BM2021

ABSORPTION AND VARIABLE COSTING

Absorption, Variable, and Throughput Costing

Income is one of the many significant measures managers use to make decisions and evaluate operational
performance. In a manufacturing firm, two (2) alternative accounting treatments of fixed manufacturing
overhead can result in different reported income amounts for the company. The difference in reported
income can alter management’s view of the profitability of a particular decision or segment of the
company (Hilton & Platt, 2017). Normally, accountants and managers make a judgment when measuring
income, and one of the most important factors is choosing the appropriate method in calculating the
product cost.
When managers realized that product costing would affect their evaluation, they started to pay attention
to the determination of product costs. The two (2) product costing methods that differ in the treatment
of the fixed manufacturing overhead are absorption costing and variable costing.
1. Absorption Costing. It is also known as “full costing” or “conventional costing.” In this method, all
manufacturing costs (i.e., direct materials, direct labor, and manufacturing overhead) are recognized
as product costs, regardless of whether they are variable or fixed (Garrison et al., 2018). This means
that all manufacturing costs are assigned to (or absorbed by) the units produced.

Figure 1. Manufacturing costs for absorption costing

Figure 1 illustrates all manufacturing costs needed to produce the product. These are direct
materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. As the
goods are produced, these costs are recognized in the balance sheet as part of inventory. As the
goods are sold, all manufacturing costs of the units sold will be part of the cost of goods sold (an
account recognized in the income statement). In using the absorption costing, the fixed overhead per
unit is computed based on the level of production.
Since absorption costing includes all manufacturing costs in costing the product, it cannot be used to
prepare a contribution margin income statement (a measure for evaluating the performance of a
segment or department). In this regard, an alternative costing is used by the management for internal
use only. This is called variable costing.

2. Variable Costing. It is also known as “marginal costing” or “direct costing.” It recognizes that the cost
of the product must include only those production costs that vary directly within the volume of
production. This method only includes variable manufacturing costs in the cost of a unit of product.
It treats fixed manufacturing overhead as period cost.

Figure 2. Manufacturing costs for variable costing

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In Figure 2, all manufacturing costs (except for the fixed manufacturing overhead) are considered
part of the cost of the product. These costs are recognized in the balance sheet as part of the
inventory. As the goods are sold, the cost of the product will be recognized in the income statement
as cost of goods sold. However, the fixed manufacturing overhead will be considered as period cost,
i.e., the cost will be expensed as incurred. This is because this cost will be incurred whether or not
production occurs, and it is improper to allocate these costs to production and defer current costs of
doing business.
Under variable costing, there is a method called throughput costing. It is also known as
“supervariable costing,” which is an extreme form of variable costing in which only direct material
costs are considered product costs included as cost of inventory. All other costs are period costs that
are expensed as incurred.
Table 1 shows the principal differences between variable and absorption costing:
Variable Costing Absorption Costing
1. Cost segregation Costs are segregated into Costs are seldom segregated
variable or fixed. into variable and fixed costs.
2. Cost of inventory Cost of inventory includes only Cost of inventory includes all
the variable costs. the manufacturing costs,
variable and fixed.
3. Treatment of fixed Fixed manufacturing overhead Fixed manufacturing overhead
manufacturing overhead is treated as period cost. is treated as product cost.
4. Income statement Distinguishes between variable Distinguishes between
and fixed costs production and other costs
5. Net Income Net income may differ from each other because of the difference
in the amount of fixed overhead costs recognized as expense
during an accounting period. In the long run, however, both
methods give substantially the same results since sales cannot
continuously exceed production, nor can production continually
exceed sales.
Table 1. Differences between variable costing and absorption costing

