Strategic Cost Management

Marian G. Magcalas, CPA, MBA

Tricia Nicole G. Embelino, CPA

 TABLE OF CONTENTS
Page
Module 8. Cost-Volume-Profit Analysis 165
Introduction 165
Learning Outcomes 166
Lesson 1. Cost-Volume-Profit Analysis 166
Lesson 2. Applications of CVP Analysis 167
Lesson 3. Inherent Assumptions of CVP Analysis 168
Lesson 4. The Contribution Margin Income Statement 169
Lesson 5. Break-even Analysis 171
Lesson 6. Margin of Safety 175
Lesson 7. Composite Break-even Point 177
Assessment Task 179
Summary 183
References 184

Modules 9. Variable Costing Versus Absorption Costing 185

Introduction 185
Learning Outcomes 186
Lesson 1. Absorption Costing and Variable Costing 186
Lesson 2. Applications of Variable Costing 188
Lesson 3. Advantages and Disadvantages of Variable Costing 188
Lesson 4. Effects on Net Income 189
Lesson 5. Illustrative Problem 190
Lesson 6. Standard Costs Under Absorption and Variable 193
Costing 196
Assessment Task 2
Summary 199
References 200

Module 10. Activity-Based Management and Costing 201

Introduction 201
Learning Outcomes 202
Lesson 1. Definition of Terms 202
Lesson 2. Activity-Based Management 203
Lesson 3. Manufacturing Cycle Effieciency 204
Lesson 4. Activity-Based Costing 204
Lesson 5. Differences Between Traditional and ABC Costing 205
Lesson 6. Steps in Activity-Based Costing 206
Lesson 7. Illustrative Problem 208
Assessment Task 3 209
Summary 211
References 212
 MODULE 8
COST VOLUME PROFIT
ANALYSIS

Introduction

This module explains a planning tool called cost volume-profit (CVP) analysis. CVP
analysis examines the behavior of total revenues, total costs, and operating income (profit) as
changes occur in the output level, selling price, variable cost per unit, and/or fixed costs of a
product or service. The reliability of the results from CVP analysis depends on the
reasonableness of the assumptions (Verma et al., n.d.).

The study of cost-volume profit analysis is often referred to as breakeven analysis.

Break-even analysis is an extension of the marginal costing principles. It is interpreted in
narrow as well as broader sense. In its narrow sense, break even analysis is concerned with

165
finding out the break even point, i.e. the point of no profit and no loss. When used in broader
sense, it is a system of analysis that can be used to determine probable profit/loss at any
given level of output (Verma et al., n.d.).

Learning Outcomes
At the end of this module, students should be able to:
1. elucidate the meaning of break even point.
2. Determine the break even point in number of units and in total sales.
3. Determine the number of units to be sold to attain a targeted profit.
4. Prepare a profit-volume graph.
5. Prepare a cost-volume-profit graph.
6. Elaborate the meaning and computation of contribution margin.
7. Explain the impact of risk, uncertainty, and changing variables on cost-volume-
profit analysis.

Lesson 1. Cost-Volume-Profit (CVP) Analysis

(Edwards & Hermenson, n.d.)

Cost-Volume-Profit Analysis- a systematic examination of the relationships among

costs, cost driver and profit.

Companies use cost-volume-profit (CVP) analysis (also called break-even analysis)

to determine what affects changes in their selling prices, costs, and/or volume will have on
profits in the short run. A careful and accurate cost-volume-profit (CVP) analysis requires
knowledge of costs and their fixed or variable behavior as volume changes.

A cost-volume-profit chart is a graph that shows the relationships among sales,

costs, volume, and profit. Look at illustration below. The illustration shows a cost-volume-
profit chart for Video Productions, a company that produces DVDs. Each DVD sells for P20.
The variable cost per DVD is P12, and the fixed costs per month are P 40,000.

166
 Figure 8.1 The cost-volume-profit chart (Edwards & Hermenson, n.d.)

The total cost line represents the fixed costs of P40,000 plus P12 per unit. Thus, if
Video Productions produces and sells 6,000 DVDs, the company’s total costs are P112,000,
made up of P40,000 fixed costs and P 72,000 total variable costs (P 72,000 = P 12 per unit X
6,000 units produced and sold).

The total revenue line shows how revenue increases as volume increases. Total
revenue is P 120,000 for sales of 6,000 tapes (P 20 per unit X 6,000 units sold). In the chart,
we demonstrate the effect of volume on revenue, costs, and net income, for a particular price,
variable cost per unit, and fixed cost per period.

Lesson 2. Applications of CVP Analysis

Planning and decision-making, which may involve choosing the (Roque, 2013):

1. Type of product to produce and sell.

167
 2. Pricing policy to follow.
3. Marketing strategy to use, and
4. Type of productive facilities to acquire.

Strategic Questions Answered by CVP Analysis (Ali al Masudi, 2018):

1. What is the expected level of profit at a given sales volume?

2. What additional amount of sales is needed to achieve a desired level of profit?
3. What will be the effect on profit of a given increase in sales?
4. What is the required funding level for a governmental agency, given desired service
levels?
5. Is the forecast for sales consistent with forecasted profits?
6. What additional profit would be obtained from a given percentage reduction in unit
variable costs?
7. What increase in sales is needed to make up a given decrease in price to maintain
the present profit level?
8. What sales level is needed to cover all costs in a sales region or product line?
9. What is the required amount of increase in sales to meet the additional fixed
charges from a proposed plant expansion?

Lesson 3. Inherent Assumptions of CVP Analysis

(Verma et al., n.d.)

1. All costs can be separated into .fixed and variable components.

2. Variable cost per unit remains constant and total variable cost varies in direct
proportion to the volume of production.
3. Total fixed cost remains constant.
4. Selling price does not change as volume changes.
5. There is only one product or in the case 0 multiple products, the sales mix does
not change. In other words, when several products are being sold, the sale of various
products will always be in some predetermined proportion.
6. There is synchronisation between production and sales.
7. Productivity per worker does not change.

168
 8. There will be no change in the general price level.

Lesson 4. The Contribution Margin Income Statement

(Roque, 2013)

The costs and expenses in the Contribution Margin Income Statement are classified
as to behavior ( variable and fixed). The contribution margin income statement is prepared
for management’s own use. The format facilitates cost-volume-profit analysis.

The amount of contribution margin, which is the difference between sales and variable
costs is shown below:

Contribution Margin Income Statement

Sales (units x selling price) Pxx

Less: Variable costs (units x variable cost per unit) xx
Contribution Margin Pxx
Less: Total fixed costs xx
Income before tax Pxx

Costs Classified as to Variability (Verma et al., n.b.)

Depending on the variability behavior costs can be classified into variable and fixed
costs. The distinction between fixed and variable cost is important in forecasting the effect of
shortrun changes in volume upon costs and profits.

