overhead, in traditional costing system, overhead costs
are grouped together under cost center and then absorbed into product costs on one
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 and need to be able to determine it with
reasonable accuracy. The latter organisations have been greatly benefitted from
the development of activity based costing (ABC), which is more a modern
absorption costing method, and was evolved to give more accurate product costs.
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
situation:
1. High amount of Overhead: When Production overheads are high and
significant cost, ABC will be very much useful instead of traditional costing
system.

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 ACTIVITY BASED COSTING 5.3

2. Wide range of products: ABC is most suitable, when, there is a 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 also
can 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

5
(i) Activity – Activity, here, refers to an event that incurs cost.
(ii) A Cost Object–It is an item for which cost measurement is required e.g. a
product or a customer.

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 5.4 COST AND MANAGEMENT ACCOUNTING

(iii) A Cost Driver–It is a factor that causes a change in the cost of an activity.
There are two categories of cost driver. Example Production runs
• A 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.
• An 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 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 and • Number of products in design
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

5
Under activity based cost allocation overheads are attributed to products on an
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

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 ACTIVITY BASED COSTING 5.5

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 ABSORBTION COSTING VS ABC

5
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

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 5.6 COST AND MANAGEMENT ACCOUNTING

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 2 Costs are related to cost centers
and 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 rate (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.

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 ACTIVITY BASED COSTING 5.7

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 materials/consumables tends to
consumption of resources increase in proportion to the
can be identified with the number of units produced.
number of units • The inspection or testing of every
produced. 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 is placed for every batch of
or 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

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 5.8 COST AND MANAGEMENT ACCOUNTING

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 are 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, so that, 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.

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 ACTIVITY BASED COSTING 5.9

Activity cost driver rate = Total cost of activity

Activity driver

The activity driver rate can be used to cost products, as in traditional

absorption costing, but it can also cost 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 and 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?

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 5.10 COST AND MANAGEMENT ACCOUNTING

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.

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 ACTIVITY BASED COSTING 5.11

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.
Example of cost drivers for different activity pools in a production department can
be explained below:

Activity Cost Pools Related Cost Drivers

Ordering and Receiving Materials cost Number of purchase orders
Setting up machines costs Number of set-ups
Machining costs Machine hours
Assembling costs Number of parts
Inspecting and testing costs Number of tests
Painting costs Number of parts
Supervising Costs Direct labour hours

ILLUSTRATION 1
ABC Ltd. is a multiproduct company, manufacturing three products A, B and C. The
budgeted costs and production for the year ending 31st March, 20X8 are as follows:

A B C
Production quantity (Units) 4,000 3,000 1,600
Resources per Unit:
- Direct Materials (Kg.) 4 6 3
- Direct Labour (Minutes) 30 45 60

The budgeted direct labour rate was `10 per hour, and the budgeted material cost
was ` 2 per kg. Production overheads were budgeted at ` 99,450 and were
absorbed to products using the direct labour hour rate. ABC Ltd. followed an
Absorption Costing System.
ABC Ltd. is now considering to adopt an Activity Based Costing system. The
following additional information is made available for this purpose.

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 5.12 COST AND MANAGEMENT ACCOUNTING

1. Budgeted overheads were analysed into the following:

(`)
Material handling 29,100
Storage costs 31,200
Electricity 39,150
2. The cost drivers identified were as follows:

Material handling Weight of material handled

Storage costs Number of batches of material
Electricity Number of Machine operations

3. Data on Cost Drivers was as follows:

A B C
For complete production:
Batches of material 10 5 15
Per unit of production:
Number of Machine operators 6 3 2
You are requested to:
1. PREPARE a statement for management showing the unit costs and total costs
of each product using the absorption costing method.
2. PREPARE a statement for management showing the product costs of each
product using the ABC approach.
3. STATE what are the reasons for the different product costs under the two
approaches?
SOLUTION
1. Traditional Absorption Costing

A B C Total
(a) Quantity (units) 4,000 3,000 1,600 8,600
(b) Direct labour (minutes) 30 45 60 -
(c) Direct labour hours (a × b)/60 minutes 2,000 2,250 1,600 5,850

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 ACTIVITY BASED COSTING 5.13

Overhead rate per direct labour hour:

= Budgeted overheads ÷Budgeted labour hours
= ` 99,450 ÷ 5,850 hours
= ` 17 per direct labour hour
Unit Costs:

