UNIT 5

ACTIVITY BASED COSTING SYSTEM

5.1 Introduction

Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.

Let's discuss activity based costing by looking at two products manufactured by the same company. Product A is a low volume item which requires certain activities such as special engineering, additional testing, and many machine setups because it is ordered in small quantities. A similar product, Product B, is a high volume product—running continuously—and requires little attention and no special activities. If this company used traditional costing, it might allocate or "spread" all of its overhead to products based on the number of machine hours. This will result in little overhead cost allocated to Product A, because it did not have many machine hours. However, it did demand lots of engineering, testing, and setup activities. In contrast, Product B will be allocated an enormous amount of overhead (due to all those machine hours), but it demanded little overhead activity. The result will be a miscalculation of each product's true cost of manufacturing overhead. Activity based costing will overcome this shortcoming by assigning overhead on more than the one activity, running the machine.

Activity based costing recognizes that the special engineering, special testing, machine setups, and others are activities that cause costs—they cause the company to consume resources. Under ABC, the company will calculate the cost of the resources used in each of these activities. Next, the cost of each of these activities will be assigned only to the products that demanded the activities. In our example, Product A will be assigned some of the company's costs of special engineering, special testing, and machine setup. Other products that use any of these activities will also be assigned some of their costs. Product B will not be assigned any cost of special engineering or special testing, and it will be assigned only a small amount of machine setup.

Activity based costing has grown in importance in recent decades because (1) manufacturing overhead costs have increased significantly, (2) the manufacturing overhead costs no longer correlate with the productive machine hours or direct labor hours, (3) the diversity of products and the diversity in customers' demands have grown, and (4) some products are produced in large batches, while others are produced in small batches.

5.2 Meaning of Terms used in ABC

1. Activity – Activity, here, refers to an event that incurs cost.
2. A Cost Object– It is an item for which cost measurement is required e.g. a product or a customer.
3. 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

1. 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.
2. 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.

4.      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.

5.3 Advantages of Activity Based Costing

• Provides realistic costs of manufacturing for specific products
• Allocates manufacturing overhead more accurately to products and processes that use the activity
• Identifies inefficient processes and target for improvements
• Determines product profit margins more precisely
• Discovers which processes have unnecessary and wasted costs
• Offers better understanding and justification of costs in manufacturing overhead

5.4 Limitations of Activity Based Costing

• Collection and preparation of data is time-consuming
• Costs more to accumulate and analyze information
• Source data isn't always readily available from normal accounting reports
• Reports from ABC don't always conform to generally accepted accounting principles and can't be used for external reporting
• Data produced by ABC may conflict with managerial performance standards previously established from traditional costing methods
• May not be as useful for companies where overhead is small in proportion to total operating costs
• ABC produces more accurate costing of products by essentially converting broad indirect costs into direct costs of production. It determines the costs of the various sources of indirect costs and allocates these expenses to the specific activities that use them.
• Setting up an ABC system is time-consuming and expensive to maintain, but it provides management with valuable information that can be used to improve the efficiency of processes and increase product profit margins.

5.5 ABC Steps

Step 1: Identify the products that are the chosen cost objects.

Step 2: Identify the direct costs of the products.

Step 3: Select the activities and cost-allocation bases to use for allocating indirect costs to the products.

Step 4: Identify the indirect costs associated with each cost allocation base (activity).

Step 5: Compute the rate per unit of each cost-allocation base (activity) used to allocate indirect costs to the products.

Step 6: Compute the indirect costs allocated to the products.

Step 7: Compute the total costs of the products by adding all direct and indirect costs assigned to the products.

5.6 Identification of Cost Drivers

Various cost drivers for overhead costs are as discussed in the table below:

5.7 Activity Based Costing v/s Traditional Costing

In the field of accounting, activity-based costing and traditional costing are two different methods for allocating indirect (overhead) costs to products.

Both methods estimate overhead costs related to production and then assign these costs to products based on a cost-driver rate. The differences are in the accuracy and complexity of the two methods. Traditional costing is more simplistic and less accurate than ABC, and typically assigns overhead costs to products based on an arbitrary average rate. ABC is more complex and more accurate than traditional costing. This method first assigns indirect costs to activities and then assigns the costs to products based on the products’ usage of the activities.

Traditional Costing Method

Traditional costing systems apply indirect costs to products based on pre determined overhead rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to direct costs. There are several steps in the traditional costing process, including the following:

1. Identify indirect costs.

2. Estimate indirect costs for the appropriate period (month, quarter, year).

3. Choose a cost-driver with a causal link to the cost (labor hours, machine hours).

4. Estimate an amount for the cost-driver for the appropriate period (labor hours per quarter, etc.).

5. Compute the predetermined overhead rate (see below).

6. Apply overhead to products using the predetermined overhead rate.

Predetermined Overhead Rate Calculation

Use the following formula to calculate predetermined overhead rate:

Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost-Driver Amount

For example:

Rs.30/labor hr = Rs.3,60,000 indirect costs / 12,000 hours of direct labor

Activity-Based Costing Benefits

Activity based costing systems are more accurate than traditional costing systems. This is because they provide a more precise breakdown of indirect costs. However, ABC systems are more complex and more costly to implement. The leap from traditional costing to activity based costing is difficult.

Traditional Costing Advantages and Disadvantages

Traditional costing systems are simpler and easier to implement than ABC systems. However, traditional costing systems are not as accurate as ABC systems. Traditional costing systems can also result in significant under-costing and over-costing.