(a) Variable cost : The variable cost is a cost that tends to vary in accordance with
level of activity within the relevant range and within a given period of time. The
product costs i.e., direct material, direct labor and direct expenses tend to vary in
direct proportion to the level of activity. An increase in the volume means a
proportionate increase in the total variable costs and a decrease in volume will
lead to a proportionate decline in the total variable costs. There is a linear
relationship between volume and variable costs. They are constant per unit.

169
(b) Fixed cost :
The fixed cost is a cost that tends to be unaffected by changes in the level of
activity during a given period of time. The fixed costs remain constant in the total
regardless of changes in volume up to a certain level of output. They are not
affected by changes in the volume of production. There is an inverse relationship
between volume and fixed cost per unit. Fixed costs tend to remain constant for all
levels of activity within a certain range. It follows that some fixed costs will continue
to be incurred even when the activity comes down to nil. Some fixed costs are
liable to change from one period to another. For example salaries bill may go up
because of annual increments or due to change in the pay rates and due to pay
structure.

(c) Semi-variable cost or semi-fixed cost

Many costs fall between these two extremes. They are called as semi-variable
cost or semi- fixed costs. They are neither perfectly variable nor absolutely fixed in
relation to changes in volume. They change in the same direction as volume but
not in direct proportion thereto.

An example is found in telephone charges. The rental element is a fixed cost

whereas charges for call made are a variable cost.

CVP analysis begins with the basic profit equation (Ali al Masudi, 2018)
Profit =Total revenue - Total costs
Separating costs into variable and fixed categories, we express profit as:
Profit = Total revenue -(Total variable costs +Total fixed costs)

We use the profit equation to plan for different volumes of operations.

CVP analysis can be performed using either:
1. Units (quantity) of product sold
2. Revenues (in pesos)

170
Contribution Margin:
Contribution margin per unit tells us how much revenue from each unit sold can be
applied toward fixed costs it is:

Figure 8.2 Unit contribution margin (Ali al Masudi, 2018)

(CMR) is the percent by which the selling price (or revenue) per unit exceeds the
variable cost per unit, or contribution margin as a percent of revenue, it is

Figure 8.3 Contribution Margin Ratio

Figure 8.3 Contribution margin ratio (Ali al Masudi, 2018)

Lesson 5. Break Even Analysis

A company breaks even for a given period when sales revenue and costs charged to
that period are equal. Thus, the break-even point is that level of operations at which a
company realizes no net income or loss. A company may express a break-even point in peso
sales revenue or number of units produced or sold. No matter how a company expresses its
break-even point, it is still the point of zero income or loss (Edwards & Hermenson, n.d.).

171
 The break-even point is the volume of output at which total cost is exactly equal to
revenue. It is a point of no profit and no loss. This is the minimum point of production at which
total cost is recovered and after this point profit begins (Edwards & Hermenson, n.d.).

The break even point formulas for a single product are presented below:

Figure 8.4 Break even point in units (Harina, 2003)

Figure 8.5 Break even point in peso sales (Harina, 2003)

Illustrative problem:

The BEP company plans to market a new product. Based on its market studies,
BEP estimates that it can sell 70,000 units during the year. The selling price per unit
is P2.00. Variable cost ratio is 40% of sales. Fixed costs are estimated to be P60,000.

Required: Compute the break-even point

172
 a. In units
b. In Sales pesos

Solution:

a. Break even point in units = Fixed costs = P60,000 = 50,000 units

CM per unit P1.20*
*(P2.00 – (40% x P2.00)= P1.20

b. Break even point in pesos= Fixed costs = P60,000 = P100,000

CM ratio 1-40%

The break even formula with Net income desired Before income tax:

Figure 8.6 Target Sales (Harina, 2003)

Formula for Net income Desired After Income Tax:
Net Income
Target sales in units = Fixed costs + 1-Tax rate
Contribution Margin per unit
Net Income
Target sales in pesos = Fixed costs + 1-Tax rate
Contribution Margin Ratio
Illusttrative problem: (Harina, 2003)

173
 The TS Company sells Product A for P60 each. Variable costs are P36 per
unit. Fixed costs are P375,000. How much sales (in units and in pesos) must be
reached to realize a
1. Net income of P102,000 before income taxes.
2. Net income of P102,000 after income taxex. Tax rate is 32%.
3. Net income is 15% of sales. Ignore income taxes.
4. 20% Return on Sales. Ignore income taxes.
Solution:
1. a. Target Sales in units = FC + Net Income = P375,000 +P102,000 = 19,875 units
CM per unit P60- P36

b.Target Sales in pesos = FC + Net Income = P375,000 +P102,000 = P1,192,500

CM ratio 40%*
*(P60 – P36) ÷ P60 = 40%
Net Income
2. a. Target sales in units = Fixed costs + 1-Tax rate
Contribution Margin per unit
P102,000
= P375,000 + 100%-32% = P375,000 + P150,000
(P60 P36) P24
= 21,875 units
Net Income
b.Target sales in pesos = Fixed costs + 1-Tax rate
Contribution Margin ratio
P102,000
= P375,000 + 100%-32% = P375,000 + P150,000
40% 40%
= P1,312,500

3. Sales = Variable cost + Fixed Cost + Profit

a. 60X = P36X +P375,000 + 15%(P60X)
60X= P36X + P375,000 + P9X

174
 60X - 45X = P375,000
15X = P375,000
X = 25,000 units

b. Peso sales = 25,000 x P60 = P1,500,000

4. Target Sales = Fixed Cost = P375,000 = P1,875,000

CM ratio - % of Return on Sales 40%-20%

Sensitivity Analysis (Ali al Masudi, 2018)

1. CVP provides structure to answer a variety of “what-if” scenarios

2. “What” happens to profit “if”:
A. Selling price changes
B. Volume changes
C. Cost structure changes
1) Variable cost per unit changes
2) Fixed cost changes
Sensitivity Analysis is based on
1. Changes in Fixed Costs
2. Changes in Unit Contribution Margin

Lesson 6. Margin of Safety (Ali al Masudi, 2018)

The Margin of Safety is the difference between the expected level of sales and
breakeven sales.
It may be expressed in units or dollars of sales.
1. Margin of safety in units = Actual(estimated) units of activity -Units at breakeven point
2. Margin of safety in revenues = Actual(estimated)revenue - Revenue at breakeven point
3. The MOS Ratio removes the firm’s size from the output, and expresses itself in the form of
a percentage:

175
 Figure 8.7. Margin of Safety (Harina, 2003)

Illustrative Problem (Harina, 2003)

MS Company’s break even sales are P528,000. The variable costs ratio to sales is
60%, while the net income percentage to sales is 8%.

