The document discusses activity-based costing (ABC). It provides an example of calculating activity rates for a purchase invoice processing activity. It shows calculating the activity usage and unused activity amounts as well as the total cost of resources supplied broken into usage and unused amounts. The document also provides an example comparing traditional overhead allocation and ABC for two products. ABC results in more accurate product costs that reflect resource usage compared to traditional methods.

3. Overheads are absorbed on volume related
measures like:
 Number of units produced
 Amount of material consumed
 Amount of direct labour cost
 Machine hours
 Direct labour hours
But there are many activities not related to
physical volume.

4. Overheads have been allocated to products
by using three steps:
(i) From ledger accounts to production and
service departments
(ii)From service departments to production
departments
(iii)From production departments to end
products

5. Overhead
Cost
Stage 1: Overheads assigned
to production departments
Production
Departments Products
Stage 2: Overheads
allocated to products
Departmental overhead
allocation rates

6. 1)Blanket overhead recovery acceptable when
valuing stocks for financial reporting but
inappropriate when used for decision making
and typical product strategy decisions.
Such decisions have implications over 3-5
years and over this period many fixed costs
become variable.

7. 2)Traditional fixed versus variable cost split is
often unrealistic since as business grows they
often become more complex.
3)Decisions based on distorted cost
information because of difficulties in
traditional costing system in collection,
classification, allocation and recovery of
overheads to individual products.

8. 4)Traditional accounting confined merely to
furnishing information at product level. The
new manufacturing technology demands the
feedback of performance while production is
still in progress rather than history.
To overcome these inadequacies of overhead
absorption and short term biasing of
marginal costing, Activity Based Costing
(ABC) has been researched

10. ABC is a technique under which the overhead
costs of the organization are identified with
each activity, which is acting as the cost
driver.
Examples of cost drivers are:
Machine set-ups, purchase orders, quality
inspections, power consumed, miles driven
etc.

11. Activity Based Costing (ABC) is that costing
in which costs are first traced to activities and
then to products.
The more complex an organization’s
operations , the more cost driving activities it
is likely to have.

12. Overhead
Cost
Stage 1: Overheads assigned
to cost centres / cost pools
Activity Cost pools Activity Cost driver rates Products
Stage 2: Overheads assigned to
products using cost driver rates

13. The key areas of ABC are:
 Product Cost differentiation
 Activities and their cost drivers
 Identification of non-value added cost

15.  Identify the functional areas or major activities
involved in production.
 Examples: machine related activities, divert
labour related activities, support activities like
ordering, receiving etc.
 The activities may fall into four categories
 Unit level activities or Primary Activities
 Batch Level Activities
 Product Level Activities
 Facility Level Activities

16.  Activities performed each time a unit is
produced.
 They are repetitive activities
 Example: Direct labour hours, Machine hours,
Power are used each time a unit is produced
 Costs of unit level activities vary with the
number of units produced

17.  Activities performed each time a batch of
goods or products is produced
 Costs of batch level activities vary with the
number of batches but are fixed with respect
to the number of units in each batch
 Example: Machine setups, inspections,
production scheduling, materials handling

18.  Activities performed to support the
production of each different type of product
 Example: Maintenance of equipment,
engineering charges, testing routines,
maintaining bills of materials

19.  Activities needed to sustain a factory’s
general manufacturing process
 These are common to a variety of products
 Most difficult to link to product specific
activities
 Examples: Factory management,
maintenance, security, plant depreciation

20.  A cost centre also called a cost pool be
created for each activity.
 Cost of resources consumed over a specified
period must be assigned to each activity
 These costs will have to be apportioned on
some suitable basis.
 Example: Total costs of all set ups might
constitute one cost centre for all setup
related costs.

21.  Cost Driver is a factor that influences cost
 Most suitable cost driver in each activity
under functional areas should be identified
 Example: In production scheduling, driver will
probably be the number of batches ordered.

22. FUNCTIONAL
AREAS
ACTIVITIES SUITABLE COST DRIVERS
Materials
Management
• Issue of purchase orders • Number of purchase orders
• Inspection of materials • Number of purchase orders
Stores
Management
• Storing of materials • Value of materials stored
• Servicing of requisitions • Number of requisitions
• Inspection & Verification • Number of times inspected
• Stock Taking • Value of stock
Quality Control • Testing of Samples • Number of batches produced

23. FUNCTIONAL
AREAS
ACTIVITIES SUITABLE COST DRIVERS
Marketing • Demand Creation • Increase in sales
• Advertising • Increase in sales
• Despatches •Number of orders
Personnel
Management
• Recruitment of employees • Number of employees
recruited
• Maintenance of leave
records & attendance
• Number of employees
Research &
Development
• Research • Number of research Projects
Machining • Setup Cost • Number of production runs
• Power cost •Machine hours

24.  Cost of the activities is traced to products on
the basis of their usage of the activity,
expressed in terms of the chosen cost
driver(s).
 Example:
Thus a batch generating 3 purchase orders would be charged 3 x Rs. 200
= Rs. 600 for purchasing overheads.
Total Costs of purchasing Rs. 2,00,000
Number of Purchase Orders 1,000
Cost Driver rate Rs. 200

25. ABC is needed in organizations for product
costing where:
 Production overheads are high in relation to
direct costs
 There is a great diversity in product range
 Products use different amounts of overhead
resources
 Consumption of overhead resources is not
primarily driven by volume

26. TRADITIONAL ABC
1. Cost Pools One or a limited number Many, to reflect different
activities
2. Applied Rate Volume based, financial Activity based, non – financial
3. Suited for Labour intensive, Low
overhead companies
Capital intensive, product
diverse, high overhead
companies
4. Benefits Simple, inexpensive Accurate product costing,
possible elimination of non-
value –added activities

27. The following are the advantages of ABC:
 Helps in reducing costs by providing
meaningful information for cost management
which helps in making the right decision
 Provides due importance to non-
manufacturing cost which constitute a
substantial portion of total cost
 Provides reliable and accurate cost
information

28.  Enables management in formulating an
effective pricing policy while fixing prices
 Accuracy in indirect cost allocation to
products, helpful in make or buy decisions and
transfer pricing
 Uses multiple cost drivers since concerned
with all activities within & beyond the factory

29.  Can be more complex than traditional since
uses numerous cost pools & multiple cost
drivers
 Difficulties in the implementation of ABC
system such as selection of cost drivers,
assignment of common costs, varying cost
driver rates etc.

