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 Activity Based costing allows an organization
to determine the actual cost associated with
each product and service produced by the
organization. 

 The goal is to measure and then price out all

the resources used for activities that support
the production and delivery of products and
services to customers 
 An organization performs activities to do its
business. These activities define the business
you are in. 

 All activities consume resources and the cost of

these can be calculated. 

 The basis of ABC is to look at the activities

required to produce the cost of the product or
service.  
 Activity
 Resource
 Cost of the activity
 Cost driver
 Activity driver
 Cost object
Conventional Costing AB Costing
Economic
Resources Element
Expenses

Work
Activities
Performed
Cost Objects

Product or
Cost Objects
service
 Understand TRUE profitability of products or services

 Quantify the cost of non-value added activities such as errors

and reworks

 Identify opportunities to reduce costs and/or increase

efficiency

 Obtain actionable information to negotiate price increases for

unprofitable clients

 To minimise overhead costs so they can be managed more

effectively
 What activities are being performed by the
organisational resources?

 How much does it cost to perform activities?

 Why does the organization need to perform those

activities?

 How much of each activity is required for the

organization's products, services, and customers?
 Pricing & product-mix decisions

 Cost reduction & process

improvement decisions
 WITHOUT ABC WITH ABC
 Direct materials  Direct materials

 Direct manufacturing  Direct manufacturing

overheads overheads

 Direct labour hours  Direct labour hours

 Other indirect overhead

included in direct overheads
The first stage in an initial ABC study is to develop a
fundamental understanding of the Resources (expenditures)
and Activities (work performed) of an organization. The
Resources are then mapped to the Activities, thereby
quantifying the cost of performing each of these Activities.
These costs are traced to Cost Objects (customers, products,
or services) providing tremendous insight into where an
organization is making and losing money.
 Resources Activities

Expenditure Work Performed Cost of each

activity

• Product’s • Service’s • Customer’s

 Identify the Resources
 Determine Activities
 Define Cost Objects
 Develop Resource Drivers
 Develop Cost Drivers
 Resources represent the expenditures of an organization.
These are the same costs that are represented in a
traditional accounting view; unlike traditional
accounting, ABC links these costs to products,
customers, or services.
 Production Labour
 Sales and Marketing Labour
 Occupancy
 Utilities
 Expenses and Supplies
 Etc…..
Activities represent the work performed in an
organization. ABC Activities for the sales department in
a typical organization might include:
 Making sales calls to existing customers
 Making sales calls to potential customers
 Making customer service calls
 Training product representatives
 Evaluating products and improving product knowledge
 Distributing samples
 Attending trade shows and other events
ABC provides profitability by one or more cost object,
usually represented by products, customers, and/or
services.

Cost Object profitability is utilized to identify money

losing customers, to validate separate divisions or
business units, or to measure the performance of
individual projects, jobs, or contracts. Defining the
outputs to be viewed is an important step in a successful
ABC implementation.
Resource Drivers provide the link between the
expenditures of an organization and the Activities
performed within the organization.

For example, the total salary of a customer service

representative would likely be allocated to the Activities
performed based on the amount of time spent performing
the Activity. If 50% of her time is spent performing the
activity, taking orders for existing customers, 50% of her
salary (including all costs such as benefits, taxes, and
insurance) would be allocated to this Activity.
Determination of Cost Drivers completes the last stage of
the model. Cost Drivers trace, or link, the cost of
performing certain Activities to Cost Objects.

For example, taking orders for existing customers may be

linked to specific customers based on the number of
orders taken, if each order takes approximately the same
amount of time. If order taking time varies based on the
customer, this cost may be linked based on another driver
or multiple drivers.
 PRODUCT A
 Low in Volume
 Requirements:
 Special Engineering
 Additional Testing
 Many machine Setups
 Ordered in small quantities
PRODUCT B
 High in Volume
 Requirements:
 Little attention
 No special activity
 Ordered in large quantities
 Running continuously

-If traditional costing is used here, overhead will be allocated

on the number of machine hours used.
- Product B will have more machine hours so the cost will be
more in product B.
- This will lead to miscalculation & true cost not be determined.
 Activity Based Costing includes Special Engineering,
Special Testing, machine setups & other such activities
that include cost.

 This cost will be assigned to the products that demands

such activities.

 In our example product A will be charged with all such

cost. Whereas, in case of product B special activities cost
will not be include.
(1) The setting up of a production machine for running batches of
products, and
(2) the actual production of the units of product.
 Assumptions:
 Annual Manufacturing Overhead Rs. 20 lacs

 Out of which Rs. 2 lacs are used for setting up the

production units.
 Total 400 machine setup a year.

 Batch size will vary from batch to batch.

 Total machine hours is 1,00,000.

 With ABC Without ABC

Mfg overhead costs assigned to setups Rs.200,000 Rs.–0–

Number of setups 400 Not applicable

    Mfg overhead cost per setup Rs.500 Rs.–0–

Total manufacturing overhead costs Rs.2,000,000 Rs.2,000,000

Less: Cost traced to machine setups 200,000 –0–

Mfg O/H costs allocated on machine hours Rs.1,800,000 Rs.2,000,000

Machine hours (MH) 100,000 100,000

    Mfg overhead costs per MH Rs.18 Rs.20

Rs.500 setup cost per batch +

Mfg Overhead Cost Allocations Rs.20 per MH
Rs.18 per MH
 Let's see what impact these different allocation techniques
and overhead rates would have on the per unit cost of a
specific unit of output.

 Assume that a company manufactures a batch of 5,000

units and it produces 50 units per machine hour, here is
how the cost assigned to the units with activity based
costing and without activity based costing compares:
 With ABC Without ABC

Mfg overhead for setting up machine Rs.500 Rs.–0–

No. of units in batch 5,000 Not applicable

    Mfg O/H caused by Setup – Per Unit Rs.0.10 Not applicable

Mfg overhead costs per machine hour Rs.18 Rs.20

No. of units produced per machine hour 50 50

    Mfg O/H caused by Production – Per Unit Rs.0.36 Rs.0.40

Total Mfg O/H Allocated – Per Unit Rs.0.46 Rs.0.40

 If a company manufactures a batch of 50,000 units
and produces 50 units per machine hour, here is how
the cost assigned to the units with ABC and without
ABC compares:
 With ABC Without ABC

Mfg overhead for setting up machine Rs.500 Rs.–0–

No. of units in batch 50,000 Not applicable

    Mfg O/H caused by Setup – Per Unit Rs.0.01 Not applicable

Mfg overhead costs per machine hour Rs.18 Rs.20

No. of units produced per machine hour 50 50

    Mfg O/H caused by Production – Per Unit Rs.0.36 Rs.0.40

Total Mfg O/H Allocated – Per Unit Rs.0.37 Rs.0.40

 With activity based costing the cost per unit decreases from
0.46 to 0.37 because the cost of the setup activity is spread
over 50,000 units instead of 5,000 units.

 Without ABC, the cost per unit is 0.40 regardless of the

number of units in each batch.

 The company may end up doing lots of production for little or

no profit.

 The cost per unit using the activity based costing method is
more accurate in reflecting the actual efforts associated with
production.
 Costly to operate & difficult to understand
 activity-cost rates needs to be updated regularly
 ABC surveys can be time-consuming, expensive
to perform and irritating to the employees who
have to provide the data
 Better- informed decisions about pricing
 What type of customers to pursue
 What products or services to offer
 Helps to measure the costs & profits of an
organization based on the activities
 Helps to determine accurately how each process
relates back to specific products, customers, or
services.