Activity

Based Costing System

 Activity Based Costing
System

Traditional ABC for Marketing,

Manufacturing Selling and
Costing system Distribution Expenses

Activity Based
ABC for Service
Costing/Management
Companies
(ABC/ABM) System

Cost of Resource
PROs and CONs
Capacity
TRADITIONAL MANUFACTURING
COSTING SYSTEM
The traditional costing system (TCS) assigns indirect
costs/overheads to job/products in two stages:

First, the accumulated cost are allocated to production

departments (cost centers).
Second, the accumulated costs in cost centres are assigned to
individual job/products on the basis of an overhead allocation
rate based on/in proportion to some measure of volume of
production such as direct labour cost, direct labour-hour
rate, machine-hour rate and so on.
It has the merit of being simple, easy to use and understand,
and applied consistently from year to year. It is adequate
for financial reporting of inventory valuation.
 Exhibit 1: Montex Pen Total and Product
Profitability

Particulars Blue Black Red Purple Total

Pens Pens Pens Pens
(1) (2) (3) (4) (5)
Production/Sales volume 25,000 20,000 4,500 500 50,000
Unit sale price Rs 45 Rs 45 Rs 46.5 Rs 49.5
Sales (a) 11,25,000 9,00,000 2,09,250 24,750 Rs 22,59,000
Material costs 3,75,000 3,00,000 70,200 8,250 7,53,450
Direct labour costs 1,50,000 1,20,000 27,000 3,000 3,00,000
Overheads (300% of
direct labour) 4,50,000 3,60,000 81,000 9,000 9,00,000*
Total costs (b) 9,75,000 7,80,000 1,78,200 20,250 19,53,450
Total operating income
[(a) – (b)] 1,50,000 1,20,000 31,050 4,500 3,05,550
Return on sales (%) 13.3 13.3 14.8 18.2 13.5
 Limitations/Inadequacies of
Traditional Costing System
It has, however, serious limitations/inadequacies due to its assumption
that all overheads are proportionate to volume of production. Many
overheads costs are, actually, not proportionate to volume.

Examples of such costs are setup costs of machines/equipment, cost of

inspection/handling of materials and so on. They are affected by
complexity rather than volume.

As a result, simple high-volume products would be overcosted

(i.e. receive a larger allocation of overheads) and low-volume
complex products would be undercosted (i.e. receive a smaller allocation
of overheads).

The use of volume-related allocation base of TCS for allocating

overheads would result in product cost distortion in an environment of
complex and high product variety. The ABC system eliminates this
source of cost distortion.
ACTIVITY BASED COSTING/MANAGEMENT
(ABC/ABM) SYSTEM

ABC System is a system based on activities linking

spending on resources to the products/services
produced/delivered to customers. The
ABC system also uses a two-stage
overhead allocation:

(i) Tracing costs to activities

(ii) Tracing costs from activities to products/jobs

 1. Tracing Cost to Activities

This step is to identify major activities that

cause/drive overhead costs to be incurred. Some of
the activities are related to production volume (such
as production runs, salary of supervisors and so on)
but others are not (such as inspection/handling of
materials, setting up equipment and so on). The cost
of resources consumed in performing these
activities are grouped into cost pools.
Exhibit 2: Common Activities and Associated Costs/Cost Drivers
Major Activities Associated Costs Cost Driver
(1) (2) (3)
Processing purchase order Labour costs for workers determining order Number of purchase
for materials and parts quantities, contacting vendors, and orders processes
preparing purchase orders
Handling material and Labour costs for workers handling material Number of material
parts and parts, depreciation of equipment used requisitions
to move material and parts
Inspecting incoming Labour costs for workers performing Number of receipts
material and parts inspections, depreciation of equipment used
to test strength of materials, tolerances, etc.
Setting up equipment Labour costs for workers involved in Number of setups
setups, depreciation of equipment used to
adjust equipment
Producing goods using Depreciation on manufacturing equipment Number of machine-
manufacturing equipment hours
Supervising assembly Salary of assembly supervisors Number of assembly
workers labour-hours
Inspecting finished goods Labour cost for finished goods inspections, Number of inspections
depreciation of equipment used to test
whether finished goods meet customer
specifications, etc.
Packing customer orders Labour cost for packing workers, cost of Number of boxes
packing materials, etc. packed
 2. Tracing Costs from Activities
to Products
The next step is to assign costs to products/jobs using cost
drivers as a measure of activity. Cost drivers represent the
quantity of activities used to produce individual products.
They identify the linkage between activities and cost objects and
serve as quantitative measures of the output of activities. In fact,
they are the central innovation of ABC system. Three types of
cost drivers are:

