Activity Based Costing - Management Accounting | CMA Inter Syllabus
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Under traditional cost system, overheads costs are first allocated and apportioned to various production and service departments and after that the overheads costs of service departments are re-apportioned to various production departments and once the same are done then finally overheads costs of production departments are absorbed to the cost objects (products, customer) on the basis of labour hours, machine hours, prime cost, direct materials costs and direct wages costs, etc. The principle involved is that the finished products consume the resources in proportion to production volume.
The traditional cost accumulation system of absorption costing was developed at a time when most organisations produced only a narrow range of products (so that products underwent similar operations and consumed similar proportions of overheads). The overhead costs were only a very small fraction of total costs.
The benefits of more accurate systems for overhead allocation would probably have been relatively small. In addition, information processing costs were high.
In recent years, however, there has been a dramatic fall in the costs of processing information, and with the advent of advanced manufacturing technology (AMT), overheads are likely to be far more important and in fact direct labour may account for as little as 5% of a product’s cost. Therefore, now it appears difficult to justify the use of direct labour or direct material as the basis for absorbing overheads or to believe that errors made in attributing overheads will not be significant.
Many resources are used in non-volume related support activities, (which have increased due to AMT) such as setting-up, production scheduling, inspection and data processing. These support activities assist the efficient manufacture of a wide range of products and are not, in general, affected by changes in production volume. They tend to vary in the long term according to the range and complexity of the products manufactured rather than the volume of output.
The wider the range and the more complex the products, the more support services will be required. Consider, for example, factory X which produces 10,000 units of one product, the Gama, and factory Y which produces 1,000 units each of 10 slightly different versions of the Gama. Support activity costs in the factory Y are likely to be a lot higher than in factory X, but the factories produce an identical number of units. For example, factory X will only need to set-up once, whereas Factory Y will have to set-up the production run at least ten times for the ten different products. Factory Y will therefore incur more set-up costs for the same volume of production.
Traditional costing systems, which assume that all products consume all resources in proportion to their production volumes, tend to allocate too great a proportion of overheads to high volume products (which cause relatively little diversity and hence use fewer support services) and too small a proportion of overheads to low volume products (which cause greater diversity and therefore use more support services).
Volume-Based Overhead Rate
The factory overhead rate in a volume-based costing system is either a single over-head rate for the entire operation (plant wide rate) or a set of overhead rates with various rates for different departments or divisions (department rates). These overhead rates use an output-volume-based activity or activities to assign (or to spread) factory overhead costs to products or services. An output-volume-based costing system spreads costs evenly so that each cost object (product or service) receives the same amount.
Let us now recap the various overheads rates that are used in the context of absorption of overheads costs to the products/ jobs/ customer/ work-order, etc.
There are several different methods which can be used to absorb overheads. The following data to determine the total production cost of job number M 626:
| Total cost centre overhead | ₹62,100 |
| Production output | 13,800 units |
| Direct labour hours | 27,000 hours |
| Machine hours | 34,500 hours |
| Direct wages cost | ₹17,250 |
| Direct materials cost | ₹49,680 |
| Prime Cost | ₹66,930 |
Solution :
A Company is manufacturing two products, Product A and Product B and the annual outputs of the two products are 10,000 units and 20,000 units respectively. Total annual overheads of the company is ₹3,00,000. The machine hours required for Product A are 20,000 hours and that of Product B are 10,000 hours, respectively. Then the overhead absorption rates under traditional costing system, using machine hours as the basis can be computed, as under:
| NO.. | Particulars | Product A | Product B |
| 1. | Annual Outputs (units) | ₹10,000 | ₹20,000 |
| 2. | Total Machine Hours | ₹20,000 | ₹10,000 |
| 3. | Overhead Absorption Rate on the basis of Machine Hours (Total Overheads/ Total Machine Hours) = (₹3,00,000/30,000) = ₹10 per hour | ||
| 4. | Total Overheads Costs on the basis of machine hours (No. of machine hours × Rate per machine hour) | ₹2,00,000 | ₹1,00,000 |
| 5. | Overheads Cost per unit (4 ÷ 1) | ₹20 | ₹5 |
From the above, the following inferences can be made for the Traditional Cost System:
a. The finished products consume resources in proportion to the production volume.
b. The proper identification of value added and non-value added activities cannot be made.
c. It does not facilitate the control over those activities, which cause fixed overhead costs.
d. A Single/ Blanket rate is used to absorbs the overheads costs to the cost objects, causing cost distortion.
e. It is a subjective approach, since this system uses arbitrary bases for apportionment of overheads costs over the cost objects.
Activity-based costing is an effective costing system that focuses on activities. ABC is a refined costing system, or a more specific way to assign costs to cost objects. The system avoids using big, generic categories, such as splitting a cost evenly between divisions. Instead, it allocates indirect costs to the activities that generate those costs. The result is likely to be more accurate costing and product pricing.
ABC Basic Premises:
ABC emphasizes the importance of linking indirect costs to activity in the cost allocation exercise. It argues that cost is derived from activities. When there are more activities, more costs will be incurred. Based on this logic, cost should be allocated according to the activities that drive costs to the cost object. Cost objects are the defined objects for allocation of indirect costs, e.g., product portfolio, customers, or business units. Cost pools are the costs gathered to serve similar functions, e.g., production, marketing units, and finance department. Cost drivers are the key attributes or proxies which are the causes of spending, e.g., no. of purchase orders for purchase department, service hours for engineering department, and no. of employees for human resource units. Cost drivers serve as allocation base for allocation of cost to cost objects, and the degree of costs allocated rests with the level of activity (in terms of the consumption base). Using this allocation method, cost can be more accurately allocated to the cost object.
Activity-based costing plays an important role in companies’ strategies and long-range plans to develop a competitive cost advantage. While activity - based costing focuses attention on activities in allocating overhead costs to products, activity-based management focuses on managing activities to reduce costs. Cost reduction generally requires a change in activities. Top management can send notices to company employees to reduce costs, but the implementation requires a change in activities. An entity cannot know the effect of a change in activities on costs without the type of cost information provided by activity-based costing.
Activity-Based Costing (ABC) is that costing in which costs begin with tracing of activities and then to producing the product. In other words, it is the process of costing system which focuses on activities performed to produce products. This system assumes that activities are responsible for the incurrence of costs and products creates the demand for activities. Costs are charged to products based on individual product’s use of each activity.
ABC aims at identifying as many costs as possible to be subsequently accounted as direct cost of production. Any cost that is traced to a particular product via its consumption of activity becomes direct of the product. For instance, in conventional costing system, cost of setup and adjustment time is considered as factory overhead and subsequently assigned to different products on the basis of direct labour hours, but in Activity-Based Costing, set-up and adjustment time is determined for
each product and its costs are directly charged to each product. Thus, by emphasizing activities, ABC tries to ascertain the factors that cause each major activity, cost of such activities and the relationship between activities and products produced.
Activity-Based Costing had its genesis in the increasing importance of indirect costs in the manufacturing operations. The direct processing costs which are easier to handle are being relegated to the background with each passing day due to automation. In this changing scenario where indirect costs outweigh the direct processing costs in many a situation, one cannot be content with rough and ready methods of dealing with indirect costs.
The concept of ABC was first defined in the late 1980s by Robert Kaplan and William Burns. Initially ABC focused on manufacturing industry where technological developments and productivity improvements had reduced the proportion of direct labour and material costs, but increased the proportion of indirect or overhead costs. ABC is generally used as a tool for understanding cost and profitability of individual products.
ABC costing will enable management to better understand the cause of costs, and from here action can be taken to control and reduce costs through controlling and reducing the demand for cost causing activities.
According to CIMA Official Terminology, Activity Based Costing is ‘An approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs.’
An ABC system assigns overheads to each major activity (rather than departments). With ABC systems, many activity-based cost centres (alternatively known as activity cost pools) are established, whereas with traditional systems overheads tend to be pooled by departments, although they are normally described as cost centres.
Activities consist of the aggregation of many different tasks, events or units of work that cause the consumption of resources. Typical support activities include: schedule production, set-up machines, move materials, purchase materials, inspect items, process supplier records, expedite and process customer orders. Production process activities include machine products and assemble products. Within the production process, activity cost centres are sometimes identical to the cost centres used by traditional cost systems. Support activities are also sometimes identical to cost centres used by traditional systems, such as when the purchasing department and activity are both treated as cost centres. Overall, however, ABC systems will normally have a greater number of cost centres compared with traditional systems.
The second stage of the two-stage allocation process allocates costs from cost centres (pools) to products or other chosen cost objects. Traditional costing systems trace overheads to products using a small number of second stage allocation bases (normally described as overhead allocation rates), which vary directly with the volume produced. Instead of using the terms ‘allocation bases’ or ‘overhead allocation rates’ the term ‘cost driver’ is used by ABC systems. Direct labour and machine hours are the allocation bases that are normally used by traditional costing systems. In contrast, ABC systems use many different types of second-stage cost drivers, including non-volume-based drivers, such as the number of production runs for production scheduling and the number of purchase orders for the purchasing activity
The purpose of moving from a traditional costing system to an ABC system must be based on the premise that the new information provided will lead to action that will increase the overall profitability of the business. This is most likely to occur when the analysis provided under the ABC system differs significantly from that which was provided under the traditional system, which is most likely to occur under the following conditions:
(i) When production overheads are high relative to direct costs, particularly direct labour.
(ii) Where there is great diversity in the product range.
