Chapter 5: Activity Based Costing (ABC)

Activity based costing (ABC) 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 as well as variable costs. It is ordinarily used as a supplement to, rather than as a
replacement for, a company’s usual costing system. Most organizations that use this costing
have two costing systems- the official costing system that is used for preparing external
financial reports and the activity-based costing system that is used for internal decision
making and for managing activities.
Its a costing method that identifies activities in an organization and assigns the cost of each
activity to all products and services according to the actual consumption by each relating to
the costing and monitoring of activities which involves tracing resource consumption and
costing final outputs where 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. With ABC, a company can soundly estimate the cost elements of entire products,
activities and services, that may help inform a company's decision to either:

to dentify and eliminate those products and services that are unprofitable and lower the prices
of those that are overpriced (product and service portfolio aim), or
to identify and eliminate production or service processes which are ineffective, and allocate
processing concepts that lead to the very same product at a better yield (process re-
engineering aim)

Activity cost pool: An activity cost pool is an aggregate of all the costs associated with
performing a particular business task, such as making a particular product. By pooling all
costs incurred in a particular task, it is simpler to get an accurate estimate of the cost of that
task. One example of the use of activity costs is in manufacturing. A manager may be asked
to evaluate production costs of each product produced by a factory. Activity-based
costing (ABC) is a common method for determining those production costs. ABC defines
production as consisting of a variety of activities, and it assigns costs to those activities. For
example, machine set-up might be one activity associated with the production of a particular
product. The cost of set-up would be one cost included in an activity cost pool. Purchasing
materials might be another cost assigned to the pool. Assigning costs accurately is important
to determine the profitability of products and subsequently to make rational production
decisions.

Activity cost driver: A cost driver directly influences a business activity. There may be

multiple cost drivers associated with an activity. For example, direct labor hours are
a driver of most activities in product manufacturing. If the cost of labor is high, this will
increase the cost of producing all company products or services. If the cost of warehousing is
high, this will also increase the expenses incurred for product manufacturing or providing
services. More technical cost drivers are machine hours, the number of engineering change
orders, the number of customer contacts, the number of product returns, the machine setups
required for production, or the number of inspections. If a business owner can identify the
cost drivers, the business owner can more accurately estimate the true cost of production for
the business.

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Batch-level activities: Batch-level activities are work actions that are classified within
an activity-based costing accounting system, often used by production companies. Batch-
level activities are related to costs that are incurred whenever a batch of a certain product is
produced. However, these costs are accounted for regardless of the related production run’s
size. Examples of these batch-level cost drivers can often include machine setups,
maintenance, purchase orders, and quality tests.
By more accurately and reliably classifying overhead costs at the batch level than traditional
cost accounting systems, it is easier for manufacturers to determine the breakeven point of
cost and units produced, through cost-volume-profit analysis. This helps managers identify
non-value-adding activities and process inefficiencies, and increase profitability.

Example 1: Application of Activity-Based Costing

Alex Erwin started Interwood, a niche furniture brand, 10 years ago. He ran the business as a
sole proprietorship. While he has 50 skilled carpenters and 5 salespeople on his payroll, he
has been taking care of the accounting by himself. Now, he intends to offer 40% of the
ownership to public in next couple years and is willing to make changes and has hired you as
the management accountant to organize and improve the accounting systems.
Interwood's total budgeted manufacturing overheads cost for the current year is Tk.5404639
and budgeted total labor hours are 20000. Alex has been applying traditional costing method
during the whole 10 years period and based the pre-determined overhead rate on total labor
hours.
Interwood's sofa range includes the 2-set, 3-set and 6-set options. Platinum Interiors recently
placed an order for 150 units of the 6-set type. The order is expected to be delivered in one-
month time. Since it is a customized order, Platinum will be billed at cost plus 25%.
You are not a fan of traditional product costing systems. You believe that the benefits of
activity-based costing system exceed its costs, so you sat down with Aaron Mason, the chief
engineer, to identify the activities which the firm undertakes in its sofa division. Next, you
calculated the total cost that goes into each activity, identified the cost driver that is most
relevant to each activity and calculated the activity rate.
The results are summarized below:
C=A/B (in
Activity A (in Tk.) Relevant Cost Driver B
Tk.)
Production of
2313132 Machine hours 25000 93
components
Assembly of Number of labor
1231312 20000 62
components hours
Packaging 213123 Units 5000 43
Shipping 231230 Units 5000 46
Setup costs 34243 Number of setups 240 143
Designing 123132 Designer hours 1000 123
Product testing 24234 Testing hours 500 48
Rent 1234233 Labor cost Tk.1645644 75%

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Once the order was ready for packaging, Aaron gave you a summary of total cost incurred,
and a statement of activities performed (also called the bill of activities) as shown below:
Order No: 15X2020
Customer: Platinum Interiors
Units: 150
Type: 6 unit
Amounts in Tk.