Reconciliation of Net Income

The following observations can be developed regarding variable costing and absorption costing in relation
to production and sales (Garrison et al., 2018):
1. Production equals sales. When units produced is equal to units sold, there is no change in
inventory. The same net income will be realized regardless of the method used.
2. Production is greater than sales. When units produced exceed units sold, there is an increase in
inventory. The fixed overhead expensed under absorption costing is less than the fixed overhead
expensed under variable costing. Therefore, the net income reported under absorption costing
will be greater than the net income reported under variable costing.
3. Production is less than sales. When units sold exceeds units produced, there is a decrease in
inventory. The fixed overhead expensed under absorption costing is greater than the fixed cost
expensed under variable costing. Therefore, the net income reported under absorption costing
will be less than the net income reported under variable costing.
When inventory increases or decreases during the year, reported income differs under absorption and
variable costing. This results from the fixed overhead that is inventoried under absorption costing but
expensed immediately under variable costing. The following formula may be used to compute the

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difference in the amount of fixed overhead expensed in a given period under the two (2) costing methods
(Hilton & Platt, 2017):
𝑫𝒊𝒇𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒊𝒏 𝒇𝒊𝒙𝒆𝒅 𝒐𝒗𝒆𝒓𝒉𝒆𝒂𝒅 = 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝒖𝒏𝒊𝒕𝒔 𝒙 𝑭𝒊𝒙𝒆𝒅 𝒐𝒗𝒆𝒓𝒉𝒆𝒂𝒅 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕
The difference in fixed overhead is also the difference between the net income under the two (2) methods.

Pro forma reconciliation

1. Absorption to Variable Costing
Absorption costing Net Income P xxx
Add: Fixed overhead in beginning inventory xxx
Less: Fixed overhead in ending inventory xxx
Variable costing net income P xxx
2. Variable to Absorption Costing
Variable costing Net Income P xxx
Add: Fixed overhead in ending inventory xxx
Less: Fixed overhead in beginning inventory xxx
Absorption costing net income P xxx

EXAMPLE:
ANJY Corporation has the following information in its first year of operations in 201A:
Units produced 40,000
Units sold 36,000
Selling price per unit P60
Variable manufacturing costs P24 per unit produced
Variable selling expenses P6 per unit sold
Fixed manufacturing costs P500,000
Fixed administrative expenses P250,000
Assume that the actual production is the same as the normal operating level for the year. Income
statements under the two (2) methods will be presented as follows:

ANJY Corporation
Income Statement (Absorption Costing)
December 31, 201A

Sales (36,000 x P60) P2,160,000

Less: Cost of Goods Sold (36,000 x P36.50) 1,314,000
Gross Profit 846,000
Less: Selling and Administrative Expenses
Variable Selling (36,000 x P6) P216,000
Fixed administrative 250,000 466,000
Net Income P380,000

The cost of goods sold by P36.50 per unit is computed as the sum of variable and fixed manufacturing
costs per unit [P24 + (P500,000/40,000)]. The cost of ending inventory will be P146,000 (P36.50 x P4,000
units unsold).

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ANJY Corporation
Income Statement (Variable Costing)
December 31, 201A
Sales (36,000 x P60) P2,160,000
Less: Variable Costs
Cost of Goods Sold (36,000 x P24) P864,000
Selling Costs (36,000 x P6) 216,000 1,080,000
Contribution Margin 1,080,000
Less: Fixed Costs
Manufacturing Costs 500,000
Administrative Costs 250,000 750,000
Net Income P330,000

The income statement under variable costing separates variable costs and fixed costs and shows a
contribution margin instead of a gross profit, as shown under absorption costing. The cost of ending
inventory under variable costing is P96,000 (P24 x 4,000 units unsold).
As shown in the two (2) income statements, the difference between the net income of the two (2)
methods is P50,000. This is also the difference between the cost of ending inventory and comprises the
fixed manufacturing overhead in ending inventory of P50,000 (P12.50 x 4,000 units unsold).
To reconcile the net income in the two (2) methods, it shall be computed as follows:
P330,000 Absorption costing net income P380,000
Variable costing net income
Add: Fixed manufacturing costs in Less: Fixed manufacturing costs in
ending inventory (4,000 x P12.50) 50,000 ending inventory (4,000 x P12.50) 50,000
Absorption costing net income P380,000 Variable costing net income P330,000