(iii) Where there is considerable diversity of overhead resource input to products.
(iv) When consumption of overhead resources is not driven primarily by volume.
Information from an ABC analysis may indicate opportunities to increase profitability in a variety of ways, many of which are long term. For example, an activity-based analysis often reveals that small-batch items are relatively expensive to produce, and are therefore unprofitable at current prices. A number of responses to this information could be adopted. The first response might be to consider stopping production of such items, and concentrate on the apparently more profitable high-volume lines. Another approach would be to investigate how the production process could be organized in such a way as to bring the cost of producing small-batch items closer to that of producing high-volume goods. By identifying the cost of carrying out particular activities, the new approach provides opportunities for directing attention to matters of cost control. It can therefore be viewed as a much longer-term technique then the word ‘costing’ in the title suggests. The establishment of an ABC product cost may thus be considered to be merely the beginning of a process, rather than an end in itself. The recent use of the term activity-based management suggests this forward-looking orientation, which is assuming increasing importance.
Traditional product costing systems were designed when most of the companies manufactured a narrow range of products. Direct materials and direct labour were the dominant factors of production then. Companies were in the sellers’ market. Overheads were relatively small and distortions due to inappropriate treatment were not significant. Cost of processing information was high.
Today, companies produce a wide range of products. Overheads are of considerable importance Simple methods of apportioning overheads based on direct labour are not justified. Intense global competition calls for correct costing of products to avoid errors in decision-making. Traditional systems can measure volume related costs. Non-volume related activities like material handling, set-up etc. are important and their costs cannot be apportioned on volume basis. Hence, the need for emergence of activity based costing arises.
1. To identify the different activities within the organisation. Usually the number of cost centres that a traditional overhead system uses is quite small, say up to 15. In ABC the number of activities will be much more, say 200; the number will depend on how the management subdivides the organisation’s activities. It is possible to break the organisation down into many very small activities, but if ABC is to be an acceptable and practical system it is necessary to use larger groupings, so that, say, 40 activities may be used in practice. The additional number of activities over cost centres means that ABC should be more accurate than the traditional method.
2. To determine what causes the cost of each activity – the cost driver (e.g. machine hours; number of dispatch orders).
3. To calculate the total cost for each activity – the cost pool (e.g. total machining costs; total costs of dispatch department).
4. To calculate an overhead absorption rate for each cost driver.
5. Activity Cost Driver Rate = Total Cost of an Activity / Cost Driver
6. To calculate the total overhead cost for each product manufactured.
7. To calculate the overhead cost per unit for each product.
Activities comprise of units of work or tasks. For example, purchase of materials is an activity consisting a series of tasks like purchase requisition, advertisement inviting quotations, identification of suppliers, placement of purchase order, follow - up, etc.
Manufacturing activities can be classified along a cost hierarchy dimension consisting of:
a. Unit-level activities;
b. Batch-level activities;
c. Product-sustaining activities;
d. Facility-sustaining activities.
In the following lines the above mentioned activities are discussed:
a. Unit-level activities (also known as volume-related activities) are performed each time a unit of the product or service is produced. Expenses in this category include direct labour, direct materials, energy costs and expenses that are consumed in proportion to machine processing time (such as maintenance). Unit-level activities consume resources in proportion to the number of units of production and sales volume. For example, if a firm produces 10 per cent more units it will consume 10 per cent more labour cost, 10 per cent more machine hours and 10 per cent more energy costs.
Typical cost drivers for unit level activities include labour hours, machine hours and the quantity of materials processed. These cost drivers are also used by traditional costing systems. Traditional systems are therefore also appropriate for assigning the costs of unit-level activities to cost objects.
b. Batch-related activities, such as setting up a machine or processing a purchase order, are performed each time a batch of goods is produced. The cost of batch-related activities varies with the number of batches made, but is common (or fixed) for all units within the batch. For example, set-up resources are consumed when a machine is changed from one product to another. As more batches are produced, more set-up resources are consumed. It costs the same to set-up a machine for 10 or 5000 items. Thus, the demands for the set-up resources are independent of the number of units produced after completing the set-up. Similarly, purchasing resources are consumed each time a purchasing order is processed, but the resources consumed are independent of the number of units included in the purchase order. Other examples of batch-related costs include resources devoted to production scheduling, first-item inspection and materials movement. Traditional costing systems treat batch-related expenses as fixed costs, whereas ABC systems assume that batch-related expenses vary with the number of batches processed.
c. Product-sustaining activities or service-sustaining activities are performed to enable the production and sale of individual products (or services). These activities are performed to support the production of each different type of product. Maintenance of equipment, engineering charges, testing routines, maintaining bills of materials etc. are the few examples of product level activities.
d. The final activity category is facility-sustaining (or business-sustaining) activities. They are performed to support the facility’s general manufacturing process and include general administrative staff, plant management and property costs. They are incurred to support the organisation as a whole and are common and joint to all products manufactured in the plant. There would have to be a dramatic change in activity, resulting in an expansion or contraction in the size of the plant, for facility-sustaining costs to change. Such events are most unlikely in most organisations. Therefore, these costs should not be assigned to products since they are unavoidable and irrelevant for most decisions. Instead, they are regarded as common costs to all products made in the plant and deducted as a lump sum from the total of the operating margins from all products.
It is an item for which cost measurement is required e.g. a product or a customer.
ABC Company manufactures three products: A, B, and C. Data for the period just ended is as follows:
| Particulars | A | B | C |
| Production (units) | 20,000 | 25,000 | 2,000 |
| Sales price (per unit) | ₹20 | ₹20 | ₹20 |
| Material cost (per unit) | ₹5 | ₹10 | ₹10 |
| Labour hours (per unit) | 2 hours | 1 hour | 1 hour |
(Labour is paid at the rate of ₹5 per hour)
Overheads for the period were as follows: Amount (₹)
| Set-up costs | 90,000 |
| Receiving | 30,000 |
| Despatch | 15,000 |
| Machining | 55,000 |
| 1,90,000 |
| Cost driver data | A | B | C |
| Machine hours per unit | 2 | 2 | 2 |
| Number of set-up | 10 | 13 | 2 |
| Number of deliveries received | 10 | 10 | 2 |
| Number of orders dispatched | 20 | 20 | 20 |
a. Calculate the cost and profit per unit, absorbing all the overheads on the basis of labour hours.
b. Calculate the cost and profit per unit absorbing the overheads using an Activity Based Costing approach.
Solution :
The term cost pools are used to describe a location to which overhead costs are initially assigned. Normally cost centres consist of departments, but in some cases they consist of smaller segments such as separate work centres within a department. A cost pool is a grouping of individual costs, typically by department or service center. Cost allocations are then made from the cost pool. For example, the cost of the maintenance department is accumulated in a cost pool and then allocated to those departments using its services.
Cost pools are commonly used for the allocation of factory overhead to units of production, as required by several accounting frameworks. They are also used in activity-based costing to allocate costs to activities. A business that wants to allocate costs at a highly-refined level may choose to do so using a number of cost pools.
The various Cost Pools may be as under in a manufacturing company:
a. Purchasing Department
b. Receiving Department
c. Material Handling
d. Set-up of Machines
e. Inspection and Quality Control
f. Research and Developments
g. Customer Service
h. Production Control
It is a factor that causes a change in the cost of an activity.
Some Cost Drivers that are used in the context of Activity Based Costing:
It is an item for which cost ascertainment is required. For example, a product, a service, a job, a work order no, or a customer, etc.
The numbers of uses to which an ABC system can be put are only limited by the imagination of the user. Here are some of its more common applications:
a. ABC recognizes the increased complexity of modern businesses with its multiple cost drivers, many of which are transaction based rather than volume based.
b. ABC is concerned with all overhead costs, including such ‘non-factory floor’ costs as quality control and customer service, and so it takes cost accounting beyond its ‘traditional’ factory floor boundaries.
c. ABC gives a meaningful analysis of costs which should provide a suitable basis for decisions about pricing, product mix, design and production.
d. ABC helps with cost reduction because it provides an insight into causal activities and allows organisations to consider the possibility of outsourcing particular activities, or even of moving to different areas in the industry value chain.
e. ABC can be used in conjunction with customer profitability analysis (CPA) to determine more accurately the profit earned by serving particular customers.
f. ABC can be used by service and retail organisations. Many service and retail businesses have characteristics very similar to those required for the successful application of ABC in modern manufacturing industry.
The main advantages of ABC can further be summarized under the following points:
a. To link the cost to its causal factor – i.e. the Cost Driver
b. To identify costs of activities rather than cost centres
c. To ascertain product costs with greater accuracy by relating overheads to activities
d. To overcome the inherent limitations of traditional absorption costing and use of blanket overhead rates
e. To assist managers in budgeting and performance measurement
f. To provide the links between the activities, the organizational acts and the resources consumed, and illustrate the differences between resource consumption and resource provision
g. To help in cost control and cost reduction, as well as improved profitability.
h. To provide valuable economic information to support a company’s operational improvement and customer satisfaction programs.
i. To furnish many significant benefits over traditional costing techniques:
(i) most accurate data about product cost;
(ii) more comprehensive cost information for performance measurement;
(iii) relevant data for management’s decision-making;
(iv) more potential for sensitivity analysis;
(v) providing a model prospect on value-adding organizational transactions and activities.
ABC can be applied most effectively in the following situations:
(i) A highly competitive market
(ii) Diversity of products, processes and customers
(iii) Significant overhead costs which are not easily assigned to individual products
(iv) Demands placed on overhead resources by individual products and customers, which are not proportional to volume.
