Activity Based Costing

Managerial Accounting – Vigario, 6th Edition –

Ch. 5
Management and Cost Accounting – Drury:
Ch. 11
Learning outcomes
On completion of this study unit you should be able to:

 Explain the concept of an activity based costing (ABC) system;

 Define all the relevant ABC terms, e.g. cost driver, activity etc.;
 Compare and contrast an ABC system with a traditional cost
allocation system;(Tabulate the differences)
 Identify and explain each of the four stages involved in designing
ABC systems (or design an ABS system)
 Analyse an ABC system and apply it to manufacturing- and
service organisations; and
 Calculate the product cost by means of an ABC system.
Introduction into an ABC System
• So far we have learned and applied the absorption costing
system, where
Allocated fixed costs to departments, then re-allocating costs of the
service department to the production department,
Then calculating the absorption rate using volume based cost
drivers, such as machine hours or labour hours
This resulted in one allocation rate to allocate fixed costs to the
various product units.

• In this study unit we will look at a new system, called

Activity based costing, or ABC
It allocates overhead costs according to activities spent
Activity based costing terms
1. Cost pool:
1. A cost pool is a grouping of individual costs, typically by department
or service center. Cost pools are commonly used for the allocation of
factory overhead to units of production, or then in activity-
based costing to allocate costs to activities, e.g. material
procurement, quality control or production.
2. Activity Cost driver (or Non-unit-based cost drivers)
1. An activity cost driver is a factor that influences or contributes to the
expense of certain business operations. In activity-based costing (ABC),
an activity cost driver drives the costs of labor, maintenance or other
variable expenses, e.g. material procurement  material movements,
quality control  number of inspections; production  direct labour
hours (or machine hours).
2. Activity cost drivers consist of three types:
o Transaction
o Duration
o Intensity
investopedia.com
Activity based costing terms
1. Activity Cost driver (or Non-unit-based cost drivers)
1. Activity Cost driver or Non-unit-based cost drivers are factors,
other than the number of units produced, that cause fixed costs
2. Examples of Activity based cost driver or non-unit-based cost
drivers are e.g. the number of set-ups, material handling hours
and inspection hours..
2. Unit-based cost drivers are
1. factors that increase in direct proportion to the number of
units produced and are therefore responsible for the variable
costs in the production environment
2. Examples of unit-based cost drivers are, among others, direct
labour hours, machine hours and direct material
Traditional Overhead allocation system
Overhead
accounts
(G/L): Total
- Electricity overhead
- Stationery Absorp # labor-
cost -tion
- Salaries = x machine
÷ rate / hours
(excl. direct
Total labor hour
labour)
- Etc. hours or
machine
hours
 Methodology: ABC recognises that there are many activities or “cost drivers” causing costs to be incurred.ABC involves two stages:

Stage one Stage two

Overhead costs are pooled according to the Each cost activity is then linked by a cost driver
activities which cause the costs to the product output

Even though all the activities relate to purchasing

E.g. purchasing material can be broken into
material, the cost drivers are different

Purchase requests Number request

Ordering Number of orders

Material handling Number of movements

Quality control Number of inspections

ABC Overhead allocation system
Processing Setting up Quality
of orders machines control

Activity 1 Activity 2 Activity 3

Overhead Allocating
accounts costs to..
Cost pools Cost pools Cost pools
(G/L):
- Electricity ÷ ÷ ÷
- Stationery Total Cost Total Cost Total Cost
- Salaries Driver Driver Driver

(excl. direct = = =
labour) Cost per Cost per Cost per
Driver unit Driver unit Driver unit
- Etc.
x x x
# Cost driver # Cost driver # Cost driver
Product A, B etc. used used used