Assume that the direct material per unit is P12; the following is the income statement using throughput
costing:
ANJY Corporation
Income Statement (Throughput Costing)
December 31, 201A
Sales (36,000 x P60) P2,160,000
Less: Direct Materials (36,000 x P12) 432,000
Throughput Margin 1,728,000
Less:
Variable manufacturing costs (40,000 x
P12) P480,000
Variable Selling Expenses (36,000 XP6) 216,000
Fixed Manufacturing Costs 500,000
Fixed Administrative Expenses 250,000 P1,446,000
Net Income P282,000

In throughput costing, only the cost of materials is included in the cost of inventory. Direct labor and
manufacturing overhead costs are all treated as period costs, treating them as expenses as they are
incurred. This means that it is based on the units produced, not on the units sold. When production
exceeds sales, the net income reported in throughput costing is much lower than variable and absorption
costing.

References:
Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2018). Managerial accounting. McGraw-Hill Education.
Hilton, R. W., & Platt, D. E. (2017). Managerial accounting: Creating value in a dynamic business environment. McGraw-Hill Education.

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COST–VOLUME–PROFIT AND BREAK-EVEN ANALYSIS

Cost-Volume-Profit (CVP) Analysis (Lalitha & Rajasekaran, 2010; Rante, 2016)

The cost-volume-profit (CVP) analysis determines how changes in costs and volume affect a company's
operating income and net income. This analysis assumes that the volume of production drives cost and
revenue.
The following are the objectives of CVP Analysis:
• Optimum pricing. It assists in estimating the market value of products and services to earn a
profit.
• Profit planning. It is essential in assessing the income or loss at different levels of activity.
• Exercise cost control. It assists in evaluating profit and expenses incurred to facilitate cost control.
• Forecasting profit. It assists in analyzing the relationship among earnings, costs, and volume to
precisely forecast the expected income of a business undertaking.
• Deciding on alternatives. It helps in analyzing various courses of action to make accurate and
informed decisions.
• Planning for cash requirements. It assists in planning for financial resources at a given volume of
output.
• New product decisions. It helps in launching a new product/service based on nature, the volume
of output, price, and volume of sale.
• Determining overheads. It helps in determining the amount of overhead cost to be charged at
various levels of activity because overhead rates are generally predetermined to a selected
volume of production.
• Setting up flexible budgets. It helps in estimating the required working capital, which indicates
costs at different levels of activity.

The basic formula used in CVP analysis is derived from the profit equation as follows:
𝑥𝑝 = 𝑥𝑣 + 𝐹𝐶 + 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡
where:
p is the price per unit; x is the total number of units produced and sold;
v is the variable cost per unit; FC is the total fixed cost
ILLUSTRATION: An entrepreneur desires to earn a profit of P100,000 by selling 10,000 pieces of anime
figures. The fixed cost in producing the product is P200,000, while the variable cost per anime figure is
P20.
SOLUTION:
𝑥𝑝 = 𝑣𝑥 + 𝐹𝐶 + 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑃𝑟𝑜𝑓𝑖𝑡
10,000𝑝 = (10,000)(𝑃20) + 𝑃200,000 + 𝑃100,000
10,000𝑝 = 𝑃200,000 + 𝑃200,000 + 𝑃100,000
10,000𝑝 = 𝑃500,000
𝒑 = 𝑷𝟓𝟎
KEY POINTS: The entrepreneur must sell each anime figure for P50 to earn the desired profit.

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Break-Even Analysis (Lalitha & Rajasekaran, 2010; Rante, 2016)

