Activity-Based Costing System — All About ABC

Activity-Based Costing
Costingitle
Includes:
► Activity-Based Budgeting
► Activity-Based Management
Ahmad Tariq Bhatti
FCMA (Pak), ACMA (UK), CGMA (USA), FPFA, MA (Eco.), BSc

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Preface
In the ever-evolving field of management accounting, understanding the intricacies of
costing methods is essential for businesses seeking to gauge and increase operational
efficiency and profitability. This book on Activity-Based Costing (ABC) has been
meticulously revised and expanded to provide a comprehensive resource for both
students and practitioners in the field.
In this edition, we have significantly increased the number of illustrations and numerical
examples to aid in the practical application of the ABC system. These enhancements are
designed to clarify complex ideas and provide a more hands-on approach to
understanding how activity-based costing can be utilized in various business scenarios.
Moreover, we are excited to introduce insights on Activity-Based Budgeting and
Activity-Based Management. These complementary frameworks not only build upon
the fundamental principles of the ABC system but also offer strategic perspectives on
budgeting and management practices that can lead to better decision-making for resource
allocation.
Whether you are new to the world of activity-based costing or seeking to deepen your
existing knowledge, this book aims to equip you with the tools and insights needed to
master the complexities of modern management accounting practices. I hope you find it
as enlightening and valuable resource as I intended it to be.
Thank you for joining me on this journey.
Ahmad Tariq Bhatti, FCMA, CGMA
Dubai
September 29, 2024

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Contents
1. Introduction ________________________________________ 5
2. Origin _____________________________________________ 5
3. Definitions__________________________________________ 6
4. Related Concepts _____________________________________ 6
5. Activity-Based Costing System ___________________________ 9
6. Advantages of the ABC System __________________________ 13
7. Drawbacks of the ABC System___________________________ 14
8. Industries Where the ABC System Has Produced Best Results____ 16
9. Renowned Companies Using ABC System __________________ 17
10. Outsource Implementation or do it In-house? _______________ 19
11. Softwares that Facilitate the Implementation of ABC System ____ 19
12. Differences between ABC and ABB System __________________ 21
13. Activity-Based Budgeting ______________________________ 21
14. Activity-Based Management ____________________________ 22
15. Case 1: Applying ABC to a manufacturing company ___________ 25
16. Case 2: Applying Activity-Based Management to a manufacturing
company __________________________________________ 29
17. Case 3: ABC system applied to a services-providing firm _______ 32
18. Case 4: Applying Activity-Based Budgeting to services providing
firm ______________________________________________ 34
19. Case 5: Applying Activity-Based Budgeting on a manufacturing
company __________________________________________ 37
20. Case 6: Applying Activity-Based Costing system to a trading
company __________________________________________ 39
21. Abbreviations Used __________________________________ 41

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1. Introduction
Accurately determining the manufacturing cost of each product is vital for effective
decision-making. For instance, understanding the cost to produce a single unit not only
influences a company's budgeting for that unit's production but also serves as a critical
reference point for establishing its sales price.
A basic consideration in calculating the total production costs of a product or project is
the accurate allocation of overhead costs. While the traditional allocation system—often
characterized by its simplicity—works well for certain companies, it may not adequately
address the complexities associated with overhead allocation for many products. In such
cases, implementing an Activity-Based Costing (ABC) system is typically the most
suitable approach.
The ABC system diverges from the traditional absorption costing approach by first
accumulating overhead costs associated with each organizational activity and
subsequently assigning these costs to specific products, services, or customers (normally
referred to as cost objects).
An important factor in selecting between these two major overhead allocation systems is
the cost involved in collecting and analyzing the necessary information. Companies must
consider the financial investments required for implementation. The ABC system often
incurs higher costs related to time and resources.
The distinction between the traditional system, which relies on a single cost driver, and
the ABC system, which employs multiple cost drivers, is more intricate than merely the
quantity of drivers used. In scenarios where direct labor constitutes a significant portion
of the product cost, overhead expenses are generally influenced by a single cost driver—
typically either direct labor or machine hours. In such cases, the traditional system
effectively allocates overhead costs based on direct labor or machine hours. Conversely,
when overhead costs represent a substantial portion of the total product cost, they are
influenced by multiple drivers. The use of multiple cost drivers in the ABC system
facilitates a more accurate allocation of overhead expenses.
2. Origin
The 1980s marked a critical period during which the limitations
of the absorption costing system became increasingly apparent. As
companies aimed to enhance their competitiveness, there was a
pressing need for a costing system that accurately reflected true
product costs. Absorption costing had been conceived decades
earlier, at a time when most companies operated with a limited
product range. Under those conditions, overhead costs were
relatively low, allowing for a clearer identification of actual product
costs. However, as businesses expanded their offerings or

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products, the inadequacies of this traditional system became
evident.
The criticism of absorption costing prompted David Cooper and Robert Kaplan to
develop the concept of Activity-Based Costing (ABC). In 1990 and 1992, they published
articles detailing their findings, which facilitated the widespread acceptance of this
innovative system. Today, the ABC model is integral to management accounting curricula
and is utilized globally by organizations seeking more accurate cost allocation methods.
3. Definitions
 ABC system refers to a cost attribution to cost units based on benefits received from
indirect activities.
— CIMA Official Terminology
 Activity: An event that incurs costs.
 Cost Object: Any product, service, process, or project for which a separate
measurement of cost is desired or required.
 Activity Cost Pool: The total overhead costs allocated to a specific type of activity or
related activities.
 Cost Driver: Any factor or activity that directly influences the consumption of
resources.
 Cost per Unit: The expenditure associated with the manufacture of one unit of a
product or the provision of one unit of service.
 Cost Accounting: The process of identifying, analyzing, summarizing, recording,
and reporting costs related to a business's operations.
 Direct Costs: Costs directly tied to the manufacturing process, including direct
materials and direct labor.
 Indirect/Overhead Costs: Costs that cannot be directly traced to a unit of
production, encompassing indirect materials, indirect labor, and other indirect
expenses associated with producing goods.
4. Related Concepts
Direct Costing System
This costing system assigns only direct costs (also known as variable costs) to products,
highlighting their contribution to covering indirect costs. It is widely regarded as suitable
for decision-making purposes.