The demerits of ABC are as follows:
a. The cost of obtaining and interpreting the new information may be considerable. ABC should not be introduced unless it can provide additional information for management to use in planning or control decisions.
b. Some arbitrary cost apportionment may still be required at the cost pooling stage for items like rent, rates and building depreciation. If an ABC system has many cost pools, the amount of apportionment needed may be greater than ever.
c. Many overheads relate neither to volume nor to complexity. The ability of a single cost driver to fully explain the cost behaviour of all items in its associated pool is questionable.
d. There will have to be a trade-off between accuracy, the number of cost drivers and complexity.
e. ABC tends to burden low-volume (new) products with a punitive level of overhead costs and hence threatens opportunities for successful innovation if it is used without due care.
f. Some people have questioned the fundamental assumption that activities cause cost; they suggest that decisions cause cost or the passage of time causes cost or that there may be no clear cause of cost.
The main drawbacks of ABC can also be summarized under the following points:
a. Implementing an ABC system requires substantial resources, which is costly to maintain.
b. Activity Based Costing is a complex system which needs lot of record for calculations.
c. In small organisation mangers are accustomed to use traditional costing systems to run their operations and traditional costing systems are often used in performance evaluations.
d. Activity based costing data can be easily misinterpreted and must be used with care when used in decision making. Managers must identify which costs are really relevant for the decisions at hand.
e. Reports generated by these systems do not conform to generally accepted accounting principles (GAAP). Consequently, an organisation involved in activity based costing should have two cost systems - one for internal use and one for preparing external reports.
Further the areas in which Activity based information is used for decision making are as under:
ABC supports corporate strategy in the following manner:
ABC supports corporate strategy in many ways such as:
In discussing the question ‘Does your company need a new cost system?’ Cooper suggested that the managers should ask themselves ‘Do I really know what my products cost?’ If the answer to this question is ‘no’, he urged that managers should consider whether it is necessary to undertake a detailed analysis of their cost accounting system, but rather than undertaking a major and costly analysis in every case, he suggested that managers look for the following symptoms which are indicative of a need for ABC:
Managers should look for these symptoms and ask themselves whether they have confidence in their product costinformation. As symptoms may have other explanations, it is important to consider: the range of possibilities and to evaluate which is more likely. However, even if it appears that, existing product costs are misleading it may not always be necessary to incorporate ABC into the accounting system. It must be remembered that the introduction of the ABC system involves major expense and thus managers must ask themselves whether the benefits to be derived from the superior information exceed the cost of the new accounting system.
In the present industrial scenario, it becomes difficult in the industry to survive unless the overhear costs are correctly accounted for, controlled and reduced so as to sustain, remain and grow in the industry. We cannot reduce the direct cost of the product, (unless materials of cheaper value are used) but we can control very much the overheads. This can be done only when one has the information of the cost centers with respect to function or activity. The overhead costs involved, for a product do not usually give a clear picture so as to control and reduce these costs. Therefore, it becomes necessary to have a costing system based on activity done, because of this need for ABC arises. Thus ABC has a wide scope in the context of cost reduction and cost control.
It may be made clear that ABC cannot be applied where a distinction cannot be made for the costs attached to various activities or functions. Implementation of ABC should be made from shop floor to managerial level. If ABC is applied correctly at the correct place and time, the company can attain more profits than before.
Although the activity based approach looks attractive, it is unlikely to be practical to relate all overheads to specific activities. Moreover, the approach implicitly assumes a sense co-operative behaviour among operating units and between operating units and service functions. It does not acknowledge the possibility of conflict over the allocation process of overheads. Apart from their narrow concern over efficiency and optimal profitability, the advocates of activity based approach have not attempted to explain why firms insist on using simple methods of allocation of overheads.
However, ABC system has been widely implemented in large organisations in US and Europe. ABC system can be successfully used in other segments of the organisation i.e., administration, selling, distribution etc. It can equally be applied in service sectors like banks, insurance, hospitals and other institutions providing services.
ABC has the same objectives in service firms as in manufacturing organisations. ABC can prove very useful to many service organizations such as airlines, insurance companies, banks, hospitals, hotels, railways, financial service firms. In these service organisations, managers need accurate information about the cost of services being provided by them. Further, such service firms require using this information to improve their operations and to fulfill the needs of their customers in a more cost effective manner.
Large-scale service organizations have a number of features that have been identified as being necessary to derive significant benefits from the introduction of ABC:
(i) They operate in a highly competitive environment;
(ii) They incur a large proportion of indirect costs that cannot be directly assigned to specific cost objects;
(iii) Products and customers differ significantly in terms of consuming overhead resources;
(iv) They market many different products and services.
The uses for ABC information for service industries are similar to those for manufacturing organisations:
(i) It leads to more accurate product costs as a basis for pricing decisions when cost-plus pricing methods are used;
(ii) It results in more accurate product and customer profitability analysis statements that provide a more appropriate basis for decision-making;
(iii) ABC attaches costs to activities and identifies the cost drivers that cause the costs. Thus, ABC provides a better understanding of what causes costs and highlights ways of performing activities more effectively by reducing cost driver transactions. Costs can therefore be managed more effectively in the long term. Activities can also be analyzed into value added and non-value added activities and by highlighting the costs of non-value added activities attention is drawn to areas where there is a potential for cost reduction without reducing the products’ service potentials to customers.
A company manufactures the following two products:
X - A standard product
Y - A low volume complex product requiring specialized skills and activities
Cost of production is as under (₹ 000):
| Materials (equal for both) | 300 |
| Labour (5000 hrs. @ ₹10/hr.) | 50 |
| Overheads | 100 |
| Total | 450 |
To apply ABC, the following information was collected after detailed analysis of operation:
| Activities | Prod-X | Prod-Y | Cost |
| Set-ups | 5 Times | 10 Times | 20.00 |
| Material Handling | 30% | 70% | 15.00 |
| Inspection | 45% | 55% | 35.00 |
| Maintenance Requests | 15 Times | 20 Times | 30.00 |
| Total cost (‘000) | 100.00 |
| Activities | Prod-X | Prod-Y |
| Materials | 150.00 | 150.00 |
| Labour | 30.00 | 20.00 |
| Overheads | ||
| Set Ups | 6.60 | 13.40 |
| Material Handling | 4.50 | 10.50 |
| Inspection | 15.75 | 19.25 |
| Maintenance Requests | 12.90 | 17.10 |
| Total Cost as - ABC System | 219.75 | 230.25 |
| Total Cost - Traditional System | 240.00* | 210.00* |
| Percentage (Decrease)/Increase | (8.44%) | 9.64% |
As a Management Accountant of the Company, you are required to comment on the impact of pricing of the two products. Overheads are recovered under Traditional system on the basis of labour hour rate.
| Activities | X | Y |
| Materials | 150 | 150 |
| Labour @ 0.01 × hours X 0.01 × 3000 Y 0.01 × 2000 |
30 | 20 |
| Overheads X 0.02 × 3000 Y 0.02 × 2000 |
60 | 40 |
| Total | 240 | 210 |
From the above calculations, it is evident that, the Company is able to reduce that cost by ` 2.20, with application Fof ABC System and this will improve that overall profitablity of the Company.
You are the Cost Controller of ABC Company Limited. You are vouching for the introduction of Activity Based Costing in the Company and in the meeting with other executives of the Company, you said ‘Why is using a single plant wide allocation rate not always accurate?’
You are required to give your view, in support of the above statement.
Your Cost Controller is not happy about the existing system of charging overheads to its Products, A and B. You have been newly appointed as a Management Accountant of the company and you are asked to implement the ABC Costing for allocation of overheads to the Products. You have identified the following activities, budgeted costs, and activity consumption cost drivers as follows:
| Activity | Budgeted Cost | Activity Consumption Cost Driver |
| Engineering | ₹ 1,25,000 | Engineering hours |
| Setups | 3,00,000 | Number of setups |
| Machine operation | 15,00,000 | Machine-hours |
| Packing | 75,000 | Number of packing orders |
| Total | ₹ 20,00,000 |
You have also gathered the following operating data pertaining to each of its products:
| Particulars | Product A | Product B | Total |
| Engineering hour | 5,000 | 7,500 | 12,500 |
| Number of setups | 200 | 100 | 300 |
| Machine hours | 50,000 | 1,00,000 | 1,50,000 |
| Number of packing orders | 5,000 | 10,000 | 15,000 |
You are now required to provide with necessary calculations and relevant information, in the form of a report to the Cost Controller about the allocation of overheads costs to the products.
Large service organisations, such as Insurance, Banks and Hospitals, used to be noted for their lack of standard costing systems, and their relatively unsophisticated budgeting and control systems compared with large manufacturing organisations. But this is changing and many large service organisations are now revising their use of management accounting techniques.
a. Explain which features of large-scale service organisations encourage the application of activity-based approaches to the analysis of cost information.
b. Explain which features of service organisations may create problems for the application of activity-based costing.
c. Explain the uses for activity-based cost information in service industries.
d. Many large service organisations were at one time state-owned, but have been privatized. Examples in some countries include electricity supply and telecommunications. They are often regulated. Similar systems of regulation of prices by an independent authority exist in many countries, and are designed to act as a surrogate for market competition in industries where it is difficult to ensure a genuinely competitive market.
Explain which aspects of cost information and systems in service organisations would particularly interest a regulator, and why these features would be of interest.