Break-even analysis is an analytical technique for studying the relationship between costs and revenues.
It shows the profitability or non-profitability of an undertaking at various levels of activity, and as a result,
it indicates the point at which sales will equal total costs or the break-even point. This analysis depicts the
variable costs, fixed costs, total costs, sales value, break-even point, and profit or loss at different levels
of production or activities.
The following are some of the assumptions underlying break-even analysis:
• Cost variability concept. In this method, the concept of cost variability is valid, and the costs are
classified as fixed and variable costs.
• Fixed costs are constant. In this method, fixed costs remain constant, and there are certain factors
for which the costs may not change, whatever may be the level of activity.
• Segregation of semi-variable costs. In this method, semi-variable costs can be segregated into
fixed and variable.
• Constant selling price. In this method, the selling price does not change as the volume of sales
changes.
• No change in a product. In this method, there will be no change in the product if there is only one
(1) product. Also, the sales mix remains constant if there is more than one product.
• Short-term price level. In this method, the general price level remains stable at the short-run
level.
• Constant product mix. In this method, the product mix remains unchanged.
• Operating efficiency. In this method, the operating efficiency of the firm neither increases nor
decreases.
• Production and sales. In this method, the number of units of sales coincides with the number of
units of production so that the inventory may remain constant.
• Profit-volume ratio. In this method, the relationship between the contribution and selling price
of a product or service is represented in terms of percentage.
• Break-even point in units. In this method, the production level (where total revenues equal total
expenses) is represented in terms of the number of output or unit of product or service.
• Break-even point in values. In this method, the production level (where total revenues equal total
expenses) is represented in terms of the equivalent amount or peso value of a product or service.
ILLUSTRATION: Scented candles are sold at P100 per unit with a variable cost of P80 per unit and a
contribution margin of P20 per unit. The fixed expense of the business is P10,000 per year. Determine the
following: Break-even point in units; Break-even point in values; Profit for sales of 620 units; and Required
sales to earn a profit of P10,000 for the year.
PROCEDURE:
• Step 1. Determine the contribution margin per unit by deducting the variable cost per unit to the
selling price per unit:
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 − 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
= 𝑃100 − 𝑃80 = 𝑷𝟐𝟎

• Step 2. Determine the profit-volume (P/V) ratio using the following formula:
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑃20
𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜 = × 100 = × 100 = 0.2 × 100 = 𝟐𝟎%
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑃100

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• Step 3. Determine the break-even point (BEP) in units using the following formula:

𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 𝑃10,000

𝐵𝐸𝑃 𝑖𝑛 𝑢𝑛𝑖𝑡𝑠 = = = 𝟓𝟎𝟎 𝒖𝒏𝒊𝒕𝒔
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑃20
• Step 4. Determine the break-even point (BEP) in values using the following formula:

𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 𝑃10,000

𝐵𝐸𝑃 𝑖𝑛 𝑣𝑎𝑙𝑢𝑒𝑠 = = = 𝑷𝟓𝟎, 𝟎𝟎𝟎
𝑃 0.2
𝑉 𝑟𝑎𝑡𝑖𝑜

• Step 5. Determine the total contribution margin by multiplying the estimated number of units for
sale by the contribution margin per unit:
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑛𝑜. 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑓𝑜𝑟 𝑠𝑎𝑙𝑒 × 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
= 620 𝑢𝑛𝑖𝑡𝑠 × 𝑃20 = 𝑷𝟏𝟐, 𝟒𝟎𝟎
• Step 6. Determine the profit for the sales of 620 units by getting the difference of total
contribution margin and total fixed cost for the year:
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 − 𝑇𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 = 𝑃12,400 − 𝑃10,000 = 𝑷𝟐, 𝟒𝟎𝟎
• Step 7. Determine the required sales to be made to earn a profit of P10,000 using the following
formula:
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 + 𝐷𝑒𝑠𝑖𝑟𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 =
𝑃
𝑉 𝑟𝑎𝑡𝑖𝑜
𝑃10,000 + 𝑃10,000 𝑃20,000
= = = 𝑷𝟏𝟎𝟎, 𝟎𝟎𝟎
0.2 0.2

References:
AccountingExplained. (2021). Cost volume profit analysis.
https://accountingexplained.com/managerial/cvp-analysis/
Cliffsnotes. (2020). Cost-volume-profit analysis. https://www.cliffsnotes.com/study-
guides/accounting/accounting-principles-ii/cost-volume-profit-relationships/cost-volume-profit-
analysis
Lalitha, R. & Rajasekaran, V. (2010). Costing accounting. India: Pearson.

