Traditional Costing

and
Activity Based Costing

Dr. Prateeksha Maurya

Indian Institute of Management Jammu
Traditional Costing Systems
• Product Costs Appear on the income
statement when
– Direct labor goods are sold, prior
to that time they are
– Direct materials stored on the balance
sheet as inventory.
– Factory Overhead
Appear on the income
• Period Costs statement in the
period incurred.
– Administrative expense
– Sales expense
Traditional Costing Systems
• Product Costs Direct labor and direct
materials are easy to
– Direct labor trace to products.

– Direct materials The problem comes

with factory
– Factory Overhead overhead.

• Period Costs
– Administrative expense
– Sales expense
Traditional Costing Systems
• Typically used one rate to allocate overhead to
products.
• This rate was often based on direct labor
dollars or direct labor hours.
• This made sense, as direct labor was a major
cost driver in early manufacturing plants.
1. Focus on the product in the costing
Traditional Product Costing process.
2. Costs are traced to the product with
Costs assumption to consuming of the
resources in proportion to the
Allocation: volume produced.
Costs are 3. These volume drivers, fails to
allocated to account for product diversity in the
products based form of size or complexity.
on assumed 4. There is not a direct relationship
linkages or between production volume and
Consumed by: convenient cost consumption.
alternatives such
as direct labor
hours

Products

5
• Burden rate or allocation rate=
Total Overheads/Total base driver
Base could be Total direct labour hour or Total
machine hour
Problems with Traditional Costing
Systems
• Manufacturing processes and the products
they produce are now more complex.
• This results in over-costing or under-costing.
– Complex products are not allocated an adequate
amount of overhead costs.
– Simple products get too much.
Today’s Manufacturing Plants
• Are more complex
• Are often automated
• Often make more than one product
• Use proportionately smaller amount of direct
labor making direct labor a poor allocation
base for factory overhead.
When the manufacturing process is
more complex:
• Then multiple allocation bases should be
used to allocate overhead expense.
• In such situations, managers need to
consider using activity based costing
(ABC).
ABC Definitions
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 attributed
to a distinct type of activity.
Examples:
Purchasing materials.
Setting up machines.
Cost Drivers: Any factors or activities that have a
direct cause-effect relationship with the
resources consumed.
Activity-Based Costing

Products consume activities,

and
Activities consume resources.
Activity-Based Costing
ABC allocates overhead costs in two stages:

Stage 1: Overhead costs are allocated to activity

cost pools.

Stage 2: The overhead costs allocated to the cost

pools is assigned to products using cost drivers.

The more complex a product’s manufacturing

operation, the more activities and cost drivers
likely to be present.
OVERHEAD COSTS

Illustration 17-2
Overhead Costs
Activity-Based Costing
ABC does not replace an existing job
order/process cost system.

ABC does segregate overhead into various

cost pools to provide more accurate cost
information.

ABC, thus, supplements – it does not

replace – the traditional cost system.
ABC Steps
• Overhead cost drivers are determined.
• Activity cost pools are created.
– A activity cost pool is a pool of individual costs
that all have the same cost driver.
• All overhead costs are then allocated to one of
the activity cost pools.
ABC Steps:
• An overhead rate is then calculated for each
cost pool using the following formula:
– Costs in activity cost pool/base
– The base is, of course, the cost driver
• Overhead costs are then allocated to each
product according to how much of each base
the product uses.
Activity-Based Costing
Atlas Company produces two automotive antitheft
devices:
The Boot: A high volume item with sales totaling 25,000 per year.
The Club: A low volume item with sales totaling 5,000 per year.

Each product requires 1 hour of direct labor

Total annual direct labor hours (DLH) 30,000 (25,000 + 5000).
Direct labor cost $12 per unit for each product.

Expected annual manufacturing overhead costs

$900,000
Direct materials cost:
The Boot - $40 per unit.
The Club - $30 per unit.
Costing Under Traditional Costing

Products
Manufacturing Costs The Boot The Club
Direct Materials $40 $30
Direct Labor 12 12
Overhead 30 30*
Total unit cost $82 $72

* Predetermined overhead rate: $900,000 ÷ 30,000 DLH = $30 per DLH

Overhead = predetermined overhead rate times direct labor hours
($30 × 1 hr. = $30)
Four Steps of Activity-Based Costing

Identify and classify the major activities and

allocate manufacturing overhead costs to the
appropriate cost pools.

