Activity-Based Costing

Job costing system with single cost pool and single indirect
cost rate will suffice if the jobs, products or services are
alike in the way they consume indirect costs.

If they are not alike, a simple costing system will yield

inaccurate cost numbers for different jobs, products or
services.
Dell Computer produces desktops, laptops and servers.
Three basic activities for manufacturing computers are:
Designing computers;
Ordering component parts; and
Assembly.
Different products require different quantities of three
activities.
A server has a more complex design, many more parts, and
a more complex assembly than a desktop.
Undercosting and Overcosting
Product undercosting: a product consumes a high level of
resources but is reported to have a low cost per unit

Product overcosting: a product consumes a low level of

resources but is reported to have a high cost per unit
Cost of a restaurant bill for 4 partners who meet monthly to
discuss business developments. Each one orders separate
entrees, deserts and drinks.
Restaurant bill for the most recent meeting:

Anita Anurag Ajit Anshul Total Average

Entrée Rs.110 Rs.200 Rs.150 Rs.140 Rs.600 Rs.150
Dessert 0 80 40 40 160 40
Drinks 40 140 80 60 320 80
Total 150 420 270 240 1,080 270
Plastim Corporation manufactures lenses for rear taillights
of automobiles.

A lens, made from black, red, orange, white plastic, is part

of the lamp visible on the automobile’s exterior.

Lenses are made by injecting molten plastic into a mold to

give the lamp its desired shape.

Mold is cooled to allow the molten plastic to solidify, and

the lens is removed.
Under its contract with Tata Motors Plastim makes 2 types
of lenses: Complex Lens (CL) and Simple Lens (SL)

Rates offered to Tata

SL Rs.630 per lens
CL Rs.1,370 per lens

Manufacturing CL is complex and needs more resources.

SL is simpler to make and needs comparatively less

resources.
Plastim is operating at capacity and incurs very low
marketing costs.

Because of high quality products, it has a minimal

customer service costs.

Business of SL is very competitive.

The same competitive pressures do not exist for CL.

Plastim is currently using a simple costing system and
allocates all indirect costs using a single indirect-cost
rate.

Step 1: Identify the cost objects:

SL plans to produce 60,000 lenses
CL plans to produce 15,000 lenses
Step 2: Identify direct costs of the products
2 direct cost categories: direct mats and direct mfg. labour
SL 60,000 lenses CL 15,000 lenses
Total Per Total Per Total
unit unit (Rs.)
(Rs.) (Rs.) (Rs.) (Rs.)
Direct 1,12,50,000187.50 67,50,000 450.00 1,80,00,000
mat
Direct 60,00,000100.00 19,50,000 130.00 79,50,000
mfg.
labour
Total 1,72,50,000287.50 87,00,000 580.00 2,59,50,000
direct
cost
Step 3: Select cost-allocation bases to allocate ind. costs

Majority of indirect costs consist of salaries paid to

supervisors, engineers, manufacturing support, and
maintenance staff

Plastim uses direct manufacturing labour hours as the only

allocation base to allocate mfg. and nonmfg. overheads
to SL and CL

Plastim plans to use 39,750 direct mfg. labour hours for the
upcoming year (30,000 for SL and 9,750 for CL)
Step 4: Identify indirect costs associated with cost-
allocation base

Plastim groups all budgeted indirect costs into a single

overhead cost pool

Budgeted indirect costs Rs.2,38,50,000

Step 5: Compute rate per unit of each cost-allocation base

Budgeted indirect-cost rate =

budgeted total costs in indirect-cost pool Rs.2,38,50,000
budgeted total qty of cost-allocation base (39,750 hrs)

= Rs.600 per direct manufacturing labour-hour

Step 6: Compute indirect costs allocated to the products

Total budgeted labour hours 39,750

SL 30,000 hours CL 9,750 hours
SL 30,000 hours * Rs.600 per hour
Rs.1,80,00,000

CL 9,750 hours * Rs.600 per hour

Rs.58,50,000
Step 7: Compute total costs of products

SL 60,000 lenses CL 15,000 lenses

Total
Total Per unit Total Per unit
(Rs.)
(Rs.) (Rs.) (Rs.) (Rs.)
Direct mat 1,12,50,000 187.50 67,50,000 450.00 1,80,00,000
Direct 60,00,000 100.00 19,50,000 130.00 79,50,000
mfg.
labour 1,72,50,000 287.50 87,00,000 580.00 2,59,50,000
Total
direct cost 1,80,00,000 300.00 58,50,000 390.00 2,38,50,000
Ind costs 3,52,50,000 587.50 1,45,50,000 970.00 4,98,00,000
Total costs
Plastim’s business for SL is very competitive.

