Activity Based Costing: Definition, Advantages, Disadvantages, Process

  • Post last modified:7 March 2021
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What is Activity Based Costing?

Activity-based costing (ABC) system is a method of accounting you can use to find the total cost of activities necessary to make a product. The ABC system assigns costs to each activity that goes into production. It is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each.

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product.

Definition of Activity Based Costing

According to Cooper and Kaplan, “Activity-Based Costing systems calculate the costs of individual activities and assign costs to cost objects such as products and services on the basis of activities undertaken to produce each product or service”.

Process G. Stigler

CIMA, London, defines Activity-Based Costing as, “Cost attribution to cost units on the basis of benefits received from indirect activities, i.e., ordering, setting up, assuring quality, etc.”


Objectives of Activity Based Costing

The major objectives of Activity Based Costing are as follows:

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  1. To identify value added activities in transactions.

  2. To focus high cost activities.

  3. To distribute overheads on the basis of activities.

  4. To identify the opportunities for improvements and reduction of costs.

  5. To validate the success of the quality drive with ABC.

  6. To ensure accurate product costing for decision-making.

  7. To use information to improve product mix and pricing decisions.

Difference between Traditional Costing and ABC

Traditional Product Costing Approach differs from Activity Based Costing Approach in the following respects:

BasisActivity-Based CostingTraditional Costing
ObjectiveIt is a subjective approach because it uses arbitrary bases for apportionment of overheads.It is an objective approach because it uses activities as bases for distribution of overheads. It aims at identifying as many costs as possible to be subsequently accounted as direct cost of production.
AssumptionIt is based on the assumption that end products consume resources in proportion to the volume of production.It is based on the assumption that end products consume resources in proportion to the volume of activities.
ProcedureOverheads are first allocated and apportioned to various production departments and service departments, then overheads of service departments are reapportioned to production departments and then overheads of production departments are charged to the end products on some suitable basis like machine hours, labour hours, direct wages etc.Activity Based Costing is a technique of charging overheads to cost objects i.e. products, services, jobs, customers etc., under which overheads are first calculated separately for each activity and then are charged to various cost objects on the basis of activities consumed by these cost objects.
AccuracyIt is not so accurate, as Activity Based Costing, does not facilitate the identification of unnecessary activities.It is an accurate system of costing because the distribution of overheads is based on the cause-and-effect relationship in the cost incurrence. However, it facilitates the identification of unnecessary activities.
ControlIt does not facilitate the control over those activities which cause fixed overheads.It facilitates the control over those activities which cause fixed overheads. This is possible because behaviour of fixed overheads costs in relation to activities become more visible and clear.

Advantages of Activity Based Costing

These are importance or advantages of activity based costing:

  1. ABC helps to reduce costs by providing meaningful information for cost-management. It helps in making the right decision.

  2. ABC technique provides due importance to non-manufacturing cost which constitutes a substantial portion of total cost. Traditionally non-manufacturing costs have been allocated under volume basis and thus, high volume products have been overvalued.

  3. ABC technique provides accurate and reliable cost information. This cost information is essential for recent approaches in productivity improvement like Total Quality Management (TQM) and Business Process Reengineering.

  4. ABC enables the management in formulating an effective pricing policy while fixing prices.

  5. Cost of each activity is determined with the help of ABC. There is accuracy in indirect cost-allocation to products. This technique is helpful in make or buys decisions and transfer pricing.

Disadvantages of activity based costing

These are limitations or disadvantages of activity based costing which is given below:

  1. ABC can be difficult and time-consuming to collect data about activities and cost drivers.

  2. It can be costly to implement, run and manage an ABC system.

  3. Even in ABC, some overhead costs are difficult to assign to products and customers. These costs still have to be arbitrarily applied to products and customers.

  4. It is based on historical costs; while for planning decisions, future costs are more relevant.

  5. For many short-term decisions, identification of variable costs is very important. But ABC system does not partition variable and fixed elements of overhead costs.

  6. The accuracy of the ABC system fully depends upon the quality of cost drivers. The allocation and absorption of costs may become an arbitrary allocation process if the cost drivers are not associated with the factors causing costs.

  7. ABC system tends to be more costly than the traditional methods of applying costs to products.

Process of activity based costing

There are two primary stages in Activity Based Costing, viz. (i) tracing costs to activities, (ii) tracing activities to products:

  1. Identification of Major Activities
  2. Creation of Cost-pool
  3. Selecting Appropriate Cost Drivers
  4. Ascertainment of Cost Driver Rate as per Activity identified
  5. Charging of Overhead Costs of Activities to Products

Identification of Major Activities

Firstly, activities are identified and then classified into different categories that have relationship with the different parts of the production process. For example direct labour related activities, machine related activities (machine cost centers) and various support activities, such as ordering, receiving materials, handling, production scheduling, packing and dispatching etc.

