Activity Based Costing [ABC] 

Activity-Based Costing1 (ABC), a business practice was invented by Dr. Robert Kaplan of Harvard. In
this system costs are collected and accounted activity-wise, so that return on investment and
improvement effectiveness can be evaluated.

 
Activity Based Costing:
2.3.1 Definition:- CIMA defines Activity Based Costing as, ‘cost attribution to cost units on the basis of
benefit received from indirect activities e.g. ordering, setting up, assuring quality.’
Another definition of Activity Based Costing is, ‘ the collection of financial and operational
performance information tracing the significant activities of the establishment to product costs.’
2.3.2 Objectives of Activity Based Costing
1. To remove the distortions in computation of total costs as seen in the traditional costing system and
bring more accuracy in the computation of costs of products and services.
2. To help in decision making by accurately computing the costs of products and services.
3. To identify various activities in the production process and further identify the value adding activities.
4. To distribute overheads on the basis of activities.
5. To focus on high cost activities.
6. To identify the opportunities for improvement and reduction of costs.
7. To eliminate non value adding activities.

2.3.3 Steps in Activity Based Costing

The steps in Activity Based Costing are explained below.
1. Understanding and analyzing manufacturing process:-
For installation of any costing system, study of manufacturing process is essential. For Activity Based
Costing system also, it is necessary to study the manufacturing process and ascertain various stages
involved in the product or service so that ‘activities’ involved in that can be identified.
2. Study of the Activities involved:-
The next step is to study the activities involved in the manufacturing process. In this step, the activities
involved in a process are identified.
For example, in a bank, opening of an account is one of the services offered to customers In this
service, activities involved are studied. It may be revealed that opening of a new account involves
activities like issuing the application form, verification of the same and accepting the initial amount
required for opening of an account.
Similarly in case of a manufacturing company, purchase procedure may involve activities like receiving
of purchase requisition for concerned department or the stores department, inviting quotations from
various suppliers, placing of an order, follow up of the same and finally receiving and inspection of the
goods.
In case of an educational institute, activities in a library may include activities like issue of books,
receipt of books, ordering new books, stock taking, removing obsolete and outdated books, identification
of slow moving and fast moving items etc. In this manner, whether in manufacturing or in service sector,
activities are identified and the next step is to divide the activities into value adding and non value
adding. The objective behind this is that attention can be focused on the value adding activities while non
value adding activities can be eliminated in the future.
3. Activity Cost Pool:-
Cost pool is defined by CIMA as, ‘the point of focus for the costs relating to a particular activity in an
activity based costing system.’
For example, in case of a manufacturing organisation, as regards to stores, cost of classification, cost
of issue of stores requisitions, inspection costs etc. can be pooled under the heading ‘stores’. Thus
cost pool concept is similar to the concept of cost center. The cost pool is the point of focus or in other
words, it is the total cost assigned to an activity. It is the sum of all the cost elements assigned to an
activity.
4. Cost Drivers:-
According to CIMA, ‘cost driver is any factor which causes a change in the cost of an activity,e.g. the
quality of parts received by an activity is a determining factor in the work required by that activity and
therefore affects the resources required. An activity may have multiple cost drivers associated with it.’
In other words, cost driver means the factors which determine the cost of an activity. For example, in
stores, no. of stores requisitions will be cost drivers, in customer order processing the no. of customers
as well as no. of orders will be cost drivers
Thus a cost driver is an activity which generates cost. Activity Based Costing is based on the belief that
activities cause costs and therefore a link should be established between activities and product. The cost
drivers thus are the link between the activities and the cost.
5. Identification of costs with the products:-
The final step in Activity Based Costing is to identify the cost with the final products which can also be
called as cost objects. Cost objects include, products, services, customers, projects and contracts.
As mentioned earlier, direct costs can be identified easily with the products but the indirect costs can be
linked with the products by identifying activities and cost drive` Thus Activity Based Costing is the
process of tracing costs first from resources to activities and then from activities to specific products.
To conclude that, the Activity Based Costing is a costing system, that tries to charge the indirect costs to
the products and services fairly and accurately. However for effective implementation there is a need of
involvement of the staff and their training on continuous basis. Similarly there is a need to review the
working of the system at periodic intervals and keep a follow up of the feedback received. These actions
will ensure effective implementation of the system. Support of top management is also required for
effective implementation of this system. Activity Based Costing system is definitely a better system but
much depends on the implementation of the same.
2.3.4 Limitations of Activity Based Costing:
1. Activity Based Costing is a complex system and requires lot of records and tedious calculations.
2. For small organisations, traditional cost accounting system may be more beneficial than Activity Based
Costing due to the simplicity of operation of the former.
3. Sometimes it is difficult to attribute costs to single activities as some costs support several activities.
4. There is a need of trained professionals who are limited in number.
5. This system will be successful if there is a total support from the top management.
6. Substantial investment of time and money is required for the implementation of this system.
Activity, Resource and Cost Drivers
For activity-based costing, several terms are used viz. activity, resource, activities, resource consumption
cost driver, and activity consumption cost driver.
An activity is a specific task or action of work done such as Production set-up, number of purchase
orders etc.
The activities may also be work performed by people, equipment, technologies or facilities.
Activities comprises of all operational activities including management and support functions.
Activities consist of sub-activities and processes and sub-processes.
l A resource is an economic element needed or consumed in processing products or performing

activities such as salaries and supplies. The resources can be taken from the General Ledger or Chart of
Accounts.
A cost driver is the underlying factor(s) which causes the incurrence of cost relating to that activity and
helps to attribute the cost as accurate to the activity as far as possible. Cost drivers are the variables that
can be used to explain the behavior of activity costs. They reflect the consumption of costs by activities
and the consumption of activities by other activities, products, or services.
A cost driver is either a Resource consumption cost driver or an Activity consumption cost driver:
— Resource consumption cost drivers measure the amount of resources consumed by an activity, such
as the number of items in a purchase or sales order or labour hours or machine hours etc.
— Activity consumption cost drivers measure the amount of activity performed for an object, such
as the number of batches used to manufacture a product.