Hamid & Co, make laptop computers for use in dangerous environments. The company’s main customers are organisations like oil companies and the military that require a laptop that can survive rough handling in transport to a site and can be made to their unique requirements.
The company started as a basic laptop manufacturer but its competitors grew much larger and RL had to find a niche market where its small size would not hinder its ability to compete. It is now considered one of the best quality producers in this sector.
Hamid & Company had the same finance director for many years who preferred to develop its systems organically. However, due to fall in profitability, a new chief executive officer (CEO) has been appointed who wishes to review Hamid’s financial control systems in order to get better information with which to tackle the profit issue.
The CEO wants to begin by thinking about the pricing of the laptops to ensure that selling expensive products at the wrong price is not compromising profit margins. The laptops are individually specified by customers for each order and pricing has been on a production cost plus basis with a mark-up of 45 per cent. The company uses an absorption costing system based on labour hours in order to calculate the production cost per unit.
The main control system used within the company is the annual budget. It is set before the start of the financial year and variances are monitored and acted on by line managers.
The CEO has been reading about major companies that have stopped using budgets and wants to know how such a radical move works and why a company might take such a step. He has been worried by moves by competitors into Hamid’s market with impressive new products. This has created unrest among the staff at Hamid with two experienced managers leaving the company.
Required:
An evaluation of the current method of costing against an activity-based costing (ABC) system.
“The basic idea justifying the use of Activity-Based Costing (ABC) and Activity-Based Budgeting (ABB) are well publicized, and the number of applications has increased. However, there are apparently still significant problems in changing from existing systems”.
a. Explain which characteristics of an organisation, such as its structure, product range, or environment, may make the use of activity based techniques particularly useful.
b. Explain the problems that may cause an organisation to decide not to use, or to abandon use of, activity based techniques.
c. Some categorizations of cost drivers provide hierarchical models:
(i) unit-level activities, (ii) batch activities, (iii) product sustaining activities, (iv) facility sustaining activities.
Other analyses focus on ‘value adding’ and ‘non-value adding’ activities.
Explain what is meant by ‘non-value adding activities’, and discuss the usefulness of this form of analysis.
State with a brief reason whether you would recommend an activity based system of costing in each of the following independent situations:
(i) Company Dee produces one product. The overhead costs mainly consist of depreciation.
(ii) Company BC produces 5 different products using different production facilities.
(iii) A consultancy firm consisting of lawyers, accountants and computer engineers provides management consultancy services.
(iv) Company Simens produces two different labour intensive products. The contribution per unit in both products is very high. The BEP is very low. All the work is carried on efficiently to meet the target costs
State whether each of the following independent activities is value-added or non-value-added:
(i) Polishing of furniture used by a systems engineer in a software firm.
(ii) Maintenance by a software company of receivables management software for a banking company
(iii) Painting of pencils manufactured by a pencil factory
(iv) Customers’ computer key board cleaning by a computer repair centre.
(v) Providing, brake adjustments in cars received for service by a car service center.
ABC Ltd. uses activity based costing and accumulates overhead costs in the following cost pools:
You are to find out for each cost pool whether the cost pool would be unit-level, batch-level, product-level or facility level.
| Particulars | Percentage (%) |
| Costs relating to sets-up | 35 |
| Costs relating to materials handling | 15 |
| Costs relating to inspection | 50 |
| Total production overhead | 100 |
The following total activity volumes are associated with each product line for the period as a whole:
| Product | No. of Set-up | No. of movement of materials | No. of Inspections |
| A | 75 | 12 | 150 |
| B | 115 | 21 | 180 |
| C | 480 | 87 | 670 |
| 670 | 120 | 1,000 |
Required:
Identify the cost drivers for each of the cost mentioned above.
| Total Overheads | ₹1,00,000 |
| Costs relating to set ups | 50% |
| Costs relating to inspections | 50% |
| Number of Set ups | 100 |
| Number of Inspections | 50 |
Required
Calculate the various Cost Driver Rates.
ABC & Associates provides consulting and tax preparation services to its clients. It charges a ₹100 fee per hour for each service. The firm’s revenues and costs for the month March 2022 are shown in the following income statement:
| Particulars | Tax Preparation | Tax Consulting | Total Total |
| Revenue - Amount (₹) | 1,30,000 | 2,70,000 | 4,00,000 |
| Expenses: | |||
| Secretarial support | 80,000 | ||
| Supplies | 72,000 | ||
| Computer costs, etc | 40,000 | ||
| Profit | 1,92,000 |
The firm uses ABC and the following are the cost drives:
| Overhead Cost | Cost Driver | Tax Preparation | Tax Consulting |
| Secretarial support | Number of clients | 72 | 48 |
| Supplies | Transactions with clients | 200 | 300 |
| Computer costs | Computer hours | 1,000 | 600 |
Required:
a. Complete the income statement using activity-based costing and the firm’s three cost drivers.
b. Recompute the income statement using direct-labour hours as the only allocation base: 1,300 hours for tax preparation; 2,700 hours for tax consulting.
c. How might the firm’s decisions be altered if it were to allocate all overhead costs using direct labour hours?
d. Under what circumstances would the about-based allocation and activity-based costing (using the three cost drivers) result in similar profit results?
A manufacturing company has three accounts clerks responsible for processing purchase invoices of suppliers. Each clerk is paid a salary of ₹1,50,000 per annum and is capable of processing 5,000 purchase invoices per year. In addition to the salary, the company spends ₹45,000 per year for printing of forms, postage etc. (assuming that 15,000 purchase invoices are processed).
During the year, 12,500 purchase invoices were processed. You are required to:
a. Calculate the activity rate for the purchase order activity. Break the activity rate into fixed and variable components.
b. Calculate the total activity availability and break this into activity usage and unused activity.
c. Calculate the total cost of resources supplied and break this into activity usage and unused activity.
ABC Company manufactures four products, A, B, C and D, using the same manufacturing process. The following data are available relating to a production period:
| Product | Volume | Material Cost per unit (₹) | Direct Labour per unit | Machine Time per unit | Labour Cost Cost per unit (₹) |
| A | 500 | 5 | 0.5 hour | ¼ hour | 3 |
| B | 5,000 | 5 | 0. 5 hour | ¼ hour | 3 |
| C | 600 | 16 | 2 hours | 1 hour | 12 |
| D | 7,000 | 17 | 2.5 hours | 1.5 hours | 9 |
Total Production Overheads are as under:
| Particulars | ₹ |
| Machine related Costs | 37,749 |
| Set-up Costs | 4,250 |
| Ordering Costs | 1,920 |
| Material Handling Costs | 7,560 |
| Spare parts Administration Costs | 8,400 |
| 59,879 |
The Company absorbs factory overheads to the products by machine hour rate method and the hourly rate per machine hour is ₹4.80. The overheads cost of the products are as under:
| Product | ₹ |
| A | 1.2 |
| B | 1.2 |
| C | 4.8 |
| D | 7.2 |
The production overheads activities for the period reveal the following:
| Products | No. of Set-ups | No. of Materials Orders | No. of times Materials handled | Number of Spare parts |
| A | 1 | 1 | 2 | 2 |
| B | 6 | 4 | 10 | 5 |
| C | 2 | 1 | 3 | 1 |
| D | 8 | 4 | 12 | 4 |
Prepare a Statement of Overhead Cost for all the Products, by using Activity Based Costing and compare the results with Traditional Costing.
Solution :
C Ltd manufactures four products W, X, Y and Z. Output and cost data for the period just ended are as follows:
| Products | Output units | Material Cost per unit ₹ | Labour Cost per unit ₹ | Machine Time per unit (Hours) |
| W | 3,000 | 50 | 50 | 0.50 |
| X | 500 | 70 | 60 | 0.50 |
| Y | 300 | 160 | 100 | 2.00 |
| Z | 1,000 | 180 | 75 | 4.00 |
| Products | W | X | Y | Z | Total |
| No. of Set-up | 10 | 1 | 2 | 5 | 18 |
| No. of Purchase Orders | 6 | 1 | 1 | 5 | 13 |
| No. of Material Handling | 12 | 1 | 2 | 15 | 30 |
The following are the Overhead Costs:
| Particulars | ₹ |
| Set-up Costs | 9,000 |
| Purchase Ordering Costs | 10,400 |
| Handling Costs | 6,000 |
| Other Factory Overhead Costs | 1,27,000 |
| 1,52,400 |
Presently overheads costs are charged to the products on the basis of Machine Hours.
Prepare the Cost Statements under Traditional and ABC.
Solution :
A.Ltd. manufactures four products, namely A, B, C and D using the same plant and process. The following information relates to a production period:
| Product | A | B | C | D |
| Output in units | 720 | 600 | 480 | 504 |
| Cost per unit (₹): Direct Material | 42 | 45 | 40 | 48 |
| Direct labour | 10 | 9 | 7 | 8 |
| Machine hours per unit | 4 hrs | 3 hrs | 2 hrs | 1 hr |
The four products are similar and are usually produced in production runs of 24 units and sold in batches of 12 units. Using machine hour rate currently absorbs the production overheads. The total overheads incurred by the company for the period is as follows:
| Particulars | ₹ |
| Machine operation and Maintenance cost | 63,000 |
| Setup costs | 20,000 |
| Store receiving | 15,000 |
| Inspection | 10,000 |
| Material handling and dispatch | 2,592 |
| 1,10,592 |
During the period the following cost drivers are to be used for the overhead cost:
| Cost | Cost driver |
| Setup cost | No. of production runs |
| Store receiving | No. of Requisition raised |
| Inspection | No. of production runs |
| Material handling and dispatch | Orders executed |
It is also determined that:
Required:
(i) Calculate the total costs of each product, if all overhead costs are absorbed on machine hour rate basis.
