Unit 13: Activity Based Costing - Subjective Questions

Activity Based Costing (ABC) is a costing methodology that identifies activities in an organisation and assigns the cost of each activity to products and services according to the actual consumption of resources by each.

Basic Concept:

• ABC is based on the principle that activities consume resources and products consume activities.
• Overheads are first traced to activities (grouped into cost pools) and then charged to products using cost drivers.

Difference from conventional approach:

• Traditional costing absorbs overheads using volume-based rates (labour hours, machine hours).
• ABC uses multiple cost drivers that reflect the actual cause-and-effect relationship between activities and cost.
• ABC gives more accurate product costs, especially where products differ in complexity and volume.

Thus, ABC refines the process of assigning indirect costs by focusing on the activities that drive those costs.

The successful application of ABC depends on the following pre-requisites:

• Identification of activities: All significant activities carried out in the organisation must be clearly identified.
• Grouping into cost pools: Related activities should be grouped into homogeneous cost pools.
• Suitable cost drivers: Appropriate cost drivers that establish a cause-and-effect relationship must be selected.
• Availability of data: Accurate data on resource consumption and driver quantities must be available.
• Management support: Top management commitment is essential due to the cost and effort involved.
• High proportion of overheads: ABC is most beneficial when overheads form a significant part of total cost.
• Product diversity: The organisation should have a diverse product range with varying complexity and volumes.
• Adequate information system: A sound accounting and information system is needed to capture activity-level data.

When these conditions are met, ABC delivers more accurate and useful cost information.

The key differences between ABC and Traditional Costing are:

Conclusion: Traditional costing over-costs high-volume products and under-costs low-volume complex products, whereas ABC corrects these distortions by tracing costs to activities.

The implementation of ABC involves the following steps:

1. Identify activities: Determine the major activities carried out within the organisation (e.g., machine setup, ordering, inspection).
2. Create cost pools: Group the costs of similar activities into activity cost pools.
3. Determine cost drivers: Identify the factor that causes the cost of each activity (the cost driver).
4. Calculate cost driver rate: Compute the rate using the formula:
   
5. Assign costs to products: Charge overheads to products by multiplying the cost driver rate by the quantity of driver consumed by each product.
6. Compute total cost: Add direct costs and the assigned overheads to arrive at the total product cost.

These steps ensure that overheads are allocated based on actual activity consumption.

A Cost Driver is any factor or activity that causes a change in the cost of an activity. It establishes a cause-and-effect relationship between an activity and its cost.

Role in ABC:

• Cost drivers are used as the basis for allocating overhead costs from activity cost pools to products.
• The choice of an appropriate cost driver directly affects the accuracy of product costing.

Examples of Cost Drivers:

A well-chosen cost driver reflects the actual consumption of the activity and leads to accurate cost assignment.

Cost drivers in ABC are broadly classified into the following types:

1. Resource Cost Drivers:

• Measure the amount of resources consumed by an activity.
• Used to assign the cost of resources to activity cost pools.

2. Activity Cost Drivers:

• Measure how much of an activity is consumed by products or cost objects.
• Used to assign activity costs to products.

Activity cost drivers are further categorised (based on Cooper's hierarchy) as:

• Unit-level drivers: Vary with the number of units produced (e.g., machine hours, direct labour hours).
• Batch-level drivers: Vary with the number of batches (e.g., number of setups, purchase orders).
• Product-level drivers: Relate to activities performed to support individual products (e.g., number of product designs).
• Facility-level drivers: Relate to general activities that sustain the plant (e.g., factory management, building maintenance).

The selection of appropriate drivers at each level improves costing accuracy.

In ABC, activities and their associated costs are classified into a cost hierarchy consisting of four levels:

1. Unit-Level Activities:

• Performed each time a unit is produced.
• Cost varies directly with production volume.
• Example: Machining, assembly, power consumption per unit.

2. Batch-Level Activities:

• Performed each time a batch is produced, regardless of the number of units in the batch.
• Example: Machine setups, material ordering, batch inspection.

3. Product-Level (Product-Sustaining) Activities:

• Performed to support the production of a particular product line.
• Example: Product design, engineering changes, maintaining product specifications.

4. Facility-Level (Facility-Sustaining) Activities:

• Performed to sustain the overall manufacturing facility.
• Cannot be traced to individual products.
• Example: Factory security, building rent, plant management salaries.

This hierarchy helps in identifying appropriate cost drivers for each activity level and improves the accuracy of cost allocation.

