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ACCORDING TO AMERICAN ACCOUNTING ASSOCIATION

• Cost is a forgoing, measured in monetary terms, incurred

or potentially to be incurred to achieve a specific objective.

• Each modification implies a certain attribute which is

important in computing and measuring the cost which is to
serve the management levels in achieving their basic
objectives of planning and control.

• It is a fundamental axiom that a cost must be understood

in its relationship to the aims or purposes which it is to
serve.

• To discover opportunities for cost improvement.

• To prepare and actualize a business plan.
• To improve strategic decision making.

1. Direct costing.
2. Traditional costing.
3. Activity based costing ABC.

ABC was first clearly defined in 1987 by Roberts Kaplan and

W.Bruns. They initially focused on manufacturing industry
where increasing technology and productivity improvements
have reduced the relative proportion of the direct costs of
labor and materials, but have increased relative proportion of
indirect cost. For Example, Increased automation has reduced
labor, which is a direct cost, but has increased depreciation,
which is an indirect cost.

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DEFINITION OF ACTIVITY-BASED COSTING

“A method of measuring the cost and performance of

activities and cost objects.”

DETIALS ABOUT ABC SYSTEM:-

Activity based costing (ABC) is a costing method that is

designed to provide managers with cost information for
strategic and other decisions that potentially affect capacity
and therefore fixed costs. Activity based costing is ordinarily
used as a supplement to rather than as a replacement for the
companies usual costing system. Most organization that use
activity based costing have two costing system the official
costing system that is used for preparing external financial
reports and the activity based costing system that is used for
internal decision making and for managing activities.

IN ACTIVITY-BASED COSTING SYSTEM:

1. Non-manufacturing as well as manufacturing costs may

be assigned to product.
2. Some manufacturing costs may be excluded from
product cost.
3. A number of over head cost pools are used, each of
which is allocated to product and other costing objects
using its own unique measure of activity.
4. The allocation bases often differ from those used in
traditional costing systems,
5. The overhead rates, or activity rates, may be based on
the level of activity at capacity rather than on the
budgeted level of activity.

You cannot compete or even begin to compare until you know

how to cost. ABC is a cost accounting methodology that can
provide definitions of processed, identify what the cost drivers
of those processes are, determine the unit costs of various

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products and services, and create various reports on agency

components that can be utilized to generate activity or
performance based budgets.

A major advantage of using ABC is that is avoids or minimizes

distortions in product costing that result from arbitrary
allocations of indirect costs. Unlike more traditional line item
budgets which cannot be tied to specific outputs, ABC
generates useful information on how money is being spent, if
a department is being cost effective, and how to benchmark
(or compare oneself against others) for quality improvements.

Activity based costing also provides a clear metric for

improvement. It encourages management to evaluate the
efficiency and cost effectiveness of program activities. Some
ABC systems rank activities by the degree to which they add
value to the organization or its outputs. This helps managers
identify what activities are really value added those that will
best accomplish a mission, deliver a service, or meet
customer demand thus improving decision making through
better information, and helping to eliminate waste by
encouraging employees to look at all costs. That is why an
essential aspect of any ABC endeavor is to get a clear picture
of the activities a business area performs, when employees
understand the activities they perform, they can better
understand the costs involved.

Up to this point in managerial accounting we have discussed

product costing systems primarily designed to provide unit
product cost information for financial statement purposes.
These systems use actual direct material cost, actual direct
labor cost, and a volume based allocation rate to apply
overhead to cost products. Overhead is applied based on a
predetermined overhead rate calculated by dividing total
estimated manufacturing over head by some volume
allocation base such as direct labor hours or machine hours.
Now we are going to study a new costing system, activity
based costing. Note that ABC will not take the place of the
financial statement costing system but will be used as a
supplemental costing system for management purpose.

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1. Sales are increase but profits are declining.

2. Overhead rates are very high and increasing overtime.
3. Product lines are diverse.
4. Direct labor is small percent of total cost.
5. Competitors’ high-volume product seems to be priced
unrealistically low.

