Introduction to Activity-Based Costing

Traditional cost systems identify the cost centres (departments) in which

costs may accumulate. They reflect a functional/hierarchical view.

Such systems typically reflect the question…..

“Who is consuming resources within the organization? Which department? “

1
 Summary of Traditional
Costing Systems

1st
Stage

To Departments
(Cost Centres)

2nd
Stage
Usually Direct Labour,
Materials Cost.

To Products
 Activity-Based Costing (ABC)

requires a new kind of thinking !

A systematic way of allocating indirect costs based on careful analyses of cause and
effect relationships between cost objects (e.g. products, customers), activities and
resources (costs).

It examines the activities being performed through the usage of organizational

resources?

How much does it cost to perform organizational activities and business processes?

How much of each activity is required for the organization’s products, services and
customers?
 Summary of ABC Systems

1st
Stage

To Activities
(Activity Cost Pools) E.g
Machine Set up costs

2nd
Stage

Allocated through
“Cost Drivers” e.g.
Number of machine
To Products
set ups per product
 ABC Traditional
1st 1st
Stage Stage

To Activities To Departments
(Activity Cost Pools) E.g (Cost Centres)
Machine Set up costs

2nd 2nd
Stage Stage
Allocated
through “Cost
Drivers” e.g.
Usually Direct
Number of
To Products Labour, To Products
machine set
Materials Cost.
ups per product
 Steps in Designing an ABC System

1 Map out key business processes and activities and create an activity
dictionary.

2 Create activity cost centres (cost pools) related to each activity.

3 Determine appropriate activity cost drivers for each activity and calculate
activity cost driver rates.

4 Allocate activity cost pools to cost objects based on their consumption of

activity cost drivers.
 Cost Allocation Under ABC: 3 stages

Activity-
Cost
Cost Pools Based
Drivers
Rates

Identify logical
Break overhead
drivers of the Allocate costs
costs down into
activities based on their
major activities
e.g. number of consumption of
that drive the
setups / activities
overhead (called
inspections, and
activity cost pools)
cost p/driver
 Case Study: Classic Pen Company

Jane Dempsey (FC) was concerned

Classic Pen Company had been low cost producer of traditional BLUE and
BLACK Pens.

Several years ago, new products had been introduced which sold at a premium
e.g. Red and Purple pens.

But financial results showed that whilst Red and Purple pens were more
profitable than BLUE and BLACK Pens, overall profitability was down.

Perception is that Red and Purple are most profitable.

Sales manager claims that consumers will pay more for these speciality
colours.
Manufacturing manager is concerned 

Increased production stoppages and changeovers

Worried about capability to handle complexity of new products

Overheads allocated at 300% of direct labour cost (rate was previously 200%)

ABC perceived as a means of addressing problems at Classic Pen Company

Ltd.
 Case Study: Classic Pen Company

As (Management Accounting)
consultants, can you help Classic Pen
Company?
 Steps in Designing an ABC System

1 Map out key business processes and activities and create an activity
dictionary.

2 Create activity cost centres (cost pools) related to each activity.

3 Determine appropriate activity cost drivers for each activity and calculate
activity cost driver rates.

4 Allocate activity cost pools to cost objects based on their consumption of

activity cost drivers.
 ABC: The Classic Pen Company Case

Scheduling
/handling Physical
Activities production change- Maintaining Running Machine
runs over records machines maintenance

Indirect Indirect
labour labour
(50%) (10%)
Indirect
Page 3 – 2ndlabour Page 3 – 4th
Fringe Page 3 – 8th
Cost Fringe
Paragraph (40%) Paragraph
benefits benefits Machinery Mainte-
Paragraph
pools (5%) (100%) nance
(25%) Fringe (100%)
Computer benefits Computer Energy
(80%) (20%) (20%) (100%)

Activity
cost No of Set-up time No of units No of No of
production per run produced machine machine
drivers runs (hours) hours hours
 ABC: The Classic Pen Company Case
4th
Para –
Scheduling Pg 3
/handling Physical
Activities production change- Maintaining Running Machine
runs over records machines maintenance

