Activity Based Costing System

Learning objectives
• Concepts and process of Activity Based Costing(ABC)
• Understanding the difference in traditional costing and ABC
• Computation of cost of product using traditional costing and ABC and
their comparison
• Advantages and disadvantages of ABC
Learning Outcomes
By the end of the session the students will be able to understand
• Activity-based costing – Technique ,Designing and mechanics
• ABC versus traditional costing
• ABC as tool in costing to price product and determine customer
margins.
• Advantages and disadvantages of ABC
Traditional Costing Systems
Appear on the income
• Product Costs statement when
goods are sold, prior
• Direct labor to that time they are
• Direct materials stored on the balance
• Factory Overhead sheet as inventory.

• Period Costs Appear on the income

statement in the
• Administrative expense period incurred.
• Sales & Distribution expense
Traditional Costing Systems
Direct labor and direct
• Product Costs materials are easy to
trace to products.
• Direct labor
• Direct materials The problem comes
• Factory Overhead with factory
overhead.
• Period Costs
• Administrative expense
• Sales expense
Traditional Costing Systems
• Typically used one rate to allocate overhead to products.
• This rate was often based on direct labor costs or direct labor hours.
• This made sense, as direct labor was a major cost driver in early
manufacturing plants.
Problems with Traditional
Costing Systems
• Manufacturing processes and the products
they produce are now more complex.
• This results in over-costing or under-costing.
­ Complex products are not allocated an adequate
amount of overhead costs.
­ Simple products get too much.
Today’s Manufacturing Plants
• Are more complex
• Are often automated
• Often make more than one product
• Use proportionately smaller amount of direct labor making direct
labor a poor allocation base for factory overhead.
 When the manufacturing process is more
complex:

• Then multiple allocation bases should be used to allocate overhead

expense.
• In such situations, managers need to consider using activity based
costing (ABC).
Activity Based Costing: Concept
It is not the departments
that cause costs, it is the
activities! So it will be a good
idea to determine the cost of
activities rather than
departments!!
Activity Based Costing: Concept
• In the industrial age, when labor was the dominant factor of production, overhead cost
were first allocated from service departments to production departments and then
distributed, using an “overhead charging rate,” to specific products.
• In the service economy (as well as in modern, computer-driven manufacturing facilities),
direct manufacturing labor is no longer the overriding factor of production.
• Cooper and Kaplan (1988) described ABC as an approach to solve the problems of
traditional cost management systems.
R. Cooper and R. S. Kaplan, “How Cost Accounting Distorts Product Costs,” Management Accounting, Vol.
69, No. 10, 1988, pp. 20-27.
A. Moisello, "ABC: Evolution, Problems of Implementation and Organizational Variables," American Journal
of Industrial and Business Management, Vol. 2 No. 2, 2012, pp. 55-63. doi: 10.4236/ajibm.2012.22008.
Activity Based Costing: Concept
The emergence of ABC systems
• Traditional systems were appropriate when:
1. Direct costs were the dominant costs

2. Indirect costs were relatively small

3. Information costs were high

4. There was a lack of intense global competition

5. A limited range of products was produced.

ABC Concepts
• Activity based costing is an approach for allocating overhead costs.
• An activity is an event that incurs costs.
• A cost driver is any factor or activity that has a direct cause and effect
relationship with the resources consumed.
ABC Steps:Process
• Overhead cost drivers are determined.
• Activity cost pools are created.
• A activity cost pool is a pool of individual costs that all have the same cost driver.
• All overhead costs are then allocated to one of the activity cost pools.
• An overhead rate is then calculated for each cost pool using the following
formula:
• Costs in activity cost pool/base
• The base is, of course, the cost driver
• Overhead costs are then allocated to each product according to how
much of each base the product uses.
Comparison of Traditional and ABC systems

Both systems use the two-stage allocation process.

• In the first stage traditional systems tend to allocate costs to departments whereas ABC systems
allocate costs to activities: (ABC systems tend to have more cost centres/cost pools)

• In the second stage traditional systems rely on a small number of volume-based cost drivers
(typically direct labour or machine hours) whereas ABC systems use many second stage cost drivers.

• ABC systems seek to use only cause-and-effect cost drivers whereas traditional systems often rely
on arbitrary allocation bases.

• ABC systems tend to establish separate cost driver rates for support departments whereas
traditional systems merge support and production centre costs.
Let’s work an example . . .
• Assume that a company makes widgets
• Management decides to install an ABC system
Overhead Cost Drivers are Determined
• Management decides that all overhead costs only have three cost
drivers—sometimes called activities (obviously a simplification of the
real world)
• Direct labor hours
• Machine hours
• Number of purchase orders
All overhead costs are then allocated to one of the
activity cost pools.
Direct Labor
General Ledger
Payroll taxes $1,000
Machine maintenance $500
Purchasing Dept. labor $4,000
Fringe benefits $2,000 Machine Hours
Purchasing Dept. Supplies $250
Equipment depreciation $750
Electricity $1,250
Unemployment insurance $1,500
# of Purchase Orders

Which overhead costs do you

think are driven by direct labor
hours?
All overhead costs are then allocated to one of the
activity cost pools.
Direct Labor
General Ledger
Payroll taxes $1,000 $1,000
2,000
Machine maintenance $500
1,500
Purchasing Dept. labor $4,000 $4,500
Fringe benefits $2,000 Machine Hours
Purchasing Dept. Supplies $250
Equipment depreciation $750
Electricity $1,250
Unemployment insurance $1,500
# of Purchase Orders

