Chapter 5: Activity Based Costing (ABC)

Activity based costing (ABC) is a costing method that is designed to provide managers with
cost information for strategic and other decisions that potentially affect capacity and therefore
fixed as well as variable costs. Most organizations that use this costing have two costing
systems- the official costing system that is used for preparing external financial reports and
the activity-based costing system that is used for internal decision making and for managing
activities.
Its a costing method that identifies activities in an organization assigns the cost of each
activity to all products and services according to the actual consumption by each relating to
the costing and monitoring of activities which involves tracing resource consumption and
costing final outputs where resources are assigned to activities, and activities to cost objects
based on consumption estimates.

Activity cost pool: An activity cost pool is an aggregate of all the costs associated with
performing a particular business task, such as making a particular product. By pooling all
costs incurred in a particular task, it is simpler to get an accurate estimate of the cost of that
task. One example of the use of activity costs is in manufacturing. A manager may be asked
to evaluate production costs of each product produced by a factory. Activity-based
costing (ABC) is a common method for determining those production costs. ABC defines
production as consisting of a variety of activities, and it assigns costs to those activities. For
example, machine set-up might be one activity associated with the production of a particular
product. The cost of set-up would be one cost included in an activity cost pool. Purchasing
materials might be another cost assigned to the pool. Assigning costs accurately is important
to determine the profitability of products and subsequently to make rational production
decisions.

Activity cost driver: A cost driver directly influences a business activity. There may be
multiple cost drivers associated with an activity. For example, direct labor hours are
a driver of most activities in product manufacturing. If the cost of labor is high, this will
increase the cost of producing all company products or services. If the cost of warehousing is
high, this will also increase the expenses incurred for product manufacturing or providing
services. More technical cost drivers are machine hours, the number of engineering change
orders, the number of customer contacts, the number of product returns, the machine setups
required for production, or the number of inspections. If a business owner can identify the
cost drivers, the business owner can more accurately estimate the true cost of production for
the business.

Batch-level activities: Batch-level activities are work actions that are classified within
an activity-based costing accounting system, often used by production companies. Batch-
level activities are related to costs that are incurred whenever a batch of a certain product is
produced. However, these costs are accounted for regardless of the related production run’s
size. Examples of these batch-level cost drivers can often include machine setups,
maintenance, purchase orders, and quality tests.

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Example 1: A manager estimated that the company would purchase 100,000 pieces of
materials for overhead costs Tk.200000. Setting up machines for a new product would need
400 setups and overhead of Tk.800000. The company would have 4000 inspections and
overhead of Tk.400000. Finally, running machines would cost Tk.600000 for 20000 machine
hours. There are two activities in the business such as Touring that requires 6000 pieces of
materials, 10 setups, 200 inspection hours and 1500 machine hours; whereas Monitoring
requires 4000 pieces of materials, 30 setups, 200 inspection hours and 500 machine hours.
Determine total cost for both activities.

Solution:

The activity cost rates (predetermined overhead rates) are calculated as follows:

Activity Cost Driver (activity) Overhead Estimated Units Rate (Tk.)

Cost (Tk.)

Purchasing Pieces of materials 200000 100000 pieces 2

Materials
Machine setups Machine setups 800000 400 setups 2000
Inspections Inspection hours 400000 4000 inspection 100
hours
Running machine Machine hours 600000 20000 machine 30
hours
Total overhead 2000000

Total cost calculation:

Touring (Tk.) Monitoring (Tk.)

Purchasing materials (6000 piecesX2)12000 (4000 piecesX2) 8000
Machine setups (10 setupsX2000) 20000 (30 setupsX200) 60000
Inspections (200 hoursX100) 20000 (200 hoursX100) 20000
Running machine (1500 hoursX30) 45000 (500 hoursX30) 15000
Total 97000 103000

Problem 2: Given,
(%)
Activity cost pools
Customer Product Order Customer Other Total
orders design size relations
Production department:
Indirect factory wages 25 40 20 10 5 100
Factory equipment depreciation 20 0 60 0 20 100
Factory utilities 0 10 50 0 40 100
Factory building lease 0 0 0 0 100 100
General administration department:
Administrative wages and salaries 15 5 10 30 40 100
Office equipment depreciation 30 0 0 25 45 100

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 Administrative building lease 0 0 0 0 100 100
Marketing department:
Marketing wages and salaries 22 8 0 60 10 100
Selling expenses 10 0 0 70 20 100

Amount in Tk.
Activity cost pools
Customer Product Order Customer Other Total
A company
orders design size relations has two
Production department: products
Indirect factory wages 125000 200000 100000 50000 25000 500000 such as paper
Factory equipment depreciation 60000 0 180000 0 60000 300000 and pencils
Factory utilities 0 12000 60000 0 48000 120000 where for
Factory building lease 0 0 0 0 80000 80000
paper 30000
General administration
units were
department:
Administrative wages and salaries 60000 20000 40000 120000 160000 400000
ordered
Office equipment depreciation 15000 0 0 12500 22500 50000 comprising
Administrative building lease 0 0 0 0 60000 60000 600 separate
Marketing department: orders,
Marketing wages and salaries 55000 20000 0 150000 25000 250000 required 150
Selling expenses 5000 0 0 35000 10000 50000 product
Total 320000 252000 380000 367500 490500 1810000 designs, 80
customer
relations and 17500 machine hours to complete. For pencil, 400 orders were received, 250
product designs were prepared, 170 customer relations and 2500 machine hours were used.
Determine overhead rates and calculate total overhead costs for above products.

Problem 3: Ferris corporation makes a single product – a fire resistant commercial filing
cabinet that it sells to office furniture distributors. The company has a simple ABC system
that it uses for internal decision making. The company has two overhead departments whose
costs are as follows:
Manufacturing overhead Tk.500000
Selling and administrative overhead Tk.300000
The company’s ABC system has the following activity cost pools and activity measures (cost
drivers):
Activity cost pool Activity measure
Assembling units Number of units
Processing orders Number of orders
Supporting customers Number of customers
Other Not applicable
Ferris corporation distributes the costs of manufacturing overhead and selling and
administrative overhead to the activity cost pools based on employee interviews, the results
of which are given below:

Assembly Processing Supporting Other Total

units orders customers
Manufacturing overhead (%) 50 35 5 10 100
Selling and administrative 10 45 25 20 100
overhead
Total activity 1000 250 orders 100 N/A N/A
units customers

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a) Allocate overhead costs to the activity cost pools and determine activity rates
b) One of the customers Mr. X placed 4 orders for 80 filing cabinets during last period.
Calculate the total cost for Mr. X.
c) Selling of each filing cabinet is Tk.595, the cost of direct material is Tk.180, direct labor
cost is Tk.50. Determine the customer margin.