Activity-based costing (also popularly known as ABC) is a new and scientific approach developed by Rabin Cooper and Roberk Kaplan (1988) of the Harvard University for assigning overhead costs to end-products, jobs and processes.
It refines a costing system by focusing on individual activities as the fundamental cost objectives. In the course of accumulating costs, this system takes into consideration not only volume-related but also non-volume-related activities (i.e., support activities) such as material procurement, material handling, machine set-ups, etc.
In the words of Cooper and Kaplan, ABC systems calculate the costs of individual activities and assign costs to cost objects such as products and services on the basis of activities undertaken to produce each product or service. In this system overhead costs are assigned to activities or grouped into cost pools before they are charged to cost objects (i.e., products or services).
CIMA, London defines ABC as “cost attribution to cost units on the basis of benefits received from indirect activities e.g., ordering, setting up, assuring quality.”
Activity-based costing is not a distinct method of costing like job costing and process costing. It is only a modern tool of charging overhead costs in which costs are first traced to the activities and then to products or jobs.
Its main focus is on activities performed in the production of goods or services. Thus, activities become the focal point for cost accumulation. This costing system assumes that activities are responsible for the incurrence of costs and that a link should therefore be made between activities and products by assigning costs of activities to products or services based on individual product’s demand for each activity.
The heart of ABC is the activity concept and the basic premise of ABC approach is that a firm’s products or services are the results of activities and activities consume resources which incur costs. In short, in activity-based costing, overhead costs are first assigned to activities and then absorbed by cost objects on the basis of activities consumed by these cost objects.
The relationship between activities and products has been shown below:
The above figure shows that activities consume resources (for example, workers are paid to pack and ship finished goods to customers). Then, products that consume the activities (packing and shipping) are allocated the costs of those activities.
There are two primary stages in ABC—first, tracing costs to activities, second, tracing activities to products or jobs.
The different steps in the two stages of ABC are given below:
(i) Identification of the main activities:
The first stage is to identify the functional areas or major activities involved in the production. In ABC system an organisation is viewed as a collection of activities.
All the major activities in the organisation are grouped under two categories, viz., volume-related activities (e.g., machine-related activities, labour-related activities) and non-volume-related or support activities like material ordering, material receiving, material handling, machine set-up, production scheduling, packing, despatch etc.
Both these categories are performed to design, produce, sell and distribute to individual products or services of the organisation. These activities convert input resources acquired from suppliers to output intended for customers. The number of activities in an organisation should neither be too large or too small. Total cost involved in the activity should be significant enough to justify to give an activity a separate entity.
(ii) Creation of cost pool:
The next step in activity-based costing is the creation of a cost pool for each major activity. Cost pool is like a cost centre or activity centre around which costs are accumulated. For example, the total of machine set-up might constitute are cost pool for all set-up related costs.
(iii) Determination of the activity cost driver:
The next step in the application of activity-based costing is the ascertainment of the factors that influence the cost of each major activity. The factors or the forces that cause costs are known as cost drivers. A cost driver not merely causes cost but also explains its behaviour.
Thus a cost driver is a factor which causes a change in the cost of an activity. Examples of cost drivers are number of machine set-ups, number of purchase orders, number of customer orders placed etc.
(iv) Calculation of the activity cost driver rate:
After cost pool is defined and cost drivers identified, the cost per unit of the cost driver is computed for that pool. This is called the pool rate. The pool rate links costs and cost drivers with the resource use.
A cost driver rate is calculated as follows:
(v) Charging the costs of activities to products:
This is the last step in application of activity-based Costing. Here, the costs of activities are traced to products on the basis of demand by products. The cost drivers are used to measure product demand of activities. For example, if the total costs of purchasing materials were Rs. 1,00,000 and there were 1,000 purchase orders (the chosen cost driver) during the period.
The rate per purchase order is Rs. 1,00,000 + 1,000 = Rs. 100. If a particular product needs 2 purchase orders, charge to that product will be Rs. 100 x Rs. 2 = Rs. 200. If 10 units of the product are produced, cost per unit will be Rs. 200 + 10 units = Rs. 20. In this way cost of other activities will be charged to product.
