ACTIVITY-BASED COSTING (ABC) AND ACTIVITY-BASED MANAGEMENT (ABM)

Management Accounting Review

/RCROQUE

ACTIVITY-BASED COSTING (ABC)

Activity-based costing (ABC) is based upon two principles. First, activities consume resources. Second,
these resources are consumed by products, services, or other cost objectives (output). ABC allocates overhead
costs to products on the basis of the resources consumed by each activity involved in the design, production,
and distribution of a particular good. This is accomplished through the assignment of costs to homogeneous
cost pools that represent specific activities and then the allocation of these costs, using appropriate cost drivers,
to the product. ABC may be used in conjunction with either job order or process costing systems.

Central to ABC are the activities performed to fulfill organizational objectives (producing products or services for
customers). Activities may be value-added or non-value added.

Value-added activities are those which customers perceive as increasing the worth of a product or service
and for which customers are willing to pay. They include only production activities.

Non-value-added activities increase the cost of a product but do not increase its value to customers.
Examples include materials handling and rework. Packaging is required for some products such as milk or
potting soil, but it may be non-value-added for other products such as books (it is also costly and takes up huge
amounts of landfill space). Thus, these activities may be eliminated and/or restructured without customers
perceiving a decline in the value of the product/service. An activity (process) map is a flowchart which indicates
all activities involved in the production process and identifies both value-added and non-value-added activities.

Cost drivers are those activities which have a direct cause and effect relationship to the incurrence of such cost.

Unit-level costs are those costs that can be directly apportioned to volume. These costs may include such
activities as direct labor hour costs, directly attributable material costs, and costs per machine operating hour.
Traditional costing uses only variable and fixed or total overhead cost pools and views cost drivers at the output
unit level, wherein costs are allocated based on labor hours, machine hours, etc.

Batch-level costs are those costs that can be directly apportioned to the batch-run. For this type of cost,
certain activities are consumed in direct proportion to the number of batch-runs for each product. These batch-
level costs may include set-up, ordering, material handling, and transportation costs. Some costs though, such
as setup costs, vary at the batch level (batch-level costs) and should be spread over the units in the batch to
which they relate (not machine hours).

Product-level costs are those costs that can be directly apportioned to the product, which assumes that
certain activities are consumed to develop or permit production of different products. These product-level costs
may include such activities as research and development (R&D), parts and material acquisition and inventory
costs, technical administration, and specialized pre-production safety and manufacturing training. Product-
sustaining (process-level) costs such as engineering change orders should be assigned to the products for which
the orders were issued.

Facility-level costs cause problems in an ABC environment because these costs are associated with the
sustainment of a general manufacturing process. These facility-level costs may include such activities as travel
costs, directors’ fees, and general administration and can include a large segment of the estimated product cost.
Facility-sustaining costs incurred at the organizational level support operations and can only be arbitrarily
assigned to products.

As shown by the following table, ABC uses both transaction-related (e.g., purchase orders) and volume-related
(e.g., machine hours) cost drivers. Traditional product costing tends to use only volume-related cost drivers.

Activity Cost driver

Purchase of materials Number of purchase transactions
Receiving Number of shipments received
Disbursing Number of checks issued
Setup costs Number of setups or setup hours
Machining Number of machine hours
Repair costs Number of machine hours engineering
Changes to products Number of engineering change notices

The activities listed above are all examples of direct activities which can be traced to an output or service. In
contrast, indirect activities such as human resources are not directly attributable to output. The cost of indirect
activities may be allocated or simply labeled as non-traceable.
To illustrate, ABC traces the costs of setup activities to the production batch that caused the setup costs to be
incurred. The cost of each setup is then spread over the units in that batch. On the other hand, a traditional
costing system would typically allocate setup costs as overhead on the basis of a volume-related cost driver such
as direct manufacturing labor hours. Assume that product A and product B incur setup costs as follows:
A B Total
Production volume 7,500 10,000
Batch size 250 1,000
Number of setups 30 10
Total setup costs incurred $60,000 $20,000 $80,000
Total cost per setup $ 2,000 $ 2,000
Direct manuf. labor hours/unit 3 3
Total direct manuf. labor hours 22,500 30,000 52,500
Setup cost per DMLH ($80,000 ÷ 52,500) $ 1.52
Traditional setup cost/unit
A ($1.52 3 DMLH required) $ 4.56
B ($1.52 × 3 DMLH required) $ 4.56
ABC setup cost/unit
A ($2,000/setup ÷ 250 units/batch) $ 8.00
B ($2,000/setup ÷ 1,000 units/batch) $ 2.00

In this case, products A and B are assigned different total setup costs. However, because they require the
same number of direct manufacturing labor hours per unit, traditional costing allocates equal setup costs per
unit to both products. In effect, one product picks up cost that was caused by another product (cross-
subsidization), which distorts product costing information. ABC assigns different setup costs per unit to each
product because each unit of product A demands more resources for setup activity than does each unit of
product B. Note that the total setup cost remains the same under either method.

