Unit 13: Activity Based Costing

Activity Based Costing (ABC) is a cost attribution system developed in the late 1980s (notably by Robin Cooper and Robert Kaplan) to correct the distortions that arise when overheads are spread using volume-based rates. It assigns indirect costs to products or services according to the activities those products actually consume, on the premise that "activities consume resources and products consume activities."

• Governing principle: Costs are traced to activities first, then from activities to cost objects (products, jobs, customers) using drivers that reflect real consumption.
• Cost object: Anything for which a separate cost measurement is wanted — a product, batch, order or customer segment.
• Two-stage assumption: Resources → activity cost pools (stage 1); activity cost pools → cost objects (stage 2).
• Cause-and-effect convention: Each allocation base must have a causal link to the cost incurred, not merely a convenient volume measure.
• Relevance context: Most useful where overheads are large, products are diverse in volume and complexity, and competition demands accurate pricing.

II. Concept and Pre-requisites

The foundation that makes ABC meaningful and workable.

A. Concept

ABC is a refined costing method that recognises multiple causes of overhead rather than a single volume driver.

• Definition: A system that identifies activities in an organisation and assigns the cost of each activity to products in proportion to actual consumption of that activity.
• Activity: A unit of work or task, such as machine set-up, purchase order processing or quality inspection.
• Cost pool: The total cost accumulated for one activity, e.g. all costs of running the set-up department gathered into a single "set-up" pool.
• Hierarchy of activities: ABC classifies activities into four levels:
  • Unit-level: performed for each unit, e.g. machining (varies with output).
  • Batch-level: performed per batch, e.g. set-ups, material handling.
  • Product-level: sustains a product line, e.g. design, product specification.
  • Facility-level: sustains the plant overall, e.g. factory rent, general management.

B. Pre-requisites

ABC only pays off when certain organisational conditions hold.

• Significant overhead share: Overheads must form a large proportion of total cost, so refining their allocation genuinely matters.
• Product diversity: Products must differ in volume, size, complexity or batch size, so a single rate would cross-subsidise.
• Identifiable activities: Operations must be separable into discrete activities with measurable outputs.
• Availability of driver data: The firm must be able to record volumes such as number of set-ups, orders or inspections.
• Cost-benefit justification: The information gained must outweigh the effort of designing and running the system.

III. Activity Based Costing versus Traditional Costing

Contrasting single-rate absorption with activity-driven tracing.

A. Basis of comparison

The two systems differ chiefly in how overheads reach the product.

1. Traditional (absorption) costing: Overheads are pooled by department or plant and absorbed using a single volume base — labour hours, machine hours or units.
   • Weakness: High-volume simple products over-absorb overhead; low-volume complex products under-absorb, distorting profitability.
   • Anchor: A blanket rate of ₹50 per machine hour applies equally whether a product needs 1 set-up or 20.
2. Activity Based Costing: Overheads are pooled by activity and traced by multiple drivers reflecting real demand.
   • Strength: Complex, low-volume products carry the batch and product-level costs they truly cause.
   • Anchor: Set-up cost is charged per set-up, so a product with 20 set-ups bears 20× the set-up cost of one needing a single set-up.

B. Key points of difference

• Number of cost drivers: Traditional uses one or few volume drivers; ABC uses many, both volume and non-volume.
• Cost accuracy: ABC gives more accurate product costs; traditional is simpler but coarser.
• Focus: Traditional focuses on where cost is incurred (departments); ABC focuses on why (activities).
• Cost of operation: ABC is more expensive to design and maintain; traditional is cheaper.
• Decision support: ABC supports pricing, product-mix and outsourcing decisions; traditional can mislead them.

IV. Steps Involved in Activity Based Costing

The design sequence from resources to product cost.

A. The procedure

ABC follows an ordered set of steps that build the two-stage allocation.

