Activity Based Costing – Introduction, Concept and Classification

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The latest methodology in cost accounting is activity based costing. Under this method, the expenditures related to the production activities are calculated first and then product expenses are found out. The emphasis of activity based costing is towards product manufacture.

In conventional costing method, there is no proper system of cost assignment. The decision lies under a company’s cost accountant who makes his decision on appropriate grounds for cost assignment. If the so called precise costing information which is provided through the conventional costing method are used, the steps used for regulating and controlling sell price of a commodity may be based on an incorrect decision.

In the production operation, the rising necessity of indirect costs is commenced on activity based costing. With the introduction of various upgraded machineries, direct processing costs are downgraded at the backdrop which is much easier to handle than indirect cost which is mostly preferred in various industrial sector.

The weight of indirect processing costs is heavier than direct processing costs in the present financial situation, which is seen exceeding production costing method. Still, many industries do not like applying indirect costs which are termed as cost information made ready using past years data. Many organisations find this method to be difficult and complicated.

Currently, many industries use upgraded manufacturing technology for cost assignment as conventional costing system is seen unsuitable for many present hi-tech organisations.

According to the terminology set by CIMA (Chartered Institute of Management Accountants), activity based costing is defined as cost criteria to cost units which are based on advantages acquired from indirect activities.

Concept of Activity Based Costing

In this present financial times, every industry can compete with each other by using effective activity based costing. A company needs to control its market worth and also its value chain at various phases. It needs to make a comparative study of total value at every stage with the cost related to it.

Decisions are to be taken for execution only after correct comparison report is made. When such decisions are taken, it helps industries to understand what are important and non-essential activities. Then they can remove the needless activities and include new activities. Activity based costing enhances the decision quality of management by contributing precise cost information.

Execution of Activity Based Costing

There are 5 necessary steps of activity based costing which when applied can provide appropriate results.

  1. Recognising the functional area which is implied in a company.
  2. Regulate the fundamental activities which are associated in the functional area.
  3. Assignment of indirect costs to every activity involved in the functional area.
  4. Ascertain appropriate cost driver to every activity which comes under management’s functional area.
  5. Preparing expense statement based on each activity.

Functional Area of a Corporation

  • Production Management
  • Administration
  • Sales management
  • Quality Control Management
  • Public Relations
  • Personnel Management
  • Repairs maintenance

Cost Drivers inActivity Based Costing

  • Number of receiving orders for the receiving department
  • Number of parts received per month
  • Number of despatch orders for the despatch department
  • Number of Labour transactions
  • Number of units
  • Total number of employees
  • Number of inspections
  • Amount incurred in Labour cost
  • Number of direct Labour hours
  • Material value in a product
  • Total number of ordering and purchasing hours
  • Aggregate number of Customers orders processed

Factors to be taken into account before cost driver selection

There are two major factors that need to be focused on an organisation regarding cost driver.

  1. Association level between cost drivers and actual use of expenditure
  2. Cost measurement

Classification of Activities

Activities are recognised and are diversified into various categories or phases under the process involved in the production. Generally, activities are categorised into 4 divisions.

  • Activities in unit level
  • Activities in batch level
  • Activities in product level
  • Activities in facility level

Advantages of administering Activity Based Costing

There are few essential advantages of administering activity based costing which are stated as follows.

  1. There are certain areas where cost can be reduced. Activity based costing helps management to recognise those areas and take effective measures. Even if an organisation’s economic condition is at question, it instructs the administrative body to take necessary measures for its abstinence.
  2. The most important part in current approaches of goods productivity is information related to cost. That precise cost info is given by activity based costing to the administrative body.
  3. An efficacious appraisal policy can be prepared by the management body with the help of activity based costing.
  4. It helps the management body to make appropriate decisions and take steps accordingly. These decision usually revolves around the execution of activities to be done within the production house or assigning it to another agency.
  5. A prominent role in the total elementary cost is played by non-manufacturing costs in this present scenario. Proper guidance is provided by activity based costing which helps in the assignment of correct non-manufacturing costs.

Every cost activity can be precisely resoluted in assistance to activity based costing. The operation of transference and transferred departments can be assessed by the manager of a company with the help of it.

Test Questions

  1. What do you understand by Activity Based Costing?
  2. Explain Activity Based costing in details.
  3. Explain in details the classification of activities.
  4. Describe various steps which are used for executing Activity Based Costing
  5. What are the advantages of administering Activity Based Costing?
  6. What are the different functional areas of a company?


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