ACTIVITY-BASED COSTING 

Activity based costing (ABC) is alternative technique to traditional absorption costing technique, which is used to absorb indirect cost to cost object. It is a costing method that assigns indirect cost to activities and products based on each product’s use of activities. In simple words, in ABC, “Products consume activities and activities consume resources”. 

ABC involves the process of identification of the factors which results the costs of an organisation’s major activities (Cost Pool). Overheads are allocated and apportioned to activity cost centres or cost pool. The overhead costs are ultimately absorbed into product on the basis of usage of activities. Products using more activities should be charged with high cost of respective ‘cost pool’ cost, irrespective of high or low volume. The absorption rate for each activity is cost per unit of relevant cost driver. 

Activity based costing can be defined as: “method of costing which involves identifying the costs of the main support activities and the factors that drive the costs of each activity. Support overheads are charged to products by absorbing cost on the basis of the product’s usage of the factor driving the overheads.” 


. REASONS FOR THE DEVELOPMENT OF ACTIVITY BASED COSTING 

Absorption costing is based on the fact that production overheads are driven by units of products as higher units will be produced, higher production overheads are absorbed into products. These are normally absorbed into products on the basis of volume i.e. labour hours, machine hours etc. However, activity-based costing is based on various cost driver rates because of the following. 

Traditional absorption costing was developed in a time when most manufacturers produced small range of products which underwent similar operations. It was justified to include similar proportion of overheads into product cost. In addition to above, overhead costs comprised of small fraction of total production cost or in other words, the proportion of direct cost was higher than indirect cost. With the introduction of advanced manufacturing technologies or computer-aided manufacturing, the proportion of indirect costs were increased significantly. The drastic shift from direct to indirect cost requires more complex system of absorption and therefore, ABC was developed in order to calculate realistic cost of product. 

In the past, most of the manufacturing was considered as labour-intensive and machine depreciation cost was not significant, but with introduction of modern manufacturing environment, the dependence on machines was enhanced, resulting higher depreciation cost. It increased the indirect cost to higher extent than direct cost because of manufacturing environment was shifted from labour-intensive to machine-intensive. 

The increase in market competition and more complex manufacturing environments, the product range have increased. In this environment, the use of absorption costing may result in over-statement of cost due to higher volume or understatement of cost to product with low volume. ABC attempts to overcome this problem. 



. COST POOL AND COST DRIVER 

Cost Pool 

A cost pool is an activity which consumes resources and for which overheads costs are identified and allocated. Cost pool is major activity which accumulates the cost relevant to this specific activity. The term activity and cost pool are often used interchangeably. 

For example, set up or batch cost is cost pool and it accumulates any indirect cost relating to batch. More cost will be incurred in case of more batches are produced. 

Cost Driver 

A cost driver is a factor that influences or drives the level of cost of an activity. For example, number of batches is the cost driver as increase in number of batches will influence or drive the set-up cost. 

Following table explains the relation of cost pool and cost driver: 

Cost Pool               Cost driver 

Machine set up cost  Number of batches or set ups 

Materials handing cost  Number of production runs 

Dispatching cost          Number of orders dispatched 

Ordering cost            Number of customer’s orders 

Machine operational cost Number of machine hours 

Production scheduling cost Number of production run



COSTING UNDER ACTIVITY BASED COSTING 

Cost of product can be calculated under activity-based costing with help of five basic steps: 

Step-I 

Identify an organization’s major activities that support the manufacture of the organization’s products or services.  

Step-II 

Use cost allocation and apportionment methods to accumulate overhead costs to each of the organisation’s major activities. In other words, group production overheads into major activities of the organization. The costs that accumulate for each activity cost centre is called cost pool. 

Step-III 

Identify the factors which determine the size of the costs of an activity. It is called the cost driver and these are identified for each cost pool.  

Step-IV 

Calculate overhead absorption rate for each activity, which can be calculated by dividing the cost pool by its cost driver. 

Step-V 

Absorb the activity costs into products after charging overhead costs on the basis of their usage of the activity. Overheads are charged by absorbing them into product costs at a rate per unit of cost driver. 




MERITS AND DEMERITS OF ACTIVITY BASED COSTING 

Merits 

1. The complexity of manufacturing has increased due to use of advance technologies and multiple products range, along with shorter product life cycles. Activity based costing recognizes this complexity with multiple cost drivers. 

2. In competitive environment, entities must be able to assess its product profitability in more realistic manner. Activity based costing technique helped entities to absorb indirect costs into products on the basis of activities in order to calculate realistic product cost. 

3. Activity based costing can be applied to all overhead costs, and not restricted to production overheads. 

4. Activity based costing can be used easily in service costing as in product costing. 

Demerits 

1. Activity based costing will be of limited benefit if overhead costs are primarily volume related or overhead costs is not significant proportion of total costs. 

2. Cost apportionment may still be required at the cost poling stage for shared items of costs like rent, depreciation of building. Apportionment can be an arbitrary way of sharing costs. 

3. The cost of implementing and maintaining an activity-based costing system might exceed the benefits of improved accuracy in product or service costs. 

4. This model is difficult to understand and even can create problems in implementation due to fair understanding activities and their related costs. 

5. The choice of both activities and cost drivers might be inappropriate.