Cost object: Products, Services, Processes, Customers

Differences between ABC & Traditional
ABC COSTING
SYSTEM
TRADITIONAL COSTING SYSTEM
• Allocate costs to
• Tend to allocate costs on an equal basis to
activities
all products manufactures  result in low-
• Has more costs
volume products tend to be under-costed
centres or cost pools
while high-volume products are over-priced.
• use many cost drivers
• Rely on small no. of volume-based cost
• Seeks to use only
drivers (typically machine- or direct labour
cause-and-effect cost
hours)
drivers
• Merge support and production department’s
• ABC systems tend to
costs
establish separate
• System based on volumes and if volumes
cost driver rates for
bases are not the cause of indirect costs, it
support department
could result in wrong unit cost calculations
• Cost allocation to
• unit-based cost drivers cannot assign fixed
underlying products
costs (indirect costs) to products accurately
makes it more
relevant
Differences between ABC & Traditional
ABC COSTING SYSTEM
TRADITIONAL COSTING
Appropriate, when:
SYSTEM  Recognising that low-volume
Appropriate, when: products require greater proportion
 Single product or a limited of manufacturing support costs,
range of products are e.g. set-up costs, packaging,
produced selling etc.
 Direct costs are dominant  When multi-product manufacture or
costs Product lines are diverse
 relatively small Indirect costs  consumption rate of unit-based and
 high Information costs non-unit-based activities differ
 There’s a lack of intense significantly
global competition  the non-unit-based costs (fixed
 non-unit-based overhead manufacturing costs) are a
costs are a small percentage significant percentage of the total
of the total overhead costs overheads
 Production process is labour  Production process is capital
intensive  shift away from direct
intensive
variable costs to indirect fixed
costs.
Designing an ABC System
STEP 1: Identify the major activities that take place in an organisation

STEP 2: Assign costs to cost pools/cost centres for each activity

STEP 3: Determine the cost driver for each major activity

STEP 4: Assign the cost of activities to products

 STEP 1: Identify the major activities that
take place in an organisation

• Activities chosen should be at a reasonable level of aggregation 

based on cost/benefit criteria
• Choice of activities must be
• influenced by the total cost of the activity centre and
• the ability of a single cost driver to provide a satisfactory determinant of
the cost of the activity
• Activities can be classified into four major categories:
1. Unit level activities  Maintenance costs  machine hours
2. Batch level activities Set-up costs  number of set-ups
3. Product support (sustaining) activities  Technical support  no. of
parts
4. Facility support (sustaining) activities  General administrative costs
(these are usually irrelevant and not allocated)
• Example
Example: R # R
Unit level
Direct material cost per unit 180
Direct labour cost per unit 150
Power cost per unit 120
550 3 000 1 650 000
Batch related costs
Design cost per batch 30 000
Machine set-up cost per batch 34 000
Distribution costs per batch 12 000
Selling costs per batch 60 000
Administration costs per batch 24 000
220 000 5 1 100 000
Product sustaining (order level) costs
Engineering design and support costs per order 350 000
Marketing costs per order 200 000 1 1 650 000
Facility sustaining costs
Facility sustaining costs allocated 1 500 000 1 500 000
6 500 000
 STEP 2: Assign costs to cost pools/cost
centres for each activity

• Costs assigned to activity cost pools will include

direct and indirect costs
• Resource cost drivers used to assign indirect
costs
• Reliability of cost information will be reduced if
arbitrary allocations are used to assign a
significant proportion of costs to activities
STEP 3: Determine the cost driver for each
major activity

• Drivers at this stage are called activity drivers and

should:
• Provide a good explanation of costs of each activity
pool
• Be easily measureable
• Data should be easily obtainable
• Activity cost drivers consist of three types:
1. Transaction
2. Duration
3. Intensity
 STEP 4: Assign the cost of activities to
products