Based on the above data, compute for the following:

a. Margin of safety ratio
b. Actual sales
c. Margin of safety
d. Fixed Costs
e. Net income

176
Solution:
a. Margin of safety ratio = Profit margin ratio = 8% = 20%
Contribution margin ratio 100%- 60%

b. Actual Sales = Breakeven Sales = P528,000 = P660,000

(1 – Margin of safety ratio) (1 – 20%)

c. Margin of safety = Actual Sales - Break even Sales

= P660,000 – P528,000
= P132,000

d. Fixed Costs = Break even sales x CM ratio = P528,000 x 40% = P211,200

e. Sales P660,000 100%

Variable costs 396,000 60%
Contribution margin P264,000 40%
Fixed costs 211,200 32%
Net Income P 52,800 8%

Lesson 7. Composite Break Even Point – More Than One

Product (Harina, 2003)

For a company with more than one product, sales mix is the relative combination in
which a company’s products are sold. Different products have different selling prices, cost
structures, and contribution margins.

A weighted-average CM must be calculated (in this case, for two products) This new
CM would be used in CVP equations.

Multi-Product BEP = Fixed Costs

Weighted Average CM per unit

Let’s assume X sells see how we deal with break-even analysis.

177
 Break-even Point in unit = Fixed expenses
Weighted-average unit contribution margin

1. Weighted average CMu = ( Prod#1 CMu x Product #1 Q ) + ( Prod #2 CMu x Product #2 Q )

Total Units Sold (Q) for Products

2. Weighted average CMu = Total contribution margin

Total Units Sold (Q) for Products

Break-even Point in pesos = Fixed expenses

Weighted-average unit contribution margin ratio

1. Weighted average CM percent = ( CM ratio Product #1 ) + ( CM ratio Product #2 )

Total revenue for Products

2. Weighted average CM percent = total contribution margin

Total revenue for Products

Example:
X provides us with the following information:
Input section Youth Road Mountain Total
Expected sales volume-units 10,000 18,000 12,000 40,000
Price per unit 200 700 800
Variable cost per unit 75 250 300
Contribution Margin 125 450 500
Fixed costs 14,700,000
Desired after-tax profit 100,000
Income tax rate 30%

178
Solution:

Figure 8.8. Composite Break Even Solution (Harina, 2003)

ASSESSMENT TASK (Prenhall, n.d.)

Fill in the blank(s) to complete each statement.

1. __________________________________ is equal to selling price minus variable cost per unit.
2. The financial report that highlights the contribution margin as a line item is called the
_______________________________.
3. The possibility that an actual amount will deviate from an expected amount is called
_______________.
4. ________________________ is a “what if” technique that, when used in the context of CVP
analysis, examines how an outcome such as operating income will change if the original
predicted data are not achieved or if an underlying assumption changes.
5. The quantities of various products (or services) that constitute total unit sales of a company
is called the ________________.

179
True-False Indicate whether each statement is true (T) or false (F).

__1. Generally, the breakeven point in revenues can be easily determined by simply summing
all costs in the company’s contribution income statement.
__ 2. At the breakeven point, total fixed costs always equals contribution margin.
__ 3. The amount by which budgeted (or actual) revenues exceed breakeven revenues is
called the margin of forecasting error.
__ 4. An increase in the income tax rate increases the breakeven point.
__ 5. Trading off fixed costs in a company’s cost structure for higher variable cost per unit
decreases downside risk if demand is low and decreases return if demand is high.
__6. At any given level of sales, the degree of operating leverage is equal to contribution
margin divided by operating income.
__ 7. If the budget appropriation for a government social welfare agency is reduced by 15%
and the cost-volume relationships remain the same, the client service level would decrease
by 15%.
__ 8. The longer the time horizon in a decision situation, the lower the percentage of total
costs that are variable.
__ 9. Cost of goods sold in manufacturing companies is a variable cost.

Multiple Choice Select the best answer to each question. Space is provided for computations
after the quantitative questions.

__ 1. CVP analysis does not assume that:

a. selling prices remain constant.
b. there is a single revenue and cost driver.
c. total fixed costs vary inversely with the output level.
d. total costs are linear within the relevant range.

__ 2. Given for Winn Company in 2020: revenues $530,000, manufacturing costs $220,000
(one-half fixed), and marketing and administrative costs $270,000 (twothirds variable). The
contribution margin is:
a. $40,000.

180
b. $240,000.
c. $310,000.
d. $330,000.

__ 3. Using the information in question 2 and ignoring inventories, the gross margin for Winn
Company is:
a. $40,000.
b. $240,000.
c. $310,000.
d. $330,000.

__ 4. Koby Company has revenues of $200,000, variable costs of $150,000, fixed costs of
$60,000, and an operating loss of $10,000. By how much would Koby need to increase its
revenues in order to achieve a target operating income of 10% of revenues?
a. $200,000
b. $231,000
c. $251,000
d. $400,000

__ 5. The following information pertains to Nova Co.’s CVP relationships: Breakeven point in
units 1,000 Variable cost per unit $500 Total fixed costs $150,000 How much will be
contributed to operating income by the 1,001st unit sold?
a. $650
b. $500
c. $150
d. $0

__ 6. During 2020, Thor Lab supplied hospitals with a comprehensive diagnostic kit for $120.
At a volume of 80,000 kits, Thor had fixed costs of $1,000,000 and an operating income of
$200,000. Due to an adverse legal decision, Thor’s liability insurance in 2021 will increase by
$1,200,000. Assuming the volume and other costs are unchanged, what should the selling
price be in 2021, if Thor is to earn the same operating income of $200,000?
a. $120

181
b. $135
c. $150
d. $240
__ 7. In the fiscal year just completed, Varsity Shop reported net income of $24,000 on
revenues of $300,000. The variable costs as a percentage of revenues are 70%. The income
tax rate is 40%. What is the amount of fixed costs?
a. $30,000
b. $50,000
c. $66,000
d. $170,000
__ 8. The amount of total costs probably will not vary significantly in decision situations in
which:
a. the time span is quite short and the change in units of output is quite large.
b. the time span is quite long and the change in units of output is quite large.
c. the time span is quite long and the change in units of output is quite small.
d. the time span is quite short and the change in units of output is quite small.

__ 9. Product Cott has revenues of $200,000, a contribution margin of 20%, and a margin of
safety of $80,000. What are Cott’s fixed costs?
a. $16,000 c. $80,000
b. $24,000 d. $96,000

__ 10. For a multiple-product company, a shift in sales mix from products with high
contribution-margin percentages toward products with low contribution-margin percentages
causes the breakeven point to be:
a. lower. c. unchanged
b. higher. d. different but undeterminable.

Summary

CVP analysis examines the behavior of total revenues, total costs, and operating
income (profit) as changes occur in the output level, selling price, variable cost per unit, and/or

182
fixed costs of a product or service. The reliability of the results from CVP analysis depends on
the reasonableness of the assumptions.

The study of cost-volume profit analysis is often referred to as breakeven analysis.

