Q.) What do you mean by Activity Based Costing?

Explain the different concepts used in Activity Based Costing

like Cost Object & Cost Driver.
Ans. Simply put, activity-based costing is a process where costs are assigned due to the cause and effect relationship
between costs and the activities that drive costs. Traditional costing systems have a tendency to assign indirect costs based
on something easy to identify (such as direct labor hours). This method to assigning costs can be very inaccurate, as there
is not necessarily a relationship between the costs that are being assigned, and the activity they are being assigned to. This
can make evaluating costs tricky and inaccurate.
Activity-based costing is a type of costing system that can be used to assign costs more accurately to products and
departments in today's complex business world.
There are many types of costing systems available for businesses to use; most of these costing systems are designed to
assign costs to products. Activity-based costing (ABC) on the other hand is designed to assign costs to activities. ABC has
become popular due to the fact that as businesses grow in complexity, so does their need to assign increasingly large
indirect costs to the appropriate area or activity. Computers have contributed both to the complexity of businesses and to
their ability to track costs more closely through systems like activity-based costing.
Direct labour and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect
costs to products. Where products use common resources differently, some sort of weighting is needed in the cost
allocation process. The measure of the use of a shared activity by each of the products is known as the cost driver. For
example, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product's
transactions takes at the counter and then by measuring the number of each type of transaction.
A cost object is a tangible input for a product manufactured/Service provided, like labor or material. For example a cloth
manufacturing firm requires some amount of predetermined labor and predetermined raw material for any amount of cloth
being manufactured. The cost of employing labor can be directly fixed as "per man per hour" or "per man per day", so the
labor is a cost object as you can directly associate cost with it. Similarly the raw material like cotton or threads or fabric can
be another cost object. Other examples may include services taken by another firm, for example a transportation company/
courier company can offer some service to all customers at a fixed rate. So the cost can be directly associated with it and
the company/service can be then called as cost object.

Q.)What are the different steps involved in implementation of Activity Based Costing? Explain with case studies.

Ans.) Activity-Based Costing Procedures

Activity-based costing can be more complicated to set up and operate than other costing systems. Generally, the process
will look something like this:

• All activities that use resources are identified

• Cost pools are set up for each of the activities identified
• Overhead costs are assigned to the cost pools based on a cost driver
• A cost driver is an activity that has a proven cause and effect relationship with the costs associated with the cost
pool
• Cost drivers can be based off of resources or activities
• Only if a cost driver cannot be recognized will a cost be assigned on an allocative basis
• Related cost pools are assigned an overhead rate based on cost drivers
• Cost pools are used to assign costs; the basis depends on the company and industry
• Costs can then be assigned to units, batches, or products
• These pools can be combined to look at facility, division, or other levels of cost categories
• Costs can then be evaluated to see where and how costs are occurring, from that point management can discern
what costs are controllable and how they arise
 Conventional AB Costing
Costing Economic
Element Building an ABC Model
Expenses Resources
Identify Identify Identify
Resource Activitie Cost
s s Objects
Work
Activities Performed
Cost Objects Define Define
Activit Resourc
y e
Product or Drivers Drivers
Cost Objects service
Enter Enter Enter
Calculat
Resourc Resource Activity
e
e Driver Driver
Costs
Costs Qty. Qty.

BACKGROUND Sun Life Insurance is an international insurance company, providing individual and corporate life
insurance, group retirement services and benefit management services. The Canadian operations have offices located
throughout Canada; with the head office in Toronto.The Group Claims division provides drug and dental claim management
and claim adjudication to companies in Canada through its 4 main centres in Toronto, Ottawa, Edmonton and Montreal.
Clients include the Federal Government, City of Toronto, Royal Bank of Canada and Magna International.

Business Issues Several issues have led Sun Life to undertake the implementation of an Activity Based Costing (ABC)
analysis. Increased competition, the introduction of new computing technology, and increasing client demands have caused
margins to decrease and costs to rise. The increased costs and decreased per unit revenue have pressured management to
seek to reduce costs significantly to maintain profitable operating results.Competition and customer demands have forced
the organization to dramatically reduce the length of time to process a claim, while also increasing the due diligence
performed on each claim. Each processing center performs tasks using different operational processes, and standards with
greatly differing processing times for various types of claims. The organization needs to identify the best practice for each
process, and institutionalize that best practice across all their operations.To make management and strategic decisions,
senior management decided that a better set of decision-making tools were needed in the group claims division. This
includes better costing information and better performance data.

Approach Focused Management Information was engaged to assist the Group Claims division implement and internalize
an Activity Based Costing system, and then tie it in to best practice analysis, process improvement and budgeting.A cross-
functional team of eight Sun Life employees representing all locations, including group finance, was formed and guided
through the implementation process and the data collection with the ongoing assistance of FMI. After a thorough training on
ABC concepts and implementation methodology, the team conducted activity analysis on all positions in the group claims
area and then created a consolidated activity dictionary and Cost Flow Diagram, which represents all activities and
processes within the area, as well as maps the flow of activities throughout the area. "One of the things we’ve discovered
through our work with Focused Management is the simple act of examining what activities occur in which department has
yielded valuable insights and caused us to change the way we perform what we do", explains Henry Kowal, senior analyst
at Sun Life.The team, with the assistance of the systems department, collected resource and activity driver information and
entered all the information into their ABC software. Activity, process and unit activity costs were obtained and validated by
the team and then by senior division management.

