UNIVERSITY OF EDUCATION

WINNEBA
SCHOOL OF BUSINESS
DEPARTMENT OF ACCOUNTING
COST ACCOUNTING LECTURE SLIDES
Topic: ACTIVITY BASED COSTING (ABC) TECHNIQUE
Instructor: I.A. Ahmed
• Activity-Based Costing (ABC) is the second method used in accounting for overheads or charging
overhead costs to cost units.
• It is a costing system, which focuses on activities performed to produce products.
• It requires that, costs are first traced to activities and then to products.
• Under this method, it is assumed that, activities are responsible for the incurrence of costs and
create the demand for activities.
• For instance, a university lecturer is paid based on the occurrence of an activity—teaching.
• It is this activity (teaching) which leads to the incurrence of cost (salary).
• In ABC therefore, costs are only charged to products based on how each product uses an activity.
However, in traditional absorption costing system, costs are first traced not to activities but to an
organizational unit, such as department or plant and then to products. It means under both, ABC
and traditional absorption costing system the second and final stage consists of tracing costs to
the product.
Intro (contd)
• In ABC therefore, costs are only charged to products based on how
each product uses an activity.
• However, in traditional absorption costing system, costs are first
traced not to activities but to an organizational unit, such as
department or plant and then to products.
• Under both ABC and traditional absorption costing system the second
and final stage consists of tracing costs to the product.
Definition
• CIMA definition
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.’
• The Consortium for Advanced Management (CAM-1) defines it as “the
collection of financial and operational performance information
tracing the significant activities of the firm to product Costs”.
• ABC focuses on activities as the fundamental cost object.
• It ‘costs’ all the activities that go into producing a product.
ABC has the following features
• It is a two-stage product costing method that first assigns costs to activities and
then allocates them to products based on each product’s consumption of activities.
• Within the two-stage process, cost pools are used to accumulate activity-related
costs.
• An activity is any discrete task that an organization undertakes to make or deliver a
product or service.
• Activity-based costing is based on the concept that products consume activities and
activities consume resources.
• Activity-based costing can be used by any organization that wants a better
understanding of the costs of the goods and services it provides, including
manufacturing, service, and even nonprofit organizations.
Differences between ABC and the Traditional
System
• Can you list the differences between the two systems??????
Objectives of ABC System
• To improve product costing
• To identify non-value adding activities in the production process
which might be a suitable focus for attention or elimination
• To provide required information for decision making
• To reduce the frivolous (non-essential) use of common resource
• To encourage managers to evaluate the efficiency of internally
provided services
• To calculate the full cost of products for financial reporting purposes
and for determining cost-based prices.
Some terminologies associated with ABC
• Activity: it is the value adding process which consumes resources.
Example: set ups required, purchase order issue, inspections carried
out etc. Value adding activities are those perceived by customers as
enhancing or adding value to the products they purchase.

• Cost driver: In an ABC system, the allocation basis that are used for
applying costs to services or procedures are called cost drivers. It is a
factor that causes a change in the cost of an activity. Simply put, it is
that factor or activity which generates costs.
Terminologies
• Cost Driver Volume (CDV): it is the quantity of activities which are
carried out. That is, the quantity of cost drivers that generate cost.

• Cost Pool: it is the pooling (bringing together) of overhead cost which

relate to a specific activity. It is similar to cost center under the
traditional approach to overhead absorption. The pool represents
activities such as set ups, purchase orders, inspections, materials
handling etc. it is the monetary value of activities; example: total
value of set ups.
Terminologies
• Cost Driver Rate (CDR): it is the product of dividing the cost pool for the
activity by the cost driver volume. Example: total of the cost pool for
inspection divided by the number of inspections planned. It is similar to
the OAR.
• Unit level cost: Traditionally, cost drivers were viewed only at the unit
level. These drivers create unit-level costs meaning that they are caused
by the production or acquisition of a single unit of product or the delivery
of a single unit or service.
• Batch level cost: costs which are caused by a group of things being made,
handled or processed at a single time are referred to as batch level costs.
Terminologies
• Product-level cost: a cost caused by the development, production or
acquisition of different items is called a product level or process level
cost. These include engineering change orders, equipment
maintenance, product development and scrap, if related to product
design.
• Facility-level cost: some costs cannot be related to a particular
product line. These are instead related to providing a facility. Example:
cost of maintaining a building or plant security or advertisement
promoting the organization.
Terminologies
• Organizational-level cost: certain costs are incurred at organizational
level for the single purpose of supporting continuing facility
operations. These organizational level costs may be common to many
different activities, products and services. They can therefore be
prorated among services and products on an arbitrary basis only.
These costs are not product related, thus they should be subtracted
from net product revenues instead of an arbitrary and illogical
apportionment.
Uses of ABC in decision making
• Activity costs tracking
• Customer profitability
• Distribution cost
• Make or buy
• Determining Margins
• Helps to fix Minimum price
• Production facility cost
Limitations
• Implementing an ABC system requires substantial resources, which is costly to maintain.
• Activity Based Costing is a complex system which needs lot of record for calculations.
• In small organization mangers are accustomed to use traditional costing systems to run
their operations and traditional costing systems are often used in performance
evaluations.
• Activity based costing data can be easily misinterpreted and must be used with care
when used in decision making. Managers must identify which costs are really relevant
for the decisions at hand.
• Reports generated by this systems do not conform to Generally Accepted Accounting
Principles (GAAP). Consequently, an organization involved in activity based costing
should have two cost systems - one for internal use and one for preparing external
reports.
END OF SLIDES
• Refer to chapter 6 for worked examples on ABC

Thank you