Introduction

What is The Problem

Undercosting and Overcosting
of products and services

Undercosting and
Overcosting Example
Jose, Roberta, and Nancy order
separate items for lunch.
Joses order amounts to
Roberta consumed
Nancys order is
Total

$14
30
16
$60

What is the average cost per lunch?

Undercosting and
Overcosting Example
$60 3 = $20

Jose and Nancy

are overcosted.

Roberta is
undercosted.

What Is ABC
Activity Based Cost (ABC) system is
A cost accounting system that uses
both unit and non-unit-based activity
drivers to assign costs to cost objects
(Hansen Mowen Guan)

ACTIVITY BASED COSTING

CIMA : An approach to the costing and monitoring of

activities, which involves tracing resource

consumption and costing final outputs. Resources are
assigned to activities and activities to cost objects
Horngren and Foster (2003:39) : An approach to
costing that focuses on activities as the fundamental
cost objects. It uses the costs these activities as the
basis for assigning costs to other cost objects such as
products, services or customer.

ACTIVITY BASED COSTING MODEL

Design Steps For an ABC System

Can ABC Help

Our Company?

PISANG KEJU FACTORY

Traditional, Volume-Based Product-Costing

System
Aerotech produces three complex printed circuit boards

referred to as Mode I, Mode II, and Mode III.

The following information is obtained from company
records:

P rodu ction :
Un its
Ru n s

Mode I

Mode II

Mode III

10,000
1 of 10,000

20,000
4 of 5,000

4,000
10 of 400

Traditional, Volume-Based Product-Costing

System
Additional information includes:
Mode I
Dire ct mate rials
$
50.00
Dire ct labor (h r/board)
3
Se tu p time (h r/ru n )
10
Mach in e time (h r/board)
1

Mode II
$
90.00
4
10
1.25

Mode III
$ 20.00
2
10
2

Mode I
Dire ct m ate rials
$
50.00
Dire ct labor
60.00
Man u factu rin g ove rh e ad
99.00
Total
$
209.00

Mode II
$
90.00
80.00
132.00
$ 302.00

Mode III
$ 20.00
40.00
66.00
$ 126.00

Manufacturing overhead is determined as follows

Traditional, Volume-Based Product-Costing System

Mode I
10,000
3
30,000

Un its produ ce d
Dire ct labor (h r/u n it)
Total h ou rs

Mode II
20,000
4
80,000

Total h ou rs re qu ire d

118,000

Budgeted manufacturing overhead

Budgeted direct-labor hours

$3,894,000
118,000

Mode I
Dire ct labor (h r/u n it)
Ove rh e ad rate pe r h ou r
Ove rh e ad pe r u n it

Mode III
4,000
2
8,000

$
$

3
33
99

= $33 per hour

Mode II
$
$

4
33
132

Mode III
2
$
33
$
66

Traditional, Volume-Based ProductCosting System

With these product costs, Aerotech established target
selling prices (Cost 125%).
Mode I
Dire ct m ate rials
$
50.00
Dire ct labor
60.00
Man u factu rin g ove rh e ad
99.00
Total
$
209.00

Cos t pe r u n it
Targe t s e llin g price

209.00 x 1.25

Mode I
$
209.00
261.25

Mode II
$
90.00
80.00
132.00
$ 302.00

Mode II
$
302.00
377.50

Mode III
$ 20.00
40.00
66.00
$ 126.00

Mode III
$ 126.00
157.50

Traditional, Volume-Based Product-Costing

System
Aerotech wishes to see what target selling prices
would be suggested when using activity-based
costing.

Lets see how ABC works.

Activity Based Costing System (ABC)

ABC systems follow a
two-stage procedure to
assign overhead costs
to products.

Assigning
overhead to products
is a
difficult process.

I agree!

Activity Based Costing System (ABC)

ABC systems follow a
two-stage procedure to
assign overhead costs
to products.

Stage One
Identify significant
activities and assign overhead
costs to each activity in
proportion to resources used.

Lets begin
by identifying
our major
activities.

Activity Based Costing System (ABC)

ABC systems follow a
two-stage procedure to
assign overhead costs
to products.

Stage Two
Identify cost drivers
appropriate to each activity
and allocate overhead to
the products.

