Activity Based Costing (ABC) – Concepts and Implementation

• Activity Based Budgeting analyse the resource input or cost for each activity.
• It provides a framework for estimating the amount of resources required as per the budgeted level of activity.
• Actual results can be compared with budgeted results to highlight (both in financial and non-financial terms) those activities with major discrepancies from budget for potential reduction in supply of resources.
• It is a planning and control system which seeks to support the objectives of continuous improvement.
• It means planning and controlling the expected activities of the organisation to derive a cost effective budget that meet forecast workload and agreed strategic goals.
• ABB is the reversing of the ABC process to produce financial plans and budgets.

Fundamental difference between ABC and Traditional costing are as follows –

(i) Cost Object – It is an item for which cost measurement is required e.g. product or customer.

(ii) Cost Driver – It is a factor that causes a change in the cost of an activity.

Categories of cost driver –

• Resource Cost Driver – It is a measure of quantity of resources consumed by an activity. It is used to assign the cost of a resource to an activity or cost pool.
• Activity Cost Driver – It is a measure of the frequency and intensity of demand, placed on activities by cost objects. It is used to assign activity costs to cost objects.

(iii) Cost Pool – It represents a group of various individual cost items. It consists of costs that have same cause and effect relationship e.g. machine set-up.

1. Unit level activities – Those activities for which the consumption of resources can be identified with the number of units produced e.g. use of indirect materials/consumables tends to increase in proportion to the number of units produced.
2. Batch level activities – The activities such as setting up of a machine or processing a purchase order are performed in batches. The cost of batch related activities varies with number of batches made, but is common (or fixed) for all units within the batch e.g. (i) Material ordering, where an order is placed for every batch of production; or (ii) Machine set-up costs, where machines need resetting between each different batch of production.
3. Product level activities – Activities which are performed to support different products in product line e.g. designing the product, producing parts specifications, keeping technical drawings of products up to date.
4. Facilities level activities – Those activities which cannot be directly attributed to individual products. These activities are necessary to sustain the manufacturing process and are common and joint to all products manufactured e.g. maintenance of buildings, plant security.

• More accurate costing of products/services.
• Overhead allocation is done on logical basis.
• Enables better pricing policies by supplying accurate cost information.
• Utilizes unit cost rather than just total cost.
• Help to identify non-value added activities which facilitates cost reduction.
• It is helpful to the organizations with multiple products.
• It highlights problem areas which require attention of the management.

• It is more expensive, particularly in comparison with traditional costing system.
• It is not helpful to the small organizations.
• It may not be applied to organizations with limited products.
• Selection of the most suitable cost driver may not be easy.

1. Staff Training – Workforce cooperation is essential for successful implementation of ABC. Staff training should be done to create an awareness on the purpose of ABC.
2. Process Specification – Informal, but structured interviews with key members of personnel will identify the different stages of the production process, the commitment of resources to each, processing times and bottlenecks.
3. Activity Definition – The activities must be defined clearly in the early stage in order to manage the problems, if any, effectively.
4. Activity Driver Selection – Cost driver for each activity shall be selected.
5. Assigning Cost – A single representative activity driver can be used to assign costs from the activity pools to the cost objects.

The three key elements of activity based budgeting are as follows –

• Type of work to be done
• Quantity of work to be done
• Cost of work to be done.

• It can enhance accuracy of financial forecasts and increasing management understanding.
• When automated, ABB can rapidly and accurately produce financial plans and models based on varying levels of volume assumptions.
• It eliminates much of the needless rework created by traditional budgeting techniques.

Cost Driver – It is a factor that causes a change in the cost of an activity. There are two categories of cost driver.

• Resource Cost Driver – It is a measure of the quantity of resources consumed by an activity. It is used to assign the cost of a resource to an activity or cost pool.
• Activity Cost Driver – It is a measure of the frequency and intensity of demand, placed on activities by cost objects. It is used to assign activity costs to cost object

Distribution

• Number of units distributed
• Number of customers

Research and Development

• Number of research projects
• Personnel hours on a project

Customer Service

• Number of service calls
• Number of products serviced
• Hours spent on servicing products