04/12/23 VACA 1

CA.Chandra Sekhar VeeraghantaCA.Chandra Sekhar Veeraghanta

A B C A B C Activity Based Activity Based

CostingCosting

04/12/23 VACA 2

ABC Concepts What is ABC ?

Inventory Valuation method ? Yes, if it replaces traditional full absorption/ variable

costing method Resource Consumption Decision Support

Model ? Yes, provides info about how & why resources are

consumed Cost Accumulation Method ?

Does not replace job order costing & process costing but, enhances the accuracy of product costs

04/12/23 VACA 3

Problems with Traditional Systems

Product Cost Distortions O/H allocation based on production volume

while the consumption of resources is not in proportion to volume of products produced.

Excluding Non-Manufacturing Costs Product related Design, Admin, Selling &

Distribution, Customer Service costs are not traced to inventory

04/12/23 VACA 4

Causes for Product Cost Distortions Product Volume Diversity

Low Volume product receives low O/H High Volume product receives high O/H Both products require Engg., Purchase, etc support

irrespective of number of units produced.

Product Diversity Small products require less production volume related

inputs – such as direct labour; but, may not necessarily mean less on support.

Small product – design complexity, longer setup hrs etc

04/12/23 VACA 5

SUMMARY OF COST DISTORTIONSTHAT TEND TO OCCUR IN TRADITIONAL COST SYSTEMS

TYPE OF DIVERSITY

PRODUCT TYPE OR CHARACTERISTIC

TYPE OF COST DISTORTION THAT TENDS TO OCCUR IN 

TRADITIONAL COST SYSTEMS

Production volume Low Volume specialty Undercost, i.e., too little overhead is allocated to these products.

High Volume main line Overcost, i.e., too much overhead is allocated to these products.

Product Size Small Undercost

Large Overcost

Product Complexity Complex design Undercost

Simple design Overcost

Product Materials requirements

Requires many, or unique parts, i.e., only used on a single product.

Undercost 

Requires few, or common parts, i.e., same part used on many products.

Overcost

Product Machine setup requirements

Requires many, long or complex machine setups.

Undercost

Requires few, short or simple machine setups.

Overcost

04/12/23 VACA 6

The Logic of ABC

Designing, Producing & Distribution of Products/ service requires – activities to be performed.

Performing these activities requires resources – to be purchased & used

Using Resources - costs

04/12/23 VACA 7

The Logic of ABC

Restate in reverse order :

Resources generate costs

Activities consume resources

Products consume activities

04/12/23 VACA 8

The Logic of ABC

04/12/23 VACA 9

The Logic of ABC

Company’s activities are identified Costs are traced to these activities ( or activity cost pools ) based on the resources they require Costs are traced / assigned from each of these activity cost pools to the products / services in proportion to the demands that each product places on each activity.

04/12/23 VACA 10

ACTIVITY VOLUME – ACTIVITY MEASURES

Activity Volume refers to an input or output measurement of the quantity of the work performed to accomplish an activity.

These measurements may represent the frequency, duration, or physical volume of an activity

ABC uses both production volume and non-production volume activity measures to trace costs

04/12/23 VACA 11

EXAMPLES OF ACTIVITY COST POOLS AND ACTIVITY MEASURES

ACTIVITY COST POOL POTENTIALLY USEFUL ACTIVITY MEASURES

PROBABLE COST CLASSIFICATION*

Machining parts Number of machine hours. Unit level.

Purchasing Number of purchase orders or ordering hours.

Product or batch level.

Receiving and Storing Number of purchase orders or shipments received.

Product or batch level.

Engineering Number of engineering work orders or hours.

Product level.

Packing Number of shipments, number of cubic feet or packing hours.

Product or batch level.

Shipping Number of pounds shipped. Product or batch level.

Machine Setup Number of setups or setup time. Batch level.

Materials handling Number of times handled or material handling hours.

Product or batch level.

Inventory control and materials planning Number of part numbers or administrative hours.

Product or batch level.

Inspection and quality control Number of inspections or inspections time. Product or batch level.

04/12/23 VACA 12

ABC COST HIERARCHY A cost classification scheme which places

all costs into one of the following categories : Unit level – the cost of an activity required

once each time a unit of product is produced. Batch level – the cost of an activity required

each time a batch of products is produced. Product level – the cost of an activity required

to support a specific type of product.

