ACTIVITY BASED

COSTING

CHAPTER- 8
Traditional Manufacturing
Costing Systems
 Traditionally, job-order and process costing
systems have assigned direct labor and
direct materials costs to products.
 Indirect costs were accumulated as
support department expenses.
 These expenses were allocated to
production departments in a simple
proportion.
 Undercosting and Overcosting
Example
 Jose, Robert, and Nancy order separate
items for lunch.
 Jose’s order amounts to Rs14
 Roberta consumed 30
 Nancy’s order is 16
 Total Rs60
 What is the average cost per lunch?
Undercosting and Overcosting Example

Rs60 ÷ 3 = Rs20

 Jose and Nancy are overcosted.

Activity-Based
Activity-Based Costing
Costing Model
Model
Cost of Resources
Costs assigned using driver tracing and
direct tracing

Activities
Costs assigned using activity drivers

Products
 Activity Based Costing
 View the manufacturing organization as a
collection of distinct activities.
 These activities are the fundamental building
blocks of the cost system.
 The focus is not on departments but on distinct
activities that are carried out in departments.
 The underlying assumption: activities cause costs,
and products create a demand for activities.
 Ultimate objective is accurate product costing by
focusing on indirect cost.
Operational Steps in ABC

 Set up a two-stage system with

minimum top-layer pools and
maximum intermediate-layer pools.
 Choose activities not departments as
your intermediate cost objects.
 Allocate costs from top-layer pools to
activities and also trace costs by
activities.
 Identify a cost driver in each activity
area.
 Allocate a particular activity cost to
all the products (using that activity)
through the chosen driver.
 Make sure that excess capacity costs
are not allocated.
 Different types of activities
 Unit level activities: This type of activity
must be carried out on each unit of
production. A machine-related activity
cost pool represents a unit level activity
since every product unit may require
machining time.
 Energy , Depreciation, Repairs
 Batch-related activities: Performed each
time a batch of goods is produced.
These are independent of number of
units in the batch. E.g., set-up,
purchase orders processing, production
scheduling, first-item inspection etc.
 Set-up hours, Procurement hours
 Product-sustaining activities: Performed
to enable individual products to be
produced and sold. The resources
consumed by activities are independent
of units or batches of product. E.g.,
process engineering, product design,
product enhancement etc.
 Design costs, Engineering costs
 Facility-sustaining activities: Not related
to volume and mix of individual
products. E.g., plant management,
building maintenance, security etc.
 General Administration, Rent , building
security.
Differences between
traditional costing systems
and ABC
 Traditional costing systems: Intermediate
cost objects are typically departments -
indirect costs are generally allocated
through volume-based drivers (number of
units, direct labor hours etc.,) to products.
 ABC: Intermediate cost objects are
activities - allocation through cost drivers
(number of set-ups, number of parts etc.,
need not be volume-based) to products.
Firms for which ABC is especially
useful
 Firms that have,
 High overhead costs.
 Diverse set of operating activities.
 Diverse range of products.
 Wide variation in number of production
runs and costly setups.
Activity Based Management
(ABM)

 ABC is only one component of a total

cost management system.
 It should be followed by ABM.
 ABM involves using knowledge gained
in the design of ABC for continuous
improvement activities.
 Indicators for implementation of ABC
 Complex products that are difficult to manufacture are reported
to be very profitable although they are not priced at a premium.
 Line managers do not believe product costs reported by
accounting department.
 Company is losing bids it is supposed to win.
 Company is outsourcing products in which it has expertise in
manufacturing.
 Competitors’ high volume products are priced unrealistically
low.
 Activity-Based Costing
System
Fundamental Assignment to Other
Cost Objects Cost Objects
Activities Cost of:
• Product
• Service
Costs of Activities • Customer
 Implementing
Activity-Based Costing
Step 1 Step 2
Identify the direct costs
Identify cost objects. of the products.
Direct material
NL
Direct labor
CL
Mold cleaning and
 Implementing
Activity-Based Costing
Cleaning and maintenance costs of
Rs360,000 are direct batch-level costs.
Why?
Because these costs consist of workers’
wages for cleaning molds after each
batch of lenses is run.
 Implementing
Activity-Based Costing

Normal Lenses (NL)

Cost Hierarchy
Description Category
Direct materials Unit-level Rs1,520,000
Direct mfg. labor Unit-level 800,000
Cleaning and maint. Batch-level 160,000
Total direct costs Rs2,480,000
Implementing
Activity-Based Costing

Complex Lenses (CL)

Cost Hierarchy
Description Category
Direct materials Unit-level Rs 920,000
Direct mfg. labor Unit-level 260,000
Cleaning and maint. Batch-level 200,000
Total direct costs Rs1,380,000
 Implementing
Activity-Based Costing
Step 3

Select the cost-allocation bases to use for

allocating indirect costs to the products.
(1) (2) (3)
Activity Cost Hierarchy Total Costs
Design Product-sustaining 450,000
Setups Batch-level 409,200
Operations Unit-level 637,500
 Implementing
Activity-Based Costing
Step 4
Identify the indirect costs associated
with each cost-allocation base.

Overhead costs incurred are assigned

to activities, to the extent possible, on
the basis of a cause-and-effect relationship.
 Step 5

Compute the rate per unit.

(1) (5)
NL CL Total
Setup-hours: 640 2,000 2,640

Rs409,200 ÷ 2,640 = Rs155

 Step 6

Compute the indirect costs allocated

to the products.
NL: Rs155 × 640 = Rs 99,200
CL: Rs155 × 2,000 = 310,000
Total Rs409,200
 Step 7

Compute the costs of the products.

NL and CL would show three

direct cost categories.
1. Direct materials
2. Direct manufacturing labor
3. Cleaning and maintenance
 NL and CL would show six
indirect cost pools.
1. Design
2. Molding machine setups
3. Manufacturing operations
4. Shipment setup
5. Distribution
6. Administration
 ABC: Some Key Issues

The
The Past
Past The
The Present
Present

 Small
Small number
number ofof 
 Numerous
Numerous products
products
products with
with more
more and
and
products which
which did
did
complicated
complicated production
production
not
not differ
differ much
much in
in requirements.
requirements.
required
required Labor

 Labor is
is becoming
becoming an an
manufacturing
manufacturing ever
ever smaller
smaller part
part
support.
support. component
component of of total
total

 Labor
Labor was
was the
the production
production costs.
costs.
dominant
dominant element
element in
in
the
the cost
cost structure.
structure.
 Indicators of Need for
ABC

Direct
Direct labor
labor is
is aa
small
small percentage
percentage Product-line
Product-line profit
profit
of
of total
total costs
costs margins
margins are
are hard
hard
to
to explain
explain

Sales
Sales are
are increasing,
increasing, Line
Line managers
managers do
do not
not
but
but profits
profits are
are declining.
declining. believe
believe the
the product
product
costs
costs reports
reports

Marketing
Marketing does
does not
not Some
Some products
products that
that
use
use costs
costs reports
reports for
for have
have reported
reported high
high
pricing
pricing decisions
decisions profit
profit margins
margins are
are not
not
sold
sold by
by competitors
competitors
End of Chapter 5
This is
real value-added
time!