Cost of direct materials 25000

Cost of purchased components 35000
Labor cost 15600

Activity Relevant Cost Driver Activity Usage

Production of components Machine hours 320
Assembly of components Number of labor hours 250
Packaging Units 150
Shipping Units 150
Setup costs Number of setups 15
Designing Designer hours 70
Product Testing Testing hours 22
Rent Labor cost 4500
Part A: Traditional Costing System
Calculate the total cost of the order and the invoice value of the order based on traditional
costing system.
Solution
In the traditional costing system, cost equals materials cost plus labor cost plus manufacturing
overhead costs charged at the pre-determined overhead rate.
The pre-determined manufacturing overhead rate based on direct labor hours
= Tk.5404639/20000 = Tk.270 per labor hour
The actual number of labor hours spent on the order is 250. Once we have this data, we can
estimate the manufacturing overheads and the total cost as follows:
Direct materials 25000
Purchased components 35000
Labor cost 15600
Manufacturing overheads (Tk.270 × 250) 67500
Total cost under traditional product costing system 143100
Interwood bills Platinum at cost plus 25%, so the amount of sales to be booked would amount
to Tk.178875 (= Tk.143100 × 1.25).

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 Part B: Calculating Total Cost under Activity-Based Costing
You know activity-based costing is a more refined approach. Now, since you have all the
data needed, calculate the order cost using activity-based costing.
Solution
In activity-based costing, direct materials cost, cost of purchased components and labor cost
remains the same as in traditional product costing. However, the value of manufacturing
overheads assigned is more accurately estimated. The following worksheet estimates the
manufacturing overhead costs that should be assigned to the order of Platinum Interiors:

(A) (B) (A × B)
Activity Activity Rate Activity Usage Activity Cost Assigned
Production of components 93 320 29,760
Assembly of components 62 250 15,500
Packaging 43 150 6,450
Shipping 46 150 6,900
Setup costs 143 15 2,145
Designing 123 70 8,610
Product testing 48 22 1,056
Rent 75% 15,600 11,700
82,121
Total cost of the order is hence (Tk.):

Direct materials 25000

Purchased components 35000
Labor cost 15600
Manufacturing overheads 82121
Total cost under activity-based costing 157721
Based on the more accurate estimation of the order cost, the invoice should be raised at
Tk.197150 (=Tk.157721 × 1.25) instead of Tk.178875 calculated under traditional product
costing system.
The example highlights the importance of correct estimation of the product cost and the
usefulness of activity-based costing in achieving that goal. It is because accurate allocation of
cost is critical for identification of profitable products and allocating resources.

Example 2:
In using activity-based costing, the company identified four activities that were important
cost drivers and a cost driver used to allocate overhead. These activities were (1) purchasing
materials, (2) setting up machines when a new product was started, (3) inspecting products,
and (4) operating machines.
Accountants estimated the overhead and the volume of events for each activity. For example,
management estimated the company would purchase 100,000 pieces of materials that would
require overhead costs of Tk.200000 for the year. These overhead costs included salaries of
people to purchase, inspect, and store materials. Setting up machines for a new product would

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need 400 setups and overhead of Tk.800000.  The company would have 4000 inspections and
overhead of Tk.400000.  Finally, running machines would cost Tk.600000 for 20000 machine
hours.
These estimates were made last year and will be used during all of the current year. In
practice, companies most frequently set rates for the entire year, although some set rates for
shorter periods, such as a quarter. Note that the total overhead for current year is Tk.2000000
using activity-based costing, just as it was using a traditional costing method. There are two
activities in the business such as Touring that requires 6000 pieces of materials, 10 setups,
200 inspection hours and 1500 machine hours; whereas Monitoring requires 4000 pieces of
materials, 30 setups, 200 inspection hours and 500 machine hours. Determine total cost for
both activities.
Solution:
The activity cost rates (predetermined overhead rates) are calculated as follows:
Activity Cost Driver (activity) Overhead Estimated Units Rate (Tk.)
Cost (Tk.)

Purchasing Pieces of materials 200000 100000 pieces 2

Materials

Machine setups Machine setups 800000 400 setups 2000

Inspections Inspection hours 400000 4000 inspection 100

hours

Running machine Machine hours 600000 20000 machine 30

hours

Total overhead 2000000

Total cost calculation:

Touring (Tk.) Monitoring (Tk.)

