MANAGERIAL ACCOUNTING - ABC SYSTEM

Activity-Based Costing
Pricing products - ZAM started Interwood, a niche furniture brand

Pricing products or services is one of the difficult decisions that can either make or break your
business. You want to price high enough so you can grow your company with a decent profit
margin, but your prices also need to be competitive to get customers through the door. Many
large businesses, particularly in the huge manufacturing sector, use activity-based costing to

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help them accurately price their offerings. But small businesses can also benefit from using
this costing method. Highlighting activity-based costing depending on what activity-based
costing is, how to find it, and how it can help ZAM started Interwood business.
ZAM started Interwood, a niche furniture brand, 11 years ago. He ran the business as a sole
proprietorship. While he has 50 skilled carpenters and 5 salespeople on his payroll, he has
been taking care of the accounting by himself. Now, he intends to offer 40% of the ownership
to public in next couple years and is willing to make changes.

Introduction Activity Based Costing:

Activity-based costing (ABC) is a methodology for more precisely allocating overhead costs
by assigning them to activities. Once costs are assigned to activities, the costs can be assigned
to the cost objects that use those activities. The system can be employed for the targeted
reduction of overhead costs. ABC works best in complex environments, where there are many
machines and products, and tangled processes that are not easy to sort out. Conversely, it is
of less use in a streamlined environment where production processes are abbreviated. Also,
Activity based costing (ABC) assigns manufacturing overhead costs to products in a more
logical manner than the traditional approach of simply allocating costs on the basis of machine
hours. Activity based costing first assigns costs to the activities that are the real cause of the
overhead. It then assigns the cost of those activities only to the products that are actually
demanding the activities.

Activity based costing (ABC) vs traditional Costing system:

Let's discuss activity-based costing by pricing a product at ZAM started Interwood to improve
and organize the accounting systems. Comparing between pricing using traditional Costing
system and pricing using Activity based costing (ABC). Interwood’s total budgeted
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manufacturing overheads cost for the current year is $5,404,639 and budgeted total labor
hours are 20,000. ZAM applied traditional costing method during all of the 11 years period,
and based the predetermined overhead rate on total labor hours. Interwood's sofa range
includes the 2 set, 3set and 6set options. Platinum Interiors recently placed an order for 150
units of the 6-set type. The order is expected to be delivered in 1-month time. Since it is a
customized order, Platinum will be billed at cost plus 25%. We are not a fan of traditional
product costing system. We believe that the benefits of activity-based costing system exceed
its costs, so we sat down with Samer Alselwi, the chief engineer, to identify the activities
which the firm undertakes in its sofa division. Then, we calculated the total cost that goes into
each activity, identified the cost driver that is most relevant to each activity and calculated the
activity rate. The results are summarized below:

Activity Activity Cost Pool Cost Driver Cost Driver Quantity Pool Rate

Production of components 2,313,132$ Machine hours 25,000 93$

Assembly of components 1,231,312$ Number of labor hours 20,000 62$

Packaging 213,123$ Units 5,000 43$

Shipping 231,230$ Units 5,000 46$

Setup costs 34,243 $ Number of setups 240 143$

Designing 123,132$ Designer hours 1,000 123$

Product testing 24,234$ Testing hours 500 48$

Rent 1,234,233$ Labor cost $1,645,644 .75$

Once the order was ready for packaging, there is a summary of total cost incurred and a
statement of activities performed (also called the bill of activities) as shown below:
Order No: 15X2019
Customer: Platinum Interiors
Units: 150
Type: 6 unit
Amounts in $
Cost of direct materials 25,000$
Cost of purchased components 35,000$
Labor cost 15,600$
Activity Relevant Cost Driver Activity Usage
Production of components Machine hours 320$
Assembly of components Number of labor hours 250$
Packaging Units 150$
Shipping Units 150$
Setup costs Number of setups 15$
Designing Designer hours 70$
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 Order No: 15X2019
Customer: Platinum Interiors
Units: 150
Type: 6 unit
Amounts in $
Testing hours Testing 22$
Rent Labor cost 4500$

The Product is a low volume item which requires certain activities such as special engineering,
additional testing, and many machine setups because it is ordered in small quantities. If this
company used traditional costing, it might allocate or "spread" all of its overhead to products
based on the number of machine hours. This will result in little overhead cost allocated to the
Product, because it did not have many machine hours. However, it did not demand lots of
engineering, testing, and setup activities. It will be allocated a little amount of overhead (due
to all those machine hours), but it demanded a lot overhead activity. The result will be a
miscalculation of each product's true cost of manufacturing overhead. Activity based costing
will overcome this shortcoming by assigning overhead on more than the one activity, running
the machine.