The main benefits of ABC are:

• Accurate product costing: Overheads are traced to products based on actual activity consumption, giving more precise costs.
• Better cost control: By identifying activities and their drivers, management can control and reduce costs at the activity level.
• Improved decision-making: Provides reliable information for pricing, product mix, make-or-buy, and outsourcing decisions.
• Identifies non-value-adding activities: Highlights wasteful activities that can be eliminated or reduced.
• Supports performance management: Facilitates activity-based management (ABM) and continuous improvement.
• Better overhead allocation: Corrects distortions caused by traditional volume-based allocation.
• Enhanced profitability analysis: Enables accurate customer and product profitability analysis.
• Useful in service industries: Applicable to service organisations where overheads are significant.

Thus, ABC helps organisations gain a clearer understanding of cost behaviour and profitability.

Despite its advantages, ABC suffers from the following limitations:

• Costly to implement: Requires substantial investment in time, resources, and system development.
• Complex system: Identification of activities and cost drivers is complicated and requires expertise.
• Difficulty in selecting cost drivers: Choosing appropriate drivers for every activity is challenging.
• Not suitable for all firms: Provides limited benefit where overheads are small or products are similar.
• Data collection burden: Requires large volumes of accurate data, increasing clerical work.
• Some costs remain arbitrary: Facility-level costs cannot be traced to products and are still allocated arbitrarily.
• Resistance to change: Employees and management may resist the new system.
• Time-consuming: Regular updating of activity and driver data is necessary.

Hence, ABC should be adopted only after weighing its costs against the expected benefits.

Cost Driver Rate is calculated using the formula:

1. Setup Cost Driver Rate:

2. Ordering Cost Driver Rate:

Significance:

• These rates are used to assign overhead costs to products based on the number of setups and orders each product consumes.
• For example, a product requiring 20 setups and 15 orders would be charged:
  

This ensures overheads are charged in proportion to the actual activities consumed by each product.

Under ABC, the cost of a product is determined by tracing overheads through activities. The procedure is:

Step 1 – Identify Activities and Cost Pools: e.g., machine setup, material handling, inspection.

Step 2 – Accumulate Costs in Pools: Assign total overhead costs to respective activity cost pools.

Step 3 – Identify Cost Drivers: Select an appropriate driver for each pool.

Step 4 – Compute Cost Driver Rate:

Step 5 – Assign Overheads to Products:

Step 6 – Compute Total Cost:

Illustration: If the inspection pool is for 200 inspections, rate = per inspection. A product using 30 inspections absorbs of inspection cost, which is added to its direct costs and other activity costs to arrive at total cost.

Distortion under Traditional Costing:

• Traditional costing allocates overheads using volume-based measures such as direct labour hours or machine hours.
• This assumes all overheads vary with production volume, which is not true for many modern overheads (setups, inspections, design).
• As a result:
  • High-volume, simple products are over-costed (they absorb too much overhead).
  • Low-volume, complex products are under-costed (they absorb too little overhead).
• This leads to wrong pricing, product mix, and profitability decisions.

How ABC Overcomes This:

• ABC uses multiple cost drivers (both volume and non-volume based).
• Overheads are traced to activities and then to products based on actual activity consumption.
• Complex, low-volume products that consume more support activities are charged accordingly.
• This produces accurate product costs reflecting real resource usage.

Conclusion: By recognising that costs are caused by activities rather than volume alone, ABC eliminates the cross-subsidisation inherent in traditional costing.

Resource Cost Drivers and Activity Cost Drivers operate at two different stages of ABC:

Summary:

• Resource cost drivers link resources → activities.
• Activity cost drivers link activities → cost objects.

Together, they enable the two-stage allocation process that is central to ABC.

Scenario: Product X is produced in large volumes with few setups; Product Y is produced in small volumes but requires frequent setups, inspections, and special handling.

Under Traditional Costing:

• Overheads are absorbed on the basis of volume (e.g., machine hours).
• Since X has higher volume, it absorbs a larger share of overheads, even though it is simple to produce.
• Product Y absorbs less overhead despite consuming many support activities.
• Result: X is over-costed and Y is under-costed.

Under ABC:

• Overheads are traced through activity cost drivers (setups, inspections, handling).
• Product Y, which triggers many setups and inspections, is charged with the actual cost of those activities.
• Product X bears overheads only in proportion to the activities it genuinely consumes.
• Result: Y's cost increases and X's cost decreases, reflecting true resource usage.

Conclusion: ABC reveals that low-volume complex products (Y) are more expensive than traditional costing suggests. This helps management make better pricing and product mix decisions.

