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 Activity based costing - a tool for decision making
By: Dr. P. Chellasamy & Ligy V. K. (Sr. Elaiza Chf)

Dr.P.CHELLASAMY LIGY V.K.(SR.Elaiza Chf)

Lecturer M.Phil Scholar
Department of Commerce Department of Commerce
Bharathiar University Bharathiar University
Coimbatore-641046 Coimbatore-641046
E-mail: [email protected] [email protected]

ABSTRACT

Activity Based Costing (ABC) is a method for developing cost estimates in which the project is subdivided
into discrete, quantifiable activities or a work unit. The concepts of ABC were developed in the
manufacturing sector of the United States during the 1970s and 1980s. ABC systems calculate the costs of
individual activities and assign costs to cost objects such as products and services on the basis of the
activities undertaken to produce each product or services. The CIMA technology defines ABC as “a cost
attribution to cost units on the basis of benefit received from indirect activities”.

This paper is presented by the following topics,

• Activity-Based Costing
• Important Terms in Activity Based Costing
• Stages of Activity Based Costing
• Traditional Costing and Activity Based Costing
• Activity Based Costing In 1980s And 1990s
• Activity Based Costing Methodology
• ABC and Healthcare
• Activity Based Costing: A Decision Making Tool
• Software Packages for ABC
• Growing Interest in Activity Based Costing

Activity Based Costing is based on a philosophy of estimation that: "it is better to be approximately right,
than precisely wrong." In summary, activity-based costing is a management decision-making tool. By
associating cost to the activity, a clear relationship can be established between sources of activity demand
and the related costs. This association can benefit the distributor in determining where costs are being
incurred, what is initiating the costs and where to apply efforts to curb inflationary costs. This can be of
particular value in tracking new products or customers.

Introduction

A powerful tool for measuring performance, Activity-Based Costing (ABC) is used to identify, describe,
assign costs to, and report on agency operations. A more accurate cost management system than traditional
cost accounting; ABC identifies opportunities to improve business process effectiveness and efficiency by
determining the "true" cost of a product or service. Activity Based Costing is a method for developing cost
estimates in which the project is subdivided into discrete, quantifiable activities or a work unit. ABC systems
calculate the costs of individual activities and assign costs to cost objects such as products and services on
the basis of the activities undertaken to produce each product or services. It accurately identifies sources of
profit and loss.

Activity-Based Costing

The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and
1980s.It is a practice in which activities are identified and all related costs of performing them are calculated,
providing actual costs chargeable. The focus of activity based costing is activities. Thus identifying activities
is a logical first step in designing an activity based costing. An activity is an event, task or unit of work with a
specified purpose. For example; designing products, setting up machines, operating machines and
distributing products.

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The CIMA technology defines ABC as “a cost attribution to cost units on the basis of benefit received from
indirect activities”. Peter B. B. Turney defines ABC as "a method of measuring the cost and performance of
activities and cost objects. Assigns cost to activities based on their use of resources and assigns cost to cost
objects based on their use of activities. ABC recognizes the causal relationship of cost drivers to activities."
ABC can be defined by the following equation:

C/A = HD + M + E + S
Where C/A = Estimated cost per activity
H = Number of labor hours required to perform the activity one time
D = Wages per labor hour
M = Material costs required to perform the activity one time
E = Equipment costs to perform the activity one time
S = Subcontracting costs to perform the activity one time

The total cost for performing the activity will be based on the number of times the
activity is performed during a specific time frame. An activity based costing system first traces costs to
activities and then to products and other cost objects. The following figure diagrammatically explains the
basic flow of Activity-Based Costing.

Expenses

Resource drivers

Activity Costs

Activity drivers

Cost Object Costs

(Products, customers,
i )

Important Terms in Activity Based Costing

The operation of the ABC system involves the use of the following terms:

Cost object: It refers to an item for which cost measurement is required.e.g. a product, a service, or a
customer.
Cost pool: A cost pool is a term used to indicate grouping of costs incurred on a particular activity which
drives them.
Cost driver: A cost driver is any factor or force that causes a change in the cost of activity. Cost driver may
be involved two parts:

1. Resource cost driver 2. Activity cost driver

A resource cost driver is a measure of the quantity of resources consumed by an activity. An activity cost
driver is a measure of the frequency and intensity of demand, placed on activities by cost objects. The cost
drivers for various functions i.e., production, marketing, research, and developments are given below.

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 Business functions Cost driver
Production Number of units
Number of set-ups
Marketing Number of sales personnel
Number of sales orders
Research& development Number of research projects
Personnel hours spend on projects
Technical complexities of the projects
Customer service Number of service calls
Number of products serviced
Hours spend on servicing products

Stages of Activity Based Costing

The different steps or stages in ABC system can be given as follows:

1. Identify the chosen cost objects

The cost objects of any organization are the products or services and the goal is to first calculate the total
cost of manufacturing and distributing these products and their unit cost.