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Traditional or Absorption Costing System
This system accounts for the total cost of a product, making it straightforward to
implement and commonly utilized. The traditional approach assigns overhead costs by
using a single overhead rate.
The major differences between Absorption and the ABC system
The ABC system allocates overhead costs by utilizing multiple cost pools tied to specific
activities that drive those costs. This approach assigns costs to activities based on their
resource consumption, resulting in a more precise allocation of overhead costs compared
to traditional methods. By employing several cost drivers rather than relying on a single
one, the ABC system provides a more accurate reflection of cost per unit, distinguishing
itself from the absorption costing system.
In contrast, the traditional or absorption costing system assigns manufacturing overhead
costs based on a single cost driver—such as direct labor hours, direct labor cost, or
machine hours. This method is most effective when there is a clear relationship between
the chosen activity base and overhead costs. For example, using the labor hour rate is
common when direct labor constitutes a significant portion of product costs. The
underlying principle is that as overhead costs increase, the selected cost driver also rises.
However, this reliance on a single cost driver can lead to inaccuracies in overhead cost
allocation, as the absorption costing system applies the same rate across all production
activities. This limitation represents a significant drawback of the absorption costing
approach.
Both systems have their respective advantages and disadvantages. The traditional
system offers several benefits:
 All manufacturing costs are classified into materials, labor, and overhead, with
allocations made to products regardless of direct production relevance.
 While manufacturing costs are included in product costs, non-manufacturing costs
are not considered production costs and are therefore excluded from product
allocations. For instance, expenses related to machines that handle customer orders
are essential for processing product requests but are not assigned to specific products.
The predetermined overhead rate is calculated based on estimated costs at the budgeted
activity level. Consequently, while the overhead rate remains consistent across products,
there may be instances of over- or under-applied overhead costs.

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Description Absorption Costing System ABC System
 Overhead assigned Single cost driver Multiple cost drivers
 Optimal usage
When direct labor is a large
portion of the product cost
When technology is a large
portion of the product cost
 Orientation Cost-driven Process-driven
Limitations of the Traditional or Absorption Costing System
The traditional or absorption costing system allocates overhead costs across the entire
product range using a single overhead recovery rate, also referred to as a
predetermined overhead rate or overhead absorption rate. This method
aggregates the total overhead costs for all production. For example:
 In job order costing, overhead absorption rates are typically based on direct labor
costs or direct labor hours.
 In process costing, these rates are generally determined by the number of machine
hours utilized.
Consequences of the Limitations
 Relying on a single cost driver can lead to the over-allocation of overhead to one
product while under-allocating it to another, resulting in distorted total product costs
per unit and potentially incorrect sales pricing. Setting incorrect prices is a major
factor contributing to product failures in the market, which could be mitigated by
adopting the ABC system.
 The use of a single cost driver does not facilitate accurate overhead cost allocation
compared to employing multiple cost drivers.
 Products with high-profit margins may inadvertently subsidize those with low profit
margins.
 Inaccurate cost accumulation undermines effective profit planning for products.
 If a product's costs are not accurately tracked and reflected in the costing records, it
may struggle to compete in the market.

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5. Activity-Based Costing System
ABC is a costing system that assigns indirect costs (overhead costs) to products and
services with a high degree of accuracy. It establishes a clear relationship between
overhead costs and production activities by allocating those costs based on relevant
activity levels. This method effectively addresses the limitations of traditional absorption
costing. ABC serves both as a planning tool and a management control mechanism after
production is completed. It underpins critical business decisions related to pricing,
inventory valuation, profitability analysis, and overhead allocation, making it applicable
to both products and services.
An overhead cost allocation system that:
 Distributes overhead costs across multiple activity cost pools
 Assign these activity cost pools to products or services using cost drivers.
The Overhead Cost Allocation Process
 Identify the activities necessary for product
completion.
 Assign overhead costs to these activities.
 Determine the cost driver for each activity.
 Calculate a predetermined overhead rate
for each activity.
 Allocate overhead costs to products.
Caveat:
There are no definitive standards for determining activity cost drivers; they serve merely
as a tool to help elucidate which activities contribute to specific expenses and to reveal the
true costs of producing products or services. In larger and more complex organizations,
cost drivers will always remain estimates.
Allocation Stage
The diagram below illustrates the process of allocating overhead costs associated with the
Design, Setup, and Shipping departments to Products A, B, and C, based on the
relevant cost drivers.

