Activity Based Costing

1 Activity Based Costing – Defined

ABC identifies the activities and accumulates the cost under each activity and then divides the accumulated activity cost among products on the basis of proportion of activity consumed by each product.

1.1 Overhead absorption basis

We can absorb/allocate/distribute overheads using:

  • Plant wise (plant wide absorption rate)
  • Department wise (Departmental absorption rate)
  • Activity wise (activity based costing, ABC)

1.2 How ABC works

In ABC, cost is allocated in two stages, just like traditional cost (which also allocates cost in 2 stages). However, instead of assigning overhead costs only to departments in stage one, overhead costs are assigned to a larger number of cost pool that represent the most significant activities comprising the production process.

After assigning costs to the activity cost pools in stage one, cost drivers are identified that are appropriate for each cost pool. Then in stage two the overhead costs are allocated from each activity cost pool to each production job in proportion to the amount of activity consumed by the job.

1.2.1 What is cost pool?

Summation of all the costs related to specific activity. For example all costs related to inspection will be cumulated under the name “Inspection Cost” and the total of these will be Inspection cost pool.

1.2.2 What is cost driver?

It is an activity that causes the cost to increase. Inspection costs will increase with the number of inspections done.

1.3 ABC Costing Summarized

  • Stage 1
    • Step 1: Identify activities comprising the production process
    • Step 2: Divide Total overheads under activities to form cost pools
  • Stage 2
    • Step 3: Identify Cost drivers
    • Step 4: Distribute the cost driver in each product using absorption rate 

2 Merits and Demerits of ABC

2.1 Merits

  1. With the introduction of cost drivers, we can allocate overheads more accurately even in complex production processes in which tradition overhead allocation method does not seem to be reliable.
    Traditional system tends to allocate too great a proportion of overheads to high volume products (even if they are insignificant) and allocates too small a proportion of overheads to low volume products. This happens because traditional system usually uses only two bases i.e. Direct Material, Direct Labor. Therefore high volume products have high cost of material and labor, and as overhead are attached with one of these costs it tends to behave in the same pattern resulting in inaccurate product costs.
  2. ABC accumulates costs on the basis of cost activities and thus it is easy to understand and control the application of cost on products
  3. As ABC focuses on activities so all costs are taken into consideration and form part of the product, where as in traditional system only such costs were included which were incurred inside factory. Customer service, product design etc.

2.2 Demerits:

  1. Finding appropriate cost driver is not an easy task especially in case of non volume cost drivers.
  2. It intensely focuses on activities related to production and almost ignores the non production activities and remain silent how to deal with such costs, like audit fees etc.
  3. It is costly as we have to keep track of all costs with respect to every activity