Overhead driver by direct labor

hours
All overhead costs are then allocated to one of the
activity cost pools.
Direct Labor
General Ledger
Payroll taxes $1,000 $1,000
2,000
Machine maintenance $500
1,500
Purchasing Dept. labor $4,000 $4,500
Fringe benefits $2,000 Machine Hours
Purchasing Dept. Supplies $250
$ 500
Equipment depreciation $750 750
Electricity $1,250 1,250
$2,500
Unemployment insurance $1,500
# of Purchase Orders

Which overhead costs are

driven by machine hours?
All overhead costs are then allocated to one of the
activity cost pools.
Direct Labor
General Ledger
Payroll taxes $1,000 $1,000
2,000
Machine maintenance $500
1,500
Purchasing Dept. labor $4,000 $4,500
Fringe benefits $2,000 Machine Hours
Purchasing Dept. Supplies $250
$ 500
Equipment depreciation $750 750
Electricity $1,250 1,250
$2,500
Unemployment insurance $1,500
# of Purchase Orders

And finally, which overhead $4,000

costs are driven by # of 250
$4,250
purchase orders?
An overhead rate is then calculated for each cost pool:

Direct Labor
Again the formulas is:
$1,000
Costs in Activity Cost Pool/Base = rate 2,000
1,500
Assume the following bases: $4,500
Machine Hours
Direct labor hours = 1,000
Machine hours = 250
$ 500
Purchase orders = 100 750
1,250
$2,500

The ABC rates are: # of Purchase Orders

$4,500/1,000 = $4.50 per direct labor hour
$4,000
$2,500/250 = $10 per machine hour
250
$4,250/100 = $42.50 per purchase order $4,250
Overhead costs are then allocated to each product according to how much of each base the
product uses.

The ABC rates are:

$4,500/1,000 = $4.50 per direct labor hour

$2,500/250 = $10 per machine hour
$4,250/100 = $42.50 per purchase order

Lets assume the company makes two products, Widget A and Widget B:

Let’s also assume that each product uses the following quantity
of overhead cost drivers:

Base  Widget A Widget B Total

Notice that
Direct labor hours 400 600 1,000
all base units
Machine hours 100 150 250 are
Purchase orders 50 50 100 accounted
for.
Now let’s allocate overhead to Widget A:
Base A Rate Allocated

Direct labor hours 400 $ 4.50 $ 1,800.00

Just like we learned in Accounting, we multiply

the base used by the rate.
In this case, 400 hours used to make Widget A is
multiplied by the rate of $4.50. This gives total overhead
applied for this activity cost pool of $1,800 to
Widget A.
Continuing the calculation:
Let’s do the same thing for the other two rates, to get the total amount
of overhead applied to Widget A:

Widget A Base Rate Allocated

Direct labor hours 400 $ 4.50 $ 1,800.00
Machine hours 100 $ 10.00 $ 1,000.00
Purchase orders 50 $ 42.50 $ 2,125.00
Total     $ 4,925.00
Now let’s allocate overhead to Widget B:

Let’s do the same thing for the other two rates, to get the total amount
of overhead applied.

Widget B Base Rate Allocated

Direct labor hours 600 $ 4.50 $ 2,700.00
Machine hours 150 $ 10.00 $ 1,500.00
Purchase orders 50 $ 42.50 $ 2,125.00
Total     $ 6,325.00

The original overhead to be applied was $4,500 of direct labor

driven overhead + $2,500 of machine hour driven overhead + $4,250 of
purchase order driven overhead = $11,250 total overhead to apply.

The actual overhead allocated was $4,925 for Widget A + $6,350 =

$11,250 overhead applied.
Same Problems Traditional Method
• Okay, so what if we had allocated the overhead in this company using
traditional cost accounting allocation.
• Let’s assume the base is direct labor hours.
• What would be the amount allocated to each product?
Calculation
General Ledger

Payroll taxes $1,000 This the total

Machine maintenance $500 overhead we were
given, the total
Purchasing Dept. labor $4,000 amount is $11,250
Fringe benefits $2,000 as explained on
the previous slide.
Purchasing Dept. Supplies $250
Equipment depreciation $750 Total direct labor
Electricity $1,250 hours are 1,000, also
given earlier.
Unemployment insurance $1,500

Base  Widget A Widget B Total

Direct labor hours 400 600 1,000
Machine hours 100 150 250
Purchase orders 40 60 100
Calculation
• The rate would be:
• OH Rate = Overhead/Direct Labor Hours
• $11,250/1,000 = $11.25 per hour.
• Applying overhead using this rate:
• Widget A: 400 hours x $11.25 = $4,500
• Widget B: 600 hours x $11.25 = $6,750
• Total overhead applied = $11,250
Comparison
Widget A Widget B Total
Traditional Method $4,500 $6,750 $11,250
Activity Based $4,925 $6,325 $11,250
Costing
Difference -$425 $425 -0-

Which is more accurate?

ABC Costing!
Note these are total costs. To get per-unit costs we would divide by the
number of units produced.
When do we use ABC costing?
• When one or more of the following conditions are present:
• Product lines differ in volume and manufacturing complexity.
• Product lines are numerous and diverse, and they require different
degrees of support services.
• Overhead costs constitute a significant portion of total costs.
When do we use ABC costing?
• The manufacturing process or number of products has changed
significantly—for example, from labor intensive to capital intensive
automation.
• Production or marketing managers are ignoring data provided by the
existing system and are instead using “bootleg” costing data or other
alternative data when pricing or making other product decisions.