1

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
• 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 labor 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

• 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
 INTRODUCTION TO ACTIVITY-BASED COSTING 4

The activity-based costing system asserts that products create

demand for activities and activities bring about the costs to be
incurred
ABC system accumulates overhead costs, for each of the activities
(cost pools) in an organization and the assigns those cost to products
or services, or cost objects based on the number of activity used. To
established a cause-effect relationship between an activity and a
cost object, cost driver is identified for each activity.
Activity Cost Pools Cost driver
Purchasing Department Number of purchase order
Receiving Department Number of shipment received
Materials Handling Number of materials requisition
Machine set-up Number of machine set-up required
Machining Number of machine hours
Inspections Number of inspections
Supervisors Number of direct labor hours
Servicing Customers Number of customers served
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WHAT STEPS?

1. Identity major activities performed by the business that

consume resources. Calculate the total cost of each
activity over the period (i.e. cost center or cost pool)
2. Determine the cost driver for each activity. Cost drivers
are the factors which cause the activity cost pool to
increase. Calculate the cost driver rate (i.e. total cost in
a cost pool/ no. of cost driver)
3. Assign the cost-center overheads to the products
according to their cost driver rates
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EXAMPLE
Para Gibo Toy Ltd. Manufactures toy products. Product7

A is a low-volume product while Product B is a high-

Volume product. Details of production are shown as
follows: Product A Product B
Materials cost per unit P130 P130
Direct Labor cost per hour P 50 P 50
Direct machine hour per unit 4 hrs 4 hrs
Direct labor 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 P6,600
Machinery set-up costs P4,800
Materials handling P2,100
P13,500
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• Required
Calculate the product costs using:
(a) Absorption costing based on machine hour
(b) Activity-based costing
(A) ABSORPTION COSTING BASED 9

ON MACHINE HOUR
Product A Product B
Direct Materials 130 130
Direct labor 100 100
Overheads
(P13,500*4/440) 123 123
Product cost per unit 353 353
4*10+100*4
 (B) ACTIVITY BASED COSTING 10

Product A Product B
Overheads
Factory power
(6,600*40/440) 600
(6,600*400/440) 6,000
Machinery set-up cost
(4,800*40/120) 1,600
(4,800*80/120) 3,200
Materials handling
(2,100*3/7) 900
(2,100*4/7) 1,200
Total Overhead Cost 3,100 10,400
Units Produced 10 units 100 units
Overhead Cost per Unit 310 104
 (B) ACTIVITY BASED COSTING 11

Product A Product B
Direct Materials 130 130
Direct labor 100 100
Overheads
Factory power
(6,600*4/440) 60 60
Machinery set-up cost
(4,800*40/120*1/10) 160
(4,800*80/120*1/100) 32
Materials handling
(2,100*3/7*1/10) 90
(2,100*4/7*1/100) 12
Product cost per unit 540 334
(A) ABSORPTION COSTING BASED 12

ON MACHINE HOUR
Product A Product B
Trad. ABC Trad. ABC
Direct Materials 130 130 130 130
Direct labor 100 100 100 100
Overheads 123 310 123 104
Product cost per unit 353 540 353 334
 Traditional Activity based
Objective ◼Ensure all ◼Focus on the
overheads are activities incurred
absorbed into the ◼Assign to each
total production product only those
cost costs that would
◼The product cost be avoided if the
enable the production was
production cost discontinued
and stock
valuation
Allocation ◼ the basis volume- ◼The basis of non-
of related criteria e.g. volume-related
overhead machine hours and activities e.g. the
direct labour hours no. of purchase 13
 Traditional Activity based
Assignment ◼Overheads cost ◼Overheads are
of are assigned to assigned to the
overhead each cost centre for
department each activities
Adoption of ◼ a single ◼Numerous cost
overhead absorption rates drivers are used
rate is used for different
activities

14
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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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ADVANTAGES OF ACTIVITY-
BASED COSTING
• More realistic/accurate cost assignment of all activities
in an organization.
• It easily identifies incurrence of excessive costs and the
reason thereof.
• It helps management in understanding the nature of
overhead costs affecting the product for better
decision-making.
• Better control over cost. It facilitates the determination
of the cost and selling price of a new product before it
is launched.
• The cost of individual activities are determined based
on the used of their resources.
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LIMITATION OF ACTIVITY-
BASED COSTING
• Difficult to apportion common costs. Gathering of the
required cost data maybe cumbersome especially if all
activities are to be included.
• Difficult to implement. It may be difficult to set up and
establish for an organization that uses more traditional
accounting systems.
• It may require to much detail, obscuring the bigger
picture.
 ACTIVITY-BASED COSTING 18

Bermuda Company uses ABC system with three activity cost pools
and has provided the following information:
Manufacturing overhead P420,000
Selling and Admin Expenses 180,000
Total P600,000
Resources are distributed as follows:
Activity cost pools
Order size Cust. Support Others Total
M. Overhead 20% 70% 10% 100%
S,G, & Admin 50% 30% 20% 100%

Required: Compute for the cost allocated to:

1. Order size 2. Customer Support 3. Others
P174,000.00 P348,000.00 P78,000.00
 ACTIVITY-BASED COSTING 19

Order size Cost Allocated

M. Overhead 20% x P420,000 = 84,000
S,G, & Admin 50% x P180,000 = 90,000
174,000
Customer Support
M. Overhead 70% x P420,000 = 294,000
S,G, & Admin 30% x P180,000 = 54,000
348,000
Others
M. Overhead 10% x P420,000 = 42,000
S,G, & Admin 20% x P180,000 = 36,000
78,000