2. Identify the different activities within the organization

After the identification of cost objects, the main activities, which are being performed in the organization,
have to be identified. Usually the number of activities over cost centers in ABC will be much more as
compared to traditional overhead system. The exact number will depend on how the management
subdivides the organization’s activities.

3. Identifying the direct cost of products

The direct cost of products or objects may comprise direct material cost, direct labor cost and direct
expenses. Classification of as many of the total costs as direct costs as is economically feasible should be
made. It reduces the amount of costs classified as indirect.

4. Relating the overhead to the activities

After identifying the organization’s activities, the various items of overhead are related to activities both
support and primary, that caused them. As a result of relating the items of overhead to various activities,
‘cost pool’ or ‘cost buckets’ are created.

5. Spreading the support activities across the primary activities

The spreading of support activities (i.e., activities which support or assist manufacturing) across the primary
activities (correlated to the number of units produced) is done on some suitable base which reflects the use
of support activity. The base is the cost driver and is measured of how the support activities are used.

6. Determining the activity cost drivers

The determination of the activity cost drivers is done in order to relate the overhead collected in cost pools to
the cost objects of products. It is done on the basis of the factor that drives the consumption of the activities.

7. Calculating the activity cost driver rates

The activity cost rates for each activity are calculated in the way in which overhead absorption rates would
be calculated under the traditional system. It can be presented as follows:

Activity cost driver rate = Total cost of activity

Activity driver

These activity cost driver rates are to be used for ascertaining the amount of overhead chargeable to various
cost objects or products.

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8. Computing the total cost of products or cost objects

The total costs of the products shall be computed by adding all direct and indirect costs assigned to them.
The amount of overhead chargeable to a product or cost object shall be calculated by multiplying the activity
cost drivers rates by different amounts of each activity that each product or other cost object consumes.

Traditional Costing and Activity Based Costing

Traditional costing can lead to undercosting or overcosting of products or services. Over or under costing of
products distorts cost information. A poor quality of cost information causes management to make poor
decisions for pricing, product emphasis, make or buy etc. ABC differs from the traditional system only in
respect of allocations of overheads or indirect costs. Direct costs are identified with, or assigned to, the cost
object, in the same manner as is done in case of traditional costing system. Overhead costs are linked to the
cost objects based on activities. This is shown in the following figure:

Direct Cost
Cost Tracing

Cost Cost of Product

Ascertainment or Service
Indirect Cost
Cost Allocation

Traditional Costing Activity Based Costing

Volume based allocation Cost drivers are

bases used as
allocation bases

The following figure explains the entire process of cost allocation under ABC.

Activities Cost of Activities Cost Drivers Cost allocated to

cost objects

Activity Based Costing In 1980s And 1990s

The activity based costing systems, described by Robin Cooper and Robert Kaplan in the 1980's and
1990's, has attracted much attention. These systems identify the major activities of a facility’s production
process and then classify these activities into one of the following categories:
• unit-level activities;
• batch-level activities;
• product-sustaining level activities and;
• facility-sustaining level activities.

In the example below, described by Robin Cooper,

• the number of direct labor hours a product consumes is the cost driver for unit-level activities;
• the number of setups a product consumes is the cost driver of batch-level activities;
• and the number of parts a product consumes is the cost driver of product-sustaining level activities.

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Consumption Patterns by product

Unit level activities Batch level activities Product- Total

sustaining overhead
activities costs
Product Size Volume Material Direct Machine No. of No. of Times No. of
costs labor hours setups orders Handled parts
hours
P1 Small Low $60 5 5 1 1 1 1
P2 Small High $600 50 50 3 3 3 1
Amounts consumed $660 55 55 4 4 4 2
Activity cost(over head) $66 $550 $825 $480 $500 $100 $1000
Aggregated activity cost - - $1441 - - $1080 $1000 $3521

Overhead costs reported by an ABC system

Unit level Batch level Product- Total

activities activities sustaining overhead
activities costs
Total overhead $1441.00 $1080.00 $1000.00 $3521.00
costs
Total cost driver 55 4 2
units
Consumption $26.20 $270.00 $500.00
intensity

Unit level activities Batch level activities Product-sustaining

activities
Dire Consump Cost Consump Cost Consumpti Cost
ct tion tion on traced
Numbers
Product

labor intensity traced intensity trace intensity

setups

hour d
Part

s
P1 5 $26.20 $131. 1 $270.00 $270 1 $500.00 $500.0
00 .00 0
P2 50 $26.20 $131. 3 $270.00 $810 1 $500.00 $500.0
00 .00 0

According to Robin Cooper activity based costing systems can be used to monitor how an organization's
resources are consumed and help to manage consumption and spending in a company. With activity based
costing systems managers can attempt to perform its activities more efficiently, reprice products or alter the
company's product mix.

