The Institute of Finance Management

Department Accounting and Finance

Management Accounting
BAIT 3 & BACC 3
Lecture Notes
Activity Based Costing (ABC) System

Instructor Dr. Zawadi Ally

Learning aims
Students should be able to
• Explain what is meant by the term cost driver
• identify appropriate cost drivers under activity-based costing (ABC)
• Calculate costs per driver and per unit using (ABC)
• Compare ABC and traditional methods of overhead absorption based on
production units, labour hours or machine hours
• Understand Value-added and Non-value-added activities
• Understand Just in Time (JIT) Processing System

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2.1 Introduction

With the increasingly high level of automation in world class business, overhead
costs (indirect costs) are today the main component of total costs. Absorption
(traditional) costing has led to the incorrect apportionment of overhead costs if
the overhead costs are shared by different products lines/departments in an
organization, this will result a poor basis for decision making.

A more accurate apportionment of overhead costs is becoming necessary in the

modern business environment where cost information is being used for decision
making purposes, such as pricing, make-or-buy decisions etc.. This has led to the
introduction of activity based costing (ABC), under which it is easier to trace
overhead costs to individual products/departments and which provides a better
apportionment of overhead costs and thus better costs information.

Hence ABC system is an overhead cost allocation system that apportions overhead
costs to multiple activity cost pools and assigns the activity cost pools to
products/services or departments by means of cost drivers that represent the
activities used

2.2 The Need for Activity Based Costing System

• Tremendous change in manufacturing and service industries
• Decrease in amount of direct labour usage
• Significant increase in total overhead costs
• Traditional costing fails to capture cause and effect relationship
• Traditional costing often fails to highlight inter-relationship among activities in
different departments.
• Market place is very competitive
• Availability of computer has enhanced requirement for improvement in
information-gathering technology for advanced decision making to gain
competitive advantage

2.3 Categories of Activities Identified in ABC System

There are four broad categories of activities identified in an activity-based
costing system

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Unit-level activities: are resources sacrificed on activities performed on each
individual unit of product or service.
• Energy
• Machine maintenance, repairs (depreciation?)
• Labor

Batch-level activities: are resources sacrificed on activities that are related to a

group of units of product or service
• Setup hours to run a batch
• Procurement costs of placing an order

Product-sustaining activities: are resources sacrificed on activities to support

individual products or services.
• Design costs
• Engineering costs

Facility-level (or general-operations-level) activities: are resources sacrificed

on activities that cannot be traced to individual products or services but support
the organization as a whole.
• General administration
• Rent
• Building security

2.4 Basic Terms of Activity Based Costing System

• Activity: any event, action, transaction, or work sequence that incurs cost
when producing a product or providing a service.
• Activity Cost Pool: the overhead cost attributed to a distinct type of activity
For example: ordering materials or setting up machines
• Cost Driver: any factor or activity that has a direct cause-effect
relationship with the resources consumed. In ABC cost drivers are used to
assign activity cost pools to products or services. The following three factors
are important in selecting the cost drivers for an ABC system:
Degree of correlation between consumption of an activity and
consumption of the cost driver
Cost of measurement of the cost driver.
Behavioral effects, that is, how the cost driver selected will affect the
behavior of the individuals involved in the activity related to the cost
driver.

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The illustration below show how the cost drivers are selected from the cost pools

Fig. 2.1 ABC system design

Source: Lift Jack Company

2.5 The Main steps in implementing ABC system

In implementing activity-based costing in an organization involves the following
four steps.

Step 1: Identify and classify the major activities and allocate overhead costs
to the appropriate cost pools.
See the example below the Overhead costs are assigned directly to the
appropriate activity cost pool

Activity Cost Pool Estimated Overhead Costs (Shs)

Ordering Cost 300,000,000
Machining Cost 500,000,000
Inspection & quality control cost 100,000,000

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Step 2: Identify the cost driver that has a strong correlation to the costs in
the cost pool.
The cost driver must accurately measure the actual consumption of the activity by
the various products

Activity cost pool Cost driver Expected use of cost driver

Ordering Costs Number of orders 15,000
Machining Costs Machine hours 500,000
Inspection costs Number of inspections 20,000

Step 3: Compute the overhead rate for each pool .

