Chapter Five: Activity-Based Costing System

In this chapter we will be looking at an alternative method of cost accumulation,

ABC. ABC is a modern alternative to absorption costing which attempts to overcome
the problems of costing in a modern manufacturing environment.

Traditional costing systems

Traditional costing systems use a single basis for absorbing all overheads into cost
units for a particular production department cost centre.

Activity based costing

Production overheads are by no means all volume-related and hence a single basis for
absorption, eg labour hours, would not adequately reflect the complexity of producing
certain products/cost units as opposed to others.

ABC is an extension of Traditional costing system specifically considering what

causes each type of overhead category to occur, ie what the cost drivers are. Each type
of overhead is absorbed using a different basis depending on the cost driver.

The ABC approach is to link overhead costs to the products or services that cause
them by absorbing overhead costs on the basis of activities that ‘drive’ costs (cost
drivers) rather than on the basis of production volume.

Activities Cost drivers

PRODUCTION SET UP COSTS NUMBER OF PRODUCTION SET UPS

SUPERVISOR SALARY TOTAL LABOUR HOURS

1Page Dr. Mahmoud Nassar /AAU

• A cost pool is an activity that consumes resources and for which overhead costs are
identified and allocated. For each cost pool, there should be a cost driver.

• A cost driver is a unit of activity that consumes resources. An alternative definition

of a cost driver is a factor influencing the level of cost.

Steps in ABC

(1) Group overheads into activities, according to how they are driven. These are
known as cost pools.
(2) Identify the cost drivers for each activity, ie what causes the activity cost to be
incurred.
(3) Calculate a cost per unit of cost driver.
(4) Absorb activity costs into production based on usage of cost drivers.

Advantages and disadvantages of ABC

ABC has a number of advantages:

• It provides much better insight into what drives overhead costs.

• ABC recognises that overhead costs are not all related to production and sales
volume.
• In many businesses, overhead costs are a significant proportion of total costs, and
management needs to understand the drivers of overhead costs in order to manage the
business properly. Overhead costs can be controlled by managing cost drivers.
• It can be applied to derive realistic costs in a complex business environment.
• ABC can be applied to all overhead costs, not just production overheads.
• ABC can be used just as easily in service costing as in product costing.

2Page Dr. Mahmoud Nassar /AAU

Criticisms of ABC:

• It is impossible to allocate all overhead costs to specific activities.

• ABC costs are based on assumptions and simplifications. The choice of both
activities and cost drivers might be inappropriate.

• ABC can be more complex to explain to the stakeholders of the costing exercise.
• The benefits obtained from ABC might not justify the costs.

The implications of switching to ABC

The use of ABC has potentially significant commercial implications:

• Pricing can be based on more realistic cost data.

• Sales strategy can be more soundly based.

• Performance management and decision making can be improved

3Page Dr. Mahmoud Nassar /AAU

Example 1

A company manufactures two products, P and Q. Monthly data relating to production

and sales are as follows.

Product P Product Q
Direct material cost per unit $15 $20
Direct labour hours per unit 1 hour 2 hours
Direct labour cost per unit $20 $40
Sales demand 100 units 950 units

Production overheads are $200,000 each month and are absorbed on a direct labour
hour basis. The OAR is $100 per direct labour hour.

The management accountant has produced a report on the potential value of ABC as a
preferred alternative to the traditional absorption costing system, and has found that
there are five main areas of activity that can be said to consume overhead costs. The
management accountant has gathered the following monthly information:

Activity Total cost Cost driver Total N P Q

Setting up 20000 Number of setups 4 1 3

Machining 80000 Machine hours 2000 100 1900
Order handling 20000 Number of orders 4 1 3
Quality control 20000 Number of inspections 5 1 4
Engineering 60000 Engineering hours 1000 500 500
Total 200000

Calculate the costs, in total and per unit, for Product P and Product Q, using ABC.

