CENTRE FOR DISTANCE AND ONLINE EDUCATION

CENTRE FOR DISTANCE AND ONLINE EDUCATION

Live Session – Session No. 3

MCOMC303 – Management Accounting

Unit No. 3: ACTIVITY BASED COSTING (ABC)
M.Com. Semester-3
SURAJ AGARWAL
M.COM, M.B.A, UGC NET
(Qualified)
FACULTY CDOE, SMU
Learning Outcomes

1 2 3 4
Describe joint Describe the Distinguish between Know accounting
venture. features of joint joint ventures and treatment in joint
ventures. consignment sales. ventures.
Meaning of Activity Based Costing

The Chartered Institute of Management Accountants, UK (CIMA)

defines1 ABC as “an approach to the costing and monitoring of
activities which involves tracing resource consumption and costing
final outputs. Resources are assigned to activities, and activities to
cost objects based on consumption estimates. The latter utilise cost
drivers to attach activity costs to outputs”.
 Features of Activity Based Costing
An organisation can choose the Activity-based Costing method when they find that their overhead
costs are much higher when compared to other direct costs. The ABC system is extremely helpful
when the range of the products manufactured is diverse or when the quantity of the products
manufactured does not affect the consumption of overhead resources. Here are the primary
features of the ABC system.
•The apportionment of costs is not done according to the department but based on the activities
that were involved in the production.
•It does not use the average overhead distribution rate as in the traditional costing method.
Rather, it charges the overhead costs to the products as per the activities involved.
•As the costs can be traced to the activities involved in the production of each product, the cost
information provided is much more accurate.
•The activities that do not add any value to the production of the products and services can be
eliminated with the ABC method. Thus, removing such activities brings down the cost of the
product.
 Objectives of Activity Based Costing
The ABC method was created to correct the inaccurate cost information derived from the
conventional costing method. It can accurately determine the sum of the indirect cost allocation.
The following are the essential objectives of the costing method.
•It helps us understand the total costs related to products and customers.
•It derives the exact figure of profitability based on the processes related to the production and
performance of the product or service.
•It provides a structured analysis of complex processes involved in production.
•It helps to remove the activities that do not add value to the production because of the diversity
of manufactured products.
•It provides the management with information regarding the cost of the activities that can aid in
decision-making.
•As the diversity of products and consumer demands grows, the ABC method helps to increase the
value of each method and process.
 Requirements for the Activity-Based System
With an ABC approach for management costing, one can account for the following aspects:
•Activities and processes
•The frequency at which the activities occur
•Costs incurred in these activities
•The situation when no activity takes place
•The processes that provide value
Based on these aspects, the following are the basic requirements that an organisation needs to
fulfill to ensure that the ABC method is implemented accurately and derives correct results.
An information system: Setting a detailed information system is essential to trace the cost related
to different cost objects.
Support system: To trace the costs as well as to ensure that the system runs smoothly, the
contribution of various people and managers will be required. These are included in the support
system.
Integration: Once the data is collected, it must be integrated or computerized so it can be used
alongside the organisation's financial system.
 Steps for Activity Based Costing
To implement the ABC method for management costing, one will have to follow the following steps.
Identify the Activities: The Activity-Based costing method is based on the activities that are involved in the
manufacturing of the product. Thus, the first step should be to identify the activities that take place during the
production of the organisation. The number of activities differs for each product and organisation. When
identifying the activities, one should make sure some positive value to the complete production process.
Determine the Cost Centre for Each Activity: Now that you have the list of activities, the next step is to identify
the major activities and group their costs. Thus, the costs are allocated and apportioned among different
activities instead of different departments as done in the traditional costing method. Similar activities should be
grouped together to ease the process of apportionment of costs.
Cost Driver for Each Major Activity: Next, all the major activities are identified as cost drivers. These are the
activities that play an essential role in the determination of the cost of the production of the product or the
service. Cost driver refers to the factors or aspects that result in substantial changes in the total cost of the
object.
Calculation of Cost Driver Rate: Now that all the cost drivers are determined, the rate of activity cost drivers will
be calculated with the help of the formula provided below.
Activity Cost Driver Rate = Total Cost of the activity/cost driver
Assigning Activity Cost to the Product Cost: Once the Cost of each activity is determined with the help of the
cost driver rate, the cost will be charged to the product. The product will be charged as per the requirements
during the process of manufacturing.
Differentiate between Traditional and ABC
costing

Traditional Costing Method Activity Based Costing Method

Apportionment of overhead costs is Multiple cost drivers are used to allocate
unit-based costs
Uses single base to allocate cost Multiple cost bases used to allocate cost
Less time-consuming method Time consuming and costly process
Less accuracy More accurate method
Cost drivers can be of the following types.
Transaction Drivers: These include the number of transactions that amount to overhead costs. For example,
several purchase orders, inspections, etc., are considered as transaction drivers.
Duration Drivers: It refers to the time taken to accomplish an activity. These drivers include the number of hours
taken in inspection, set-up, etc.
Intensity Drivers: These are the drivers that can substantially change the number of resources used in each
activity. It depends upon the actual activity that is involved in the manufacturing of the product.
•The budgetoverheads and cost driver volumes of SLtd. Areas follows-
Thecompanyhasproducedabatchof3,000componentsofAB-30.ItsmaterialcostisRs. 1,50,000 and direct labour cost Rs. 3,00,000. The usage activities of said
batch are as follows-
1. Calculatecostdriverratesthatareusedfortreatingappropriateamountofoverheadsto the said batch.
2. Ascertainthecost ofbatchof componentsusing ActivityBasedCosting.

CostPools Budget Cost Driver Budged

Overheads Volumes
MachineryPurchased 9,00,000 No. oforders 3,000
Material Handling 4,00,000 No.ofMovements 1,000
Setup 3,00,000 No. ofSet-ups 600
Maintenance 10,00,000 MaintenanceHours 10,000
Quality control 2,00,000 No. of Inspection 1,000
Machinery 10,00,000 No.ofMachineHours 20,000

MachineHours 2,500 Setup 30

Material orders 30 MaintenanceHours 500
Material Movements 15 No. of Inspections 30
Solution:
•CalculationofCost Driver Rates
MaterialPurchasing=9,00,000/3000=Rs.300 Material Handling = 4,00,000/1,000 = Rs. 400 Setup =
3,00,000/600 = Rs 500
Maintenance =10,00,000/10,000 = Rs 100 Qualitycontrol=2,00,000/1,000=Rs.200 Machine =
10,00,000/20,000 = Rs. 50
•CalculationofCost ofBatchof 3,000 components ofAB-30

Direct Materials 1,50,000

DirectLabour 3,00,000
PrimeCost 4,50,000
Overheads:
Material Procurement 30*300 = 9,000
Material Handling 15*400= 6,000
Set-up Cost 30*500 = 15,000
Maintenance 500*100= 50,000
Quality control 30*200 = 6,000
Machine 2,500*50= 1,25,000 2,11,000
TotalCost 6,61,000
Human resources slide 9

Thank You

Queries are Welcome!