Break-even analysis is an extention of the marginal costing principles. It is interpreted in
narrow as well as broader sense. In its narrow sense, break even analysis is concerned with
finding out the break even point, i.e. the point of no profit and no loss. When used in broader
sense, it is a system of analysis that can be used to determine probable profit/loss at any
given level of output.

CVP is useful in planning and decision-making, which may involve choosing the:
type of product to produce and sell, pricing policy to follow, marketing strategy to use, and
type of productive facilities to acquire.
The break-even point is the volume of output at which total cost is exactly equal to
revenue. It is a point of no profit and no loss. This is the minimum point of production at which
total cost is recovered and after this point profit begins.

The Margin of Safety is the difference between the expected level of sales and
breakeven sales. It may be expressed in units or dollars of sales.

For a company with more than one product, sales mix is the relative combination in
which a company’s products are sold. Different products have different selling prices, cost
structures, and contribution margins. A weighted-average CM must be calculated

References

Ali al Masudi, H. (2018). Cost-Volume-Profit Analysis Ch. 3.

https://www.researchgate.net/publication/329758697

183
Cost-Volume-Profit Analysis Chapter 3. (n.d).
https://wps.prenhall.com/wps/media/objects/2272/2326812/cost12_study03.pdf

De Leon, N.D,, De Leon, E.D., De Leon, G.M. Jr. (2019). Cost Accounting and Control.
Manila City, Phils. GIC Enterprises & Co. Inc.

Edwards, J. D., Hermanson, R.H. n.d. Accounting Principles: A Business Perspective.

Endeavour International Corporation.(n.d.) https://courses.lumenlearning.com/sac-
managacct/chapter/cost-volume-profit-analysis-in-planning/

Harina, R.M. (2003). Management Advisory Services.Mandaluyong City, Philippines.

National Book Store.

Roque, R.S. (2013). Reviewer in Management Advisory Services. Manila City,

Philippines. GIC Enterprises and Co.,Inc.

Verma, H.L, Turan, M. S., Bodla, B. S., Garg, M. C., Singh, M. C. (n.d.) Cost &
Managerial Accounting. Directorate of Distance Education Guru Jambheshwar
University. Hisar, India. Competent Printing Press.

MODULE 9
VARIABLE COSTING VERSUS
ABSORPTION COSTING

184
 Introduction

Variable costing is a concept used in managerial and cost accounting in which the
fixed manufacturing overhead is excluded from the product-cost of production. The method is
in contrast with absorption costing, in which the fixed manufacturing overhead is allocated to
products produced. In accounting frameworks such as GAAP and IFRS, variable costing is

not allowed in financial reporting (Corporate Finance Institute ).

Although accounting frameworks such as GAAP and IFRS prohibit the use of variable
costing in financial reporting, this costing method is commonly used by managers to:

 Conduct break-even analysis to determine the number of units needed to be sold to

begin earning a profit.
 Determine the contribution margin on a product which help tpunderstand the
relationship between cost, volume and profit.
 Facilitate decision-making by excluding fixed manufacturing overhead costs, which
can create problems due to how fixed costs are allocated to each product.

185
 Learning Outcomes
At the end of this module, students should be able to:
1. Explain the meaning and salient features of variable costing.
2. Recognize the difference between variable costing and absorption costing
methods.
3. Prepare income statements using absorption and variable costing.
4. Reconcile absorption costing income with variable costing income.
5. Determine how the standard cost accounting system is used with absorption
and variable costing.
6. Distinguish the advantages and disadvantages of using variable costing.

Lesson 1. Absorption Costing and Variable Costing

Absorption Costing
Under absorption costing, (also called full or conventional costing), product costs
include all the cost elements of production, namely, direct materials, direct labor, and all
factory overhead costs. Since all of the manufacturing costs are considered as product costs
under absorption costing, this method therefore includes both variable and fixed
manufacturing costs in determining product costs (Roque, 2013).

Under absorption costing, the following costs go into the product (Roque, 2013):

 Direct material (DM)

 Direct labor (DL)
 Variable manufacturing overhead (VMOH)
 Fixed manufacturing overhead (FMOH)

Variable Costing
Variable costing, also called direct costing, is a product costing method that includes
only the variable manufacturing costs (direct materials, direct labor and variable overhead) in
the computation of product costs. Note, that fixed overhead though a manufacturing cost, is

186
not considered as product cost under the variable costing methods. Instead, fixed overhead
costs are treated as period costs, i.e., they are expensed during the period in which they are
incurred, together with the non-manufacturing costs (Roque, 2013).

Under variable costing, the following costs go into the product:

 Direct material (DM)

 Direct labor (DL)
 Variable manufacturing overhead (VMOH)

Figure 9.1 Comparison of Absorption and Variable Costing (Roque, 2013)

Lesson 2. Applications of Variable Costing

In accordance with the accounting standards for external financial reporting, the cost
of inventory must include all costs used to prepare the inventory for its intended use. It follows
the underlying guidelines in accounting – the matching principle. Absorption costing better
upholds the matching principle, which requires expenses to be reported in the same period
as the revenue generated by the expenses (Corporate Finance Institute, n.d.).

187
 Variable costing poorly upholds the matching principle, as related expenses are not
recognized in the same period as related revenue. In our example above, under variable
costing, we would expense all fixed manufacturing overhead in the period occurred.
However, if the company fails to sell all the inventory manufactured in that year, there would
be poor matching between revenues and expenses on the income statement. Therefore,
variable costing is not permitted for external reporting. It is commonly used in managerial
accounting and for internal decision-making purposes (Corporate Finance Institute, n.d.).

Application of variable costing (Harina, 2003):

1. Inventory valuation
2. Income measurement
3. Relevant cost analysis
4. Cost-volume-profit analysis and other short-run decision making
situations.

Lesson 3. Advantages and Disadvantages of Variable Costing

(Harina, 2003)

Advantages of variable costing:

1. Total fixed cost is reported in the income statement when incurred. This
highlights the effect of fixed cost on net income.
2. Fixed cost is not accounted for as inventoriable cost. This simplifies the record
keeping and provides a better basis for accounting and control of the total fixed
cost incurred.
3. Net income is not influenced by production and inventory changes. Net income
varies with sales.
4. The income statement-reporting format is extremely useful for management
purposes like determining cost-volume relationships and contribution margin data.
Disadvantages of variable costing:
1. Variable costing is not acceptable for external and income tax reporting.
2. Costs are required to be separated into fixed and variable. This can be very difficult
and often subject to individual judgement.

188
 3. Costs are not properly matched with revenues in accordance with the generally
accepted accounting principles.
4. Too much attention may be given to variable costs at the expense of disregarding
fixed costs.

Lesson 4. Effects on Net Income (Harina, 2003)

1. If production is equal to sales, absorption profit is equal to variable costing profit.

2. If production is greater than sales, absorption profit is higher than variable costing
profit.
3. If production is less than sales, absorption profit is lower than variable costing profit.
4. Under variable costing, income tends to move with sales, whereas under absorption
costing income tends to move with production. Thus, net income can be influenced by
inventory changes under absorption costing, but not under direct costing.

