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Unit 13: Activity-based Costing

13.3 Working of Activity-based Costing Notes

The working of Activity-based Costing is explained below:
 Understanding and analysing manufacturing process: For installation of any costing
system, study of manufacturing process is essential. For Activity-based Costing system
also, it is necessary to study the manufacturing process and ascertain various stages involved
in the same so that ‘activities’ involved in the same can be identified.
 Study of the Activities involved: The next step is to study the activities involved in the
manufacturing process. This step is very crucial as the entire Activity-based Costing is
based on identification of activities. In this step, the activities involved in a process are
identified. For example, in a bank, opening of an account is one of the services offered to
customers. In this service, activities involved are studied. It may be revealed that opening
of a new account involves activities like issuing the application form, verification of the
same and accepting the initial amount required for opening of an account. Similarly in
case of a manufacturing company, purchase procedure may involve activities like receiving
of purchase requisition for concerned department or the stores department, inviting
quotations from various suppliers, placing of an order, follow up of the same and finally
receiving and inspection of the goods. In case of an educational institute, activities in a
library may include activities like issue of books, receipt of books, ordering new books,
giving accession numbers, stock taking, removing obsolete and outdated books,
identification of slow moving and fast moving items etc. In this manner, whether in
manufacturing or in service sector, activities are identified and the next step is to divide
the activities into value adding and non value adding. The objective behind this is that
attention can be focused on the value adding activities while non value adding activities
can be eliminated in the future.
 Activity Cost Pool: Cost pool is defined by CIMA as, ‘the point of focus for the costs
relating to a particular activity in an activity-based costing system.’

Example: In case of a library, the cost of issue and receipts, cost of ordering, stock taking
costs etc. can be identified with ‘Library Cost’. In other words, ‘Library’ will be the cost pool in
which all the costs mentioned above may be clubbed. In case of a manufacturing organisation,
as regards to stores, cost of classification, cost of issue of stores requisitions, inspection costs etc.
can be pooled under the heading ‘stores’.
Thus, cost pool concept is similar to the concept of cost centre. The cost pool is the point of
focus or in other words, it is the total cost assigned to an activity. It is the sum of all the cost
elements assigned to an activity.

 Cost Drivers: According to CIMA, ‘cost driver is any factor which causes a change in the
cost of an activity, e.g. the quality of parts received by an activity is a determining factor
in the work required by that activity and therefore affects the resources required. An
activity may have multiple cost drivers associated with it.’ In other words, cost driver
means the factors which determine the cost of an activity. For example, if we repeat the
example of library, the number of receipts and issue of books will be cost drivers, in
stores, no. of stores requisitions will be cost drivers, in customer order processing the no.
of customers as well as no. of orders will be cost drivers. Thus a cost driver is an activity
which generates cost.

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