Creation of Cost-pool

Secondly, factory overhead costs of the activities are determined and classified into homogenous cost pools. A homogenous cost pool is a collection of overhead costs that are logically related to the tasks being performed. A cost pool should be created for each activity. Cost pool is like a cost center or activity center around which costs are accumulated.

Selecting Appropriate Cost Drivers

Thirdly, the factors that influence the cost of a particular activity should be identified, which are known as Cost Drivers. Cost driver is an activity which generates cost. It should be understood that direct costs do not need cost drivers as they can be traced directly to a product. Direct costs are themselves cost drivers.

However, all other factory or manufacturing costs need cost drivers. Cost signify factors, forces or events that determine the costs of activities. Cost drivers are the links and they can link a pool of costs in an activity centre to a product. Activity Based Costing is based on the assumption that cost behaviour is influenced by cost drivers. Therefore, in order to trace overhead costs to products, appropriate cost drivers should be identified.

Ascertainment of Cost Driver Rate as per Activity identified

Fourthly, cost driver rate as per the activity identified is ascertained by using the following formula:

Activity Cost Driver Rate = Activity Cost ÷ Cost Drivers

These rates can be used to measure activity performance and efficiency and also provide a more suitable basis for budgeting.

Charging of Overhead Costs of Activities to Products

Finally, the overhead costs of activities are charged to the products produced, and the product costs are ascertained more accurately.


Benefits of Activity-Based Costing

The following are certain important benefits of Activity Based Costing system:

  1. Activity costs
  2. Customer profitability
  3. Distribution cost
  4. Make or buy
  5. Margins
  6. Minimum price
  7. Production facility cost

Activity costs

ABC is designed to track the cost of activities, so you can use it to see if activity costs are in line with industry standards. If not, ABC is an excellent feedback tool for measuring the ongoing cost of specific services as management focuses on cost reduction.

Customer profitability

Though most of the costs incurred for individual customers are simply product costs, there is also an overhead component, such as unusually high customer service levels, product return handling, and cooperative marketing agreements.

An ABC system can sort through these additional overhead costs and help you determine which customers are actually earning you a reasonable profit. This analysis may result in some unprofitable customers being turned away, or more emphasis being placed on those customers who are earning the company its largest profits.

Distribution cost

The typical company uses a variety of distribution channels to sell its products, such as retail, Internet, distributors, and mail order catalogues.

Most of the structural cost of maintaining a distribution channel is overhead, so if you can make a reasonable determination of which distribution channels are using overhead, you can make decisions to alter how distribution channels are used, or even to drop unprofitable channels.

Make or buy

ABC provides a comprehensive view of every cost associated with the in-house manufacture of a product, so that you can see precisely which costs will be eliminated if an item is outsourced, versus which costs will remain.

Margins

With proper overhead allocation from an ABC system, you can determine the margins of various products, product lines, and entire subsidiaries. This can be quite useful for determining where to position company resources to earn the largest margins.

Minimum price

Product pricing is really based on the price that the market will bear, but the marketing manager should know what the cost of the product is, in order to avoid selling a product that will lose a company money on every sale. ABC is very good for determining which overhead costs should be included in this minimum cost, depending upon the circumstances under which products are being sold.

Production facility cost

It is usually quite easy to segregate overhead costs at the plant-wide level, so you can compare the costs of production between different facilities.


Classification of Activity-Based Costing

Under activity based costing system, activities are identified and classified into different categories or segments of the production process. The grouping of activities is preferably done using the different levels at which activities are performed.

Unit Level Activities

Unit-level activities are those activities which are performed each time a unit is produced. They are repetitive activities. For example, direct labour hours, machine hours, power, they are used each time a unit is produced. Direct materials and direct labour activities are also unit level activities, although they are not overhead costs of unit level activities, and vary with the number of units produced.

Batch Level Activities

Batch level activities are those activities which are performed each time a batch of good or product is produced. The costs of batch level activities vary with the number of batches, but are fixed with respect to the number of units in each batch. Machine set-up inspections, production scheduling, materials handling are examples of batch level activities which are related to batches, but not to individual products.

Product Level Activities

Product level activities are those activities which are performed to support the production of each different type of product. Maintenance of equipment, engineering charges testing routines, maintaining bills of materials, handling materials are some of the examples of batch level activities.

Facility Level Activities

Facility level activities are those which are needed to sustain a factory’s general manufacturing process. These activities are common to a variety of products and are most difficult to produce specific activities.

Examples of facility level activities are factory management, maintenance, security, plant depreciation. In Activity Based Costing system, facility level activities and costs are treated as period costs as they are found difficult to assign to different products.

The costs associated with the first three categories, viz, unit level, batch level, product level are assigned to products, using cost drivers that reflect the cause and effect relationship between activity consumption and cost.


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