A (`) B (`) C (`)

Direct Costs:
- Direct Labour 5.00 7.50 10.00
- Direct Material 8.00 12.00 6.00
Production Overhead: 8.50 12.75 17.00
 17×30   17×45   17×60 
     
 60   60   60 
Total unit costs 21.50 32.25 33.00
Number of units 4,000 3,000 1,600
Total costs 86,000 96,750 52,800

2. Activity Based Costing

A B C Total
Quantity (units) 4,000 3,000 1,600 -
Weight per unit (Kg.) 4 6 3 -
Total weight 16,000 18,000 4,800 38,000
Machine operations per unit 6 3 2 -
Total operations 24,000 9,000 3,200 36,200
Total batches of Material 10 5 15 30

Material handling rate per kg. = ` 29,000 ÷ 38,800 kg. = ` 0.75 per kg.
Electricity rate per machine operations = ` 39,150 ÷ 36,200
= ` 1,082 per machine operations
Storage rate per batch = ` 31,200 ÷ 30 batches
= ` 1,040 per batch

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 5.14 COST AND MANAGEMENT ACCOUNTING

Unit Costs:

A (`) B (`) C (`)

Direct Costs:
Direct Labour 5.00 7.50 10.00
Direct material 8.00 12.00 6.00
Production Overheads:
Material Handling 3.00 4.50 2.25
(`0.75 × 4) (`0.75 × 6) (`0.75 × 3)
Electricity 6.49 3.25 2.16
(`1.082 × 6) (`1.082 × 3) (`1.082 × 2)
Storage 2.60 1.73 9.75
 ` 1,040   `1,040   `1,040 
 `10 ×   `5×   `15× 
 4,000   3,000   1,600 
Total unit costs 25.09 28.98 30.16
Number of units 4,000 3,000 1,600
Total costs ` 1,00,360 ` 86,940 ` 48,256

3. Comments: The difference in the total costs under the two systems is due
to the differences in the overheads borne by each of the products. The Activity
Based Costs appear to be more precise.

5.8 ADVANTAGES OF ACTIVITY BASED COSTING

The main advantages of using Activity Based Costing are:
(i) More accurate costing of products/services.
(ii) Overhead allocation is done on logical basis.
(iii) It enables better pricing policies by supplying accurate cost information.
(iv) Utilizes unit cost rather than just total cost
(v) Help to identify non-value added activities which facilitates cost reduction.
(vi) It is very much helpful to organization with multiple product.
(v) It highlights problem areas which require attention of the management.

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 ACTIVITY BASED COSTING 5.15

5.9 LIMITATIONS OF ACTIVITY BASED COSTING

The main limitations using Activity Based Costing are:
(i) It is more expensive particularly in comparison with Traditional costing
system.
(ii) It is not helpful to small Organization.
(iii) It may not be applied to organization with very limited products.
(iv) Selection of most suitable cost driver may not be useful.

5.10 REQUIRMENTS IN ABC IMPLEMENTATION

A number of distinct practical stages are required in the ABC implementation
which are given as below:
(1) Staff Training: The co-operation of the workforce is critical to the
successful implementation of ABC. Staff training should be done to create an
awareness of the purpose of ABC.
(2) Process Specification: Informal, but structured, interviews with key members
of personnel will identify the different stages of the production process, the
commitment of resources to each, processing times and bottlenecks.
(3) Activity Definition: Early activity should be clearly defined the problem must
be kept manageable at this stage, despite the possibility of information overload
from new data, much of which is in need of codification.
(4) Activity Driver Selection: Cost driver for each activity shall be selected.
(5) Assigning Cost: A single representative activity driver can be used to assign
costs from the activity pools to the cost objects.

5.11 PRACTICAL APPLICATIONS OF ACTIVITY

BASED COSTING
5.11.1 As a Decision-Making Tool
ABC can act as a decision making tools in the following ways:
(i) ABC along with some other Cost Management technique can be utilized to
improve performance and profitability of an organization.

