BB211 Managerial Accounting

Activity-Based Costing (ABC Costing)

 Activity-based costing system is a method of assigning overhead costs to products, which
focuses on the major activities performed in the production process.
 Activity-based costing is a costing method that identifies activities in an organization and
assigns the costs of each activity to all products and services according to the actual
consumption by each.
 Traditionally, in a job order cost system and process cost system, overhead is allocated to a
job or function based on direct labor hours, machine hours, or direct labor dollars.
However, in some companies, new technologies have changed the manufacturing environment
such that the number of hours worked or dollars earned by employees are no longer good
indicators of how much overhead will be needed to complete a job or process through a
particular department.
In such companies, activity‐based costing (ABC) is used to allocate overhead costs to jobs or
functions.
Activity-based costing is a more refined approach to costing products and services than the
traditional cost allocation methods.
Important Terms in Activity-Based Costing:
Cost Object: It is an item for which cost is calculated using the Activity-based costing System.
For Example, a service, a customer or a product.
Cost Driver: It is any factor or force that causes a change in the cost of an activity.
The following are some of the activities with their respective cost drivers for various company
purposes
Activity Cost drivers
1) Production  Number of units
 Number of set ups
2) Marketing  Number of sales personnel
 Number of sales orders
3) Research & development  Number of research projects
 Personnel hours spent on the project
 Technical complexities of the project
4) Customer service  Number of service calls
 Number of products serviced
 Hours spent on servicing the products
5) Purchasing  Number of purchases
6) Receiving department  Number of purchases
7) Material handling  Number of requisitions
8) Set up  Number of machine set ups
9) Inspection  Number of inspections
10) Supervisor  Number of direct labour hours

ABC costing involves the following steps:

1) Identify the activities that consume resources.
2) Assign costs to activities.
3) Identify the cost driver associated with each activity
4) Compute the cost rate per cost driver unit.
5) Assign costs to products by multiplying the cost driver rate by the volume of cost drivers
consumed by the product.
When using ABC, the total cost of each activity pool is divided by the total number of units of
the activity to determine the cost per unit.

Example # 1
BAC ltd is considering shifting from the traditional costing method to ABC costing method, and
it has got the following details.
Activity Budgeted cost ($) Cost driver Activity level
Machine set-up 200,000 No. of machine setups 340
Inspection 140,000 Inspection hours 7,500
Required; Using ABC costing formula, find out the new overhead rates for the company.
We are given two activities. The first one is a machine set-up activity, and the second one is
inspecting the same.
Total cost pool
Using the ABC formula: =
Cost driver

Calculation of Machine set-up;

Machine set up
= No . of machine set ups
200,000
= 340
= $588.24 per machine set up
 Calculate the Inspection Cost;
Inspection cost
= Inspection hours

140,000
= 7,500

= $18.67 per inspection hour

Example # 2
The following details pertain to different activities and their costs for Gamma Ltd. You are
required to calculate the overhead rate for each activity.
Below is given data for calculation.
Activity cost pool Estimated OHs Cost driver Expected activity
Standard Specialty Total
Purchasing $120,000 No. of purchase orders 82 118 200
Production steps $202,500 No. of setups 50 200 250
Inspection $160,000 Inspection hours 300 500 800
Assembling $80,000 Assembly hours 800 800 1,600
Machine maintenance $300,000 Machine hours 5000 5000 10,000
Required; calculate overhead rate for each cost pool
Note;
Total cost pool
Using the ABC formula:
Cost driver
Each activity pool’s total cost is divided by its cost driver to arrive at different rates.
Solution
Gamma Ltd, Activity pool Overhead Rates
Activity cost pool EstimatedOHs Cost driver
(A) Expected Activity
Standard Specialty Total ( A)
(B) C=
(B)
Purchasing $120,000 No. of purchase 82 118 200 $600
orders
Production steps $202,500 No. of setups 50 200 250 $810
Inspection $160,000 Inspection hours 300 500 800 $200
Assembling $80,000 Assembly hours 800 800 1,600 $50
Machine $300,000 Machine hours 5,000 5,000 10,000 $30
maintenance
Total Estimated
Overhead $862,500

Example # 3
Yazz, Inc. produces 130,000 units of Product A and 400,000 units for Product B. Using the
following cost information, how much overhead should be allocated to Product A?
Activity Cost-Driver Base Cost-Driver Rate Resources Used by Product A

Factory Floor Space Square Footage $50 20,000 Sq. Ft.