In the traditional costing system, cost equals materials cost plus labor cost plus
manufacturing overheads charged at the pre-determined overhead rate. The pre-
determined overhead rate based on direct labor hours = $5,404,639/20,000 = $270 per
labor hour. The actual number of labor hours spent on the order is 250. Once we have
this data, we can estimate the manufacturing overheads and the total cost as follows:
Direct materials 25,000
Purchased components 35,000
Labor cost 15,600
Manufacturing overheads ($270*250) 67,500
Total cost under traditional product costing system 143,100
Platinum is billed at cost plus 25%, so the amount of sales to be booked would amount
to $178,875 (= $143,100*1.25).

Activity-based costing is a more refined approach. Now calculating the cost of the order
using activity-based costing:
Activity based costing recognizes that the special engineering, special testing, machine
setups, and others are activities that cause costs. they cause the company to consume
resources. Under ABC, the company will calculate the cost of the resources used in each of
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these activities. Next, the cost of each of these activities will be assigned only to the products
that demanded the activities.
In activity-based costing, direct materials cost, cost of purchased components and labor
cost remains the same as in traditional product costing. However, the value of the
assigned manufacturing overheads is more accurately estimated.
Cost Hierarchy
The first step in activity-based costing involves identifying activities and classifying them
according to the cost hierarchy. Cost hierarchy is a framework that classifies activities
based the ease at which they are traceable to a product. The levels are (a) unit level, (b)
batch level, (c) product level, and (d) facility level.

The following worksheet estimates the manufacturing overheads that should be assigned
to the order of Platinum Interiors:
(A) (B) (A * B)
Activity Activity Activity Cost
Activity
Rate$ Usage$ Assigned$
Production of components 93 320 29,760
Assembly of components 62 250 15,500
Packaging 43 150 6,450
Shipping 46 150 6,900
Setup costs 143 15 2,145
Designing 123 70 8,610
Product testing 48 22 1,056
Rent 75% 15,600 11,700
Total 82,121$

In our company, the Product will be assigned some of the company's costs of special
engineering, special testing, and machine setup. Other products that use any of these
activities will also be assigned some of their costs.

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Total cost of the order is hence:

US$
Direct materials 25,000
Purchased components 35,000
Labor cost 15,600
Manufacturing overheads 82,121
Total cost under activity-based costing 157,721

Based on the more accurate estimation of the order cost, the invoice should be raised at
$197,150 (=$157,721 * 1.25) instead of $178,875 calculated under traditional product
costing system.

The difference highlights the importance of a correct estimate of the cost of the product
and the usefulness of activity-based costing to achieve that goal.

Activity based costing has grown in importance in recent decades because…

(1) manufacturing overhead costs have increased significantly.
(2) The manufacturing overhead costs no longer correlate with the productive machine
hours or direct labor hours.
(3) The diversity of products and the diversity in customers' demands have grown.
(4) Some products are produced in large batches, while others are produced in small
batches.

How to Calculate? (With online Examples)

Traditionally, direct costs for such firms are costs they can assign to specific product units. In product
manufacturing, these might include direct materials and direct labor costs:
▪ Direct labor costs.
These can include the cost for person minutes or person-hours per product unit for running production
machines.
▪ Direct materials.
Direct materials costs might include costs per product unit for metal stock, fasteners, and lubricants.

DIRECT COSTS ARE THE SAME IN TRADITIONAL AND ACTIVITY-BASED COSTING

Management must estimate the profitability of each product to decide which products to produce and sell and
how to price them. These estimates, in turn, require an understanding of the full cost per unit of each product.
While the direct costs per unit are easy to find, the indirect costs are less noticeable. As a result, the firm will
have to uncover indirect product costs through a costing methodology—either traditional cost allocation or
activity-based costing.
Direct costs are the same under both traditional costing and ABC. For direct costs, accountants measure a
product unit cost for each direct cost category. The two costing methods differ, however, in the way they assign

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values to so-called indirect costs for products. Consequently, the two costing approaches sometimes
give entirely different pictures of the profitability of individual products.

EXAMPLE SOURCES OF INDIRECT COSTS

Traditionally, indirect costs for such firms are manufacturing overhead expenses they cannot assign directly to
specific product units. Instead, they allocate these costs to specific production runs, batches, or periods. These
might include indirect costs such as the following:
▪ Materials purchase order costs.
Firms typically do not order materials for each product unit, but instead, for entire batch runs. They may
also order supplies to cover a specific time span.
▪ Machine set up costs.
Manufacturing firms do not set up production machines for each product unit. They are set up instead for
the production run of each product model.
▪ Product packaging costs.
Manufacturers can sometimes package multiple product units in a single package. And, they may fill
numerous packages in a single packaging run.
▪ Machine testing and calibration costs.
Manufacturing firms perform these operations regularly and often, but not for each product unit.
▪ Machine maintenance and cleaning costs.
Firms usually perform these operations only after producing multiple product units.