Overhead assigned to
activities are called
activity cost pools.

Overhead Costs
Activity
must be
done on
each unit
produced.

Total budgeted cost = $3,894,000

Activity
Cost
Pools

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

Activity
performed
on each
batch
produced.

Activities needed to support

an entire product line

Identification
of Activity
Cost Pools

Facility
Level
Facility
cost pool
$507,400

Activity required in order

for the production
process to occur.

Overhead Costs
Total budgeted cost = $3,894,000

Activity
Cost
Pools

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

More
Cost
Pools

Identification
of Activity
Cost Pools

Facility
Level
Facility
cost pool
$507,400

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

Receiving/Inspection
cost pool $200,000
Material-Handling
cost pool $600,000
Quality-Assurance
cost pool $421,000
Packaging/Shipping
cost pool $250,000

Facility
Level
Facility
cost pool
$507,400

STAGE ONE
Various overhead
costs related
to machinery

Activity
cost
pool

Maintenance

Lubrication

Depreciation

Electricity

Computer Support

Calibration

Machinery Cost Pool

Total budgeted cost = $1,212,600

STAGE TWO
Calculate
the pool
rate

Cost
Assignment

Budgeted Machinery Costs

Budgeted Machine Hours

Mode I:
$28.20 per hr.
1 hr. per unit
$28.20 per unit

=$1,212,600
43,000
=
$28.20/hour

Mode II:
$28.20 per hr.
1.25 hr. per unit
$35.25 per unit

Mode III:
$28.20 per hr.
2 hr. per unit
$56.40 per unit

STAGE ONE
Calculation of
total setup cost

Activity
cost
pool

Total budgeted setup cost

$20 per hour
10 hr. per setup
$200 cost per setup
15 production runs
$ 3,000 Total

Setup Cost Pool

Total budgeted cost = $3,000

STAGE TWO
Calculate
the pool
rate

Cost
Assignment

Budgeted Setup Costs

Planned Production Runs

Mode I: (1 Run)
$200 per run
10,000 units per run
= $.02 per unit

=$3,000
15 runs
=
$200
per run

Mode II: (4 Runs)

$200 per run
5,000 units per run
= $.04 per unit

Mode III: (10 Runs)

$200 per run
400 units per run
= $.50 per unit

STAGE ONE
Various overhead
costs related
to engineering

Activity
cost
pool

Engineering salaries

Engineering software

Engineering supplies

Depreciation

Engineering Cost Pool

Total budgeted cost = $700,000

STAGE TWO
Allocate based
on engineering
transactions

Cost
Assignment

Engineering Cost Pool

Total budgeted cost = $700,000

Mode I:
25% $700,000
10,000 units
= $17.50 per unit

Mode II:
45% $700,000
20,000 units
= $15.75 per unit

Mode III:
30% $700,000
4,000 units
= $52.50 per unit

STAGE ONE
Various overhead
costs related
to general
operations

Activity
cost
pool

Plant depr.

Property taxes

Plant mgmt.

Insurance

Plant maint.

Security

Facility Cost Pool

Total budgeted cost = $507,400

STAGE TWO
Calculate
the pool
rate

Cost
Assignment

Budgeted Facilities Cost

$507,400
=
Budgeted Direct-Labor Hours
118,000
=
$4.30/hour

Mode I:
$4.30 per hr.

3 hr. per unit

$12.90 per unit

Mode II:
$4.30 per hr.

4 hr. per unit

$17.20 per unit

Mode III:
$4.30 per hr.

2 hr. per unit

$8.60 per unit

Product
Cost
from
ABC
Here are the new product costs so far . . .
Direct materials
Direct labor
Machinery
Setup
Engineering
Facilities

