Activity based costing (ABC) is a new approach to accumulating costs that traces resource consumption and costs final outputs based on activity consumption estimates. Traditional costing systems accumulated costs by cost centers and assumed proportional relationships between overhead costs and products. However, ABC addresses limitations of traditional systems by classifying activities as value-adding or non-value adding, identifying cost drivers, creating cost pools, and tracing activity costs to products. ABC involves performance analysis to identify best ways to measure important organizational factors and stimulate continuous improvement.

1. ACTIVITY BASED COSTING Arun George Joseph

2. Activity Based Costing is NOT another method of costing. It is in fact a new approach to accumulation of costs. Thus it must not be confused with basic methods of costing like Job , batch or process costing. Activity Based Costing is not just a tool of costing, but of any processes.

3. Traditional System For understanding Activity Based Costing, one must understand what traditional approach to costing is. A traditional costing system was more involved in accumulation of costs in production activity. Eg, Job Costing. Later, as the discipline grew, accumulation of costs in service activity was also included. Eg. Operating costing. In a traditional costing system, costs are accumulated on the basis of cost centres.

4. Following are considered as the limitations of traditional costing systems. Cannot report accurate product costs volume related resources consumed in proportion to number of units produced gets more attention, when non volume related activities are sidelined. Traditional methods assume that the products consume all resources in proportion to their production volumes. This may result in distortion in product costs. Eg. Allocation of electricity charges to various departments. The relationship between overhead costs and product costs cannot be clearly established in traditional methods. the interrelationship among various activities of production department are often ignored in traditional methods.

5. definitions Activity: Under Activity Based Costing, activities are classified into value adding and non value adding activities. Activity based costing: Three Definitions by Chartered Institute of Management Accountants,(CIMA), London. 1)“An approach to the costing and monitoring of activities, which involves tracing resources consumption and costing final outputs. Resources are assigned to activities and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach costs to outputs” 2) “Cost attribution to cost units on the basis of benefit received from indirect activities” 3) The collection of financial and operational performance information tracing the significant activities of the firm to product costs.

6. Steps in ABC analysis Identification of Activities Determination of cost drivers Creation of cost pool Tracing costs of activities to products

7. Definitions in ABC Activity : The act of production, or a process or stage in production, or an act of rendering service, or a stage in rendering a service. Activity Cost Pool : is the point of focus for the costs relating to a particular activity in an activity based costing sytem. For eg, in a college, library is a ‘cost pool’, and cost of issue and receipts of books, cost of ordering of books, stock taking of books etc are clubbed to form this cost pool. Thus cost pool is the total cost assigned to an activity. Cost Drivers: Cost driver is any factor which causes a change in the cost of an activity. Thus cost driver means those factors which determine the cost of an activity. For eg, in the college library, no of books issued and received, no of books ordered etc are cost drivers. Therefore, when a cost driver changes, the activity cost also changes. Uses of Activity Based Costing: Cost driver analysis : The factors that cause activities to be performed need to be identified inorder to manage activity costs. Analysis of cost drivers helps in addressing the root problems in an activity. For eg, the analysis of cost involved in issue of each book can be analysed to reduce the overall cost of the college library. Activity analysis: Activities are of two types. Value adding activities and non value adding activities. Activity analysis aims at identifying various activities into above two categories. This will help in reduction/control of costs. Efforts can be made to reduce or avoid non value adding activities. Performance Analysis: Performance analysis involves the identification of appropriate measures to report the performance of activity centers or other organizational units.It aims at identifying best ways to measure the performance of factors that are important to organizations in order to stimulate continuous improvement.

8. Thank You. May almighty Lord help each and everyone to come out in flying colours in the forthcoming SAS exams. Arun George Joseph Asst. Audit Officer (P)