CHAPTER 3

ACTIVITY BASED COSTING

 Introduction
• Costing - is the process of determining the
costs of products, services or activities.
• Cost accounting is used to determine the cost
of products, jobs or services (whatever the
organization happens to be involved in).
• Such costs have to be built up using a process
known as cost accumulation.
 Introduction . . .
• A total product/service cost may included :
• Direct costs : D/Material cost, DL cost, Direct
expense
• Indirect costs or Overhead costs: Production costs
and non –production costs.
• Indirect production costs- are costs which can be
absorbed /traceable in to production cost.
Indirect non- production- are over/under absorbed
overhead cost which can be adjustable to total cost.
 Alternative methods of overhead cost allocation . . .

1. Absorption/traditional costing - is a means of

incorporating share all costs into the cost of a unit of
product or service provided based on certain allocation
basis.
• This approach assume that - All production overheads
are incurred in the production of the organization's
output and so each unit of the product receives some
benefit from these costs.
• Each unit of output should therefore be charged with
some of the overhead costs.
• Commonly based on labor hours of machine hour rates
 Alternative methods of overhead cost
allocation . . .
2. Using marginal costing- is at type of costing take
the view that only the variable costs of making
and selling a product or service should be
identified and considered as cost of the product.
• Fixed costs should be dealt with separately and
treated as a cost of the accounting period rather
than shared out somehow between units
produced
3. ABC method
 Activity based costing
• An alternative to absorption costing is activity
based costing (ABC).
Definition of ABC:
• Activity based costing (ABC) is a costing system
that 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.
 Activity based costing . . .
According to ABC:
• For costs that vary with production level in the short
term, the cost driver will be volume related (labor or
machine hours).
• Overheads that vary with some other activity (and not
volume of production) should be traced to products
using:
 Transaction-based cost drivers such as production
runs or number of activities /orders receive.
 Duration driver - A measure of the amount of time
needed for an activity.
 Activity based costing . . .
• The major ideas behind activity based costing are
as follows.
(a) Activities cause costs. Activities include
ordering, materials handling, machining,
assembly, production scheduling and dispatching.
(b) Producing products creates demand for the
activities.
(c) Costs are assigned to a product on the basis of
the product's consumption of the activities.
• Based on cost hierarchies in ABC
 COST HIERARCHIES In ABC

• In an ABC system, costs are categorized on the basis of the

different types of cost drivers utilized.
• ABC systems commonly use a cost hierarchy having four
levels. These cost drivers differ in their relationship between
the indirect cost and the product or service.
• Output unit-level costs are the costs of activities performed
on each individual unit of a product or service.
– These costs increase as the number of units produced
increases.
• Batch-level costs are the costs of activities related to a group
of units of products or services rather than the individual
unit.
– Set-up costs are an example of batch level costs, as this cost is
incurred once for each batch, regardless of the size of the
batch.
 COST HIERARCHIES In ABC . . .