4Page Dr. Mahmoud Nassar /AAU

Solution (1)

Activity Total Cost $ Cost driver P$ Q$

Setting up 20,000 Cost per setup 5,000 5,000 15,000

Machining 80,000 Cost per machine hour 40 4,000 76,000
Order handling 20,000 Cost per order 5,000 5,000 15,000
Quality control 20,000 Cost per inspection 4,000 4,000 16,000
Engineering 60,000 Cost per engineering hour 60 30,000 30,000
––––– ––––– –––––
200,000 48,000 152,000
––––– ––––– –––––

Product
Product
P Q
$ $
Direct materials 1,500 19,000
Direct labour 2,000 38,000
Overheads 48,000 152,000
––––– –––––
Total cost 51,500 209,000
––––– –––––
Number of units 100 950
Cost per unit $515 $220

5Page Dr. Mahmoud Nassar /AAU

Solution (1)

Activity Total Cost $ Cost driver P$ Q$

Setting up Cost per setup

Machining Cost per machine hour
Order handling Cost per order
Quality control Cost per inspection
Engineering Cost per engineering hour
––––– ––––– –––––

––––– ––––– –––––

Product Product
P Q
$ $
Direct materials
Direct labour
Overheads
––––– –––––
Total cost
––––– –––––
Number of units
Cost per unit $ $

6Page Dr. Mahmoud Nassar /AAU

Example 2

Cabal makes and sells two products, Plus and Doubleplus. The direct costs of
production are $12 for one unit of Plus and $24 per unit of Doubleplus. Information
relating to annual production and sales is as follows:

Plus Doubleplus
Annual production and sales 24,000 units 24,000 units
Direct labour hours per unit 1.0 1.5
Number of orders 10 140
Number of batches 12 240
Number of setups per batch 1 3
Special parts per unit 1 4

Information relating to production overhead costs is as follows:

Cost driver Annual cost $

Setup costs Number of setups 73,200
Special parts handling Number of special parts 60,000
Other materials handling Number of batches 63,000
Order handling Number of orders 19,800
Other overheads 216,000
––––––––
432,000

Other overhead costs do not have an identifiable cost driver, and in an ABC system,
these overheads would be recovered on a direct labour hours basis.

(a) Calculate the production cost per unit of Plus and of Doubleplus if the
company uses traditional absorption costing and the overheads are recovered
on a direct labour hours basis.
(b) Calculate the production cost per unit of Plus and of Doubleplus if the
company uses ABC.

7Page Dr. Mahmoud Nassar /AAU

Solution (2)
A Traditional absorption costing

Budgeted direct labour hours 60,000

(24,000 × 1.0) + (24,000 × 1.5) /
Budgeted overhead costs $432,000

Recovery rate per direct labour hour $7.20

Plus Doubleplus
$ $
Direct costs 12.00 24.00
Production overhead 7.20 10.80
––––– –––––
19.20 34.80
Full production cost ––––– ––––

B ABC
Plus Doubleplus Total
Batches 12 240 252
Setups 12 720 732
Special parts 24,000 96,000 120,000
Orders 10 140 150
Direct labour hours 24,000 36,000 60,000

Cost driver rates

Setup costs $73,200/732 $100 per setup
Special parts handling $60,000/120,000 $0.50 per part
Order handling $19,800/150 $132 per order
Materials handling $63,000/252 $250 per batch
Other overheads $216,000/60,000 $3.60 per hour

Plus Doubleplus Total

Setup costs 1,200 72,000 73,200
Special parts handling costs 12,000 48,000 60,000
Order handling costs 1,320 18,480 19,800
Materials handling costs 3,000 60,000 63,000
Other overheads 86,400 129,600 216,000
_______ _______
103,920 328,080 432,000
_______ _______ _______
Number of units 24,000 24,000
Direct cost 12.00 24.00
Overhead cost per unit 4.33 13.67
_______ _______
Full cost 16.33 37.67

8Page Dr. Mahmoud Nassar /AAU

Note: In the example above the full production costs were:

Plus Doubleplus
• Using traditional absoprtion costing $19.20 $34.80
• Using ABC $16.33 $37.67
• Assume the selling prices are $25.00 $40.00
• Using absorption costing sales margins are 3.2% 13.0%
• ABC sales margins are 34.7% 5.8%

Thus, using ABC it is apparent that Plus is approximately 6 times as profitable as

Doubleplus and should therefore, subject to any other considerations, be given much
greater emphasis than Doubleplus in terms of sales and production.