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 5.16 COST AND MANAGEMENT ACCOUNTING

(ii) Wholesale distributors can gain significant advantage in the decision-

making process through implementation of ABC concepts by correlating costs to
various activity. Introduction of new product or vendor can be better decided
through ABC.
(iii) ABC can assist in decisions related to facility and resource expansion. Often
the basis for relocation or opening of a new distribution center is based on cost
associations. Reduction in freight or other logistic costs can offset the expense of
the new facility, staff or equipment. The ABC model can identify the specific cost
elements being targeted, providing a much clearer picture from which
management can act.
(iv) Decision support for human resources can be augmented by ABC. Where
activity, and therefore cost, can be associated to an individual, new levels of
financial performance can be determined. This might be appropriate in cases of
branch management or sales.
(v) Companies who wish to determine price based on cost plus markup basis
find ABC method of costing very relevant and are able to determine competitive
prices for their products.
5.11.2 As Activity Based Management
Meaning of Activity Based Management
The term Activity based management (ABM) is used to describe the cost
management application of ABC. The use of ABC as a costing tool to manage
costs at activity level is known as Activity Based Cost Management (ABM).
ABM is a discipline that focuses on the efficient and effective management of
activities as the route to continuously improving the value received by customers.
ABM utilizes cost information gathered through ABC.
Various analysis in Activity Based Management
The various types of analysis involved in ABM are as follows:
(1) Cost Driver Analysis: The factors that cause activities to be performed need
to be identified in order to manage activity costs. Cost driver analysis identifies
these causal factors.
(2) Activity Analysis.
(a) Value-Added Activities (VA): The value-added activities are those
activities which are indispensable in order to complete the process.
The customers are usually willing to pay (in some way) for these

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 ACTIVITY BASED COSTING 5.17

services. For example, polishing furniture by a manufacturer dealing in

furniture is a value added activity.
(b) Non-Value-Added Activities (NVA): The NVA activity represents 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. Moving
materials and machine set up for a production run are examples of
NVA activities.
(3) Performance Analysis: Performance analysis involves the identification of
appropriate measures to report the performance of activity centres or other
organisational units, consistent with each unit’s goals and objectives.
Activity Based Management in Business
Activity based management can be used in the following ways
(i) Cost Reduction: ABM helps the organisation to identify costs against
activities and to find opportunities to streamline or reduce the costs or eliminate
the entire activity, especially if there is no value added.
(ii) Business Process Re-engineering: Business process re-engineering
involves examining business processes and making substantial changes to
how organisation currently operates. ABM is a powerful tool for measuring
business performance, determining the cost of business output and is used as a
means of identifying opportunities to improve process efficiency and
effectiveness.
(iii) Benchmarking: Benchmarking is a process of comparing of ABC-derived
activity costs of one segment of company with those of other segments. It
requires uniformity in the definition of activities and measurement of their costs.
(iv) Performance Measurement: Many organisations are now focusing on
activity performance as a means of facing competitors and managing costs by
monitoring the efficiency and effectiveness of activities.

Area Measure
Quality of purchased component Zero defects
Quality of output % yield
Customer awareness Orders; number of complaints

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 5.18 COST AND MANAGEMENT ACCOUNTING

5.11.3 Facilitate Activity Based Budgeting

Meaning of Activity Based Budgeting (ABB)
Activity based budgeting analyse the resource input or cost for each activity. It
provides a framework for estimating the amount of resources required in
accordance with the budgeted level of activity. Actual results can be compared
with budgeted results to highlight both in financial and non-financial terms those
activities with major discrepancies from budget for potential reduction in supply
of resources. It is a planning and control system which seeks to support the
objectives of continuous improvement. It means planning and controlling the
expected activities of the organization to derive a cost-effective budget that meet
forecast workload and agreed strategic goals. ABB is the reversing of the ABC
process to produce financial plans and budgets.
Key Elements of ABB
The three key elements of activity based budgeting are as follows:-
♦ Type of work to be done
♦ Quantity of work to be done
♦ Cost of work to be done
Benefits of ABB
Few benefits of activity based budgeting are as follows:-
1. Activity Based Budgeting (ABB) can enhance accuracy of financial forecasts
and increasing management understanding.
2. When automated, ABB can rapidly and accurately produce financial plans
and models based on varying levels of volume assumptions.
3. ABB eliminates much of the needless rework created by traditional
budgeting techniques.
ILLUSTRATION 2
MST Limited has collected the following data for its two activities. It calculates
activity cost rates based on cost driver capacity.