Purchasing materials (6000 piecesX2)12000 (4000 piecesX2) 8000

Machine setups (10 setupsX2000) 20000 (30 setupsX200) 60000

Inspections (200 hoursX100) 20000 (200 hoursX100) 20000

Running machine (1500 hoursX30) 45000 (500 hoursX30) 15000

Total 97000 103000

Problem 3: Given,
(%)
Activity cost pools
Customer Product Order Customer Other Total
orders design size relations
Production department:
Indirect factory wages 25 40 20 10 5 100

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Factory equipment depreciation 20 0 60 0 20 100
Factory utilities 0 10 50 0 40 100
Factory building lease 0 0 0 0 100 100
General administration department:
Administrative wages and salaries 15 5 10 30 40 100
Office equipment depreciation 30 0 0 25 45 100
Administrative building lease 0 0 0 0 100 100
Marketing department:
Marketing wages and salaries 22 8 0 60 10 100
Selling expenses 10 0 0 70 20 100

Amount in Tk.
Activity cost pools
Customer Product Order Customer Other Total
orders design size relations
Production department:
Indirect factory wages 125000 200000 100000 50000 25000 500000
Factory equipment depreciation 60000 0 180000 0 60000 300000
Factory utilities 0 12000 60000 0 48000 120000
Factory building lease 0 0 0 0 80000 80000
General administration department:
Administrative wages and salaries 60000 20000 40000 120000 160000 400000
Office equipment depreciation 15000 0 0 12500 22500 50000
Administrative building lease 0 0 0 0 60000 60000
Marketing department:
Marketing wages and salaries 55000 20000 0 150000 25000 250000
Selling expenses 5000 0 0 35000 10000 50000
Total 320000 252000 380000 367500 490500 1810000

A company has two products such as paper and pencils where for paper 30000 units were ordered
comprising 600 separate orders, required 150 product designs, 80 customer relations and 17500
machine hours to complete. For pencil, 400 orders were received, 250 product designs were
prepared, 170 customer relations and 2500 machine hours were used. Determine overhead rates
and calculate total overhead costs for above products.

Problem 4: Ferris corporation makes a single product – a fire resistant commercial filing
cabinet that it sells to office furniture distributors. The company has a simple ABC system
that it uses for internal decision making. The company has two overhead departments whose
costs are as follows:
Manufacturing overhead Tk.500000
Selling and administrative overhead Tk.300000
The company’s ABC system has the following activity cost pools and activity measures (cost
drivers):
Activity cost pool Activity measure
Assembling units Number of units
Processing orders Number of orders
Supporting customers Number of customers
Other Not applicable
Ferris corporation distributes the costs of manufacturing overhead and selling and
administrative overhead to the activity cost pools based on employee interviews, the results
of which are given below:

Assembly Processing Supporting Other Total

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 units orders customers
Manufacturing overhead (%) 50 35 5 10 100
Selling and administrative 10 45 25 20 100
overhead
Total activity 1000 250 orders 100 N/A N/A
units customers
a) Allocate overhead costs to the activity cost pools and determine activity rates
b) One of the customers Mr. X placed 4 orders for 80 filing cabinets during last period.
Calculate the total cost for Mr. X.
c) Selling of each filing cabinet is Tk.595, the cost of direct material is Tk.180, direct labor
cost is Tk.50. Determine the customer margin.

Problem 5: A company manufactures two products, L and M, using the same

equipment and similar processes. An extract of the production data for these
products in one period is shown below.
L M
Quantity produced (units) 5,000 7,000
Direct labor hours per unit 1 2
Machine hours per unit 3 1
Set-ups in the period 10 40
Orders handled in the period 15 60
Overhead costs Tk.
Relating to machine activity 220,000
Relating to production run set-ups 20,000
Relating to handling of orders 45,000
285,000

Calculate the production overheads to be absorbed by one unit of each of the

products by using activity based costing approach, using suitable cost drivers to
trace overheads to products.

Problem 6: Suppose that Cooplan manufactures four products, W, X, Y and Z. output and
cost data for the period just ended are as follows:
Products Output Number of Material cost Direct labor Machine
units production runs per unit (Tk.) hours per hours per unit
in the period unit
W 10 2 20 1 1
X 10 2 80 3 3
Y 100 5 20 1 1

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Z 100 5 80 3 3

Direct labor cost per hour is Tk.5

Overhead costs (Tk.):
Short-run variable costs 3080
Set-up costs 10920
Expediting and scheduling costs 9100
Materials handling costs 7700
Total overhead costs 30800
Determine unit cost for each product under ABC costing.