The firm computes an activity-based overhead rate per cost driver by using the
following formula:

Activity cost pool Overhead Costs (Shs) ÷ cost driver ABC Overhead rate
Ordering Costs 300,000,000 15,000 Shs. 20,000 per order
Machining Costs 500,000,000 500,000 Shs.1,000 per machine hr.
Inspection costs 100,000,000 20,000 Shs. 5,000 per inspection

Step 4: Assign overhead costs for each costs to products/departments using

the overhead rates.
In assigning overhead costs, it is necessary to know the expected use of cost
drivers for each product/department. To assign overhead costs, firm multiplies the
activity-based overhead rates per cost driver by the number of cost drivers
expected to be used per product/department.

2.6 Benefits and Limitations of ABC

Implementing ABC can be a challenging task for any business and the process
carries several advantages and disadvantages.

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❑ Benefits of ABC
• It assists the management to understand the behaviour of overheads costs and
their relationship to products, services, customers and market segments
• It can be used to identify non-valued added activities and can help to better
allocate resources to efficient and profitable activities
• The method also helps to fix the price of products or services that are
excessive or incorrect
• It assists the management to allocate the resources to those activities that will
increase shareholders value
• It links profitability analysis to operational decisions
• It ensures that the cost of non-value added activities is visible to the
management
• It gives the right information for performance measurement because it focuses
on activities rather than resources.
• The understanding of the cost driver for each activity gives better control over
factors that cause costs
• It gives accurate information on profit margin and performance measurement
for profit improvement

❑ Limitations of ABC
• The ABC system is time consuming as analysis of activity, determining the cost
of those activities and identification of appropriate cost drivers takes a
significant amount of time
• Setting up an ABC system can be expensive, it requires establishment of
activities in detail. This may be a complex and time taking job
• It is often difficult to identify an appropriate cost driver for an activity cost
pool in order to apportion the cost.
• In ABC system some arbitrary allocations continue
• The ABC system may not justify the cost-benefit analysis. Cost incurred for
the implementation and maintenance of the system may go beyond the benefits
gained from it

2.7 Difference between ABC and Traditional (Absorption) Costing

If the firm has more than one products/ departments, if the ABC system is used,
therefore the apportionment of indirect costs among those products/ departments
will be differ from the traditional (Absorption) system, instead of using single
overhead absorption rate as calculated at the beginning using appropriate activity

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such labour hours, machine hours, output etc. In ABC system the cost drivers
which have identified will be used to apportion the overhead costs. Therefore ABC
system provides more accurate of apportionment of overhead costs than
traditional costing. However, the allocation of direct costs, such direct materials,
direct labour, direct expenses and short run variable costs will be similar to
traditional method.

2.8 When to Use ABC

Factors to consider:
• Product lines differ in volume and manufacturing complexity.
• Product lines are numerous and diverse.
• Overhead costs constitute a significant portion of total costs.
• The manufacturing process or the number of products has changed
significantly.
• Production or marketing managers are ignoring data provided by the existing
system
2.9 Value-Added Versus Non–Value-Added Activities
Activity-Based Management (ABM):
An extension of ABC from a product costing system to a management function that
focuses on reducing costs and improving processes and decision making.
➢ Value-added activities
➢ Non–value-added activities
Value-added activities: An activity that increases the worth of a product or
service such as:
Manufacturing Company
Engineering design
Machining services
➢ Assembly
➢ Painting
➢ Packaging

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Service Company
➢ Performing surgery
➢ Legal research
➢ Delivering packages
Non–Value-Added Activities: An activity that adds cost to, or increases the time
spent on, a product/service without increasing its market value such as:
Manufacturing Company
➢ Repair of machines
➢ Storage of inventory
➢ Moving of inventory
➢ Building maintenance
➢ Inspections Inventory control
Service Company
➢ Taking appointments Reception
➢ Bookkeeping and billing Traveling Ordering supplies
➢ Advertising

2.10 Just-in-Time Processing

Objective of JIT Processing
To eliminate all manufacturing inventories
Elements of JIT Processing
➢ Dependable suppliers.
➢ Multiskilled work force.
➢ Total quality control system.

Benefits of JIT Processing

➢ Significant reduction or elimination of manufacturing inventories.
➢ Enhanced product quality.
➢ Reduction or elimination of rework costs and inventory storage costs.
➢ Production cost savings from the improved flow of goods through the
processes.