COST ACCOUNTING

Chapter 12 - Activity Based Costing

Traditional Costing and Activity-Based Costing
• Often, the most difficult part of computing accurate unit costs is determining the proper amount
of overhead cost to assign to each product, service, or job.

Traditional Costing System

• A traditional costing system allocates overhead to products on the basis of predetermined plantwide
or departmentwide volume of unit-based output rates, such as direct labor or machine hours.

Activity-Based Costing (ABC)

• Activity-based costing (ABC) allocates overhead to multiple activity cost pools and assigns
the activity cost pools to products and services by means of cost drivers.

– In ABC, an activity is any event, action, transaction, or work sequence that causes the incur-
rence of cost in producing a product or providing a service.
– A cost driver is any factor or activity that has a direct cause-effect relationship with the
resources consumed.
– Under ABC, overhead costs are usually shifted from a high-volume product to a low-volume
product.

ABC Allocates Overhead in a Two-Stage Process

• In the first stage, overhead costs are allocated to activity cost pools, rather than to departments.
Each is a distinct type of activity.

• In the second stage, the overhead allocated to the activity cost pools is assigned to products using
cost drivers that represent and measure the number of individual activities undertaken or performed
to produce products or provide services.

Activity-based costing involves the following four steps:

1. Identify and classify the major activities involved in the manufacture of specific products and
allocate manufacturing overhead costs to the appropriate cost pools.
2. Identify the cost driver that has a strong correlation to the costs accumulated in the cost pool.

3. For each cost pool, compute the activity-based overhead rate per cost driver:
Estimated Overhead per Activity
Overhead Rate =
Expected Use of Cost Driver per Activity

4. Assign manufacturing overhead costs for each cost pool to products, using the overhead rates (cost
per driver).

Benefit of ABC
• The primary benefit of ABC is more accurate product costing because:
– ABC leads to more cost pools being used to assign overhead costs to products.
– ABC leads to enhanced control over overhead costs; companies can trace many overhead costs
directly to activities under ABC.
– ABC leads to better management decisions; more accurate product costing should contribute
to desired product profitability levels.

Page 1 of 6
UNIVERSITY OF CALOOCAN CITY – CAMARIN — FOR CLASSROOM DISCUSSION PURPOSES ONLY
COST ACCOUNTING

Limitations of ABC
• Although ABC systems often provide better product cost data than traditional volume-based
systems, the following limitations exist:

– ABC can be expensive to use; identifying multiple activities and applying numerous cost
drivers results in increased costs.
– Some arbitrary allocations continue; certain overhead costs still have to be allocated by some
arbitrary volume-based cost driver (i.e., labor hours).

When to Use ABC

The presence of one or more of the following factors would point to possibly using ABC:
• Product lines differ greatly in volume and manufacturing complexity.

• Product lines are numerous, diverse, and require offering degrees of support services.
• Overhead costs constitute a significant portion of total costs.
• The manufacturing process or the number of products has changed significantly.

Value-Added Versus Non-Value-Added Activities

• Activity-based management (ABM) is 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 increase the worth of a product or service to customers.

∗ Examples include engineering design, machining, assembly, painting, and packaging.
– Non-value-added activities are product- or service-related activities that simply add cost
to, or increase the time spent on, a product or service without increasing its market value.
∗ Examples include repair of machines, storage of inventory, moving of raw materials, as-
semblies and finished product, building maintenance, inspections, and inventory control.
• The purpose of ABM is to reduce or eliminate the time and cost devoted to non-value-added
activities.

Classification of Activity Levels

• A classification of ABC activities consisting of four levels are defined as:
– Unit-level activities: activities performed for each unit of production.
– Batch-level activities: activities performed for each batch of products rather than each unit.
– Product-level activities: activities performed in support of an entire product line.
– Facility-level activities: activities required to support an entire production process.
• Companies may achieve greater accuracy in overhead cost allocation by recognizing the different
levels of activities and developing specific activity cost pools and their related cost drivers.
• Nonrecognition of this classification of activities is one of the reasons that volume-based cost
allocation causes distortions in product costing.
• The resources consumed by batch-, product-, and facility-level supporting activities do not vary at
the unit level, nor can managers control them at the unit level.

Page 2 of 6
UNIVERSITY OF CALOOCAN CITY – CAMARIN — FOR CLASSROOM DISCUSSION PURPOSES ONLY
COST ACCOUNTING

Classification
1. A list of possible cost drivers is presented below:

Code Description Code Description

A Engineering hours D Number of subassemblies
B Setups E Boxes
C Machine hours F Orders

For each of the following activity cost pools, select the most appropriate cost driver:

1. Machine setup
2. Ordering and receiving
3. Packaging and shipping
4. Engineering design
5. Machining
6. Assembly

2. Label the following costs as value-adding (VA) or non-value-adding (NVA):

1. Engineering design
2. Machine repair
3. Inventory storage
4. Machining
5. Assembly
6. Painting
7. Inspections
8. Packaging

3. Roz Company manufactures small tools. Classify each of the following

activity costs as either unit level, batch level, product level, or facility level:
1. Plant management
2. Drilling
3. Painting
4. Machine setups
5. Product design
6. Cutting
7. Inspection
8. Inventory management

Page 3 of 6
UNIVERSITY OF CALOOCAN CITY – CAMARIN — FOR CLASSROOM DISCUSSION PURPOSES ONLY
COST ACCOUNTING

4. Brightbill Company manufactures hand-made pine storage boxes for a

variety of clients. As production manager, you have developed the following
value chart:
(a) Determine the value-added activities and their total time.
(b) Determine the non-value-added activities and their total time.
(c) Calculate the manufacturing cycle efficiency.

