ACTIVITY BASED COSTING

MUHAMMAD WASEEM SALEEM

MP17-11
 Contents
• Definition
• History Development
• Reasoning for ABC
• Methodology
• Activity
• Cost Pools
• Cost Drivers
• Computation of Overhead Rate
• Assign Overhead Cost
• Benefits of ABC
• Limitations of ABC
• Supplementary
• Example of ABC
• Comparison of Traditional vs ABC System
• Switch to ABC
 Definition
•An overhead cost allocation system that allocates
overhead cost to products or service.
•An overhead cost allocation system that allocates
overhead to multiple activity cost pools and assigns
the activity cost pools to products or services by
means of cost drivers that represent the activities
used.
 Historical Development
Traditionally, cost accountants had arbitrarily added a broad percentage of
analysis into the indirect cost.
However, as the percentages of indirect or overhead costs rose, this
technique became increasingly inaccurate, because indirect costs were not
caused equally by all products.
For example, one product might take more time in one expensive machine
than another product—but since the amount of direct labor and materials
might be the same, additional cost for use of the machine is not being
recognized when the same broad 'on-cost' percentage is added to all
products.
Consequently, when multiple products share common costs, there is a
danger of one product subsidizing another.
 Historical Development
Activity-based costing was first clearly defined in 1987 by Robert S.
Kaplan and W. Bruns as a chapter in their book Accounting and
Management: A Field Study Perspective. They initially focused on
the manufacturing industry, where increasing technology and
productivity improvements have reduced the relative proportion of
the direct costs of labor and materials but have increased relative
proportion of indirect costs.
For example, increased automation has reduced labor, which is a
direct cost, but has increased depreciation, which is an indirect cost.
Reasoning for ABC

Product Consumes Activities

Activities Consumes Resources

 Methodology
Calculate unit cost:
Step 1: Identify activities
Step 2: Identify activity cost pools
Step 3: Identify cost driver
Step 4: Compute overhead rate
Step 5: Assign overhead costs
 Step 1: Activity
Any event, action, transaction, or work sequence that causes a
cost to be incurred in producing a product or providing a
service. Examples of activity cost pool are;
• Product Level Activity
• Unit Level Activity
• Batch Level Activity
• Facility Level Activity
 Step 2: Activity Cost Pool
The overhead cost allocated to a distinct type of activity or
related activities. Examples of activity cost pool are;
• Purchasing Department
• Materials Handling
• Packaging
• Shipping
• Setup costs
• Designing
• Product testing
Step 3: Cost Driver
Any activity that has a direct cause-effect relationship
with the resources consumed.

The “cost driver” is a factor that creates or drives the

cost of the activity.

In ABC cost drivers are used to assign activity cost to

products or services.
Step 3: 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
 Step 4: Compute overhead rate

An overhead rate is then calculated for each cost pool

using the following formula:

•Costs in activity cost pool / Cost Driver

 Step 5: Assign overhead costs

Overhead costs are then allocated to each product

according to how much of each base the product
uses.
Benefits of ABC

More accurate product costing which necessitates:

•More cost pools used to assign overhead
•Enhanced control over overhead
•Better management decisions
Limitations of ABC
Applicability of ABC is bound to cost of required
data capture. That drives the prevalence to slow
processes in services and administrations, where
staff time consumed per task defines a dominant
portion of cost.
•Treating fixed costs as variable
•Tracing Costs
•Single Product
SUPPLEMENTARY
 EXAMPLE OF ABC:
• Assume that a company makes widgets
• Management decides to install an ABC system

• Management decides that all overhead costs only have

three cost drivers.
• Direct labor hours
• Machine hours
• Number of purchase orders
All overhead costs are then allocated to one of the
activity cost pools.
Direct Labor (PKRs.)
General Ledger (PKRs.)
Payroll taxes 1,000
Machine maintenance 500
Purchasing Dept. labor 4,000
Fringe benefits 2,000 Machine Hours (PKRs.)
Purchasing Dept. Supplies 250
Equipment depreciation 750
Electricity 1,250
Unemployment insurance 1,500
# of Purchase Orders (PKRs.)

Which overhead costs do you

think are driven by direct labor
hours?
All overhead costs are then allocated to one of the
activity cost pools.
Direct Labor (PKRs.)
General Ledger (PKRs.)
Payroll taxes 1,000 1,000
2,000
Machine maintenance 500 1,500
Purchasing Dept. labor 4,000 4,500

Fringe benefits 2,000 Machine Hours (PKRs.)

Purchasing Dept. Supplies 250
Equipment depreciation 750
Electricity 1,250
Unemployment insurance 1,500
# of Purchase Orders (PKRs)

Overhead driver by direct labor

hours
All overhead costs are then allocated to one of the
activity cost pools.
Direct Labor (PKRs.)
General Ledger (PKRs)
Payroll taxes 1,000 1,000
2,000
Machine maintenance 500 1,500
Purchasing Dept. labor 4,000 4,500

Fringe benefits 2,000 Machine Hours (PKRs.)

Purchasing Dept. Supplies 250
500
Equipment depreciation 750 750
Electricity 1,250 1,250
2,500
Unemployment insurance 1,500
# of Purchase Orders (PKRs.)