Mode I
$ 50.00
60.00
28.20
0.02
17.50
12.90

Mode II
$ 90.00
80.00
35.25
0.04
15.75
17.20

Mode III
$ 20.00
40.00
56.40
0.50
52.50
8.60

Re c e ivin g an d In s pe c t ion Cos t P ool

Other Overhead Costs

Board
Mode I
Mode II
Mode III

Ove rh e ad
$ 200,000
200,000
200,000

%
6%
24%
70%

Un its
10,000
20,000
4,000

= Cos t/Un it
= $
1.20
=
2.40
=
35.00

Mat e rial-Han dlin g Cos t P ool

Board
Mode I
Mode II
Mode III

Ove rh e ad
$ 600,000
600,000
600,000

%
7%
30%
63%

Un its
10,000
20,000
4,000

= Cos t/Un it
= $
4.20
=
9.00
=
94.50

Qu alit y-As s u ran c e Cos t P ool

Board
Mode I
Mode II
Mode III

Ove rh e ad
$ 421,000
421,000
421,000

%
20%
40%
40%

Un its
10,000
20,000
4,000

= Cos t/Un it
= $
8.42
=
8.42
=
42.10

P ac kagin g an d Sh ippin g Cos t P ool

Board
Mode I
Mode II
Mode III

Ove rh e ad
$ 250,000
250,000
250,000

%
4%
30%
66%

Un its
10,000
20,000
4,000

= Cos t/Un it
= $
1.00
=
3.75
=
41.25

Product Cost from ABC

These are the new product costs when Aerotech uses
ABC.

Mode I
Direct materials $ 50.00
Direct labor
60.00
Machinery
28.20
Setup
0.02
Engineering
17.50
Facilities
12.90
Other
14.82
Total
$ 183.44

Mode II
$ 90.00
80.00
35.25
0.04
15.75
17.20
23.57
$ 261.81

Mode III
$ 20.00
40.00
56.40
0.50
52.50
8.60
212.85
$ 390.85

Product Diversity
Both original and ABC target selling prices are based
on (Cost 125%).
Tradition al cos tin g
ABC cos tin g
Origin al targe t s e llin g price
ABC targe t s e llin g price

Mode I
$
209.00
183.44

Mode II
$
302.00
261.81

Mode III
$ 126.00
390.85

261.25
229.30

377.50
327.26

157.50
488.56

The selling price of Mode I and II are reduced

and the selling price for Mode III is increased.
[$209.00 1.25]

[$183.44 1.25]

Cost
Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .
Degree of
Correlation

Behavioral
Effects
Cost of
Measurement

Homogeneous Activity Cost Pools

A homogeneous cost pool is a grouping of overhead
costs in which each cost component is consumed in
roughly the same proportion by each product line.

A homogeneous cost pool

uses a single cost driver.

Transaction Costing

Usually
Result In

Activities

Paperwork

Transaction
processing
provides a
readily
measurable
gauge of
departmental
activity.

Storyboarding
A procedure used to develop a detailed process flow
chart, which visually represents activities and the
relationships among activities.

Step
1
Step
2
Step
3
Step
4

These are the steps we

follow to build a
memory board.

Direct versus Indirect Costs

Volume-Based Costing
All production costs
except direct materials
and direct labor are
lumped together in one
overhead cost pool.

Activity-Based Costing
An effort is made to
account for as many
costs as possible as
direct costs of
production.

Indirect
Costs

Indicators of Need for ABC

Direct labor is a
small percentage
of total costs

Product-line profit
margins are hard
to explain

Sales are increasing,

but profits are declining.

Line managers do not

believe the product
costs reports

Marketing does not

use costs reports for
pricing decisions

Some products that

have reported high
profit margins are not
sold by competitors

Optimal Product-Costing System

Cost
High

Total Cost

Cost of
inferior
decisions
resulting
from
inaccurate
information.

Design, implementation
and maintenance costs

Low
Low

Optimal
system

Information
System
High Accuracy

Cost Management Systems

Objectives

Measure the cost of resources consumed.

Identify and eliminate non-value-added costs.

Determine the efficiency and effectiveness of all

major activities.
Identify and evaluate new activities that can
improve future performance.

Non-Value-Added Costs
Suppose our production process looks like this:

Storage
Time

NVA

VA
NVA

Waiting
Time

NVA

Process
Time

= Valued-added activity
= Non-value-added activity

VA

Move
Time

NVA

Inspection
Time
NVA

Non-Value-Added Costs
Our goal is to reduce or eliminate the non-value-added activities.