In a recent meeting, Tata’s purchasing manager indicates

that a new supplier, Jain Motors, which makes only
simple lenses, is offering to supply SL to Tata at a price
of Rs.530.

Unless Plastim can lower its selling price, it will lose Tata
business for SL for the upcoming year
Five-step decision making process

Step 1: Identify the problem and uncertainties

Reduce the price and cost of SL
Five-step decision making process
Step 2: Obtain information
Asks a team of its design and process engineers to analyze
and evaluate the design, manufacturing, and distribution
operations for SL
The team is very confident that the technology and
processes for SL are not inferior to any competitor.
Why profit margin is low for SL, where the company has
strong capabilities, but high on newer CL?
Management starts to believe that the problem lies with
Plastim’s costing system.
Five-step decision making process
Step 3: Make predictions about future

Step 4: Make decisions by choosing among alternatives

Whether to bid for Tata’s SL business
and if it does bid, what price it should offer

Step 5: Implement the decision, evaluate performance, and

learn
Refining a costing system
Reduces the use of broad averages for assigning the costs
of resources to cost of objects

Provides better measurement of costs of indirect resources

used by different cost objects
Refining a costing system

Direct cost tracing: Identify as many direct costs as is

economically feasible.
Reduce the amount of costs classified as indirect

Indirect-cost pools: Expand the number of indirect-cost

pools

Cost-allocation bases: Use cost-driver as the cost-

allocation base
Activity-Based Costing System
ABC refines a costing system by identifying individual
activities as the fundamental cost objects
Designing products
Setting up machines
Operating machines
Distributing products
 Traditional Activity-Based
Costing System Costing System

Resource Costs Resource Costs

Cost Pools: Plants Cost Pools:

or Departments Activities

Cost Objects Cost Objects

Activity-Based Costing System
Team identifies the following 7 activities:
1. Design products and processes
2. Set up molding machines to ensure that the molds are
properly held in place and parts are properly aligned
3. Operate molding machines to manufacture lenses
4. Clean and maintain molds after lenses are manufactured
5. Prepare batches of finished lenses for shipment
6. Distribute lenses to customers
7. Administer and manage all processes
Direct cost tracing: Identify as many direct costs as is
economically feasible.
Costs in cleaning and maintenance activity cost pool is also
a direct cost

Indirect-cost pools: Considers remaining six activities as

indirect cost pools

Cost-allocation bases: For each activity cost pool, the cost

driver is used as the cost-allocation base
Cost-allocation bases: For each activity cost pool, the cost
driver is used as the cost-allocation base
Design products and processes Parts-square feet
Set up molding machines Setup-hour
Operate molding machines Molding machine-hours
Shipment Setup Shipments
Distribution Cubic feet delivered
Administration Direct mfg. labour hours
Implementing ABC at Plastim

Step 1: Identify the cost objects:

SL plans to produce 60,000 lenses
CL plans to produce 15,000 lenses
Step 2: Identify direct costs of the products
3 direct cost categories: direct mats, direct mfg. labour and
direct mold cleaning and maintenance costs
SL 60,000 lenses CL 15,000 lenses
Total Per unit Total Per unit Total
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.)

Direct mat 1,12,50,000 187.50 67,50,000 450.00 1,80,00,000

Direct mfg. 60,00,000 100.00 19,50,000 130.00 79,50,000
labour
Dir. mold 12,00,000 20.00 15,00,000 100.00 27,00,000
cleaning &
maintenance
costs
Step 3: Select activities and cost-allocation bases
Design products Parts-square feet 100 parts-sq ft
and processes 30 SL + 70 CL
Set up molding Setup-hour 2,000 set-up hrs
machines 500 SL + 1,500 CL
Operate molding Molding machine- 12,750 molding machine-
machines hours hrs 9,000 SL + 3,750 CL

Shipment Setup Shipments 200 shipments

100 SL + 100 CL
Distribution Cubic feet delivered 67,500 cubic ft
45,000 SL + 22,500 CL
Administration Direct mfg. labour 39,750 mfg. lab. Hrs.
hours 30,000 SL + 9,750 CL
Step 4: Identify indirect costs associated with each cost-
allocation base