Rante, G. A. (2016). Cost accounting. Mandaluyong City: Millenium Books, Inc.

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ACTIVITY-BASED COSTING
The Strategic Role of Activity-Based Costing (Blocher et al., 2019)
Activity-based costing (ABC) is a method for improving the accuracy of cost determination. While ABC is a
relatively recent innovation in cost accounting, it has been adopted by companies in varying industries
and within government and non-profit organizations. Here is a quick example of how it works and why it
is important. Suppose Jordan and two (2) friends (Joe and Al) go out for dinner. Each one (1) ordered a
personal-size pizza, and Al suggests ordering a plate of appetizers for the table. Jordan and Joe figured
they would have a bite or two (2) of the appetizers, so they agree. Dinner is great, but at the end, Al is still
hungry, so he orders another plate of appetizers, but this time, he eats all of it. When it is time for the
check, Al suggests the three (3) of them split the cost of the meal equally. Is this fair? Perhaps Al should
offer to pay more for the two (2) appetizer plates. The individual pizzas are direct costs to each friend so
that an equal share is fair, but while the appetizer plates were intended to be shared equally, it turns out
that Al consumed most of them.
There are similar examples in manufacturing. Suppose Jordan, Joe, and Al are also product managers at a
plant that manufactures furniture. There are three (3) product lines. Al is in charge of sofa manufacturing,
Joe handles dining room tables and chairs, and Jordan is in charge of bedroom furniture. The direct
materials and labor costs are traced directly to each product line. Also, there are indirect manufacturing
costs (overhead) that are associated with activities that cannot be traced to a single product, including
materials acquisition, materials storage and handling, product inspection, manufacturing supervision, job
scheduling, equipment maintenance, and fabric cutting. What if the company decides to charge each of
the three (3) product managers a “fair share” of the total indirect cost using the proportion of units
produced in a manager’s area relative to the total units produced? This approach is commonly referred
to as volume-based costing. Note that whether the proportions used are based on units of product, direct
labor hours, or machine hours, each of these is volume-based. But if, as is often the case, the usage of
these activities is not proportional to the number of units produced, then some managers will be
overcharged, and others undercharged under the volume-based approach. For example, suppose Al
insists on more frequent inspections of his production; then he should be charged a higher proportion of
overhead (inspection) than that based on units alone. Moreover, why should Jordan pay any portion of
fabric cutting if the bedroom furniture does not require fabric?
Another consideration is that the volume-based method provides little incentive for the manager to
control indirect costs. Unfortunately, the only way Jordan could reduce his share of the indirect costs is
to reduce the units produced (or hope that Joe and/or Al increase production)—not much of an incentive.
On reflection, the approach that charges indirect costs to products based on units produced does not
provide very accurate product costs and certainly does not provide the appropriate incentives for
managing the indirect costs. One solution is to use activity-based costing to charge these indirect costs to
the products, using detailed information on the activities that make up the indirect costs—inspection,
fabric cutting, and materials handling.
Role of Volume-Based Costing (Blocher et al., 2019)
Volume-based costing can be a good strategic choice for some firms. It is generally appropriate when
common costs are relatively small or when activities supporting the production of the product or service
are relatively homogeneous across different product lines. This may be the case, for example, for a firm
that manufactures a limited range of paper products or a firm that produces a narrow range of agricultural
products. Similarly, a professional service firm (law firm, accounting firm, etc.) may not need ABC because
labor costs for the professional staff are the largest cost of the firm, and labor is also easily traced to clients

