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ACTIVITY BASED COSTING

PROFITABILTY ANALYSIS
 INTRODUCTION
Activity-based costing (ABC) is a product costing system when a company
allocates factory overhead costs to activity pool centers (e.g. machine set ups, running
machines)
and then uses activity cost drivers to allocate factory overhead costs to individual products
or
services.

An activity cost driver is a quantity of activities needed to produce a product (e.g.

‘machine set ups’ activity center will have set-up hours as the activity cost driver).

The activity cost driver rate is calculated by dividing activity expenses by the total quantity
of
the activity cost driver (e.g. machine set up expenses divided by total number of machine set
up
hours).

An easy way to remember the relationship between products, activity cost drivers, and
resources, is to recall that products consume activities and activities consume resources.
Methods to collect, measure, and
allocate manufacturing costs

Before we can discuss the differences between activity-based and volume-based costing
systems, we should think of the following categories of product costing methods: cost
accumulation, cost measurement, and factory overhead assignment methods.

Cost accumulation methods represent methods used to accrue costs. There are two
types: job costing and process costing. These methods depend on the type of
production.

Job costing is a product costing system when costs are accumulated by specific job
orders (e.g. Job Order XX2, Job Order 02357) and assigned to batches of products. In
other words, manufacturing costs are assigned to specific jobs: specific customers,
specific orders, specific projects, specific contracts, etc. Job costing is often used in the
following: professional services (e.g. medical, legal), advertising agencies, construction,
shipbuilding, custom equipment/furniture manufacturing, etc.
Methods to collect, measure, and
allocate manufacturing costs continue...
Process costing is a product costing system when costs are accumulated by
departments or processes (e.g. Printing Department, Assembling Department) and
assigned to a large number of homogenous, identical products. Process costing is often used in
the following industries: textiles, food processing, automobile manufacturing, electronics,
drugs,
paper, paint, oil refining, chemicals, service companies offering homogenous services, etc.

Cost measurement methods represent methods used to measure and record the cost of direct
materials, direct labor, and factory overhead. There are three methods: actual costing, normal
costing, and standard costing.

1. Actual costing is a product costing system when a company measures actual costs of direct

materials, direct labor, and factory overhead. Actual costing system is rarely used because it
does not provide accurate information on a timely basis.
Methods to collect, measure,
and allocate manufacturing costs continue...
2. Normal costing is a product costing system when a company measures the actual
costs of direct materials and direct labor, but uses predetermined factory overhead
rates to measure the factory overhead cost for a period.

3. Standard costing is a product costing system when a company measures all costs –
direct materials, direct labor, and factory overhead – using standard quantities and
costs. It is often used to measure performance, determine target costs, and improve
production process.

Overhead assignment methods represent methods used to collect and allocate factory
overhead costs. These methods depend on a type of cost drivers that a company uses
to
allocate factory overhead costs to products or batches of products.
Volume-based (traditional) costing
versus activity-based costing (ABC)
Volume-based costing system can be also used by companies that manufacture
products or offer services that require a small amount of factory overhead costs
or use the same amount of activity. Overall, when factory overhead costs have a
high correlation with direct labor-costs, traditional costing system can be a
relatively appropriate system to use.

Even though traditional costing system can be used relatively effectively in some
cases, it has many limitations. Because volume-based costing uses an aggregate
rate rather than a specific one, it loses a lot of information and control over
product costs. A selected volume-based cost driver (e.g. direct labor-hours)
might have little to do with how factory overhead costs accumulate. This can
cause not only product price distortions, but it can also decrease the incentives
for department managers to control product costs.
Volume-based (traditional) costing versus
activity-based costing (ABC) continue......
Volume-based costing, also called traditional costing or conventional
costing, is a product costing system when a company allocates factory
overhead costs to a single cost pool (e.g. factory overhead) and then uses
volume-based cost drivers to allocate factory overhead costs to individual
products or services. Cost bases (or drivers) often used are: labor hours,
machine hours, labor costs, etc.

Many companies, especially small and medium-sized businesses, use the

traditional volume- based costing system to allocate factory overhead costs
to individual products or services. Volume-based costing system is simple
and easy to use and understand, and it does not cause much product cost
distortions if a company produces goods with very similar production
volumes and batch sizes, or in other words, the company uses simple
production. When using volume- based costing system, a company
determines factory overhead rates for the entire production (i.e. plant-wide
rate) or for each department separately (i.e. department-rate).
Volume-based (traditional) costing
versus activity-based costing (ABC) continue.....
On the other hand, an activity-based costing (ABC) system is a complex cost
system that provides detailed and accurate information about each
product’s cost and thus each product’s profitability. The ABC system is very
expensive and time-consuming system to implement due to the high cost of
collecting, measuring, and recording production information, especially for
companies that produce many different products that require hundreds of
various activities.

Both manufacturing and non-manufacturing (period) costs could be allocated

to products. Some manufacturing costs that are not related to product costs
can be excluded from product costs. There are multiple specific cost drivers
that are more accurate than a single plant-wide rate or multiple department
overhead rates, which are used in volume-based costing
The advantages of an activity-based
costing
An activity-based costing system has the following advantages:

Accurate product cost and product and customer profitability measurement: It can help to make
better-informed management decisions concerning product pricing, product volumes, market
segments, product lines, and target costing.

Better-informed strategic decisions: The information about cost drivers for each activity
enables management to make better-informed decisions concerning product design, customer
support, etc.

