Activity Based Costing

Meaning 

 Activity-based costing (ABC) is a new and scientific approach developed by Cooper and Kaplan (1988) for assigning overhead to end products, jobs, and processes. It aims to rectify the problems of inaccurate cost information due to the selection of wrong bases of indirect cost apportionment. In the words of Kooper and Kaplan "ABC system calculate the cost of individual activities and assigned cost to cost object such asproduct and services on the basis of activites undertaken to produce eachprodct or service" 

According to CIMA, London, Activity Based Costing is " Cost attribution to cost units on the basis of benefits received from indirect activities ie ordering, setting, assuring quality, etc.

Activity-based costing is not an alternative to Job Costing or Process Costing. Rather it is a modern tool of charging overhead costs in which costs are first traced to activities and then to product or job thus activities become the focal point for cost computation. 

Step in Activity Based Costing 

The following are the steps in activity-based cost allocation 

1. Identification of the main activities- 

first of all, all major activities in the organization are identified. The number of activities in an organization should neither be too large or too small.

2. Creation of cost pool 

A cost pool is the grouping of individual cost items. A cost pool or cost bucket should be created for each activity. a cost pool is like a cost center around which costs are accumulated e.g the total cost of machine setups might constitute one cost pool for all set up related costs. 

3. Determination of the activity cost driver 

The factor that influences the cost of a particular activity is known as the activity cost driver. In other words, cost drivers signify the factors or events that determine the cost of an activity. eg cost drivers as given above are number of machine setups, number of purchases orders.  

4. Calculation of the activity cost driver rate  

Just as an overhead absorption rate calculated in a traditional costing system in ABC, the activity cost driver rate is calculated as follows-

Activity cost driver =  total cost of an activity 

                                    ___________________

                                     Cost Driver 

5. Charging cost of activities to product 

the cost of activities is traced to the product on the basis of demand by product. The cost driver is used to measure the product demand of activities. e.g the total cost allocated to the cost center for machine setup related costs are Rs 50,000/- and that there were 100 setups during the period thus the rate per set up is Rs 50000/100= 500 

if a particular product needs 10 setups,  charge to that product will be Rs 5000. if 20 units of the product are produced,  cost per unit will be Rs 5000/20 = 250. In this way cost of other activities  also will be charged to product. 

Advantages of Activity Based Costing   

ABC is  being implemented by a growing number of companies around the world 

1. Accurate and reliable - ABC  is a more accurate and reliable system of determination of product cost as it is based on cause and effect relationships. 

2. Better pricing decision - It helps in overcoming the problem of overcasting and under costing. 

3. Realistic- This method is more realistic because the distribution of overhead based on activity-based costing is an objective approach It may be recalled that traditional costing uses a more arbitrary base for apportionment of overhead and is a subjective approach. 

4. Control of cost -  ABC produces more meaningful information regarding cost behavior and helps management to control many fixed overheads by exercising more control over those activities which caused this fixed overhead.

5. Greater cost-efficiency-  and helps to identify unnecessary activities so that these may be weeded out and thus achieving greater cost efficiency.  

Dr. Sucheta Dalvi 

T J College, Khadki,Pune