Reconciliation of absorption and variable costing income figures (Roque, 2013)

Absorption costing income xx
Add: Fixed overhead in the beginning inventory xx
Total xx
Less: Fixed overhead in the ending inventory xx
Variable costing income xx

Accounting for difference in income

Change in inventory (Production less sales) xx
x Fixed OH cost per unit xx
Difference in income xx
Lesson 5. Illustrative Problem (Harina, 2003):

During the year 200A, Wouie Corporation’s production was equal to the normal
capacity of 1,000 units. It sold 900 units at a price of P50 per unit.
The following costs were incurred during the year:
Total Cost Cost per unit
Direct materials P12,000 P 12

189
 Direct labor 10,000 10
Variable factory overhead 8,000 8
Fixed factory overhead 6,000 6
Variable selling and administrative 4,500 5*
Fixed selling and administrative 3,000 3

*Variable selling and administrative = Total = P4,500 = P5

cost per unit Units sold 900
Required:
1. Product costs per unit under absorption and variable costing.

Product Costs per Unit

Absorption Variable
Costing Costing
Direct materials P12 P12
Direct labor 10 10
Variable factory overhead 8 8
Fixed factory overhead 6 -
Product cost per unit P36 P30

 The difference between the two product costs per unit is the fixed FOH per
unit.
 Under both methods, selling and administrative costs, whether variable or
fixed, are treated as period costs.

2. Income under absorption costing

Sales (900 units X P50) P45,000
Less Cost of goods sold (900 x P36) 32,500
Gross income P12,600
Less Selling and administrative expenses
Variable P4,500
Fixed 3,000 7,500

190
 Income- Absorption costing P5,100

Allocation of the Fixed Overhead Cost:

Total fixed overhead (1,000 units @ P6 per unit) P6,000
Charged to cost of goods sold
(900 units sold X P6 per unit) P5,400
Allocated to inventory cost
(100 unsold units x P6) 600 6,000

Cost of ending inventory:

Number of units
(1,000 units produced - 900 units sold) 100
x Cost per unit- absorption P 36
Cost of ending inventory P3,600*
*Includes fixed overhead cost of P600.

3. Income under variable costing

Sales P45,000
Less Variable costs
Cost of goods sold (900 X P30) P27,000*
Selling and administrative (900 x P5) 4,500 31,500
Contribution margin P13,500
Less Fixed costs
Factory overhead P 6,000**
Selling and administrative expenses 3,000 9,000
Income- Variable costing P 4,500
*The cost of goods sold consists of variable manufacturing costs only. Fixed
factory overhead is not charged to the cost of goods sold.
**The whole amount of fixed factory overhead is charged as a period cost,
regardless of whether all the units produced were sold or not.

Cost of ending inventory:

Number of units 100

191
 x Cost per unit- absorption P30
Cost of ending inventory P3,000*

*Consists of variable manufacturing costs only. Fixed factory overhead is not

an inventoriable cost.

Computation of and accounting for the difference in income:

Absorption costing income P5,100
Variable costing income 4,500
Difference in income P 600

The difference in income represents the amount of fixed factory overhead

charged to inventory (treated as asset).

Accounting:
Change in inventory (Production – Sales) 100 units
(1,000 – 900)
x Fixed FOH cost per unit P6
Difference in income P600

Lesson 6. Standard Costs Under Absorption and Variable

Costing (Roque, 2013)

When a firm uses the standard costing system and income statements are prepared
under the absorption and variable costing methods:

1. Cost of goods sold are computed at standard.

2. The standard cost of goods sold is adjusted to actual costs by adding
unfavorable variances and/or deducting favorable variances.
3. In absorption costing, both the variable and fixed manufacturing cost variances
are used as adjustment to the standard cost of goods sold.
4. In variable costing, only the variable manufacturing cost variances are used as
adjustments to the standard cost of goods sold.

192
Illustrative example:

Irish Corporation uses a standard costing system for a product that it manufactures. For the
year 200A, the following standards were established based on normal production of 1,000
units.

Total Cost
Materials 2 pcs @ P6 per piece P12
Labor 6 hrs @ P4 per hour 20
Variable overhead 5 hrs @ P3 per hour 15
Fixed factory overhead 5 hrs @P2 per hour 10
Total standard cost per unit P57

Following are the actual data for the year 200A:

Production 1,100 units
Sales 950 units
Selling price P 80
Materials (2,250 @ P5.80) P13,050
Labor (5,420 hrs @ P4.30 per hour) 23,306
Variable overhead 15,718
Fixed factory overhead 12,000
Selling and administrative expenses: Variable 5,700
Fixed 8,000

Required:
1. Variances for each cost element of production.

Materials Labor Variable FOH Fixed FOH

Actual costs P13,050 P23,306 P15,718 P12,000
Standard costs* 13,200 22,000 16,500 11,000
Variances P 150 F P 1,306 U P 782 F P 1,000 U

193
 *Standard costs = Actual production x standard cost per unit

Materials = 1,100 x P12 = P13,200

Labor = 1,100 x P20 = 22,000
Variable FOH = 1,100 x P15 = 16,500
Fixed FOH = 1,100 x P10 = 11,000

2. Comparative Income Statements – Absorption and Variable Costing

Absorption Variable
Costing Costing
Sales (950 units x P80 P76,000 P76,000
Cost of goods sold/Variable costs:
Standard cost of goods sold:
(950 x P57) P54,150
(950 x P47) 44,650
Add (Deduct) variances:
Materials – favorable ( 150) ( 150)
Labor – unfavorable 1,306 1,306
Variable OH- favorable ( 782) ( 782)
Fixed OH- unfavorable 1,000 -
Total cost of goods sold P55,524 P45,024
Add variable selling and administrative expenses - 5,700
Total cost of goods sold/Variable costs P55,524 P50,724
Gross income/Contribution Margin P20,476 P25,276
Less Operating expenses/Fixed costs:
Fixed FOH P - P12,000*
Fixed selling and Admin expenses 8,000 8,000
Variable selling and admin expenses 5,700 -
Total Operating expenses/Fixed costs P13,700 P20,000
Income P 6,776 P 5,276

*The total actual fixed overhead cost incurred during the period.

194
 Difference in income (P6,776 – P5,276) P1,500
Accounted for as follows:
Change in inventory (Production – Sales)
(1,100 – 950) 150 units
x Fixed OH cost per unit P 10
Difference in income P1,500

Assessment task (Hafez, n.d.)