• Step 1 — Identify activities: List the major activities in the process, e.g. purchasing, set-up, inspection, dispatch.
• Step 2 — Create cost pools: Accumulate the overhead cost of each activity into its own pool.
• Step 3 — Identify cost drivers: Choose the factor that causes each pool's cost, e.g. number of orders for purchasing.
• Step 4 — Compute activity cost driver rate:
  
  TEXT

    Cost driver rate = Total cost of activity pool / Total quantity of cost driver

• Step 5 — Assign costs to products: Multiply each product's driver consumption by the rate:
  
  TEXT

    Overhead to product = Cost driver rate × Driver units consumed by product

• Step 6 — Compute total product cost: Add direct materials and direct labour to the assigned overheads.

V. Cost Drivers

The causal links that carry cost from pools to objects.

A. Meaning and types

A cost driver is any factor whose change causes a change in the cost of an activity.

• Definition: The event or measure that determines how much of an activity's cost a product consumes.
• Resource cost driver: Measures resources consumed by an activity, used in stage 1, e.g. floor area for allocating rent to activities.
• Activity cost driver: Measures how much of an activity a cost object consumes, used in stage 2, e.g. number of inspections.
• Categories by hierarchy:
  • Transaction drivers: count how often an activity occurs, e.g. number of set-ups, orders — cheap but assume each event costs the same.
  • Duration drivers: measure time an activity takes, e.g. set-up hours — more accurate when events vary in length.
  • Intensity drivers: charge for resources used each time, most accurate and most costly.

B. Selecting a cost driver

• Causality: The driver must genuinely cause the cost, e.g. number of purchase orders drives purchasing cost.
• Measurability: Data on the driver must be readily obtainable.
• Example pairing: Material handling → number of material movements; quality control → number of inspections; machining → machine hours.

VI. Determination of Cost under ABC

Applying the rates to arrive at per-unit cost.

A. The costing mechanics

Product cost under ABC sums direct costs and activity-based overhead.

• Formula:
  
  TEXT

    Total cost = Direct materials + Direct labour + Σ(Driver rate × Driver units used)
    Unit cost  = Total cost / Number of units produced

• Symbols: Driver rate = pool cost ÷ total driver volume; Driver units used = the product's share of that driver.

B. Worked example

A firm has set-up costs of ₹1,00,000 and ordering costs of ₹60,000.

• Driver volumes: 200 set-ups in total; 300 orders in total.
  • Set-up rate = ₹1,00,000 / 200 = ₹500 per set-up
  • Ordering rate = ₹60,000 / 300 = ₹200 per order
• Product X consumes 40 set-ups and 50 orders:
  • Set-up cost = 40 × ₹500 = ₹20,000
  • Ordering cost = 50 × ₹200 = ₹10,000
  • Overhead assigned to X = ₹30,000
• If X makes 1,000 units, overhead per unit = ₹30,000 / 1,000 = ₹30, added to X's direct material and labour to give the full unit cost.

VII. Benefits and Limitations

What ABC delivers and where it falls short.

A. Benefits

ABC improves the quality of cost information and the decisions built on it.

• Accurate product costing: Traces overhead by cause, ending the cross-subsidy between simple and complex products.
• Better pricing and product-mix: Reveals which products or customers are truly profitable, guiding discontinuation or repricing.
• Cost control: Highlighting activity costs supports Activity Based Management, e.g. reducing the number of set-ups to cut cost.
• Identifies non-value-adding activities: Makes waste visible, e.g. excessive inspections or handling.
• Supports strategic decisions: Informs outsourcing, budgeting (activity-based budgeting) and process improvement.

B. Limitations

ABC's refinement carries practical costs and judgement risks.

• Costly and complex: Identifying activities and collecting driver data is time-consuming and expensive to maintain.
• Difficult driver selection: Some costs, especially facility-level, have no clear driver and remain arbitrary.
• Not suited to all firms: Where overheads are small or products uniform, the extra effort yields little benefit.
• Resistance and interpretation: Requires staff cooperation and training; misreading activity costs can mislead as much as traditional rates.
• Historical orientation: Rates are based on past data and may not reflect future capacity or cost behaviour.