Activity Cost Driver Capacity Cost

Power Kilowatt hours 50,000 kilowatt hours `2,00,000
Quality Inspections Number of Inspections 10,000 Inspections ` 3,00,000

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 ACTIVITY BASED COSTING 5.19

The company makes three products M, S and T. For the year ended March 31, 20X9,
the following consumption of cost drivers was reported:

Product Kilowatt hours Quality Inspections

M 10,000 3,500
S 20,000 2,500
T 15,000 3,000
Required:
(i) COMPUTE the costs allocated to each product from each activity.
(ii) CALCULATE the cost of unused capacity for each activity.
(iii) DISCUSS the factors the management considers in choosing a capacity level
to compute the budgeted fixed overhead cost rate.
SOLUTION
(i) Statement of cost allocation to each product from each activity

Product
M (`) S (`) T (`) Total
(`)
Power (Refer 40,000 80,000 60,000 1,80,000
to working (10,000 kWh (20,000 kWh (15,000 kWh
note) × `4) ×`4) ×`4)
Quality 1,05,000 75,000 90,000 2,70,000
Inspections (3,500 (2,500 (3,000
(Refer to inspections × inspections × inspections ×
working note) `30) ` 30) ` 30)

Working note
Rate per unit of cost driver:

Power (` 2,00,000 / 50,000 kWh) ` 4/kWh

Quality Inspection (` 3,00,000 / 10,000 ` 30 per inspection
inspections)

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 5.20 COST AND MANAGEMENT ACCOUNTING

(ii) Computation of cost of unused capacity for each activity:

(`)
Power (`2,00,000 – ` 1,80,000) 20,000
Quality Inspections (`. 3,00,000 – ` 2,70,000) 30,000
Total cost of unused capacity 50,000

(iii) Factors management consider in choosing a capacity level to compute

the budgeted fixed overhead cost rate:
- Effect on product costing & capacity management
- Effect on pricing decisions.
- Effect on performance evaluation
- Effect on financial statements
- Regulatory requirements.
- Difficulties in forecasting chosen capacity level concepts.
ILLUSTRATION 3
ABC Ltd. Manufactures two types of machinery equipment Y and Z and
applies/absorbs overheads on the basis of direct-labour hours. The budgeted
overheads and direct-labour hours for the month of December, 20X8 are
` 12,42,500 and 20,000 hours respectively. The information about Company’s
products is as follows:

Equipment Equipment
Y Z
Budgeted Production volume 2,500 units 3,125 units
Direct material cost ` 300 per unit ` 450 per unit
Direct labour cost
Y : 3 hours @ ` 150 per hour
X : 4 hours @ ` 150 per hour ` 450 ` 600
ABC Ltd.’s overheads of ` 12,42,500 can be identified with three major activities:
Order Processing (` 2,10,000), machine processing (` 8,75,000), and product
inspection (` 1,57,500). These activities are driven by number of orders processed,
machine hours worked, and inspection hours, respectively. The data relevant to

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 ACTIVITY BASED COSTING 5.21

these activities is as follows:

Orders processed Machine hours worked Inspection hours
Y 350 23,000 4,000
Z 250 27,000 11,000
Total 600 50,000 15,000

Required:
(i) Assuming use of direct-labour hours to absorb/apply overheads to production,
COMPUTE the unit manufacturing cost of the equipment Y and Z, if the
budgeted manufacturing volume is attained.
(ii) Assuming use of activity-based costing, COMPUTE the unit manufacturing costs
of the equipment Y and Z, if the budgeted manufacturing volume is achieved.
(iii) ABC Ltd.’s selling prices are based heavily on cost. By using direct-labour
hours as an application base, CALCULATE the amount of cost distortion
(under-costed or over-costed) for each equipment.
SOLUTION
(i) Overheads application base: Direct labour hours

Equipment Equipment
Y (`) Z (`)
Direct material cost 300 450
Direct labour cost 450 600
Overheads* 186.38 248.50
936.38 1,298.50

Budgeted overheads ` 12, 42,500

*Pre-determined rate = = = `62.125
Budgeted direct labour hours 20, 000 hours

(ii) Estimation of Cost-Driver rate

Overhead cost Cost-driver level Cost driver rate

Activity
(`) (`)
Order processing 2,10,000 600 350
Orders processed

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 5.22 COST AND MANAGEMENT ACCOUNTING

Machine 8,75,000 50,000 17.50

processing Machine hours
Inspection 1,57,500 15,000 10.50
Inspection hours

Equipment Equipment
Y (`) Z (`)
Direct material cost 300 450
Direct labour cost 450 600
Prime Cost 750 1,050
Overhead Cost
Order processing 350 : 250 1,22,500 87,500
Machine processing 23,000 : 27,000 4,02,500 4,72,500
Inspection 4,000 : 11,000 42,000 1,15,500
Total overhead cost 5,67,000 6,75,500