…

04/12/23 VACA 13

ABC COST HIERARCHY A cost classification scheme which places

all costs into one of the following categories : … Facility Level – the cost of an activity

associated with maintaining the facility or plant Customer level – the cost of an activity

required to support a specific customer

04/12/23 VACA 14

Activities – Drivers - Measures

Activities : Types of work performed – purchasing, designing etc

Cost and Activity Drivers : Underlying cause for the cost

Activity Measure : A unit of measurement chosen to represent the activity volume

04/12/23 VACA 15

ABC CONCEPTS AND TERMINOLOGY

Activities - A type of work or function.

Type Definition Examples

Main activitiesA major type of work, function or high level activity.

Purchasing raw materials.

Sub activitiesA lower level type of work, or activity that supports a main activity.

Preparing purchased orders.

TasksA minor type of work that supports a sub activity.

Calling vendors.

Sub tasks Part of a task.Dialing a vendor's phone number.

04/12/23 VACA 16

ABC CONCEPTS AND TERMINOLOGY

Drivers - Whatever causes the need for activities to be performed.

Type Definition Examples

Primary drivers

The initial cause of an activity that requires resources, i.e., whatever creates the demand for an activity.

Company's overall objectives, customer demands and product specifications.

Secondary drivers

A resource consuming activity that is caused by a previous activity or event.

Purchasing raw materials, preparing purchase orders.

04/12/23 VACA 17

ABC CONCEPTS AND TERMINOLOGY

Activity measures - A unit of measure chosen to represent an activity volume.

Type Definition Examples

Frequency measures

The number of times an activity is performed.

Number of purchase orders, number of engineering work orders.

Duration measures

The time consumed performing the activity.

Ordering hours, engineering hours, machine hours.

Physical measures

The quantity of a resource processed by an activity.

Cubic feet packed, pounds shipped.

04/12/23 VACA 18

ABC TECHNIQUE

FOUR STEPS IN DESIGNING AN ABC SYSTEM OR SUB-SYSTEM

1) identifying a company's main activities, 2) determining the primary and secondary

drivers for these activities, 3) aggregating activities into homogenous

cost pools and 4) selecting activity measures to represent

each pool.

04/12/23 VACA 19

THREE STEPS TO OBTAIN ABC COSTSTHREE STEPS TO OBTAIN ABC COSTS

1) Calculate the activity overhead rates for each activity cost pool by dividing the total annual cost of each cost pool by the total annual quantity of the activity measure associated with each pool. More precisely in equation form:

    Rj = Annual costs of activity j ÷ Annual quantity of activity j

where: Rj = the activity overhead rate for activity j.

      j = the number of the activity.

04/12/23 VACA 20

THREE STEPS TO OBTAIN ABC COSTSTHREE STEPS TO OBTAIN ABC COSTS

2) Determine the total annual costs of each product by multiplying the activity overhead rates by the activity quantities associated with each product as follows,

    Ci = Di + Σ (Rj)(Aji)where: Ci = Total annual cost of product i.           Di = Direct cost of product i.          Aji = Quantity of activity j consumed by product i.           Rj = the activity overhead rate for activity j.             j = the number of the activity.             i = the number of the product.            Σ = Sigma sign meaning "the sum of".

04/12/23 VACA 21

THREE STEPS TO OBTAIN ABC COSTSTHREE STEPS TO OBTAIN ABC COSTS

3) Calculate each product's unit costs by dividing the total annual costs for each product i by the number of units of product i produced.

    ABC unit cost for product i = Ci ÷ Units of

product i.

04/12/23 VACA 22

EXAMPLEEXAMPLE ANNUAL PRODUCT DATA FOR COMPANY A

PRODUCT RELATED DATA V1 V2

Annual production quantity in unitsMaterial cost per unitDirect labour hours per unitDirect labour cost per hourNumber of purchase orders required per yearNumber of engineering work orders required per yearNumber of machine setups required per year

100 Rs.50

1Rs.10

142

1,000 Rs.50

1Rs.10

284

ANNUAL ACTIVITY COSTS FOR COMPANY A

ACTIVITYANNUALCOSTS ACTIVITY MEASURE

Purchasing and receivingEngineeringMachine setupMachining, power & maintenanceMaterials planning & handlingTotal factory overhead costs

Rs.24,00018,00024,60022,00011,000

Rs.99,600======

  Number of purchase orders  Number of engineering work orders  Number of machine setups  Number of direct labour hours  Number of materials rupees

