• TOPIC OUTLINE:

• PROBLEM WITH CONVENTIONAL PRODUCT

COSTING SYSTEMS
• UNDERSTANDING THE BASIC
ACTIVITY TERMINOLOGY OF ABC : - ACTIVITY COST
POOL, COST DRIVER, COST DRIVER RATE
BASED • THE TWO-STAGE ALLOCATION OF
COSTING OVERHEAD UNDER ABC
• TRADITIONAL METHOD COSTING VERSUS
ABC
• ADVANTAGES & LIMITATIONS OF ABC
 CONVENTIONAL PRODUCT COSTING
SYSTEM IS A PRODUCT COSTING SYSTEM
THAT TRACES DIRECT MATERIAL AND DIRECT
PROBLEM WITH LABOUR TO PRODUCT, AND ALLOCATES
CONVENTIONAL
PRODUCT MANUFACTURING OVERHEADS TO PRODUCT
COSTING USING A PREDETERMINED OVERHEAD RATE,
SYSTEMS WHICH IS USUALLY BASED ON A VOLUME-
BASED COST DRIVER THAT RESULTED TO
HIGH VOLUME PRODUCT IS OVER-COSTED
AND LOW VOLUME PRODUCT IS UNDER-
COSTED.
 Definition
• ABC is a costing model that identifies
activities in an organization and assigns the
cost of each activity resource to all products
and services according to the actual
ACTIVITY consumption .

BASED Cost Driver

COSTING • Cost drivers or activity driver are factors or
(ABC) activity that causes costs.

Cost Pool
• Each activity is treated as a cost pool. A
cost pool is the pooling of overhead cost
into individual activities
 Similar costs items are conveniently grouped
together under one pool or category.

COST Examples of cost pools include Machine cost pool, Set-up

cost pool and Inspection cost pool. This is different from the
POOLS traditional approach of grouping overhead costs according
to departments such as overheads for machining department,
assembly department and so on.

Each cost pool contains specific overhead costs. For example,

a machinery cost pool may typically contain the following
items:
Maintenance Electricity Lubrication Depreciation
costs of Machines
 Cost drivers are the basis used to allocate
overheads to cost objects. It is formerly known
as the overhead absorption basis.
Examples:
COST
Activity Cost Pool Cost Drivers
DRIVERS
Machine-related costs Machine hours

Setup costs No. of production runs

Inspection costs No. of inspections

Purchasing costs No of purchase orders

Packaging costs Packaging hours

The cost driver rate is the term that is synonymous

to the overhead absorption rates (OAR)
traditionally used.
 This costing system can be
defined as “a two-stage
procedure used to absorb
TWO- overheads to products and
services”
STAGE
OF In 1st stage : OH are assigned to
activity cost pools
ABC In 2nd stage: OH are allocated
from the activity cost pools to
individual products/services
 • IDENTIFY THE ACTIVITIES IN THE QUESTIONS
• GROUPED THE ACTIVITIES IN THE COST POOL

STAGE 1: • COSTS ARE THEN ASSIGNED TO ACTIVITY COST

POOLS FOR EACH ACTIVITY ACCORDING TO
(COST HOW RESOURCES ARE CONSUMED BY
ACTIVITIES AS SHOWN BELOW:
POOL COST POOL AMOUNT (RM)
AND MACHINE COSTS RM400,000

COSTS) SET-UP COSTS RM560,000

INSPECTION COSTS RM120,000
 The appropriate cost driver for each major activity
needs to be determined.

For instance, the cost drivers that can be used for the
above cost pools are:
STAGE 2:
(POSSIBLE Cost pool Possible Cost drivers

COST Machine costs Machine hour

DRIVERS)
Set-up costs Number of production runs

Inspection costs Inspection hour

 Overheads are then absorbed to each product line
in proportion to the “cost driver” consumed.

To do this, the cost driver rates need to be

computed as follows:
STAGE 2:
(COST Cost pool Cost driver rate (CDR)

DRIVER
Machine costs (RM400,000/Total machine hrs)
RATE)
Set-up costs (RM560,000/Total no of prod runs)

Inspection costs (RM120,000/Total Inspection hrs)

 To absorb overheads for the total production
cost, the cost driver rate is applied using the
STAGE 2: following method:
(ABSORB Cost pool Overhead absorbed to job A
OVERHEAD
USING
Machine costs Cost driver rate x machine hrs
COST of job A
DRIVER
RATE) Set-up costs Cost driver rate x prodn runs of
job A

Inspection costs Cost driver rate x inspection

hours of job A
 Traditional Costing
Method
• Identify overhead cost
• Allocate and apportion cost to cost centre
using suitable basis of apportionment
• Measure using volume related resources
TRADITIONAL • Identify relationship between overhead
COSTING and the volume related resources and
absorb to cost unit
METHOD
VERSUS ABC
ABC
• Identify activities that causes cost
• Identify appropriate cost driver
• Group similar cost driver to cost pools
• Include the cost of activities to cost unit
according to the product’s consumption of
each activity
• Identifies areas of high overhead costs
per unit and so directs attention to finding
ways to reduce the costs.
 Advantages
• ABC provides a more accurate cost per unit. As
a result, pricing, sales strategy, performance
management and decision making should be
improved
• It provides much better insight into what drives
overhead costs
• ABC recognizes that overhead costs are not all
related to production and sales volume.
• ABC can be used just as easily in service
ADVANTAGES costing as in product costing.
& • ABC system allocates indirect costs based on a
product’s cost driver or the factor that creates
LIMITATIONS the cost.
OF ABC
Limitations
• It is impossible to allocate all overhead costs to
specific activities
• The choice of both activities and cost drivers
might be inappropriate
• ABC can be more complex to explain to the
stakeholders of the costing exercise
• Setting up an ABC system can be costly and
time consuming.
• The benefits obtained from ABC might not
justify the costs of implementing of ABC system.