Per unit cost

5,67,000 /2,500 226.80 `. 216.16
6,75,500/ 3,125
Unit manufacturing cost ` 976.80 ` 1,266.16
(iii)

Equipment Equipment
Y (`) Z (`)
Unit manufacturing cost–using direct labour
hours as an application base 936.38 1,298.50
Unit manufacturing cost-using activity based 976.80 1,266.16
costing
Cost distortion (-)40.42 + 32.34

Low volume product Y is under-costed and high volume product Z is over

costed using direct labour hours for overhead absorption.

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 ACTIVITY BASED COSTING 5.23

SUMMARY
♦ 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.
♦ Unit level activities, batch level activities, product level activities and facility
level activities are the categories of activities helps to determine the type of
activity cost driver required.
♦ ABC is very much useful to the organization with multiple product.
♦ One of the few weakness of ABC is, it is very costly and cannot be applied to
all companies.
♦ The use of ABC as a costing tool to manage costs at activity level is known as
Activity Based Cost Management (ABM). ABM is a discipline that focuses on
the efficient and effective management of activities as the route to
continuously improving the value received by customers. ABM utilizes cost
information gathered through ABC.
♦ The value-added activities are those activities which are indispensable in
order to complete the process.
♦ NVA activity represents 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.
♦ Activity-based budgeting is a process of planning and controlling the
expected activities for the organisation to derive a cost-effective budget that
meets forecast workload and agreed strategic goals.
♦ Key elements of ABB are type of work/activity to be performed, quantity of
work/activity to be performed and cost of work/activity to be performed.

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 5.24 COST AND MANAGEMENT ACCOUNTING

TEST YOUR KNOWLEDGE

MCQs based Questions
1. A cost driver is:
(a) An item of production overheads
(b) A common cost which is shared over cost centres
(c) Any cost relating to transport
(d) An activity which generates costs
2. In activity based costing, costs are accumulated by activity using:
(a) Cost drivers
(b) Cost objects
(c) Cost pools
(d) Cost benefit analysis
3. A cost driver:
(a) Is a force behind the overhead cost
(b) Is an allocation base
(c) Is a transaction that is a significant determinant of cost
(d) All of the above
4. Which of the following is not a correct match:

Activity Cost Driver

a) Production Scheduling Number of Production runs
b) Despatching Number of dispatch orders
c) Goods receiving Goods received orders
d) Inspection Machine hours

5. Transactions undertaken by support department personnel are the

appropriate cost drivers. They are:
(a) The number of purchase, supplies and customers’ orders drives the
cost associated with new material inventory, work-in-progress and
finished goods inventory

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 ACTIVITY BASED COSTING 5.25

(b) The number of production runs undertaken drives production

scheduling, inspection and material handling
(c) The quality of raw material issued drives the cost of receiving
department costs
(d) The number of packing orders drives the packing costs
6. Steps in ABC include:
(a) Identification of activities and their respective costs
(b) Identification of cost driver of each activity and computation of an
allocation rate per activity
(c) Allocation of overhead cost to products/ services based on the
activities involved
(d) All of the above
7. Which of the following is not a benefit of ABC?
(a) Accurate cost allocation
(b) Improved decision making
(c) Better control on activity and costs
(d) Reduction of prime cost
8. The steps involved for installation of ABC in a manufacturing company
include the following except:
(a) Borrowing fund
(b) Feasibility study
(c) Building up necessary IT infrastructure and training of line employees
(d) Strategy and value chain analysis
9. Which of the following statements are true: (1) Activity based Management
involves activity analysis and performance measurement. (2) Activity based
costing serves as a major source of information in ABM.
(a) (1) True; (2) False
(b) (1) True; (2) True
(c) (1) False; (2) True

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 5.26 COST AND MANAGEMENT ACCOUNTING

(d) (1) False; (2) False

10. The key elements of activity based budgeting are:
(a) Type of activity to be performed
(b) Quantity of activity to be performed
(c) Cost of activity to be performed
(d) All of the above
Theoretical Questions:
1. DEFINE the following terms:
(i) Cost driver
(ii) Activity cost pool
2. EXPLAIN in brief the problems of traditional costing where overhead costs
are allocated based on volume
3. STATE what is Activity based costing? How are product costs determined in
ABC?
4. A manufacturing company in India wants to replace its traditional costing
system by ABC. It produces a number of products, each having complex
production process of different degree. SUGGEST various requirements for
installing activity based costing.
5. DESCRIBE various level of activities under ABC.
6. STATE what are the benefits of ABC?
7. STATE what are the limitations of ABC?
8. STATE what are the practical application of ABC?
9. STATE what is Activity based Management? How does ABC help ABM?
10. DEFINE Activity based Budgeting. STATE what are its key elements?

