ACTIVITY BASED COSTING
- Adebowale Olayinka
Content
› What is ABC?
› Definition of terms
› Advantages and Disadvantages of ABC
› Allocation of costs using Traditional costing
› Allocation of Cost using ABC
What is ABC?
Activity-based costing can be defined as the system of managing cost by controlling activities that
drive cost or activities that cause cost to be incurred.
It can also be defined as an accounting method that identifies the activities that a firm perform and
then assigns indirect cost to cost objects.
ABC involves the identification of the factors which cause the costs of an organization’s major
activities. Support overheads are charged to products on the basis of their usage of the factor
causing the overheads. The major idea behind activity-based costing are as follows:
i. Activities cause costs. Activities include ordering, materials handling, machining, assembly,
production scheduling and dispatching.
ii. Producing products creates demand for the activities.
iii. Costs are assigned to a product on the basis of the product’s consumption of the activities
.
The principal idea of ABC is to focus attention on what causes costs to increase,
ie the cost drivers.
Definition of Terms
Activity: this is any event that incurs cost
A cost object: this is an item for which cost measurement is required e.g. a product.
Cost drivers: it is the factors that causes changes in the cost of an activity.
There are two categories of cost driver
1. A resource cost driver; it is a measure of the quantity of resources consumed by an activitiy. It
is used to assign the cost of a resource to an activity
2. An activity cost driver; it is a measure of the frequency and intensity of demand placed on
activities
bye cost objects. It is used to assign activity cost to cost objects.
Cost pool: this is a subset of total indirect cost that can be associated with a distinct cost driver
Advantages and Disadvantages of ABC
Advantages Disadvantages
› It provides more accurate costing of › It is expensive
products/ services
› It is not helpful to small organizations
› Overhead allocation is done on logical
basis › It may not be applied to organization
with limited products
› It enables better pricing policies by
supplying accurate cost information › Selection of most suitable cost driver
may not be useful
› Utilizes unit cost rather than just total
cost › ABC does not conform with
accounting standards so it cannot be
› It highlights problem areas which used for external reporting
require attention of the management
› It is very much helpful to organization
with multiple products
› It is easy to compute
Allocation of costs using Traditional costing
The traditional costing mostly refers to absorption costing. It involves allocating of
overheads using total labor hours or machine hours.
Here, the total overhead of the company is divided by the total number of labor hours used
to attain the Overhead Absorption Rate (OAR). The OAR is then used to allocate cost to
the various division or products.
Allocation of costs using Traditional costing
Steps in allocating Costs
1. Calculate the total amount of overhead – Sum up all indirect cost incurred
2. Calculate the total number of hours used – Sum up total hours used by each division/product
3. Divide the total overhead(1) by the total number of hour used (2) to get the OAR.
4. Multiply the OAR (3) by the hours used by each division/product to get the allocation for each
division/Product.
Allocation of costs using Traditional costing
Example
Apex Tutorial is a company with three PM groups. The following budgeted information relates to Apex
Tutorial for the forthcoming period:
Machine Services 300,000.00
Transportation 250,000.00
Set up cost 450,000.00
Group 1 Group 2 Group 3
Budgeted Production 5000 6000 5000
Hours per unit 6 7.5 5
Total Hours 30,000 45,000 25,000
Required: Calculate the overhead cost per unit and per group using Absorption costing.
SOLUTION
Step 1: Total overhead
Overhead = 300,000 + 250,000 + 450,000 = 1,000,000.
Step 2: Total hours used
Total hours = 30,000 + 45,000 + 25,000 = 100,000 hours
Or
group 1 group 2 group 3
Units produced 5,000 6,000 5,000
Hours per unit 6 7.5 5
Total hours 30,000 45,000 25,000
Step 3: Calculate OAR
OAR = Total overhead/ Total hours used
OAR = 1,000,000 / 100,000 hours = N10 per hour
Step 4: Allocation
Overhead per unit
Group 1 Group 2 Group 3
Hours per unit 6 7.5 5
OAR 10 10 10
60 75 50
Allocation of costs using ABC
STAGES IN ACTIVITY-BASED COSTING (ABC)
1. Identify the different activities within the organization
2. Determine the activity cost drivers
3. Calculate activity cost driver rates(CDR) for each activity.
Activity cost driver rate = total cost of activity / total activity driver
4. Allocation of costs
Cost = CDR * activity driver for each division
5. Preparation of the profit statement
Allocation of costs using ABC
Example
Apex Tutorial is a company with three PM groups. The following budgeted information relates to Apex
Tutorial for the forthcoming period:
Cost pools Drivers
Machine Services 300,000.00 Labor hours
Transportation 250,000.00 Deliveries
Set up cost 450,000.00 Set up
Group 1 Group 2 Group 3
Budgeted Production 5000 6000 5000
Hours per unit 6 7.5 5
Number of Deliveries 10,000 8,000 7,000
Set up 30,000 25,000 45,000
Required: Calculate the overhead cost per unit and per group using ABC
SOLUTION
Step 3: Calculate of CDR
CDR = Total cost of activity / Total cost driver
Machine services = N300,000.00 / 100,000 hours = N3 per hour
Transport = N250,000.00 / (10,000 + 8,000 +7,000) = N10 per delivery
Set up = N450,000 / 100,000 = N4.5 per set up
Step 4: Allocation of Cost
Group 1 Group 2 Group 3
Machine services @N3/hour 90,000 135,000 75,000
Transport @N10/delivery 100,000 80,000 70,000
Set up cost @N4.5/ set up 135,000 112,500 202,500
Total 325,000 327,500 347,500
Step 4: Allocation
Overhead per unit
Group 1 Group 2 Group 3
Total overhead 325,000 327,500 347,500
Unit produced 5,000 6,000 5,000
65 54.58 69.5
EXAM EXAMPLES
