ACTIVITY BASED COSTING Maria Cristina P.

Obeso, CPA, MBA

Costing Products
Direct materials and direct labor costs are easy to trace
Overhead cannot be traced easily and must be assigned with estimates

Traditional Costing Methods

Spreads overhead cost over entire customer base
Each order “appears” to cost the same
Orders with high profit margins subsidize orders with low profit margins

A single or plantwide rate called a predetermined overhead rate is used:

*Job Order = Direct Labor Costs
*Process Cost = Machine Hours

Therefore, there is a need for a new system….

ACTIVITY BASED COSTING

- Is a cost accounting system that focuses on the various activities performed in an organization
and collects costs on the basis of the underlying nature and extent of those activities
- An overhead cost allocation system that allocated overhead to multiple activity cost pools and
assigns the activity cost pools to products or services by means of cost drivers that represent the
activities used.

ACTIVITY
- Any event, action, transaction, or work sequence that causes a cost to be incurred in producing
a product or providing a service.

ACTIVITY COST POOL

- The overhead cost allocated to a distinct type of activity or related activities.
ACTIVITY COST POOLS COST DRIVER
Purchasing No. of purchase orders
Storing Amount of Square Footage
Machining No. of machine hours
Supervising No. of employees

COST DRIVER
- Any factor or activity that has a direct cause-effect relationship with the resources consumed.
- In ABC cost drivers are used to assign activity cost pools to products or services.

REASONING FOR ACTIVITY BASED COSTING

- Products consume activities – Activities consume resources
- ABC is based on the premise that if a product consumes many resources (activities) that
comprise overhead, it should bear a greater share of overhead costs that another product that
does not consume as many activity units.

BENEFITS OF ACTIVITY BASED COSTING

 More accurate product costing which necessitates:
More cost pools used to assign overhead
Enhanced control over overhead
Better management decisions

LIMITATIONS OF ACTIVITY-BASED COSTING

 Can be expensive to use
WHEN TO SWITCH TO ABC
How does a company know when to switch to ABC? The presence of one or more of the
following factors would point to ABC as the superior costing system:
 Products differ greatly in volume and manufacturing complexity
 Product lines are numerous, diverse and require differing degrees of support services
 Overhead costs constitute a significant portion of total costs
 The manufacturing process or number of products has changed significantly, for example,
from labor intensive to capital-intensive due to automation
 Production or marketing managers are ignoring data provided existing system

STEPS IN APPLYING ABC:

 Identify activities
 Identify cost driver
 Compute overhead rate
 Assign overhead costs

Activity-Based Management
An extension of ABC from a product costing system to a management function that focuses on
reducing costs and improving processes and decision making.

Value-Added Activities
An activity that increases the worth of a product or service such as:
Engineering design
Machine set-ups
Machining
Assembling
Painting
Packaging

Non Value-Added Activities

An activity that adds cost to, or increases the time spent on, a product/service without increasing its
market value such as:
Repair of machines
Storage of inventory
Moving of materials
Building maintenance
Inspections
Inventory control

Value added activities involve use of resources wherein customers are willing to pay for, while non-value
added activities should be minimized and reduced at all cost

The four levels of activities are classified as:

Unit-Level Activities
Activities performed for each unit of production
Ex. Drilling, cutting, milling, assembling, painting, sanding
Batch-level Activities
Activities performed for each batch of products.
Ex. Equipment setups, purchase ordering, inspection, material handling
Product-Level Activities
Activities performed for and identifiable with an entire product line.
Ex. Product design, engineering changes, inventory management
Facility-Level Activities
Activities required to support or sustain an entire production process and not dependent on
number of products, batches, or units produced
Ex. Plant management, personnel administration, training, security
This hierarchy provides managers and accountants a structured way of thinking about
relationships between activities and the resources they consume. In contrast, traditional volume-based
costing recognizes only unit-level costs. Failure to recognize this hierarchy of activities is one of the
reasons that volume-based cost allocation causes distortions in product costing.