(ii) Calculate the total costs of each product using activity base costing.
(iii) Comment briefly on differences disclosed between overhead traced by present system and those traced by activity based costing.
Solution :
Kalyani Manufacturing Company has three salaried accounts payable clerks responsible for processing purchase invoices. Each clerk is paid a salary of ₹30,000 and is capable of processing 5,000 invoices per year (working efficiently).
In addition to the salaries, Kalyani spends ₹9,000 per year for forms, postage and so on (assuming 15,000 invoices are processed). During the year, 12,500 invoices were processed.
Required
a. Calculate the activity rate for the purchase order activity. Break the activity into fixed and variable components.
b. Compute the total activity availability, and break this into activity usage and unused activity.
c. Calculate the total cost of resources supplied, and break this into activity usage and unused activity.
Solution :
Information relating to the four products made and sold by a company is as follows for one period.
| Particulars | A | B | C | D |
| Output in units | 120 | 100 | 80 | 120 |
| Direct material (₹ per unit) | 40 | 50 | 30 | 60 |
| Direct labour (₹ per unit) | 28 | 21 | 14 | 21 |
| Machine hours per unit | 4 | 3 | 2 | 3 |
The four products are similar and are usually produced in production runs of 20 units and sold in batches of of 10 units.The total of the production overhead for the period has been analysed as follows:
| Particulars | Amount (₹) |
| Machine department costs (rent, business rates, depreciation and supervision) | 10,430 |
| Set-up costs | 5,250 |
| Stores receiving | 3,600 |
| Inspection/quality control | 2,100 |
| Materials handling and dispatch | 4,620 |
| 26,000 |
You have ascertained that the cost drivers to be used in an ABC exercise are as listed below for the overhead costs shown:
| Cost pools | Cost driver |
| Set-up cost | Number of production runs |
| Stores receiving | Requisitions raised |
| Inspection/quality control | Number of production runs |
| Materials handling and dispatch | Orders executed |
The number of requisitions raised on the stores was 20 for each product, and the number of orders executed was 42, each order being for a batch of 10 of a product.
Calculate the production costs per unit, using ABC.
Solution :
Theoretical Questions
1. Which of the following is a correct definition of activity-based management?
A. An approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs.
B. The identification and evaluation of the activity drivers used to trace the cost of activities to cost objects. It may also involve selecting activity drivers with potential to contribute to the cost management function with particular reference to cost reduction.
C. A method of budgeting based on an activity framework and utilizing cost driver data in the budgetsetting and variance feedback processes.
D. A system of management which uses activity-based cost information for a variety of purposes including cost reduction, cost modeling and customer profitability analysis.
Answer:- D. A system of management which uses activity-based cost information for a variety of purposes including cost reduction, cost modeling and customer profitability analysis.
2. Which of the following characteristics would be an indicator that a company would benefit from switching to activity based costing?
A. Only one homogenous product is produced on a continuous basis
B. The existing cost system is reliable and has produced excellent results
C. Overhead costs are high and increasing and no one seems to know why
D. The costs of implementing ABC out-weigh the benefits
Answer:- C. Overhead costs are high and increasing and no one seems to know why
3. According to the Chartered Institute of Management Accountants (CIMA), cost attribution to cost units on the basis of benefits received from indirect activities e.g. ordering, setting up, and assuring quality is known as:
A. Absorption costing
B. Marginal costing
C. Activity-based costing
D. Job costing
Answer:- C. Activity-based costing
4. In an ABC system, which of the following is likely to be classified as a batch level activity?
A. Machine set-up
B. Product design
C. Inspection of every item produced
D. Production manager’s work
Answer:- A. Machine set-up
5. Activity based costing:
A. Uses a plant wide overhead rate to assign overhead
B. Is not expensive to implement
C. Typically applies overhead costs using direct labour hours
D. Uses multiple activity rates
Answer:- D. Uses multiple activity rates
6. Which of the following activities is not a batch level activity?
A. Processing purchase orders
B. Designing products
C. Receive raw materials from suppliers
D. Setting up equipment
Answer:- B. Designing products
7. Which of the following is not included in batch level activities?
A. Material ordering cost
B. Machine set-up cost
C. Inspection cost
D. Designing the product
Answer:- D. Designing the product
8. Assigning overhead using ABC often:
A. Shifts overhead costs from high-volume products to low-volume products
B. Shifts overhead costs from low-volume products to high-volume products
C. Provides the same results as traditional costing
D. Requires one predetermined overhead rate
Answer:- A. Shifts overhead costs from high-volume products to low-volume products
9. In Activity Based Costing:
A. Non-manufacturing costs may not be assigned to products
B. Some manufacturing costs may be excluded from product costs
C. Allocation bases are the same as those used in traditional costing methods
D. Similar to traditional costing, ABC only uses one overhead cost pool
Answer:- B. Some manufacturing costs may be excluded from product costs
10. In an ABC system, the allocation bases that are used for applying costs to services or procedures are called:
A. Cost Pool
B. Cost Driver
C. Cost Absorption
D. Cost Object
Answer:- B. Cost Driver
11. Which of the following would not be deducted from sales in a management report prepared using ABC?
A. Direct materials
B. Direct labour
C. Variable selling and administration costs
D. Shipping costs
Answer:- D. Shipping costs
12. ………. an item for which cost measurement is required e.g. product, job or a customer
A. Cost Pool
B. Cost Driver
C. Cost Absorption
D. Cost Object
Answer:- D. Cost Object
13. Which of the following is different in ABC when compared to traditional costing?
A. Traditional costing and ABC costing usually yield very similar product costs
B. In an ABC costing system, costs are only assigned to products that actually required work that gave rise to a particular cost
C. In ABC, batch-level costs are applied to products using unit-level bases
D. Under traditional costing, batch-level costs are shifted from high-volume products to low-volume products
Answer:- B. In an ABC costing system, costs are only assigned to products that actually required work that gave rise to a particular cost
14. Process of Cost allocation under Activity Based Costing is
A. Cost of Activities—Activities—Cost Driver – Cost allocated to cost objects
B. Cost Driver — Cost of Activities— Cost allocated to cost objects – Activities
C. Activities— Cost of Activities—Cost Driver – Cost allocated to cost objects
D. Activities—Cost Driver – Cost allocated to cost objects — Cost of Activities
Answer:- C. Activities— Cost of Activities—Cost Driver – Cost allocated to cost objects
15. Cost of maintaining a building is
A. Unit Level Cost
B. Batch Level Cost
C. Product Level Cost
D. Facility Level Cost
Answer:- D. Facility Level Cost
16. --------- should be subtracted from net product revenues instead of an arbitrary and illogical apportionment.
A. Facility Level Cost
B. Product Level Cost
C. Organizational Level Cost
D. High Level Cost
Answer:- C. Organizational Level Cost
17. The basis of apportionment of overheads which takes into account the profitability of various departments is called:
A. FIFO basis
B. LIFO basis
C. Ability to pay basis
D. Activity basis
Answer:- D. Activity basis
18. Which of the following is the main cost driver of customer order processing activity?
A. Flow of the product from the assembly line
B. Order value
C. Number of problem suppliers
D. Number of machine charges
Answer:- B. Order value
19. Painting the product would be an example of which activity level groups
A. Facility-level activity
B. Product-level activity
C. Unit-level activity
D. Batch-level activity
Answer:- C. Unit-level activity
20. Which of the following tasks is not normally associated with an activity-based costing system?
A. Calculation of cost application rates
B. Identification of cost pools
C. Preparation of allocation matrices
D. Identification of cost drivers
Answer:- C. Preparation of allocation matrices
21. All of the following are examples of batch level activities except:
A. Purchase order processing
B. Setting up equipment
C. The clerical activity associated with processing purchase orders to pro-duce an order for a standard product
D. Worker recreational facilities
Answer:- D. Worker recreational facilities
22. Plant depreciation is an example of which activity-level group?
A. Unit-level activity
B. Facility-level activity
C. Batch-level activity
D. Product-level activity
Answer:- B. Facility-level activity
23. Under activity-based costing, ‘material ordering’ is considered as —
A. Unit-level activity
B. Batch level activity
C. Product level activity
D. Facility level activity
Answer:- B. Batch level activity
24. Samsung an appliance manufacturer is developing a new line of ovens that uses controlled-laser technology. Research and testing costs associated with the new ovens is said to arise from a:
A. Unit Level Activity
B. Competitive Level Activity
C. Facility Level Activity
D. Product Sustaining Activity
Answer:- D. Product Sustaining Activity
25. The salaries of a manufacturing plant’s management are said to arise from:
A. Unit Level Activities
B. Batch Level Activities
C. Product Sustaining Activities
D. Facility Level Activities
Answer:- D. Facility Level Activities
26. The division of activities into unit level, batch level, product sustaining level, and facility level categories is commonly known as a
A. Cost Object
B. Cost Application Method
C. Cost Hierarchy
D. Cost Estimation Method
Answer:- C. Cost Hierarchy
27. The main reason for the usage of Activity Based Costing, by replacing the traditional costing system is that:
A. The overhead recovery rates used in traditional costing systems are inappropriate for decision-making.
B. The companies deal with more number of products at present
C. No scope for cause and effect relationship in traditional costing
D. The new manufacturing technology needs information for feedback of performance even the product is in progress.
Answer:- B. The companies deal with more number of products at present
28. Costs that are caused by a group of things being made or processed at a single time are referred to as:
A. Product-level costs
B. Cost pool
C. Organizational-level costs
D. Batch level costs
Answer:- D. Batch level costs
29. The following statements have been made in relation to activity-based costing:
(1) A cost driver is a factor which causes a change in the cost of an activity
(2) Traditional absorption costing tends to under-estimate overhead costs for high volume productsWhich of the above statements is/are true?