The implementation process is broken down into following six

basic steps:

STEP 1: IDENTIFY AND DEFINE ACTIVITIES AND

ACTIVITY
COST POOLS:

The first step in implementing an ABC system is to identify the

activities that will form the foundation for the system. A common
procedure is to interview people who work in overhead
departments about their major activities. This results in very
long list of activities. On one hand, the greater the list of
activities tracked in the ABC system, the more accurate the costs
are likely to be. On the other hand, it is costly to design,
implement, maintain, and use a complex system involving large
numbers of activities. The original list of activities is usually
reduced to a handful by combining similar activities. For
example, several actions may be involved in handling and
moving raw materials – from receiving raw materials to sorting
them into the appropriate bins in the storeroom. All these
activities might be combined into single activity called “material
handling”.

A general way of combining activities is to organize them into

five levels:
1. UNIT-LEVEL: Unit-level activities are performed each time a
unit is produced.
2. BATCH-LEVEL: Batch-level activities are performed each
time a batch is handled or processed, regardless of how many
units in the batch.

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3. PRODUCT-LEVEL: Product-level activities relate to specific

products and typically must be carried out regardless of how
many batches are run or units of product are produced or
sold.
4. CUSTOMER-LEVEL: Customer-level activities relate to
specific customers and include activities such as sales calls,
catalog mailings, and general technical support that are not
tied to any specific product.
5. ORGANIZATION-SUSTAINING: Organization-sustaining
activities are carried out regardless of which customers are
served, which products are produced, how many batches are
run, or how many units are made.

In general it is best to combine only those activities that are

highly correlated with each other within a level i.e., if they tend
to move in tandem.

After this activity cost pools are selected. An activity cost pool is
a “bucket” in which costs are accumulated that relate to a single
activity measure in the ABC system.
An activity measure is an allocation base in an activity based
costing system. The term cost driver is also used to refer to an
activity measure. The activity measure should drive the cost
being allocated.
Activity measures are often very rough measures of resource
consumption. Probably the least accurate type of activity
measure is known as transaction driver. Transaction drivers
are simple counts of the number of times an activity occurs such
as the number of bills sent out to customers. However a more
accurate type of activity measure known as duration driver may
be used. Duration drivers are measures of the amount of time
required to perform an activity such as time spent in preparing
such bills.

STEP 2: DIRECTLY TRACE OVERHEAD COSTS TO ACTIVITY

AND COST OBJECTS:

The second step in implementing an ABC system is to directly

trace as many overhead costs as possible to the ultimate cost
objects. The ultimate cost objects are products, customers
orders, and customers.
Consider an example below:
The company’s annual cost includes manufacturing overhead and
selling, general, and administrative costs. In the ABC system , all

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of these costs are considered to be “overhead” and will be

assigned to cost objects where appropriate.
One of these overhead costs-shipping-can be traced directly to
customer orders. The company is directly billed for each
customer order it ships, so it is a simple matter to trace these
costs to the customer orders. Customers do not pay these actual
shipping costs; instead they pay a standard shipping charge that
can differ substantially from actual bill that company receives
from the freight company.

STEP 3: ASSIGN COSTS TO ACTIVITY COST POOLS:

In this step costs should be traced directly to the activity to the

activity cost pools. It is quiet common for an overhead
department to be involved in several of the activities that are
tracked in the ABC system. In such situations, the costs of the
department are divided among the activity cost pools via an
allocation process called first-stage allocation. First-stage
allocation is the process by which overhead costs are assigned to
activity cost pools.

Step 4: CALCULATE ACTIVITY RATES:

In this step the total activity for each cost pool that would be
required to produce the organization’s present product mix and
to serve its present customers is determined. The activity rates
are computed by dividing the total cost for each activity by its
total activity.