As indicated earlier, allocating all overhead costs by unit-based cost drivers can send false
signals to managers; Dividing batch, product, or facility level costs by the number of units produced
gives the mistaken impression that these costs vary with the number of units. The resources consumed
by batch, product and facility level supporting activities do not vary at the unit level, not can they be
controlled at the unit level. The number of activities performed at the batch level goes up as the number
of batches rises- not as the number of units within the batches changes. Similarly, the number of
product-level activities performed depends on the number of different products- not on how many units
or batches are produced. Furthermore, facility-sustaining activity costs are not dependent upon the
number of products, batches, or units produced. Batch, product and facility level costs can be controlled
only by modifying each batch, product and facility level activities.

Figure 9.1 shows examples of Activity Centers, Cost Drivers, and Traceable Costs.

Figure 9.1
I. Unit-Level Activities
Activity Centers Cost Drivers Traceable Costs
Machine-related activities, Machine-hours Power costs
Such as milling, cutting, and Maintenance costs
maintenance. Labor costs
Labor-related activities, Labor-hours Factory supplies
including fringe benefits Number of units of output Depreciation of general-use
machines and equipment
Depreciation of
maintenance equipment

II. Batch-Level Activities

Activity Centers Cost Drivers Traceable Costs

Purchase order processing Number of orders Clerical costs
Production order processed Supplies consumed
processing Labor setup costs
Material handling Number of material receipts Labor cost to handle
Pounds of material handled material
Equipment setups Number of setups Depreciation of office,
Hours of setup time setup, and material-
Quality inspection Number of inspections handling equipment
Hours of inspection time Quality control costs

III. Product-Level Activities

Activity Centers Cost Drivers Traceable Costs
Product testing Number of tests Testing facility costs
Hours of testing time Parts administration costs
Parts inventory Number of part types Parts carrying costs
management Product engineering costs
Product design Hours of design time Design costs
Number of engineering
change orders
IV. Facility-Level Activities
Activity Centers Cost Drivers Traceable Costs
General factory Machine-hours Plant management salaries
Plant occupancy Labor-hours Plant depreciation
Personnel administration Number of employees Property taxes & insurance
and training* (head count) Personnel administration
Hours of training time costs
Employee training costs
Employee training costs
Work recreational facilities
*The costs of some of these activities may be traceable in part to the facility level and in
part to other activity centers at the unit level, product level, and batch level. Personnel
administration and training may be such an activity.

Illustrative problem:

Gonzales Company uses activity-based costing to compute unit product costs for external financial
reports. The company manufactures two products, the Megastar and the Superstar. During the coming
year the company expects to produce 20,000 units of the megastar and 5,000 units of the superstar.
Listed below are other selected data relating to the coming year.
Basic Data
Expected Activity
Activity Center Estimated
(and Cost Driver) Overhead Costs Total Megastar Superstar
Labor related P 80,000 10,000 8,000 2,000
(direct labor-hours)
Machine setups 420,000 1,400 500 900
(number of setups)
Product testing 600,000 8,000 6,400 1,600
(number of tests)
General factory 900,000 45,000 30,000 15,000
(machine hours)

Required:
1. Compute the overhead rates by activity center.
2. Determine the overhead cost per unit for each product.

Suggested Answers:
1. Overhead rates by activity center.
(Column A) (Column B) (Column C) [(Column B) / (Column C)]
Activity Center Estimated Overhead Expected Activity Predetermined OH Rates
Cost
Labor related P 80,000 10,000 P8.00 per Direct Labor
Hour
Machine setups 420,000 2,400 P300.00 per setup
Product testing 600,000 8,000 P75.00 per test
General factory 900,000 45,000 P20.00 per machine hour

2. Overhead cost per unit

Megastar Product Superstar Product
Activity center Activity Amount Activity Amount
Labor related, @ P8.00 per DLH 8,000 P 64,000 2,000 P 16,000
Machine setups, @P300 per setup 500 150,000 900 270,000
Product testing, @P75.00 per test 6,400 480,000 1,600 120,000
General factory, @P20.00 per MH 30,000 600,000 15,000 300,000
Total cost assigned P1,294,000 P 706,000
/ Number of units produced 20,000 5,000
= Overhead cost per unit P 64.70 P 141,200