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Costing Simplified: Activity Based Costing

Prof. Priyanka Patel

In my point of view, the most crucial factor in any business or organization is the “Cost”. Since cost being a crucial factor in every decision making process, the company has to make sure that the process of evaluation and determination of cost is veracious. For that purpose, major companies for the longest time relied on Traditional Costing. The term tradition itself means “An inherited pattern of thought or action”. But in late 1980s, Activity Based Costing was introduced to overcome the deficiencies of Traditional Costing. Now the question is what are the deficiencies?

Let me explain with help of an example. Five friends go to a restaurant for a dinner where they decide to share the bill. One friend say Mr. A orders Pizza which is shared by Mr. B and Mr. C. Mr. D and Mr. E order drinks which are shared by them. Then Mr. B orders main course which is shared between Mr. B, Mr. D and Mr. E. Now when the bill arrives, the friends decide to divide the total amount by 5 and pay the bill equally. This exactly is absorption costing wherein the products of the company may not use all the activities but the overheads are divided equally between all the products. This type of arrangement is fair when it comes to friends but not when it comes to business. Businesses cannot simply rely on assumptions and hence activity based costing comes into the picture.

Here is how ABC will work. Suppose in a fast food centre there are 2 types of burgers. One is Regular Burger and one is Special Burger. The regular burger goes through 3 stages whereas the Special Burger goes through 5 stages. By stages I mean “Cost Drivers”. They are nothing but the steps that each product takes to reach a customer. Now Regular Burger needs LPG supply for roasting Patties and Special burger needs both LPG as well as Electricity supply for roasting and baking. Electricity is not required at all for making Regular Burgers. Hence the electricity cost should not be divided between two burgers but should be allocated to Special Burgers. Similarly, the supplies can also be divided as per the usage. For e.g. Regular Burger uses more ketchup as compared to Special burger then the cost has to be divided as per the usage.

Hence ABC is an accounting method which assigns costs to activities rather than products or services. This helps resources (supplies) and overhead costs to be more accurately designed to the products and services that consume them.