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Chapter 3 - Activity Based Costing

Activity based costing (ABC) assigns overhead costs to products based on their use of activities, rather than a single volume-based measure. It traces resource consumption and costs final outputs using cost drivers. Traditional costing assigns overhead using a single predetermined overhead rate, while ABC assigns costs based on activities like set-ups, material handling, and quality control. ABC classifies activities as unit, batch, process, or organizational level. An illustrative problem shows ABC provides more accurate overhead allocation than traditional costing.

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Joey Lazarte
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234 views4 pages

Chapter 3 - Activity Based Costing

Activity based costing (ABC) assigns overhead costs to products based on their use of activities, rather than a single volume-based measure. It traces resource consumption and costs final outputs using cost drivers. Traditional costing assigns overhead using a single predetermined overhead rate, while ABC assigns costs based on activities like set-ups, material handling, and quality control. ABC classifies activities as unit, batch, process, or organizational level. An illustrative problem shows ABC provides more accurate overhead allocation than traditional costing.

Uploaded by

Joey Lazarte
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Chapter 3 – Activity Based Costing

LEARNING OBJECTIVES Success is the sum of small efforts,


repeated day in and day out
After completing this module, you should be able Robert Collier
to know the following:
1. What is activity based costing?
2. What is the difference between activity based costing and
traditional costing?
3. What are the levels of activities in activity based costing?
4. How to compute overhead costs under activity based costing?

Activity Based Costing (ABC)


As defined by the Chartered Institute of Management Accountants (CIMA), activity based
costing is an approach to the costing and monitoring of activities which involves tracing
resource consumption and costing final outputs. Resources are assigned to activities, and
activities to cost objects based on consumption estimates. The latter utilize cost drivers to
attach activity costs to outputs.
ABC is mainly focused on highly automated manufacturing industry where technological
intensive companies had diminished the use of direct labor since products are produced in a
manner where computer-driven processes are being incorporated, thus generating a
significant amount of overhead costs.
Consequently, instead of allocating overhead costs to a single volume measure or its cost
drivers, activity based costing assigns costs to the activities that are the real source of the
overhead. Then, assigns the cost of those activities only to the products that actually gone
through from those activities.

Difference between Traditional Costing and Activity Based Costing

Both the activity based costing and traditional costing are being used in allocating the
overhead costs to the products manufactured. Both of these methods use a cost driver to
estimate the overhead rate.

However, in traditional costing, overhead costs are being assigned based on a predetermined
rate that was calculated using a single volume of measure like direct labor hours and machine
hours

On the contrary, activity based costing assigns overhead to products produced on a basis of
usage of activities during the production process like purchase order activities, machine set-
ups and other activities that are required to complete the manufacturing process.

Levels of Activities in Activity Based Costing


If a company opt to use the activity based costing in allocating their overhead costs, those
companies must first classified at which level of activities costs were incurred. Accordingly,
under ABC, there four levels of activities namely,
• unit level activity,
• batch level activity
• product or process level activity
• organizational level activity

Unit level activity


This level of activity occurs every time a product is made. Hence, costs are being incurred
for each unit produced. Costs of direct materials and direct labor are the common unit level
activities.

Batch level activity


In this level, costs are incurred evenly for every group or batch of products are produced.
For instance, purchase orders, number of machine set-ups, etc.

Product or process level activity


If costs are driven by the development, innovation and marketing the product as well as
equipment maintenance, such costs are incurred in the process level activity since these
activities are carried out notwithstanding how many batches or units of product are
produced.

Organizational level activity


Costs that are incurred in this level are driven by supporting the operations such as the
corporate administration, depreciation of building used by the administration department,
and wages, company- wide advertising.

Costs under this level are always classified as part of period costs rather product costs.

Illustrative Problem:

XYZ Furniture Manufacturing Company produces three types of sofas: Leather Sofa,
Sleeper Sofa and Chaises. The company uses traditional overhead allocation and assigns
overhead to products at Php30 per direct labor hour. The costs per unit for each category
of the product are as follows:
Because goal of profitability is not being achieved and strong competition in the market, XYZ
Furniture Manufacturing Company is considering adopting the activity based costing.

In analyzing its cost data, it has been determined that P36, 000,000 of the overhead costs incurred
during the period could be assigned to the following activities - quality control, setups, material
handling, and equipment operation. The costs associated with each of the aforementioned activities
are as follows:
Based on the product costing shown above, it can be inferred that under activity based
costing, overhead costs are accurately allocated as compared to traditional costing.
Nowadays, even non-highly automated companies are already adopting activity based
allocation since it provides more comprehensive details of overhead. However, implementing
ABC involves a vigorous task and it is more costly to implement.

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