Activity Based Costing Methodology

The insight brought in by ABC methodology can be broadly categorized as:

Customer Profitability
Product Profitability
Process Efficiency

Customer Profitability

Traditionally it is believed that:

• High volume customers are profitable customers
• Loyal customer is also a profitable one
• Profits will follow a happy customer.

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The ABC studies on customer profitability have unveiled that the above are often exceptions. With the
costing based on activities, the cost of serving a customer can be ascertained individually. Deducting the
product cost and the cost to serve each customer one can arrive at customer’s profitability. This method of
dealing customer cost and product cost separately has lead to identifying the profitability of each customer
and to position their products or services accordingly.

Product Profitability

ABC costs the products based on the activities that goes into it. This facilitates arriving at the accurate cost
of the products and enhances effective strategic decisions to:
• Position their products better
• Facilitate better Product mix for the market
• Enhance the bargaining power with the customer

Process Efficiency

ABC implementation will make the employees, across functions, to understand the various costs involved,
which will in turn enable them to
• Analyze the Cost.
• Identify the Value Added and Non Value Added Activities.
• Implement the improvements and realize the benefit.

This is a continuous improvement process in terms of analyzing the cost, to reduce or eliminate the Non
Value Added activities and to achieve an over all efficiency.

ABC and Healthcare

More and more, healthcare enterprises are finding that their accounting systems do not provide useful
operations management information. In their quest to reduce costs and develop an advantaged marketplace
position, healthcare providers are discovering ABC. It offers an approach and the type of information
required to realize performance breakthroughs:
• It recognizes that cost and quality are the direct result of the activities providers undertake to deliver
services to their patients.
• It is business-process and end-product focused, and invites cooperation, rather than competition,
between functional departments.
• It is developed based on the process knowledge and insight of those directly involved in the delivery
of the service. In the case of patient care, physicians, nurses, therapists, et al, participate and
contribute to its development.

As a result, activity-based cost information is both intuitive and logical. In short, it makes sense to those
charged with the responsibility for improving performance and provides them with transparent information on
the cost ramifications of their decisions. Example applications include:

• Evaluating the cost implications of alternative clinical pathways

• Streamlining care delivery practices across the care continuum
• Decision-making regarding management levels and spans of control
• Enhancing staff utilization by time of day
• Resourcing consolidated departments/deployed functions

A report by the US-aided Quality Assurance Project on “Can ABC work in developing countries?” with
Peruvian Healthcare System as the case, says: “Traditional cost accounting methods pool all indirect costs
and then allocate them to the various services in proportion to service direct costs. This approach tends to
overestimate the unit cost of high volume services and underestimate low-volume services. When indirect
costs are large, often the case in healthcare, the cost of services may be misinterpreted. ABC solves this
problem by estimating the cost of the work activity that consume resources and by linking these costs to the
services that are provided.” And even though the authors say that ABC may be difficult to implement, even
in the US, it is still feasible in a developing country.

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Activity Based Costing: A Decision Making Tool

Prior to the emergence of ABC, companies typically calculated profitability using the allocation method. This
allocation method involves allocating costs to a product or customer using metrics such as the total number
of accounts, customers, products produced, or transactions. Table 1 gives a hypothetical example of how
this method calculates the profitability of three customer channels: store, catalog, and internet. In this
example, the company allocates overhead costs—including accounting, IT, marketing, and call-center
costs—to customer channels, based on the number of customers per channel.

Table 1. Simple Allocation of Call-Center Overhead

Total Store Catalog Internet

Revenue $3,500,000 $2,000,000 $1,000,000 $500,000
Number of Customers 50,000 35,000 10,000 5,000
Cost per Customer $10 $10 $10 $10
Call-Center Costs $500,000 $350,000 $100,000 $50,000
Net Revenue $3,000,000 $1,650,000 $900,000 $450,000
Margin 85.7% 82.5% 90.0% 90.0%
(Source: www.cxoamerica.com)

From the example above, management might conclude that all channels are performing relatively well, but
the big opportunity lies in growing the catalog and internet channels through additional investments. These
two channels—though smaller in overall revenue—appear more attractive after cost allocations and could
realize explosive, profitable growth—given management attention and aggressive investments.
Table 2 shows the more realistic outcome when an organization applies ABC and apportions call center
expenses to each customer channel, based on the number of incoming calls each channel generates. Since
catalog customers create 80% of the incoming call-center volume, this channel should incur a greater
proportion of the total cost.

