Activity Based Costing

Cost Allocation

Cost common to more than one department are to be allocated

among the production departments receiving benefits, and
service department costs are to be distributed
among producing departments.

The cost allocation process is comprised of three basic activities.

1) Accumulating the costs on the basis of department or division or
product.
2) Identifying the cost objects or recipients of the allocated costs, say, a
unit of product or a department.
3) Selecting a method for relating the costs so accumulated to the cost
objects.
 Labour-related Factory Overheads
(Say supervisor’s salaries, canteen expenses) are usually allocated on the
basis of number of employees, direct labour-hours, wages paid or similar
other labour related criteria.

Machine-related Factory Overheads

(Say insurance, maintenance, depreciation) are normally allocated on the
basis of machine-hours, current book value of machinery, number of
machines, or similar other machine-related criteria.

Space-related Factory Overheads

(Say factory building rent and insurance, lighting, maintenance of building)
are usually allocated on the basis of space occupied or similar other space-
related criteria.

Service-related Costs
(Say materials handling, utility) are normally allocated on the basis of value,
quantity, time and similar other service related criteria.
In the past, overhead costs were relatively small, and
the problems arising from inappropriate overhead
allocations were not so significant
But nowadays, factories are highly automated,
resulting in increasing depreciation charges,
maintenance cost and machinery set-up cost
Errors in overhead absorption may seriously affect
the management decisions
• The Activity-based costing (ABC) system is developed to provide
better approach for assigning overheads to products and computing
product costs
Limitation of traditional costing

• Traditional systems adopt volume-related allocation bases e.g. direct

labour hour and machine hour. However, different resources are used
in non-volume related support activities e.g. materials ordering,
machinery set-up, production scheduling and first-item inspection
• Traditional systems allocate overheads to products in proportion to
their production volumes. High overheads are allocated to the high-
volume products. As a result, the high-volume simple products may
be over-costed while the low-volume complex products may be
under-costed
Introduction to Activity-based costing

• The activity-based costing system asserts that products create

demand for activities and activities bring about the costs to be
incurred
 What steps?

1. Identity major activities performed by the business

2. Calculate the total cost of each activity over the period (i.e. cost
centre or cost pool)
3. Determine the cost driver for each activity. Cost drivers are the
factors which cause the activity cost pool to increase
4. Calculate the cost driver rate (i.e. total cost in a cost pool/ no. of cost
driver)
5. Assign the cost-centre overheads to the products according to their
cost driver rates
Example
Martin Ltd. Manufactures tow products. Product A is a high-
Volume product while Product B is a low-volume product.
Details of production are shown as follows:
Product A Product B
Materials cost per unit $130 $130
Direct Labour cost per hour $50 $50
Direct machine hour per unit 4 hrs 4 hrs
Direct labour hour per unit 2 hrs 2 hrs
Output 10 100
No. of purchase orders 3 4
No. of set up 40 80

Total Overhead costs are $ 13500

Company has policy use machine hrs. for allocation of overheads

(a) Absorption costing based on
machine hour
Product A Product B
$ $
Direct Materials 130 130
Direct labour 100 100
Overheads
($13500*4/440) 123 123
Product cost per unit 353 353

4*10+100*4
Martin Ltd. Manufactures tow products. Product A is a high-
Volume product while Product B is a low-volume product.
Details of production are shown as follows:
Product A Product B
Materials cost per unit $130 $130
Direct Labour cost per hour $50 $50
Direct machine hour per unit 4 hrs 4 hrs
Direct labour hour per unit 2 hrs 2 hrs
Output 10 100
No. of purchase orders 3 4
No. of set up 40 80