Activity rate = Total cost of each activity

Total activity

STEP 5: ASSIGN COST TO COST OBJECTS:

The fifth step in the implementation of activity-based costing is

called second-stage allocation. In the second stage allocation,
activity rates are used to apply costs to products and customers.
This allocation can be done using the following formula
Activity Rate * Amount of Activity

STEP 6: PREPARE MANAGEMENT REPORTS:

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In this step a report is prepared showing activity-based costing

margins from an activity view. The overhead costs computed in
previous steps are combined with direct materials and direct
labor cost data. For each of the products, these combined costs
are deducted from sales to arrive at product margins.

1. NON MANUFACTURING COSTS:

In traditional cost accounting, only manufacturing costs are

assigned to products, Selling, general and administrative
expenses are treated as period expenses and are not
assigned to products .However, many of these non
manufacturing costs are also part of the costs of producing,
selling, distributing and servicing products. For example,
commissions paid to salespersons, shipping costs, and
warranty repair costs can be easily allocated to individual
products. In activity-based costing , products are assigned all
of the overhead costs – manufacturing as well as non
manufacturing- that they can reasonably be supposed to have
caused.

2. MANUFACTURING COSTS:

In traditional cost accounting, all manufacturing costs are

assigned to products – even manufacturing costs that are not
caused by the products. For example, a portion of the factory
security guard’s wages would be allocated to each product
even though the guard’s wages are totally unaffected by
which products are made or not made during a period. In
activity-based costing, a cost is assigned to a product only if
there is good reason to believe that the cost would be
affected by decisions concerning the product.

3. COST OF IDLE CAPACITY:

In traditional cost accounting , predetermined overhead rates

are computed by dividing budgeted overhead costs by a
measure of budgeted activity such as budgeted direct labour-
hours.

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Predetermined Overhead rate = Total Estimated Manufacturing Overhead

Direct-labour hours or Machine hours

This practice results in

• Applying the costs of unused, or idle capacity to products
• Unstable unit product costs

If budgeted activity falls, the overhead rate increases because

the fixed components of overhead are spread over a smaller
base, resulting in increased unit product costs.

In contrast to traditional cost accounting, in activity-based

costing, products are charged for the costs of capacity they
use – not for the costs of capacity they don’t use. In other
words, the costs of idle capacity are not charged to products.
This results in
• more stable unit costs
• consistency with the objective of assigning only those costs
to
products that are actually caused by the products

Instead of assigning the costs of idle capacity to products, in

activity-based costing these costs are considered to be period
costs that flow through to the income statement as an
expense of the current period. This treatment highlights the
cost of idle capacity rather than adding it in inventory and
cost of goods sold.

4. FLOW OF ACTIVITIES:

ABC tracks the flow of activities by creating a cause and effect

link between the activity (resource consumption) and the cost
object. The flow is through five core areas:

• Resources
• Resource drivers (% of time, sq ft occupied, equipment
hours, etc)
• Activities
• Activity drivers (number of reports, number of items,
number of moves, etc)
• Cost objects (products services, customers, market areas)

Diagrammatically we can show this as follows:

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You will notice that the direction of the arrows are different;
the ABC model brings detailed information from the processes
up to assess costs and manage capacity on many levels
whereas the TCA model simply allocates costs, down onto the
cost objects without considering any 'cause and effect'
relations.

5. CONSUMPTION OF RESOURCES VERSUS

CONSUMPTION OF ACTIVITIES:

In traditional cost accounting, underlying assumption is that

costs can be managed. The benefit of the ABC mindset is that
it opens up for a much wider array of measures when it
comes to improving productivity. By investigating
systematically what is being done, i.e. the activities, one will
not only be able to identify surplus capacity if it occurs, but
also lack of capacity and misallocation of capacity. A result of
this might be that costs are cut the traditional way, but it
might as well lead to a reallocation of capacity to where it is
most needed which will yield high productivity

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6. STRUCTURE-ORIENTATION VERSUS PROCESS-

ORIENTATION:

Traditional costing systems are more concerned about the

organizational charts than the actual process. Traditional cost
accounting systems are therefore structurally oriented and
the process view is completely missing. The result is capacity
management is known and resource management is unknown
because the process is unknown. Capacity is measured as an
expense and found easily in the traditional cost accounting
system. Resources are required in order to do a job and
measured as a cost, but the resource measures can only be
found by investigating the processes.