9Page Dr. Mahmoud Nassar /AAU

Solution (2)
A Traditional absorption costing
Budgeted direct labour hours
( )+( ) /
Budgeted overhead costs $

Recovery rate per direct labour hour $

Plus Doubleplus
$ $
Direct costs
Production overhead
––––– –––––

Full production cost ––––– ––––

B ABC
Plus Doubleplus Total
Batches
Setups
Special parts
Orders
Direct labour hours

Cost driver rates

Setup costs $ / $ per setup

Special parts handling $ / $ per part
Order handling $ / $ per order
Materials handling $ / $ per batch
Other overheads $ / $ per hour

Plus Doubleplus Total

Setup costs
Special parts handling costs
Order handling costs
Materials handling costs
Other overheads
_______ _______ _______

_______ _______ _______

Number of units
Direct cost
Overhead cost per unit
_______ _______
Full cost

10Page Dr. Mahmoud Nassar /AAU

Case 1:

Hettich Corporation uses an activity-based costing system with the following three
activity cost pools:

Activity Cost Pool Total Activity

Fabrication 20,000 machine-hours
Order processing 200 orders
Other Not applicable

The Other activity cost pool is used to accumulate costs of idle capacity and
organization-sustaining costs.

The company has provided the following data concerning its costs:

Wages and salaries $480,000

Depreciation 120,000
Occupancy 200,000
Total $800,000

The distribution of resource consumption across activity cost pools is given below:
Activity Cost Pools
Fabrication Order Processing Other Total
Wages and salaries 55% 20% 25% 100%
Depreciation 10% 45% 45% 100%
Occupancy 25% 40% 35% 100%

The activity rate for the Order Processing activity cost pool is closest to:
A) $1,400 per order B) $1,600 per order C) $1,150 per order D) $800 per order

11Page Dr. Mahmoud Nassar /AAU

Case 2:
Poskey Corporation uses an activity-based costing system with three activity cost
pools. The company has provided the following data concerning its costs and its
activity based costing system:

Costs:
Wages and salaries $400,000
Depreciation 160,000
Utilities 100,000
Total $660,000

Distribution of resource consumption:

Activity Cost Pools
Assembly Setting Up Other Total
Wages and salaries 40% 40% 20% 100%
Depreciation 20% 35% 45% 100%
Utilities 25% 55% 20% 100%

How much cost, in total, would be allocated in the first-stage allocation to the
Assembly activity cost pool?

A) $187,000 B) $264,000 C) $217,000 D) $165,000

12Page Dr. Mahmoud Nassar /AAU

Case 3:

Radakovich Corporation has provided the following data from its activity-based
costing system:

Activity Cost Pool Total Cost Total Activity

Assembly $436,240 28,000 machine-hours
Processing orders $60,896 1,600 orders
Inspection $82,767 1,410 inspection-hours

The company makes 230 units of product F60N a year, requiring a total of 480
machine-hours, 50 orders, and 30 inspection-hours per year. The product's direct
materials cost is $12.70 per unit and its direct labor cost is $45.93 per unit. The
product sells for $126.60 per unit.

According to the activity-based costing system, the product margin for product F60N
is:

A) $6,251.70 per unit B) $4,490.70 per unit

C) $6,393.70 per unit D) $15,633.10 per unit

13Page Dr. Mahmoud Nassar /AAU

Case 4:

Rosenbrook Corporation has provided the following data from its activity-based
costing system:

Activity Cost Pool Total Cost Total Activity

Assembly $710,770 37,000 machine-hours
Processing orders $39,690 1,800 orders
Inspection $119,116 1,940 inspection-hours

Data concerning one of the company’s products, Product H73N, appear below:

Selling price per unit $125.10

Direct materials cost per unit $34.94
Direct labor cost per unit $49.21
Annual unit production and sales 460
Annual machine-hours 510
Annual orders 80
Annual inspections 10

According to the activity-based costing system, the product margin for product H73N
is:

A) $7,275.90 per unit B) $6,661.90 per unit

C) $18,837.00 per unit D) $8,425.90 per unit

14Page Dr. Mahmoud Nassar /AAU