Activity Based Costing

Chapter: 5
 Traditional Costing Systems
 Product Costs Appear on the income
statement when
◦ Direct labor goods are sold, prior
to that time they are
◦ Direct materials stored on the balance
◦ Factory Overhead sheet as inventory.

 Period Costs Appear on the income

statement in the
◦ Administrative expense period incurred.

◦ Sales expense
Traditional Costing Systems
 Product Costs Direct labor and direct
materials are easy to
◦ Direct labor trace to products.

◦ Direct materials The problem comes

◦ Factory Overhead with factory
overhead.
 Period Costs
◦ Administrative expense
◦ Sales expense
Traditional Costing Systems
 Typically used one rate to allocate
overhead to products.
 This rate was often based on direct labor
dollars or direct labor hours.
 This made sense, as direct labor was a
major cost driver in early manufacturing
plants.
Problems with Traditional Costing
Systems
 Manufacturing processes and the
products they produce are now more
complex.
 This results in over-costing or under-
costing.
◦ Complex products are not allocated an
adequate amount of overhead costs.
◦ Simple products get too much.
Today’s Manufacturing Plants
 Are more complex
 Are often automated
 Often make more than one product
 Use proportionately smaller amount of
direct labor making direct labor a poor
allocation base for factory overhead.
 When the manufacturing process is
more complex:
 Then multiple allocation bases should be
used to allocate overhead expense.
 In such situations, managers need to
consider using activity based costing
(ABC).
ABC Definitions
 Activity based costing is an approach for
allocating overhead costs.
 An activity is an event that incurs costs.
 A cost driver is any factor or activity that
has a direct cause and effect relationship
with the resources consumed.
ABC Steps
 Overhead cost drivers are determined.
 Activity cost pools are created.
◦ A activity cost pool is a pool of individual
costs that all have the same cost driver.
 All overhead costs are then allocated to
one of the activity cost pools.
ABC Steps:
 An overhead rate is then calculated for
each cost pool using the following
formula:
◦ Costs in activity cost pool/base
◦ The base is, of course, the cost driver
 Overhead costs are then allocated to
each product according to how much of
each base the product uses.
Let’s work an example . . .
 Assume that a company makes widgets
 Management decides to install an ABC
system
Overhead Cost Drivers are
Determined:
 Management decides that all overhead
costs only have three cost drivers—
sometimes called activities (obviously a
simplification of the real world)
◦ Direct labor hours
◦ Machine hours
◦ Number of purchase orders
All overhead costs are then allocated to one of the activity cost
pools.

Direct Labor
General Ledger
Payroll taxes $1,000
Machine maintenance $500
Purchasing Dept. labor $4,000
Fringe benefits $2,000 Machine Hours
Purchasing Dept. $250
Supplies
Equipment $750
depreciation
Electricity $1,250 # of Purchase Orders
Unemployment $1,500
insurance

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
General Ledger
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

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

Overhead driver by direct labor

hours
All overhead costs are then allocated to one of the activity
cost pools.
Direct Labor
General Ledger
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

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

Which overhead costs are

driven by machine hours?
All overhead costs are then allocated to one of the activity
cost pools.
Direct Labor
General Ledger
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

Purchasing Dept. $250
$ 500
Supplies
750
Equipment $750 1,250
depreciation $2,500
Electricity $1,250 # of Purchase Orders
Unemployment $1,500
insurance $4,000
250
And finally, which overhead $4,250
costs are driven by # of
purchase orders?
An overhead rate is then calculated for each cost pool:
Direct Labor
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
Direct labor hours = 1,000
Machine hours = 250
$ 500
Purchase orders = 100 750
1,250
$2,500

The ABC rates are: # of Purchase Orders

$4,500/1,000 = $4.50 per direct labor hour
$2,500/250 = $10 per machine hour $4,000
250
$4,250/100 = $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:

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

$2,500/250 = $10 per machine hour
$4,250/100 = $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 $ 4.50 $ 1,800.00

Just like we learned in Accounting 2020, we multiply

the base used by the rate.
In this case, 400 hours used to make Widget A is
multiplied by the rate of $4.50. This gives total overhead
applied for this activity cost pool of $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 Allocated

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 let’s 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 Allocated

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 $4,500 of direct labor

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

The actual overhead allocated was $4,925 for Widget A + $6,350 =

$11,250 overhead applied.
Same Problems Traditional Method
 Okay, so 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

Payroll taxes $1,000

Machine maintenance $500
Purchasing Dept. labor $4,000 This the total
Fringe benefits $2,000 overhead we were
given, the total
Purchasing Dept. $250 amount is $11,250
Supplies as explained on
Equipment $750 the previous slide.
depreciation
Electricity $1,250
Unemployment $1,500
insurance

Base Widget A Widget B Total Total direct

Direct labor hours 400 600 1,000 labor hours
Machine hours 100 150 250 are 1,000, also
Purchase orders 40 60 100 given earlier.
Calculation
 The rate would be:
◦ OH Rate = Overhead/Direct Labor Hours
◦ $11,250/1,000 = $11.25 per hour.
 Applying overhead using this rate:
◦ Widget A: 400 hours x $11.25 = $4,500
◦ Widget B: 600 hours x $11.25 = $6,750
◦ Total overhead applied = $11,250
 Comparison
Widget A Widget B Total
Traditional $4,500 $6,750 $11,250
Method
Activity Based $4,925 $6,325 $11,250
Costing
Difference -$425 $425 -0-

Which is more accurate?