A. 1 only
B. 2 only
C. Neither 1 nor 2
D. Both 1 and 2
Answer:- A. 1 only
30. Which of the following statements is true about activity-based costing (ABC)?
A. ABC is a costing method designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore “fixed” costs
B. ABC is an ordinary a replacement, rather than a supplement for, the company’s usual costing system
C. Most organizations that use ABC have only one costing system that serves the needs of external reports and internal decision-making
D. In practice, ABC can only be done one way correctly, meaning that different “flavors” are not allowed
Answer:- A. ABC is a costing method designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore “fixed” costs
31. To calculate activity rates, all of the following are necessary except:
A. Determine the total activity for each cost pool that would be required to produce the current product mix
B. Determine the total activity for each cost pool that would be required to serve present customers
C. Calculate activity rates by dividing the total cost for each activity by its total activity
D. Calculate activity rates by dividing the total cost for each activity by the percentage of the activity allocated to the product
Answer:- D. Calculate activity rates by dividing the total cost for each activity by the percentage of the activity allocated to the product
32. Activity-based costing:
A. Uses a plant-wide overhead rate to assign overhead
B. Is not expensive to implement
C. Typically applies overhead costs using direct labor-hours
D. Uses multiple activity rates
Answer:- D. Uses multiple activity rates
33. Cost attribution to cost units on the basis of benefit received from indirect activities, such as ordering, setting-up, assuring quality is known as:
A. Allocation
B. Activity-based costing
C. Always better control
D. Absorption
Answer:- B. Activity-based costing
34. In activity-based costing, the allocation basis used for applying costs to services or products is called—
A. Cost driver
B. Cost object
C. Allocation
D. Application
Answer:- A. Cost driver
35. In activity-based costing, an item for which cost measurement is required is called —
A. Cost driver
B. Cost object
C. Allocation
D. Cost pool
Answer:- B. Cost object
36. A homogeneous cost pool is one that:
A. Does not change over time
B. Needs many activity drivers to be allocated to a cost object
C. Can be explained with a single activity driver
D. Has only one type of material assigned to it
Answer:- C. Can be explained with a single activity driver
37. Review cost of commercial loan applications is cost.
A. Unit level
B. Facility level
C. Batch level
D. Product sustaining
Answer:- A. Unit level
38. In Traditional absorption costing system cost are first traced to:
A. Activities
B. Organizational unit
C. Products
D. Cost centers
Answer:- B. Organizational unit
39. An Activity-Based Costing, an inspection of the product is a -------- level activity:
A. Unit
B. Batch
C. Product
D. Facility
Answer:- B. Batch
40. ABC is defined as cost attribution to __________ on the basis of benefit received from indirect activities.
A. Cost units
B. Cost objects
C. Cost centres
D. Production units
Answer:- A. Cost units
41. Which of the following is not a correct match?
Activity Cost Drivers
A. Production scheduling Number of production runs
B. Dispatching No. of Dispatch orders
C. Goods receiving Goods received order
D. Inspection Machine hours
Answer:- D. Inspection Machine hours
42. Basic types of cost pool allocations include:
A. Allocation of costs to segments, products, and services
B. Determining inputs for CVP models
C. Establishing cash flows for capital budgeting analyses
D. Reallocation of costs among service departments
Answer:- A. Allocation of costs to segments, products, and services
43. Activity based cost systems would probably provide the greatest benefits for organizations that use
A. Job order costing
B. Process costing
C. Standard costing
D. Historical costing
Answer:- A. Job order costing
44. Under a traditional costing system, which of the following costs would likely be classified as indirect with respect to the various products manufactured?
A. Plant maintenance
B. Factory supplies
C. Machinery depreciation
D. All of the above
Answer:- D. All of the above
45. PKS Ltd. is changing from a traditional costing system to an activity based system. As a result of this action, which of the following costs would likely change from indirect to direct?
A. Direct materials, factory supplies
B. Production setup, finished-goods inspection & direct materials
C. Production setup, finished-goods inspection and product shipping
D. All of the above
Answer:- C. Production setup, finished-goods inspection and product shipping
46. Which of the following statements about activity based costing is false?
A. Activity based costing cannot be used by service businesses.
B. In comparison with traditional costing systems, activity based costing tends to use more cost pools and more cost drivers.
C. In comparison with traditional costing systems, activity based costing results in less cost averaging of various diversified activities.
D. In comparison with traditional-costing systems, activity based costing results in more costs being classified as direct costs.
Answer:- A. Activity based costing cannot be used by service businesses.
47. Which of the following is least likely to be classified as a batch level activity in an activity based costing system?
A. Quality assurance
B. Receiving and inspection
C. Property taxes
D. Production set-up
Answer:- C. Property taxes
1. The purpose of moving from a traditional costing system to an ABC system must therefore be based on the premise that the new information provided will lead to action that will increase the overall profitability of the business. Answer:- True
2. Traditional product costing systems were designed when most of the companies manufactured a narrow range of products. Answer:- True
3. Activities comprise of units of work or tasks. Answer:- True
4. Unit-level activities (also known as volume-related activities) are performed each time a unit of the product or service is produced. Answer:- True
5. The term cost pools are used to describe a location to which overhead costs are initially assigned. Answer:- True
6. An ABC analysis cannot reveal the cost of each activity within an organization. Answer:- False
7. ABC recognizes the increased complexity of modern businesses with its multiple cost drivers, many of which are transaction based rather than volume based. Answer:- True
8. ABC tends to burden low-volume (new) products with a punitive level of overhead costs and hence threatens opportunities for successful innovation if it is used without due care. Answer:- True
9. ABC is not a complement to Total Quality Management (TQM) and it provides quantitative data that can track the financial impact of improvements implemented as part of the TQM initiative. Answer:- False
10. Activity based costing is not expensive to implement. Answer:- False
1. Designing products activity is not a Batch level activities
2. LG an appliance manufacturer is developing a new line of ovens that uses controlled-laser technology. Research and testing costs associated with the new ovens is said to arise from a Product sustaining activities
3. Costs that are caused by a group of things being made or processed at a single time are referred to as Batch level cost
4. Activity-based costing uses Multiple activity rates
5. An item for which cost measurement is required in ABC is called Cost object
6. A method of allocating indirect costs to cost objects that correlate a product’s consumption of overhead resources with the number of units produced is known as Volume based cost drivers
7. A two-stage cost assignment assigns resource costs to activity Cost pools and then to cost objects
8. Value-added activities- for which Customers are willing to pay.
9. Basic types of cost pool allocations include Allocation of costs to segments, products & services
10. A Product-level activity supports the production of a specific product or service.
1. What is the main purpose of Activity-Based Costing (ABC)?
Answer:-
2. What are the benefits of activity based costing?
Answer:-
3. What is a ‘Cost Driver’? What is the role of cost driver in tracing cost to products?
Answer:-
4. How to calculate activity-based overhead rate?
Answer:-
5. What is an activity center?
Answer:-
6. Describe the ABC cost hierarchy.
Answer:-
7. Distinguish between resource cost drivers and activity cost drivers.
Answer:-
8. Give two examples for each of the following categories in activity based costing:
(i) Unit Level activities
(ii) Batch Level activities
(iii) Product Level activities
(iv) Facility Level activities
Answer:-
1. Explain the concept of activity based costing. How ABC system supports corporate strategy?
Answer:-
2. What are the areas in which activity based information is used for decision making?
Answer:-
3. What is the fundamental difference between Activity Based Costing System (ABC) and Traditional Costing System? Why more and more organizations in both the manufacturing and non-manufacturing industries are adopting ABC?
Answer:-
4. Explain the concept of cost drivers and indicate what you will consider as cost drivers for the following business function: Research & development; and Customer service.
Answer:-
5. Differentiate between ‘Value-added’ and ‘Non-value-added’ activities in the context of Activity-based costing. Give examples of Value-added and Non-value-added activities.
Answer:-
6. How do managers use ABC systems to price goods or services?
Answer:-
7. Discuss the steps in applying Activity Based Costing?
Answer:-
8. How are activities grouped in a manufacturing company?
Answer:-
9. Distinguish between Traditional Costing System and Activity Based Costing.
Answer:-
10. What factors led to the emergence of ABC systems?
Answer:-
11. Describe the circumstances when traditional costing systems are likely to report distorted costs.
Answer:-
12. Describe each of the four stages involved in designing ABC systems.
Answer:-
13. The traditional methods of cost allocation, cost apportionment and absorption into products are being challenged by some writers who claim that much information given to management is misleading when these methods of dealing with fixed overheads are used to determine product costs. You are required to explain what is meant by cost allocation, cost apportionment and absorption and to describe briefly the alternative approach of activity-based costing in order to ascertain total product costs.
Answer:-
14 (a) Why are conventional product costing systems more likely to distort product costs in highly automated plants? How activity does based costing deal with such a situation?
