Activity Based Costing

Activity Based Costing is a method of costing, where the cost of products, processes, customers are
determined through Activities performed in the production/ support unit. It is more logical method of
determining overhead cost for the product than the historically method of using machine hours or man
hours to distribute the cost. In activity based costing process, first the activities are identified, which
attract cost and then the total cost are distributed to product on the basis of number of activities
consumed in the manufacturing and production processes.

Activity Based Costing

ABC is more logically, accurate, better way of allocating overhead cost, but on the other hand it’s more
complicated to design and implement. If we define the processes, it includes the below steps:

a. Determining the cost objects, the organizational unit which can be used for tracking cost and
distributing to product

b. Identifying cost carriers or the activities performed in the cost object

c. Bifurcation between direct and indirect costs associated with activities related to cost object

d. Identify linkage between overhead cost and activities

e. Select the method of overhead allocation, e.g. Push method (Assessment, Distribution cycles) or
Pull method (Indirect activities allocation, template allocations)

Activity based costing is activity driven concept with a key assumption that all the overhead costs are
caused by different types of activity.
Method of allocating cost:

i. Push Approach (Cost flow method)

Push approach is a method of overhead allocation, where we transfer the cost from sender cost object
to receiver cost object with a flow from sender to receiver. Here the full or pre-defined percentage of
cost from sender cost center is transferred to receiver cost objects. It is like pushing the overhead cost
from sender to receiver cost object. E.g. Assessment, Distribution

ii. Pull Approach (Quantity input method)

Pull approach is a method of overhead allocation, where quantities of receiver cost objects are used as a
base to take the cost from sender cost centers. For example: in case of Indirect Activity Allocation, which
is a method of pull approach, the activities on receiver cost objects are combined and a same values are
transferred to sender cost objects as sender activity, which later on are used to transfer overhead cost
from sender cost center to receiver cost centers. Here the Quantity of receiver cost centers are used as
input to transfer the sender cost, that’s why it is called as Quantity input method. E.g. Direct/Indirect
activity allocation, template allocations

To illustrate the scenario in more details, I have taken a hypothetical example of an automobile industry:

In general an automobile organization includes the below manufacturing departments.

1. Press Shop/ Stamping

Manufacturing of car start with creation of different steel plates for different parts of car, for example
doors, body of cars etc. These activities are performed in press shop, where different pieces are made
out of rolls of steels. These pieces are later converted into different shape with help of automatic
press/stamp machine. Generally both activities are performed one after other on same or different
machine. If we need to apply the concept of Activity based costing, then we need to identify the
activities which are performed in press shop, for example

1. A) SETUP: setup is an activity of putting the iron plates on the machines in right places to perform the
cutting and stamping. In general before cutting, a lubricant is used on iron plat so that it doesn’t get
damaged while pressing. Setup is a manual process, which involve individuals to perform the activities.

1. B) PRESSING: pressing is an activity performed by machine to cut the iron plat in the piece and then
put the stamp to convert the iron plate into the design of different parts of car.

How the cost will be consider as Setup and pressing, it’s depend upon the nature of the activities, here
in this example we are considering SETUP as a manual activity so all the wages paid to the workers could
be consider as Variable Setup cost and cost for lubricant oil used in press shop could also be consider as
variable cost. In this way we can decide activity dependent and activity independent cost and in SAP it
can be used to distribute the cost to the product. The details can be seen from the below document on
how to differentiate activity dependent and activity independent cost:
2. Body Shop/ Welding

The next department in automobile organization is where welding of different body parts are done to
shape the car. After this step the structure of car is ready. For activity based costing, we need to identify
the different activities performed in body shop. Before deciding what all activities can be there, we need
to validate whether having two different activities is going to have any impact on product cost for two or
more products, if not, then there is no point in using the second additional activity. Suppose the
organization is making only two different types of car, standard module and custom built car, suppose
machines are used to weld standard modules and individual are used to weld custom module of cars. In
this way we need to identify the different activities, as there is no specific rule for this. After identifying
the activities we need to link the cost to the activity.

3. Paint Shop

The next department is Paint shop, where different layers of color coating are done on body of car
based as per standard procedure or requirement by customer. Then drying/ heating activity is done to
make the color permanent. All these activities like Painting activity, or drying activity can be used in
activity based costing as cost carrier and used to transfer the cost of paint shop to different Production
order and finally to the product.

4. Engine Plant

In engine plant all different parts of engine are manufactured and assembled. After manufacturing of
engine, it is sent to assembly line to be included in car. Here we can identify two different activities, like
manufacturing of engine parts and assemble of parts. These activities can be used to track cost.

5. Assembly Line

The next department is assembling line, where the painted car body and its engine are assembled. Then
car is sent for quality testing.

6. Finish Line or Warehouse

The car is driven on a few miles test track to check for rattles or other issues. Once a car meets all
quality standards, kept in warehouse and are ready to send to customer, dealers.

Ø Need to identify the different activities which can be used in different departments as cost carrier

Ø Try to keep less number of activities as possible and validate whether creating a new activity is going
to provide more accuracy in the product costing or not.