PRODUCT SPECIFIC COST SOURCES

For this example, consider a firm that manufactures and sells two product models, Model A and Model B. Some
aspects of A and B compare as Table 1 shows:

Products Compared Product A Product B

Selling Price Higher price Lower price

Materials purchased More materials purchase orders, smaller orders Fewer materials purchase orders, larger orders

Production Runs More production runs, smaller runs Fewer production runs, larger runs

Mach. Setups More machine setups Fewer machine setups

Packaging 1 Unit per package 4 Units per package

Direct labor More direct labor required Less direct labor required

Direct materials Higher direct materials cost Lower direct materials cost

Product A and Product B compared.

How to Apply Traditional Costing for Direct and Indirect Costs

Calculate in 5 Steps
Cost accountants can apply traditional costing methods to find total production costs for Products A and B in
Table 1 above. In one accounting period, the firm produces and sells
▪ 900,000 units of product A at $3.00 each.
Product A sales revenues = $2,700,000.
▪ 2,100,000 units of product B at $2.00 each.
Product B sales revenues = $4,200,000.

To find product gross profits and profit margins, however, accountants will use traditional costing
methods to estimate total production costs per unit, and with that, gross profit margin per unit.
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Step 1. Find Total Direct Costs
TC Step 1. Direct costs: Employees who work directly on individual product units are direct labor.
Direct labor costs are the same under both traditional costing and Activity-Based Costing.
For this example, product manufacturing direct costs consist of direct labor costs and direct
materials cost.
STEP 1A. FIND TOTAL DIRECT LABOR COST FOR EACH PRODUCT
The firm's accounting system carries general ledger T-accounts for each product's direct labor costs.
For one accounting period, these costs are:
Product A direct labor: $450,000
Product B direct labor: $1,050,000
STEP 1B FIND TOTAL DIRECT MATERIALS COST FOR EACH PRODUCT.
The accounting system also carries accounts for each product's direct materials costs. The ledger
shows these direct materials costs for the period:
Product A direct materials: $675,000 Product B direct materials: $1,050,000

Step 2. Find Direct Labor and Direct Materials Costs per Unit
TC Step 2. Direct Costs: Cost accountants calculate the per-unit direct materials cost and per
unit direct labor cost for each product.
The Manufacturing organization provides product unit counts. For the current period:
Product A: 900,000 units Product B 2,100,000 units
STEP 2A. FIND EACH PRODUCT'S DIRECT LABOR COST PER UNIT
Product A Direct labor per unit: $450,000 / 900,000 = $0.50 / unit
Product B Direct labor per unit: $1,050,000 / 2,100,000 = $0.50 / unit
STEP 2B FIND EACH PRODUCT'S DIRECT MATERIALS COST PER UNIT
Product A direct materials per unit $675,000 / 900,000 = $0.75 / unit
Product B direct materials per unit: $1,050,00 / 2,100,000 = $0.50 / unit

Step 3. Find Each Product's Total Direct Costs Per Unit

TC Step 3. Total Direct costs per unit. Total per-unit direct cost is simply the sum of per-unit
costs for direct labor and direct materials.
The final step in finding product direct costs, Step 3, is simply adding individual product direct
labor cost to the individual product direct materials cost. These figures are the results of Step 2,
above.
Product A Direct costs per unit calculate as $0.70 + $0.50 = $1.25 / unit
Product B Direct costs per unit: $0.50 + $0.50 = $1.00 / unit
DIRECT COST SUMMARY, TRADITIONAL COSTING
Table 2 below shows the resulting direct costs for these sales, along with the given per unit sales revenues:
Products Compared Product A Product B Total

1. Units produced & sold 900,000 2,100,000 3,000,000

2. Selling price/unit $3.00 $2.00

3. Direct labor cost/unit $50.0 $0.50

4. Direct materials cost/unit $0.75 $0.50

5. Sales revenues
$2,700,000 $4,200,000 $6,900,000
[=1*2]

Direct costs

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 6. Direct labor costs
$450,000 $1,050,000 $1,500,000
[=1*3]

7. Direct materials costs

$675,000 $1,050,000 $1,725,000
[=1*4]

8. Total Direct costs

$1,125,000 $2,100,000 $3,225,000
[=6+7]

Sales revenues and direct costs for Products A and B.

Step 4. Allocate to Find Indirect Labor and Materials Costs

TC Step 4. Indirect costs: Employees who maintain production machinery but do not work
directly on product units are indirect labor. Traditional cost accounting often assigns value to
product indirect labor and indirect materials costs using allocation rules.
The company's cost accountants will also find cost totals for the period's production support
activities. In traditional cost accounting, these are overhead or indirect costs, as Table 3 shows.
The simple form of traditional cost accounting appearing here uses only the Total Indirect cost
line from Table 3. Traditionally, firms allocate this cost total to each product, A or B, based on
proportional usage of a given resource. The resource chosen for this purpose is usually one of
the direct cost items. Note especially that this approach is also called production volume-based
(PVB) cost allocation, for obvious reasons.
Indirect Components Prod. A & B Indirect % of Total Indirect