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Examples of Cost Pools and Cost Drivers
Activity Cost Pools Activity Cost Drivers
 Production
 Number of units
 Number of set-ups
 Number of electricity units consumed
 Marketing
 Number of sales personnel
 Number of sales orders
 Research and Development
 Number of research projects
 Personnel hours spend on projects
 Technical complexities of the projects
 Customer Service
 Number of service calls
 Number of products serviced
 Hours spend on servicing products
 Number of customer contracts
 Number of customer change orders
 Purchasing  Number of purchase orders
 Material Handling  Number of material requisitions

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Types of Cost Drivers
Levels of Activities
1. Unit-Level Activities
These activities incur costs directly related to individual units produced, such as direct
materials, direct labor, and machine maintenance.
2. Batch-Level Activities
These costs are incurred whenever a batch of units is produced. Examples include
expenses related to purchase orders, machine setups, and quality testing.
3. Product-Line Activities
These activities pertain to specific product lines and include engineering changes on
the assembly line, product design modifications, and warehousing or storage costs
associated with each product line.
4. Facility Support Activities
These costs are administrative in nature and encompass expenses such as
depreciation, property taxes, plant security, insurance, accounting, landscaping
maintenance, and salaries for plant management and support staff.
Cost Ascertainment
A product consists of three primary cost elements: direct materials, direct labor, and
overhead costs. The overhead cost can be further divided into three components: indirect
materials, indirect labor, and indirect costs. The combined costs of direct materials and

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direct labor are referred to as the direct costs of a product. Overhead costs can be
categorized into fixed and variable components. Examples of fixed overhead costs include
factory rent, insurance, and depreciation of plant and machinery, while variable overhead
costs may encompass supplies, production materials, electricity bills, and indirect labor.
In both absorption costing and ABC systems, direct material and direct labor costs
remain consistent or the same across products. However, the methods of overhead cost
allocation differ significantly. Accurate estimation and assignment of overhead costs are
essential for determining the true cost of a product, which is crucial for various business
decision-making processes.
The ABC system applies overhead costs to products in a more systematic way by utilizing
multiple cost drivers. In contrast, the absorption costing system uses a single overhead
recovery rate based on production characteristics. For labor-intensive production, the
most suitable recovery rate is often based on labor hours worked, while for machine-
intensive production, it is typically determined by machine hours worked. The diagram
below illustrates the cost allocation process.
 Increased Cost Accuracy
The ABC system allows for a more precise allocation of manufacturing overhead by
linking costs directly to specific activities, improving overall cost accuracy.
 Shifts in Cost Distribution
Adopting ABC can result in a shift from period- or product-based overhead costs to
an activity-based approach, leading to more insightful and detailed financial analysis.
 Variability in Per-Unit Costs
This system enables better assignment of unit-level, batch-level, product-level, and
facility-level costs, which may lead to increased per-unit costs for low-volume
products and decreased per-unit costs for high-volume products.

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 Asymmetrical Cost Changes
The impact on per-unit costs is often asymmetrical, with low-volume products
typically experiencing larger fluctuations in their cost structure compared to high-
volume products.
 Informed Decision-Making
With improved cost visibility, management can make more informed pricing,
budgeting, and strategic decisions, ultimately enhancing profitability and
competitiveness.
6. Advantages of the ABC System
The ABC system offers several advantages:
 Accurate Costing
ABC provides precise costing for products and services, leading to better financial
insights.
 Enhanced Understanding of Overhead Costs
Management gains a clearer understanding of overhead costs and their drivers.
 Focus on Unit Costs
Unlike traditional absorption costing, ABC emphasizes unit costs rather than total
costs, allowing for a more nuanced analysis.
 Integration with Improvement Programs
The ABC system aligns well with Six Sigma and other continuous improvement
initiatives, facilitating enhanced operational efficiency.
 Visibility of Waste
An in-depth analysis of overhead costs under ABC highlights waste and non-value-
added activities, enabling better controls to reduce production waste and cost
leakages.
 Support for Performance Management
ABC contributes to performance management and the development of the
Balanced Scorecard framework.

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 Accurate Costing Processes
It enhances the accuracy of costing processes, supply chains, and value streams.
 Benchmarking Capability
The system facilitates benchmarking against other products, enabling performance
comparisons.
 Multiple Overhead Cost Pools
By utilizing various overhead cost pools, ABC provides more accurate rates for
overhead applications, though it requires more time and incurs higher costs during
implementation.
 Diverse Allocation Bases
The allocation bases in ABC often differ from those in traditional systems, allowing
for the grouping of costs influenced by similar drivers and consideration of additional
cost drivers beyond labor or machine hours, resulting in more accurate overhead
application rates.
 Activity Rates Based on Capacity
Activity rates can reflect the level of activity at a given capacity rather than solely the
budgeted level, leading to more accurate cost allocations.
 Comprehensive Cost Assignment
Both manufacturing and non-manufacturing costs can be assigned to products based
on their relationship with the cost, ensuring that overhead costs increase by product
volume.
7. Drawbacks of the ABC System
 Higher Initial Implementation Costs
Implementing the ABC system requires a larger initial budget compared to traditional
costing methods.
 Ongoing Maintenance Expenses
After implementation, maintaining the system can be costly, as it necessitates regular
collection, verification, and entry of data related to numerous activity measures.