Ø Activity based costing are beneficial to be used in more complex manufacturing processes, so it’s
advisable to use additional activities only if it has an impact on accuracy of product cost.
Master Data

Creation of Activity: transaction KL01

For defining the activity, the below details need to be configured

· Name: name of activity

· Description of activity

· Activity Unit: kg, hours etc

· CCtr Categories: cost center categories depend upon the cost centers where this activity will be
used. For production activities, the activity categories should be “F”; for utility cost centers it should be
“U”. We can select the activity categories depending upon the nature of cost centers

· Activity Type Categories: this defines how we are going to put the values of plan & actual activity
and what method will be used for distributing or allocating activities. Different standard options are:

a. Manual entry, manual allocation (category 1): category 1 activity used plan activities to allocate
activities to receiver cost centers or objects based on manual activity planning in KP26. Actual activities
for category type 1 are determined through business transaction (e.g. confirmation of activity in process
order or production orders).

b. Indirect calculation, indirect allocation (category 2): category 2 activities are used in indirect
activity allocation and the price of these activities are calculated automatically through indirect activity
allocation with the help of relationship between sender & receiver cost centers, or receiver tracing
factor, or fixed quantities defined in segments. Here plan activities are automatically reconciled with
scheduled activities.

c. Manual entry, indirect allocation (category 3): This category activity takes the values entered
manually and the allocation happened through indirect activity allocation.

d. Manual entry, no allocation (category 4): This category activity takes the values entered manually
and but it’s not allocated.

· Allocation Cost element: while defining an activity in controlling, we need to define and assign a
secondary cost element with category 43 (indirect activity allocation)

· Price indicator: price indicator represent, what method will be used to calculate activity price. We
can say this about plan activity price. For actual activity price we can define the method in the below tab
where it’s mentioned as Actual price indicator.

i. Indicator 001: if we select 001, then plan activity price are calculated automatically based
on Plan Total Cost divided by plan activity.

ii. Indicator 002: in 002, the variable plan activity price is calculated based on plan activity and
fixed activity price is calculated by considering the Capacity.

iii. Indicator 003: here the activity price are s`et manually.
· Actual price indicator: if we define the actual price indicator then system use this for calculating
actual price otherwise previous price indicator will be used.

iv. Indicator 005: here the actual activity price is calculated by considering the actual activity.

v. Indicator 006: the variable portion of cost is determined through actual activity and fixed
portion is determined through actual capacity.

Configuration of Splitting Structure:

For the purpose of splitting of fixed cost to the different activities assigned to cost center, need to define
Splitting structure. It includes the rules which should be followed to distribute the fixed cost to different
activities. For the purpose of Planning and Budgeting this is an important configuration.

Transaction: OKEW (Assign the new cost center to the splitting structure)
Specify Cost center and Fiscal year

Double click on splitting structure and assign the cost centers to the respective splitting structure
Here the splitting is defined that all the cost elements on manufacturing cost center will be distributed
to activities on the basis on Plan Capacity. (Source: http://scn.sap.com/docs/DOC-46028)

Planning:

For planning and budgeting of activities, the below processes need to be followed:

a. Define activities on the cost centers through KP26:

After designing the overall structure of value flows, activities need to be linked to cost centers through
KP26. Here we need to define Plan Activity, and Plan Capacity. Quantity defined for plan activity or
capacity are used to calculate activity prices at KSPI depending upon price indicator set while defining
master data. If we select price indicator as 002, then fixed activity price is calculated by considering plan
capacity and variable activity price is calculated by dividing plan activity.
b. Primary cost planning on cost centers through KP06

All the primary expenses are planned on cost centers through KP06. Here we can also defined activity
dependent cost with the combination of planning at cost element for activity at cost center.

c. Allocation of expenses or activities:

i. Indirect Activity allocations: it is one of the pull approaches of allocating the cost from sender
cost object to receiver cost object. Here overhead costs are allocated in two step process. First the
sender cost centers activities are determined by combining receiver cost center activities and second
the cost are allocated from sender cost center to receiver cost center/ object. It basically worked on
Quantity calculated inversely. Once we execute indirect activity allocation cycles, then only activities are
allocated but no cost is transferred from sender cost center to receiver cost centers. Transfer of cost to
receiver cost center can only be viewed after plan cost split (KSS4) and plan activity price calculation
(KSPI). It doesn’t follow the same process as assessment and distribution, for distributing the overhead
cost. In assessment and distribution the cost are transferred exactly after executing the cycles.

ii. Distribution: It is a method of push cost allocation. Distribution cycles are used to distribute
primary cost from sender cost object to receiver cost object on the basis of fixed percentage, or fix
proportion, or statistical key figures.

iii. Assessment: It is also a method of push cost allocation. Assessment cycles are used to
distribute primary & secondary cost from sender cost object to receiver cost object on the basis of fixed
percentage, or fix proportion, or statistical key figures. In assessment cycles the allocation of cost done
through assessment cost element.

d. Plan Cost Splitting through (KSS4): plan cost split distribute the plan fixed cost to the activities
assigned to the cost center. The distribution of cost happened on the basis of splitting rule defined in
splitting structure. So the assignment of cost centers to the splitting structure is important.

e. Plan Activity Price calculation (KSPI): KSPI calculates plan activity price or activity rate.

f. Product costing CK40N or CK11N & CK24

Ø Accurate product cost calculation based on based assigning overhead cost based on overhead carriers
as activities.

Ø Monitoring of direct and indirect activity cost possible with the help of controlling activities.

Ø More accurate calculation of profitability and selling prices for multi-product organization.

Limitations of Activity based Costing:

Ø Not suitable and cost effective for small manufacturing organization to implement

Ø Difficult to identify cost driver or activities performed in cost centers