ACTIVITY BASED COSTING

(ABC)
(a tool to aid decision making)
03.12.2024
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 (ABC)
- 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 allocates 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 is allocated to a distinct type of
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.
- In other words, cost driver is any activity that
causes costs to be incurred
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 than 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
• Enhances 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 the data provided in the 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.

Objective of ABC - reduce or eliminate non-

value-added activities incurred to make a
product or provide a service
FOUR LEVELS OF ACTIVITIES
1. Unit-Level Activities

2. Batch-Level Activities

3. Product-Level Activities

4. Facility-Level Activities
FOUR LEVELS OF ACTIVITIES

Unit-Level Activities

Activities performed for each unit of production

Ex. Drilling, cutting, milling, assembling, painting,
sanding
FOUR LEVELS OF ACTIVITIES
Batch-level Activities

Activities performed for each batch of products.

Ex. Equipment setups, purchase ordering, inspection,
material handling
FOUR LEVELS OF ACTIVITIES
Product-Level Activities

Activities performed for and identifiable with an entire

product line.
Ex. Product design, engineering changes, inventory
management
FOUR LEVELS OF ACTIVITIES
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, nor 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.­
ACTIVITY CENTERS, COST DRIVERS,
AND TRACEABLE COSTS
I. Unit-Level Activities
Activity Centers Cost Drivers Traceable Costs
Machine-related activities, Machine-hours Power costs
Such as milling, cutting, Maintenance costs
and maintenance. Labor costs
Factory supplies
Labor-related activities, Labor-hours Depreciation of general-
including fringe benefits Number of units of output use machines and
equipment
Depreciation of
maintenance equipment
ACTIVITY CENTERS, COST DRIVERS,
AND TRACEABLE COSTS
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 Labor cost to handle
receipts material
Pounds of material Depreciation of office,
handled setup, and material-
Equipment setups Number of setups handling equipment
Hours of setup time Quality control costs
Quality inspection Number of inspections
Hours of inspection time
ACTIVITY CENTERS, COST DRIVERS,
AND TRACEABLE COSTS
III. Product-Level Activities
Activity Centers Cost Drivers Traceable Costs
Product testing Number of tests Testing facility costs
Hours of testing time
Parts inventory Number of part types Parts administration costs
management Parts carrying costs

Product design Hours of design time Product engineering costs

Number of engineering Design costs
change orders
ACTIVITY CENTERS, COST DRIVERS, AND
TRACEABLE COSTS
IV. Facility-Level Activities
Activity Centers Cost Drivers Traceable Costs
General factory Machine-hours Plant management
Plant occupancy Labor-hours salaries
Personnel administration Number of employees Plant depreciation
and training* (head count) Property taxes &
Hours of training time insurance
Personnel administration
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.
ILLUSTRATION
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) /

Activity Center Estimated Expected (Column C)]
Overhead Cost Activity Predetermined OH
Rates
Labor related P 80,000 10,000 P8.00 per Direct
Labor Hour
Machine setups 420,000 1,400 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
SUGGESTED ANSWERS
2. Overhead cost per unit Megastar Product Superstar Product
Activity center Activity Amount Activity Amount
Labor related, @ 8,000 P 64,000 2,000 P 16,000
P8.00 per DLH
Machine setups, 500 150,000 900 270,000
@P300 per setup
Product testing, 6,400 480,000 1,600 120,000
@P75.00 per test
General factory, 30,000 600,000 15,000 300,000
@P20.00 per MH
Total cost P1,294,000 P 706,000
assigned
/ Number of 20,000 5,000
units produced
= Overhead cost P 64.70 P 141.20
per unit ========= =========
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