(b) ‘Attributing direct costs and absorbing overhead costs to the product/service through an activity-based costing approach will result in a better understanding of the true cost of the final output.’ You are required to explain and comment on the above statement.
Answer:-
1. A company makes two products using the same type of materials and skilled workers. The following information is available:
| Particulars | Product A | Product B |
| Budgeted volume (units) | 1,000 | 2,000 |
| Material per unit (₹) | 10 | 20 |
| Labour per unit (₹) | 5 | 20 |
Fixed costs relating to material handling amount to ₹1,00,000. The cost driver for these costs is the volume of material purchased.
General fixed costs, absorbed on the basis of labour hours, amount to ₹1,80,000.
Using activity-based costing, what is the total fixed overhead amount to be absorbed into each unit of product B (to the nearest whole ₹) ?
A. ₹113
B. ₹120
C. ₹40
D. ₹105
Answer:- B. ₹120
2. A company uses traditional standard costing system. The inspection and set-up costs are actually ₹1,760 against a budget of ₹2,000. ABC system is being implemented and accordingly the number of batches isidentified as the cost driver for inspection and set up. The budgeted production is 10,000 units in batches of 1,000 units whereas actually 9,000 units were produced in 11 batches. The cost per batch under ABC system will be
A. ₹160
B. ₹200
C. ₹180
D. ₹220
Answer:- B. ₹200
3. X Company uses activity-based costing for Product B and Product D. The total estimated overhead cost for the parts administration activity pool was ₹5,50,000 and the expected activity was 2000 part types. If Product D requires 1200 part types, the amount of overhead allocated to product D for parts administration would be:
A. ₹2,75,000
B. ₹3,00,000
C. ₹3,30,000
D. ₹3,45,000
Answer:- C. ₹3,30,000
4. Fast Ltd. manufactures three types of products A, B, and C following ABC System. During a period, the company incurred ₹73,000 as inspection cost and it was worked for 10, 20 and 9 production runs respectively for producing products A, B, and C. The inspection costs for product B under the ABC system was:
A. ₹ 15,000
B. ₹ 40,000
C. ₹ 18,000
D. ₹ 24,000
Answer:- B. ₹ 40,000
5. A company manufactures and sells packaging machines. It recently introduced activity-based costing to refine its existing system. Each packaging machine requires direct materials costs of ₹50,000; 50 equipment parts; 12 machine hours; 15 assembly line hours and 4 inspection hours. The details about the cost pools, allocation bases and allocation rates are given below:
| Indirect cost pool | Cost allocation base | Budgeted allocation rate |
| Material handling | No. of component parts | ₹8 per part |
| Machining | Machine hours | ₹68 per machine hour |
| Assembly | Assembly line hours | ₹75 per assembly hour |
| Inspection | Inspection hours | ₹104 per inspection hour |
The company has received an order for 40 can-packaging machines from a customer. Using activity-based costing, indirect costs allocated to the order of the customer would be:
A. ₹1,30,850
B. ₹1,25,280
C. ₹1,15,050
D. ₹1,10,280
Answer:- D. ₹1,10,280
6. A company operates an activity based costing (ABC) system to attribute its overhead costs to cost objects. In its budget for the year-ending 31st August, 2022. The company expected to place a total of 2000 purchase orders at a total cost of ₹1,00,000. This activity and its related costs were budgeted to occur at a constant rate throughout the budget year which is divided into 13 four week periods.
During the four-week period ended 30th June 2021, a total of 200 purchase orders were placed at a cost of ₹ 9,000. The over recovery of these costs for the four-week period was
A. ₹ 2,000
B. ₹ 3,000
C. ₹ 1,500
D. ₹ 1,000
Answer:- D. ₹ 1,000
7. The following information relate to ABC
| Activity level | 60% | 80% |
| Variable costs (₹) | 12,000 | 16,000 |
| Fixed costs (₹) | 20,000 | 22,000 |
The differential cost for 20% capacity is
A. ₹4,000
B. ₹2,000
C. ₹6,000
D. ₹5,000
Answer:- C. ₹6,000
8. A company manufactures 500 units of product AX the material cost to manufacture is ₹ 1,50,000, Labour cost ₹2,65,000. Material reordering cost is ₹4,500, Material handling cost is ₹2,500 Material order – 35, Material movement – 20.
Total Material cost under Activity based costing is.
A. ₹554
B. ₹4,22,000
C. ₹1,57,000
D. ₹1,084
Answer:- C. ₹1,57,000
1. Quality Ltd. is engaged in production of three types of ice-cream products: Coco, Strawberry and Vanilla. The company presently sells 50,000 units of Coco @ ₹ 25 per unit, Strawberry 20,000 @ ₹ 20 per unit and Vanilla 60,000 units @ ₹ 15 per unit. The demand is sensitive to selling price it has been observed that every reduction at ₹ 1 per unit in selling price increases the demand for each product by 10% to the previous level. The company has the production capacity of 60,500 units of Coco, 24,200 units of Strawberry and 72,600 units of Vanilla. The company marks up 25% on cost of the product.
The Company management decides to apply ABC analysis. For this purpose, it identifies four activities and the rate as follows:
| Activity | Cost Rate |
| Ordering | ₹ 800 per purchase order |
| Delivery | ₹ 700 per delivery |
| Shelf stocking | ₹ 199 per hour |
| Customer support and assistance | ₹ 1.10 p.u sold |
The other relevant information for the products are as follows:
| Particulars | Coco | Strawberry | Vanilla |
| Direct Material p.u (₹) | 8 | 6 | 5 |
| Direct Labour p.u (₹) | 5 | 4 | 3 |
| No. of Purchase Orders | 35 | 30 | 15 |
| No. of Deliveries | 112 | 66 | 48 |
| Shelf Stocking Hours | 130 | 150 | 160 |
Under the traditional costing system, store support costs are changed @ 30% of prime cost. In ABC these costs area coming under customer support and assistance.
A. Calculate the total cost and unit cost of each product at the maximum level using traditional costing.
B. Calculate the total cost and unit cost of each product at the maximum level using activity based costing.
C. Compare the cost of each product calculated in (1) and (2) above and comment on it.
Solution :
2. Analyst Ltd. makes a single product with the following details:
| Description | Current Situation | Proposed Change |
| Selling Price (₹/unit) | 10 | |
| Direct Costs (₹/unit) | 5 | |
| Present number of setups per production period, (before each production run, setup is done) | 42 | |
| Cost per set-up (₹) | 450 | Decrease by ₹90 |
| Production units per run | 960 | 1,008 |
| Engineering hours for production per period | 500 | 422 |
| Cost per engineering hour (₹) | 10 |
The company has begun Activity Based Costing of fixed costs and has presently identified two cost drivers, viz. production runs and engineering hours. Of the total fixed costs presently at ₹ 96,000, after the above, ₹ 72,100 remains to be analyzed. There are changes as proposed above for the next production period for the same volume of output. Required:
(i) How many units and in how many production runs should Catalyst Ltd. produce in the changed scenario in order to break-even?
(ii) Should Analyst Ltd. continue to break up the remaining fixed costs into activity based costs? Why?
Solution :
3. M Ltd. was absorbing overheads on the basis of direct labour hours. A newly appointed CMA has suggested that the company should introduce ABC system and has identified cost drivers and cost pools as follows:
| Activity Cost Pool | Cost Driver | Associated Cost (₹) |
| Stores Receiving | Purchase Requisitions | 2,96,000 |
| Inspection | Number of Production Runs | 8,94,000 |
| Dispatch | Orders Executed | 2,10,000 |
| Machine Set-up | Number of Set-up | 12,00,000 |
The following information is also supplied:
| Particulars | Product A | Product B | Product C |
| No. of Set-up | 360 | 390 | 450 |
| No. of Orders Executed | 180 | 270 | 300 |
| No. of Production Runs | 50 | 1,050 | 1,200 |
| No. of Purchase Requisitions | 300 | 450 | 500 |
Calculate activity based production cost of all the three products.
Solution :
4. Zee Ltd. manufactures three types of products namely P, Q and R. The data relating to a period are as under:
| Particulars | P | Q | R |
| Machine hours per unit | 10 | 18 | 14 |
| Direct Labour hours per unit @ 20 | 4 | 12 | 8 |
| Direct Material per unit (₹) | 90 | 80 | 120 |
| Production (units) | 3,000 | 5,000 | 20,000 |
Currently the company uses traditional costing method and absorbs all production overheads on the basis of machine hours. The machine hour rate of overheads is ₹6 per hour. The company proposes to use activity based costing system and the activity analysis is as under:
| Particulars | P | Q | R |
| Batch size (units) | 150 | 500 | 1,000 |
| Number of purchase orders per batch | 3 | 10 | 8 |
| Number of inspections per batch | 5 | 4 | 3 |
The total production overheads are analyzed as under:
| Machine set up costs | 20% |
| Machine operation costs | 30% |
| Inspection costs | 40% |
| Material procurement related costs | 10% |
(i) Calculate the cost per unit of each product using traditional method of absorbing all production overheads on the basis of machine hours.
(ii) Calculate the cost per unit of each product using activity based costing principles.