2nd
Para – Indirect Indirect
Pg 3 labour labour
(50%) (10%)
Indirect
Cost Fringe labour Fringe
benefits (40%) benefits Machinery Mainte-
pools (5%) (100%) nance
(25%) Fringe (100%)
Computer benefits Computer Energy
(80%) (20%) (20%) (100%)

Activity
cost No of Set-up time No of units No of No of
production per run produced machine machine
drivers runs (hours) hours hours
 ABC: The Classic Pen Company Case

Scheduling
/handling Physical
Activities production change- Maintaining Running Machine
runs over records machines maintenance

Indirect Indirect
labour labour
(50%) (10%)
Indirect
Cost Fringe labour Fringe
benefits (40%) benefits Machinery Mainte-
pools (5%) (100%) nance
(25%) Fringe (100%)
Computer benefits Computer Energy
(80%) (20%) (20%) (100%)

Activity
NoFringe
of Benefits:
Set-up Para – Page
(1st time No of – 40% of labour
3) units No of (direct andNo
indirect)
of =
cost However only indirect
production per run being considered
produced here (overhead)
machine so = ½ of Fringe
machine
drivers runsbenefits allocated
(hours)to each area where Indirecthours
labour is used (pro
hoursrata).
Scheduling 25% + Changeover 20% + Maintaining records 5% = 50%
 ABC: The Classic Pen Company Case

Scheduling
/handling Physical
Activities production change- Maintaining Running Machine
runs over records machines maintenance

Indirect Indirect
labour labour
(50%) (10%)
Indirect
Cost Fringe labour Fringe
benefits (40%) benefits Machinery Maintenance
pools (5%) (100%) (100%)
(25%) Fringe
Computer benefits Computer Energy
(80%) (20%) (20%) (100%)

Activity
cost No of Set-up time No of units No of No of
production
th Para – per run produced machine machine
th Para –
drivers 7runs Pg(hours)
3 8
hours Pg 3
hours
 ABC: The Classic Pen Company Case

Scheduling
/handling Physical
Activities production change- Maintaining Running Machine
runs over records machines maintenance

Indirect Indirect
labour labour
(50%) (10%)
Indirect
Cost Fringe labour Fringe
benefits (40%) benefits Machinery Mainte-
pools (5%) (100%) nance
(25%) Fringe (100%)
Computer benefits Computer Energy
(80%) (20%) (20%) (100%)

Activity
cost No of Set-up time No of units No of No of
production per run produced machine machine
drivers runs (hours) hours hours
 ABC: The Classic Pen Company Case

Scheduling
/handling Physical
Activities production change- Maintaining Running Machine
runs over records machines maintenance

Indirect Indirect
labour labour
(50%) (10%)
Indirect
Cost Fringe labour Fringe
benefits (40%) benefits Machinery Mainte-
pools (5%) (100%) nance
(25%) Fringe (100%)
Computer benefits Computer Energy
(80%) (20%) (20%) (100%)

Activity
cost No of Set-up time No of units No of No of
production per run produced machine machine
drivers runs (hours) hours hours
 Calculating Activity Cost Driver Rates
Activity Total Scheduling/ Physical Maintainin Running machines Machine
handling change-over g records maintenan
production ce
runs
Indirect labour
($)
Fringe
benefits ($)
(50% of 16k)
Computer ($)

Machinery
Depreciation
($)
Energy ($)
Maintenance
($)
Total cost
pool ($)
Cost Driver

Activity cost
driver rate ($)
 Allocating Costs to Products
Product Total Blue Black Red Purple

Sales ($)

Direct material ($)

Direct labour ($)

Fringe benefits
(40% of DL) 50%
DL
Production runs ($)

Changeover ($)

Maintaining records
($)

Running machines
($)

Machine
maintenance ($)

Profit ($)

Return on sales (%)

 Group Work

• Please now refer to the assignment brief to assist Classic Pen Co in

influencing change

• Your tutor is there to support you, but not to provide you with
complete solutions. You should complete these blank templates in
your groups, and your tutor will guide discussions.