Materials purchasing $180,000 12.6%

Machine setups $375,000 26.4%

Product packaging $280,000 19.7%

Machine testing & calibration $300,000 21.1%

Machine maintenance & cleaning $287,000 20.2%

Total Indirect $1,422,500 100.0%

Table 3. Indirect cost components for Traditional Costing

Under PVB cost allocation, accountants allocate (apportion) the total indirect cost to Products A and B
based on factors such as the proportion of the total:
▪ Production machine time for each product.
▪ Direct labor costs for each product.
▪ Factory floor space for each product.
Other factors may also apply. For this example, the firm's accountants chose to allocate indirect costs
referring to direct labor costs.
The indirect cost total from Table 3 above is $1,422,500. The direct labor total (line 6 from Table 1) is
$1,500,000. From these figures, the firm allocates indirect labor cost to each product as a percentage of the
product's own direct labor cost:
STEP 4A. FIND TOTAL INDIRECT LABOR COSTS AS PERCENTAGE OF TOTAL DIRECT LABOR
Indirect labor cost / direct labor cost ratio:
= $1,422,500 / $1,500,000
= 0.948 = 94.8%
▪ For product A, Direct labor costs are $450,00 (Table 2, line 6). The indirect cost allocation for A is
therefore 94.8% of this, or $426,750.
▪ For product B, Direct labor costs are $1,050,000 (Table 2, line 6). The indirect cost allocation for B is
therefore 94.8% of this, or $995,750.

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Table 4, below, shows how this allocation produces indirect cost estimates per unit. And, the table also
shows the conventional costing solutions for gross profit and gross margin for each product unit.
STEP 4B. FIND INDIRECT COST PER UNIT
Estimated Indirect cost per unit is the same for both products, $0.47 (Table 4, line 14). These two indirect
costs must be equal because both products use the same allocation rate (94.8%) applied to direct labor
costs, based on the same direct labor rate ($0.50/unit).
Products Compared Product A Product B Total

9. Units produced and sold

900,000 2,100,000 3,000,000
[Table 2, line 1]

10. Total direct costs

$1,125,000 $2,100,000 $3,225,000
[Table 2, line 8]

11. Total indirect costs

$426,750 $995,750 $1,422,500
[allocation shown above]

12. Revenues per unit

$3.00 $2.00
[Table 2, line 2 ]

13. Direct costs/unit

$1.25 $1.00
[ = 10 / 9 ]

14. Indirect costs/unit

$0.47 $0.47
[ = 11 / 9 ]

15. Gross profit/unit

$1.28 $0.53
[ = 12 − 13 − 14 ]

16. Gross profit margin

42.5% 26.3%
[ = 15 / 12 ]

Table 4. Gross profit and gross margin calculation for each product, using
traditional cost accounting approaches for indirect costs.

Step 5. Find Product Cost Per Unit and Gross Margin Per Unit
TC Step 5. Product profit abilities. With the product revenue figures and the individual product cost figures from steps 1 - 4,
the accountant calculates individual product profit abilities (gross margins).
To find product gross margins for Products A and B, the analyst calculates as line 16 of Table 4 above
shows. The result is that traditional cost accounting shows:
▪ Product A gross margin = 42.5%
▪ Product B gross margin = 26.3%.
On a per-unit basis, this traditional costing finds Product A more profitable than product B.
These Product profitability results are directly comparable with the profitabilities for products A and B found
in Step 6 of the activity-based costing example below.

HOW TO APPLY ACTIVITY-BASED COSTING FOR DIRECT AND INDIRECT COSTS

CALCULATE IN 6 STEPS

This section presents an ABC version of the same product costing situation presented above as Traditional
Costing. The examples show how ABC and traditional costing can yield different indirect cost estimates for
the same products. This means the two approaches can also estimate product-specific profitability
differently.
Finally, the examples show that ABC requires more data and a more detailed analysis than the traditional
PVB allocation approach.

Step 1. Find Total Direct Costs

ABC Step 1. Direct Costs. Employees working directly on individual product units are direct labor. Activity-based costing and
traditional cost accounting assign the same values to direct labor costs and direct materials.

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ABC costing for products A and B begins with the starting data appearing above for the traditional costing
example. Data for starting the ABC analysis include:
▪ Units produced and sold.
▪ Sales revenues.
▪ Direct costs.
The ABC example, therefore, begins with Table 5 (an exact copy of Table 2 above).
Products Compared Product A Product B Total

1. Units produced & sold 900,000 2,100,000 3,000,000

2. Selling price/unit $3.00 $2.00

3. Direct labor cost/unit $50.0 $0.50

4. Direct materials cost/unit $0.75 $0.50

5. Sales revenues
$2,700,000 $4,200,000 $6,900,000
[=1*2]

Direct costs

6. Direct labor costs

$450,000 $1,050,000 $1,500,000
[=1*3]

7. Direct materials costs

$675,000 $1,050,000 $1,725,000
[=1*4]

8. Total Direct costs

$1,125,000 $2,100,000 $3,225,000
[=6+7]

