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CASE STUDY: ACTIVITY-BASED-COSTING

Updated on February 26, 2012

The main purpose of any Costing Accounting System is to ascertain “True Cost" of a Product. If a company is making only one product, its true cost is the same as shown in the Profit & Loss account. Matter gets complicated as one deals with more than one product.

There are various accounting systems which have been developed over time. Product Cost would be different under different systems. Under "Traditional Cost Accounting" (TCA), only Manufacturing Costs are considered as Product Costs. On the other hand, "Activity Based Costing" (ABC) would add up Manufacturing costs and Selling, General & Administrative Expenses (SG&A) for the same purpose. Economic Value Added (EVA) only considers Cost of Funds provided by banks, bond-holders and owners. As such, ABC & EVA combined would embrace all costs.

The side chart shows cost classifications. Under TCA, the Cost of Production would be Rs.6,000 while in ABC the same would be Rs.7,500. As would be explained later, ABC is more near to "True Cost" and results in better decisions.

To keep it simple, this paper would concentrate only on ABC for a non-accounting person. Also, no difference would be made in Cost and Expense and all expenditure would be treated as Cost.

A TASTE OF ABC

A company was engaged in fabrication of steel parts in two categories: large parts and small parts. A sum of Rs.612,000 was incurred over repair, maintenance and depreciation of carts used for internal movements of these parts. Since both parts were fabricated in equal quantity, the cost was distributed equally.

While traditional accounts looks for apparent cause and effect relationship, ABC goes much deeper and finds out who is the real beneficiary of cost incurred. A study revealed that each small part required five internal movements while large parts required 20 internal movements. Further, a standard cart could carry 120 small parts or 30 large parts.

With this information, we can work out overall movements of carts and distribute the cost accordingly as shown below:

It would be observed that under TCA, small parts were being over-charged which would certainly reduce their profitability and the company might consider dropping their fabrication.

HOW ABC WORKS

Under ABC, the cost incurred is first assigned to activities performed and then the cost of those activities is charged to the products on the basis of their usage.

Ascertaining cost of each activity is a real challenge and a multiple approach is adopted for this purpose such as:

  • Direct tracing cost to a particular product
  • Cause and Effect Relationship
  • Time and Motion study for ascertaining cost of an activity.

Suppose a small bank has an Administration Department which serves two main departments i.e. Investment Department and Loan Department. Traditionally, all costs incurred in Admn Dep’t are distributed between the beneficiaries according to number of employees.

Almost all companies keep operational statistics. Necessary figures are available about the activities performed. The only problem is finding out cost of each activity. This can be done through using a spread sheet.

Now we need to find out cost of each activity. This would be ascertained on the following basis:

A study was conducted to find out cost per job. It was observed that, in terms of rupees, staff and computer time was Rs.2,000 and Rs.1,500 respectively per job.

Some expenses were directly traced as under:

  • Staff salaries included a sum of Rs.30,000 for court cases.
  • Time Sheet shows that a sum of Rs.10,000 was due to computer time spent in record keeping.

The building area occupied by the staff in various activities was estimated as under:

  • Recruitment 25%
  • Court Cases 15%
  • Record Keeping 60%

The misc. expanses can be distributed equally among these three activities.

Since we have Department-wise data on all activities, we can now distribute the cost on the basis activities consumed by each Department.  This would show that Loan Department was charged 90% of total costs whereas its true share was only 28%. When performance awards are distributed, staff of Loan Department may suffer only because of unjustified cost-allocation by the Accounts Department.

This shown below: 

Apart from finding cost of activities, ABC uses multiple Cost Drivers. The activities are divided into four categories as shown below:

  • UNIT LEVEL: This is a volume related driver. If each student is given a set of book or a laptop, the cost would increase accordingly. In our case, admission and examination records are the same for each student. Therefore, Admn. & Staff Salaries would be distributed on the basis of number of students. (No difference from traditional basis).
  • BATCH LEVEL: Batch level drivers are triggered for every batch produced. A teacher salary would remain whether he is teaching to 10 student or 100 students. It is in nature of step-variable cost. Since in MSc students per class are only 15 as against 45 in MBA, it should be given weight in allocation. (Of course, teachers in MBA are different from those in MSc but for the sake of simplicity, they are being treated as common or no records were kept separately.
  • PRODUCT LEVEL: Here number of units or batches is of no consideration. The cost is applicable to entire product line or range. The consultants were asked to develop course contents for a particular subject and therefore the cost be charged to that subject alone.
  • FACTILITY LEVEL: It includes library, canteen, laboratories, games and recreational facilities. These are used by the students irrespective of their subjects. So long as the students are required to remain in the campus as per their time-tables, they would use all facilities. Therefore number of students per program is used. This is under ‘cause and effect relationship’.

Their usage would be explained with the following example.

Under TCA, cost allocation in case of MSc students was Rs.12,057(,000) as against Rs.22,464(,000) as per ABC, the difference being Rs.10,406(,000). If we divide the difference with the number of students in MSc, we would know that each student was being lesser-charged to the extent of Rs.43,359. In other words, if number of MSc increases, each student would cause a cash out-flow the same amount. On the other hand, MBA Students were being over-charged and if they start leaving, the institute would collapse.

For a judicious cost allocation, one may treat Staff Salaries at Unit Level, teacher salaries at Batch Level, Consultant Fee at Product Level and Services at Facility Level.  In this way, the cost-allocation would be entirely different and may give us a clue for loss despite increase in number of students. 

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    • profile image

      michael schmidt 8 years ago

      A good, clear description of how ABC accounting works. Thanks, Hafeezrm!!!