Practical Problems
1. RST Limited specializes in the distribution of pharmaceutical products. It
buys from the pharmaceutical companies and resells to each of the three
different markets.
(i) General Supermarket Chains

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 ACTIVITY BASED COSTING 5.27

(ii) Drugstore Chains

(iii) Chemist Shops
The following data for the month of April, 20X9 in respect of RST Limited
has been reported:

General Drugstore Chemist

Supermarket Chains Shops
Chains
(`) (`) (`)
Average revenue per delivery 84,975 28,875 5,445
Average cost of goods sold 82,500 27,500 4,950
per delivery
Number of deliveries 330 825 2,750

In the past, RST Limited has used gross margin percentage to evaluate the
relative profitability of its distribution channels.
The company plans to use activity –based costing for analysing the
profitability of its distribution channels.
The Activity analysis of RST Limited is as under:

Activity Area Cost Driver

Customer purchase order processing Purchase orders by customers
Line-item ordering Line-items per purchase order
Store delivery Store deliveries
Cartons dispatched to stores Cartons dispatched to a store
per delivery
Shelf-stocking at customer store Hours of shelf-stocking

The April, 20X9 operating costs (other than cost of goods sold) of RST
Limited are ` 8,27,970. These operating costs are assigned to five activity
areas. The cost in each area and the quantity of the cost allocation basis
used in that area for April, 20X9 are as follows:

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 5.28 COST AND MANAGEMENT ACCOUNTING

Activity Area Total costs Total Units of

in April, Cost Allocation
20X9 (`) Base used in
April, 20X9
Customer purchase order processing 2,20,000 5,500 orders
Line-item ordering 1,75,560 58,520 line items
Store delivery 1,95,250 3,905 store
deliveries
Cartons dispatched to store 2,09,000 2,09,000 cartons
Shelf-stocking at customer store 28,160 1,760 hours

Other data for April, 20X9 include the following:

General Drugstore Chemist

Supermarket Chains Shops
Chains
Total number of orders 385 990 4,125
Average number of line items per 14 12 10
order
Total number of store deliveries 330 825 2,750
Average number of cartons 300 80 16
shipped per store delivery
Average number of hours of 3 0.6 0.1
shelf-stocking per store delivery
Required:
(i) COMPUTE for April, 20X9 gross-margin percentage for each of its
three distribution channels and compute RST Limited’s operating
income.
(ii) COMPUTE the April, 20X9 rate per unit of the cost-allocation base for
each of the five activity areas.
(iii) COMPUTE the operating income of each distribution channel in April,
20X9 using the activity-based costing information. Comment on the
results. What new insights are available with the activity-based cost
information?

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 ACTIVITY BASED COSTING 5.29

(iv) DESCRIBE four challenges one would face in assigning the total April,
20X9 operating costs of ` 8,27,970 to five activity areas.
2. Alpha Limited has decided to analyse the profitability of its five new
customers. It buys bottled water at ` 90 per case and sells to retail
customers at a list price of ` 108 per case. The data pertaining to five
customers are:

Customers
A B C D E
Cases sold 4,680 19,688 1,36,800 71,550 8,775
List Selling Price ` 108 ` 108 `. 108 ` 108 ` 108
Actual Selling Price ` 108 ` 106.20 ` 99 ` 104.40 ` 97.20
Number of Purchase 15 25 30 25 30
orders
Number of Customer 2 3 6 2 3
visits
Number of deliveries 10 30 60 40 20
Kilometers travelled 20 6 5 10 30
per delivery
Number of expedited 0 0 0 0 1
deliveries
Its five activities and their cost drivers are:

Activity Cost Driver Rate

Order taking ` 750 per purchase order
Customer visits ` 600 per customer visit
Deliveries ` 5.75 per delivery Km travelled
Product handling ` 3.75 per case sold
Expedited deliveries ` 2,250 per expedited delivery
Required:
(i) 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.
(ii) STATE what insights are gained by reporting both the list selling price
and the actual selling price for each customer?