Sales revenues and direct costs for Products A and B. Table 5 are identical to Table 2, above.
In this ABC example, as well, Product manufacturing direct costs consist of direct labor costs and direct
materials cost.
ABC STEP 1A. FIND TOTAL DIRECT LABOR COST FOR EACH PRODUCT
From the firm's general ledger accounts, these costs for the period are:
Product A direct labor: $450,000 Product B direct labor: $1,050,000
ABC STEP 1B FIND TOTAL DIRECT MATERIALS COST FOR EACH PRODUCT.
The ledger shows these direct materials costs for the period:
Product A direct labor: $675,000 Product B direct labor: $1,050,000

STEP 2. FIND DIRECT LABOR AND MATERIALS COSTS PER UNIT

ABC Step 2 Directct materials. Per-unit direct materials costs and direct labor costs will combine in the next ABC step, Step
3, to produce total direct cost.
The Manufacturing organization provides these product unit counts for the period:
Product A: 900,000 units Product B 2,100,000 units
ABC STEP 2A. FIND EACH PRODUCT'S DIRECT LABOR COST PER UNIT
Product A Direct labor per unit: $450,000 / 900,000 = $0.50 / unit
Product B Direct labor per unit: $1,050,000 / 2,100,000 = $0.50 / unit
ABC STEP 2B FIND EACH PRODUCT'S DIRECT MATERIALS COST PER UNIT
Product A direct materials per unit $675,000 / 900,000 = $0.75 / unit
Product B direct materials per unit: $1,050,00 / 2,100,000 = $0.50 / unit

Step 3. Find Total Direct Cost for Each Product Unit

ABC Step 3. Total direct costs per unit. Finding per-unit direct costs are the sums of per-unit costs for direct labor and direct
materials.
For the final step in finding product direct costs, Step 3, is simply individual product direct labor cost to
the individual product direct materials cost. These figures are the results of Step 2, above.
Product A Direct costs per unit calculate as $0.70 + $0.50 = $1.25 / unit
Product B Direct costs per unit: $0.50 + $0.50 = $1.00 / unit

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DIRECT COST SUMMARY, ACTIVITY-BASED COSTING
Table 5 above summarizes direct costs for these product sales, along with the given per unit sales
revenues

Step 4. Identify indirect Activity Pools, Cost Drivers, Unit Costs.

ABC Step 4. Indirect costs. Employees who adjust and maintain production equipment, but who do not work directly on
individual product units are indirect labor. Activity-based costing assigns values to indirect labor and materials by measuring
activities and the resources they consume.
In ABC Step 4, the analyst Identifies Indirect (or Overhead) Activity Pools, Cost drivers, and Unit Costs.
The analyst, in other words, completes Stage 1 Allocation (or Batch Level Allocation).
In ABC, analysts view the indirect or overhead cost contributors as activity pools.
Activity Pools
Under activity-based costing, an activity pool is the set of all activities necessary for completing a task,
such as (a) processing purchase orders, or (2) performing machine setups.
To cost activity pools, ABC identifies activity units that drive costs for each pool. For example:
▪ The total cost of for the activity pool Processing purchase orders is driven by the number of
purchase orders processed.
▪ The total cost for the activity pool Performing machine setups is driven by the number of setups.

STEP 4A. IDENTIFY ACTIVITY POOLS, THEIR COST DRIVERS (CDS), AND UNIT COST
Tables 6 A and 6B, below, list 5 Indirect or Overhead Activity Pools in producing each product unit, their
cost drivers (CDs), and per-unit cost for each activity pool. For example:
▪ Activity Pool: Purchase orders.
Cost Drover: Number of POs.
Cost Driver Unit Cost: $1,800.
▪ Activity. Pool: Machine setup.
Cost Drover: Number of setups.
Cost Driver Unit Cost: $1,500.
▪ Activity. Pool: Product packaging.
Cost Driver: Number packed.
Cost Driver Unit Cost: $0.20.
▪ Activity. Pool: Machine test, calibration.
Cost Driver: Number of tests.
Cost Drover Unit Cost: $100.
▪ Activity Pool: Maintenance, cleaning
Cost Driver: Number of batch runs.
Cost Driver Unit Cost: $1,150
▪ Activity Pool: Purchase orders.
Cost Drover: Number of POs.
Cost Driver Unit Cost: $1,800.
▪ Activity. Pool: Machine setup.
Cost Drover: Number of setups.
Cost Driver Unit Cost: $1,500.
▪ Activity. Pool: Product packaging.
Cost Driver: Number packed.
Cost Driver Unit Cost: $0.20.
▪ Activity. Pool: Machine test, calibration.
Cost Driver: Number of tests.
Cost Drover Unit Cost: $100.