Storage
Time

NVA

VA
NVA

Waiting
Time

NVA

Process
Time

= Valued-added activity
= Non-value-added activity

VA

Move
Time

NVA

Inspection
Time
NVA

ABC in the Service Industry

Activities tend to
be nonrepetitive
human tasks.

Implementation
Problems
High proportion of
facility-level costs

Video ABC

Next ABM

What Is ABM
Activity Based Management (ABM)
is a systemwide, integrated approach that
focuses managements attention on activities
with the objectives of improving customer
value and increasing the profit achieved by
providing this value (Hansen Mowen Guan)

The Relationship Between Activity Based

Costing and Activity Based Management
Activity-based costing(ABC) is the major source of
information for activity-based management
The activity-based management model has two dimensions:
1. a cost dimension
2. a process dimension.

The Two-Dimensional Activity-Based

Management Model

Use activity-based
costing systems for
Activity-Based management

Activity-Based Management

ABM describes management decisions that use

activity-based costing information to satisfy
customers and improve profits.
Product pricing and mix decisions

Cost reduction and process improvement decisions

Design decisions

Product Pricing and

Mix Decisions
ABC gives management insight into the cost
structures for making and selling diverse products.
It provides more accurate product cost
information and more detailed information
on costs of activities and the drivers of those costs.

Cost Reduction and Process

Improvement Decisions
Manufacturing and distribution personnel use
ABC systems to focus on cost-reduction efforts.
Managers set cost-reduction targets in terms of
reducing the cost per unit of the cost-allocation base.

Design Decisions
Management can identify and evaluate new designs
to improve performance by evaluating how product
and process designs affect activities and costs.
Companies can work with their customers to
evaluate the costs and prices of alternative designs.

Financial Measures Of Activity Efficency

Formulas For Value Added and Non Value Added Cost

Illustrate The Power of Concept

Activity Based Performance Report

Activity Capacity Variances

ABM Implementation Model

The Responsibility Accounting

Model

Responsibility Assignment
Compared

Performance Measures Compared

Performance Evaluation Compared

Rewards Compared

Benefit of ABC Systems

Significant amounts of indirect costs are
allocated using only one or two cost pools.

All or most costs are identified

as output unit-level costs.

Products make diverse demands on

resources because of differences in
volume, process steps, batch size,
or complexity.

Benefit of ABC Systems

Products that a company is well-suited to
make and sell show small profits while
products for which a company is less
suited show large profits.

Complex products appear to be very

profitable and simple products
appear to be losing money.
Operations staff have significant
disagreements with the accounting
staff about the costs of manufacturing
and marketing products and services.

Limitations of ABC Systems

The main limitations of ABC are the
measurements necessary to
implement the system.
ABC systems require management
to estimate costs of activity pools
and to identify and measure cost
drivers for these pools.

Activity-cost rates also need to be

updated regularly.
Very detailed ABC systems are costly
to operate and difficult to understand.

ABC In Service and

Merchandising Companies
The general approach to ABC in the
service and merchandising areas is very
similar to the approach in manufacturing.
Costs are divided into homogeneous cost
pools and classified as output unit-level,
batch-level, product- or service-sustaining,
and facility-sustaining costs.
The cost pools correspond to key activities.
Costs are allocated to products or customers
using activity drivers or cost-allocation
bases that have a cause-and-effect
relationship with the cost in the cost pool.

Conclusion

ABC will be used When :

1. Products differ greatly in volume and manufacturing

complexity
2. Products lines are :
numerous
diverse
require differing degrees of support services
3. Overhead costs constitute a significant portion of total costs
4. The manufacturing process or number of products has
changed significantly
5. Production or marketing managers are ignoring data provided
existing system

References
2009 South Western, A part of cengage learning, Accounting and
Control 6/e, Hansen/Mowen/Guan
2007 Mc Graw Hill, Management Control System 12/e,
Anthony/Robert/Govinda
2003 Prentice Hall Business, Cost Accounting 11/e,
Hongren/Data/Foster
2002 John Willey Son, Managerial Accounting 6/e,
Weygandt/Kieso/Kimmel
www.cimaglobal.com
www.cgma.com
http://www.mpdv-china.cn/en/why-use-manufacturing executionsystem-mes/
www.mbabullshit.com
www.flikcr.com