04/12/23 VACA 23

EXAMPLEEXAMPLE

ARE THERE ANY HOMOGENEOUS COST POOLS ? one for non-production volume related costs

and one for production volume related costs consumption proportions for the three non-

production related costs pools (purchasing/receiving, engineering and setups) are the same and

consumption proportions for the two production related cost pools (machining/power/maintenance, and materials planning/ handling) are the same

Combine the cost pools into a single homogeneous cost pool and trace to products

04/12/23 VACA 24

EXAMPLEEXAMPLE

ANNUAL ACTIVITY COSTS FOR COMPANY ACOMBINED HOMOGENEOUS COST POOLS

ACTIVITY POOL ANNUALCOSTS

ACTIVITY MEASURE

Non-production volume relatedProduction volume relatedTotal factory overhead costs

 Rs.66,60033,000

Rs.99,600

 Number of purchase orders Number of direct labour hours

04/12/23 VACA 25

Calculating ABC Costs for Company A

Step 1: Calculating Activity Overhead Rates Rj = Annual costs of activity j ÷ Annual quantity of activity j

1. Non-production volume related = Rs.66,600 ÷ 3* = Rs.22,200 per purchase order.* Total purchase orders = 1 for V1 and 2 for V2.

2. Production volume related = Rs.33,000 ÷ 1,100* = Rs.30 per direct labour hour.* Total direct labour hours = 100 for V1 and 1,000 for V2.

EXAMPLEEXAMPLE

04/12/23 VACA 26

EXAMPLEEXAMPLE COMPANY ACOSTS TRACED TO PRODUCTS V1 AND V2

USING AN ACTIVITY BASED COST (ABC) SYSTEM

 

COST POOL OR CATEGORY

ACTIVITY RATE MULTIPLIED BY

QUANTITY OF ACTIVITY MEASURE

(Rj)(Aji)

 C1=COST

TRACED TO V1

ABC UNIT COST

V1*

 C2=COST

TRACED TO V2

ABCUNIT COST

V2**

1. Non-production volume related:

(Rs.22,200)(1 PO)(Rs.22,200)(2 PO'S)

Rs.22,200 Rs.222.00Rs.44,400 Rs.44.40

2. Production volume related:

(Rs.30)(100 DLH)(Rs.30)(1,000 DLH)

3,000 Rs.30.0030,000 30.00

Total Overhead   Rs.25,200 Rs.252.00 Rs.74,400 Rs.74.40

3. Direct Material: (Rs.50)(100)(Rs.50)(1,000)

5,000 50.0050,000 50.00

4. Direct Labour: (Rs.10)(1hr)(100)(Rs.10)(1hr)(1,000)

1,000 10.0010,000 10.00

Totals   Rs.31,200=======

Rs.312.00======

Rs.134,400=======

Rs.134.40======

04/12/23 VACA 27

EXAMPLEEXAMPLECOMPANY A

COST TRACED TO PRODUCTS V1 AND V2 USING ATRADITIONAL PRODUCTION VOLUME BASED (PVB) COST SYSTEM

 COST POOL OR

CATEGORY

ACTIVITY RATE MULTIPLIED BY

QUANTITY OF ACTIVITY MEASURE

COST ALLOCATED TO

V1

PVB UNIT COST

V1*

COST ALLOCATED TO

V2

PVB UNIT COST V2**

1.Non-production volume related:

(Rs.60.5455)(100DLH)(Rs.60.5455)(1,000)

Rs.6,054.55 Rs.60.55Rs.60,545.45 Rs.60.55

2. Production volume related:

(Rs.30)(100 DLH)(Rs.30)(1,000)

3,000.00 Rs.30.0030,000.00 30.00

Total Overhead   Rs.9,054.55 Rs.90.55 Rs.90,545.45 Rs.90.55

3. Direct Material: (Rs.50)(100 units)(Rs.50)(1,000)

5,000.00 50.0050,000 50.00

4. Direct Labour: (Rs.10)(1hr)(100 units)(Rs.10)(1hr)(1,000)

1,000.00 10.0010,000 10.00

Totals   Rs.15,054.55========

Rs.150.55======

Rs.150,545.45========

Rs.150.55======

04/12/23 VACA 28

EXAMPLEEXAMPLE

04/12/23 VACA 29

EXAMPLE 2EXAMPLE 2ANNUAL PRODUCT DATA FOR COMPANY B

PRODUCT RELATED DATA V2 V3

Annual production quantity in unitsMaterial cost per unitDirect labour hours per unit Direct labour cost per hourNumber of purchase orders requiredNumber of engineering work orders requiredNumber of machine setups required