(I) TRANSACTION

(II) DURATION

(III) INTENSITY (DIRECT CHARGING)

Transaction Drivers
Transaction drivers are used to count the frequency
of an activity/the number of times an
activity is performed.

Duration Drivers
Duration drivers represents the amount of time
required to perform an activity.

Intensity Drivers
Intensity drivers are used to charge directly for
the resources used each time an
activity is performed.
Activity Cost Driver Rate
The next step is to compute the Activity Cost Driver Rate
(ACDR).
The ACDR is the amount determined dividing the activity
expenses by the total quantity of the activity cost driver.

Activity-Based Costing Products Profitability Report

Finally, ABC Products Profitability Report is prepared. It

combines activity expenses assigned to each product with
their direct (labour and material) costs.
The activity expenses assigned to a product is arrived at
multiplying the ACDR by the quantity of each activity cost
driver used by each product.
Example 1
We will now illustrate the step-wise cost allocation of overhead
costs and the preparation of the ABC Products Profitability Report
for the Montex Pen Manufacturing Company in Exhibit.1.
(A) The total overheads (aggregating Rs 9,00,000) were comprised
of the following:
Expense category Expenses
Indirect labour Rs 3,00,000
Fringe benefits 2,40,000
Computer system expenses 1,50,000
Machinery 1,20,000
Maintenance 60,000
Energy 30,000
Total 9,00,000
(B) The activities and activity expenses of the Montex Pen Manufacturing Company
are summarised below:
Overhead cost Cost driver
items
Handle Set up Support Run Total
production machines machine expenses
runs products
(1) Indirect
labour and 1/2
50% 40% 10% — Rs 4,20,000
fringe benefits
(2) Computer 80% — 20% — 1,50,000
expenses
(3) Machine — — — 100% 1,20,000
depreciation — — — 100% 60,000
(4)Maintenance — — — 100% 30,000
(5) Energy
Activity Rs 3,30,0001 Rs 1,68,0002 Rs 72,0003 Rs 2,10,0004 7,80,000
Expenses
1 (Rs 4,20,000 × 0.50) + (Rs 1,50,000 × 0.80) = Rs 2,10,000 + Rs 1,20,000 = Rs
3,30,000
2 (Rs 4,20,000 × 0.40) = Rs 1,68,000
3 (Rs 4,20,000 × 0.10) + (Rs 1,50,000 × 0.20) = Rs 42,000 + Rs 30,000 = Rs 72,000
4 (Rs 1,20,000 + Rs 60,000 + Rs 30,000) × 1.00 = Rs 2,10,000
Activity Cost Driver Products
Blue Black Red Purple Total@
Pens Pens Pens Pens
Direct labour-hour/unit 0.02 0.02 0.02 0.02 2,000
Machine-hour/unit 0.10 0.10 0.10 0.10 10,000
Production runs 70.00 65.00 50.00 15.00 200
Setup time/run 4.00 2.40 5.60 5.60 —
Total setup time (hour) 280.00 156.00 280.00 84.00 800
Number of products 1.00 1.00 1.00 1.00 4
@Total labour and machine-hours are obtained by multiplying the unit
amounts by the quantity of each type of pen sold (from Exhibit 1), that is,
25,000 blue, 20,000 black, 4,500 red and 500 purple pens.
(C) The activity cost driver rates and the activity expenses assigned to
products are shown below:
Activity Activity Activity cost Activity Activity cost
expenses driver cost driver rate
driver
quantity
Handle Number of
Production production
runs Rs 3,30,000 runs 200 Rs 1,650 per run
Set up machines 1,68,000 Number of 800 210 per setup
setup hours hour
Support products 72,000 Number of 4 18,000 per
products product
Run machines 2,10,000 Number of 10,000 2.10 per
________ machine-hours machine-hour
Total 7,80,000
Activity Expenses Assigned to Products