Production improvement: An ABC system provides information helpful in improving production

processes.

Better product cost information: An ABC system provides a lot of information necessary for
strategic ]
budgeting, planning, and product pricing decisions.
The disadvantages of an activity-based costing

Though an ABC system has many benefits and advantages, it fails to

properly include all product-related costs and fails to allocate the cost
activities with ambiguous cost drivers. Many general costs, such as
marketing, research and development, and engineering, are not
included into an ABC system since they are classified as period costs
(i.e. not product costs) according to GAAP (generally accepted
accounting principles). For some activities, also, it is either
impossible or unreasonable to try to identify a cost driver, and it is
often better to use a volume- based cost system in that case. For
example, it is better to allocate factory property taxes (i.e. factory
overhead) using a volume-based cost driver (e.g. square-footage).
The same will be true for a factory’s manager salary, factory
insurance, etc
Development of an activity-based
system
There four steps are involved to develop an ABC system. They are:

1. Identifying activities

2. Assigning costs to activity cost centres

3. Selecting appropriate cost drivers for assigning the cost of activities to

the cost
objects

4. Assigning the costs of activities to cost objects (i.e. products, batches

of products)
Step 1: Identifying activities
At first, a company developing an ABC system has to identify the resources consumed by the
company and their cost. Note that a resource is an economic goods consumed in performing
activities. For example, manufacturing equipment, supplies, utilities, wages, office expenses,
furniture, etc.

In addition to identifying available resources, the company has to determine the activities that
consume the company’s resources, or in other words, resource-consumption cost drivers.

Activity levels of resource consumption:

A unit-level activity is an activity performed on each individual product or service. At this level,
the cost drivers will be volume-based since the amount of activity will proportionally depend on
the number of units produced. Example of unit-level machine related activities, the cost driver
of
machine related activities is machine hour and the traceable cost is depreciation of machinery.
Step 1: Identifying activities
continue....
A facility-level activity (also called, a business/organization sustaining activity)
is an activity
that supports business operations in general and cannot be traced to individual
units, batches, or products. Example of facility-level activity is factory
personnel training, the cost driver is hours of training time and traceable cost
is employee training costs.

Note, that the activities can be traced in the ascending order and not vice
versa. For example, a unit-level activity can be traced to a batch-level activity,
and a batch-level activity can be traced to a product level activity, but not vice
versa. In addition, within each group of activities, the activity cost centers that
use the same cost driver are combined into homogeneous cost pools (e.g.
Customer Orders, Customer relations).
Step 1: Identifying activities
continue.....
A batch-level activity is an activity performed on each batch of products or
services regardless of how many units are in the batch. Example of batch-
level activity is placing purchase orders, cost driver is the number of orders
processed and the traceable cost is the ordering costs.

A product-level activity (also called, a product- or service-sustaining activity)

is an activity performed to support production of a specific product or service
regardless of how many batches are run or how many items are produced.
Example of product-level activity is testing products, the cost driver is the
number of tests and the traceable cost is testing facility costs.

A customer-level activity is an activity that relates to specific customers, not

specific products. Examples of customer-level activities are: sales calls and
sales visits, the cost driver is the number of sales calls and sales visits; and
the traceable costs are sales calls and sales visits costs.
Step 2: Assigning costs to activity cost centres

 Then, once the company has identified its available resources and
resource-consuming activities, it will assign the cost of resources to the
activities that consume those resources. The cost of resources consumed
by an activity can be determined through direct tracing or estimation.
Step 3: Selecting appropriate cost drivers for
assigning the cost of activities to the cost objects
Resource-consumption cost drivers can be divided into three categories: Transaction
drivers, Duration drivers and Intensity drivers.

Transaction drivers count the number of times an activity occurs (e.g. number of orders
processed, number of orders shipped, number of items inspected).

Duration drivers measure the time required to perform an activity. For example, duration
drivers measure the amount of time required to inspect items, to process bills, to process
orders, etc.

Intensity drivers charge the resources used each time an activity is performed.

Besides collecting data regarding activities, the company ranks activities according to
their level of resource consumption.
Step 4: Assigning the costs of activities to cost objects
(i.e. products, batches of products

Finally, the company will assign cost of activities to cost objects

based on activity consumption cost drivers. Examples of cost objects
are: individual products or services, job orders, projects, customers,
business units, etc. Activity-consumption drivers measure amount of
activity consumed by a cost object.
Benefits of activity-based costing
Companies likely to benefit from ABC are those with:

1. Relatively high factory overhead costs

2. Complex operations (i.e. products or services with various production

volumes
and requiring many diverse activities)

3. Operations that undergone significant technological changes

Benefits of activity-based costing continue...
Even though both manufacturing and service companies can benefit from
an ABC system, service businesses might have more difficulties
implementing an ABC system. First of all, service companies tend to have a
lot of facility-level activities and costs that are difficult to allocate to
specific service units. In addition, service companies’ employees often
engage in
many non-uniformal activities for which it might be challenging to collect
cost data. Nonetheless, activity-based costing has been implemented by
various banks, health care providers, and insurance companies

ABC can be used not only to improve product pricing, but also to improve
the value of products or services to customers, which could help to increase
the firm’s profitability. After developing an ABC system, a firm’s
management can utilize such tools as activity-based management (ABM)
and customer profitability analysis discussed in other accounting tutorials.