ACTIVITY-BASED COSTING MANAGEMENT (ABM)

Activity-based management (ABM) integrates ABC with other concepts such as total quality management
(TQM) and target costing to produce a management system that strives for excellence through cost reduction,
continuous process improvement, and productivity gains.

Test 1. TRUE OR FALSE QUESTIONS.

________ 1. If a manufacturing company is using activity-based costing for internal purposes only,
then organization-sustaining overhead costs should not be allocated to any of the
products.
________ 2. Batch-level activities are performed each time a batch of goods is handled or processed.
________ 3. Organization-sustaining activities are carried out regardless of how many units are made,
how many batches are run, or how many different products are made.
________ 4. Direct labor hours or direct labor cost should not be used as a measure of activity in an
activity-based costing system.
________ 5. Activity-based costing is a costing method that is designed to provide managers with cost
information for strategic and other decisions that potentially affect capacity and therefore
“fixed” costs.
________ 6. Activity-based costing is a costing method that is designed to provide managers with cost
information for strategic and other decisions that potentially affect only variable costs.
________ 7. A duration driver provides a measure of the amount of time required to perform an
activity.
________ 8. In general, transaction drivers are more accurate measures of the consumption of
resources than duration drivers.
________ 9. The costs of idle capacity should not be assigned to products in activity-based costing.
________ 10. In traditional costing systems, all manufacturing costs are assigned to products – even
manufacturing costs that are not caused by the products.
________ 11. Activity-based costing involves a two-stage allocation in which overhead costs are first
assigned to departments and then to jobs on the basis of direct labor hours.
________ 12. In activity-based costing, some costs may be broken down and assigned to two activity
cost pools, e.g., part of a supervisor's salary may be classified as a product-level activity.
________ 13. Activity rates in activity-based costing are computed by dividing costs from the first-stage
allocations by the activity measure for each activity cost pool.
________ 14. In the second-stage allocation in activity-based costing, activity rates are used to apply
costs to products, customers, and other cost objects.
________ 15. When a company shifts from a traditional cost system in which manufacturing overhead is
applied based on direct labor hours to an activity-based costing system in which there are
batch-level and product-level costs, the unit product costs of high volume products
typically decrease whereas the unit product costs of low volume products typically
increase.
________ 16. Traditional costing systems use multiple predetermined overhead rates.
________ 17. Traditionally, overhead is allocated based on direct labor cost or direct labor hours.
________ 18. Current trends in manufacturing include less direct labor and more overhead.
________ 19. Activity-based costing allocates overhead to multiple cost pools and assigns the cost pools
to products using cost drivers.
________ 20. A cost driver does not generally have a direct cause-effect relationship with the resources
consumed.
________ 21. The first step in activity-based costing is to assign overhead costs to products, using cost
drivers.
________ 22. To achieve accurate costing, a high degree of correlation must exist between the cost
driver and the actual consumption of the activity cost pool.
________ 23. Low-volume products often require more special handling than high-volume products.
________ 24. When overhead is properly assigned in activity-based costing, it will usually decrease the
unit cost of high-volume products.
________ 25. Activity-based costing leads to enhanced control over overhead costs.
________ 26. Activity-based costing usually results in less appropriate management decisions.
________ 27. Activity-based costing is generally more costly to implement than traditional costing.
________ 28. Activity-based costing eliminates all arbitrary cost allocations.
________ 29. Activity-based costing is particularly useful when product lines differ greatly in volume and
manufacturing complexity.
________ 30. Activity-based costing is particularly useful when overhead costs are an insignificant
portion of total costs.

Test 2. MULTIPLE CHOICE QUESTIONS.

1. Traditionally, managers have focused cost reduction efforts on

A. Activities. B. Processes. C. Departments. D. Costs.

2. Today, traditional accounting methods are

A. Still appropriate for financial reporting. C. Still appropriate for both internal and
B. Still appropriate for providing useful cost external financial reporting.
information to internal managers. D. Outdated for all purposes.