Solution :
5. Lime Limited manufactures three products P, Q and R which are similar in nature and are usually produced in production runs of 100 units. Product P and R require both machine hours and assembly hours, whereas product Q requires only machine hours. The overheads incurred by the company during the first quarter are as under:
| Particulars | ₹ |
| Machine Department expenses | 18,48,000 |
| Assembly Department expenses | 6,72,000 |
| Set-up costs | 90,000 |
| Stores receiving cost | 1,20,000 |
| Order processing and dispatch | 1,80,000 |
| Inspect and Quality control cost | 36,000 |
The data related to the three products during the period is as under:
| Particulars | P | Q | R |
| Units produced and sold | 15,000 | 12,000 | 18,000 |
| Machine hours worked (hrs.) | 30,000 | 48,000 | 54,000 |
| Assembly hours worked (direct labour hours | 15,000 | - | 27,000 |
| Customers orders executed (in numbers) | 1,250 | 1,000 | 1,500 |
| Number of requisitions raised on the stores | 40 | 30 | 50 |
Required:
Prepare a statement showing details of overhead costs allocated to each product type using activity based costing.
6. A company produces four products, viz. P, Q, R and S. The data relating to production activity are as under
| Product | Quantity of production | Material cost/ unit (₹) | Direct labour hours/unit | Direct Labour cost/unit (₹) | Machine hours/unit |
| P | 1,000 | 10 | 1 | 6 | 0.50 |
| Q | 10.000 | 10 | 1 | 6 | 0.50 |
| R | 1,200 | 32 | 4 | 24 | 2.00 |
| S | 14,000 | 341 | 3 | 18 | 3.00 |
| Production overheads are as under: | ₹ |
| (i) Overheads applicable to machine oriented activity | 1,49,700 |
| (ii) Overheads relating to ordering materials | 7,680 |
| (iii) Set-up costs | 17,400 |
| (iv) Administration overheads for spare parts | 34,380 |
| (v) Material handling costs | 30,294 |
The following further information has been compiled:
| Product | No. of set -up | No. of materials orders | No. of times materials handled | No. of spare parts |
| P | 3 | 3 | 6 | 6 |
| Q | 18 | 12 | 30 | 15 |
| R | 5 | 3 | 9 | 3 |
| S | 24 | 12 | 36 | 12 |
Required:
(i) Select a suitable cost driver for each item of overhead expense and calculate the cost per unit of cost driver.
(ii) Using the concept of activity based costing, compute the factory cost per unit of each product.
Solution :
7. The cost accountant of XYZ Manufacturing attended a workshop on activity-based costing and was impressed by the results. After consulting with the production personnel, he prepared the following information on cost drivers and the estimated volume for each driver:
| Products | A | B | C | Total |
| Units produced | 25,000 | 15,000 | 5,000 | 45,000 |
| Direct materials Cost Per Unit in ₹ | 40.0 | 30.0 | 55.0 | |
| Direct labour in ₹ | 15.0 | 15.0 | 15.0 |
| Cost driver | Cost driver volume | |||
| A | B | C | Total | |
| Number of setups | 125 | 75 | 50 | 250 |
| Machine Hours | 2,500 | 1,500 | 2,000 | 6,000 |
| Direct labour hours | 25,000 | 15,000 | 5,000 | 45,000 |
| Number of Inspection | 50 | 25 | 25 | 100 |
The cost accountant also determined how much overhead costs were incurred in each of the four activities as follows:
| Activity | Overhead costs in ₹ |
| Machining- Set-up | 1,50,000 |
| Machining | 7,50,000 |
| Assembly | 3,60,000 |
| Inspection | 90,000 |
Required:
(i) Determine the cost driver rate for each activity cost pool.
(ii) Use the activity-based costing method to determine the unit cost for each product.
Solution :
8. The information and data in the following tables will be used to determine cost drivers and calculate overheads.
| Product X | Product Y | Product Z |
| High volume | Medium volume | Low volume |
| Large batches | Medium batches | Small batches |
| Few purchase orders placed | Medium purchase orders placed | Many purchase orders placed |
| Medium components | Many components | |
| Few customer orders placed | Medium customer orders placed | Many customer orders placed |
| Product X | Product X | Product X | Total | |
| Typical batch size | 2,000 | 600 | 325 | |
| No. of production runs | 25 | 50 | 50 | 125 |
| No. of inspections | 25 | 25 | 50 | 125 |
| Purchase orders placed | 25 | 100 | 200 | 325 |
| Customer orders received | 10 | 100 | 200 | 310 |
| Analysis of indirect labour | ₹000 | Total | ₹000 |
Machining:
| Supervision | 100 | |
| Set-up | 400 | |
| Quality control | 400 | 900 |
| Assembly: | ||
| Supervision | 200 | |
| Quality control | 400 | 600 |
| Purchasing/order processing: | ||
| Resource procurement | 300 | |
| Customer liaison/expediting | 300 | 600 |
| Factory management: | ||
| General administration | 100 | 2,200 |
Prepare an ABC analysis and calculate product costs.
9. Blue Star Company manufactures two products, Deluxe and Regular, and uses a traditional two-stage cost allocation system. The first stage assigns all factory overhead costs to two production departments A and B, based on machine-hours. The second stage uses direct labour-hours to allocate overhead to individual products.
For 2022, the firm budgeted ₹10,00,000 total factory overhead cost for these operations.
| Particulars | Production Department A | Production Department B |
| Machine-hours | 4,000 | 16,000 |
| Direct labour-hours | 20,000 | 10,000 |
The following information relates to the firm’s operations for the month of January:
| Particulars | Deluxe | Regular |
| Units produced and sold | 200 | 800 |
| Unit cost of direct materials | ₹100 | ₹50 |
| Hourly direct labour wage rate | ₹25 | ₹ 20 |
| Direct labour-hours in Department A per unit | 2 | 2 |
| Direct labour-hours in Department B per unit | 1 | 1 |
The Company is considering implementing an activity-based costing system. Its management accountant has collected the following information for activity cost analysis for 2022:
| Activity | Budgeted Overheads (₹) |
| Material movement | 7,000 |
| Machine setups | 400,000 |
| Inspections | 588,000 |
| Shipment | 5,000 |
| 10,00,000 |
| Particulars | Budgeted Quantity | Driver Consumption | |
| Deluxe | Regular | ||
| Number of production runs | 350 | 15 | 20 |
| Number of setups | 500 | 25 | 50 |
| Number of units | 19,600 | 200 | 800 |
| Number of shipments | 250 | 50 | 100 |
Required
(i) Calculate the unit cost for each of the two products under the existing volume-based costing system.
(ii) Calculate the overhead per unit of the cost driver under the proposed ABC system.
(iii) Calculate the unit cost for each of the two products if the proposed ABC system is adopted.
10. Company ABC has the following information applicable to its products:
Total Overheads = ₹1,00,000
Total machine Hours = 50,000
| Product | A | B |
| Units of Production | 2,500 | 5,000 |
| Material Cost per/unit (₹) | 30 | 50 |
| Labour Cost per unit (₹) | 20 | 16 |
| Machine Hrs. Per/unit | 10 | 5 |
| Particulars | Percentage Overheads (%) |
| Set-up Costs | 35 |
| Inspections | 45 |
| Materials Handling | 20 |
| Particulars | A | B | Total |
| No. of Set-up | 300 | 50 | 350 |
| No. of InspectionsNo. of Set-up | 500 | 250 | 750 |
| No. of Movements of Goods | 300 | 700 | 1000 |
What is the Cost per unit of A and B?
(i) Under Traditional Absorption Costing.
(ii) Under ABC.
Solution :
1. You have recently been employed by STU Ltd. as their Management Accountant. The senior partner, Mr. X, has doubts about the usefulness of the figures produced by the previous accountant. He has heard that Activity Based Costing (ABC) may be an appropriate system for the firm to adopt.
In response to the request from Mr. X, you are required to prepare a brief report on how Activity Based Costing System (ABC) works and what benefits the company can expect from introducing the ABC system. Explain with the help of a simple illustration.
a. Designing moulds
b. Creating moulds
c. Inspecting moulds
d. Modifying moulds
e. Setting up production
f. Requesting and moving materials
g. Machining
h. Insuring equipment
i. Paying suppliers
j. Heating the factory
You are a newly appointed Cost Accountant, having knowledge in ABC approach, are requested by the Managing Director to classify the above activities into unit-level, batch-level, product-level or facility-level activity and also to identify a proper cost driver for each activity.
Activity - based costing (ABC) is a costing approach that assigns resource costs to cost objects based on activities performed for the cost objects.
A two - stage cost assignment assigns resource costs to activity cost pools and then to cost objects.
An activity is a specific task or action of work done.
A resource is an economic element needed or consumed in performing activities.
A resource consumption cost driver is a measure of the amount of resources consumed by an activity.
An activity consumption cost driver measures how much of an activity a cost object uses.
A unit- level activity is performed for each unit of the cost object.
A batch- level activity is performed for each batch or group of products or services.
A product- level activity supports the production of a specific product or service.
A facility- level activity supports operations in general.
Batch- related activities- Activities that are performed each time a batch of goods is produced.
Business- sustaining activities- Activities performed to support the organization as a whole, also known as facility-sustaining activity.
Consumption ratio-the proportion of each activity consumed by a product.
Facility-sustaining activities- Activities performed to support the organization as a whole, which are normally not affected by a decision that is to be taken. It is also known as business-sustaining activities.
Resource cost driver- A cause-and-effect cost driver used to allocate shared resources to individual activities.
Volume-based cost drivers- A method of allocating indirect costs to cost objects that correlate a product’s consumption of overhead resources with the number of units produced.
Value-added activities- for which customers are willing to pay.
Non-value added activities- for which customers are not willing to pay.
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