ACDR ACDQ Activity ACD Activity AC Activity AC Activity

for Expenses: Q for Expenses DQ expenses DQ Expenses
Blue Blue Black Black for : Red for : Purple
Red pur
ple

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Handle
Production Rs 1,650 70 Rs 1,15,500 65 Rs 1,07,250 50 Rs 82,500 15 Rs 24,750
Run
Setup
Machines 210 280 58,800 156 32,760 280 58,800 84 17,640
Support
Products 18,000 1 18,000 1 18,000 1 18,000 1 18,000
Run
Machines 2.10 5,000 1,05,000 4,000 84,000 900 18,900 100 210

Note: ACDR = Activity Cost Driver Rate; ACDQ = Activity Cost Driver Quantity
(D) The ABC product profitability report for the Montex Pen Manufacturing Company is
shown in Exhibit 3.
Exhibit 3 Activity-Based Costing Products Profitability Report
Blue Pens Black Pens Red Pens Purple Total
Pens
Sales revenues Rs 11,25,000 Rs 9,00,000 Rs 2,09,250 Rs 24,750 Rs 22,59,000
Material cost 3,75,000 3,00,000 70,200 7,53,450
Direct labour cost 1,50,000 1,20,000 27,000 8,250 3,00,000
Gross Margin 6,00,000 4,80,000 1,12,050 3,000 12,05,550
Overheads: 13,500
—50% fringe
benefit on direct
labour 60,000 48,000 10,800 1,20,000
—Handle 1,200
production runs 1,15,500 1,07,250 82,500 3,30,000
—Setup machines 58,800 32,760 58,800 24,250 1,68,000
—Support 17,640
products 18,000 18,000 18,000 72,000
—Run machines 1,05,000 84,000 18,900 18,000 2,10,000
Total 3,57,300 2,90,010 1,89,000 2,100 9,00,000
Operating income 2,42,700 1,89,990 (76,950) 63,690 3,05,550
Return on sales(%) 21.7 21.1 (36.8) (50,190) 13.5
(202.8)
 Activity-Based Management (ABM)

The activity-based management (ABM) refers to a set of actions

that management can take, based on information from an
ABC study, to increase/improve profitability. These
include a combination of

1) Repricing of unprofitable products,

2) Increasing sales volume of highly profitable products,
3) Process improvement e.g. how to reduce setup times in
contrast to faster run of production, equipment and
4) Engineering and design improvements.

Their combined effect would be production of the same

volume and mix of products with fewer resources.
 Cost of Resource Capacity
Practical capacity

Practical capacity is a better measure of cost of resources to handle each

production (i.e. capacity expenses ÷ practical capacity). It is the maximum
amount of work that can be performed by resources supplied for
production/services and is expressed as a percentage of theoretical capacity.
Duration Drivers

Theoretical capacity means the normal working hours of a machine/working

employee. The difference between theoretical capacity and practical capacity is
the time utilised by the employees for breaks, arrivals, departures and so on,
which are not related to actual work performance. It may also represent
allowances for downtimes of machines due to maintenance, repair and
rescheduling fluctuations and so on.
Unused Capacity
The expenses of resources unused during the production (difference between
theoretical capacity and practical capacity) is the cost of unused capacity. Such
a cost should be assigned to the person/customer/department/market segment
concerned with/responsible for it.
 ABC FOR MARKETING, SELLING
AND DISTRIBUTION EXPENSES
Marketing, selling and distribution expenses are significant
components of overhead costs of companies. Most of these costs
are associated with customers, market segments and distribution
channels rather than to individual products. The ABC is applicable
to such costs also.
Its focus is on tracing these costs to customer segments. The
activities performed by these services are first identified together
with activity cost drivers linking each activity to individual
customers.