3. Product costing systems in use over the last 40 years

A. Concentrated on using multiple cost pools and cost drivers.
B. Were often technologically incapable of handling activity-based costing information.
C. Have generally been responsive to changes in the manufacturing environment.
D. Have been appropriate for managerial decision purposes as long as they met the requirements of
generally accepted accounting principles.

4. Traditional overhead allocations result in which of the following situations?

A. Overhead costs are assigned as period costs to manufacturing operations.
B. High-volume products are assigned too much overhead, and low-volume products are assigned too
little overhead.
C. Low-volume products are assigned too much, and high-volume products are assigned too little
overhead.
D. The resulting allocations cannot be used for financial reports.

5. Traditionally, overhead has been assigned based on direct labor hours or machine hours. What effect does
this have on the cost of a high-volume item?
A. Over-costs the product C. Has no effect the product cost
B. Under-costs the product D. Cost per unit is unaffected by product
volume

6. Relative to traditional product costing, activity-based costing differs in the way costs are
A. Processed. B. Allocated. C. Benchmarked. D. Incurred.

7. Under activity-based costing, benchmarks for product cost should contain an allowance for
A. Idle time. C. Spoilage.
B. Idle time and scrap materials. D. None of these.
8. In activity-based costing, final cost allocations assign costs to
A. Departments. B. Processes. C. Products. D. Activities.

9. In activity-based costing, preliminary cost allocations assign costs to

A. Departments. B. Processes. C. Products. D. Activities.

10. In allocating fixed costs to products in activity-based costing,

A. Direct labor hours should always be used as the allocation base.
B. A company should use the same allocation base that it uses for variable costs.
C. A cost driver that is not volume-related should be used.
D. Machine hours should always be used.

11. Of the following, which is the best reason for using activity-based costing?
A. To keep better track of overhead costs
B. To more accurately assign overhead costs to cost pools so that these costs are better controlled
C. To better assign overhead costs to products
D. To assign indirect service overhead costs to direct overhead cost pools

12. Activity-based costing should be used in which of the following situations?

A. Single-product firms with multiple steps C. Multiple-product firms with multiple
B. Multiple-product firms with only a single processing steps
process D. In all manufacturing firms

13. The overhead of American manufacturing firms has risen in recent years due to
A. An increase in direct labor. C. The implementation of activity-based
B. An increase in product variety. costing.
D. The cost of product life cycle planning.

14. Activity-based costing and activity-based management are effective in helping managers do all of the
following, except
A. Trace technology costs to products. C. Identify only value-added activities.
B. Promote excellence standards. D. Analyze performance problems.

15. Global competition has forced American industry to

A. Seek increased governmental regulation. C. Narrow product lines.
B. Improve product quality and customer D. Decrease its social responsibility.
service.

Use the following information to answer the next two questions:

Apple Company predicted factory overhead for 2016 and 2017 would be ₱120,000 for each year. The predicted
activity for 2016 and 2017 were 30,000 and 20,000 direct labor hours, respectively. Additional data are as
follows:

2015 2016
Sales in units 25,000 25,000
Selling price per unit ₱20 ₱20
Direct materials and direct labor per unit ₱10 ₱10

The company assumes that the long-run normal production level is 20,000 direct labor hours per year. The
actual factory overhead cost for the end of 2015 and 2016 was ₱120,000. Assume that it takes one direct labor
hour to make one finished unit.

16. When the annual estimated factory overhead rate is used, the gross profits for 2016 and 2017,
respectively, are
A. ₱150,000 and ₱150,000. C. ₱150,000 and ₱100,000.
B. ₱250,000 and ₱250,000. D. ₱150,000 and ₱100,000.

17. When the normal factory overhead rate is used, the gross profits for 2016 and 2017, respectively, are
A. ₱80,000 and ₱80,000. C. ₱120,000 and ₱140,000.
B. ₱200,000 and ₱200,000. D. ₱100,000 and ₱100,000.

Use the following information to answer the next two questions:

The following information is provided for the year:

 Actual direct labor hours worked 36,000
Budgeted overhead ₱300,000
Budgeted direct labor hours 30,000
Actual overhead costs incurred ₱360,000

18. If normal costing is used, the amount of overhead applied for the year is
A. ₱299,880. B. ₱300,000. C. ₱380,000. D. ₱360,000.