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 Inconsistencies in Profit Reporting
The ABC system often yields different product margins than those produced by
traditional costing systems, which may create confusion for management accustomed
to the latter, especially for external reporting requirements.
 Risk of Misinterpretation
Data generated by the ABC system can be misinterpreted; therefore, it must be used
cautiously in decision-making. Costs assigned to products, customers, and other cost
objects are only potentially relevant.
 Non-compliance with GAAP/IFRS
Reports generated by the ABC system do not adhere to Generally Accepted
Accounting Principles (GAAP) or International Financial Reporting Standards
(IFRS). As a result, organizations using the ABC system may need to maintain two
cost systems: one for internal purposes and another for external reporting. In contrast,
traditional costing methods comply with GAAP/IFRS by assigning costs as either
period or product costs and including all product costs in inventory valuation.
 Exclusion of Some Manufacturing Costs
Certain manufacturing costs, such as heating the factory, may be excluded from
product costs under the ABC system because they do not align with specific activity-
driven cost pools, despite being essential for production.
Implementation Challenges
Transitioning from a traditional allocation system to ABC is a complex process that
presents several challenges for organizations.
Common difficulties encountered during the implementation of the ABC system
include:
 Employee Buy-In
Convincing employees of the benefits of the ABC system is essential, as they must
engage with consultants and respond to queries throughout the process.
 Top Management Support
Strong backing from top management is required for successful implementation. This
initiative involves extensive communication and inquiries with employees.

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 Cross-Functional Team Design
The design and implementation of the ABC system should be handled by a cross-
functional team of technicians, typically comprising representatives from accounting,
finance, IT, marketing, production, and engineering departments.
 Consultant Engagement
Hiring an ABC system consultant is important to avoid wasting resources and time,
ensuring a smoother transition.
 Time-Consuming Process
The ABC system requires more time to implement and operate, as it necessitates the
objective collection of information regarding cost drivers.
 Increased Costs
The implementation of ABC is generally more expensive, given the costs associated
with collecting and analyzing cost driver data, as well as allocating overhead based on
multiple cost drivers.
 Software Selection
Choosing ABC software that can effectively implement and automate the processing
of the system should be done with expert guidance to ensure optimal functionality.
8. Industries Where the ABC System Has
Produced Best Results
 Manufacturing
ABC is particularly effective in manufacturing environments, where overhead costs
can vary significantly between products. It helps in accurately allocating costs to
complex production processes.
 Healthcare
In the healthcare sector, ABC helps organizations better understand the costs
associated with patient care and treatment, enabling more informed financial
decisions and resource allocation.
 Service Industries
Service-based industries, such as consulting and IT services, can benefit from ABC by
providing insights into the costs of delivering services, leading to improved pricing
strategies and profitability.

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 Retail Industry
Retailers use ABC to analyze the costs associated with different products and services,
allowing for more strategic inventory management and pricing decisions.
 Aerospace and Defense
In industries with high complexity and regulatory requirements, such as aerospace
and defence, ABC aids in managing the intricate costs associated with production and
project management.
 Telecommunications
ABC enables telecommunications companies to accurately assign costs to different
service lines, improving profitability analysis and decision-making regarding service
offerings.
 Pharmaceuticals
In the pharmaceutical industry, ABC helps in understanding the costs associated with
research, development, and production, facilitating better budgeting and pricing
strategies.
 Food & Beverage
Companies in this sector use ABC to analyze the costs of different products and
production processes, enhancing efficiency and reducing waste.
By implementing the ABC system, these industries have been able to achieve greater
cost visibility, improve resource allocation, and increase overall profitability.
9. Renowned Companies Using ABC System
Here are some renowned companies that have successfully implemented the ABC
system:
 Coca-Cola
Utilized ABC to better understand the costs associated with its various products and
improve pricing strategies.
 General Electric
Implemented ABC to enhance cost management and operational efficiency across its
diverse business units.

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 Procter & Gamble
Adopted ABC to analyze the costs of product development and marketing, leading to
more informed decision-making.
 Ford Motor Company
Used ABC to assess manufacturing costs and improve resource allocation in its
production processes.
 Nestlé
Implemented ABC to gain insights into the costs associated with different product
lines, helping to optimize pricing and profitability.
 Boeing
Utilized ABC in its defence and aerospace divisions to better manage complex
production costs and enhance project management.
 Deloitte
Employed ABC in its consulting practices to provide clients with detailed insights into
cost structures and improve operational efficiency.
 American Express
Used ABC to analyze costs related to various services, helping to improve financial
performance and strategic decision-making.
These companies have leveraged the ABC system to enhance cost visibility, optimize
resource allocation, and improve overall profitability.

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10.Outsource Implementation or do it In-house?
Whether to outsource the implementation of an ABC system or to handle it in-house
depends on several factors:
Outsourcing the Implementation
Advantages
 Expertise
External consultants often have specialized knowledge and experience with ABC
systems, leading to a smoother implementation.
 Time Efficiency
Consultants can expedite the process by allowing internal teams to focus on their core
responsibilities.
 Objectivity
An external perspective can provide unbiased insights and recommendations.
 Resource Availability
 If your team lacks the necessary skills or time, outsourcing can fill that gap.
Disadvantages
 Cost
Hiring external consultants can be expensive.
 Less Internal Knowledge Transfer
Relying on outsiders may hinder the development of internal expertise.
11. Softwares that Facilitate the Implementation of
ABC System
There are several specialized software solutions designed to facilitate the implementation
of the ABC system.
Here are the top ten software options that include built-in capabilities for ABC System:

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 Oracle NetSuite
A comprehensive cloud ERP solution that supports ABC, helping organizations
manage costs effectively.
 SAP Business ByDesign
An integrated cloud ERP that offers tools for activity-based costing and financial
management.
 Microsoft Dynamics 365
Provides functionality for ABC as part of its broader financial management
capabilities.
 Sage Intacct
A cloud-based financial management solution that supports ABC to improve cost
visibility and analysis.
 IBM Cognos Analytics
A business intelligence and performance management tool that allows for ABC
implementation and analysis.
 Infor CloudSuite
Offers industry-specific solutions with ABC capabilities, enabling detailed cost
tracking and management.
 CostPerform
A dedicated cost management solution that focuses on ABC and provides extensive
functionality for cost analysis.
 Prophix
A performance management software that supports ABC, facilitating budgeting,
forecasting, and reporting.
 Adaptive Insights (Workday Adaptive Planning)
Provides tools for financial planning and analysis, including support for ABC
methodologies.