Exercise 1 (Unit product cost under variable and absorption costing)

Super Bike Manufacturing Company presents the following data for 2011:
Opening inventory 0
UnitsSales 8,000
UnitsProduction 10,000
UnitsClosing inventory 2,000 Units
Direct materials P240
Direct labor P280
Variable manufacturing overhead expenses P100
Variable selling and administrative expenses P40
Fixed manufacturing overhead expenses P1,200,000
Fixed selling and administrative expenses P800,000

Required:
Compute the unit product cost of one bike under:
1. Absorption costing system.
2. Variable costing system.

Exercise 2 (Variable costing income statement, Reconciliation of net operating income)

195
The following is the absorption costing income statement of a manufacturing company:

Sales (40,000 units @ $67.50) P2,700,000

Less cost of goods sold:
Opening inventory 0
Add cost of goods manufactured
(50,000 ×42) P2,100,000
Available for use 2,100,000
Less closing inventory 420,000 1,680,000
Gross margin 1,020,000
Less selling and administrative expenses 840,000
Net operating income P180,000

Fixed selling and administrative expenses are P600,000. Variable selling and administrative
expenses are $6 per unit sold.
The unit product cost under absorption costing is computed as follows:
Direct materials P20
Direct labor 8
Variable manufacturing overhead 4
Fixed manufacturing overhead(P500,000/50,000) 10
Total cost per unit P42
Required:
1. Prepare a contribution margin income statement using variable costing system.
2. Reconcile any difference between net operating income figure under variable costing
income statement and net operating income figure under absorption costing income
statement.
Exercise 3 (Variable and absorption costing unit product costs and income statements)

A company manufactures a unique device that is used to boost Wi-Fi signals. The following
data relates to the first month of operation:
Beginning inventory 0
Units produced 40,000
Units sold 35,000

196
 Selling price per unit $120
Selling and administrative expenses:
Variable per unit $4
Fixed (total for the month) $1,120,000
Manufacturing costs:
Direct materials cost per unit $30
Direct labor cost per unit $14
Variable manufacturing overhead cost per unit $4
Fixed manufacturing overhead cost $1,280,000

Management is anxious to see the profitability of newly designed unique booster.

Required:
1. Calculate unit product cost and prepare income statement under variable costing
system and absorption costing system.
2. Prepare income statement under two costing systems.
3. Prepare a schedule to reconcile the net operating income under variable and absorption
costing system.

Summary

Variable costing is a concept used in managerial and cost accounting in which the fixed
manufacturing overhead is excluded from the product-cost of production. The method is in
contrast with absorption costing, in which the fixed manufacturing overhead is allocated to
products produced. In accounting frameworks such as GAAP and IFRS, variable costing is
not allowed in financial reporting.

Although accounting frameworks such as GAAP and IFRS prohibit the use of variable
costing in financial reporting, this costing method is commonly used by managers to:

 Conduct break-even analysis to determine the number of units needed to be sold to

begin earning a profit

197
  Determine the contribution margin on a product, which helps to understand the
relationship between cost, volume, and profit
 Facilitate decision-making by excluding fixed manufacturing overhead costs, which
can create problems due to how fixed costs are allocated to each product.

Under absorption costing, (also called full or conventional costing), product costs include
all the cost elements of production, namely, direct materials, direct labor, and all factory
overhead costs. Since all of the manufacturing costs are considered as product costs under
absorption costing, this method therefore includes both variable and fixed manufacturing
costs in determining product costs.

Under absorption costing, the following costs go into the product:

 Direct material (DM)

 Direct labor (DL)
 Variable manufacturing overhead (VMOH)
 Fixed manufacturing overhead (FMOH)

Variable costing, also called direct costing, is a product costing method that includes
only the variable manufacturing costs (direct materials, direct labor and variable overhead)
in the computation of product costs. Note, that fixed overhead though a manufacturing cost,
is not considered as product cost under the variable costing methods. Instead, fixed
overhead costs are treated as period costs, i.e., they are expensed during the period in
which they are incurred, together with the non-manufacturing costs.

Under variable costing, the following costs go into the product:

 Direct material (DM)

 Direct labor (DL)
 Variable manufacturing overhead (VMOH)

198
 References

Corporate Finance Institute. (n.d.). Variable Costing.

https://corporatefinanceinstitute.com/resources/knowledge/accounting/variable-
costing/

Hafez, O. (n.d.). Unit product cost under variable and absorption costing.
https://www.academia.edu/25355350

Harina, R.M. (2003). Management Advisory Services.Mandaluyong City, Philippines.

National Book Store.

Roque, R.S. (2013). Reviewer in Management Advisory Services. Manila City,

Philippines. GIC Enterprises and Co.,Inc.

MODULE 10
ACTIVITY BASED MANAGEMENT AND
COSTING

199
 Introduction
The traditional product costing methods assume that individual product cause costs.
When the major cost components of a product are direct materials, direct labor, or overhead
that can be directly associated with individual products, traditional methods are quite accurate.
In situations where manufacturing overhead is a significant cost and is not directly related to
volume of products, traditional product costing methods can generate inaccurate product
costs. These inaccurate product costs can lead to poor decision making regarding product
marketing, product design, investment, and budgeting issues, causing the company to be less
competitive. Overhead allocation is most troublesome in multiple-product companies
(Punzalan, 2012).

Learning Outcomes

At the end of this module, students should be able to:

200
 1. Define activity-based management, activity, cycle efficiency, value-added and
nonvalue-added activities, activity based costing (ABC), cost driver, homogenous
activities, cost levels, unit level cost, batch level cost, product level cost, facility cost
and cost pools.
2. State the rationale behind activity-based costing.
3. Compute for unit cost using activity-based costing.
4. Compare product costing using the traditional method and ABC method.

Lesson 1. Definition of Terms (Harina, 2003)

Activity-Based Management is using information about activities to manage many aspects of

Activity-Based Costing
Activity Center
Cost Pool
Plantwide Allocation
Departmental Allocation
an organization, and focuses on processes and on tasks and
activities within processes, rather than simply managing costs.
It is a method of assigning indirect costs, including non-
manufacturing overhead, to products and services. It first
assigns costs to activities, then to the products based on each
product’s use of activities. It is a premise that products consume
activities and activities consume resources.
Unit of the organization that performs a set of tasks.
Means indirect cost pool. Refer to groupings or aggregations
Leof costs, usually for subsequent analysis.
uses the entire plant as a cost pool. Then, allocate all costs from
that pool to product using a single overhead allocation rate, or
one set of rates, to all the products of the plant, independent of
the number of departments in the plant.
Each department is a separate cost pool, which accumulates
costs. Then, using separate rates, or sets of rates, for each
department, allocate from each cost pool to products produced
in that department.

Cost Driver A factor that causes or “drives” an activity’s costs.

Cost Pools Group Costs Into Either:

201
 1. Plants, which are entire factories, stores, banks, and so forth.
2. Departments within the plants.
3. Activity centers

Lesson 2. Activity-Based Management (Mejorada, 2006)

Activity-based management is concerned with planning and controlling activities

involved in the production/performance process to improve a “firm’s cycle efficiency”. For a
manufacturing firm, it is to improve the manufacturing cycle efficiency. For a service concern,
it is to improve service cycle efficiency and for a retailer, retail cycle efficiency. Activities are
classified into value-added and no-value added with the intention of minimizing, if not
eliminating the latter.