19. The actual overhead rate for applying manufacturing overhead is

A. ₱7.14. B. ₱7.50. C. ₱10. D. ₱10.50.

Use the following information to answer the next two questions:

The following information is provided:

Estimated manufacturing overhead ₱690,000

Estimated machine hours 46,000
Actual machine hours worked 50,000

Actual costs incurred:

Indirect materials ₱170,000
Indirect labor 230,000
Utilities 120,000
Insurance 100,000
Rent 80,000

20. The amount of over-applied or under-applied overhead is

A. ₱65,200 under-applied. C. ₱50,000 over-applied.
B. ₱60,000 over-applied. D. ₱10,000 under-applied.

21. The company uses a predetermined overhead rate to apply overhead. Manufacturing overhead applied is
A. ₱750,000. B. ₱700,000. C. ₱690,000. D. ₱648,000.

22. The following information pertains to Pink Corporation for 2017:

Estimated total overhead costs for 2011 ₱37,500

Estimated direct labor costs for 2011 25,000
Actual direct labor costs 22,500
Actual overhead costs 36,000
Activity base Direct labor costs

What is the predetermined overhead rate for Black Corporation for 2017?
A. 150% B. 66.7% C. 160% D. 62.5%

23. Big Bang Company uses a predetermined rate to apply overhead. At the beginning of the year, Big Bang
estimated its overhead costs at ₱240,000, direct labor hours at 40,000, and machine hours at 10,000.
Actual overhead costs incurred were ₱249,280, actual direct labor hours were 41,000, and actual machine
hours were 11,000.

What is the predetermined overhead rate per machine hour for Carlson?
A. ₱6.08 B. ₱5.85 C. ₱24 D. ₱22.66

Use the following information to answer the next two questions:

Samsung Company made the following predictions for 2017:

Factory overhead costs ₱300,000

Direct labor hours 50,000 hours
Machine hours 100,000 hours

Job 2C (which was started and completed in May) used 3,000 direct labor hours, 2,000 machine hours, and
₱57,000 of prime costs.

24. If factory overhead is applied based on direct labor hours, the cost of Job 2C for the Samsung Company is
A. ₱60,000. B. ₱75,000. C. ₱63,000. D. ₱66,000.
25. If factory overhead is applied based on machine hours, the cost of Job 2C for the Samsung Company is
A. ₱69,000. B. ₱75,000. C. ₱63,000. D. ₱66,000.

26. The Garfield Company uses a predetermined overhead rate of ₱12 per direct labor hour to apply
overhead. During the year, 30,000 direct labor hours were worked. Actual overhead costs for the year
were ₱320,000. The overhead variance is
A. ₱36,000 over-applied. C. ₱40,000 under-applied.
B. ₱35,560 under-applied. D. None of the choices.

27. The following information is provided for the year:

Actual overhead ₱450,000
Actual machine hours worked 25,000
Budgeted machine hours 27,500
Applied overhead ₱487,500

If normal costing is used, budgeted overhead used to calculate the predetermined rate would be
A. ₱443,250. B. ₱450,000. C. ₱487,500. D. ₱536,250.

28. Assume the following: Actual overhead costs equaled estimated overhead. Actual direct labor hours
exceeded estimated direct labor hours used to calculate the predetermined overhead rate. If overhead is
applied using the predetermined overhead rate, then overhead is
A. Over-applied. C. ₱0.
B. Under-applied. D. Cannot be determined.

29. The following information is provided for the year:

Actual direct labor hours worked 27,500

Budgeted overhead ₱525,000
Budgeted direct labor hours 30,000
Actual overhead costs incurred ₱481,250

If normal costing is used, the amount of overhead applied for the year is
A. ₱568,750. B. ₱441,031.25. C. ₱481,250. D. ₱525,000.

30. Choco Delight uses a job-order costing system. The Molding Department applies overhead based on
machine hours, while the Assembly Department applies overhead based on direct labor hours. The
company made the following estimates at the beginning of the current year:
Molding Assembly
Manufacturing overhead cost ₱600,000 ₱400,000
Machine hours 10,000 4,000
Direct labor hours 12,000 16,000

The following information was available for Job A1, which was started and completed during July:

Job No. A1
Molding Assembly
Direct materials ₱3,500 ₱ 7,500
Direct labor ₱9,000 ₱12,500
Direct labor hours 900 1,250
Machine hours 500 400

The predetermined overhead rate for the molding department is

A. ₱50.
B. ₱60.
C. ₱83.
D. ₱100.
Problem 1

The Juneau plant produces two calculators and has two production departments: assembly and packaging.
Information for the products is given below:

Deluxe Regular Total

Units produced 2,000 20,000 220,000
Prime costs ₱160,000 ₱1,500,000 ₱1,660,000
Direct labor hours 20,000 160,000 180,000
Number of setups 60 40 100
Machine hours 10,000 80,000 90,000
Inspection hours 2,000 16,000 18,000
Number of moves 180 120 300

The following table presents activity information about the departments and products:

Assembly Packaging Total

Direct labor hours:
Deluxe 10,000 10,000 20,000
Regular 150,000 10,000 160,000
Total 160,000 20,000 180,000
Machine hours:
Deluxe 2,000 8,000 10,000
Regular 8,000 72,000 80,000
Total 10,000 80,000 90,000

Overhead Costs:
Setting equipment ₱120,000 ₱120,000 ₱240,000
Moving material 60,000 60,000 120,000
Machining 20,000 180,000 200,000
Inspection 16,000 144,000 160,000
Total ₱216,000 ₱504,000 ₱720,000

Requirements:
Calculate the unit cost of each product using plant-wide, departmental and ABC.

Problem 2

Kare Foods Company specializes in the production of frozen dinners. The first of the two operating departments
cooks the food. The second is responsible for packaging and freezing the dinners. The dinners are sold by the
case, each case containing 25 dinners. Two support departments provide support for Kare’s operating units:
Maintenance and Power. Budgeted data for the coming quarter are given below. The company does not separate
fixed and variable costs.

Support Departments Producing Departments

Particulars Packaging
Maintenance Power Cooking
and Freezing
Overhead Costs ₱340,000 ₱200,000 ₱75,000 ₱55,000
Machine Hours ---------- 40,000 40,000 20,000
Kilowatt Hours 20,000 ---------- 100,000 80,000
Direct Labor Hours ---------- ---------- 5,000 30,000

The predetermined rate for Cooking is computed based on machine hours; direct labor hours are used for
Packaging and Freezing. The prime costs for one case of standard dinner total ₱16. It takes two machine hours to
produce a case of dinners in the Cooking Department and 0.5 direct labor hour to process a case of standard
dinners in the Packaging and Freezing Department. Recently, the Air Force has requested a bid on a three-year
contract that will supply standard frozen dinners to Minuteman missile officers and staff on duty in the field. The
locations of the missile sites were remote, and the Air Force had decided that frozen dinners were the most
economical means of supplying food to personnel on duty. The bidding policy of Kare Foods is full manufacturing
costs plus 20%.

1. Determine Kare’s Bid Price using direct, step and algebraic methods.
Problem 3

Samsonite Company makes a variety of Luggage. The activity centers and budgeted information for factory
overhead for the year are:

Activity Center Overhead Costs Cost Driver Activity Center rate

Materials Handling P 6,000,000 Weight of materials P 3.00 /lb.
Cutting 12,000,000 Number of shapes 30.00/shape
Assembly 45,000,000 Direct labor hours 120.00/ DLH.
Sewing 12,000,000 Machine hours 80.00/MH

Two classes of luggage were produced in October, the Class A and the Class B. The quantities and other
operating data for the month are:

Class A Class B
Direct materials costs P 200,000 P 150,000
Direct labor cost 150,000 300,000
Direct materials weight in pounds 15,000 50,000
Number of shapes 15,000 35,000
Direct labor hours 1,200 7,500
Sewing machine hours 1,800 12,500
Units produced 1,000 5,000

Using traditional costing method wherein overhead is applied based on the number of direct labor hours:
1. The overhead rate is _____________________
2. Total cost of Class A is _____________________
3. Total cost of Class B is _____________________

Using ABC method:

4. Total overhead applied to Class A _____________________
5. The cost per unit of Class A is _____________________
6. The total cost of Class B is _____________________

Problem 4

BB Company has two service departments (HR and R&M) and two producing departments (A and B). HR
allocates its direct cost based on the number of employees while R&M allocates based on number of repair hours.

Service Departments Production Departments Total

HR R&M A B
Direct Cost (peso) 200,000.00 400,000.00 1,200,000.00 800,000.00 2,600,000.00
# of employees 120 200 500 300 1,120
Repair hours 50 40 50 100 240

1. Using direct method to allocate service cost, the total OH cost of Department A is _____________________
2. Using the step method, the service cost allocated to Department B is _____________________
3. Using the sequential method, the total OH of department A is _____________________
4. Using algebraic method, the total OH of Department B is _____________________