Operation Time Chart

Operation Average Number of Days

Receiving materials 1
Storing materials 2
Handling materials 3
Cutting/measuring materials 6
Assembling materials 4
Building boxes 7
Attaching hinges 2
Inspection 1

Illustrative Problems
1.
The controller for Loudwing Corporation has established the following overhead cost pools and cost
drivers:
Overhead Cost Pool Budgeted Overhead Cost Cost Driver
Machine setups P240,000 Number of setups
Material handling 90,000 Units of raw material
Quality control inspection 48,000 Number of inspections
Other overhead costs 160,000 Machine hours
Total P538,000

Overhead Cost Pool Breakdown:

Overhead Cost Pool Budgeted Level for Cost Driver Overhead Rate
Machine setups 200 setups P1,200 per setup
Material handling 60,000 units P1.50 per unit
Quality control 1,200 inspections P40 per inspection
Other overhead 20,000 machine hours P8 per machine hour

Order no. 715 has the following production requirements:

• Machine setups: 7
• Raw material: 11,200 units
• Inspections: 16
• Machine hours: 850
Questions:
(a) Compute the total overhead that should be assigned to order no. 715 by using activity-based
costing.
(b) Suppose that Loudwing were to use a single, predetermined overhead rate based on machine hours.
Compute the rate per hour and the total overhead assigned to order no. 715.

Page 4 of 6
UNIVERSITY OF CALOOCAN CITY – CAMARIN — FOR CLASSROOM DISCUSSION PURPOSES ONLY
COST ACCOUNTING

2.
Chitchat Corporation has provided the following data from its activity-based costing system:

Activity Cost Pool Total Cost Total Activity

Assembly P613,250 55,000 machine-hours
Processing orders P46,170 1,500 orders
Inspection P146,110 1,900 inspection-hours

Data concerning one of the company’s products, Product X, appear below:

Item Value
Selling price per unit P113.70
Direct materials cost per unit P48.14
Direct labor cost per unit P11.62
Annual unit production and sales 360
Annual machine-hours 1,040
Annual orders 60
Annual inspection-hours 30

According to the activity-based costing system, the product margin for Product X is:

3.
The Beavers Company uses activity-based costing. The company produces two products: coats and hats.
The annual production and sales volume of coats is 8,000 units and of hats is 6,000 units. There are
three activity cost pools with the following expected activities and estimated total costs:

Activity Cost Pool Estimated Cost Expected Activity (Coats) Expected Activity (Hats)
Activity 1 P20,000 100 400
Activity 2 P37,000 800 200
Activity 3 P91,200 800 3,000
Total P148,200 1,700 3,600

Question 1: Using ABC, the cost per unit of coats is approximately:

4.
Fink Accounting performs two types of services, Tax and Consulting. The overhead costs consist of
computer support, P200,000; and legal support, P100,000. Information on the two services is:

Tax Consulting
Direct labor cost P50,000 P100,000
CPU minutes 40,000 10,000
Legal hours used 200 800

Question 1: Overhead applied to tax services using traditional costing is

Question 2: Overhead applied to consulting services using traditional costing is
Question 3: Overhead applied to tax services using activity-based costing is
Question 4: Overhead applied to consulting services using activity-based costing is

5.
The Bears Company produces two products, A and B, and uses a costing system in which all overhead is
accumulated in a single cost pool and allocated based on machine hours. The management has decided
to implement ABC because a cost study has revealed significant amounts of overhead cost related to
setup activity and design activity. The number of setups and the number of design hours will be the
activity drivers for the two new cost pools, and machine hours will continue as the base for allocating
the remaining overhead. Selected information follows for the company’s most recent year of operations:

Page 5 of 6
UNIVERSITY OF CALOOCAN CITY – CAMARIN — FOR CLASSROOM DISCUSSION PURPOSES ONLY
COST ACCOUNTING

A B Total
Units produced 500 15,500 16,000
Direct material cost:
Per unit P200 P20
Total P100,000 P310,000 P410,000
Machine hours 3,000 47,000 50,000
Direct labor cost: P50,000 P350,000 P400,000
Setups 120 80 200
Design hours 6,000 4,000 10,000
Overhead:
Setup-related P250,000
Design-related P350,000
Other P900,000
Total overhead P1,500,000

Questions:
1. Calculate the total and per-unit costs reported for the two products by the existing costing system.

2. Calculate the total and per-unit costs reported for the two products by the ABC system.

6.
Peter Brown Corporation manufactures three types of remote-control devices: Economy, Standard, and
Deluxe. The company, which uses activity-based costing, has identified five activities and related cost
drivers. Each activity, its budgeted cost, and related cost driver is identified below:

Activity Cost Cost Driver

Material handling P225,000 Number of parts
Material insertion P2,475,000 Number of parts
Automated machinery P840,000 Machine hours
Finishing P170,000 Direct labor hours
Packaging P170,000 Orders shipped
Total P3,880,000

The following information pertains to the three product lines for next year:

Economy Standard Deluxe

Units to be produced 10,000 5,000 2,000
Orders to be shipped 1,000 500 200
Number of parts per unit 10 15 25
Machine hours per unit 1 3 5
Labor hours per unit 2 2 2

Question 1: What is the cost application rate for the material-handling activity?
Question 2: What is the cost application rate for the automated machinery activity?
Question 3: What is the cost application rate for the finishing activity?
Question 4: What is the cost application rate for the packaging activity?
Question 5: Under an activity-based costing system, what is the per-unit cost of Economy?
Question 6: Under an activity-based costing system, what is the per-unit cost of Standard?
Question 7: Under an activity-based costing system, what is the per-unit cost of Deluxe?

Page 6 of 6
UNIVERSITY OF CALOOCAN CITY – CAMARIN — FOR CLASSROOM DISCUSSION PURPOSES ONLY