Read this article to learn about the definition, stages, purposes and benefits of Activity Based Costing (ABC).
ABC has been defined by CIMA as ‘cost attribution to cost units on the basis of benefit received from indirect activities e.g. ordering setting up, assuring quality’. According to Horngren, Foster and Datar ‘ABC is not an alternative costing system to job costing or process costing. Rather ABC is an approach to developing the cost numbers used in job costing or process costing systems. The distinctive feature of ABC is its focus on activities as the fundamental cost objects. In contrast most traditional approaches used in job and process costing systems rely on general purpose accounting systems, not tailored to the activities found in individual organisations. The ABC approach has the potential to provide managers with information they find more useful for costing purposes’.
Activity Based Costing is based on the belief that in production process there are various activities which give rise to costs. ABC creates a link between activities and products by assigning a cost of activities to products based on an individual product.
According to Dansby and Lawrence ‘In ABC costs are not initially traced to departments. Instead, costs are first traced to activities and then to products: Activities causing overheads (or cost drivers) are identified. These activities are later used as a base for allocating overhead costs to products.
Introduction of ABC System:
ABC system assumes that activities cause costs and also that products create demands for activities. The system recognizes that businesses must understand the factors that drive each major activity, the cost activities and how activities relate to products.
The design of ABC system involves following stages:
(1) Identifying activities i.e. identifying major activities that take place in an organisation.
(2) Assigning costs to activity cost centres i.e. assigning costs to cost pools or cost centres for each activity.
(3) Selecting appropriate cost drivers i.e. identifying the factors that influence the costs of particular activities.
(4) Assigning the cost of activities to products i.e. assigning such cost according to each products demand for activities.
These stages may be considered in detail:
1. Identifying Activities:
The first stage is to identify the functional areas or major activities involved in the production. Examples of activities include machine related activities, divert labour related activities and various support activities like ordering, receiving, material handling, packing, despatching. Various activities are identified by carrying out activity analysis. The activities may be basically fall into four categories as suggested by Cooper and Kaplan’.
(a) Unit Level Activities or Primary Activities:
The cost of primary activities (like use of indirect materials and consumables, testing of every item produced) may be correlated to number of units produced (i.e. on volume-basis).
(b) Batch Level Activities:
These are manufacturing support activities (like material ordering, machine set-up costs, inspection of products etc). The cost of such activities is driven by number of batches of units produced.
(c) Product Level Activities:
Activities like designing of the product, keeping technical drawings of product, activities upto date, advertising of a specific product are called product level. The cost of these activities is driven by the creation of a new product line and its maintenance.
(d) Facility Level Activities:
Certain activities cannot be related to a particular product, instead may be related to certain facilities like maintaining the building, security of plant, salaries of production manager, advertisement to promote organisation.
It may be noted that unit level activities and facility level activities are the same as those in traditional absorption costing which will be allocated on physical volume basis, ABC will be more useful if there is significant size of batch level and product level activities.
2. Assigning Costs to Activity Cost Centres:
The second stage requires that a cost centre (also called a cost pool) be created for each activity. After the activities have been identified the cost of resources consumed over a specified period must be assigned to each activity. These costs will have to be apportioned on some suitable basis. For example the total costs of all set ups might constitute one cost centre for all setup related costs.
3. Selecting Appropriate Cost Drivers:
The third stage of designing ABC system is to identify the factors that influence the cost of a particular activity. The term cost-driver is used to describe the significant determinant of the cost of the activity. The most suitable cost driver in each activity under functional areas should be identified. A cost driver is any factor that influences costs.
The main functional areas are:
(i) Material Management
(ii) Stores Management
(iii) Production Management
(iv) Quantity Control Management
(v) Personnel Management
(vi) Sales Management
(vii) Repairs and Maintenance
(viii) Administration and
(ix) Public Relations.
4. Assigning the Cost of the Activities to Products:
The final stage is to trace the cost of the activities to products according to each product’s demand for these activities using cost drivers as a measure of demand. A product’s demand for the activities is measured by the number of transactions it generates for the cost driver. The cost driver should be measurable in a way that enables it to be identified with individual products.
Purposes and Benefits of ABC:
As compared to traditional overhead costing, Activity Based Costing provides more accurate cost information for products. ABC provides a very different perspective of the cost structure. The managers of production are guided to adjust their pricing policies as they identify that high volume products had been over costed and low volume products under costed.
ABC has been accepted as very useful for product costing where production overheads are high in relation to direct cost, where there is diversity in the product range, where products consume different amount of overhead and where consumption of overhead is not basically driven by their volume.
In brief following are main benefits of using ABC technique:
1. ABC helps to reduce costs by providing meaningful information for cost-management. It helps in making the right decision.
2. ABC technique provides due importance to non-manufacturing cost which constitute a substantial portion of total cost. For example, in case of a number of products marketing and advertising costs constitute a big portion of cost. These overheads can be allocated easily using ABC because the relationship between such costs and their causes can be identified easily. Traditionally such non-manufacturing costs have been allocated under volume basis and thus high volume products have been overvalued.
3. ABC technique provides accurate and reliable cost information. These cost information are essential for recent approaches in productivity improvement like Total Quality Management (TQM) and Business Process Reengineering.
4. ABC enables the management in formulating an effective pricing policy while fixing prices.
5. Cost of each activity is determined with the help of ABC. There is accuracy in indirect cost-allocation to products. This technique is helpful in make or buys decisions and transfer pricing.
Thus ABC has attracted a considerable amount of interest because it provides not only a basis for calculating more accurate product cost but also a mechanism for managing overhead costs. By collecting and reporting on the significant activities in which a business engages, it is possible to understand and manage costs more effectively. It is the area of cost-management rather than product costing, where activity-based systems may have their greatest potential.