The resource spending in the various customer accounts are then

identified.

The final stage is preparation of customer profitability analysis.

Tracing Costs to Customers
The focus of ABC system is on tracing marketing, selling and distribution
costs to customer segments. To illustrate, consider two customers, Simple
and Complex, of Avon Industries Ltd. Avon Ltd. currently uses the
traditional/conventional cost accounting system and distributes the
marketing, selling and distribution to customers based on sales revenue,
that is, approximately one-third of total sales. The traditional costing-based
profitability of Simple and Complex (customers) is summarised in Exhibit 4:

Exhibit 4: Traditional Costing Based Customer Profitability Analysis

Simple Complex
Sales revenue Rs 12,80,000 Rs 12,60,000
Costs of goods sold 6,16,000 6,24,000
Gross margin 6,64,000 6,36,000
Marketing, selling, distribution and
administrative expenses (0.33 × sales) 4,22,000 4,15,800
Operating profit 2,41,600 2,20,200
Profit (as percentage of sale) 18.8 17.5
 Identification of Activities
and Cost Drivers
Activity Activity Cost Driver
1 Marketing and technical 1 Estimated proportion of time
support spent on each customer
2 Travel to customers 2 Actual expenditure
3 Distribution of sales catalogue 3 Number of mailings
4 Servicing of customers 4 Estimated proportion of time
spent on each customer and
supplies used by them
5 Handle customer orders 5 Number or orders
6 Warehouse inventory for 6 Quality of inventory and space
customers required by customer
7 Shipping/despatch to 7 Actual records
customers
Identify Resource Spending
The next step is to identify the resource spending in the various accounts. The
customer profile of Simple and Complex is as follows. Simple orders only a few
products in large quantities, places order predictably and with long lead times,
and requires little sales and technical support. But Complex requires a great
deal of handholding and continuously inquires whether products could be
modified to meet his specific needs. In addition to marketing resources, many
technical resources are required to service Complex. Complex also places many
small orders for special products, requires expeditious delivery and pays
slowly, increasing the demands on order processing, invoicing and accounts
receivable process of Avon Ltd. Suppose the following marketing, selling,
distribution and administrative costs are identified for the two customers.
Simple Complex
1 Marketing and technical support Rs 28,000 Rs 2,16,000
2 Travel to customers 4,800 28,800
3 Distribution of sales catalogue 400 400
4 Servicing of customers 16,000 1,68,000
5 Handling customer orders 2,000 72,000
6 Warehouse inventory 3,200 35,200
7 Ship/despatch to customers 50,400 168,000
Total activity expenses 1,04,800 6,88,400
 Customer Profitability Analysis Report
Exhibit 5: Activity-Based Costing Customer Profitability Analysis
Simple Complex
Sales revenue Rs 12,80,000 Rs 12,60,000
Cost of goods sold 6,16,000 6,24,000
Gross margin 6,64,000 6,36,000
Marketing, selling and distribution expenses:
Marketing and technical support 28,000 2,16,000
Travel to customers 4,800 28,000
Distribution of sales catalogue 400 400
Servicing of customers 16,000 1,68,000
Handling customer orders 2,000 72,000
Warehouse inventory 3,200 35,000
Ship/dispatch to customers 50,400 1,68,000
Total activity expenses 1,04,800 6,88,400
Operating profit 5,59,200 (–52,400)
Profits as percentage of sales (operating margin) 43.7 (–4.2)
According to the ABC customer profitability analysis (Exhibit 5), Simple is a highly
profitable customer while Complex is a very unprofitable customer. The reason is that
ordering and support activities of Simple places few demands on the Avon’s marketing,
selling, distribution and administrative resource as a result of which its operating
margin is much higher.
Managing Customer Profitability
The ABC customer profitability analysis can be used to
manage its profitable and unprofitable customers. To
protect them from competitive inroads profitable customers
may be offered discounts/incentives and special services to
retain them. The unprofitable customers can be transformed
into profitable customers through a number of actions:

