Key Points & Notes
1. Problems with Traditional Costing
- Overheads grouped under cost centres, absorbed using labour/machine hours.
- Inaccurate when:
- High automation (less labour hours but high overheads).
- Diverse products.
- Non-volume related activities (e.g., material handling, inspection).
2. Meaning of ABC
- Assigns costs to activities, then to cost objects (products/customers).
- Uses cost drivers to trace resource consumption.
- More accurate than traditional absorption costing.
3. Important Terms
- Activity: Event incurring cost.
- Cost Object: Item needing cost measurement (product/customer).
- Cost Driver:
- Resource Cost Driver: Quantity of resources consumed.
- Activity Cost Driver: Frequency/intensity of demand on activities.
- Cost Pool: Group of costs with same cause-effect relationship.
4. Cost Allocation under ABC
- Identify activities → Find cost drivers → Assign overheads to cost objects based on activity usage.
5. Traditional vs ABC
| ABC | Traditional |
|---|---|
| Overheads → Activities → Cost Pools | Overheads → Cost Centres |
| Realistic cost behaviour | Less realistic |
| Multiple activity drivers | Single driver (time/volume) |
| Aids cost control (eliminate non-value activities) | Limited cost control |
6. Levels of Activities (Cost Hierarchy)
- Unit-level → Varies with units produced (e.g., inspection per item).
- Batch-level → Varies with batches (e.g., machine set-up).
- Product-level → Supports product line (e.g., design, drawings).
- Facility-level → Sustains overall production (e.g., plant security, maintenance).
7. Stages in ABC
- Identify activities.
- Relate overheads to activities → Cost pools.
- Spread support activities across primary activities.
- Select activity cost drivers.
- Formula:
[ \text{Activity Cost Driver Rate} = \frac{\text{Total Cost of Activity}}{\text{Activity Driver}} ]
8. Example Formulae
- Cost Driver Rate (Labour hours) = ₹ 4,500 ÷ 1,000 = ₹ 4.50/hr
- Cost Driver Rate (Machine hours) = ₹ 2,500 ÷ 250 = ₹ 10/hr
- Cost Driver Rate (Purchase orders) = ₹ 4,250 ÷ 100 = ₹ 42.50/order
9. Advantages
- Accurate costing.
- Logical overhead allocation.
- Better pricing decisions.
- Identifies non-value activities → Cost reduction.
- Useful for multi-product organisations.
10. Limitations
- Expensive compared to traditional costing.
- Not suitable for small firms or limited product lines.
- Difficult to select appropriate cost drivers.
11. Requirements for Implementation
- Staff training.
- Process specification.
- Clear activity definition.
- Selection of cost drivers.
- Assigning costs systematically.
Quick Formula Recap:
- Activity Cost Driver Rate = Total Cost of Activity ÷ Activity Driver
- Overhead Allocation (ABC) = Activity Driver Rate × Activity Usage
- Traditional Overhead Rate = Total Overheads ÷ Total Labour/Machine Hours
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