Activity based costing (ABC) is a new costing method that assigns overhead costs to products and services based on their consumption of resources. Traditional costing methods assigned overhead costs based on direct labor hours or machine hours. However, in modern business with increased complexity and variety of products, overhead costs are not directly linked to production volume. ABC addresses this by identifying the activities performed in an organization, the costs (cost pools) associated with each activity, and assigning activity costs to products using cost drivers that indicate consumption of each activity. ABC provides more accurate product costs and helps identify value-adding vs. non-value adding activities. It has led to benefits for companies such as improved pricing, cost management, and profitability.

1. Activity Based Costing
Presentation by
Prof. Mohi-ud-Din sangmi
Former Director, Human Resource
Development Centre
Former Head & Dean
Faculty of commerce & Management Studies
University of Kashmir Srinagar

2. Business in bygone days
before2000 (characteristics)
• Low level of Mechanisation
• Large runs of relatively standardised products
• Slow rate of change in both products and
methods
• Direct costs, material and labour were a high
proportion of total cost
• Relatively small number of support functions
( like planning, financial, quality, R&D, etc.)
• Over cost high volume products and under cost
low volume products

3. Business in year 2000 and After
( characteristics )
• Emergence of world class manufacturing-
$
• Thrust on total quality management-$
• Value-Added & Non- Value-added
activities-$
• Increased trend of Diversification
• Cost leadership and lower price as market
strategy-through Total cost Mgt.
• Outsourcing as a competitive tool

4. World Class manufacturer- I
NO. Attribute Traditional
manufacturer
World class
manufacturer
1. Organizational
mind set
A mind set for
standards as a basis
for organizational
A mind set for
questioning the
standards and setting
them only to reset
again (journey in the
continuous
improvement)
2. Organizational
capabilities
Organized for building
products for specified
markets
Organized for building
certain organizational
capabilities and mind
set that could adopt to
any future
requirements in terms
of markets & products

5. World Class manufacturer -II
3.Organizational
structure
Logical building
blocks are the
functional areas
Terms based on the
business process (that
cut across and unify
several functional
areas) are the building
blocks
4.Organization
performance measure
Performance
measures based on
internal parameters
such as labour and
machine utilization,
price of purchased
items, and meeting
certain standards
Performance
measures based on
customer driven
parameters such as
quality, and on time
delivery
5.Cost Cost is function of the
trade off considerations
with quality, delivery,
quick response –controls
costs for cost reduction
Ever decreasing costs
(customer driven)
controls causes not
costs for costs
reduction…

6. Total Quality Management
(TQM)-i
• TQM is the unyielding and
continually improving effort by
everyone in the firm to
understand, meet, and exceed
the expectations of customers

7. Total Costs of Quality through 10-100-
1000 Rule (TQM)-ii
Insurance
Prevention Rs.10
1.Training
2.Systems
3.Empowerment
4.Improved
design
5.Problem
solving
Protects against
Internal failure
Rs 100
1.Mistakes &
rework
2.Errors and
wastage
3.Excess
overtime
4.Low morale
5.Low
productivity
External failure
Rs.1000
1.Lost customer
2.Poor word of
mouth
3.Law suits
4.Goods returns
5.Loose market
share

8. Impact of modern business
philosophy on cost accounting
systems
• More support services needed like R&D, industrial
engineering, quality control, data processing ,material
handling, etc.
• Material and direct labour as proportion of cost
decreased --$
• Overheads as proportion of cost increased-$
• Overheads unaffected by production volume but vary
longer term according to complexity-$
• Overheads increased due to wider range of products and
complexities-$$
• Overheads are not primarily influenced by output
volumes of products.

9. Product cost trends
Labour 5%
15%
Material
50% 55%
Overheads
35% 40%
1980 2001

10. Overheads affected by wider
range & complexity
Product
Capital
Size of factory
Production:
Blue pens
Black pens
Red pens
Green pens
Purple pens
Total output
Plant i
Ballpoint pens
same
Same
Numbers
10,00,000
-----
-----
-------
-----
10,00,000
Plant ii
Ballpoint pens ii
Same
Same
1,00,000
5,00,000
3,00,000
55,000
45,000
10,00,000

11. New Costing System-Activity
Based Costing (ABC)
• ABC is a costing approach that
assigns costs to Products,
services,or customers based on
the consumption of resources
caused by activities.

12. ABC-terminology
• Activity: It is a task/work/operation performed in
an organisation
• Resources: These are economic elements
applied/used to perform activities; expenses/
costs, etc.
• Cost Driver: t is a measure of the amount of
resources consumed by an activity.
• Cost Pool: It is a group of individual costs that a
company allocates to cost objectives using a
single cost driver.

13. ABC –Basic philosophy
• Organization has diverse activities
• Some activities add value some don’t-$
• Activities consume resources and
resources have costs
• Measuring costs by establishing link
between activities and cost objects
• Existence of multiple business processes
and this has cost implications

14. Value-added & Non-value
added activities-i

15. Value-added & Non-value
added activities-ii
Activity
Material handling
Set-up
Assembly
Testing and inspection
Rework
Packaging
Breaks and meetings
Value-added?
No
No
Yes
Maybe
No
Maybe
No

16. ABC Answers some Questions
• What causes the activities to take place?
• Why does it takes place as often as it
does?
• What are the linkages between activities?
• Why it consumes the extent of resources
it does?
• What value the activity add?
• Who is seeking the value, the activity
add?
• What are the factors that determine

17. Activities and their Cost Drivers-I
• Material Planning No. of material transactions
• Volume of material receipts
• Volume of material orders
• Inspection No. of inspection
• Gauge usage
• No. of problem suppliers
• Maintenance No. of machine breakdowns
• Maintenance hours
• Accounting No. of accounting transactions

18. Activities and their Cost Drivers-
II
• Human Resource costs---- No. of
Employees
• --No. of insurance
claims
• -----No. of training hours
• Marketing costs—No. of orders processed
• ---No. of customer service
contacts
• Adminstration costs–No. of stockholder contacts
• ---No. of hours charged to law suits

19. ABC analysis for material handling
Functional
area
Activity
Cost pool
Cost driver
Cost Item
Material
purchase
Purchase
material
Buying
Material
handling
warehouse
Receiving&
inspection
Handling
No. of
issues
Product
Material
dispensing
Dispensing
Handling

20. ABC for Indirect Labour
Activity
-----------------------------------
Inspect incoming material
Move materials
Maintenance machines
Set up machines
Prepare tooling
Cost drivers
---------------------------------
No. of receipts
No. of moves
Maintenance hours
Setup hours
No. of setups

21. Activity Based costing (ABC)-Steps
• Identify the main activities in the
organisation
• Trace the costs of resources consumed by
these activities.
• Identify factors which determine the cost of
an activity-called cost drivers
• Collect the costs of each activity-known as
cost pools/cost centers
• Charge support overheads to product on
the basis of their usage of the activity,
expressed in terms of chosen cost drivers

22. ABC Benefits :Survey of users
• Benefits % of sampling saying Leading to
• Greater accuracy in product costing 100% Improved pricing,
make or buy decision
• Greater involvement of production managers 90% Improved cost
awareness, feeling of ownership, interaction
• Improved mgt. information 70% Greater
awareness of departmental managers, better product design,
strategy improved , mgt. control and quality mgt.
• Improved profitability 40% Greater
profitability, improved investment
• Reduction in costs 60% Performance
enhanced, business operations
• Source: Bailey J ( 19991) Implementing of ABC systems by UK companies,Mgt. Accounting
CIMA Feb..30-32-

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