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ACTIVITY-BASED COSTING (ABC) SYSTEM

Key Terms of Activity-Based Costing (ABC)

Activity-based costing system is a technique of cost attribution to cost units by the benefits received from
indirect activities like ordering and set up. It involves the identification of costs with each cost-driving
activity. This is made as the basis for the absorption of costs over different products. The following key
terms are associated with ABC:
 Cost objects. This is a fundamental cost concept which focuses on individual activities such as
products, customers, services, and locations.
 Activities. These are events, tasks, or units of work with a special purpose. These are divided into two
(2) groups: the support activities and production process activities. Support activities include
scheduled production, setup machine, purchase materials, and custom order, while production
process activities include machine products and assembled products.
 Cost pool. This pertains to the grouping of individual cost items. It involves location, function, and
items of equipment in respect of which costs may be ascertained and related to cost units for cost
purposes.
 Cost drivers. These are the causes or reasons for the occurrence of overhead costs. These are a
variable or a level of activity which casually affects costs over a given period of time. The cost driver
of a variable cost is the level of activity or volume which causes proportionate changes in variable
costs. For example, the number of vehicles assembled is the cost driver of the cost of steering
wheels.
 Cost hierarchies. These designate activities based on how easily they can be traced to a product. The
cost hierarchy comprises four (4) levels as follows:
1. Output unit-level costs. These are the cost of activities performed on each unit of product or
service. The cost of activities increases in proportion to the volume of production or sales. An
example of this is the manufacturing operations cost.
2. Batch-level costs. These are the costs of activities performed on each batch or group of units of
products or services. The cost of activities increases in proportion to the volume of production or
sales. An example of this is the procurement cost.
3. Product-sustaining costs. These are the costs of activities undertaken to support products or
services irrespective of the number of units or batches. An example of this involves marketing
costs to launch new products.
4. Facility-sustaining costs. These are the costs of activities which cannot be traced to individual
products. They are common to all products, and they support the entire activities of an
organization. An example of this includes general administration costs.
Salient Features of Activity-Based Costing (ABC)
The following are the special features of Activity-Based Costing (ABC) system:
 Activity-based. The ABC system is based on activities which consist of different functions that are
associated with cost objects.
 Activity cost center. The ABC system involves identifying the overhead cost to an activity and
assigning the cost to each activity cost center.
 Use of cost drivers. The ABC system involves the causes of occurrence of overheads which are called

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cost drivers. These are used to assign costs to products.

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  Accumulation of overhead costs. The ABC system involves the accumulation of overheads which is
completed by various activities. A single unit and the entire organization is not taken into account.
 Traceability. The ABC system involves overhead costs which can be traced easily. Hence, cost data
are more reliable and accurate.
 Elimination of non-value-added activities. The ABC system states that the cost of the product would
be less since the non-value-added activities are eliminated. The non-value-added activities do not
contribute anything to the value of the product.
 Costs in proportion to cost driving activities. The ABC system involves the overhead costs which are
charged to different products in proportion to the cost-driving activities.

Implementation of Activity-Based Costing

Stages that are involved in ABC system are explained as follows:
 First Stage: Identify the activities. These activities are work performed or undertaken to produce
products such as number of setups, scheduling, orders, parts, inspections, labor hours, and designs
among others.
 Second Stage: Pool rates. The overhead cost pool is traced to products using the pool rates. These
activities are used as cost drivers in computing overhead rates. The total factory overhead is then
allocated to activity cost pools. The cost per activity is divided by the activity drivers’ practical
capacity to arrive at the overhead rate per activity.

EXAMPLE: Dragon Furniture Company has identified activity centers to which overhead costs are
assigned. The following data is available:

Activity Centers Costs Activity Drivers

Utilities P300,000 60,000 machine hours
Scheduling and Setup 273,000 780 set ups
1,600,000 pounds of
Material Handling 640,000
materials

The following are the company’s products and other operating statistics:

Product A Product B Product C

Prime costs P80,000 P80,000 P90,000
Machine hours 30,000 10,000 20,000
Number of setups 130 380 270
Pounds of materials 500,000 300,000 800,000
Number of units
40,000 20,000 60,000
produced
Direct labor hours 32,000 18,000 50,000
PROCEDURE:
 Step 1. Determine the pool rates by dividing the given costs to the activity drivers:

Activity Centers Solution Pool rates

Utilities P300,000/60,000 P5/mhr
Scheduling & setup P273,000/780 P350/set up
Materials handling P640,000/1,600,000 P.40 lbs

 Step 2. Determine the product costs by allocating the overhead or activity centers to the cost of
activity drivers using the computed pool rates:
Product A Product B Product C TOTAL
Utilities:
A. 30,000 X 5 P150,000
B. 10,000 X 5 P50,000
C. 20,000 X 5 P100,000
P300,000
Scheduling and Setup:
A. 130 X 350 45,500
B. 380 X 350 133,000
C. 270 X 350 94,500
P273,000
Material Handling:
A. 500,000 X .40 200,000
B. 300,000 X .40 120,000
C. 800,000 X .40 320,000
P640,000
TOTAL P395,500 P303,000 P514,500 P1,213,000

References
AccountingExplained. (n.d.). Activity-based costing. Retrieved on October 02, 2018, from
https://accountingexplained.com/managerial/cost-systems/activity-based-costing
Lalitha, R. & Rajasekaran, V. (2010). Costing accounting. India: Pearson.

Rante, G. A. (2016). Cost accounting. Mandaluyong City: Millenium Books, Inc.