ACTIVITY BASED COSTING (ABC)

ABC is a costing method which recognizes that costs are incurred because of the activities which
take place within the organization and for each activity a cost driver may be identified.
Those costs which are driven or incurred by the same cost drivers are grouped together into cost
pools and the cost drivers are then used as a basis for charging the cost of each activity in the
product.
A cost pool is a collection of costs which may be charged to products by the use of a common
cost driver. A cost driver is any activity or activities, series of which take place within an
organization and which cause costs to be incurred. The essence of ABC is that activities are the c

Some examples of cost pools and related cost drivers are as shown:
Cost drivers, not products, do consume activities. If the cost of activities and their relationship to
products is understood, there can be established basis for product costing, performance
measurement and profitability analysis.

Cost pool Cost driver

Power Number of machine operations
Material handling Quantity or weight of materials handled
Material receipt Number of batches of materials received
Production planning Number of jobs or materials planned
Sales administration Number of customers or orders received
Set up costs Number of jobs run

The development of ABC has been a response to a change in the cost base of many manufacturers
over the last decades. In earlier times, most manufacturing was labor intensive. The variable cost
of direct labor greatly outweighed all other costs and the overheads were a relatively small
component of the total cost. Traditional absorption costing was accurate enough in these
circumstances. Nowadays, most manufacturing processes are automated. The fixed overhead cost
of depreciation is now an important component of the total cost. At the same time, work forces
have been greatly reduced. This means that the variable cost of direct labor is now a much smaller
proportion of the total cost. Traditional absorption costing has become inaccurate as a result and
misleading product costs have led to poor decision making.
ABC analyses costs as short-term variable cost and long-term variable costs. Short-term variable
costs equate with variable costs under the traditional absorption costing. These characteristics are
volume related and change proportionately with the volume of production. Long-term variable
costs are equivalent to fixed costs under traditional cost accounting. Under ABC, such costs do
vary with activity even though there is a time lag e.g. salaried production engineers will not be
immediately made redundant if the number of products decline but they may be if decline
continues.
 Guidelines to activity based costing
1) Identification of the organization’s major activities
2) Identification of the cost drivers. These are factors which determine the size of
the costs of the activity or causes of the incurrence of costs. Volume related cost
drivers are commonly used for costs that vary with the production levels in the
short term.
Examples of some costs and their cost drivers are shown below
Activity Possible cost driver
Car fuel cost Number of kilometers
Materials handling Number of production runs
Production scheduling Number of production runs
Mailing costs Number of mails sent
3) Collection of the costs of each activity into cost pools. Cost pools are
equivalent to cost centers. They are used to describe locations to which overhead
costs are initially assigned.
4) Charging support overheads to products on the basis of their usage of the
activity. A product’s usage of an activity is measured by the number of the
activity’s cost driver it generates. The service costs are only allocated to the
production department according to the usage of the services provided.

Absorption costing and ABC are similar in many respects. In both systems, direct
costs go straight to the product and overheads are allocated to production cost
centers/cost pools. The difference lies in the manner in which overheads are
absorbed into products.

Differences between ABC and traditional costing

i. Multiple activity rates: It deals with cost pools multiples rates while traditional
costing deals with one plant wide overhead cost using machine hours, labor hours.
ii. ABC is difficult to implement while traditional costing is easy to implement
iii. ABC may allocate period cost while traditional costing only allocates product
costs
iv. ABC cannot be used for external reports while traditional costing can be used for
external reports
v. ABC requires two set of books while traditional costing requires only one set of
books
vi. ABC is more accurate while traditional costing is less accurate
The Merits of Activity Based Costing
The following are the main claims made regarding ABC:
• More realistic product costs are provided especially in Advanced Manufacturing
Technology (AMT) factories where support overheads are a significant proportion of
total costs.
• More overheads can be traced to the product. In modern factories there are a
growing number of non-factory floor activities. ABC is concerned with all activities so
takes product costing beyond the traditional factory floor basis.
• ABC recognizes that it is activities which cause cost, not products and it is products
which consume activities.
• ABC focuses attention on the real nature of cost behavior and helps in reducing
costs and identifying activities which do not add value to the product.
• ABC recognizes the complexity and diversity of modern production by the use of
multiple cost drivers, many of which are transaction based rather than based solely on
production volume.
• ABC provides a reliable indication of long-run variable product cost which is
relevant to strategic decision making.
• ABC is flexible enough to trace costs to processes, customers, areas of managerial
responsibility, as well as product costs.
• ABC provides useful financial measures (e.g. cost driver rates) and non- financial
measures (e.g.
transaction volumes).
• The principle of using activities to trace costs can be applied across a range of
service industries as well as manufacturing firms

Criticisms of ABC
• A full ABC system with numerous cost pools with multiple cost driver is
undeniably more complex than traditional systems and will thus be expensive to
administer.
• Much of work is defense related and pricing is on a cost-plus basis, hence the need
to show accurate product costs. The applicability of ABC to companies has to use
market-based pricing and do not have the same high technology structure has been
questioned.
• Many practical problems are unresolved. Examples include: common cost driver
selection, nonlinearity of cost driver rates etc.
Perhaps the key word in that definition is traceable, whether or not a cost can be traced
objectively to the production/delivery of a good/service.
 Steps in calculation of ABC
Step one
Determine the cost pools. These are equivalent to cost centres in traditional costing
Step two
Determine the cost drivers. These are equivalent to units of base in the traditional costing.
Step three
Compute the cost driver rates. Cost Driver Rate=Cost pool/Cost drivers.
Step Four
Apply the cost driver rates to cost units throughout the period.

Illustration
Assume that a firm makes four products A, B, C and D. Data for the past period are as
follows:
Product Output No. of Direct labor Machine Material Material
units production hrs. hours per cost per components
runs in period per unit unit unit Shs per unit

A 25 3 2 2 30 8
B 25 4 4 4 75 5
C 250 7 2 2 30 8
D 250 10 4 4 75 6

Direct labor cost sh.7 per hour.

Overhead costs Sh.
Short-run variable costs 8,250
Long-run variable costs: 7,680
Scheduling costs 3,600
Material handling costs 7,650
27,180

Find the unit production cost

a) Using ABC with the following cost drivers:
Short-term variable costs Machine hours
Scheduling costs: No. of production runs
Set-up costs: No. of production runs
Materials handling costs: No. of components
B) Conventional Costing Technique (Use machine hours as units of base)
Exercise 1
a) Why would a firm be reluctant to adopt Activity Based Costing despite its benefits over
Conventional Costing?
b) Explain four causes of variances in the business world and how such variances are applicable.
c) Que Ltd is a manufacturing Company that makes only three products X, Y and Z. Data
for the period ended last month are as follows:
X Y Z
Units produced and sold 12000 16000 8000
Sh Sh Sh
Sales price per unit 50 70 60
Direct material cost per unit 16 24 20
Direct labor cost per unit 8 12 8

Production overhead: Total Cost Driver

Sh

Machining costs 102,000 Machine hours

Production scheduling 84,000 Number of production runs
Quality control 49,200 Number of production runs
Set up costs 54,000 Number of production runs
Receiving materials 64,800 Number of components
Packing materials 36,000 Number of customers orders

Information on the cost drivers is given as follows:

X Y Z
Direct labor hours 1 1½ 1
Machine hours per unit ½ 1 1½
Number of components per unit 3 5 8
Numbers of components per received 18 80 64
Number of customer orders 6 20 10
Number of production runs 6 16 8
REQUIRED
Using Activity Based costing (ABC), show the cost and gross profit per unit for each
product during the period.