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 5.30 COST AND MANAGEMENT ACCOUNTING

ANSWERS/SOLUTIONS
MCQs based Questions
1. (d) 2. (c) 3. (d) 4. (d) 5. (c) 6. (d)
7. (d) 8. (a) 9. (b) 10. (d)

Theoretical Questions
1. Please refer paragraph 5.3
2. Please refer paragraph 5.1
3. Please refer paragraph 5.2 and 5.5
4. Please refer paragraph 5.10
5. Please refer paragraph 5.6
6. Please refer paragraph 5.8
7. Please refer paragraph 5.9
8. Please refer paragraph 5.11
9. Please refer paragraph 5.11.2
10. Please refer paragraph 5.11.3

Practical Questions
1. (i) RST Limited’s
Statement of operating income and gross margin percentage
for each of its three distribution channel
General Super Drugstore Chemist Shops Total
Market Chains Chains
Revenues: (`) 2,80,41,750 2,38,21,875 1,49,73,750 6,68,37,375
(330 × ` 84,975) (825 × ` 28,875) (2,750 × `5,445)
Less: Cost of 2,72,25,000 2,26,87,500 1,36,12,500 635,25,000
goods sold: (`) (330 × ` 82,500) (825 × ` 27,500) (2,750 × ` 4,950)
Gross Margin: (`) 8,16,750 11,34,375 13,61,250 33,12,375
Less: Other
operating costs:
(`) 8,27,970

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 ACTIVITY BASED COSTING 5.31

Operating 24,84,405
income: (`)
Gross Margin 2.91% 4.76 % 9.09% 4.96%
Operating 3.72
income %
(ii) Computation of rate per unit of the cost allocation base for
each of the five activity areas for April 20X9
(`)
Customer purchase order processing 40 order
(`. 2,20,000/ 5,500 orders)
Line item ordering 3 line item order
(`. 1,75,560/ 58,520 line items)
Store delivery 50 delivery
(`. 1,95,250/ 3,905 store deliveries)
Cartons dispatched 1 dispatch
(`. 2,09,000/ 2,09,000 dispatches)
Shelf-stocking at customer store ( ` ) 16 hour
(` 28,160/ 1,760 hours)
(iii) Operating Income Statement of each distribution channel
in April-20X9 (Using the Activity based Costing information)

General Super Drugstore Chemist

Market Chains Chains Shops
Gross margin (`.) : (A) 8,16,750 11,34,375 13,61,260
(Refer to (i) part of the answer)
Operating cost (`.): (B) 1,62,910 1,90,410 4,74,650
(Refer to working note)
Operating income (`.) : (A–B) 6,53,840 9,43,965 8,86,600
Operating income (in %) 2.33 3.96 5.96
(Operating income/ Revenue)
× 100

Comments and new insights: The activity-based cost information

highlights, how the ‘Chemist Shops’ uses a larger amount of RST Ltd.’s

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 5.32 COST AND MANAGEMENT ACCOUNTING

resources per revenue than do the other two distribution channels. Ratio of
operating costs to revenues, across these markets is:
General supermarket chains 0.58%
(` 1,62,910/ `. 2,80,00,750) × 100
Drug store chains 0.80%
(` 1,90,410/ ` 2,38,21,875) × 100
Chemist shops 3.17%
(` 4,74,650/ ` 1,49,73,750) ×100

Working note:
Computation of operating cost of each distribution channel:
General Super Drugstore Chemist Shops
Market Chains Chains
(`) (`) (`)
Customer 15,400 39,600 1,65,000
purchase (` 40 × 385 (` 40 × 990 (` 40 ×4125 orders)
order orders) orders)
processing
Line item 16,170 35,640 1,23,750
ordering (` 3 × 14 x 385) (` 3 × 12 x 990) (` 3 × 10 × 4125)
Store 16,500 41,250 1,37,500
delivery (` 50 × 330 (` 50 × 825 (` 50 × 2750
deliveries) deliveries) deliveries)
Cartons 99,000 66,000 44,000
dispatched ( ` 1× 300 cartons ( ` 1 × 80 cartons ( ` 1 × 16 cartons ×
× 300 deliveries) × 825 deliveries) 2,750 deliveries)
Shelf 15,840 7,920 4,400
stocking (`16 × 330 (` 16 × 825 (` 16 × 2,750
deliveries × 3 Av. deliveries × 0.6 deliveries × 0.1 Av.
hrs.) Av. hrs) hrs)
Operating 1,62,910 1,90,410 4,74,650
cost

(iv) Challenges faced in assigning total operating cost of ` 8,27,970 :

- Choosing an appropriate cost driver for activity area.