• The driver must be measureable so that it can be

identified with individual products.
• The rate used to allocate costs from cost centres
to products is calculated as follows:
• Cost centre rate = Activity cost (cost centre)
• Cost driver volume
Example
Alpha Limited produces two products: A and B. The
enterprise produces both products with the same
equipment. Product A is a high volume product while
product B is produced in low volumes. Details of cost
activities, inputs and output are as follows:
Annual output Overhead cost:
• Product A: 80 000 units Overhead cost analysis (R)
• Product B 20 000 units Material handling 150 000
Material procurement 50 000
Set-up 150 000
Quality control 250 000
Production 600 000
Total 1 200 000
 What is different? activity levels are clearly
Example identified for each of the products; Each
activity has a cost driver; previously
ignored with the traditional absorption
costing
Cost driver analysis
Overhead Cost driver Product A Product B Total
Material Handling Material Movements 100 50 150
movements
Material Number of orders 200 100 300 orders
procurement

Set-ups Number of set-ups 60 40 100 set-ups

Quality control Number of inspections 150 100 250
inspection
Production Direct labour hours 40 000 10 000 50 000
hours

Required: Calculate the overhead cost per product

using activity based costing.
Example – Cost per unit applying traditional
absorption costing method

Total overheads allocated to cost centres N$1 200 000

Total direct labour hours 50 000
Overhead rate per direct labour hour
1 200 000
50 000
= N$24 per direct labour hour

Product A Product B
Total hours per product 40 000/80 000 10 000/20
000
0,50 hours 0,5 hours

Overhead cost N$12 N$12

(0,5 x 24) (0,5 x 24)
Example – Cost per unit applying ABC Costing
method
A. Calculate activity rates

Activities Activity Cost driver Activity rates

cost volumes

R R
Material handling 150 000 150 movements 1 000 per movement
Material procurement 50 000 300 orders 166,67 per order
Set-ups 150 000 100 set-ups 1 500 per set-up
Quality control 250 000 250 inspections 1 000 per inspection

Production 600 000 50 000 hours 12 per direct hour

Example – Cost per unit applying ABC Costing
method
B. Calculate the cost per product
Product A Product B
Material handling
- (100 x N$1 000) (50 x N$ 1000) 100 000 50 000
Material procurement
- (200 x N$166,67) (100 x N$166,67) 33 333 16 667
Set-ups (60 x N$1 500) (40 x N$1 500) 90 000 60 000
Quality control
- (150 x N$1 000) (100 x N$1 000) 150 000 100 000
Production (40 000 x N$12) (10 000 x N$12) 480 000 120 000
Total 853 333 346 667
Number of products 80 000 20 000
Overhead cost per unit N$10,67 N$17,33
Reflections on difference
• Can you see the difference?
• Product A was seen as the high volume product with Product B the
low volume product. As A required 40 000 labour hours, whereas
product B required 10 000 labour hours. So based on the
traditional cost allocation, product A required more labour hours to
produce whereas product B less labour hours. But with ABC the
picture looks different.

• Both these products were assigned an overhead cost of N$12 per

unit whilst the ABC system allocated more costs to Product B
 Low volume products tend to be under costed and high volume
products tend to be over-priced

• It is now possible to compare the income of these products with

the costs to make important business decisions.
Blinkvosperd Ltd
• Blinkvosperd Ltd is a company located in Potchefstroom,
specialising in washing the cars of students and offers two
options to their clients. The first option is where the car is
washed and dried and is called the “Platsak” option,
costing the clients R60 per car. The second option is
where the car is washed, dried, vacuumed and polished
and costs R125 per car. This option is called “Blinkvos”.
The total cost incurred during May 2011 is R30 000. Costs
are currently allocated to the two options based on the
number of cars washed. A total of 500 cars were washed
during May 2011, of which 125 chose the “Blinkvos”
option. The rest found the “Platsak” option a bit more
affordable.
 Cost analysis for May 2011
Cost Driver Rand
Rent Floor space R3 000
Labourers – Washers Hours washed R4 500
Driers Hours dried R3 000
Polishers Hours polished R6 000
Vacuum – labourers Hours vacuumed R3 000
Supervisors Hours washed R2 700
Maintenance of equipment % of use R500
Soap and cloths Number of cars R2 700
Polish Number of cars R1 000
Water en electricity Number of cars R3 500
Invoice books Number of cars R100
Total R30 000
Continued: Further cost allocation type
Platsak Blinkvos
Floor space 30m2 20m2
Wash hours 110 hours 40 hours
Driers 33.2 hours 13.4 hours
Polisher 0 hours 67 hours
Maintenance 40% 60%