Which overhead costs are

driven by machine hours?
All overhead costs are then allocated to one of the
activity cost pools.
Direct Labor (PKRs.)
General Ledger (PKRs.)
Payroll taxes 1,000 1,000
2,000
Machine maintenance 500 1,500
Purchasing Dept. labor 4,000 4,500

Fringe benefits 2,000 Machine Hours (PKRs.)

Purchasing Dept. Supplies 250
500
Equipment depreciation 750 750
Electricity 1,250 1,250
2,500
Unemployment insurance 1,500
# of Purchase Orders (PKRs.)

And finally, which overhead 4,000

costs are driven by # of 250
4,250
purchase orders?
 An overhead rate is then calculated for each cost pool:
Direct Labor (PKRs.)
Again the formulas is:
1,000
Costs in Activity Cost Pool/Base = rate 2,000
1,500
Assume the following bases: 4,500
Machine Hours (PKRs.)
Direct labor hours = 1,000
Machine hours = 250
500
Purchase orders = 100
750
1,250
2,500

The ABC rates are: # of Purchase Orders (PKRs.)

PKRs. 4,500/1,000 = PKRs. 4.50 per direct labor hour

PKRs. 2,500/250 = PKRs. 10 per machine hour 4,000
250
PKRs. 4,250/100 = PKRs. 42.50 per purchase order 4,250
 Overhead costs are then allocated to each product
according to how much of each base the product uses.

The ABC rates are:

PKRs. 4,500/1,000 = PKRs. 4.50 per direct labor hour

PKRs. 2,500/250 = PKRs. 10 per machine hour
PKRs. 4,250/100 = PKRs. 42.50 per purchase order

Lets assume the company makes two products, Widget A and Widget B:

Let’s also assume that each product uses the following quantity
of overhead cost drivers:

Base Widget A Widget B Total

Notice that
Direct labor hours 400 600 1,000
all base units
Machine hours 100 150 250 are
Purchase orders 50 50 100 accounted
for.
Now let’s allocate overhead to Widget A:
Base A Rate Allocated

Direct labor hours 400 PKRs. 4.50 PKRs. 1,800.00

In this case, 400 hours used to make Widget A is

multiplied by the rate of PKRs. 4.50. This gives total overhead
applied for this activity cost pool of PKRs. 1,800 to Widget A.
Continuing the calculation:
Let’s do the same thing for the other two rates, to get the total amount
of overhead applied to Widget A:

Widget A Base Rate PKRs. Allocated PKRs.

Direct labor hours 400 4.50 1,800.00
Machine hours 100 10.00 1,000.00
Purchase orders 50 42.50 2,125.00
Total 4,925.00
Now allocate overhead to Widget B:
Let’s do the same thing for the other two rates, to get the total amount
of overhead applied.

Widget B Base Rate PKRs. Allocated PKRs.

Direct labor hours 600 4.50 2,700.00
Machine hours 150 10.00 1,500.00
Purchase orders 50 42.50 2,125.00
Total 6,325.00

The original overhead to be applied was PKRs. 4,500 of direct labor

driven overhead + PKRs. 2,500 of machine hour driven overhead + PKRs. 4,250 of
purchase order driven overhead = PKRs. 11,250 total overhead to apply.

The actual overhead allocated was PKRs. 4,925 for Widget A + PKRs. 6,350 = PKRs. 11,250 overhead applied.
 Problems Traditional Method

• What if we had allocated the overhead in this company

using traditional cost accounting allocation?

• Let’s assume the base is direct labor hours.

• What would be the amount allocated to each product?

Calculation
General Ledger (PKRs. )

Payroll taxes 1,000 This the total overhead

we were given, the total
Machine maintenance 500
amount is PKRs. 11,250
Purchasing Dept. labor 4,000 as explained on the
Fringe benefits 2,000 previous slide.

Purchasing Dept. Supplies 250

Equipment depreciation 750 Total direct labor
hours are 1,000, also
Electricity 1,250
given earlier.
Unemployment insurance 1,500

Base Widget A Widget B Total

Direct labor hours 400 600 1,000
Machine hours 100 150 250
Purchase orders 40 60 100
 Calculation
• The rate would be:
• OH Rate = Overhead/Direct Labor Hours
• PKRs. 11,250/1,000 = PKRs. 11.25 per hour.
• Applying overhead using this rate:
• Widget A: 400 hours x PKRs. 11.25 = PKRs. 4,500
• Widget B: 600 hours x PKRs. 11.25 = PKRs. 6,750
• Total overhead applied = PKRs. 11,250
Comparison
Widget A (PKRs.) Widget B (PKRs.) Total (PKRs.)
Traditional Method 4,500 6,750 11,250

Activity Based Costing 4,925 6,325 11,250

Difference -425 425 -0-

Which is more accurate?

ABC Costing!
 Switch to ABC
• Products differ greatly in volume and manufacturing complexity.
• Products lines are
• numerous
• diverse
• require differing degrees of support services
• Overhead costs constitute a significant portion of total costs.
• The manufacturing process or number of products has changed
significantly.
• Production or marketing managers are ignoring data provided
existing system.