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▪ Activity Pool: Maintenance, cleaning
Cost Driver: Number of batch runs.
Cost Driver Unit Cost: $1,150

STEP 4B. CALCULATE ACTIVITY POOL COSTS FOR EACH PRODUCT

Table 6A, moreover, shows the number of CD units (activity units) used for product A, while Table 6B
shows these figures for product B. From the given cost of each CD unit, calculate the total cost for each
activity pool, for each product.
For example, the Activity Pool "Purchase Orders" has a Cost Driver unit cost of $1,800. Product required
75 CD units for this activity. Total Product A indirect cost for this activity pool is thus (75)($1,800) =
$135,000
Completing these calculations completes Step 4, ABC Stage 1 Allocation (Batch Level Allocation). Tables
6A and 6B summarize Step 4 data and calculations.
PRODUCT A: ACTIVITY UNITS, ACTIVITY POOLS, AND COST DRIVERS
Cost Driver (CD) CD Total Activity Total Indirect
Activity Pool
Activity Units Unit Cost Product A Cost (A)

17. Purchase orders No of purchase orders $1,800 75 $135,000

18. Machine setups No of setups $1,500 150 $225,000

o
N of product
19. Product packaging $0.20 900,000 $180,000
packages packed

20. Machine testing

No of tests $100 1,000 $100,000
& calibration

21. Maintenance
No of batch runs $1,150 200 $230,000
& cleaning

Total $870,000

Table 6A. ABC Stage-1 allocation (batch level allocation) for product A: Activity pools, cost drivers, cost per cost driver unit, and
the total cost for these activities.

PRODUCT B: ACTIVITY UNITS, ACTIVITY POOLS, AND COST DRIVERS

Cost Driver (CD) CD Total Activity Total Indirect
Activity Pool
Unit Cost Product B Cost (B)

17. Purchase orders No of purchase orders $1,800 25 $45,000

18. Machine setups No of setups $1,500 100 $150,000

o
N of product
19. Product packaging $0.20 500,000 $100,000
packages packed

20. Machine testing

No of tests $100 2,000 $200,000
& calibration

21. Maintenance 50
No of batch runs $1,150 $57,500
& cleaning

Total $552,500

ABC Stage-1 allocation (batch level allocation) for Product B: Activity pools, cost drivers, cost per cost driver unit, and the total
cost for these activities.

STEP 5. FIND PER-UNIT INDIRECT COSTS FOR EACH PRODUCT

ABC Step 5. Indirect costs. Employees who operate product production systems such as IT systems that control assembly
lines or production equipment are indirect labor costs.
When each product's activity pool cost totals, the analyst can then calculate the cost per product unit, as
Table 6C shows.

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To find product unit costs, the analyst divides the activity pool cost totals by the number of product units.
From Table 5, Line 1, the firm produced 900,000 units of Product A and 2,100,000 of Product B. With
these figures, the analyst calculates per-product unit costs that appear in the third and fifth columns of
Table 6C. For example:
For the activity pool Purchase orders (line 17 of Table 6C):
Product A Cost per Product Unit = $135,000 / 900,000 = $0.15
Product B Cost per Product Unit = $45,000 / 2,100,000 = $0.02

STAGE 2 ALLOCATION IN ABC: ALLOCATING ACTIVITY POOLS TO PRODUCT UNITS

Total Indirect Cost Cost per Total Indirect Cost per Total indirect
Activity Pool Product A product unit cost Product B product unit cost
[From Table 6A] Product A [From Table 6B] Product A A+B

17. Purchase orders $135,000 $0.15 $45,000 $0.02 $180,000

18. Machine setups $225,000 $0.25 $150,000 $0.07 $150,000

19. Product packaging $180,000 $0.20 $100,000 $0.05 $280,000

20. Machine testing $100,000 $0.11 $200,000 $0.09 $300,000

& calibration

21. Maintenance $230,000 $0.26 $57,500 $0.03 $57,500

& cleaning

Total $870,000 $0.97 $552,500 $0.26 $1,422,500

Stage-2 allocation in ABC: Allocating activity pool costs to individual product units. The cost per product unit figures for product
A and product B (second and fourth columns) derive d from the cost sums for each activity pool (first and third columns) divided
by the number of product units produced and sold for each product (Table 2, line 1).

STEP 6. CALCULATE PROFITABILITY FOR INDIVIDUAL PRODUCTS.

ABC Step 6. Calculate product profit abilities. Using known product revenues and the per-unit cost
figures from ABC steps 1-5, accountants can now calculate individual product profitabilities.
The activity-based costing analyst aims to understand product costs accurately, and then understand
individual product profitability accurately. The aim, in other words, is to find the true gross profit margins for
individual products. Accountants calculate individual product profitability as a gross margin based on
product revenues and total product production costs.
Table 7 below summarizes these figures, using direct and indirect cost figures from ABC steps 1-5. Each
table row indicates the data source and calculation, if any. and profitability calculations. Gross profit margins
for Products A and B appear in Row29.
Products Compared Product A Product B Total

22. Units produced and 900,000 2,100,000

3,000,000
sold [Table 5, line 1]

23. Total direct costs $1,125,000 $2,100,000 $3,225,000

[Table 5, line 8]

24. Total overhead costs $870,000 $552,500 $1,422,500

[Table 6C, bottom line total ]

25. Revenues per unit $3.00 $2.00

[ Table 5 line 2 ]

26. Direct costs/unit $1.25 $1.00

[ = 23 / 22 ]

27. Overhead costs/unit $0.97 $0.26

[ = 24 / 22 ]

28. Gross profit/unit $0.78 $0.26

[ = 25 −26 − 27 ]

29. Gross profit margin 26.1% 36.8%

[ = 28 / 25 ]

7Gross profit and gross margin calculation for each product, using activity-based costing for indirect, or overhead costs.

