Chapter 6

Activity Based
Costing
 Activity Based Costing
Activity based costing (ABC) is an accounting methodology
that assigns costs to activities rather than products or services.
This enables resources and overhead costs to be more
accurately assigned to the products and the services that
consume them.
ABC is based on the principle that products consume
activities.
 Activity Based Costing
Activities can be defined as a named
process, function, or task that occurs
over time and has recognized results.
Activities use up assigned resources to
produce products and services.
Inputs are transformed into outputs
under the parameters set by
controls performed by the organizations
employees and their tools.
 Basis of ABC
1.Identifying major activities and their costs
2.Determining the cost drivers
Cost Object: Factor for which cost measurement is required
Cost Driver: Factor that causes a change in the cost of an
activity
Resource drivers are the measure of the frequency and intensity
of the demands placed on resources by activity.
Activity drivers measure the frequency and intensity of the
demands placed on activities by cost objects enabling costs to
be assigned to cost objects.

Resources are people and machines.

Activities are the processes performed by the people and
machine.
COST ACTIVITY ACTIVITY ACTIVITY Activity
OBJECT NAME DRIVER DESCRIPTION Type
Patient Treating Number of Administering Primary
Types Patients treatments medicine and
changing
dressings
Patient Providing Labour hours Bathing, Primary
Types hygienic care changing
bedding and
clothes, walking
patients
Patient Responding to Number of Answering calls, Primary
Types patient requests counselling,
requests providing snacks
etc.
Patient Monitoring Monitoring Checking vital Primary
Types patients hours signs and posting
patient
information
Supervising Percentage Scheduling, Seconda
Nurse of time the coordinating and ry
nurses spend performance
 How To Use ABC?
ABC is used to determine the cost and benefits
associated with reengineering processes and
systems.
ABC approach will account for
Activities or processes
Frequency and cost of the activity
The do-nothing scenario
Which process provides value
Determination cost drivers for activities
Estimate application rates for each activity driver
Application of costs to products
 Benefits Of ABC
Over Absorption Costing
More realistic product costs
Awareness of the link between activity
and cost behaviour
Support Cost reduction activities
Facilitates the preparation of an activity-
based budget
It helps in decision-making.
Identification of non-value adding
activities helps the management to
control cost.
 Situations in which an ABC system is likely to provide
the most benefits:
Significant amounts of indirect costs are allocated using only one or two cost pools.

All or most indirect costs are identified as output unitlevel costs (few indirect costs are
described as batch-level costs, product-sustaining costs, or facility-sustaining costs).
Products make diverse demands on resources because of differences in volume, process
steps, batch size, or complexity.

Products that a company is well-suited to make and sell show small profits; whereas
products that a company is less suited to make and sell show large profits.

Operations staff has substantial disagreement with the reported costs of manufacturing
and marketing products and services.
 Other Concepts Related To
ABC
Activity Based Management: It is a systematic method of
planning, controlling, and improving labour and overhead
cost. ABM is based on the principle activities consume costs.
Activity Accounting: It is a system that defines and reports the
activities, costs, characteristics, and outputs of each
department, cost center, or group of employees in an
organization.
Activity Based Budgeting: It is a systematic method of
planning and budgeting the resources of an organization. In
essence, ABB is activity accounting in reverse, e.g. start
ABB at the bottom of the activity accounting spreadsheet.
Define the cost per output target and planned activity
workloads to determine headcount and expense budgets.
ANSWERS A B C
cost cost cos
per per t
unit unit per
uni
t

Traditional Method 22.5 45 60

(Overhead Cost)
ABC (Overhead 60 43 46
Cost)
ABC (Total Cost) 170 173 181
ANSWERS Bright Delight
cost per cost per
unit unit
Traditional Method (Overhead 14.50 29.00
Cost)
ABC (Overhead Cost) 32.60 16.93
ANSWERS A B
cost per cost per
unit unit
Traditional Method (Total Overhead 1250 15000
Cost)
ABC (Total Overhead Cost) 2875 1225