ACTIVITY BASED

COSTING
Learning outcomes
• Explain why a cost accumulation system is required for generating relevant
cost information for decision-making.
• Describe the differences between activity-based and traditional product
costing systems.
• Explain why traditional costing systems can provide misleading information
for decision-making.
• Identify and explain each of the four stages involved in designing ABC
systems.
• Describe a four-ABC cost hierarchy
• Determine cost of products or services using activity-based costing.
• Evaluate the costs and benefits of implementing activity-based costing
systems.
The need for a Cost
Accumulation System in
Decision Making
A cost accumulation system collects and determines the total cost of
producing a product or a service. This information is needed, both for
budgeting purposes, setting the selling price for the product and other
management decisions.

There are 3 reasons why a cost accumulation system is needed to generate

relevant cost information for decision-making.
1. Many indirect costs are relevant for decision-making;
2. An attention-directing information system is required that periodically
identifies potentially unprofitable products;
3. Product decisions are not independent.
ABC is a form of Absorption
costing
Absorption Costing

Traditional Costing system Activity Based Costing

Traditional Costing System
• Total manufacturing costs (material, labour & overheads) are
assigned to products based on one driver, regardless of whether
they drive production or not.
• Non-manufacturing costs, e.g. ordering machine repairs, are not
assigned to product cost, regardless of whether the costs are based
on the products.
• Traditional cost systems usually rely on volume
measures such as direct labour hours and/or machine
hours to allocate all overhead costs to products.
ABC Explained
• A costing method that identifies activities in an organization
(manufacturing and non-manufacturing activities) and allocate the
cost of each activity to products and services according to their
consumption of these activities.

• It is based on the principle that production overheads are driven by

level of activities, and activities are in turn driven by the level of
production.
Comparing ABC costing
to Traditional Methods

• The absorption of overhead into products is where the main difference lies
between ABC and traditional costing.
• Traditional absorption costing uses limited, volume-based bases to absorb
overheads (e.g. labour, machine hours, etc.) to allocate overhead cost to
products, whereas ABC uses multiple cost drivers (e.g. the number of orders,
or the number of dispatches).
Traditional costing ABC
Tradition Overhead Single cost driver Multiple cost drivers
al Vs ABC assignment

When direct labor is a When technology is

Optimal usage large portion of the a large portion of
product cost the product cost
• Because of increased use of technology
and the fact that manufacturing has Orientation Cost driven Process driven
become more machine intensive,
overheads are now a larger proportion of
total costs in modern manufacturing.

• Technology has also caused the use of

multiple drivers of overhead cost, which
calls for a more precise cost allocation in
this regard.
Differences Between ABC and
Traditional Product Costs
There are three reasons why the
reported product margins for the two
costing systems differ from one another.

Traditional costing allocates all manufacturing

overhead to products. ABC costing only assigns
manufacturing overhead costs consumed by
products to those products.
 Traditional costing allocates all manufacturing
overhead costs using a volume-related allocation
base. ABC costing also uses non-volume related
allocation bases.
Weaknesses Traditional
Costing Systems
Companies are now producing different products in advanced product mixes. This resulted in a
wide variety of costs associated with each product, which cannot be captured accurately by the
simplistic method of traditional costing.
Traditional approach absorbs overheads based on a volume base, like labour or machine hours.
However, many indirect costs, e.g support cost like handling fees, set-up cost, cost of inspection,
etc. that require allocation are mostly not caused by volume. In other words, traditional cost
allocations are often based on something other than the actual root causes of the costs.
The increased use of technology and machinery has reduced direct labour cost and increased
overheads cost. A misallocation of overheads is therefore a misallocation of a larger portion of
total costs.
Activity-Based
Activity-Based Costing
Costing
Terms
Terms
Cost Pool: A grouping of individual costs, usually by department or
cost center. E.g. Machine set up cost

Activity: Any event, action, transaction, or work sequence that

consumes resources like time or money. E.g. Machine set ups

Cost Drivers: The direct cause of a cost and its effect on the total
cost incurred. E.g. Number of batches drive machine set up cost

Cost object: Anything that requires a separate measurement of cost.

E.g, A product, a service, etc.
ABC Cost Hierarchy

The
The ABC
ABC Cost
Cost Hierarchy
Hierarchy
Manufacturing cost can be classified into the following hierarchy, depending on the level of
activities involved when they are incurred in the production process.