Results The results of the ABC analysis provided a great deal of insight for the Sun Life senior management team, as well
as confirmed quantitatively what many managers assumed, but could never prove. Significant differences in activity cost,
process cost, cycle time, transaction volumes and unit costs were found both within locations and between the different
locations. In some cases, unit costs for the same activity varied by over 300%. These unit cost results varied by type of
claim, as well as the experience of the claims adjudicator.When the team looked at cycle time or FTE required to perform a
given volume of claims, large differences were found in the efficiency of the four processing centers as well as in the call
centers. Some locations could process a similar amount of claims, with a lot less personnel, than other locations. This has
led to a review of the activities, tasks and work flow in each location, with a view towards standardizing process steps as
much as possible, as well as learning from the most efficient areas.When compared with industry standards, outsource
partners and the different claims processing centers, Sun Life has been able to perform extensive benchmarking analysis.
The benchmark or best practice data has allowed them to determine how efficient and effective they are, compared with
where they can be, and has shown management where to concentrate the process improvement initiatives.The activity cost
and performance results have also allowed operations management to assess the "value" or utility of all the activities
performed within group claims. Some activities are performed which do not add any value to the process and are being
eliminated. Other activities have been found to be value adding, but are performed too often or cost too much every time
they are performed. These activities are in the process of being redesigned, so they will be performed at the right time and
cost.
Action Steps Faced with all this great new information, Sun Life, like all organizations, had to determine how best to use
the information and analysis to make changes in the way they run the business. The first step was to present the analysis to
operations management in each of the four processing locations, as well as to senior management. This was accomplished
through a full-day management briefing and workshop. The workshop provided managers an opportunity to "dive" into the
analysis and become comfortable with the results. Once they were comfortable with the results, the ABC project leader then
led the managers through an analysis of where further detail is required and what data the managers need to see on a go-
forward basis. Management then brainstormed all the uses of the ABC results and prioritized which uses were most
immediate. They then assigned responsibilities and resources, to make sure the actions were achieved. We have found that
the management workshop is a critical component in obtaining management buy-in, as well as getting management to
internalize the next steps with regard to the ABC analysis.Following the ABC management workshop, the ABC team and the
operations management set about on several action steps. The first priority was to conduct best practice analysis on their
operations. Process and work steps were shared amongst the various locations, and best practices were implemented
across the locations. This is an ongoing piece of a larger process redesign and improvement project.Ongoing education has
been a key component in the overall strategy to ensure managers understand the data and know how to use the information
properly to make decision. The continuous training and working with management has helped management understand the
results and has promoted buy-in on a continuous basis.The ABC results have focused management’s attention on the
importance of measurement and the management of those measures. The time, quality, quantity and financial data provided
by the ABC analysis has reinforced the concept of management through measurement within Sun Life. Decisions are now
beginning to be made within an overall measurement and management framework.A major focus for all managers within
group claims is now the management of unit costs across all the activities. With claims volume increasing at a steady rate, a
reduction of the unit cost of processing claims should result in an overall cost reduction for the division, and an increase in
profitability. By using the ABC data, managers have been able to significantly reduce the absolute activity cost, as well as
the unit cost of the major claims processing activities. "As a result of the ABC analysis, we have seen over a 10x reduction
in expenses compared with the implementation costs of ABC", explains Luc Chouinard, Manager, Expense Management.In
order to evaluate the progress being made with all these action steps, the ABC results have been updated several times,
and trend analysis has been undertaken to monitor the results on an activity basis. These updates are being completed
quarterly.

Next Steps As a result of the initial ABC analysis, several next steps are in the process of implementation. These include
the roll out of ABC within other divisions of Sun Life, the integration of the ABC results with ongoing NQI and ISO initiatives,
and the ongoing use in process redesign initiatives.The current ABC analysis concentrated on activities by position and their
associated cost, quantity, quality, cycle time and unit cost calculations. As the ABC analysis becomes further refined,
individual customer profitability will be analyzed. There is a recognition that customers have different profitability
characteristics that have an impact on service pricing and profitability. As a next step, activities will be costed at the unique
customer level to determine customer profitability.

Summary The ABC system implemented within Sun Life Group Claims has helped to realize significant reductions in
operational costs within the claims processing areas. The ability to compare the activities performed in different locations
has allowed operations management to install best practices observed at each location throughout all the centers. The ABC
information has acted as an important driver in implementing a measurement based management system, as well as helped
realize concrete results. ABC has been a catalyst for change within Sun Life.

Q.)What is Activity Based Costing Management and what are the different types of cost which are analyzed in
Activity Based Costing?

