ACTIVITY BASED
COSTING SYSTEM

TRADITIONAL COSTING SYSTEM
•It focused on product costing by tracing direct costs to the
product and indirect costs are allocated through cost
centres .
•Traditionally , indirect costs have been allocated to the
end products in three steps:
1. From ledger accounts to production and service
departments.
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.
STANDARD
DELUXE
ULTIMATE
PLANNED ANNUAL
PRODUCTION
VOLUME IN UNITS
PRODUCTION RUN
DIRECT MATERIAL
DIRECT LABOR
MACHINE HOURS
PER PRODUCT
TOTAL MACHINE
HOUR
10000
8000
2000
80 runs of 125 80 runs of 100 40 runs of 50
units
units
units
$100
$120
$180
$180(9hours $220(11hours $260(13hour
@20)
@20)
s@20)
10
12
17
100000
960000
340000

DIRECT MATERIAL
DIRECT LABOR
MANUFACTURING OVERHEAD
TOTAL
STANDARD DELUXE ULTIMATE
$100
$120
$180
$180
$220
$260
$216
$264
$312
$496
$604
$752
PREDETERMINED OVERHEAD RATE
BUDGETED MATERIAL OVERHEAD
DIRECT LABOUR BUDGETED
HOURS
STD: 10000 Units*9hours
DEL: 8000 Units*11hours
ULT: 2000 Units*13hours
TOTAL DIRECT LABOUR HOURS
PREDETERMINED OVERHEAD
RATE:
$4,896,000/204,000= $24Per hour
90000
88000
26000
204000
Product costs from traditional, volume
based product costing system: Patio Grill
company

Trouble in patio company
• Less profitability by the prodcts
• Unable to achieve target price( 120% of
full product cost)
standard
Deluxe
Ultimate
Production cost
under traditional
volume based
system
$496.00
$604.00
$752.00
Target selling price
$595.00
$724.80
$902.40
Actual selling price
$585.00
$705.00
$940.00

The Need for a New Approach
•Tremendous change in manufacturing and service
industries.
•Decrease in amount of direct labour and direct material
usage.
•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
up,assuring,quality.

Meaning:
Activity based costing is an accounting
methodology that assigns costs to activities
rather than products or services .
•Focuses on activities as the fundamental cost
objects.
•Costs are grouped according to what causes
them to be incurred.

Characteristics :
1)It lays emphasis on different costs for different purposes
and only those costs are identified which are relevant to a
particular decision.
2)The more important distinction between cost behaviour
patterns are volume related , time related and events
related.
3)Cost drivers(activities those generate costs) need to be
identified.
4)The reporting of costs incurred on significant activities
provides basis for understanding what causes overhead
costs.
4)Effective method of excercising cost control.
5)It aims at rectifying inaccurate cost information.

Traditional v/s ABC Approach:
Traditional approach
ABC approach
1)Lack of cause and effect
relationship between cost
allocation basis and indirect
cost pools.
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
of products.
2)Rational basis of
assigning indirect costs to
various activities.
3)Wrong pricing decisions
resuting in loss of market
share .
3)Improved decision
making such as fixing
selling price and
pinpointing the area where
cost reduction is possible.

Cost driver
It is a characteristic of an activity of an
event or activity that results in the
incurrence of costs.

Factors affecting selection of
cost drivers
• 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
ABC:
Service departments
&
Factory overheads
Assigning costs of
Individual activities
Activity
cost
pools
Product
lines
Application
of cost driver
rates

Overhead costs
Total budgeted cost = $4,896,000
Activity
cost
pools
Machine related
cost pool
$ 1,242,000
Set up cost tool
$ 210,000
purchasing cost
pool
$ 300,000
Quality assurance
cost pool
$110,000
Engineering
design cost pool
$ 130,000
Faci;ity
cost pool
$ 2,300,000
Packing cost pool
$264,000
Compute product cost of patio grill under various activity pools

Steps involved in Activity-based
costing
•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
each pool.

•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
Grill company

Total Product Cost as per ABC
STD
DEL
ULT
DIRECT MATERIAL
$100.00
$120.00
$180.00
DIRECT LABOR
$180.00
@220.00
@260.00
TOTAL DIRECT COST
$280.00
$340.00
$440.00
MACHINE RELATED
$54.00
$64.80
$440.00
SET UP
8.40
10.50
21.00
PURCHASING
10.00
12.00
52.00
MATERIAL HANDELING
13.60
17.00
34.00
QUALITY ASSURANCE
4.00
5.00
15.00
PACKING
12.00
12.00
24.00
ENGINEERING DESIGN
5.00
5.00
20.00
FACILITY
100.00
120.00
170.00
TOTAL INDIRECT COST
$207.00
$246.30
$427.80
TOTAL PRODUCT COST
$487.00
$586.30
$867.80
INDIRECT COST

Rules developed by Kaplan and
Cooper for ABC:
•Focus on expensive resources.
•Emphasis on resources whose consumption
varies significantly.
•Focus on resources whose demand patterns are
uncorrelated.

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
a unit.

•Product-sustaining level:
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
occur

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
Main activities
Cost drivers
1) Material planning
• No. of material
transactions
•Volume of material
receipts
•Volume of material orders
2)Maintenance
• No. of machine
breakdowns
•Maintenance schedule
•Capital expenditure
•Activity levels
3) Customer order
processing
•Order value
•Order source
•Customer location
4)Inspection
•Inspection plans
•Number of problem
suppliers
•Lack of good quality

Comparison of ABC v/s Traditional
costing system
STD
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
DEL
ULT
$216.00
207.00
$264.00
246.30
$312.00
427.80
496.00
487.00
604.00
586.30
752.00
867.80
595.20
724.80
902.40
584.40
703.56
1041.36
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
585.00
705.00
940.00

What prices should
we set?
Which product
should we
promote?
Which customers are
profitable?
Gaining
competitive
advantage
How should we measure
performance?
Which distribution
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
improvement.

Advantages of ABC
• More accurate
• Understand how costs are
actually consumed
• 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
service costs

Limitations of ABC
•Can be expensive to use
•Does not measure incremental costs

Ways of achieving cost reduction
under ABC
Ways of achieving cost
reduction
ABC system
1. Reducing set up time
To achieve low cost
2.Eliminating material
handling activities.
To reduce cost of handling
3.Using common
components
Wherever possible in order
to save cost and time.

Conclusion:
•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
activities.
•Implemented in different segments of an
organisation .
•Equally applied in service sectors.

Thank
You!!