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ACTIVITY BASED COSTING

Samit Paul
IIM, Ranchi
Traditional product costing
 Traditional /conventional product costing system:
 Allocating direct cost to the product
 Adding a portion of overheads deemed to be
related to the units produced.

 Note: overheads are charged to products on a


production volume related basis such as direct material,
direct labor (hours/cost)and machine hours.

 Assumption- overheads are basically related


production volume.

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Features of traditional product
costing system
 Labor based production norms- mechanization is
minimum
 Direct cost have larger portion in the total cost
of production.
 Support or overhead costs- less proportion
 Standardized products are assumed to be
produced.
 Not to be affected much by technology changes

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Traditional method of overhead
absorption
 Overheads are absorbed on volume related
measures i.e.
 number of units produced,
 amount of materials consumed,
 amount of direct labor cost,
 machine hours,
 or direct labor hours.

Note: In traditional system it is assumed that all


items of costs are consumed by products in
proportion to their production volumes.

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Traditional- Overhead allocation to
products
 Following steps:

1. From ledger accounts to - Production and service


Departments
2. From service departments to- Production departments

3. From production departments to- End products-by using an


appropriate basis related to
volume of material, direct
labor , machine hours

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Transformation of costing system
 Traditionally firms produce a narrow range of
products and direct labors and materials were
the dominant factory cost. Overhead costs were
relatively small.
 Today companies produce a wide range of
products. Direct labor and material constitute
only a small fraction of total cost, and overhead
costs are of considerable importance.

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Modern production system
 Production is automated and computerized.
 Overhead constitute a larger portion.
 Support functions and their costs have shown
increasing trends
 Overheads are less affected by production
volume (as in conventional costing) but more by
range and complexity of products
manufactured.

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Cooper and Kaplan-1980
 Criticized the traditional method of allocation of
overheads to products.
 There are number of cost items which are not
related to physical volume.
 i.e. Material handling, Material procurement,
Performing set-up, production scheduling, inspection
activities.
Note: in 1988 Cooper and Kaplan developed a
refined approach for assigning overheads to
products- Activity Based Costing

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Concept of ABC
 ABC method is a new concept of overhead
absorption.
 It is a costing system which focuses on
activities performed to produce products.
 Costs are first traced to activities and then to
products.

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Comparison of ABC and Tradition
product cost
Traditional ABC
1. Mechanism- Overheads are Separate cost centres are created
traced to production and service for each major activity i.e.
departments and then service machine related, set-up related
department to production then to and purchase related activities.
products through direct labor Each activity cost is allocated to
rates and machine hours. products on the basis of benefits
derived by each product.

2. Traditional system- Overheads 2. ABC system assigns overheads


tends to be pooled by to each major activity rather than
departments. department. Activity based cost
pools or cost centres are
established.

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Introduction of ABC System
 Design of ABC system involves following stages:
1. Identifying activities: major activities that take
place in an organization
2. Assigning costs to activity cost centres-
assigning costs to cost pools or cost centres for
each activity.
3. Selecting appropriate cost drivers- identify
factors that influence the cost of a particular
activity.
4. Assigning the cost of activities to products-
according to each products demand for activities.

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1. Identifying Activities
Activities basically fall into four categories:
1. Unit level or primary activities- cost of such activities
are driven by units (i.e. testing of every items produced.)
2. Batch Level activities: - cost of such activities are
driven by number of batches (i.e. material ordering,
machine set-up, inspection)
3. Product level activities- i.e. designing the product,
keeping technical drawings, advertising of a specific
product. Cost of such activities are driven by creation of a
new product line and its maintenance.
4. Facility level activities: related to certain activities i.e.
maintaining building, security of plant, safety measures for
workers, advertisement to promote organization.
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2. Assigning costs to activity cost
centres
 Creation of a cost centre (cost pool) for each
activity.
 For example: total costs of all set ups might
constitute one cost centre for all setup related
costs.

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3. Selecting appropriate cost drivers
 Cost driver: used to describe the significant
determinant of the cost of the activity. ANY
FACTOR THAT INFLUENCES COSTS.
 The most suitable cost driver in each activity
under functional areas needs to be identified.

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Characteristics of cost drivers
 Degree of Correlation: Accuracy of the cost
assignments depends on the degree of
correlation between consumption of the activity
and consumption of the cost driver
 Cost of measurement: Although more cost
drivers enhance accuracy, it results greater cost
of measurement. So, there should be a proper
trade-off.
 Behavioral effects: Behavioral effect also plays a
huge part. Depending on cost of measurement,
manager can opt for less cost driver while
overlooking better alternatives
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Example:
Functional area Activities Suitable cost
drivers
1. Materials management

2. Stores Management

3. Quality control

4. Personnel
management
5. Marketing

6. Research and
Development
7. Machining
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Functional area Activities Suitable cost drivers
1. Materials management -Issue of purchase orders
-inspection of materials

2. Stores Management •Storing of materials


•Servicing of requisitions
•Inspection and
verification
•Stock taking

3. Quality control Testing of samples


4. Personnel management Recruitment
leave records and
attendance
5. Marketing Demand creation
Advertising
dispatches
6. Research and Research
Development
7. Machining Set-up cost
17 Power cost
Functional area Activities Suitable cost drivers
1. Materials management -Issue of purchase Number of purchase orders
orders Number of purchase orders
-inspection of materials
2. Stores Management •Storing of materials Value of materials stored
•Servicing of No. of requisitions
requisitions No. of times inspected
•Inspection and Value of stock
verification
•Stock taking
3. Quality control Testing of samples No. of batches produced.
4. Personnel management Recruitment No. of employees recruited
leave records and No. of employees.
attendance
5. Marketing Demand creation Increase in sales
Advertising Increase in sales
dispatches No. of Orders
6. Research and Research No. of Research Projects
Development
7. Machining Set-up cost No. of production runs
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Power cost Machine hours
4. Assigning the cost of activities to
products
 Trace the cost of activities to products according
to each products demand for these activities
using cost drivers as a measure of demand.
 A products demand for the activities is
measured by the number of transactions it
generates for the cost driver.

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Example: AEC Engineering Company
Products (Units) Traditional Method ABC Method of
of Charging
Charging Overheads
Overheads

A (5000 units) 56.80 103.32

B (60,000 units) 28.40 24.53

•Traditional method is volume related – absorption of


overheads

•ABC method is activity related –absorption of overheads

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Case: Destine Brass Products Co.
 Case analysis

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