ABC is process-oriented. It gathers information from the

processes it can be used to identify both capacity and
resource allocation most productively. ABC can therefore give
managers the ability to match the resource needs with the
available capacity as closely as possible, and hence improving
productivity. From this we understand that the structure
oriented approach of traditional costing systems gives no
decision.

COST ASSIGNMENT AND ALLOCATION:

TCA historically uses direct labour or some other volume

related allocation basis for attributing costs. But as overhead
has grown and new technologies have come, it goes without
saying that assigning costs based on only 5 - 15% of total
costs is highly risky. In fact, the incurred errors are up to
several hundred percent.

ABC assigns costs according to the causal relationship

between activities and cost objects, which is captured using
drivers, of which there are two types, activity drivers that
keep track of how cost object behaviour influences activity
levels and resource drivers that keep track of how the
subsequent activity level affects the resource consumption.
The drivers are estimates of actual cost behaviour and can
therefore also be used to identify, or they are themselves, the
critical cost factors. As the drivers are related to the actual
processes, they can occur on several levels, some of the
common levels are:

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• Unit - these are triggered for every unit that is being

produced. Generally it is a volume related driver similar to
the traditional allocation bases.
• Batch - these drivers are triggered for every batch
produced, eg production planning. The number of batches
could be the driver.
• Product - product level drivers are triggered for every
product regardless of the number of units and batches
produced. Product development hours per product would
be a good driver here as the more time taken to develop a
particular product should be reflected in the product
development costs attributed to that product.
• Facility - these drivers are not related to the products at
all. Costs that are traced by such drivers will therefore be
allocated to products and not traced. The difference
between allocation and tracing is that allocation is quite
arbitrary whereas tracing is based on 'cause and effect'
relations.

In activity based costing system ease of adjustment codes are

used for cost. There are three colours used for cost classification.
1. Green Colour Cost
2. Yellow Colour Cost
3. Red Colour Cost

1. GREEN COLOUR COST:

The cost which is automatically adjusted with the changes in

activity, without management action is green colour cost.
Examples are
• Direct material cost
• Shipping cost, etc.

2. YELLOW COLOUR COST:

The cost which need to be adjusted with the changes in activity

but management action would be required are termed as green
colour cost. Examples are

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• Direct labour cost

• Indirect factory wages
• Factory utilities
• Administrative wages and salaries
• Office equipment depreciation
• Marketing wages and salaries
• Selling expenses, etc.

3. RED COLOUR COST:

The cost which are adjusted by management action and it is very

difficult to adjust with the changes in activities are red colour
cost. Examples are
• Factory equipment depreciation
• Factory/Administration building lease

Following are some limitations of activity-based costing system.

1. Implementing an activity based costing system is a major

project that requires substantial resources. And once
implemented, an activity-based costing system is more costly
to maintain than a traditional direct-labour based costing
system.

2. Activity-based costing data can be easily misinterpreted must

be used with care when used in making decisions.

3. Managers insists on fully allocating all costs to products,

customers and other costing objects in an activity-based
costing system – including the cost of idle capacity and
organization sustaining costs. This results in overstated cost
and understated margins and mistakes in pricing and other
critical decisions.

4. An organization involved in activity-based costing should have

two cost systems – one for internal use and another for
external reports. This is costlier than maintaining just one
system and may cause confusion about which system is to be
believed and relied on.

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• Activity-based costing estimates the cost of resources

consumed by cost objects such as product and customers.
• The approach taken in activity-based costing assumes that
cost objects generate activities that in turn consumes
costly resources.
• Activities form the link between costs and cost objects.
• Activity-based costing is concerned with overhead – both
manufacturing overhead and selling, general, and
administrative overhead.

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