ABC Costing!
Note these are total costs. To get per-unit costs we would divide by the
number of units produced.
When do we use ABC costing?
• When one or more of the following
conditions are present:
• Product lines differ in volume and
manufacturing complexity.
• Product lines are numerous and diverse,
and they require different degrees of
support services.
• Overhead costs constitute a significant
portion of total costs.
When do we use ABC costing?
• The manufacturing process or number of
products has changed significantly—for
example, from labor intensive to capital
intensive automation.
• Production or marketing managers are
ignoring data provided by the existing
system and are instead using “bootleg”
costing data or other alternative data
when pricing or making other product
decisions.
Additional Uses of ABC
 Activity Based Management (ABM)
◦ Extends the use of ABC from product costing
to a comprehensive management tool that
focuses on reducing costs and improving
processes and decision making.
ABM
 ABM classifies all activities as value-added
or non-value-added.
◦ Value-added activities increase the worth of a
product or service to the customer.
 Example: Addition of a sun roof to an automobile.
◦ Non-value added activities don’t.
 Example: The cost of moving or storing the
product prior to sale.
The Objective of ABM . . .
 To reduce or eliminate non-value related
activities (and therefore costs).
 Attention to ABM is a part of continuous
improvement of operations and activities.
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
Common Classification System
 Unit-level activities. Activities performed
for each unit of production.
 Batch-level activities. Activities performed
for each of bath of products.
 Product-level activities. Activities
performed in support of an entire
product line.
 Facility-level activities. Activities required
to sustain an entire production process.
Common Classification System
 This system provides a structured way of
thinking about relationship between
activities and the resources they
consume.
Facility Sustaining Activities
 Have no good cost driver
 May or may not be allocated to products
depending upon the purpose for which
the information is to be used
 Examples
◦ Housekeeping
◦ Factory yard maintenance
Chapter: 4
 Overhead is the aggregate of indirect
materials, indirect wages and indirect
expenses.

 It can not be conveniently allocated to

cost unit.
1. High and low Points Method
Variable element P. U.
= Diff. in semi-variable costs/ Diff. in Output

2. Method of Averages
=Diff in average cost/ Diff in average output

3. Scatter Diagram Method

4. Equitation Method
 The modern company has three production
departments viz. A, B and C and two service
departments (D and E).
 From the given figures apportion the costs to
various departments on the most equitable
basis.
 Assume the cost driver to be direct wages for
the service department.
 Rs.

Indirect Materials 15,000

Indirect Wages 12,000
Depreciation on Machinery 20,000
Depreciation on Buildings 10,000
Rent, Rates and Taxes 10,000
Electric Power for Machinery 15,000
Electric Power for Lighting 300
General Expenses 21,000
Total 1,03,300

Items Total A B C D E

Direct Materials (Rs.) 60,000 20,000 10,000 19,000 6,000 5,000

Direct Wages (Rs.) 40,000 15,000 15,000 4,000 2,000 4,000
Value of Machinery (Rs.) 2,50,000 60,000 1,00,000 40,000 25,000 25,000
Floor Area (sq. ft.) 50,000 15,000 10,000 10,000 5,000 10,000
No. of Light Points 50 15 10 10 5 10
Horse Power of Machines 150 50 60 30 5 5
Labor Hours 15,000 5,000 5,000 2,000 1,000 2,000
 Production Dept. Service Dept.
Expenses Basis Total
A B C D E
Direct Materials Given 60,000 20,000 10,000 19,000 6,000 5,000
Direct Wages given 40,000 15,000 15,000 4,000 2,000 4,000
Indirect Material Direct Material 15,000 5,000 2,500 4,750 1,500 1,250
Indirect Wages Direct Wages 12,000 4,500 4,500 1,200 600 1,200
Dep. of Machinery Machine Value 20,000 4,800 8,000 3,200 2,000 2,000
Dep. of Building Floor Area 10,000 3,000 2,000 2,000 1,000 2,000
Rent, Rates, etc. Floor Area 10,000 3,000 2,000 2,000 1,000 2,000
Electric Power
For Machinery H.P. 15,000 5,000 6,000 3,000 500 500
For Lighting Light Points 300 90 60 60 30 60
General Expenses Labor Hours. 21,000 7,000 7,000 2,800 1,400 2,800

2,03,300 67,390 57,060 42,010 16,030 20,810

Expenses of Dep. D In ratio to
between A,B,C Direct Wages ------- 7,072 7,072 1,886 (16030)

Expenses of Dep. E In ratio to

Direct Wages ------- 9,180 9,180 2,450 (20810)
between A,B,C

2,03,300 83,635 73,305 46,360 0000 0000

 The process of applying overheads to the
cost units is known as levy or recovery of
overheads.

 Absorption involves the distribution of

overhead relating to a particular department
among the units produced in that department
during the relevant time period.
1. Computation of Overheads Absorption Rate

= Total Overheads of Cost Centre/ Total units in base

2. Application of Rate to Cost Units

Overheads Absorbed

= No. of Units of base in the cost X Overhead rate

Types of Overhead Absorption Rates :
1.Actual Rate Predetermined
2.Rate Moving Average Rate
3.Blanket Rate
4.Multiple Overhead Rate
5.Supplementary Overhead Rate
6.Frequency of Rate Revision
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