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 Tableau
While primarily a data visualization tool, Tableau can be integrated with ABC data
to provide insightful analytics and reporting.
12. Differences between ABC and ABB System
The differences between ABC and Activity-Based Budgeting (ABB) are explained in the
following manner:
Aspect ABC ABB
Main Goal
Calculate actual costs of
products/services
Plan future budgets based on
needed activities
Focus Cost allocation Budget planning
Process
Identifies activities, assigns costs,
calculates costs
Sets goals, identifies required
activities, estimates costs
Outcome
Detailed understanding of
product/service costs
Comprehensive budget aligned with
strategic goals
Conclusion
In short, ABC helps businesses understand their current costs by analyzing activities,
while ABB helps them plan for future expenses based on those activities. Both methods
work together to enhance financial management, but they serve distinct purposes within
an organization.
13. Activity-Based Budgeting
1. Purpose
ABB is used for planning future expenses. It helps organizations set budgets based on
the activities they need to perform to achieve their goals.
2. Focus
The main focus is on budget planning. ABB uses insights from ABC to create a
budget that reflects the resources needed for performing the planned activities.

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3. Process:
 Set Goals
Define the goals or objectives for the upcoming period (e.g., launching a new
product).
 Identify Required Activities
Determine what activities are necessary to achieve those goals.
 Estimate Costs
Use the cost information from ABC to estimate the costs of the required activities.
 Create the Budget
Compile these estimates into a comprehensive budget.
4. Outcome: The result is a well-structured budget that aligns spending with strategic
priorities, ensuring resources are allocated efficiently.
14.Activity-Based Management
Activity-Based Management (ABM) is a management approach that uses insights
derived from Activity-Based Costing to improve organizational performance. ABM
focuses on identifying and managing activities within a business to optimize processes,
reduce costs, and enhance overall effectiveness. It involves proactive decision-
making based on detailed analysis of cost and performance data, aiming to align activities
with organizational goals and customer needs.
Salient Features of ABM
1. Performance Improvement
ABM emphasizes continuous improvement by identifying inefficiencies in processes
and activities.
2. Cost Control
By understanding the costs associated with specific activities, organizations can
make informed decisions to minimize waste.

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3. Strategic Alignment
ABM encourages the alignment of activities with strategic objectives, ensuring that
resources are allocated effectively.
4. Data-Driven Decisions
ABM relies on data analysis to guide management decisions, making it more
strategic than traditional management approaches.
Drawing Comparison of ABM with the Activity-Based Costing System
Feature ABC System ABM
Focus
Cost allocation and accurate
product costing.
Process optimization and
overall organizational
performance.
Purpose
To identify and assign
overhead costs to specific
activities.
To improve efficiency and
effectiveness based on activity
analysis.
Scope
Primarily financial, focused
on cost data.
Broader includes strategic and
operational aspects.
Decision-Making
Reactive, often used for
budgeting and cost control.
Proactive, focuses on strategic
management and process
improvement.
Outcome
Detailed cost information for
pricing and profitability
analysis.
Enhanced decision-making
leads to better resource
allocation and performance.
Conclusion
While ABC provides the cost information necessary for understanding how resources are
consumed by different activities, ABM takes it a step further by using that information to
drive strategic management decisions aimed at improving efficiency and effectiveness
throughout the organization. In essence, ABM builds on the insights gained from ABC,
transforming cost data into actionable strategies for overall performance enhancement.

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15. Case 1: Applying ABC to a manufacturing
company
Making a comparison of the ABC system with the Traditional or
Absorption Costing system, ensuring the accuracy of the product
costs through the application of ABC system
Alpha Ltd is manufacturing two products A and B. Both products are manufactured on
the same machines and undergo the same processes. Here is the detail of budgeted data
obtained for the two products for the financial year ending on December 31, 2022:
Description A B
Budgeted production quantity (units) 25,000 2,500
Number of purchase orders 400 200
Number of set-ups 150 100
Resources required/unit:
Direct material (Rs.) 25 62.5
Direct labor (Hours) 10 10
Machine time (Hours) 5 5
The budgeted production overhead cost for the year has been calculated as follows:
Description Amount (Rs.)
 Volume-related overhead cost 275,000
 Purchase-related overhead cost 300,000
 Set-up-related overhead cost 525,000
Total overhead cost 1,100,000
The budgeted labor rate is Rs. 20 per hour.
The company’s present system is to absorb overhead by-product units using rates per
labor hour. However, the company is considering implementing a system of Activity-
Based Costing.