Identify the cost driver that has a strong

correlation to the costs in the cost pool.

Compute the overhead rate for each pool.

Assign overhead costs for each cost pool to products

using the overhead rates.
Activity Cost Pools and Estimated
Overhead

Activity Cost Pools Estimated Overhead

Setting up machines $300,000
Machining 500,000
Inspecting 100,000
Total $900,000
Identify Cost Drivers

Expected Use
of Cost Drivers
Activity Cost Pools Cost Drivers
Per Activity
Setting up machines Number of setups
1,500
Machining Machine hours
50,000
Inspecting Number of Inspections
2,000
Formula for Computing Activity-Based
Overhead Rate

Estimated Overhead Per Activity

= Activity-Based Overhead Rate
Expected Use of Cost Drivers Per Activity

Illustration 17-6

Expected Use
Estimated of Cost Drivers Activity-Based
Activity Cost Pools Overhead Per Activity Overhead Rates
Setting up machines $300,000 1,500 setups $200 per setup
Machining 500,000 50,000 machine hrs. $ 10 per mach. hour
Inspecting 100,000 2,000 inspections $ 50 per inspection
Total $900,000
Expected Use of Costs to
Products
Assignment of Activity Cost Pools to
Products
Unit Product Costs Under Traditional and ABC Costing
Methods

The Boot The Club

Trad. Trad.
Manufacturing Costs Costing ABC Costing ABC
Direct Materials $40 $40 $30 $30
Direct Labor 12 12 12 12
Overhead 30 17 30 95
Total Cost per Unit $82 $69 $72 $137

Oversstated Understated
$13 $65

Illustration 7-11
Results of Using ABC
Under ABC, overhead costs are shifted from
the high volume product (The Boot) to the
low volume product (The Club) because:
Low volume products often require more
special handling.
Assigning overhead using ABC will
usually increase the cost per unit of low
volume products.
Benefits of Activity-Based Costing

More accurate product costing through:

Use of more cost pools to assign overhead costs.
Enhanced control over overhead costs.
Better management decisions.
Limitations of Activity-Based
Costing
Can be expensive to use (Cost/Benefit).
Some arbitrary allocations continue.
Use ABC When One or More of the Following
Exist:

Products differ greatly in volume/manufacturing complexity.

Products lines are:
Numerous.
Diverse.
Require different degrees of support services.
Overhead costs are a significant portion of total costs.
Significant change in manufacturing process or number of products.
Additional Uses of ABC
• Activity Based Management (ABM)
– Extends the use of ABC from product costing to a
comprehensive management tool that focuses on
reducing costs and improving processes and
decision making.
ABM
• ABM classifies all activities as value-added or
non-value-added.
– Value-added activities increase the worth of a
product or service to the customer.
• Example: Addition of a sun roof to an automobile.
– Non-value added activities don’t.
• Example: The cost of moving or storing the product
prior to sale.
The Objective of ABM . . .
• To reduce or eliminate non-value related
activities (and therefore costs).
• Attention to ABM is a part of continuous
improvement of operations and activities.
Activity-Based Management
(ABM)
An extension of ABC from a product costing system to
a management function
that focuses on reducing costs and improving
processes and decision making.
A refinement of ABC used in ABM classifies activities
as either value-added or non-value-added.

SO 6 Differentiate between value-added and non-value activities

Value- Added Activities
An activity that increases the worth
of a product or service such as:
Manufacturing Company Service Company
Engineering design Performing surgery
Machining Legal research services
Assembly Delivering packages
Painting
Packaging

SO 5 Understand the benefits and limitations of activity-based costing

Non-Value Activities
An activity that adds cost to, or increases the time spent
on, a product/service without increasing its market value
such as:
Manufacturing Company Service Company
Repair of machines Taking appointments
Storage of inventory Reception
Moving of raw materials, Bookkeeping/billing
assemblies, and Traveling
finished goods Ordering supplies
Building maintenance
Inspections
Inventory Control
Classification of Activity Levels
Unit-level activities:
Performed for each unit of production.
Batch-level activities:
Performed for each batch of product.
Product-level activities:
Performed in support of an entire product line, but not
always performed every time a new unit or batch is
produced.
Facility-level activities:
Required to support or sustain an entire production process.
Hierarchy of Activity Levels