Overhead costs are shown as follows: $

Factory power 6600
Machinery set-up costs 4800
Materials handling and dispatch 2100
13500
Required
Calculate the product costs using - Activity-based costing
(b) Activity based Costing
Product A Product B
$ $
Direct Materials 130 130
Direct labour 100 100
Overheads
Factory power
(6600*4/440) 60 60
Machinery set-up cost
(4800*40/120*1/10) 160
(4800*80/120*1/100) 32
Materials handling & dispatch
(2100*3/7*1/10) 90
(2100*4/7*1/100) 12
Product cost per unit 540 334
 Traditional Activity based
Objective Ensure all Focus on the
overheads are activities incurred
absorbed into the Assign to each
total production cost product only those
The product cost costs that would be
enable the avoided if the
production cost and production was
stock valuation discontinued
Allocation  the basis volume- The basis of non-
of related criteria e.g. volume-related
overhead machine hours and activities e.g. the no.
direct labour hours of purchase order,
production runs and
deliveries
 Traditional Activity based
Assignment Overheads cost Overheads are
of overhead are assigned to assigned to the cost
each department centre for each
activities
Adoption of  a single Numerous cost
overhead absorption rates is drivers are used for
rate used different activities
Cost driver analysis

• Traditional costing systems assume that all overheads

increase in proportion to the number of units produced
• In a complex manufacturing environment, a greater number
of cost drivers are used for cost accumulation
 Costs are incurred for each unit
Produced. For example,
Unit-level activities Cost per unit
•Direct materials
•Direct labour
•Factory power

Costs are incurred for each batch

produced. For example,
Batch-level activities Cost per unit in batch
•Purchase orders
•Production runs
•Number of inspection

Costs are incurred to support a product

Types or process. For example,
Production Cost per unit in batch
•Engineering change orders
-level activities
•Product development
•Process design
•Test routines
Advantages of Activity-based costing

• More realistic cost assignment

• Better decision-making
• Better control over cost
Limitation of Activity-based costing

• Difficult to apportion common costs

• Difficult to implement
• Inconsistent with the generally accepted accounting principles
(GAAP)
Activity-Based Management (ABM)

The activity-based management (ABM) refers to a set of actions that

management can take, based on information from an
ABC study, to increase/improve profitability. These
include a combination of

1) Repricing of unprofitable products,

2) Increasing sales volume of highly profitable products,
3) Process improvement e.g. how to reduce setup times in
contrast to faster run of production, equipment and
4) Engineering and design improvements.

Their combined effect would be production of the same

volume and mix of products with fewer resources.
ABC FOR MARKETING, SELLING AND
DISTRIBUTION EXPENSES
Marketing, selling and distribution expenses are significant components of
overhead costs of companies. Most of these costs are associated with
customers, market segments and distribution channels rather than to
individual products. The ABC is applicable to such costs also.

Its focus is on tracing these costs to customer segments. The

activities performed by these services are first identified together
with activity cost drivers linking each activity to individual
customers.

The resource spending in the various customer accounts are then

identified.

The final stage is preparation of customer profitability analysis.

Identification of Activities
and Cost Drivers
Activity Activity Cost Driver
1 Marketing and technical support 1 Estimated proportion of time spent
on each customer
2 Travel to customers 2 Actual expenditure
3 Distribution of sales catalogue 3 Number of mailings
4 Servicing of customers 4 Estimated proportion of time spent
on each customer and supplies
used by them
5 Handle customer orders 5 Number or orders
6 Warehouse inventory for 6 Quality of inventory and space
customers required by customer
7 Shipping/despatch to customers 7 Actual records
Managing Customer Profitability
The ABC customer profitability analysis can be used to manage its
profitable and unprofitable customers. To protect them from
competitive inroads profitable customers may be offered
discounts/incentives and special services to retain them. The
unprofitable customers can be transformed into profitable customers
through a number of actions:

(i) Process improvement,

(ii) Activity-based pricing and
(iii) Managing customer relationships.
ABC for Service Companies

The ABC system is as much applicable and useful to a service

company as it is to a manufacturing company. Service organisations
include companies in

a) Financial services (i.e. banks, insurance organisations,

money managers),
b) Transportation (i.e. airlines, roads and railways),
c) Telecommunications,
d) Wholesale and retail,
e) Healthcare and so on.
Cost Structure of Service Companies

Service companies have a unique cost structure.

Virtually all their costs are indirect/fixed.

In contrast to manufacturing companies, customer

behaviour determines the basic operating costs of
products/services of service companies. They
should, therefore, identify the differential
profitability of individual customers as they
determine the quantity of demands for their
operating activities.
Activity Cost driver
Account billing Number of printed pages
Bill verification Number of accounts verified
Account inquiry Number of inquiries
Correspondence Number of letters
Other activities Number of printed pages