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The following cost drivers for overheads are used.
 Volume related overheads  Machine hours
 Purchase related overheads  Number of purchase orders
 Set-up related overheads  Number of set-ups
Requirements:
a) Calculate the unit costs for products A and B using:
 The absorption costing system
 The proposed Activity-Based Costing system
b) Compare the results in (i) and (ii) and explain the differences.
Solution:
a) The first step is to determine the overhead absorption rate or cost driver
rates for each activity. Then utilize these rates for data given for each
product.
Description A B Total
Production quantity (units) 25,000 2,500
Direct labor hours required 250,000 25,000 275,000
Rs.
Total production overheads 1,100,000
Description A B Total
Overhead absorption rate per labor hour
(Rs. 1,100,000/275,000)
Rs. 4
 Machine hours required 125,000 12,500 137,500
 Number of purchase orders 400 200 600
 Number of set-ups 150 100 250
Cost per cost driver
Volume-related overhead cost (Rs.) 275,000
Machine hours required 137,500

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Volume-related overhead cost/machine hour
(Rs. 275,000/137,500)
Rs. 2
Purchases related to overhead cost
Rs.
300,000
Number of purchase orders 600
Purchase-related overhead cost/order (Rs. 300,000/600) Rs. 500
Set-ups related to overhead cost Rs.
525,000
Number of set-ups 250
Set-up related overhead cost per set-up (Rs. 525,000/250) Rs. 2,100
(a) (i) Unit cost working under traditional/absorption costing system
Description of cost components A B
Rs. Rs.
Direct materials cost 25.00 62.50
Direct labor cost (Rs. 20 x 10 labor hours/unit) 200.00 200.00
Overheads cost (10 labor hours x Rs. 4) 40.00 40.00
Total cost per unit 265.00 302.50
(a) (ii) Unit cost working under an Activity-Based Costing system
Description of cost components A B
Rs. Rs.
Direct materials cost 25.00 62.50
Direct labor cost 200.00 200.00
Volume-related overhead cost
(Rs. 2 x 5 machine hours/unit)
10.00 10.00
Purchases related overhead cost:
 Product A: [(Rs. 500 x 400 Orders)/ 25,000 Units]
 Product B: [(Rs. 500 x 200 Orders)/2,500 Units]
8 40

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Set-up related overhead cost:
 Product A: [(Rs. 2,100 x 150 Set-ups)/25,000 Units]
 Product B: [(Rs. 2,100 x 100 Set-ups)/25,00 Units] 12.60 84.00
Total cost per unit 255.60 396.50
(b) Difference in cost per unit under the two systems
Description A B
Rs. Rs.
Cost per traditional costing system 265.00 302.50
Cost per ABC costing system 255.60 396.50
Increase/(Decrease)  (9.40) 94.00
% Change (3.55%) 31.07%
Explanation, Conclusion & Recommendation
Under the Traditional Costing System, the cost of Product A is inflated by Rs.
9.40 per unit (equivalent to 3.55% higher), while the cost of Product B is
understated by Rs. 94 per unit (representing 31.07% lower).
These differences in unit costs arise from the inaccurate allocation of overhead
costs inherent in the Traditional or Absorption Costing system.
Consequently, the implementation of the ABC system is strongly recommended
for the company to ensure the correct overhead costs are assigned to Products
A and B.

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16.Case 2: Applying Activity-Based Management
to a manufacturing company
Beta Company is a manufacturing company that produces two products: Product A and
Product B. The company wants to optimize its processes based on the insights from
Activity-Based Costing.
Step 1: Identify Activities and Costs
Beta has identified the following activities and associated costs:
Activity
Cost
(Rs.)
Cost Driver
Cost Driver Rate
(Rs.)
Machine Setup 20,000 Number of Setups 1,000 per setup
Production 50,000 Machine Hours 50 per hour
Quality Inspection 10,000 Number of Inspections 500 per inspection
Packaging 15,000 Number of Units 1 per unit
Step 2: Assign Costs to Products
Assume the following activity data for each product:
Product Setups
Machine
Hours
Inspections
Units
Produced
Product A 10 800 15 5,000
Product B 5 400 5 3,000
Step 3: Calculate Total Costs
Using the activity cost driver rates, we can calculate the costs for each product.
For Product A
1. Machine Setup Cost:
= 10 setups x Rs. 1,000 = Rs. 10,000

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2. Production Cost:
= 800 hours x Rs. 50 = Rs. 40,000
3. Quality Inspection Cost:
= 15 inspections x Rs. 500
= Rs. 7,500
4. Packaging Cost:
= 5,000 units x Rs. 1 = Rs. 5,000
Total Cost for Product A:
= Rs. 10,000 + Rs. 40,000+ Rs. 7,500 + Rs. 5,000 = Rs. 62,500
For Product B
1. Machine Setup Cost:
= 5 setups x Rs. 1,000 = Rs. 5,000
2. Production Cost:
= 400 hours x Rs. 50 = Rs. 20,000
3. Quality Inspection Cost:
= 5 inspections x Rs. 500 = Rs. 2,500
4. Packaging Cost:
= 3,000 units x Rs. 1 =Rs. 3,000
Total Cost for Product B:
= Rs. 5,000 + Rs. 20,000 + Rs. 2,500 + Rs. 3,000
= Rs. 30,500
Step 4: Analyze Costs for Decision-Making
Now that we have the total costs for each product, we can analyze the data to make
decisions:

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Cost Per Unit:
Product A: Rs. 62,500/5,000 = Rs. 12.50
Product B: Rs. 30,500/3,000 = Rs. 10.17
Step 5: Identify Improvement Areas
The company can use these insights to make strategic decisions:
1. Product A is significantly more expensive per unit than Product B. The company
may want to analyze the setup process to see if it can be streamlined.
2. The quality inspection costs are higher for Product A, indicating potential quality
issues or inefficiencies that need to be addressed.
3. If the company wants to increase overall profitability, it may consider reducing setups
for Product A or improving production efficiency to lower costs.
Through ABM, the company can proactively make decisions to optimize
processes, reduce costs, and ultimately improve profitability. By focusing on the
activities that drive costs, management can better align resources with strategic
objectives.