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CONCLUSIONS: ACTIVITY-BASED COSTING EXAMPLE
First Conclusion
ABC finds different indirect (overhead) costs per unit for each product. ABC results are thus unlike the
traditional costing example above, where indirect costs per unit were the same for both products.
Second Conclusion
ABC analysis recognizes that product A uses more activity pool resources than product B.
THIRD CONCLUSION ON A PER-UNIT BASIS, ABC FINDS PRODUCT B MORE PROFITABLE THAN
PRODUCT A. THE GROSS MARGIN RATE OF 36.8% FOR B COMPARES WITH A GROSS MARGIN
OF 26.1% FOR A.
COMPARING ABC AND TRADITIONAL COSTING:
ADVANTAGES AND DISADVANTAGES TO EACH APPROACHCOSTING RESULTS FROM TWO APPROACHES
Table 8 below shows the per-unit profitability estimates for each product from the examples above.
Product Profitability (Gross Profit Margin) Product A Product B

Traditional cost allocation

(Production volume-based allocating) 42.5% 26.3%

Activity-based costing approach 26.1% 36.8%

Comparing profitability estimates from two different costing methods. Traditional costing shows product A more profitable than
product B. ABC based costing shows the reverse. These differences result from the different treatment of overhead costs.

KEY DIFFERENCES BETWEEN COSTING METHODS

The tables and examples above illustrate some critical differences between
the costing methods:
Data and Analysis
▪ Activity-based costing requires detailed knowledge of the activities and resources that go into overhead
(or "indirect") support work.
▪ Traditional cost accounting (production volume-based allocation) requires only a total overhead cost
and a simple allocation rule.
Overhead Components and Products: Differentiation vs. Aggregation
▪ ABC recognizes that individual overhead components can be distributed differently for different
products. One product may consume relatively more maintenance resources, for instance, while
another product may consume relatively fewer maintenance resources, but relatively more for machine
set up.
▪ Traditional cost accounting typically puts "overhead" components into fewer categories, or even a
single class, and uses a single allocation rate for all products.
Direct vs. indirect measurement
▪ Activity-based costing treats overhead costs essentially as direct costs, in that cost estimates reflect
actual cost driver usage for each product. These costs, in turn, can be reasonably be apportioned to
individual product units.
▪ In traditional cost accounting (production volume-based allocation), an accurate measure of total
overhead cost is accessible. However, in conventional costing the distribution of that total to individual
products is based on an indirect measure of that cost.

COSTING ACCURACY VS. THE COST OF COSTING

For the profitability figures appearing in Table 7 above, the activity-based costing results may be taken as
the more accurate results—more closely reflecting the "true" production costs of products A and B—than
the profitability figures from the traditional costing approach. Whether or not the improved accuracy justifies
the higher expense of applying this costing method, however, is something management will have to
investigate and answer before committing to a comprehensive new approach to cost accounting.

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What is Activity-Based Management?
Activity Based Management. The manufacturing sector has the highest percentage of firms using
activity-based costing and activity-based management. Costing accuracy is especially critical for
planning budgets and setting prices in these industries.
Organizations that use activity-based costing results consistently for decision support and planning
are practicing activity-based management ABM.

For example:
Pricing Decisions. The heart of the firm's business strategy is a business model specifying margins
the firm expects and needs to earn. With accurate knowledge of product costs, the firm can set
prices more accurately to achieve target margins.
Budgetary Planning. To create an operating budget for the next budge cycle, the firm must
anticipate future product costs accurately. ABC shows how indirect product costs depend on
production volume for each product, more accurately than traditional cost allocation methods. If the
firm can predict future production volume accurately, it can also budget future costs accurately.
ADOPTION OF ABC AND ABM
A few firms began using ABC in the mid-1970s. In the years since then, the percentage of companies
and other organizations using ABC increased more or less continuously, but slowly. Nearly five
decades after ABC first appeared, however, the majority of companies and organizations in all
industries still do not use activity-based costing, and still do not practice activity-based management.
IMPLEMENTING ACTIVITY-BASED MANAGEMENT ABM
Regarding implementation, activity-based costing requires
▪ Complete details on activities that go into specific products, services, and tasks.
▪ Complete details on the resources these activities consume (time, labor, and other goods and
services).
Implementation in large, complex organizations is therefore a labor-intensive and data-intensive
undertaking. However, ABC and ABM are becoming more more approachable to many companies as
a result of two ongoing trends.
▪ Firstly, recent improvements in costing software.
▪ Secondly, the increasing availability of data from complex, comprehensive software systems,
such as enterprise resource planning (ERP) systems, manufacturing resource planning (MRP)
systems, and customer relationship management (CRM) systems.
ABM STARTED IN MANUFACTURING
When a few firms moved to ABC in the 1970s, the benefits of ABC were most apparent in product
manufacturing settings, as the two numerical examples above show. From the start, it was clear
that in such settings, the ABC is superior to traditional cost accounting for the purposes of:
▪ Identifying truly profitable and truly unprofitable products.
▪ Finding and eliminating unnecessary costs.
▪ Identifying and distinguishing between true value-add activities and non-value add activities.
▪ Pricing products so as to achieve acceptable margins.
ACTIVITY-BASED MANAGEMENT: MOVING BEYOND MANUFACTURING
Increasingly, however, the value of more accurate costing has become more widely appreciated,
leading to the application of this methodology for the purposes of:
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▪ Budgeting and financial planning.

