ICAI Notes: Activity Based Costing | Cost and Management Accounting for CA Intermediate PDF Download

 Page 1


 
 
 
LEARNING OUTCOMES 
 
a
    
 
 
CHAPTER 
5 
 
Activity Based Costing
Concept Usefulness
Cost 
Hierarchy
Steps
 
 
 
 
   ACTIVITY BASED 
COSTING  
 
 
 
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). 
 
 
 
 
CHAPTER OVERVIEW 
© The Institute of Chartered Accountants of India
Page 2


 
 
 
LEARNING OUTCOMES 
 
a
    
 
 
CHAPTER 
5 
 
Activity Based Costing
Concept Usefulness
Cost 
Hierarchy
Steps
 
 
 
 
   ACTIVITY BASED 
COSTING  
 
 
 
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). 
 
 
 
 
CHAPTER OVERVIEW 
© The Institute of Chartered Accountants of India
a
 
 
 
 
5.2 
COST AND MANAGEMENT ACCOUNTING 
 1. INTRODUCTION 
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 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. 
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. 
© The Institute of Chartered Accountants of India
Page 3


 
 
 
LEARNING OUTCOMES 
 
a
    
 
 
CHAPTER 
5 
 
Activity Based Costing
Concept Usefulness
Cost 
Hierarchy
Steps
 
 
 
 
   ACTIVITY BASED 
COSTING  
 
 
 
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). 
 
 
 
 
CHAPTER OVERVIEW 
© The Institute of Chartered Accountants of India
a
 
 
 
 
5.2 
COST AND MANAGEMENT ACCOUNTING 
 1. INTRODUCTION 
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 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. 
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. 
© The Institute of Chartered Accountants of India
 
 
 5.3 
ACTIVITY BASED COSTING   
a
    
 5.3 
 
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. 
 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. 
© The Institute of Chartered Accountants of India
Page 4


 
 
 
LEARNING OUTCOMES 
 
a
    
 
 
CHAPTER 
5 
 
Activity Based Costing
Concept Usefulness
Cost 
Hierarchy
Steps
 
 
 
 
   ACTIVITY BASED 
COSTING  
 
 
 
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). 
 
 
 
 
CHAPTER OVERVIEW 
© The Institute of Chartered Accountants of India
a
 
 
 
 
5.2 
COST AND MANAGEMENT ACCOUNTING 
 1. INTRODUCTION 
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 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. 
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. 
© The Institute of Chartered Accountants of India
 
 
 5.3 
ACTIVITY BASED COSTING   
a
    
 5.3 
 
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. 
 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. 
© The Institute of Chartered Accountants of India
a
 
 
 
 
5.4 
COST AND MANAGEMENT ACCOUNTING 
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.” 
 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 
and procedures 
• Number of products in design 
• Number of parts per product 
• Number of engineering hours 
Customer Service • Number of service calls 
© The Institute of Chartered Accountants of India
Page 5


 
 
 
LEARNING OUTCOMES 
 
a
    
 
 
CHAPTER 
5 
 
Activity Based Costing
Concept Usefulness
Cost 
Hierarchy
Steps
 
 
 
 
   ACTIVITY BASED 
COSTING  
 
 
 
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). 
 
 
 
 
CHAPTER OVERVIEW 
© The Institute of Chartered Accountants of India
a
 
 
 
 
5.2 
COST AND MANAGEMENT ACCOUNTING 
 1. INTRODUCTION 
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 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. 
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. 
© The Institute of Chartered Accountants of India
 
 
 5.3 
ACTIVITY BASED COSTING   
a
    
 5.3 
 
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. 
 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. 
© The Institute of Chartered Accountants of India
a
 
 
 
 
5.4 
COST AND MANAGEMENT ACCOUNTING 
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.” 
 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 
and procedures 
• Number of products in design 
• Number of parts per product 
• Number of engineering hours 
Customer Service • Number of service calls 
© The Institute of Chartered Accountants of India
 
 
 5.5 
ACTIVITY BASED COSTING   
a
    
 5.5 
 
• 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 
 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. 
 
 
 
 
 
 
 
 
 
© The Institute of Chartered Accountants of India