Activity-based costing

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Introduction

 In the past, overhead costs were relatively

small, and the problems arising from
inappropriate overhead allocations were not so
significant
 But nowadays, factories are highly automated,
resulting in increasing depreciation charges,
maintenance cost and machinery set-up cost
 Errors in overhead absorption may seriously
affect the management decisions

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 The Activity-based costing (ABC) system is
developed to provide better approach for
assigning overheads to products and
computing product costs

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Limitation of traditional costing

 Traditional systems adopt volume-related

allocation bases e.g. direct labour hour and
machine hour. However, different resources
are used in non-volume related support
activities e.g. materials ordering, machinery
set-up, production scheduling and first-item
inspection

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 Traditional systems allocate overheads to
products in proportion to their production
volumes. High overheads are allocated to the
high-volume products. As a result, the high-
volume simple products may be over-costed
while the low-volume complex products may
be under-costed

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Introduction to Activity-based
costing
 The activity-based costing system asserts
that products create demand for activities and
activities bring about the costs to be incurred

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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.

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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.

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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).

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Possible Cost Drivers
• Machine hours
• Direct labor hours
• Number of setups
• Number of products
• Number of purchase orders
• Number of employees
• Number of square feet

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What steps?
1. Identity major activities performed by the
business
2. Calculate the total cost of each activity over
the period (i.e. cost centre or cost pool)
3. Determine the cost driver for each activity.
Cost drivers are the factors which cause the
activity cost pool to increase
4. Calculate the cost driver rate (i.e. total cost
in a cost pool/ no. of cost driver)
5. Assign the cost-centre overheads to the
products according to their cost driver rates
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Example

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Martin Ltd. Manufactures tow products. Product A is a high-
Volume product while Product B is a low-volume product.
Details of production are shown as follows:
Product A Product B
Materials cost per unit $130 $130
Direct Labour cost per hour $50 $50
Direct machine hour per unit 4 hrs 4 hrs
Direct labour hour per unit 2 hrs 2 hrs
Output 10 100
No. of purchase orders 3 4
No. of set up 40 80

Overhead costs are shown as follows: $

Factory power 6600
Machinery set-up costs 4800
Materials handling and dispatch 2100
13500 13
 Required
Calculate the product costs using:
(a) Absorption costing based on machine
hour
(b) Activity-based costing

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(a) Absorption costing based on machine
hour
Product A Product B
$ $
Direct Materials 130 130
Direct labour 100 100
Overheads
($13500*4/440) 123 123
Product cost per unit 353 353

4*10+100*4

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(b) Activity based Costing

Product A Product B
$ $
Direct Materials 130 130
Direct labour 100 100
Overheads
Factory power
(6600*4/440) 60 60
Machinery set-up cost
(4800*40/120*1/10) 160
(4800*80/120*1/100) 32
Materials handling & dispatch
(2100*3/7*1/10) 90
(2100*4/7*1/100) 12
Product cost per unit 540 334 16
Traditional Activity based
Objective Ensure all Focus on the
overheads are activities incurred
absorbed into the Assign to each
total production cost product only those
The product cost costs that would be
enable the avoided if the
production cost and production was
stock valuation discontinued
Allocation  the basis volume- The basis of non-

of related criteria e.g. volume-related

overhead machine hours and activities e.g. the no.
direct labour hours of purchase order,
production runs and
deliveries 17
Traditional Activity based
Assignment Overheads cost Overheads are
of overhead are assigned to assigned to the cost
each department centre for each
activities
Adoption of  a single Numerous cost

overhead absorption rates is drivers are used for

rate used different activities

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Cost driver analysis

 Traditional costing systems assume that all

overheads increase in proportion to the
number of units produced
 In a complex manufacturing environment, a
greater number of cost drivers are used for
cost accumulation

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Costs are incurred for each unit
Produced. For example,
Unit-level activities •Direct materials Cost per unit
•Direct labour
•Factory power

Costs are incurred for each batch

produced. For example,
Batch-level activities Cost per unit in batch
•Purchase orders
•Production runs
•Number of inspection

Costs are incurred to support a product

Types or process. For example,
Production Cost per unit in batch
•Engineering change orders
-level activities
•Product development
•Process design
•Test routines

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Advantages of Activity-based costing

 More realistic cost assignment

 Better decision-making
 Better control over cost

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Limitation of Activity-based costing

 Difficult to apportion common costs

 Difficult to implement
 Inconsistent with the generally accepted
accounting principles (GAAP)

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