Activity Based Costing

 

This technique is of recent origin and is primarily concerned with apportionment of overheads in an organisation having products that differ in volume and complexity of production. The crux of activity based costing is in accurately assigning the overhead cost to the end product. The traditional costing system does not serve effective purposes of product costing and pricing decisions. Charging overhead to the products on the basis of labour hour rate and machine hour rate may provide faulty data as to costs which should be properly attributed to a product. If the direct labour cost is taken as the base for charging overhead cost, high volume products may tend to get greater share of overhead cost than the low volume complicated products. Every overhead cost does not directly vary with the volume of production. The illegitimate cost attribution would give a distorted picture of the cost information resulting in a wrong decision.

Activity based costing is a method of cost attribution to cost units on the basis of benefits received from indirect activities. The performance of particular activities and demands made by the activities on the resources of organisation are linked together so that the cost of product is arrived at as per the quantum of activities performed to produce a product or render a service.

The reason for such a basis is that products themselves do not consume resources directly rather several activities are required to be performed for them, and these activities consume the resources of the organisation as driven by cost drivers, (activities generating cost). Cost centres pay for these resources, depending upon the number of activities required for a product.

Thus, the overhead costs of organisation are identified with each activity which is acting as a cost driver i.e. the cost for incurrence of the overhead cost. The number of these activities in an organisation depends upon the complexity of operations. The more complex an organisation’s operations are, the more cost driven activities it is likely to have.

After identifying the overhead cost with each cost centre, the cost per unit of cost driver can be ascertained and cost assigned to jobs (cost objects) on the basis of number of activities required for their accomplishment. Thus, ABC serves as a basis for product costing besides aiming for managing overhead cost.

Activity based costing may be defined as a technique which involves identification of costs with each cost driving activity and making it as the basis for apportionment of costs over different products or jobs.

The Chartered Institute of Management Accountants defines it as a “technique of cost attribution to cost units on the basis of benefits received from indirect activities e.g. ordering, setting up, assuring quality.”

 Significant Terms

1.       Cost Objects. Generally, the products are cost objects, but the customers, services or locations can also be the cost objects.

2.       Activities. These consist of the aggregate of different tasks and are concerned with functions associated with cost objects. There are two types of activities-

(A)   support activities, (B) Production process activities.

Support activities are, schedule production, set up machine, purchase materials, inspect items, customer orders, supplier records etc. Under the production process activities machine products and assembled products are included. Activity cost centres are, sometimes, similar to cost centres used under traditional costing system. In case the purchasing department and purchasing activity both are treated as cost centres, the support activity cost centre also becomes identical to cost centre taken under traditional costing system.

Cost Pool. It is another name given to a cost centre and, therefore, an activity cost centre may also be termed as an activity cost pool.

Cost Drivers. The causes for incurrence of overhead cost are known as cost drivers. A cost driver is a factor the change of which results in a consequential change in the total cost of a related object.

Following are some of the examples of cost drivers :

1.       Machine Setups                           7.                                                     Maintenance requests

2.        Purchase orders                           8.                                                     Machine time

3.       Quality Inspections                     9.                                                     Power consumed

4.       Production orders (Scheduling)   10.                                                   Kilometers driven

5.       Material Receipts                        11.                                                   Beds occupied

6.       Inventory movements                 12.                                                   Flight-hours logged

The activity cost drivers can broadly be classified into following three categories :

A.         Transaction drivers ;

B.         Duration drivers ;

C.         Intensity drivers;

A.       Transaction drivers. For example, the purchase orders processed, customer orders processed, inspections performed and the set-ups undertaken, all count the number of times an activity is performed.

B.          Duration drivers. Mean the amount of time required to perform an activity. Examples of duration drivers are set-up hours and inspection hours.

C.         Intensity drivers. Refer to drivers which directly charge for the resources used each time as activity is performed. Duration drivers establish an average hourly rate of performing an activity while intensity drivers involve direct charging based on the actual activity resources relevant to a product.

Characteristics

Thus, the characteristics of activity based costing can be summarised as follows :.

1.                           It increases the number of cost pools used to accumulate overhead costs. The number of pools depends upon the cost driving activities. Thus, instead of accumulating overhead costs-in a single company-wise pool or departmental pools, the costs are accumulated by activities.

2.                           It charges overhead costs to different jobs or products in proportion to the cost driving activities in place of a blanket rate based on direct labour cost or direct hours or machine hours.

3.                           It improves the traceability of the overhead costs which results in more accurate unit cost data for management.

4.                           Identification of cost during activities and their causes not only help in computation of more accurate cost of a product or a job but also eliminate non-value added activities. The elimination of non-value added activities would drive down the cost of the product. This, in fact, is the essence of activity based costing.