30.  Different levels of utility for different
organizations such as beneficial for large
manufacturing firms as compared to smaller
firms, advantageous for firms following cost
plus pricing as it gives accurate product cost.
 Can prove costly to manage ABC System

31. Most common motives for establishing ABC
System are:
 To improve product costing where a belief
exists that existing methods undercost some
products and overcost others, or
 To identify non value adding activities in the
production process which might be a suitable
focus for attention or elimination

32. Number of distinct practical stages in ABC
implementation are:
 Staff Training: Co-operation of work force is
critical to successful implementation of ABC
as they are closest to the process and most
aware of the problems

33.  Process Specification: Informal but
structured interviews with key personnel will
identify different stages of production
process, commitment of resources to each,
processing times and bottlenecks.
 Activity definition: listed transactions must
be rationalized in order to aggregate those in
similar categories and eliminate those
deemed immaterial.

34.  Activity Driver Selection: Single driver
covering all transactions grouped together in
an ‘activity’ probably does not exist and
multiple driver models are not desirable as
seen from the cost benefit analysis
 Costing: Single representative activity driver
can be used to assign costs from activity
pools to the cost objects.

35.  ‘Service organizations ideal candidates for
ABC’ Kaplan & Cooper
 Due to privatization, deregulation & increasing
competition, service organizations need to
accurately measure cost and resulting
profitability for their services, customers and
markets.
 ABC can understand their cost base and make
decisions on value added/ non value added
activities

36. ABC supports Corporate Strategy in many
ways:
 Accurate product costing helps management
compare profits from various customers,
product lines, brands or regions. Takes
decisions on pricing strategy, dropping
unprofitable products, lines etc.
 Helps in redesigning products
 Evaluate new process technologies

37.  Reduce setup times
 Rationalization of plant lay out to reduce
material handling cost
 Reduction in demand for organizational
resources by comparing resource spending
and resource consumption
 Helps managers to focus their attention &
energy on improving activities
 Activity performance and efficiency can be
measured – helps in budgeting

39. XYZ Co. has 3 clerks responsible for processing
purchase invoices. Salary paid to them is Rs. 3,00,000
p.a. and invoices processed by them are 5000 per year.
In addition to salary, company spends Rs. 90,000 per
year for forms, postage etc. During the year 12,500
invoices were processed. Required (i) activity rate for
purchase order activity and break it into fixed &
variable components (ii) total activity availability and
break it into activity usage & unused activity (iii) total
cost of resources supplied broken into activity usage &
unused activity.

40. (i) Activity Rate =
= Rs. 66 per invoice
Fixed Activity Rate = = Rs. 60 per invoice
Variable activity rate = = Rs. 6 per invoice
(ii) Activity availability = Activity usage + unused activity
= 12,500 invoices + 2500 invoices
= 15,000 invoives

41. 3. Costs of resources supplied = Cost of activity used + cost of
unused activity
Rs. 9,00,000 + (Rs. 6 x 12,500)= (Rs. 66 x12,500) + (Rs. 60 x 2500)
Rs. 9,75,000 = Rs. 8,25,000 + 1,50,000

42. A company manufacturing two products furnishes the
following data for a year:
Product Annual Output
(units)
Total Machine
hours
Total number
of purchase
orders
Total number
of set-ups
A 5,000 20,000 160 20
B 60,000 1,20,000 384 44
The annual overheads are as under:
Volume related activity costs Rs. 5,50,000
Set up related costs Rs. 8,20,000
Purchase related costs Rs. 6,18,000
Calculate cost per unit of each Product A&B based on (a) Traditional Method of
charging overheads (b) Activity based costing method

43. (a) Traditional method of charging overheads:
Rs.
Volume related activity costs 5,50,000
Set-up related costs 8,20,000
Purchase related costs 6,18,000
Total Costs 19,88,000
Total Machine Hours (20,000 +1,20,000) = 1,40,000
Total cost per hour (Rs. 19,88,ooo/ 1,40,000) = Rs. 14.20
Cost per unit of A = (20,000 x Rs. 14.20)/5000 = Rs. 56.80
Cost per unit of B = (1,20,000 x Rs. 14.20)/ 60,000 = Rs. 28.40

44. (b) Activity based costing method of charging overheads:
Volume related activity cost per machine hour: Rs. 5,50,000/ 1,40,000 = Rs. 3.9286
Set-up costs per set up: Rs. 8,20,000/ 64 = Rs. 12,812.50
Purchase related costs per purchase order: Rs. 6,18,000/ 544 = Rs. 1136.029
Cost per unit of product
Particulars Cost Driver A B
Volume related costs Machine hours Rs. 78, 572 Rs. 4,71,432
Set-up Costs Number of set ups 2,56,250 5,63,750
Purchase related Costs Number of Purchase Orders 1,81,765 4,36,235
Total Costs Rs. 5,16,587 14,71,417
Cost per unit Rs. 103.32 Rs. 24.52