Organizations can anticipate overhead costs and funding needs with greater accuracy and more
certainty under ABC.
▪ Human capital management.

Firms can now direct human resources into more profitable activities under ABC.
▪ Performance measurement.

Managers can evaluate the performance of individuals, groups, projects, initiatives, and
programs, with more certainty and accuracy when their true costs are better understood
through ABC.

Problems with Activity Based Costing

Many companies initiate ABC projects with the best of intentions, only to see a very high proportion
of the projects either fail or eventually lapse into disuse. There are several reasons for these issues,
which are:
• Cost pool volume. The advantage of an ABC system is the high quality of information that it
produces, but this comes at the cost of using a large number of cost pools – and the more cost
pools there are, the greater the cost of managing the system. To reduce this cost, run an
ongoing analysis of the cost to maintain each cost pool, in comparison to the utility of the
resulting information. Doing so should keep the number of cost pools down to manageable
proportions.
• Installation time. ABC systems are notoriously difficult to install, with multi-year installations
being the norm when a company attempts to install it across all product lines and facilities. For
such comprehensive installations, it is difficult to maintain a high level of management and
budgetary support as the months roll by without installation being completed. Success rates
are much higher for smaller, more targeted ABC installations.
• Multi-department data sources. An ABC system may require data input from multiple
departments, and each of those departments may have greater priorities than the ABC system.
Thus, the larger the number of departments involved in the system, the greater the risk that
data inputs will fail over time. This problem can be avoided by designing the system to only
need information from the most supportive managers.
• Project basis. Many ABC projects are authorized on a project basis, so that information is only
collected once; the information is useful for a company’s current operational situation, and it
gradually declines in usefulness as the operational structure changes over time. Management
may not authorize funding for additional ABC projects later on, so ABC tends to be “done”
once and then discarded. To mitigate this issue, build as much of the ABC data collection
structure into the existing accounting system, so that the cost of these projects is reduced; at
a lower cost, it is more likely that additional ABC projects will be authorized in the future.
• Reporting of unused time. When a company asks its employees to report on the time spent on
various activities, they have a strong tendency to make sure that the reported amounts equal
100% of their time. However, there is a large amount of slack time in anyone’s work day that
may involve breaks, administrative meetings, playing games on the Internet, and so forth.
Employees usually mask these activities by apportioning more time to other activities. These
inflated numbers represent misallocations of costs in the ABC system, sometimes by quite
substantial amounts.
• Separate data set. An ABC system rarely can be constructed to pull all of the information it
needs directly from the general ledger. Instead, it requires a separate database that pulls in
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 information from several sources, only one of which is existing general ledger accounts. It can
be quite difficult to maintain this extra database, since it calls for significant extra staff time
for which there may not be an adequate budget. The best work-around is to design the system
to require the minimum amount of additional information other than that which is already
available in the general ledger.
• Targeted usage. The benefits of ABC are most apparent when cost accounting information is
difficult to discern, due to the presence of multiple product lines, machines being used for the
production of many products, numerous machine setups, and so forth – in other words, in
complex production environments. If a company does not operate in such an environment,
then it may spend a great deal of money on an ABC installation, only to find that the resulting
information is not overly valuable.
The broad range of issues noted here should make it clear that ABC tends to follow a bumpy path in
many organizations, with a tendency for its usefulness to decline over time. Of the problem mitigation
suggestions noted here, the key point is to construct a highly targeted ABC system that produces the
most critical information at a reasonable cost. If that system takes root in your company, then consider
a gradual expansion, during which you only expand further if there is a clear and demonstrable benefit
in doing so. The worst thing you can do is to install a large and comprehensive ABC system, since it is
expensive, meets with the most resistance, and is the most likely to fail over the long term.

 Supervised:
Dr. Mohammed Al-Awlaki
 Done by:
Zainab AlMesbahi 61930007
Seba Khaled 61930031
Yosef AlSaifi

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