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 ACTIVITY BASED COSTING 5.33

- Developing a reliable data base for the chosen cost driver.

- Deciding, how to handle costs that may be common across several
activities.
- Choice of the time period to compute cost rates per cost driver.
- Behavioural factors.
2. Working note:
Computation of revenues (at listed price), discount, cost of goods sold
and customer level operating activities costs:
Customers
A B C D E
Cases sold: 4,680 19,688 1,36,800 71,550 8,775
(a)
Revenues (at 5,05,440 21,26,304 1,47,74,400 77,27,400 9,47,700
listed price)
(`): (b)
{(a) × ` 108)}
Discount - 35,438 12,31,200 2,57,580 94,770
( ` ): (c) (19,688 cases (1,36,800 (71,550 (8,775
{(a) × × cases × cases × cases ×
Discount per ` 1.80) ` 9) ` 3.60) ` 10.80)
case}
Cost of 4,21,200 17,71,920 1,23,12,000 64,39,500 7,89,750
goods sold
(`) : (d)
{(a) × ` 90}
Customer level operating activities costs
Order taking 11,250 18,750 22,500 18,750 22,500
costs (`):
(No. of
purchase ×
`750)
Customer 1,200 1,800 3,600 1,200 1,800
visits costs
(`)

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 5.34 COST AND MANAGEMENT ACCOUNTING

(No. of
customer
visits ×
` 600)
Delivery 1,150 1,035 1,725 2,300 3,450
vehicles
travel costs
(`)
(` 5.75 per
km)
(Kms
travelled by
delivery
vehicles × `
5.75 per km.)
Product 17,550 73,830 5,13,000 2,68,313 32,906
handling
costs (`)
{(a) ×` 3.75}
Cost of - - - - 2,250
expediting
deliveries (`)
{No. of
expedited
deliveries ×
` 2,250}
Total cost of 31,150 95,415 5,40,825 2,90,563 62,906
customer
level
operating
activities (`)

(i) Computation of Customer level operating income

Customers
A (`) B (`) C (`) D (`) E (`)
Revenues 5,05,440 21,26,304 1,47,74,400 77,27,400 9,47,700
(At list price)
(Refer to
working note)

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 ACTIVITY BASED COSTING 5.35

Less: Discount - 35,438 12,31,200 2,57,580 94,770

(Refer to
working note)
Revenue 5,05,440 20,90,866 1,35,43,200 74,69,820 8,52,930
(At actual
price)
Less: Cost of 4,21,200 17,71,920 1,23,12,000 64,39,500 7,89,750
goods sold
(Refer to
working note)
Gross margin 84,240 3,18,946 12,31,200 10,30,320 63,180
Less: 31,150 95,415 5,40,825 2,90,563 62,906
Customer
level
operating
activities costs
(Refer to
working note)
Customer 53,090 2,23,531 6,90,375 7,39,757 274
level
operating
income
Comment on the results:
Customer D is the most profitable customer, despite having only 52.30% of
the unit volume of customer C. The main reason is that C receives a ` 9 per
case discount while customer D receives only a ` 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 ` 10.80 per case, makes
more frequent orders, requires more customer visits and requires more
delivery kms. in comparison with customer A.
(ii) Insight gained by reporting both the list selling price and the actual
selling price for each customer:
Separate reporting of both-the listed and actual selling prices enables Alpha
Ltd. to examine which customer has received what discount per case,

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 5.36 COST AND MANAGEMENT ACCOUNTING

whether the discount received has any relationship with the sales volume.
The data given below provides us with the following information;

Sales volume Discount per case (`)

C (1,36,800 cases) 9.00
D (71,550 cases) 3.60
B (19,688 cases) 1.80
E (8,775 cases) 10.80
A (4,680 cases) 0
The above data clearly shows that the discount given to customers per case has a
direct relationship with sales volume, except in the case of customer E. The
reasons for ` 10.80 discount per case for customer E should be explored.

© The Institute of Chartered Accountants of India