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17. Case 3: ABC system applied to a services-
providing firm
XYZ is a consulting firm. We'll apply Activity-Based Costing to allocate overhead costs
associated with providing consulting services to different clients.
Scenario:
Firm: XYZ Consulting
Type of Services Provided: Management consulting
Total Overhead Costs: Rs. 100,000
Identified Activities and Cost Drivers
1. Client Meetings
Cost: Rs. 40,000
Driver: Number of meetings (200 meetings per year)
2. Research and Analysis
Cost: Rs. 30,000
Driver: Hours spent (1,000 hours per year)
3. Report Preparation
Cost: Rs. 30,000
Driver: Number of reports (150 reports per year)
Step 1: Calculate Activity Rates
1. Client Meetings
Activity Rate = Total Cost/Total Driver Units
Activity Rate = Rs. 40,000/200 meetings
= Rs. 200 per meeting
2. Research and Analysis
Activity Rate = Rs. 30,000/1,000 hours
= Rs. 30 per hour

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3. Report Preparation
= Activity Rate = Rs. 30,000/150 reports
= Rs. 200 per report
Step 2: Assign Costs to a Specific Client
Let's say we provide services for Client D:
Client X Activities:
 Client Meetings: 5 meetings
 Research and Analysis: 20 hours
 Report Preparation: 3 reports
Step 3: Calculate the Total Cost for Client D
1. Client Meetings Cost:
= 5 meetings × Rs. 200/meeting
= Rs. 1,000
2. Research and Analysis Cost:
= 20 hours × Rs. 30/hour
= Rs. 600
3. Report Preparation Cost:
= 3 reports × Rs. 200/report
= Rs. 600
Step 4: Total Cost for Client D
Total Cost for Client D = Meetings Cost + Research Cost + Report Cost
= Rs. 1,000 + Rs. 600 + Rs. 600
= Rs. 2,200
Using Activity-Based Costing, we have determined that the total cost to
provide services for Client D is Rs.2,200. This approach allows the
consulting firm to understand the costs associated with different activities and
make informed pricing and resource allocation decisions.

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18.Case 4: Applying Activity-Based Budgeting to
services providing firm
Scenario:
Company: ABC Software Solutions
Budget Period: One year
Services Provided: Software development and support
Identified Activities and Cost Drivers
1. Project Development
Cost Driver: Development Hours
Estimated Development Hours: 1,200 hours
Cost per Hour: Rs. 80
Total Cost: 1,200 hours x Rs. 80/hour = Rs. 96,000
2. Quality Assurance (QA) Testing
Cost Driver: Number of Test Cases
Estimated Test Cases: 300
Cost per Test Case: Rs. 50
Total Cost: 300 test cases × Rs. 50/test case = Rs. 15,000
3. Client Support
Cost Driver: Support Tickets
Estimated Support Tickets: 600
Cost per Ticket: Rs. 20
Total Cost: 600 tickets × Rs.20/ticket = Rs. 12,000
Step 1: Calculate Total Costs for each activity
1. Project Development:
Total Cost = Rs. 96,000
2. Quality Assurance Testing:
3. Client Support:

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Step 2: Total Budget
Now, let's calculate the overall budget based on the activities:
Total Budget = Project Development Cost + QA Testing Cost + Client
Support Cost
= Rs. 96,000 + Rs. 15,000 + Rs. 12,000
= Rs. 123,000
Step 3: Budget Allocation
Let’s say ABC Software Solutions expects to take on three projects during the year.
They can allocate the budget to each project based on their estimated resource needs.
Project A
Development Hours: 500 hours
Test Cases: 100
Support Tickets: 200
Budget Allocation:
Development: 500 hours × Rs. 80/hour = Rs. 40,000
QA Testing: 100 test cases × Rs. 50/test case = Rs. 5,000
Client Support: 200 tickets × Rs. 20/ticket = Rs. 4,000
Total for Project A = Rs. 40,000 + Rs. 5,000 + Rs. 4,000 = Rs. 49,000
Project B
Development Hours: 400 hours
Test Cases: 150
Support Tickets: 250
Budget Allocation:
Development: 400 hours x Rs.80/hour = Rs. 32,000
QA Testing: 150 test cases x Rs.50/test case = Rs. 7,500
Client Support: 250 tickets x Rs.20/ticket = Rs. 5,000
Total for Project B = Rs. 32,000 + Rs. 7,500 + Rs. 5,000 = Rs. 44,500
Project C
 Development Hours: 300 hours
 Test Cases: 50
 Support Tickets: 100

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Budget Allocation:
 Development: 300 hours × Rs. 80/hour = Rs. 24,000
 QA Testing: 50 test cases × Rs. 50/test case = Rs. 2,500
 Client Support: 100 tickets × Rs. 20/ticket = Rs. 2,000
Total for Project C = Rs. 24,000 + Rs. 2,500 + Rs. 2,000
= Rs. 28,500
Summary of Budgets
 Total Budget for Project A: Rs. 49,000
 Total Budget for Project B: Rs. 44,500
 Total Budget for Project C: Rs. 28,500
The firm has effectively planned its budget using Activity-Based Budgeting,
allowing it to allocate resources based on specific activities. This helps in
understanding costs better and enhances financial planning for each project.
The total projected budget for all projects is Rs.121,000, which is within the
overall budget of Rs. 123,000.
This method provides a clearer picture of resource allocation and can help in
identifying areas for cost control and efficiency improvements.