Design products and processes Rs.45,00,000

Set up molding machines 30,00,000
Operate molding machines 63,75,000
Shipment Setup 8,10,000
Distribution 39,15,000
Administration 25,50,000
2,11,50,000
Step 5: Compute the rate per unit of each cost-allocation
base
Design products and Rs.45,00,000 100 parts-sq ft 45,000/parts-sq
processes ft
Set up molding 30,00,000 2,000 set-up 1,500/set-up hr
machines hrs
Operate molding 63,75,000 12,750 500/molding
machines molding machine-hr
machine-hrs
Shipment Setup 8,10,000 200 shipments 4,050/ shipment
Distribution 39,15,000 67,500 cubic ft 58/cubic ft
Administration 25,50,000 39,750 dir. 64.151/dir mfg
mfg. lab. Hrs. lab hr
Step 6: Compute indirect costs allocated to products
SL 60,000 CL 15,000
Total
lenses lenses
(Rs.)
(Rs.) (Rs.)
Design 45,00,000
SL 30 parts-sq ft * Rs.45,000 13,50,000
CL 70 parts-sq ft * Rs.45,000 31,50,000
Setup molding machines (500 + 1,500) 7,50,000 22,50,000 30,00,000
Machine Operations(39,000 + 3,750) 45,00,000 18,75,000 63,75,000
Shipment setup (100 + 100 4,05,000 4,05,000 8,10,000
shipments)
Distribution (45,000 + 22,500 cubic ft) 26,10,000 13,05,000 39,15,000
Administration 19,24,530 6,25,470 25,50,000
(30,000 + 9,750 mfg. lab. hours)
1,15,39,530 96,10,470 2,11,50,000
Step 7: Compute total costs allocated to products
SL 60,000 CL 15,000 Total
(Rs.) (Rs.) (Rs.)
Direct materials 1,12,50,000 67,50,000 1,80,00,000
Direct mfg. lab 60,00,000 19,50,000 79,50,000
Dir. mold cleaning 12,00,000 15,00,000 27,00,000
1,84,50,000 1,02,00,000 2,86,50,000
Design 13,50,000 31,50,000 45,00,000
Setup molding machines 7,50,000 22,50,000 30,00,000
Machine Operations 45,00,000 18,75,000 63,75,000
Shipment setup 4,05,000 4,05,000 8,10,000
Distribution 26,10,000 13,05,000 39,15,000
Administration 19,24,530 6,25,470 25,50,000
1,15,39,530 96,10,470 2,11,50,000
2,99,89,530 1,98,10,470 4,98,00,000
Rs.499.80 Rs.1,320.70
Citizen Co. produces mathematical and financial
calculator. Data related to 2 products: Maths.
Fin.
Annual production in units 50,000 1,00,000
Direct materials costs (Rs.) 1,50,000 3,00,000
Dir. Mfg. Lab. Cost (Rs.) 50,000 1,00,000
Dir. Mfg. Lab. Hours 2,500 5,000
Machine-hours 25,000 50,000
Number of production runs 50 50
Inspection hours 1,000 500
Both products pass through Dept. 1 and Dept. 2. The
depts’ combined mfg. overheads are
Machining costs Rs.3,75,000
Setup costs Rs.1,20,000
Inspection costs Rs.1,05,000
Compute manufacturing overhead cost per unit for each
product.
Compute manufacturing cost per unit for each product.
GE India Ltd. has a machining facility for specializing in jobs
for the aircraft-components market.
The previous job-costing system had 2 direct cost
categories: direct materials and direct manufacturing
labour costs and a single indirect-cost pool:
manufacturing overhead, allocated using direct
manufacturing labour hours
The indirect cost-allocation rate of the previous system for
current year would have been Rs.230 per direct
manufacturing labour hour.
Recently a team with members from product design,
manufacturing, and accounting used an ABC approach
to refine its job-costing system.
The 2 direct cost categories were retained. The team
decided to replace the single indirect-cost pool with 5
indirect-cost pools. The cost pools represent 5 activity
areas at the facility, each with its own supervisor and
budget responsibility. Pertinent data are as follows:
Activity area cost-allocation base cost-allocation rate
Material handling parts Re.0.80
Lathe work lathe turns Re.0.40
Milling machine-hours Rs.40.00
Grinding parts Rs.1.60
Testing units tested Rs.30.00
Information gathering technology has advanced to the point
at which the data necessary for budgeting in these 5
activity areas collected automatically.
2 representative jobs processed under the ABC system at the
facility in the most recent period had the following
characteristics:
Particulars Job 410 Job 411
Direct materials cost per job Rs.9,700 Rs.59,900
Dir mfg lab cost per job Rs.750 Rs.11,250
Dir mfg lab hours per job 25 375
Parts per job 500 2,000
Lathe turns per job 20,000 60,000
Machine-hours per job 150 1,050
Units per job 10 200
