Activity Based Costing

Introduction
Early

Later
ABM

adopters used ABC to produce more accurate

product (or service) costs
on used as cost management application

or ABCM are terms used to describe the cost

management applications of ABC

Activity Based Costing

Types of cost systems

Costing

system varies in terms of :

Which cost are assigned to cost objects
Level of sophistication

Classification:
Direct

costing system
Traditional absorption costing system
Activity-based costing system

Activity Based Costing

Types of cost systems (cntd)

Traditional

absorption costing systems:

1. Assign indirect cost to cost object
2. Use unsophisticated methods to assign
indirect costs.

ABC systems:
1. Assign indirect cost to cost object
2. Use sophisticated methods to assign indirect
costs

Comparison between traditional and ABC systems

Both systems use the two-stage allocation

process.
Traditional
Stage

systems:

1:
allocates oheads to production & service
departments
then reallocates service department costs to
production departments
Stage 2:
allocates costs from cost centres to
products/cost objects

Comparison between traditional and ABC systems

Both systems use the two-stage allocation

process.
Traditional

systems: cntd

Cost drivers usually known as allocation basis;

ohead allocation rates
Normally use direct labour hours or machine hours
Normally allocate service /production costs to
production centres merged with production
centre costs & included as production centre
oheads

Comparison of Traditional Costing and ABC system

A two-stage allocation process:

Cost centres: production dept, service dept

2000 Colin Drury

Comparison between traditional and ABC systems

Both

systems use the two-stage allocation process

(cntd)
ABC systems:
Stage 1:
allocates oheads to each major activity (not
to departments but to activities such as
machine set-up, purchasing): (ABC systems
tend to have more activity-based cost
centres/cost pools)
Stage 2: allocates costs to products or cost
objects

Comparison of Traditional Costing and ABC system

The two-stage allocation process

Activity machine set-up, purchase material, inspection

2000 Colin Drury

Comparison between traditional and ABC systems

Both systems use the two-stage allocation

process (cntd)

Major difference:

ABC

relies on greater number of cost centres & 2nd

stage drivers that cause activity resource
consumption
ABC assigns activity costs to cost objects on basis
of cost driver usage
ABC measures resources consumed by cost
objects more accurately
Traditional

system reports less accurate cost as

cost drivers used do not have cause-and-effect
relationships exist between support cost and
cost objects

Comparison between traditional and ABC systems

Activities:
Aggregation

of many different tasks

Support

activities include: schedule production, setup machines, purchasing, inspection, process

customer order
Production

activities include: machine products &

assemble products

ABC

have more number of cost centres

Comparison between traditional and ABC systems

Cost drivers:
ABC

systems seek to use only cause-and-effect

cost drivers
Traditional systems often rely on arbitrary allocation
bases.
A cost driver is a unit of activity that results in the
consumption of resources, so leads to cost being
incurred
Example: no of orders handled for despatch costs,
no of store requisitions for materials

The emergence of ABC systems

Traditional

systems were appropriate when:

1.Direct costs were the dominant costs

2.Indirect costs were relatively small
3.Information costs were high
4.A limited range of products was produced.

Designing ABC systems

Designing ABC Systems:

1. Identify major activities that take place in an
organization
2. Assign costs to cost pools/cost centres for each
activity
3. Determine cost drivers for each major activity
4. Assign cost of activities to products according
to products demand for activities

Designing ABC systems

1.Identify the major activities that result in costs being incurred:

Aggregation of units of work or tasks such as: Machine
set-up cost, purchasing cost, cost of quality
inspection, despatch cost, warehousing cost, that
use up resources
Activities are identified by carrying out an activity analysis
The activities chosen should be at a reasonable level
of aggregation based on cost v benefit criteria.
Final choice of activities must be:
influenced by the total cost of the activity centre
(significant to justify separate treatment)
the ability of a single cost driver to provide a
satisfactory determinant of the cost of the activity.
2000 Colin Drury

Designing ABC systems (cntd)

2.Assign costs to cost pools /cost centre for each activity:
Costs of resource consumed over a period to be
assigned to each activity to determine cost
incur on each activity
Reliability of cost information will be reduced if
arbitrary allocations are used to assign a
significant proportion of costs to activities.

2000 Colin Drury

Designing ABC systems (cntd)

3. Selecting the appropriate cost drivers
Drivers at this stage called activity cost drivers.
Selection of cost driver should consider :
(a) provide a good explanation of costs of each activity cost
pool
(b) be easily measurable, data easily obtained and
identifiable with products
Activity

cost drivers consist of two types (Transaction and

duration drivers).