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19. Case 5: Applying Activity-Based Budgeting on
a manufacturing company
Company Overview:
Company Name: ABC Widgets
Type of Product: Widget A
Production Volume: 10,000 units
Activities carried out:
1. Machine Setup
2. Quality Inspection
3. Assembly
4. Packaging
Step 1: Identify Activities and Cost Drivers
Activity Cost Driver
Cost per Driver
(Rs.)
Total Drivers
Needed
Machine Setup Setups 200/setup 50 setups
Quality Inspection Inspections 100/inspection 100 inspections
Assembly Labor hours 25/hour 400 hours
Packaging Packages 10/package 10,000 packages
Step 2: Calculate Activity Costs
Machine Setup Cost:
Total Setup Cost = Cost per Setup x Total Setups Needed
= 200 x 50
= Rs. 10,000
Quality Inspection Cost:
Total Inspection Cost = Cost per Inspection x Total Inspections Needed
= 100 x 100
= Rs. 10,000

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Assembly Cost:
Total Assembly Cost = Cost per Labor Hour x Total Labor Hours
= 25 x 400
= Rs. 10,000
Packaging Cost:
Total Packaging Cost = Cost per Package x Total Packages Needed
= 10 x 10,000
= Rs. 100,000
Step 3: Total Budgeted Costs
Now, sum the costs of all activities:
Total Budgeted Costs = Setup Cost + Inspection Cost + Assembly Cost +
Packaging Cost
= 10,000+10,000+10,000+100,000
= Rs. 130,000
Step 4: Cost per Unit
To find the cost per unit, divide the total budgeted costs by the production volume:
Cost per Unit = Total Budgeted Costs/Production Volume
= 130,000/10,000
= Rs. 13/unit
 Total Budgeted Costs: Rs. 130,000
 Cost per Unit for Widget A: Rs. 13
This example illustrates how ABC Widgets can use activity-based
budgeting to allocate costs more accurately based on actual activities, leading
to better financial planning and decision-making.
This method provides a clearer picture of resource allocation and can help in
identifying areas for cost control and efficiency improvements.

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20. Case 6: Applying Activity-Based Costing
system to a trading company
Company Overview:
Company Name: Asad Trading Co.
Types of Products Traded: Electronics (e.g., TVs, Laptops, Smartphones)
Annual Sales Volume: 5,000 units across all products
Activities carried out:
1. Order Processing
2. Warehousing
3. Shipping
4. Customer Service
Step 1: Identify Activities and Cost Drivers
Activity Cost Driver
Cost per Driver
(Rs.)
Total Drivers
Needed
Order Processing Orders processed 50/order 200 orders
Warehousing Warehouse space (sq. ft.) 2/sq. ft. 1,000 sq. ft.
Shipping Shipments 30/shipment 400 shipments
Customer Service Customer Inquiries 20/inquiry 300 inquiries
Step 2: Calculate Activity Costs
Order Processing Cost:
Total Order Processing Cost = Cost per Order x Total Orders
= 50 x 200
= Rs. 10,000
Warehousing Cost:
Assuming the total warehouse space utilized is 1,000 sq. ft.:
Total Warehousing Cost = Cost per sq. ft. x Total sq. ft.
= 2×1,000
= Rs. 2,000

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Shipping Cost:
Total Shipping Cost = Cost per Shipment x Total Shipments
= 30 x 400
= Rs. 12,000
Customer Service Cost:
Total Customer Service Cost = Cost per Inquiry x Total Inquiries
= 20 x 300
= Rs. 6,000
Step 3: Total Budgeted Costs
Now, sum the costs of all activities:
Total Budgeted Costs = Order Processing Cost + Warehousing Cost +
Shipping Cost+ Customer Service Cost
= 10,000 + 2,000 + 12,000 + 6,000
= Rs. 30,000
Step 4: Cost per Unit
To find the cost per unit, divide the total budgeted costs by the annual sales volume:
Cost per Unit=Total Budgeted Costs/Annual Sales Volume (Units)
= 30,000/5,000
= Rs. 6/unit
 Total Budgeted Costs: Rs. 30,000
 Cost per Unit for Electronics: Rs. 6
This example demonstrates how Asad Trading Co. can implement an ABC
system to allocate costs based on the actual activities involved in trading,
helping the company understand its cost structure better and make informed
pricing and operational decisions.

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21. Abbreviations Used
The list of abbreviations used
# Abbreviation Description
1 ABB Activity-Based Budgeting
2 ABC Activity-Based Costing
3 ABM Activity-Based Management
4 e.g. exampli gratia
5 ERP Enterprise Resource Planning
6 GAAP Generally Accounting Principles
7 IASs International Accounting Standards
8 IFRSs International Financial Reporting Standards
9 IT Information Technology
10 QA Quality Assessment
11 TVs Televisions

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About the Author
A PricewaterhouseCoopers-trained Accountant, CFO, Financial
Consultant and Audit Expert with more than 20 years of professional
experience in a diverse range of industries and business sectors including banks,
trading, construction, and manufacturing companies. A highly motivated and
dedicated professional with extensive experience in finance who has demonstrated a
hands-on management style in the development and implementation of strategic
plans to ensure company growth. Played a key role in evaluating and strengthening
internal controls, which mitigated risk exposure. Consolidated multiple processes
and systems, which created efficiencies while reducing costs. Established, enforced
and monitored accounting policies and procedures to ensure compliance with
IFRSs/IASs. Demonstrated success in streamlining existing operations, turning
around unprofitable functions, and envisioning new concepts and future trends.

Activity-Based Costing System — All About ABC

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