Compute manufacturing cost per unit for each job under
previous job-costing system.
Compute manufacturing cost per unit for each job under
ABC system.
Lays Potatoes (LP) processes potatoes into potato chips at
its automated Noida plant. It sells chips to retail
customer market and institutional market.
LP’s existing costing system has a single direct-cost
category (direct materials, raw potatoes) and a single
indirect-cost pool (production support). Support costs
are allocated on the basis of kgs of potato chips
processed. Support costs include packaging materials.
Current year total actual costs for producing 10,00,000
kgs of chips (9,00,000 for retail mkt and 1,00,000 for
institutional mkt) are:
Direct materials used Rs.1,50,000
Production support Rs.9,83,000
Existing costing system does not distinguish between chips
processed for retail and institutional mkt.
At the end of the current year, LP unsuccessfully bid for a large
institutional contract. Its bid was reported to be 30% above
the winning bid. This feedback came as a shock because LP
included only a minimum profit margin on its bid.
Moreover, Noida plant was acknowledged as the most
efficient in the industry.
As a result of its review process of the lost contract bid, LP
decided to explore ways to refine its costing system.
First, it identified that Rs.1,88,000 of Rs.9,83,000 pertaining to
packaging materials could be traced to individual jobs:
Rs.1,80,000 for retail and Rs.8,000 for institutional. These
costs will now be classified as direct materials.
The Rs.1,50,000 of direct materials used were classified as
Rs.1,35,000 for retail and Rs.15,000 for institutional.
Second, it used ABC to examine how the 2 products used
indirect support resources. Finding was that 3 activity
areas could be distinguished:
- Cleaning Activity Area- LP uses 12,00,000 kgs of raw potatoes
to yield 10,00,000 kgs of chips. The cost-allocation base is
kgs of raw potatoes cleaned. Costs incurred in the cleaning
activity area are Rs.1,20,000.
- Cutting Activity Area- LP processes raw potatoes for retail mkt
independently of those processed for institutional mkt.
Production line produces 250 kgs of retail potato chips per
cutting-hour and 400 kgs of institutional potato chips per
cutting-hour. Cost-allocation base is cutting-hours on the
production line. Costs in cutting activity area are
Rs.2,31,000.
- Packaging Activity Area- LP packages chips for retail mkt
independently of those packaged for institutional mkt.
packaging line packages 25 kgs of retail potato chips per
packaging-hour and 100 kgs of institutional potato chips
per packaging-hour. The cost allocation base is packaging-
hours on the production line. Costs in the packaging
activity area are Rs.4,44,000.
Using existing costing system, what is the cost per kg of potato
chips produced by LP?
Using the ABC system, what is the cost per kg of retail potato
chips and institutional potato chips?
Sampoorna Departmental Store has a free gift-wrapping
service for the customers who want to get their
purchases gift wrapped. Sampoorna has a monthly
practical capacity to gift wrap 8,000 items that it
allocates among its different departments. Monthly
fixed practical capacity costs of the gift-wrapping
service are Rs.60,000. Average budgeted variable cost
to gift wrap an item is Rs.6. Though the service is free
to the customers, the department where the customer
made the purchase is allocated gift-wrapping service
costs.
Various departments’ actual use of the gift-wrapping
service during the current month and their respective
needs at practical capacity follow:
Department Actual No. of No. of gifts that can
gifts be wrapped at
wrapped practical capacity
Gifts 2,200 2,800
Men’s wear 750 1,000
Women’s wear 1,600 2,100
Footwear 450 700
China 650 900
Linen 350 500
• Allocate the costs for the gift-wrapping service to each
department using a single rate method based on actual
number of gifts wrapped.
• Compute the amount allocated to each department
using the dual rate method when fixed costs are
allocated based on practical capacity and variable costs
are allocated using actual usage.