Activity Based Management (ABM) is the use of information obtained from Activity Based Costing to improve organisational performance and profitability by managing activities.

Relationship with ABC:

• ABC provides the cost information (which activities cost how much and why).
• ABM uses that information to make decisions and improvements.

Key features of ABM:

• Value-added vs non-value-added analysis: Classifies activities and targets non-value-adding ones for elimination.
• Cost reduction: Focuses on reducing cost by improving the efficiency of activities.
• Continuous improvement: Supports ongoing operational improvements.
• Performance measurement: Evaluates activities against benchmarks.

Two dimensions of ABM:

1. Cost dimension: Provides accurate cost information (from ABC).
2. Process dimension: Provides information on why activities are performed and how well they are done.

Conclusion: ABC is the foundation that supplies data, while ABM applies that data to enhance value and efficiency across the organisation.

The selection of an appropriate cost driver is critical to the accuracy of ABC. The following criteria should be considered:

• Cause-and-effect relationship: The driver should have a clear causal link with the cost of the activity.
• Degree of correlation: There should be a high correlation between the driver and the consumption of the activity.
• Cost of measurement: The cost of collecting driver data should not exceed the benefit; simpler drivers are preferred where practical.
• Behavioural effects: The driver should encourage desirable behaviour (e.g., reducing the number of setups).
• Ease of understanding: Drivers should be easy for managers and staff to understand and use.
• Availability of data: Data for the driver should be readily available and reliable.

Conclusion: The ideal cost driver balances accuracy with the practical cost of measurement, ensuring meaningful and reliable cost allocation.

Traditional Rate:

ABC Cost Driver Rates:

1. Machining:

2. Setups:

3. Inspection:

Comment:

• Under traditional costing, all is recovered at a single blanket rate of per machine hour.
• Under ABC, only the machining overhead ( per hour) is volume-related; setup and inspection costs are charged separately based on their own drivers.
• Products requiring more setups and inspections will now absorb more overhead, giving a more accurate product cost than the single blanket rate.

ABC is Most Appropriate When:

• Overheads are a large proportion of total cost — the benefit of accurate overhead allocation is high.
• Products are diverse in volume, size, and complexity, leading to distortion under traditional costing.
• Non-volume related overheads are significant (setups, inspections, design).
• Competition is intense and accurate costing is critical for pricing decisions.
• The organisation has a good information system to capture activity data.

ABC is Least Useful When:

• Overheads are a small proportion of total cost — direct costs dominate.
• Products are similar in volume and complexity, so traditional and ABC costs are nearly the same.
• The cost of implementing and maintaining ABC exceeds the benefits.
• The organisation produces a single product or a very narrow range.

Conclusion: ABC should be adopted after a cost-benefit analysis. It suits complex, overhead-intensive, multi-product environments but adds little value in simple, low-overhead settings.

In ABC/ABM, activities are classified based on whether they add value to the product or service from the customer's perspective.

Value-Added Activities:

• Activities that increase the worth of a product or service to the customer.
• Customers are willing to pay for these.
• Examples: Machining, assembly, painting, design that meets customer needs.

Non-Value-Added Activities:

• Activities that consume resources but do not add value to the customer.
• Their elimination or reduction does not reduce product worth.
• Examples: Storage, waiting/idle time, inspection, moving materials, rework, expediting orders.

Significance:

• ABM aims to eliminate or minimise non-value-added activities to reduce costs.
• It seeks to optimise value-added activities for greater efficiency.

Conclusion: Distinguishing between the two helps management focus cost-reduction efforts on wasteful activities while preserving those valued by customers.

The statement can be examined from both perspectives:

Arguments Supporting the Statement (ABC as a refinement):

• Like traditional costing, ABC still separates direct costs and indirect costs (overheads); direct costs are treated the same way.
• Both systems ultimately aim to determine the total cost of products.
• ABC uses the same basic two-stage allocation logic but with more cost pools and drivers.
• It refines overhead allocation by replacing broad volume-based rates with activity-based drivers.

Arguments Against (ABC as more than a refinement):

• ABC changes the fundamental philosophy — from "products consume resources" to "products consume activities which consume resources."
• It introduces non-volume-based cost drivers and a cost hierarchy absent in traditional costing.
• It provides a foundation for Activity Based Management and process improvement, going beyond mere costing.

Conclusion: While ABC builds upon the structure of traditional costing and refines its weakest element (overhead allocation), it also introduces a new activity-focused perspective. Therefore, it is best described as a significant refinement with conceptual enhancements rather than an entirely unrelated system.