• Product-sustaining costs (service-sustaining costs) are

the costs of activities undertaken to support individual
products or services regardless of the number of units or
batches produced.
– Design costs are an example of this type of cost.
• Facility-sustaining costs are the costs of activities that
cannot be traced to individual products or services but
support the organization as a whole.
– Examples of this type of cost include general
administration, rent, and building security.
– These costs usually lack a cause-and-effect relationship
between the cost and the allocation base.
 Outline /steps of an ABC system
An ABC system operates as follows:
Step 1- Identify an organization's major
activities.
Step 2 - Identify the factors which determine
the size of the costs of an activity/cause the
costs of an activity. These are known as cost
drivers.
A cost driver is a factor which causes a change in the
cost of an activity.
 Example - Look at the following cost
drivers
Costs Possible cost driver
• Ordering costs . Number of order
• Machine operating . Number of
cost machine hour
• Production scheduling . Number of
Cost production runs
• Dispatching costs . Number of dispatches
• Machine set up cost . Number of machine
set ups
 steps of an ABC system . . .
• Step 3- Collect the costs associated with each
cost driver into what are known as cost pools.
• Step 4- Charge costs to products on the basis
of their usage of the activity.
A product's usage of an activity is measured
by the number of the activity's cost driver it
generates.
 ABC- Vs- traditional costing/ absorption
methods
• Both traditional absorption costing and ABC systems
adopt the two stage allocation process.
• ABC establishes separate cost pools for support
activities such as dispatching.
• As the costs of these activities are assigned directly to
products through cost driver rates, reapportionment
of service department costs is avoided.
• The principal difference between the two systems is
the way in which overheads are absorbed into
products.
 ABC- Vs- traditional costing . . .
• Absorption costing most commonly uses two
absorption bases (labor hours and/or
machine hours) to charge overheads to
products.
• ABC uses many cost drivers as absorption
bases (e.g. number of orders or dispatches).
• Absorption rates under ABC should therefore
be more closely linked to the causes of
overhead costs.
 ABC- Vs- traditional costing . . .
• Example:
• The following example illustrates the point
that traditional cost accounting techniques
result in a misleading and inequitable division
of costs between low-volume and high-volume
products, and that
• ABC can provide a more meaningful allocation
of costs.
 Example . . .
Product Output Number of Material DL hours Machine
units in the production cost per unit per unit hours per
period runs unit

W 10 2 20 1 1
X 10 2 80 3 3
Y 100 5 20 1 1
Z 100 5 80 3 3
14

Direct labor cost per hour $5

Overhead costs $
Machine operating costs 3,080
Set-up costs 10,920
Arrangement and scheduling costs 9,100
Materials handling costs 7,700
total 30,800
 Example . . .
Required
• Prepare unit costs for each product using traditional costing and ABC.

Solution - Using a conventional absorption costing approach and an

absorption rate for overheads based on either direct labor hours or machine
hours, the product costs would be as follows.
W X Y Z Total
• $ $ $ $ $
• Direct material 200 800 2,000 8,000
• Direct labor 50 150 500 1,500
• Overheads * 700 2,100 7,000 21,000
Total cost 950 3,050 9,500 30,500 44,000
• Units produced 10 10 100 100
• Cost per unit $95 $305 $95 $305

* $30,800 ÷ 440 hours = $70 per direct labor or machine hour.

 Example . . .
• Using activity based costing and assuming that :
 the number of production runs is the cost driver for
 setup costs,
 scheduling costs and
 materials handling costs and that
 machine hours are the cost driver for machine operation
short-run variable costs, unit costs would be as follows.
Workings for over head cost allocation
1. $3,080 ÷ 440 machine hours = $7 per machine hour
2. $10,920 ÷ 14 production runs = $780 per run
3. $9,100 ÷ 14 production runs = $650 per run
4 . $7,700 ÷ 14 production runs = $550 per run
 Example . . .
W X Y Z Total
$ $ $ $ $
• Direct material 200 800 2,000 8,000
• Direct labor 50 150 500 1,500
• Mach/operating OH (W1) 70 210 700 2,100
• Set-up costs (W2) 1,560 1,560 3,900 3,900
• Arrg’t/ sch/ costs (W3) 1,300 1,300 3,250 3,250
• Materials h/ costs (W4) 1,100 1,100 2,750 2,750
Total cost 4,280 5,120 13, 100 21,500
44,000
• Units produced 10 10 100 100
• Cost per unit $428 $512 $131 $215
 Example . . .
Summary of both methods
Conventional
Product costing per ABC Difference per Difference in
unit cost unit unit (ABC-Conv/) total
$ $ $ $
• W 95 428 + 333 +3,330
• X 305 512 + 207 +2,070
• Y 95 131 + 36 +3,600
• Z 305 215 – 90 –9,000

The figures suggest that the traditional volume-based absorption costing

system is resulted in.
(a) It under allocates overhead costs to low-volume products (here, W and X)
and over-allocates overheads to higher-volume products (here Z in
particular).
(b) It over allocates overheads to larger products (here X and particularly Z).
 Thanks
Chapter End

Try to refer more reading Materials about ABC

and Activity Based Management