Electricity Kilowatts $0.050 15,000 KW
Water Gallons $0.160 80,000 Gal.
Quality Control Units Inspected $0.850 135,000 Units
Packaging - Inner Ounces of popcorn $0.025 270,000 Oz.
Packaging - Outer Boxes $1.250 135,000 Boxes

Solution

Yazz Inc. Product A, OH Allocation sheet

Activity Cost-Driver Base Cost-Driver Rate Resources Used by Cost Assigned

Product A
Factory Floor Space Square Footage $50 20,000 Sq. Ft $1,000,000

Electricity Kilowatts $0.050 15,000 KW $750

Water Gallons $0.160 80,000 Gal. $12,800
Quality Control Units Inspected $0.850 135,000 Units $114,750

Packaging - Inner Ounces of popcorn $0.025 270,000 Oz. $6,750

Packaging-Outer Boxes $1.250 135,000 Boxes $168,750

Total Cost Assigned to Product A $1,303,800

Example # 4
Mamata Inc. a manufacturing company of drugs, is considering switching from their traditional
method of cost to a newly implemented system, activity-based costing so that the two products Z
serum and W serum can be sold at their proper cost and make them price competitive in the
market.
Below are the production details that have been derived from the production sheet.
Activity cost pool Estimated OHs Cost Driver Expected Activity
Z- serum W- serum Total
Purchasing $60,000 No. of purchases 410 590 1000
Material Handling $75,000 No. of purchase receipts 580 920 1500
Production steps $1,01,250 No. setups 250 1000 1250
 Inspection $80,000 Inspection hours 1500 2500 4000
Assembling $40,000 Assembly hours 4000 4000 8000
Machine maintenance $150,000 Machine hours 20000 20000 40000
Required; arrive at product-based total cost using ABC formula.
We are given six activities; hence, we need to allocate those costs based upon their cost drivers.
Using the ABC formula: Cost Pool total / Cost driver
Each activity pool’s total cost is divided by its cost driver to arrive at different rates.
Solution

Mamata Inc., Activity Overhead Rates

Activity cost pool Estimated Cost Driver Expected Activity
OHs (A)
Z serum W serum Total C=(A)/(B)
(B)
Purchasing $60,000 No. of purchases 410 590 1000 60
Material Handling 75,000 No. of purchase 580 920 1500 50
receipts
Production steps 1,01,250 No. setups 250 1000 1250 81
Inspection 80,000 Inspection hours 1500 2500 4000 20
Assembling 40,000 Assembly hours 4000 4000 8000 5
Machine maintenance $150,000 Machine hours 20000 20000 40000 3.75
Total estimated OHs
$506,250
And the total estimated overhead is $506,250
After arriving at different rates, we now have to arrive at product level total cost, which would be
nothing but multiplying different overhead rates as arrived above with their actual cost drivers.
Mamata Inc., product level total cost under ABC
Z serum W serum OH rate Z serum W serum Total
(a) (b) (c) (a)*(c) (b)*(c) (a)*(b)+(b)*(c)
Purchasing 410 590 $60 $24,600 $35,400 $60,000
Material Handling 580 920 $50 29,000 46,000 75,000
Production steps 250 1000 $81 20,250 81,000 101,250

Inspection 1500 2500 $20 30,000 50,000 80,000

Assembling 4000 4000 $5 20,000 20,000 40,000
Machine maintenance 20000 20000 $3.75 75,000 75,000 150,000
Total $198,850 $307,400 $506,250
Problem questions;
Q.1
Suppose the managers at Sail-Rite Company decide that the benefits of implementing an
activity-based costing system would exceed the cost of traditional allocation system, and thus the
company should use activity-based costing to allocate overhead. 
It has been estimated that total overhead costs are $8,000,000. However, the total is broken out
into different activities rather than departments, you are further told that Sail-Rite wants to
produces two products i.e. Basic and Deluxe sail-boats, the following are the estimates.
Activity Estimated
Cost Driver Activity level
Overhead Cost
Basic Deluxe Total
Purchasing materials $1,200,000 Purchase
7,000 3,000 10,000
requisitions
Setting up machines $1,600,000 Machine
1,100 900 2,000
setups
Running machines $2,700,000 Machine
50,000 40,000 90,000
hours
Assembling $1,500,000 Direct labor
200,000 50,000 250,000
products* hours
Inspecting finished $1,000,000 Inspection
12,000 8,000 20,000
products hours
Total $8,000,000
Required
a) Calculate the pre-determined overhead rates for each activity
b) Calculate product total cost for basic and deluxe sail boats.
Solution
a) Predetermined Overhead Rate
Estimated Activity level POR
Overhead Cost A
Activity Cost Driver
B
(A) (B)
Purchase $1,200,000 $ 120
Purchasing materials 10,000
requisitions
Setting up machines Machine setups 1,600,000 2,000 $800
Running machines Machine hours 2,700,000 90,000 $30
 Direct labor 1,500,000 $6
Assembling products 250,000
hours
Inspecting finished 1,000,000 $50
Inspection hours 20,000
products
$8,000,000

b) Product level total cost

Basic Deluxe OH rate Basic Deluxe Total
(A) (B) (C) (A)*(C) (B)*(C) (A)*(B)+(B)*(C)
Purchasing $ 120 $840,000 $360,000 $1,200,000
7,000 3,000
materials
Setting up $800 $880,000 $720,000 $1,600,000
1,100 900
machines
Running $30 $1500,000 $1200,000 $2,700,000
50,000 40,000
machines
Assembling $6 $1200,000 $300,000 $1,500,000
200,000 50,000
products
Inspecting $50 $600,000 $400,000 $1,000,000
12,000 8,000
finished products
Total $5,020,000 $2,980,000 $8,000,000

