Activity Based Costing (ABC)

ABC segregate overhead into various cost pools in an effort to provide more accurate cost
information.

Assume that Atlas Company produces two automobile antitheft devices, The Boot and The Club.
The Boot is a high-volume item-totaling 25,000 units annually. The Club is a low-volume item
totaling only 5,000 units per year. The direct material cost per unit is RM40 for The Boot and
RM30 for The Club. The direct labor cost is RM12 per unit for each product. Each product
requires one hour of direct labor for completion. Expected annual manufacturing overhead costs
are RM900,000.
Unit cost calculation under traditional costing.
1) From the information given, we can retrieved the following information;
Direct material cost
Direct labor cost
Direct labor hour

The Boot
RM40
RM12
1

The Club
RM30
RM12
1

2) Therefore, total annual direct labor hours are 30,000 (25,000 + 5,000). Expected annual
manufacturing overhead costs are RM900,000. Thus, the predetermined overhead rate
under traditional costing, using direct labor hours, is RM30 (RM900,000/30,000) per
direct labor hour. Since both products require one direct labor hour for per unit, both
product are located overhead cost of RM30 per unit under traditional costing.
Total volume

25,000 units

Manufacturing overhead cost

Total annual direct labor
hours

RM900,000
30,000

=
=

5,000 units

RM30 per direct

labor hour

Thus, the unit cost for each product under traditional costing
Direct material cost
Direct labor cost
Overhead

The Boot
RM40
RM12
RM30*

The Club
RM30
RM12
RM30*

*Predetermined overhead rate x Direct labor hours = RM30 x 1hr. = RM30

Lets now calculate unit cost under ABC

STEP 1: IDENTIFY AND CLASSIFY ACTIVITIES AND ALLOCATE OVERHEAD TO
COST POOLS
Starts with an analysis of the activities performed to manufacture a product or provide a service.
This analysis should identify all resource-consuming activities. It requires documenting every
activity undertaken to accomplish a task.
Atlas Company identified three activity-cost pools and the system assigns overhead cost directly
to the appropriate activity cost pool as follows;
Activity Cost Pools

Estimated Overhead
(RM)
Setting up machines 300,000
Machining
500,000
Inspecting
100,000
Total
900,000
Illustration 1: Activity cost pools and estimated overhead

STEP 2: IDENTIFY COST DRIVERS

After costs are allocated to the activity cost pools, the company must identify the cost drivers for
each cost pool. The cost drivers must accurately measure the actual consumption of the activity
by the various products. To achieve accurate costing, a high degree of correlation must exist
between the cost driver and the actual consumption of the overhead costs in the cost pool.
Activity Cost Pools

Cost Drivers

Setting up machines Number of setups

Machining
Machine hours
Inspecting
Number of inspections
Illustration 2: Cost drivers and their expected use

STEP 3: COMPUTE OVERHEAD RATES

Expected Use of
Cost Drivers per
Activity
1,500 setups
50,000 machine hours
2,000 inspections

Next the company computes an activity-based overhead rate per cost driver using the following
formula;
Estimated Overhead per Activity
Expected Use of Cost Drivers per Activity

= Activity-Based Overhead Rate

Atlas Company computes its activity-based overhead rates by using estimated overhead per
activity cost pool, shown in Illustration 1, and the expected use of cost driver per activity shown
in Illustration 2. The computations are presented as follows;
Activity Cost
Pools
Setting up
machines
Machining
Inspecting

Estimated
Overhead
(RM)
300,000
500,000
100,000

Expected Use of
Cost Drivers per
Activity
1,500 setups
50,000 machine
hours
2,000 inspections

Activity Based
Overhead Rate
RM200 per setup
RM10 per
machine hour
RM50 per
inspection

Total
900,000
Illustration 4: Computation of activity based overhead rates

STEP 4: ASSIGN OVERHEAD COSTS TO PRODUCTS

In assigning overhead costs, it is necessary to know the expected use of cost driver for each
product. The following table shows the expected use of cost drivers per product for each of
Atlass products.
Activity Cost Pools

Cost Drivers

Expected Use of
Cost Drivers per
Activity
Setting up machines Number of setups
1,500 setups
Machining
Machine hours
50,000 machine
hours
Inspecting
Number of inspections 2,000 inspections
Illustration 5: Expected use of cost drivers per product

Expected Use of
Cost Drivers per
Product
500
1,000
30,000
20,000
500

1,500

To assign overhead costs to each product, Atlas multiplies the activity-based overhead rates per
cost drivers expected (Illustration 4) by the number of cost drivers expected to be used per

product (Illustration 5). The following illustration shows the overhead cost assigned to each
product.
Activity
Cost Pools

Setting up
machines
Machining
Inspecting
Total cost
assigned
[(a)]
Unit
produced
[(b)]
Overhead
cost per
unit
[(a)(b)]

Expected
Use of Cost
Drivers per
Product

The Boot
Activity
Based
Overhead
Rate

Cost
Assigned

500

RM200

100,000

30,000
500

RM10
RM50

300,000
25,000
425,000

Expected
Use of
Cost
Drivers
per
Product
1,000
20,000
1,500

The Club
Activity
Based
Overhead
Rate

Cost
Assigned

RM200

200,000

RM10
RM50

200,000
75,000
475,000

25,000

5,000

17

95

Illustration 6: Assignment of activity cost pools to products

Note: The example is extracted with some modification from (Weygandt, Kimmel and Kieso
2010).
Please try to do example in the text book and try the exercise P5-48 and P5-50 (the question
number is in accordance to 9th Edition)