Non-value adding activities merely increase the time expended on a product or

service. However, some of them may result in minimal increase in product customer value.
Examples of value-added and nonvalue-added activities in a manufacturing firm are the
following:

Value Adding Activities

Extracting
Machining
Assembling
Finishing

Non-Value Adding Activities

Storing
Waiting for next step in processing
Inspection in addition to required quality control
procedures
Transfer of products from one point to another

After determining what are value adding and those that are not, activity-based
management (ABM) determines how the non-value adding activities can be minimized, if not

202
eliminated. To do so, ABM must look into their possible causes. Non-value activities may arise
from inadequacy of human resource training, limitations of plant facilities and from poor
production planning.

Lesson 3. Manufacturing Cycle Efficiency (Mejorada, 2006)

Manufacturing Cycle Efficiency (MCE) refers to the percentage of value-adding

processing time based on total cycle time. It is the ratio of the total time expended on value-
added activities to cycle time (or to the total time expended on both VA and NVA activities.

The formula is as follows:

MCE = Value-adding processing time

Manufacturing cycle time
Thus, in a firm wherein non-value adding activities account for 40% cycle time,
manufacturing cycle efficiency would be 60%. It is the objective of ABM to raise this ratio.

Lesson 4. Activity-Based Costing (De leon et al., 2019)

The growth in the automation of manufacturing has brought many challenges to

product costing. Increased use of robotics, specialized machinery, and other computer-driven
processes has changed the nature of manufacturing and the composition of total product cost.
In many highly automated manufacturing businesses the significance of direct labor
cost has diminished and overhead costs have increased. The cost of acquiring, installing,
maintaining, and operating state-of-the-art manufacturing technologies has greatly increased
overhead costs. In addition, costs that used to be classified as indirect such as quality control,
computer programming, trouble shooting, and middle level management costs have become
major components of total production cost.

The need for more representative overhead application bases has led to activity-based
costing (ABC) which is also known as transaction costing. Those activities (transactions) that
consume overhead resources are identified and related to the costs incurred. The basic
premise in activity-based costing is that the overhead costs that are caused by activities, are

203
traced to individual product units on the basis of frequency of consumption of overhead
resources by each product.

ABC is a simple concept which can provide accurate information about a particular
product’s consumption of overhead resources. ABC is an approximation of a user’s fee. A
user’s fee refers to the process of charging for services consumed by users of the service.
ABC is based on the premise that if a product consumes many resources (activities) that
comprise overhead, it should bear a greater share of overhead costs than other product that
does not consume as any activity units.

Lesson 5. Differences Between Traditional and ABC Costing

(Harina, 2003)
Traditional ABC
a. Cost pools one or a limited number Many,to reflect different activities
b. Applied rate volume-based, financial Activity based, non-financial.
c. Suited for labor intensive, low Capital intensive, product-
overhead companies diverse high overhead
companies.
d. Benefits Simple, inexpensive Accurate product costing,
non-value added activities

Lesson 6. Steps in Activity-Based Costing (Harina, 2003)

1. Identify the activities that consume resources, and assign costs to those activities.
Example: purchasing of materials.
2. Identify the cost driver/s associated with each activity. Example: Number of orders is
a cost driver in purchasing of materials. Each activity could have multiple cost
drivers.

204
3. Compute a cost rate per cost driver unit. Example: the cost per purchase order in a
driver cost rate.
4. Assign costs to products by multiplying the cost driver rate times the volume of cost
drivers consumed by the product. Example: number of purchase orders required for
a particular product times the cost per purchase order.

Major Categories of Activities in ABC System

1. Unit-level Activity- are those performed each time a unit is produced or sold. The
costs these activities are the typical variable costs. Examples: Materials, energy to
run machines.
2. Batch-level Activity- are those that a company performs when it makes a group of
units, regardless of how many units in a batch. Examples: Machine Set-ups, Quality
inspections.
3. Product (Customer) Sustaining Activities- arise because a Company does particular
types of business, or maintains a particular product or service. Examples: Customer
records and files, Product specifications, Customer service.
4. Facility-level Activities- relate to an entire plant, office, or company as a whole.
Examples: Plant management, Building depreciation and rent, Heating and lighting.

Criteria used for selecting cost drivers:

1. Causal relation- choose a cost driver that causes the cost. Although this is ideal but
is not always possible because indirect costs are generally not casually linked to cost
objects.
2. Benefits received- choose a cost driver so costs are assigned in proportion to
benefits received.
3. Reasonableness- costs are assigned based on fairness or reasonableness, if costs
cannot be linked based on causality or benefits received.

Examples of Cost Drivers:

Manufacturing labor hours or cost Number of customers
Machine hours items produced or sold
Machine set-ups flight hours
Kilos of materials handled number of operations

205
 Purchase orders scrap/rework orders
Quality inspections computer time
Number of parts in a product Hours of testing time
Square footage number of billing hours
Design time number of vendors
Asset value
Non-Manufacturing: Number of hospital beds occupied
Number of take-offs and landing for an airline
Number of rooms occupied in a hotel
Number of trips for a bus company
Number of kilometers driven

Computing a Cost rate per Cost Driver

Predetermined Indirect Cost rate = Estimated Indirect Cost

Estimated volume of the allocation base

Lesson 7. Illustrative Problem (Harina, 2003)

ABM Manufacturing Inc. provided the following information for the month of June, 2020.
Units
Machine A produced 600
Machine B produced 1,000

Cost Driver Units

Activities Machine A Machine B
Purchasing materials 600 packs 1,000 packs
Machine set-ups 10 set-ups 25 set-ups
Inspections 150 hours 200 hours
Running machines 500 hours 1,000 hours

Additional Data:
Machine A Machine B

206
 Direct materials per unit P500 P800
Direct labor per unit P100 P180

Factory overhead is applied at the rate of 150% based on direct labor cost. The estimated
overhead for June, 2020, amounts to P360,000.