 

Elements

1.                           An activity can consist of one or more of the tasks associated with one another to attain an objective. For example, customer order processing includes receiving orders from customers, as to its capacity of producing and interaction with customers regarding delivery times etc.

2.                           The result of identifying the overhead cost to an activity is called an activity cost pool.

3.                           These are used to assign costs to products by using an appropriate measure of resources consumed by each activity.

4.                           When related activities are grouped together, it is known as a process.

5.                           Are links to the whole of the enterprise.

6.                           Certain activities do not contribute anything to the value of a product, but which are required to be carried out in the organisation because of reasons beyond the control of management.

 

Steps

1.                           The already existing costing system should be able to adopt the activity based costing system so that product costs can be accurately determined and correct pricing decisions can be taken in a competitive business environment.

2.                           A physical plan of the work place and listing of pay-rolls can be examined, to begin with, supplemented by holding interviews with staff. Such an activity analysis can throw light on how the work spaces have been utilised and how the staff members have spent their time after chalking out the different tasks in detail, the prime activity can be identified. For it, a cost-benefit analysis is required to be performed. An activity can be a very small job or a combination of several small jobs.

 

3.                          The integrate past actual cost or average cost of a specified period may be used under the system.

4.                          Cost centres on cost pools should have a similarity under financial accounting and cost accounting systems in order to have a comparative utility.

5.                          Cost of resources consumed are to be associated or allocated (apportioned) to each activity, in order to find out the amount spent by the enterprise on each of its activity. Methods of direct attribution, apportionment on a reasonable basis in case of joint costs and the methods of estimation of certain costs may all be appropriately utilised for assignment of costs to activity cost centres.

6.                          Copper classified manufacturing activities as under:

A.              Unit-level activities;

B.              Batch-level activities;

C.              Product-sustaining activities;

D.              Facility-sustaining activities;

A.            Unit-level activities. These are activities which are performed each time a unit of product or service is produced. Such activities consume resources proportionate to the production or sales quantity.

B.             Batch-level activities. These are performed each time a batch operation is carried out. Such a cost varies with number of batches made but is the same for all units within the batch.

C.            Product-sustaining activities. These are performed to support diversity of products. Such costs are not in any way connected with the number of production units or batches made.

D.            Facility-sustaining activities. These are performed to support manufacturing process. Such costs are common to all the products manufactured. These are not assigned to products individually.

7.                          Outputs are required to be categorically identified because without it, the basic purpose or applying the system cannot be meaningful.

8.                          Interviews should be conducted with concerned employees to determine the cost drivers for each activity. The cost drivers should be easily measurable. Past data should be made available in order to ascertain potential cost drivers. The management can finally choose a single cost driver or multiple cost drivers for the activities.

9.                          The cost driver rates are applied to products. The aggregate cost can be computed by multiplying the rate of consumption of resources (cost driver rate) with the number of activities.

10.                   The activity cost and all the relevant data used for computation purposes should be tested to evaluate and judge the reliability of activity based costing system adopted.

Activity Based Costing Versus Traditional Costing

Following are the main differences between activity based costing system and traditional costing system :

1.                           Under ABC system, overhead costs are identified to each major activity in stead of the department as under traditional costing system. It results in greater number of cost centres under ABC system.

2.                           The term ‘cost driver’ is not used under traditional costing system. Popular terms are basis of allocation or apportionment. Under ABC system, cost derivers are fewer in number for the purpose of charging overheads to products.

3.                           ABC system uses separate rates for support centres and there is no reallocation to production centres, as is the case under traditional costing system.

Thus, traditional costing system reveals less accurate costs as compared to ABC system. This is primarily because cause and effect relationship is considered under ABC system to identity support cost objects, which is not the case under traditional costing system.

 

Optimal Costing System

Such a system is different from entity to entity. It depends upon an in-depth analysis of costs and benefits associated with designing of an appropriate costing system. ABC system is definitely more scientific because it produces more accurate product cost, but such a system should be implemented when it is more economical vis-a-vis traditional costing system. Following factors should be taken into consideration before installing activity based costing system : 1. Extent of competition, 2. Standardisation of product and 3. Proportion of overhead cost to total cost.

To conclude, activity based costing system may be more appropriate when competition is fierce, enterprise produces varied products, without standardisation with regard to consumption of resources and when overhead cost assumes a large proportion of total cost.

ABC system requires the following :

1.                           Setting-up of an information system which could help trace all the costs to cost objects.

2.                           Support from top to bottom because the system involves people at all levels.

3.                           Integration of system into financial system. For it, computerization may be required.

The final words of comment over ABC system are that adoption, implementation and operation of the system is not an end in itself. The benefits can be derived by translating the system design and its operation into action—oriented managerial performance. Ultimately, it amounts to effective cost management for the success of the system.