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(the cost object). For firms other than these, the ABC approach may be preferred to avoid the distortions
from over costing or under costing that may occur using a volume-based approach.
Activity-Based Costing (ABC)
Activity-based costing (ABC) system is an approach that assigns resource expenses to cost objects such as
products, services, or customers. The premise of this costing approach is that a firm’s products and/or
services result from activities that require resources accompanying costs or expenses. Costs of resources
are assigned to the activities that use or consume resources (resource consumption drivers), and costs of
activities are assigned to cost objects (activity consumption drivers). ABC recognizes the causal or direct
relationships between resource costs, cost drivers, activities, and cost objects in assigning costs to
activities and then to cost objects (Blocher et al., 2019).
To develop a costing system, an understanding of the relationships among resources, activities, and
products and/or services is important. Resources are used to perform activities, and products/services are
the results of activities. Many of the resources used in an operation can be traced to individual products
and/or services and identified as direct materials or direct labor costs. Most overhead costs relate only
indirectly to final products and/or services. A costing system identifies costs with activities that consume
resources and assigns resource costs to cost objects—such as products, services, or cost pools based on
activities performed for the cost objects (Blocher et al., 2019).
Stages that are involved in ABC system are explained as follows (Rante, 2016):
• First Stage: Identify the activities. These activities are work performed or undertaken to produce
products such as the number of setups, scheduling, orders, parts, inspections, labor hours, and
design, among others. To identify resource costs for various activities, a firm classifies all activities
according to how the activities consume resources as follows:
o Output unit-level costs. These are the cost of activities performed on each item of
product or service. The cost of activities increases in proportion to the volume of
production or sales. An example of this is the manufacturing operations cost.
o Batch-level costs. These are the costs of activities performed on each group of units of
products or services. The cost of activities increases in proportion to the volume of
production or sales. An example of this is the procurement cost.
o Product-sustaining costs. These are the costs of activities undertaken to support products
or services irrespective of 1the number of units or batches. An example of this involves
marketing costs to launch new products.
o Facility-sustaining costs. These are the costs of activities that cannot be traced to
individual products. They are common to all products, and they support the entire
activities of an organization. An example of this includes general administration costs.
• Second Stage: Pool rates. The overhead cost pool is traced to products using the pool rates. These
activities are used as cost drivers in computing overhead rates. The total factory overhead is then
allocated to activity cost pools. The cost per activity is divided by the activity drivers’ practical
capacity to arrive at the overhead rate per activity.
EXAMPLE: Dragon Plumbing Company has identified activity centers to which overhead costs are assigned.
The following data is available:

Activity Centers Costs Activity Drivers

Utilities P300,000 60,000 machine hours
Scheduling and Setup 273,000 780 set ups

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Activity Centers Costs Activity Drivers

1,600,000 pounds of
Material Handling 640,000
materials

The following are the company’s products and other operating statistics:

Product A Product B Product C

Prime costs P80,000 P80,000 P90,000
Machine hours 30,000 10,000 20,000
Number of setups 130 380 270
Pounds of materials 500,000 300,000 800,000
Number of units
40,000 20,000 60,000
produced
Direct labor hours 32,000 18,000 50,000
PROCEDURE:
• Step 1. Determine the pool rates by dividing the given costs to the activity drivers:

Activity Centers Solution Pool rates

Utilities P300,000/60,000 P5/mhr
Scheduling & setup P273,000/780 P350/set up
Materials handling P640,000/1,600,000 P0.40/lb

• Step 2. Determine the overhead cost allocated by multiplying the activity centers by the cost of
activity drivers using the computed pool rates:
Product A Product B Product C TOTAL
Utilities:
A. 30,000 X 5 P150,000
B. 10,000 X 5 P50,000
C. 20,000 X 5 P100,000
P300,000
Scheduling and Setup:
A. 130 X 350 45,500
B. 380 X 350 133,000
C. 270 X 350 94,500
P273,000
Material Handling:
A. 500,000 X .40 200,000
B. 300,000 X .40 120,000
C. 800,000 X .40 320,000
P640,000
TOTAL P395,500 P303,000 P514,500 P1,213,000

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Activity-Based Management (Blocher et al., 2019)