REQUIRED

Calculate the cost per car for each option if

activity-based costing is applied.
Blinkvosperd Ltd - Activity rate calculation
METHOD 1: Step 1 – Calculate Activity rate
ACTIVITY
COST POOL COST DRIVER COST
RATE
Rent Floor space 3,000 60
Labourers – Washers Hours washed 4,500 30
Driers Hours dried 3,000 64.38
Polishers Hours polished 6,000 89.55
Vacuum – labourers Hours vacuumed 3,000 Only Blinkvos
Supervisors Hours washed 2,700 18
Maintenance of equipment % of use 500 %
Soap and cloths Number of cars 2,700 5.40
Polish Number of cars 1,000 Only Blinkvos
Water en electricity Number of cars 3,500 7
Invoice books Number of cars 100 0.20
Total 30,000
Blinkvosperd Ltd - Activity rate calculation
METHOD 1: Step 2 – Allocate costs based on calculated activity rate
ACTIVITY
Platsak Blinkvos
RATE
60 1,800.00 =60*30 1,200.00 =60*20
30 3,300.00 =30*110 1,200.00 =30*40
64.38 2,137.34 =64.38*33.2 862.66 =64.38*13.4
89.55 - =89.55*0 6,000.00 =89.55*67
Only Blinkvos - 0 3,000.00
18 1,980.00 =18*110 720.00 =18*40
% 200.00 300.00
5.40 2,025.00 =5.40*375 675.00 =5.40*125
Only Blinkvos - 0 1,000.00 0
7 2,625.00 =7*375 875.00 =7*125
0.20 75.00 =0.20*375 25.00 =0.20*125
Total cost 14,142.34 15,857.66
Cars washed 375.00 125.00
Cost per car R 37.71 R 126.86
Blinkvosperd Ltd – Pro-rata cost allocation
METHOD 2 – Allocate costs on pro-rata basis
Platsak Blinkvos
Rent 1,800.00 =3,000*30/50 1,200.00 =3,000*20/50
Labourers – Washers 3,300.00 =4,500*110/150 1,200.00 =4,500*40/150
Driers 2,137.34 =3,000*33.2/46.6 862.66 =3,000*13.4/46.6
Polishers - =6,000*0/67 6,000.00 =6,000*67/67
Vacuum – labourers - - 3,000.00
Supervisors 1,980.00 =2700*110/150 720.00 =2700*40/150
Maintenance of
equipment 200.00 300.00
Soap and cloths 2,025.00 =2700*375/500 675.00 =2700*125/500
Polish 750.00 =1000*375/500 250.00 =1000*125/500
Water en electricity 2,625.00 =3500*375/500 875.00 =3500*125/500
Invoice books 75.00 =100*375/500 25.00 =100*125/500
Total cost 14,892.34 15,107.66
Cars washed 375.00 125.00
Cost per car 37.71 126.86
Why use ABC?
DEBATABLE ARGUMENTS..

Indirect costs influences pricing decisions

Profitability indicators / attention-directing information
system
Product decisions are not independent
Is ABC always better than traditional?
No!!
Does not necessarily lead to an increase in profit
Cost-benefit-analysis
Non-volume related overhead costs are a large proportion
of total overheads
Product diversity applies
Extra Class Question
• 2021 Second Opportunity – Question 1 (b)
Homework

• Extra Homework questions

(Moodle)
• Suggested extra question,
Vigario – Question 5-8 to 5-10