Overhead Estimates for 2020

Estimated Estimated
Activity Cost Driver No. of Cost Driver units Overhead costs
Purchasing Materials No. of Packs 20,000 Packs P 500,000
Machine Set-ups No. of Set-ups 400 Set-ups 2,000,000
Inspections Inspection hours 4,000 Hours 800,000
Running Machines Machine hours 20,000 Hours 1,000,000
Total Estimated Overhead P4,300,000
Required: Compute for the following:
1. Pre-determined annual overhead rates for Activity-based costing.
2. Overhead costs assigned to Machine A and machine B using Activity-based costing.
3. Cost per unit of Machine A and Machine B using the Activity-Based costing.
4. Cost per unit of Machine A and Machine B using the Traditional Approach.
Solution
X Y
1. Estimated Estimated ( Y ÷ X)
Activity No. of Cost Driver units Overhead costs Cost Driver Rate
Purchasing Materials 20,000 Packs P 500,000 P 25 per Pack
Machine Set-ups 400 Set-ups 2,000,000 5,000 per Set-up
Inspections 4,000 Hours 800,000 200 per Hour
Running Machines 20,000 Hours 1,000,000 50 per Hour
Total Estimated Overhead P4,300,000

2. Machine A
Actual Cost
Activity Cost Driver Rate Cost Driver Units Allocated
Purchasing Materials P 25 per Pack 600 P15,000

207
Machine Set-ups 5,000 per Set-up 10 50,000
Inspections 200 per Hour 150 30,000
Running Machines 50 per Hour 500 25,000
Total Overhead Costs Allocated to Machine A P120,000
Overhead cost per unit (P120,000 ÷ 600 units) P 200

Machine B
Actual Cost
Activity Cost Driver Rate Cost Driver Units Allocated
Purchasing Materials P 25 per Pack 1,000 P 25,000
Machine Set-ups 5,000 per Set-up 25 125,000
Inspections 200 per Hour 200 40,000
Running Machines 50 per Hour 1,000 50,000
Total Overhead Costs Allocated to Machine A P240,000
Overhead cost per unit (P240,000 ÷ 1,000 units) P 240

3.Activity-Based Costing Machine A Machine B

Direct materials P 500 P 800
Direct labor 100 180
Overhead 200 240
Total Cost per Unit P800 P1,220

4.Traditional Costing Machine A Machine B

Direct materials P500 P800
Direct labor 100 180
Overhead (150% of Direct labor) 150 270
Total Cost per Unit P750 P1,250

Remarks:

208
 It can be observed that in this problem, there are differences in the computation of
unit cost for Machine A and Machine B. Using the traditional costing approach, the unit cost
of Machine B is overstated, while Machine A is understated. By using the ABC approach, we
can come up with a more realistic and accurate costing than using the traditional approach.

Assessment task 10

True or False
1.Traditional costing systems use multiple predetermined overhead rates.
2.Traditionally, overhead is allocated based on direct labor cost or direct labor hours.
3.Current trends in manufacturing include less direct labor and more overhead.
4.Activity-based costing allocates overhead to multiple cost pools and assigns the cost pools
to products using cost drivers.
5.A cost driver does not generally have a direct cause-effect relationship with the resources
consumed.".
6. The first step in activity-based costing is to assign overhead costs to products, using
costdrivers..
7. To achieve accurate costing, a high degree of correlation must exist between the cost
driver and the actual consumption of the activity cost pool.
8. Low-volume products often require more special handling than high-volume products.
9. When overhead is properly assigned in ABC, it will usually decrease the unit cost of high-
volume products.
10.ABC leads to enhanced control over overhead costs.
11.ABC usually results in less appropriate management decisions.
12.ABC is generally more costly to implement than traditional costing.
13.ABC eliminates all arbitrary cost allocations.
14.ABC is particularly useful !hen product lines differ greatly in volume and manufacturing
complexity.
15.ABC is particularly useful when overhead costs are an insignificant portion of total costs.
16.Activity-based management focuses on reducing costs and improving processes.
17.Any activity that increases the cost of producing a product is a value-added activity.
18.Engineering design is a value-added activity.

209
19. onvalue-added activities increase the cost of a product but not its maket value.
20.Machining is a nonvalue-added activity.

Problem Solving
XYZ Manufacturing Inc. provided the following information for the month of
September, 2020.
Units
Model X produced 450
Model Y produced 800

Cost Driver Units

Activities Model X Model Y
Materials Handling 900 kilos 3,200 kilos
Production set-ups 9 Runs 15 Runs
Quality Inspections 80 Hours 120 Hours
Machine Depreciation 280 hours 505 hours

Additional Data:
Model X Model Y
Direct materials per unit P400 P600
Direct labor per unit P 90 P150

Factory overhead is applied at the rate of 100% based on direct labor cost. The estimated
overhead for September, 2020, amounts to P160,500.

Overhead Estimates for 2020

Estimated Estimated
Activity Cost Driver No. of Cost Driver units Overhead costs
Materials Handling No. of Kilos 50,000 Kilos P 400,000
Production Set-ups No. of Runs 300 Runs 900,000
Quality Inspections Inspection hours 4,000 Hours 800,000
Machine Depreciation Machine hours 20,000 Hours 400,000
Total Estimated Overhead P2,500,000

210
Required: Compute for the following:
1. Pre-determined annual overhead rates for Activity-based costing.
2. Overhead costs assigned to Model X and Model Y using Activity-based costing.
3. Cost per unit of Model X and Model Y using the Activity-Based costing.
4. Cost per unit of Model X and Model Y using the Traditional Approach.

Summary

The traditional product costing methods assume that individual product cause costs.
When the major cost components of a product are direct materials, direct labor, or overhead
that can be directly associated with individual products, traditional methods are quite accurate.
In situations where manufacturing overhead is a significant cost and is not directly related to
volume of products, traditional product costing methods can generate inaccurate product
costs. These inaccurate product costs can lead to poor decision making regarding product
marketing, product design, investment, and budgeting issues, causing the company to be less
competitive. Overhead allocation is most troublesome in multiple-product companies.

Activity-based management is concerned with planning and controlling activities

involved in the production/performance process to improve a “firm’s cycle efficiency”. For a
manufacturing firm, it is to improve the manufacturing cycle efficiency. For a service concern,
it is to improve service cycle efficiency and for a retailer, retail cycle efficiency. Activities are
classified into value-added and no-value added with the intention of minimizing, if not
eliminating the latter.

Non-value adding activities merely increase the time expended on a product or

service. However, some of them may result in minimal increase in product customer value.

Activity based costing (ABC) is a simple concept which can provide accurate
information about a particular product’s consumption of overhead resources. ABC is an
approximation of a user’s fee. A user’s fee refers to the process of charging for services
consumed by users of the service. ABC is based on the premise that if a product consumes

211
many resources (activities) that comprise overhead, it should bear a greater share of overhead
costs than other product that does not consume as any activity units.

References

De Leon, N.D,, De Leon, E.D., De Leon, G.M. Jr. (2019). Cost Accounting and
Control. Manila City, Phils. GIC Enterprises & Co. Inc.

Mejorada, N.D. (2006). Cost Accounting. Quezon City, Philippines. Goodwill Trading
Co. Inc.

Roque, R.S. (2013). Reviewer in Management Advisory Services. Manila City,

Philippines. GIC Enterprises and Co.,Inc.

Punzalan, A.R. (2012). CPA Examination Practical Accounting 2. Manila City,

Philippines. GIC Enterprises & Co., Inc.

212