Q.2
Business Case:
The following business case is designed to help students apply their knowledge of Activity-
Based Costing in a real-life business context.
Context:
You are the new chief accountant Furny Plus, a furniture manufacturer located in Chicago. On
your first day, you are greeted by the Chief Financial Officer.
"We are really happy to have you on board. We heard great things about your managerial
accounting skills. The most urgent task is to dive into our costing system. We have two main
divisions, Tables and Sofas. Both involve the production of custom-made orders for customers.
The table division only started operating a few months ago, so we never had to think of
allocating costs in the past. However, now that we have two divisions, I want to make sure we
have a fair costing system for both divisions. I heard that you're a pro at implementing Activity-
Based Costing. Can you help me out? Here's some data for you."
Although you were expecting a lighter first day on the job, you gather the data and head back to
your desk.
Table 1: Costs incurred

Amount budgeted
Cost Division
($)
Wood to produce tables Tables 540,000
Leather to produce sofas Sofas 850,000
Direct Labor Tables 50,000
Direct Labor Sofas 200,000
Factory utilities Both 200,000
Property taxes for factory Both 50,000
Note: The direct labor is split because each division has its own team (i.e., one division's labor
does not work for the other).

Table 2: Other information

Data Sofa Table Total

Direct labor hours budgeted 20,000 5,000 25,000
Square feet used in factory 6,000 4,000 10,000
Required:
a) Determine which of the costs provided are indirect and thus can benefit from Activity-Based
Costing.
b) Determine the appropriate cost drivers for the cost pools identified in #1.
c) Calculate the cost activity rates for each pool identified in #1 using the cost drivers in #2.
Solution:
a) The answer is Factory Utilities and property taxes for the factory since they cannot be traced
to a single division.
b) Factory utilities: Although students can argue that square footage is a good cost driver, the
rationale for selecting direct labor hours as a cost driver is that the factory utilities (e.g.,
lighting, electricity, etc.) will increase in cost based on the amount of hours worked.
Therefore, the answer is Direct Labor Hours.
Property taxes: The square footage occupied by each division should be used.
c) See below.

Cost pool Total driver

Cost pool Amount Cost Driver base Cost rate (A / B)
(A) (B)
$8 per direct labor
Factory utilities 200,000 Direct labor hours 25,000
hour
Property taxes for Square feet used in
50,000 10,000 $5 per square foot
factory factory

ADVANTAGES OF ABC COSTING

1. Product cost determination under activity-based costing is more accurate and reliable because
it focuses on the cause and effect linkage of costs and activities in the context of producing
goods.
2. Fixation of selling price for multi-products under activity-based costing is fair and correct
because overheads are allocated on the basis of relevant cost drivers.
3. Control of overheads consisting of fixed and variable becomes possible by controlling and
monitoring activities. Linkage between cost and activities are clearly identified in activity-
based costing and thus provides opportunities to control overhead costs.
4. Sufficient information can be obtained to make decisions about the profitability of different
product lines.
5. Fair allocation of overheads occupies a considerable portion in the total cost components.
6. Improves Business Processes. An ABC system allocates indirect costs based on a product’s
cost driver, or the factor that creates the cost. As costs are allocated per product, a picture
starts to emerge of which business processes are performing well and which ones need to be
 improved. ABC can be used to identify non-valued added activities and can help to better
allocate resources to efficient and profitable activities. The use of ABC can also add value to
the continuous improvement of business processes.
7. Identifies Wasteful Products. The ABC method accounts for costs similar to the way
production work is performed, allowing your business to better understand where overhead
costs are going. The data can identify wasteful products and unnecessary costs, so that
resources can be used productively
8. . Overall product and service quality can improve as ABC’s data details production and cost
issues that need to be resolved.

LIMITATIONS OF ABC COSTING

1. Difficult to identify the overall activities that influence costs.
2. Not easy to select the most suitable cost driver.
3. Difficult to evaluate cost on the basis of activities.
4. Not suitable for small manufacturing concerns.
5. Expensive Implementation. Setting up an ABC system can be expensive and time-
consuming. As business activities are analyzed, they must be broken down into each
activity’s individual components. The entire process can use up valuable resources as data
are collected, measured and entered into the new system. Businesses may also need the
assistance of a consultant who specializes in the setup of an ABC system and can provide
training on its use. Using software can add an additional expense to the implementation but it
can be used to automate many of the manual aspects involved in using ABC.
6. Misinterpretation of Data. Reports produced by an ABC system contain information, such
as product margins, that vary from the information reported for a traditional cost method. It’s
also possible that some activity-based costs may be irrelevant in certain decision-making
scenarios; for example, ABC does not conform to accounting standards and should not be
used for external reporting. Since traditional cost figures tend to be the norm, interpreting
ABC data along with regular accounting information can be confusing and lead to bad
decision-making. The use of software can streamline the process of maintaining an ABC
system and simplify its integration with regular cost accounting information.
7. ABC can be more complex to explain to the stakeholders of the costing exercise.

End