Cost driver can be production oriented production cycle

time, no of orders, no of production run, no of machine
hours, no of inspections

Cost driver can also be service oriented no of changes

to order specs
2000 Colin Drury

Designing ABC systems (cntd)

3. Selecting the appropriate cost drivers
Transaction drivers:
Least expensive but likely least accurate
Assumes same qty of resources required each
time an activity is performed
Fairly accurate if variation in amount of
resources
needed by cost object is small
Use duration drivers if condition cannot apply
Example: number of Pos processed; number of
customer orders processed; number of
inspections
performed; number of set-ups undertaken.

Designing ABC systems (cntd)

3. Selecting the appropriate cost drivers
Duration drivers:
Represent amount of time required to perform
an activity
Examples: set-up hours and inspection hours
Appropriate if one product needs shorter set-up
time compared with another, more accurate to
use set-up time as cost driver than transaction
drivers
Using number of set-ups will under-cost
product that need longer set-up time, and overcost product that need shorter set-up time
Likely to increase measurement costs

Designing ABC systems (cntd)

3. Selecting the appropriate cost drivers
Examples of cost drivers:
Activity
Material purchases
Material handling
quality control
maintenance
line set-up
Patient movement
booking appointment
patient reception
x-ray equipment preparation

Cost driver
no of POs
no of movements
no of inspections
no of break-downs
no of set-ups
no of in-patients
no of patients
no of patients
time taken

2000 Colin Drury

Designing ABC systems (cntd)

4.Assigning the cost of activities to products:
The cost driver must be measurable so that it can be
identified with individual products.
A

cost per unit of cost driver is calculated

Assign cost in the activity pool to products and

services on basis of:

Unit cost driver x cost per unit of cost driver

2000 Colin Drury

Designing ABC systems (cntd)

4.Assigning the cost of activities to products:
Example 1:
Cost pool sales order handling
Cost driver = no of orders processed
Total in cost pool = $300,000
Total orders in the year = 1,000 orders
Cost of order processing = $300 per order
Product A with 200 orders for the year
Order processing cost to charge to Product A =
$60,000($300 x 200)

Designing ABC systems (cntd)

4.Assigning the cost of activities to products:
Example

2: Product B
Function
Ind cost-$
Quality control
90,000
Process set-up
135,000
Purchasing
105,000
Customer orders
120,000
Occupancy cost
150,000
600,000

Charge out
cost drivers no CD Rate $ / unit
450 inspections
200
450 production runs
300
1,000 Pos
105
2,000 customers
60
75,000 machine hrs
2

Std product cost:

Unit material
0.50
Unit labour
0.40
Total production for coming year
1,000,000 units
No of production runs 50 (inspect once at end of each production run)
No of PO required
50
No of customer order 10
Machine hours
50,000
2000 Colin Drury

Designing ABC systems (cntd)

4.Assigning the cost of activities to products:

Example

2: Std cost of Product B (cntd)

Function
rate x usage$
allocated cost $
Quality control
200 x 50
10,000
Process set-up
300 x 50
15,000
Purchasing
105 x 50
5,250
Customer orders
60 x 10
600
Occupancy cost
2 x 50,000
100,000
130,850
Allocated cost per unit = 130,850 / 1,000,000 units = $0.14
Std unit cost for Product B:
Material
$0.50
Labour
0.40
Ohead
0.14
$1.04

2000 Colin Drury

The basics of ABC system

1.

Recognizing a few classification of major activities and

pooling the cost
Activities: inspections, machine set up, purchasing
Cost pools : inspections cost, setting up cost

2.

Establishing the cost drivers

Cost driver / activity driver is the unit of an activity that
causes a cost to be incurred
e.g. : no. of inspections, no. of set ups, no. of orders,

3.

Calculate the Cost driver rate

It is a predetermined rate for each cost pool.
Cost driver rate = cost pool / basis of activity driver
E.g. = purchasing cost / no. of orders = cost per order

The basics of ABC system

4.

Applications of cost to products and services

Once the cost driver rate is calculated, multiplied
it by the consumption rate of the cost driver
E.g. : cost driver rate (per order) x no. of order

5.

The total derived as above will then be divided by

the volume of products or services, in order to get
the overhead rate per unit for the particular cost
driver.

Advantages of ABC

Pricing and decision making are improved as product

costs are calculated more accurately, resulting in
improved pricing and decision making in general
As the cost pools identified, management will have better
control over the items charged and might able to control
the costs
ABC provides better incentive to link activities with cost
behaviour
Management will have a better understanding towards
costs that are not inly driven by volume
Budgets are better prepared as the management has
clearer view on various activities in detail

END