Activity-based management (ABM) organizes resources and activities to improve the value of products
and/or services to customers and increase the firm’s competitiveness and profitability. ABM draws on
ABC as its major source of information and focuses on the efficiency and effectiveness of key business
processes and activities. Using ABM, management can identify ways to improve operations, reduce costs,
or increase value to customers, all of which can enhance the firm’s competitiveness.
ABM applications can be classified into two (2) categories:
1. Operational ABM. It enhances operational efficiency, asset utilization, and cost reduction. It is
based on the perspective of doing things right and performing activities more efficiently.
Operational ABM applications use management techniques such as activity analysis, business
process improvement, total quality management, and performance measurement.
2. Strategic ABM. It focuses on choosing appropriate activities for the operation, eliminating non-
essential activities, and selecting the most profitable customers. Strategic ABM applications use
management techniques such as process design and value-chain analysis, all of which can alter
the demand for activities and increase profitability through improved activity efficiency.

Activity Analysis
To be competitive, a firm must assess each of its activities based on product or customer requirements,
efficiency, and value content. Ideally, a firm performs an activity for one (1) of the following reasons:
• It is required to meet the specification of the product and/or service to satisfy customer demands.
• It is required to sustain the organization.
• It is deemed beneficial to the firm.
Examples of activities required to sustain the organization are providing plant security and compliance
with government regulations. Although these activities have no direct effect on the product/service or
customer satisfaction, they cannot be eliminated. Examples of discretionary activities deemed beneficial
to the firm include a holiday party and free coffee. Figure 1 depicts an activity analysis. Some activities,
however, may not adequately meet any of the preceding criteria, making them candidates for elimination.

Figure 1. Example of an activity analysis

Source: Cost management: A strategic emphasis, 2019, p. 149.

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Value-Added Analysis
Eliminating activities that add little or no value to customers reduces resource consumption and allows
the firm to focus on activities that increase customer satisfaction. Knowing the values of activities allows
employees to see how work really serves customers and which activities may have little value to the
ultimate customers and should be eliminated or reduced. To ensure that no activities are missed in the
value-added analysis, management may want to prepare a process map. The process map is a diagram
that identifies each step that is currently involved in making a product or providing a service. Development
of the process map should include input from those currently involved in providing the product or service.
The following measures are used in assessing a firm’s activities:
• High-value-added activity. It significantly increases the value of the product or service to the
customers. Removal of a high-value-added activity perceptively decreases the value of the
product or service to the customer. Examples of high-value-added activities are pouring molten
metal into a mold and preparing a field for planting. Anything that involves designing, processing,
and delivering products and services can be classified as high value-added activity. Table 1
illustrates high value-added activities of a television news broadcasting firm. The exhibit also
includes examples of low-value-added activities.
• Low-value-added activity. It consumes time, resources, or space but adds little regarding
satisfying customer needs. If eliminated, customer value or satisfaction decreases imperceptibly
or remains unchanged. Moving parts between processes, waiting time, repairing, and rework are
examples of low-value-added activities. Reduction or elimination of low-value-added activities
reduces cost. Low-value-added activities can be eliminated without affecting the form, fit, or
function of the product or service. These also include activities that are duplicated in another
department or add unnecessary steps to the business process.

High-value-added activity Low-value-added activity

These activities, if eliminated, would affect These activities, if eliminated, would not
the accuracy and effectiveness of the affect the accuracy and effectiveness of the
newscast and decrease total viewers as well newscast. The activity contributes nothing to
as ratings for a specific time slot. the quest for viewer retention and improved
ratings.
• Verification of story sources and acquired • Developing stories not used in a
information newscast
• Efficient electronic journalism to ensure • Assigning more than one (1) person to
effective taped segments develop each facet of the same news
• Newscast story order planned so that story
viewers can follow from one (1) story to • Newscast not completed on time
the next because of one (1) or more inefficient
• Field crew time used to access the best processes
footage possible • Too many employees on a particular shift
• Meaningful news story writing or project
Table 1. Television news broadcasting firm’s activities
Source: Cost management: A strategic emphasis, 2019, p. 150.

References:
Blocher, E., Jurds, D., Smith, S., & Stout D. (2019). Cost management: A strategic emphasis. McGraw-Hill.
Rante, G. A. (2016). Cost accounting. Millenium Books, Inc.

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