1. Unit-level costs – incurred from activities performed in producing each unit of output.
These costs are incurred in proportion to production. – e.g., Direct labour & direct materials
2. Batch-level costs – activities incur costs with each ‘batch’ of output -E.g. Costs of setting
up equipment for each new batch, order processing cost etc.
3. Product-sustaining costs – Costs do not increase in relation to units/ batches produced.
These are the costs necessary to support individual products or services – E.g., design costs.
4. Facility-sustaining costs – General manufacturing overheads that cannot easily be traced
to 1 production activity. Cost incurred to support organization as a whole & are commonly
applied to all products. E.g., Admin staff salaries.
The
The ABC
ABC Cost
Cost Hierarchy
Hierarchy
Classification
of Activity
Levels

Illustration 4-13
The
The 4
4 Stages
Stages of
of Activity-
Activity-
Based
Based Costing
Costing
1. Identify and classify the major activities and allocate overhead
costs to the appropriate cost pools – This aims to determine how much
the organization is spending on each activity
2. Determine the cost driver for each major activity – to be used in
assigning cost attached to each cost pool to products
3. Compute the overhead rate for each pool/ activity
4. Assign the cost of activities to products – according to the product’s
demand for the activities, as per the overhead rate determined in 3.
Activity-Based
Activity-Based Costing
Costing Pictorial
Pictorial
Depiction
Depiction Illustration 4-2
Activities and related cost
drivers
ABC
ABC Costing
Costing Example
Example
Atlas Company produces two automobile antitheft devices:
 The Boot: high volume item with sales totaling 25,000 per year
 The Club: 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 amount to $900,000, made up of:

N$ Cost Drivers / product
The Boot The Club
Setting up Machines – N$ 300,000 500 set ups 1,000 set ups
Machining - N$ 500,000 30,000 machine hours 20,000 machine hours
Inspecting - N$ 100,000 500 inspections Required: Calculate
1,500 inspections
Direct materials cost: unit
 The Boot - $40 per unit
costs under ABC.
 The Club - $30 per unit
ABC
ABC Costing
Costing Example
Example

Identify and Classify Activities and Allocate

Overhead to Cost Pools (Step 1)
Overhead costs are assigned directly to the appropriate
activity cost pool.
ABC
ABC Costing
Costing Example
Example

Identify Cost Drivers (Step 2)

The cost driver must accurately measure the actual

consumption of the activity by the various products.
ABC
ABC Costing
Costing Example
Example

Compute Overhead Rates (Step 3)

Next, the company computes an activity-based
overhead rate per cost driver.
ABC
ABC Costing
Costing Example
Example

Assign Overhead Cost to Products (Step 4)

In assigning overhead costs, it is necessary to know the
expected use of cost drivers for each product. Because
of its low volume, The Club requires more set-ups and
inspections than The Boot.
ABC
ABC Costing
Costing Example
Example

Assign Overhead Cost to Products (Step 4)

To assign overhead costs, Atlas multiplies the activity-
based overhead rates per cost driver by the number of
cost drivers expected to be used per product.
ABC
ABC Costing
Costing Example
Example

Assign Overhead Cost to Products (Step 4)

To assign overhead costs, Atlas multiplies the activity-based
overhead rates per cost driver by the number of cost drivers
expected to be used per product.

SO4 Know how companies identify and use cost drivers in activity-based costing.
ABC
ABC Costing
Costing Example
Example

Calculating total cost / Unit – ABC Costing

The Boot The Club

Direct Material $40 $30
Direct Labour $12 $12
Overheads $17 $95

Total Cost $69 $137

ABC
ABC Costing
Costing Example
Example

Calculating total cost / Unit – Traditional Costing

Under Traditional Costing overheads would have been applied

at Direct Labour : 900,000/30,000 hours = $30/ hour, which
is also $30/unit for both products

The Boot The Club

Direct Material $40 $30
Direct Labour $12 $12
Overheads $30 $30

Total Cost $82 $72

ABC
ABC Costing
Costing Example
Example

Comparing ABC to Traditional Costing

Under Traditional costing, Atlas has been overpricing The Boot
and
possibly losing market share to competitors. It also has been
sacrificing profitability by underpricing The Club.
Under ABC, overhead costs are applied more to the low volume product
(The Club) because low volume products often require more special
handling, when compared to high volume product (The Boot). This causes
an increase in the cost per unit of low volume products.
Activity-Based
Activity-Based Costing:
Costing: A
A Closer
Closer Look
Look

Situations when ABC is beneficial

Organizations likely to benefit from ABC are those whose:

1. Product lines differ in volume and manufacturing

complexity.

2. Product lines are numerous and diverse.

3. Overhead costs constitute a significant portion of total

costs.

4. Operations underwent significant technological

changes
Activity-Based
Activity-Based Costing:
Costing: A
A
Closer
Closer
Benefits Look
of ABCLook
1. ABC provides accurate product cost and profitability measurement that improves
management decisions

2. Information on cost drivers causes better – informed strategic decisions on product

design, customer support, etc. Overhead costs can be controlled by managing cost
drivers.

3. ABC can be applied to all overhead costs, not just production overheads.

4. Production improvement – An ABC system provides information that can improve

production processes.

5. ABC provides better product cost information necessary for strategic budgeting,
planning, and product pricing decisions.
ABC Limitations
Substantial resources Resistance to
required to implement unfamiliar numbers
and maintain ABC. – Can be and reports.
expensive

Desire to fully Potential

allocate all costs misinterpretation of
to products. unfamiliar numbers.
It’s impossible to allocate all overhead cost to activities

Does not conform to

GAAP. Two costing
systems may be needed.