Ans.) In a business organization, the ABC methodology assigns an organization's resource costs through activities to the
products and services provided to its customers. It is generally used as a tool for understanding product and customer cost
and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing and
identification and measurement of process improvement initiatives. Traditionally cost accountants had arbitrarily added a
broad percentage of expenses onto the direct costs to allow for the indirect costs. However as the percentages of indirect or
overhead costs had risen, this technique became increasingly inaccurate because the indirect costs were not caused
equally by all the products. For example, one product might take more time in one expensive machine than another product,
but since the amount of direct labor and materials might be the same, the additional cost for the use of the machine would
not be recognized when the same broad 'on-cost' percentage is added to all products. Consequently, when multiple
products share common costs, there is a danger of one product subsidizing another.

The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s. During
this time, the Consortium for Advanced Manufacturing-International, now known simply as CAM-I, provided a formative role
for studying and formalizing the principles that have become more formally known as Activity-Based Costing.

Robin Cooper and Robert S. Kaplan, proponent of the Balanced Scorecard, brought notice to these concepts in a number of
articles published in Harvard Business Review beginning in 1988. Cooper and Kaplan described ABC as an approach to
solve the problems of traditional cost management systems. These traditional costing systems are often unable to
determine accurately the actual costs of production and of the costs of related services. Consequently managers were
making decisions based on inaccurate data especially where there are multiple products.

Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and affect relationships to
objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each
product to the extent that the product uses the activity. In this way ABC often identifies areas of high overhead costs per unit
and so directs attention to finding ways to reduce the costs or to charge more for costly products.Activity-based costing was
first clearly defined in 1987 by Robert S. Kaplan and W. Bruns as a chapter in their book Accounting and Management: A
Field Study Perspective.[2] They initially focused on manufacturing industry where increasing technology and productivity
improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative
proportion of indirect costs. For example, increased automation has reduced labor, which is a direct cost, but has increased
depreciation, which is an indirect cost.

Like manufacturing industries, financial institutions also have diverse products and customers which can cause cross-
product cross-customer subsidies. Since personnel expenses represent the largest single component of non-interest
expense in financial institutions, these costs must also be attributed more accurately to products and customers. Activity
based costing, even though originally developed for manufacturing, may even be a more useful tool for doing this. In cost
accounting, a part of management accounting, fixed costs are expenses that do not change in proportion to the activity of a
business, within the relevant period or scale of production. For example, a retailer must pay rent and utility bills irrespective
of sales. Unit fixed costs, called average fixed costs (AFC), decline with volume, following a rectangular hyperbola as the
inverse of the volume of production: AFC = FC/N.

Variable costs by contrast change in relation to the activity of a business such as sales or production volume. In the
example of the retailer, variable costs may primarily be composed of inventory (goods purchased for sale), and the cost of
goods is therefore almost entirely variable. In manufacturing, direct material costs are an example of a variable cost. An
example of variable costs are the prices of the supplies needed to produce a product.Along with variable costs, fixed costs
make up one of the two components of total cost. In the most simple production function, total cost is equal to fixed costs
plus variable costs.

In microeconomics and business, the difference between fixed costs and variable costs (and the related terms average cost
and marginal cost) is crucial, as each will influence production decisions for profit maximization differently. In the most
simple cases, fixed costs do not affect production decisions, because they cannot be changed, and management will
choose to produce if sales prices are above the cost of each additional unit (marginal cost).Fixed costs should not be
confused with sunk costs. From a pure economics perspective, fixed costs may not be fixed in the sense of invariate; they
may change, but are fixed in relation to the quantity of production for the relevant period. For example, a company may have
unexpected and unpredictable expenses unrelated to production, and these would not be considered part of variable costs.It
is important to understand that fixed costs are "fixed" only within a certain range of activity or over a certain period of time. If
enough time passes, all costs become variable. Similarly, not all indirect costs are fixed costs; for example, advertising
expenses or labour costs are indirect costs that are variable over a slightly longer time frame, as they may not be subject to
change in the short term, but may be easily adjustable over a longer time frame. For example, a firm may not be able to vary
the number of employees (and hence labour costs) in the short term due to contract obligations, but be able to lay
employees off or otherwise change these costs.In accounting terminology, fixed costs will broadly include all costs
(expenses) which are not included in cost of goods sold, and variable costs are those captured in costs of goods sold. The
implicit assumption required to make the equivalence between the accounting and economics terminology is that the
accounting period is equal to the period in which fixed costs do not vary in relation to production. In practice, this
equivalence does not always hold, and depending on the period under consideration by management, some overhead
expenses (such as sales, general and administrative expenses) can be adjusted by management, and the specific
allocation of each expense to each category will be decided under cost accounting.In business planning and management
accounting, usage of the terms fixed costs, variable costs and others will often differ from usage in economics, and may
depend on the intended use. For example, costs may be segregated into per unit costs (costs of goods sold), fixed costs per
period, and variable costs as a proportion of revenue. Capital expenditures will usually be allocated separately, and
depending on the purpose, a portion may be regularly allocated to expenses as depreciation and amortization and seen as
a fixed cost per period, or the entire amount may be considered upfront fixed costs.