Table 2. ABC Allocation of Call-Center Overhead

Total Store Catalog Internet

Revenue $3,500,000 $2,000,000 $1,000,000 $500,000
Number of Calls 100,000 0 80,000 20,000
Cost Per Call 5 5 5 5
Call-Center Costs $500,000 $0 $400,000 $100,000
Net Revenue $3,000,000 $2,000,000 $600,000 $400,000
Margin 85.7% 100% 60.0% 80%
(Source: www.cxoamerica.com)

The insight from this analysis is far different. After allocating costs based on the consumption of resources,
management can see that the catalog channel uses far more resources and is actually less profitable than
other channels. Rather than throwing away additional investment to grow this channel, management should
take corrective action to bring this segment up to acceptable profitability levels.

Software Packages for ABC

ABC Focus

It is tool for costing products and services and improving efficiencies. "ABC Focus is a tool which makes
ABC concepts simple to understand and use. It is a very attractive package because its flexible costing
model, consolidated reporting and a very competitive pricing regime make it suitable for large and small
business in virtually any industry." ABC Focus provides a structured approach to cost products, services,
processes, activities and unused capacity. It provides a platform on which to confidently adjust pricing and
activities for competitive advantage.

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QPR Cost Control

The user-friendly QPR Cost Control system helps to understand the real cost structure of the company and
identify how the business really works. Using the proven approach Activity Based Costing / Management,
the software identifies exactly what costs are linked to each individual customer, product, service or activity.
QPR Cost Control gives the information to make decisions about the most profitable path for the business.
QPR Cost Control is used successfully by all types of organizations, from large international corporations to
universities, hospitals and government agencies.

Growing Interest in Activity Based Costing

Activity based costing is being implemented by a growing number of companies around the globe. Specific
ABC applications vary from organization to organization. A few organizations use ABC as their basic,
ongoing cost accounting system. But many ABC applications are selective- special studies within subparts of
the organization, such as business divisions or particular functions.

A survey of US companies in the food and beverage industry found 18% of the respondents implementing
ABC and 58% considering it. A survey of Dutch companies in the food and beverage industry found 12%
currently using ABC and another 25% are considering it. Among Canadian companies one survey indicates
that 14% of the interviewed businesses have implemented ABC and another 15% are considering using
ABC it. The ABC system has replaced existing system for 24% of the Canadian respondents and it is a
supplementary (off-line) system for 76%. A United Kingdom survey found that just under 20% of 251
respondents had used ABC. An Australian survey found that 43% of the respondents were either using ABC
or implementing it. A survey of Irish manufacturing companies that have implemented ABC reported the
following percentages for the actual benefits experienced:

1 More accurate cost information for product costing and pricing 71%
2 Improved cost control and management 66%
3 Improved insight into cost drivers 58%
4 Better performance measures 46%
5 More accurate customer profitability analysis 25%

A survey of Irish service-sector companies reports similar percentages for the benefits experienced .Results
from similar studies in developed economies around the world indicate that ABC is not a passing fad. A
majority of companies still use traditional costing methods, but the use of ABC appears to be increasing.

Significance of Activity Based Costing

The following list reflects the results of several surveys of practice in the United States, the United Kingdom,
and Canada to determine why companies choose ABC.
• Cost Reduction: - ABC measures how much activities that are costly and then take steps to reduce
their costs by changing the productions process or outsourcing those activities.
• Product pricing and decisions of whether to continue producing a product or keeping a particular
customer. ABC implementers generally believe that that ABC provides more accurate cost
information than conventional costing does. Management can use this information to negotiate price
increases with customers or to drop unprofitable products.
• Budgeting and performance measurement: - Management can use more accurate cost information
to improve budgets and measures of department and division performance.

Limitations of Activity Based Costing

• More time consuming to collect data

• Cost of buying, implementing and maintaining activity based system
• In some cases, the establishment of cause and effect relationship between cost driver and costs not
be a simple affair.
• ABC does not conform to generally accepted accounting principles in some areas.

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Conclusion

Activity based costing has revolutionized product costing, planning, and forecasting in the last decade. It is
based on a philosophy of estimation that: "it is better to be approximately right, than precisely wrong." In
summary, activity-based costing is a management decision-making tool. It provides financial support data
structured in a fashion fundamentally different from accounting data provided in the general ledger. By
associating cost to the activity, a clear relationship can be established between sources of activity demand
and the related costs. This association can benefit the distributor in determining where costs are being
incurred, what is initiating the costs and where to apply efforts to curb inflationary costs. This can be of
particular value in tracking new products or customers.

References:

1. Bhabatosh Baneerjee-Cost Accounting-Theory and Practice.

2. Hansen&Mowen-Cost Management Accounting and Control.
3. Hilton, Mahar&Selto-Cost Management Strategies for Business Decisions.
4. Horngren, Datar&Foster-Cost Accounting-A Managerial Emphasis.
5. M.E.Thukaram Rao-Cost Accounting
6. www.cashfocus.com
7. www.cxoamerica.com
8. www.greenbusinesscentre.com
9. www.managerialaccounting.org
10. en.wikipedia.org/activity based costing

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