1. Activity Based Costing (ABC)
Chathuri Senarath
Senior Lecturer- University of Kelaniya
MEcon(UOC), BCom Sp (Hons) (UOC), CIMA (UK) Passed Finalist, AAT (SL) Passed Finalist.

2. What is ABC
ABC is a system of overhead cost allocation which is said to be a solution to eliminate the problems of a traditional cost allocation system.

3. Traditional Costing Systems
Product Costs
Direct labor
Direct materials
Factory Overhead
Period Costs
Administrative expense
Sales expense

4. Traditional Costing Systems
Direct labor and direct materials are easy to trace to products.
Product Costs
Direct labor
Direct materials
Factory Overhead
Period Costs
Administrative expense
Sales expense
The problem comes with factory overhead.

5. Traditional Costing Systems
Typically used one rate to allocate overhead to products.
This rate was often based on direct labor hours, machine hours or units.
This made sense, as direct labor, machine hours or units were considered as the major cost drivers in early manufacturing plants.

6. Problems with Traditional Costing Systems
Manufacturing processes and the products they produce are now more complex.
This results in over-costing or under-costing.
Complex products are not allocated an adequate amount of overhead costs.
Simple products get too much.

7. Today’s Manufacturing Plants
Are more complex
Are often automated
Often make more than one product
Use proportionately smaller amount of direct labor making direct labor a poor allocation base for factory overhead.

8. When the manufacturing process is more complex:
Then multiple allocation bases should be used to allocate overhead expense.
In such situations, managers need to consider using activity based costing (ABC).

9. ABC Definitions
Activity based costing is an approach for allocating overhead costs.
An activity is an event that incurs costs.
A cost driver is any factor or activity that has a direct cause and effect relationship with the resources consumed.

10. ABC systems contains four stages
O/H
Identifying the major activities
Cost centers / cost pools for each major activity
Cost driver for each major activity
Calculate cost per driver
&
Relate to the product
End Product

11. Example:

18. If traditional method used.
Total units = 100,000 (addition of all the customers serviced) Total O/H cost= Rs 850,000 Overhead Absorption Rate (OAR)= Total O/h ÷ Total units Rs850,000 ÷100,000 Rs8.5
Customer A
Customer B
Direct material
3.50
Direct Labour
5.50
O/H
8.50
Total cost per unit
17.5

19. When should ABC be introduced
ABC should only be introduced if the additional information it provides will result in action that will increase the organizations overall profitability.
For example situations like,
O/H (production/ non production) are high in relation to direct costs.
O/H resource consumption is not just driven by volume/value.
Organization has wide range of products / O/H’s consumed by products are significantly different.