    • profile image

      Milya 8 years ago

      I really like the article on ABC. Have been looking for an articles on it and thought this was one was very informative.

      Just what i was looking for. Thanks !!

    • shahnawaz sheikh profile image

      shahnawaz sheikh 8 years ago from karachi

      a good article sir , it actualy cleared some of the confusions i had before

      thank you sir , awaiting for more of such articles

    • hafeezrm profile image
      Author

      hafeezrm 8 years ago from Pakistan

      Dear Myila and Shahnawaz Sheikh,

      Please also go though Economic Value Added and ABC-EVA which is in fact continuation of ABC.

      Thank for your comments.

    • ammz profile image

      ammz 8 years ago from Karachi

      A very good cpmprehensive synopsis about ABC costing..

      Regards

      Muhammad Ammar Mahmood

    • profile image

      yousufabid 8 years ago

      Good explanation of ABC theory of costing for porduct costing. it is helpful for fixing the product price in correctly and represent the true intrinsic value of product in terms of value.

    • hafeezrm profile image
      Author

      hafeezrm 8 years ago from Pakistan

      Hi Yousufabid,

      Thanks for your comments. These are from a professional indeed and very encouraging.

    • profile image

      syed ali raza rizvi 8 years ago

      A good and very much easy to understand article tnx so much!

    • profile image

      murtaza ali 8 years ago

      i have read it n fell that it is very informable and valuable data for every one if he/she is a student or if professional.

      accept my thanks and best wishes about it

    • profile image

      faisal 7 years ago

      thanx sir for giving us a clear view about ABC system.

      kindly sir do a favour for ne that tell me the names of the pakistani companies who are using Activity based costing system in their copmpanies.its my project so tell me about this as soon as possible.

      m leaving my email id. so that u can easily send me any information.

      m again requesting u that plz sir send me this information (name of Pakistani companies) as soon as possible.

      regards

      faisal

      my id is this;

      me_and_faisal@yahoo.com

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Thanks Faisal for your comments. I would ask around and let you know. Personally, I do not of any such company in Pakistan.

    • profile image

      shahid Rana 7 years ago

      Thank you sir for writing a such article like my studens.

      plz tell me sir the name of pakistani companies which use ABC system?I will be thankufull to you sir.

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      I am trying to find out such companies from Pakistan Institute of Cost and Management Accountants. I would let you know after eid holidays. Please give your email address.

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Dear Faisal and Shahid Rana, No one in Pakistan is doing ABC in real sense. Some companies are doing it partially. One such company is Getz Pharma ( 111-111-511). The best person to be asked is Mr. Sohail of ICMAP (9243900/140). You contact him citing my reference.

    • profile image

      shahid rana 7 years ago

      My E Mail ID is :

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      The companies in pakistan are using ABC:

      Getz Pharma (111-111-511), Organon Pakistan (021-5611640), Reckitt Benckiser ( 111-232-323), Shan Foods (111-742-648), Lufthansa Airlines Karachi.

    • profile image

      SHAHID RANA 7 years ago

      I m again requesting u that plz sir send me datail information about name of Pakistani companies which use ABC system tat is my project as soon as possible.

      regards

      Shahid

      My E Mail ID is

      shahidbzu13@live.com

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      The following companies in pakistan are using ABC:

      Getz Pharma (111-111-511), Organon Pakistan (021-5611640), Reckitt Benckiser ( 111-232-323), Shan Foods (111-742-648), Lufthansa Airlines Karachi.

    • profile image

      Hariz 7 years ago

      Can you please give me the name of some Indian companies who uses ABC costing?

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      I am so sorry. I have no contact in India to get such information.

    • profile image

      Chucks 7 years ago

      More good informations thanks for helping me out. Always a pleasure to see information that is useful, thanks again

      http://www.kpmgaccountingfirm.info

    • profile image

      chithrasugumaran 7 years ago

      sir, your article is really mind blowing.. and am having a doubt is it i can do a project on Economic Value added analysis on a private limited company particularly. please sir am awaiting for your reply.

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Thanks Chucks for your comments.

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Please ask your question in hub relating to Economic Value Added. This hub is about ABC.

    • profile image

      salman qayyum 7 years ago

      sir thanku sir your article so conceptually.this is big problem for me about this topic.i have no any concept about this topic.thanku sir.my accounting is so good.i want your prayer for success.

      ab meri presentation sub sy achi ho gi class main.allah hafiz

    • profile image

      V.MUNNI 6 years ago

      ABC NICELY EXPLAINED. THANK U SIR ITS A VALUABLE SITE.

    • profile image

      suleiman 6 years ago

      To Mr. Hafeez ...I'm Suleiman from Jordan..i would like to thank you very much to make it easy for me to understand the ABC. the example you issued in this case was really beneficial and this is the first time i get to understand the meaning of ABC after i read your explanation.

      thank you again

    • profile image

      Fago, G. 5 years ago

      Thank you very much for describing traditional and ABC cositng in simple way.

    • profile image

      c.sitepu 5 years ago

      very detail very helpful, tq so much!

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks @C.Sitepu for your comments.

    • profile image

      Nitish 5 years ago

      tHANK YOU SIR

      IT HELPS TO CLEAR CONCEPT

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Nitish for your comments.

    • profile image

      abhi 4 years ago

      hii sir,,

      can u tell me some companies name in india ..which using abc costing

    • hafeezrm profile image
      Author

      hafeezrm 4 years ago from Pakistan

      I have no such information. In my country, Pakistan, there are few which are using ABC.

      I suggest to ask some big companies in your country whether they are using ABC or not.

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