Activity-based costing has primarily developed on account of the limitations of traditional system of charging overhead costs. It became an increasing important tool for a large majority of organisations throughout the world.
It offers the following advantages :
(i) Determination of product/service cost:
ABC is a modern tool of charging overhead costs in which costs are first identified with activities and then allocated to products or services based on appropriate cost drivers. Cost drivers reflect the cause and effect relationship between activity consumption and cost incurrence. As a result, it gives more accurate cost information for determination of product/service cost.
(ii) Supplies cost information:
It provides more accurate and reliable cost information about production and support activities and product costs so that the management can focus its attention on the products and processes with the most effective manner for increasing profit.
(iii) Better pricing decisions:
By switching over from volume-base to activity-base, ABC helps in overcoming the problem of over-costing and under-costing as result of which management is able to make judicious pricing decisions in a more competitive business environment.
Under ABC distribution of overhead costs is done on the basis of activities which is considered to be more realistic. It is said to be an objective approach. The traditional costing uses more arbitrary bases for apportionment of overhead costs and is a subjective approach.
(v) Control of cost:
ABC gives better understanding of cost behaviour and a more rational approach to fixed and variable costs. It enables management to control many fixed overheads by exercising more control over those activities which cause these fixed overheads. This is possible since behaviour of many fixed overhead costs in relation to activities now become more visible and clear.
(vi) Better performance measurement and cost reduction:
Pooling of resource costs and use of suitable cost drivers highlights the problem areas leading to better performance measurement and cost reduction. Regrouping costs from traditional cost centres to activity cost pools focuses attention to inefficient operations where costs can be reduced.
(vii) Improvement of cost objects:
Manager’s do not manage cost, they manage activities causes cost. Changes in activities lead to changes in cost. Therefore, if the activities are managed well, costs will fall and resulting products will be more competitive.
(viii) Greater cost efficiency:
ABC helps to identify unnecessary or non-value-added activities so that these may be weeded out and thus achieving greater cost efficiency.
(ix) Better decision-making:
It helps management in taking better decisions about product design, pricing, process technology, marketing product-mix and encouraging continual operating environments. ABC which is now being called Activity-Based Management (ABM) used cost information generated by ABC about an activity for controlling the activity itself rather than just using cost information of the final product.
4. Problems with the ABC Approach:
ABC is not free from certain weaknesses as argued by the critics. They are stated below:
(i) ABC fails to obtain support at all levels of management about changing in work processes to make business more competitive.
(ii) Selection of multiple cost drivers to assign overhead costs to products or services is a difficult task. It involves trade-offs between accuracy and cost, as well as the difficulties of operating a more complex costing system.
(iii) Wrong selection of cost drivers would nullify the benefits of ABC.
(iv) Cost of change will be high as everything will have to be worked out from the scratch.
(v) It rejects marginal cost analysis and the benefits thereof.
(vi) It takes no account of opportunity cost in decision-making.
(vii) The system will require a change due to changes associated with new products and new technology. This will put strain on the costing system,
(viii) It fails to capture the complexity of actual operations and took too long time to implement.
(ix) The system encourages allocation of non-product costs such as research and development to products while committed product costs such as factory depreciation are not allocated to products.
ABC system was developed due to the following factors:
(i) High incidence of overhead cost due to increasingly automated production.
(ii) High overhead costs are not proportional to the unit volume of individual products or services.
(iii) Overhead costs for support functions such as product design, quality control, customer service, production planning and sales order are as important to the customer as physical process on the shop floor.
(iv) Complexity has increased. Product ranges are wider, product cycles are shorter and demand for quality product is higher.
(v) Market place is now very competitive. As firms operating in this competitive environment adopt new strategies to achieve competitive excellence.
(vi) Availability of computer and other technology has enhanced requirement for improvement in information gathering technology for decision making to gain competitive advantage.
