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Activity Based Costing

This technique is been of recent origin and is primarily concerned with appointment of overhead (indirect costs) in an organisation having products that differ in volume and complexity of production. The crux of activity based costing is in accurately assigning the overhead cost to the end product. The traditional costing system does not serve effective purposes of product costing and pricing decisions. Charging overhead to the products on the basis of labour hour rate and machine hour rate may provide faulty data as to costs which should be properly attributed to a product. If the direct labour cost is taken as the base for charging overhead cost, high volume products may tend to get greater share of overhead cost than the low volume complicated products. Every overhead cost does not directly vary with the volume of production. The illegitimate cost attribution would give a distorted picture of the cost information, the result of which shall be arriving at a wrong decision.

Activity based costing is a method of cost attribution to cost units on the basis of benefits received from indirect activities. Their performance of particular activities and demands made by these activities on the resources of organisation are linked together so that the cost of product is arrived at as per the quantum of actual activities performed to produce a product or service. The reason for such a basis is that products themselves do not consume resources directly rather several activities are required to be performed for them, and these activities consume the resource, of organisation as driven by the cost drivers. Cost centres pay for these resources, depending upon the number of activities required for a product.

Thus, the overhead costs of organisation are identified with each activity which is acting as a cost driver i.e. the cost for incurrence of the overhead cost. The number of these activities in an organisation depends upon the complexity of operations. The more complex an organisation’s operations are, the more cost driven activities it is likely to have.

After identifying the overhead cost with each cost centre, the cost per unit of cost driver can be ascertained and cost assigned to jobs on the basis of number of activities required for their accomplishment. Thus, ABC serves as a basis for product costing besides aiming for managing overhead cost.

Activity based costing may be defined as a technique which involves identification of costs with each cost driving activity and making it as the basis for apportionment of costs over different products or jobs.

The Chartered Institute of Management Accountant (CIMA), London, defines it as “a technique of cost attribution to cost units on the basis of benefits received from indirect activities e.g. ordering, setting up, and assuring quality.”

According to Horngreen, “ABC is a system that focuses on activities as fundamental cost objects and utilizes cost of these activities as building blocks or compiling the costs of other cost objects.”