TRADITIONAL COSTING SYSTEM
•It focused on product costing by tracing direct costs to the
product and indirect costs are allocated through cost
•Traditionally , indirect costs have been allocated to the
end products in three steps:
1. From ledger accounts to production and service
2. From service departments to production departments
following reapportionment methods of allocation.
3. Finally allocating indirect costs of production
departments to the products.
Patio gill company used a job order product
costing system to find the cost of its three
products of grill the standard STD, deluxe
DEL and ultimate ULT.
VOLUME IN UNITS
80 runs of 125 80 runs of 100 40 runs of 50
$180(9hours $220(11hours $260(13hour
STANDARD DELUXE ULTIMATE
PREDETERMINED OVERHEAD RATE
BUDGETED MATERIAL OVERHEAD
DIRECT LABOUR BUDGETED
STD: 10000 Units*9hours
DEL: 8000 Units*11hours
ULT: 2000 Units*13hours
TOTAL DIRECT LABOUR HOURS
$4,896,000/204,000= $24Per hour
Product costs from traditional, volume
based product costing system: Patio Grill
Trouble in patio company
• Less profitability by the prodcts
• Unable to achieve target price( 120% of
full product cost)
Target selling price
Actual selling price
The Need for a New Approach
•Tremendous change in manufacturing and service
•Decrease in amount of direct labour and direct material
•Significant increase in total overhead costs.
•Intense global competition.
•Costs of non – volume related activities can not be
apportioned on volume basis as in traditional method.
•There was an urgent need to integrate activity
measurement and financial measurement.
Defintion as per CIMA:
Cost attribution to cost units on the basis of benefit
received from indirect activities such as ordering,setting
Activity based costing is an accounting
methodology that assigns costs to activities
rather than products or services .
•Focuses on activities as the fundamental cost
•Costs are grouped according to what causes
them to be incurred.
1)It lays emphasis on different costs for different purposes
and only those costs are identified which are relevant to a
2)The more important distinction between cost behaviour
patterns are volume related , time related and events
3)Cost drivers(activities those generate costs) need to be
4)The reporting of costs incurred on significant activities
provides basis for understanding what causes overhead
4)Effective method of excercising cost control.
5)It aims at rectifying inaccurate cost information.
Traditional v/s ABC Approach:
1)Lack of cause and effect
relationship between cost
allocation basis and indirect
1)Presence of cause and
effect relationship between
cost allocation basis and
indirect cost pools.
2)Uses a few pools of
indirect costs resulting in
overcosting or undercosting
2)Rational basis of
assigning indirect costs to
3)Wrong pricing decisions
resuting in loss of market
making such as fixing
selling price and
pinpointing the area where
cost reduction is possible.
It is a characteristic of an activity of an
event or activity that results in the
incurrence of costs.
Factors affecting selection of
• Degree of correlation
• Cost of measurement
• Behavioral effects
Activity Cost Pool:
The overhead cost attributed to a distinct type of activity.
For example: ordering materials or setting up machines
Allocation of overheads under
Assigning costs of
of cost driver
Total budgeted cost = $4,896,000
Set up cost tool
design cost pool
Packing cost pool
Compute product cost of patio grill under various activity pools
Steps involved in Activity-based
•Identify and classify the major activities and allocate
overheads to the appropriate cost pools.
•Identify the cost driver that has a strong
correlation to the costs in the cost pool.
•Compute the overhead rate for
•Establish demands made by a particular product on
activities using cost drivers.
•Assign overhead costs to products using the overhead
rates : In assigning overhead costs, it is necessary to know the expected
use of cost drivers for each product.
ABC Data and Calculation for the machine Related cost Pool: Patio
Total Product Cost as per ABC
TOTAL DIRECT COST
TOTAL INDIRECT COST
TOTAL PRODUCT COST
Rules developed by Kaplan and
Cooper for ABC:
•Focus on expensive resources.
•Emphasis on resources whose consumption
•Focus on resources whose demand patterns are
Stages of ABC
• ABC stage one -- Overhead costs are allocated to
activity cost pools.
• Unit level:
Performed each time a unit is produced
• Batch level:
Performed each time a batch is produced rather than
It includes activities that are needed to support entire product line .
• Facility level [general operations level]:
These activities are required in order for the entire production process to
ABC Stage two –
•Cost drivers are identified for each
activity cost pool.
•Unit activity costs for product lines and
activity cost pools are computed.
•The overhead costs allocated to the cost
pools is assigned to products using cost
Main activities and its cost drivers
1) Material planning
• No. of material
•Volume of material
•Volume of material orders
• No. of machine
3) Customer order
•Number of problem
•Lack of good quality
Comparison of ABC v/s Traditional
Reported unit overhead cost:
traditional costing system
activity based costing system
Reported unit product cost (direct material,
direct labour and overhead):
traditional costing system
activity based costing system
Sales price data:
Original targey price(120% of product cost
based on traditional costing system
New target price(120% of product cost based
on activity based costing system
Actual current selling price
What prices should
Which customers are
How should we measure
channels should we follow?
How to implement ABC?
1)Identify functional areas.
2) Identify key activities in each functional area.
3)Allocate common indirect costs to various activities.
4)Identify most suitable cost driver in each activity
under functional areas.
5)Prepare statement of expenditure activity-wise.
6)Compare it with value addition activity wise to
know which activities need to be eliminated or need
Advantages of ABC
• More accurate
• Understand how costs are
• Use of more cost pools to assign overhead costs
• Enhanced control over overhead costs
• Better management decisions
• Improvement in performance
• Product/service pricing
• Make or buy decision
• Transfer pricing
• Determination of products
Limitations of ABC
•Can be expensive to use
•Does not measure incremental costs
Ways of achieving cost reduction
Ways of achieving cost
1. Reducing set up time
To achieve low cost
To reduce cost of handling
Wherever possible in order
to save cost and time.
•In order to reduce the direct cost of the
product , we can control the overheads when
one has the information of cost centres.
•It becomes necessary to have a costing
system based on activity done.
•Can not be applied if there is no clear
distinction for the costs attached to various
•Implemented in different segments of an
•Equally applied in service sectors.