(i) Process improvement,

(ii) Activity-based pricing and
(iii) Managing customer relationships.
 ABC for Service Companies
The ABC system is as much applicable and useful to a
service company as it is to a manufacturing company.
Service organisations include companies in

a) Financial services (i.e. banks, insurance organisations,

money managers),
b) Transportation (i.e. airlines, roads and railways),
c) Telecommunications,
d) Wholesale and retail,
e) Healthcare and so on.
Cost Structure of Service Companies

Service companies have a unique cost structure.

Virtually all their costs are indirect/fixed.

In contrast to manufacturing companies, customer

behaviour determines the basic operating costs of
products/services of service companies. They
should, therefore, identify the differential
profitability of individual customers as they
determine the quantity of demands for their
operating activities.
 ABC Model Illustrated
Example 2

The structure/construction of the ABC system in a service company is almost

identical to that of a manufacturing company, that is, (i) identify activities, (ii) assign
resources expenses to activities, (iii) determine activity cost drivers, (iv) calculate
activity cost driver rate and (v) compute product/customer cost. We illustrate below
the ABC model for a service company with reference to IBM-Daksh.
The billing department of IBM-Daksh customer care centre requires accurate and
useful information about the cost of providing account inquiry and bill printing
services for its 1,20,000 residential and 20,000 commercial customer accounts. A
local service centre has offered to provide all the functions currently performed by
IBM-Daksh’s billing department at Rs 21.5 per residential account and Rs 40 per
commercial account.
All costs in the billing department are indirect. There are no direct or unallocated
costs. The resources used to support the billing department of IBM-Daksh in the
previous month are summarised below:
Expense Expense amount
Telecommunications Rs 2,92,600
Computer expenses 8,90,000
Supervisors 1,68,000
Paper 36,000
Occupancy 2,35,000
Account inquiry labour 8,67,300
Printing machines 2,75,000
Billing labour 2,81,750
Verification labour 56,250
Other resources 3,35,000
34,37,500
The billing department of IBM-Daksh uses a traditional costing
system that allocates all indirect costs based on (i) the number of
account inquiries, namely, 20,000 (80 per cent) for residential
customers and 5,000 (20 per cent) for commercial customers.
Suppose IBM-Daksh wants to introduce ABC system for its billing
department. They have identified the following activities and the
related cost drivers:
Activity Cost driver
Account billing Number of printed pages
Bill verification Number of accounts verified
Account inquiry Number of inquiries
Correspondence Number of letters
Other activities Number of printed pages
The resources used to perform the activities and the activities performed are shown
here:
Resources Used to Activity Performed (%)
perform activity
Account Correspo Billing Verification Others Total
Inquiry ndence
Supervisor 40 10 30 — 20 100
Account inquiry 90 10 — — — 100
labour
Billing labour — — 30 70 — 100
Verification labour — — — 100 — 100
Paper — — 100 — — 100
Computer 45 5 35 10 5 100
Telecommunications 90 — — — 10 100
Occupancy 65 — 15 — 20 100
Printing machines — 5 90 — 5 100
All other resources — — — — 100 100
The number of cost driver units for the billing department of IBM-Daksh is
shown below:
Activity Cost driver units Number of cost driver units
Residential Commercial Total
1 Account inquiry Number of inquiries 20,000 5,000 25,000
2 Correspondence Number of letters 1,800 1,000 2,800
Number of printed
pages 1,20,000 40,000 1,60,000
3 Bill printing Number of accounts
4 Verification verified — 20,000 20,000
Number of printed
5 Other activities pages 1,20,000 40,000 1,60,000
Required:
(a) Using the traditional costing system, should the IBM-Daksh accept the offer
of the local service centre to perform all the functions?
(b) Would the decision be different with ABC system?
Solution: (a) Cost Computation for Billing Department (Traditional
Costing System)
Residential Commercial
1 Cost Rs 27,50,000@ Rs 6,87,500@@
2 Number of inquiries 20,000(0.80) 5,000(0.20)
3 Number of accounts 1,20,000 20,000
4 Cost per account (1 ÷ 3) 22.9 34.4
@
Rs 34,37,5000 × (0.80)
@@
Rs 34,37,500 × (0.20)
Decision: The billing department should accept the offer of the local service
centre to service residential accounts as there is a saving of Rs 1.4
per account (Rs 22.9 – Rs 21.5). But it should continue to service
the commercial accounts because of lower cost of Rs 5.6 (Rs 40 – Rs 34.4).