(vii) A significant automation that has made it increasingly more difficult to assign overhead costs to products using the traditional direct labour hour or machine hour basis.
(viii) The demand of different products on resources is not uniform because of volume, process set-up, batch size or complexity. Use of an average overhead rate calculated using volume as denominator, for assigning overhead costs to products distorts the product cost, if the firm produces variety of products.
The steps involved in installation of ABC system are:
1. Feasibility study:
The installation of ABC requires a considerable efforts and costs. It is important to make cost-benefit analysis i.e., weigh the cost of the system against the likely benefits to be derived from it. The benefits from the ABC must exceed the amount spent on it.
Two types of costs are needed:
(a) Development cost i.e., the cost of the development of the system and
(b) Operational cost i.e., the cost of running of the system.
2. Support of information technology:
For implementation of ABC a lot of information is required to be generated. Therefore, IT infrastructure is to be built-up to provide necessary support.
3. Co-operation of employees:
The co-operation of employees is essential for implementing ABC successfully as they are closest to the process and more conversant with the problems.
4. Staff training:
The staff should be properly trained so that they can grasp the purpose of ABC. Group discussions, training programmes, case study demonstration etc. help considerably to create awareness of the concept of ABC to employees.
5. Process specification:
For identifying various stages of the production process, allocation of resources to each, processing time and bottlenecks, the senior executives should be interviewed. This will provide the basis from which a detailed listing of activities can be made in a structural manner. Once the activities have been inventoried screening is necessary to improve efficiency into the system.
6. Activity definition:
The listed activities should be rationalised for grouping them under similar categories of the production process and eliminating those considered irrelevant. A cost pool may be employed for every identified activity or sub-activity.
7. Activity driver selection:
It is very difficult to select a single activity driver which will cover all the transactions grouped together in an activity. However, multiple cost driver models could be developed with the available data. The inter-correlation of potential activity driver may be so strong that it matters little where one is selected.
Generally, a single activity cost driver can be used to assign costs to the cost objects from the activity pools. For example, if the number of machine set-ups has been selected as a driver of process costs and the total set-up cost is Rs. 50,000 for four products A, B, C and D of a company, then the number of machine set-ups per product can be used to assign these costs.
If products A, B, C and D require 5 set-ups, 10 set-ups, 15 set-ups and 20 set-ups respectively, then the average cost per set-up will be Rs. 1,000 (i.e., Rs. 50,000 + 50 set-ups). Total set-up costs can be distributed to product groups in proportion to use i.e., A Rs. 5,000, B Rs. 10,000, C Rs. 15,000 and D Rs. 20,000 and then assigned to individual units of product in proportion to the level of production units.
A manufacturing company has three accounts clerks responsible for processing purchase invoices of suppliers. Each clerk is paid a salary of Rs. 1,50,000 per annum and is capable of processing 5,000 purchase invoices per year. In addition to the salary, the company spends Rs. 45,000 per year for printing of forms, postage etc. (assuming that 15,000 purchase invoices are processed).
During the year, 12,500 purchase invoices were processed. You are required to:
(a) Calculate the activity rate for the purchase order activity. Break the activity rate into fixed and variable components.
(b) Calculate the total activity availability and break this into activity usage and unused activity.
(c) Calculate the total cost of resources supplied and break this into activity usage and unused activity.
1. Activity Rate = [(3 x Rs. 1,50,000) + Rs. 45,000] – 15,000 = Rs. 33 per invoice
Fixed Activity Rate = Rs. 4,50,000 + 15,000 = Rs. 30 per invoice
Variable Activity Rate = Rs. 45,000 + 15,000 = Rs. 3 per invoice.
2. Activity availability = Activity usage + Unused Activity
15,000 invoices = 12,500 invoices + 2,500 invoices
3. Cost of resources supplied = Cost activity used + Cost of unused activity
or, Rs. 4,50,000 + (Rs. 3 x 12,500) = (Rs. 33 x 12,500) + (Rs. 30 x 2,500)
or, Rs. 4,87,500 = Rs. 4,12,500 + Rs. 75,000