1,000Rs.50

1Rs.10

284

1,000Rs.500

10Rs.10

284

04/12/23 VACA 30

EXAMPLE 2EXAMPLE 2ANNUAL ACTIVITY COSTS FOR COMPANY B

SEPARATE AND COMBINED HOMOGENEOUS COST POOLS

ACTIVITYANNUAL COSTS

ACTIVITY MEASURE

Purchasing and receiving EngineeringMachine setupNon-production volume related

Machining, power & maintenanceMaterials planning & handlingProduction volume relatedTotal factory overhead costs

Rs.32,000 24,00032,800

Rs.88,800

220,000110,000330,000

Rs.418,800=======

 Number of purchase orders Number of engineering work orders  Number of machine setups Number of purchase orders

 Number of direct labour hours Number of materials rupees Number of direct labour hours

04/12/23 VACA 31

Calculating ABC Costs for Company B

Step 1: Calculating Activity Overhead Rates Rj = Annual costs of activity j ÷ Annual quantity of activity j

1. Non-production volume related = Rs.88,800 ÷ 4* = Rs.22,200 per purchase order.* Total purchase orders = 2 for V2 and 2 for V3.

2. Production volume related = Rs.330,000 ÷ 11,000* = Rs.30 per direct labour hour.* Total direct labour hours = 1,000 for V2 and 10,000 for V3.

EXAMPLE 2EXAMPLE 2

04/12/23 VACA 32

EXAMPLE 2EXAMPLE 2 COMPANY BCOST TRACED TO PRODUCTS V2 AND V3

USING AN ACTIVITY BASED COST (ABC) SYSTEM

 COST POOL OR

CATEGORY

ACTIVITY RATE MULTIPLIED BY

QUANTITY OF ACTIVITY MEASURE (Rj)(Aji)

C2=COST TRACED TO

V2ABC UNIT COST V2*

C3=COST TRACED TO

V3

ABCUNIT COST

V3**

1. Non-production volume related:

(Rs.22,200)(2 PO'S)(Rs.22,200)(2 PO'S)

Rs.44,400 Rs.44.40Rs.44,400 Rs.44.40

2. Production volume related:

(Rs.30)(1,000 DLH)(Rs.30)(10,000 DLH)

30,000 Rs.30.00300,000 300.00

Total Overhead   Rs.74,400 Rs.74.40 Rs.344,400 Rs.344.40

3. Direct Material: (Rs.50)(1,000 units)(Rs.500)(1,000 units)

50,000 50.00500,000 500.00

4. Direct Labour: (Rs.10)(1hr)(1,000)(Rs.10)(10hrS)(1,000)

10,000 10.00100,000 100.00

Totals   Rs.134,400=======

Rs.134.40======

Rs.944,400=======

Rs.944.40======

04/12/23 VACA 33

EXAMPLE 2EXAMPLE 2COMPANY B

COST TRACED TO PRODUCTS V2 AND V3 USING ATRADITIONAL PRODUCTION VOLUME BASED (PVB) COST SYSTEM

COST POOL OR CATEGORY

ACTIVITY RATE MULTIPLIED BY QUANTITY OF

ACTIVITY MEASURE

COSTALLOCATED TO

V2PVB UNIT COST V2*

COST ALLOCATED TO

V3PVB UNIT COST V3**

1.Non-production volume related:

(Rs.8.0727)(1,000)(Rs.8.0727)(10,000)

Rs.8,072.70 Rs.8.07Rs.80,727.00 Rs.80.73

2. Production volume related:

(Rs.30)(1,000 DLH)(Rs.30)(10,000)

30,000.00 Rs.30.00300,000.00 300.00

Total Overhead   Rs.38,072.70 Rs.38.07 Rs.380,727.00 Rs.380.73

3. Direct Material: (Rs.50)(1,000 units)(Rs.500)(1,000 units)

50,000.00 50.00500,000 500.00

4. Direct Labour: (Rs.10)(1hr)(1,000)(Rs.10)(10hrs)(1,000)

10,000.00 10.00100,000 100.00

Totals   Rs.98,072.70========

Rs.98.07======

Rs.980,727========

Rs.980.73======

04/12/23 VACA 34

Thank youThank youThank youThank you