(b) The computation of activity-based cost per account for each customer
class (residential and commercial is illustrated below).
(b) (i) Total Traceable Costs
Resource Cost Activity
Cost Pool
Account Corres- Billing Verification Others
Inquiry pondence
1. Supervisors Rs 1,68,000 Rs 67,200a Rs 16,800b Rs 50,400c — Rs 33,600d
2. Account inquiry
labour 8,67,300 7,80,570 86,730 — — —
3. Billing labour 2,81,250 — — 84,375 Rs 1,96,875 —
4.Verification
labour 56,250 — — — 56,250 —
5. Paper 36,600 — — 36,600 — —
6. Computer 8,90,000 4,00,500 44,500 3,11,500 89,000 44,500
7. Telecommuni-
cations 2,92,600 2,63,340 — — — 29,260
8. Occupancy 2,35,000 1,52,750 — 35,250 — 47,000
9. Printing
machines 2,75,000 — 13,750 2,47,500 — 13,750
10. Others 3,35,000 — — — — 3,35,500
Total traceable 34,37,500 16,64,360 1,61,780 7,65,625 3,42,125 5,03,610
cost
a (Rs 16,8,000 × 0.40) b (Rs 16,8,000 × 0.10) c (Rs 1,68,000 × 0.30) d (Rs 16,8,000 × 0.20)
(b) (ii) Costs Driver
Activity Traceable Number of Driver Units Cost per
costs Driver
Units
(1) (2) [(1) ÷ (2)]
Account inquiry Rs 16,64,360 25,000 inquiries Rs 66.5744
Correspondence 1,61,780 2,800 letters 57.7786
Account billing 7,65,625 1,60,000 printed pages 4.7852
Bill verification 3,42,125 20,000 accounts
verified 17.1062
Other activities 5,03,610 1,60,000 printed pages 3.1476
(b) (iii) Cost per Customer Class
Cost Per Residential Customer Commercial Customer
Driver Unit Accounts Accounts
Number of Cost Number of Cost
Driver Units Driver Units
(1) (2) (3) (4) (5) (6)
Account inquiry Rs 66.5744 20,000 inquiries Rs 13,31,490 5,000 inquiries Rs 3,32,870
Correspondence 57.7786 2,800 letters 1,04,001 1,000 letters 57,779
Account billing 4.7852 1,20,000 pages 5,74,224 40,000 pages 1,91,408
Billing
verification 17.1062 — — 20,000 accounts 3,42,124
Other activities 3.1476 1,20,000 pages 3,77,712 40,000 pages 1,25,904
Total Costs 23,87,415 10,50,085
Number of _______ ______
accounts 1,20,000 20,000
Cost per account Rs 19.90 Rs 52.50
Cost per account 22.90 34.40
(traditional system)
 PROs And CONs
The ABC system has advantages as well as limitations. Its major benefits
are:
1) it does not undercost complex low-volume products and overcost
high-volume simple products,
2) it may result in improved cost control.

The limitations of ABC system are two-fold:

(a) it is costly to develop and maintain and (b) it is used to develop full
costs and does not measure the incremental costs needed to produce an
item.