ACTIVITY BASED COSTING

BACT 302
 Activity Based Costing

• Activity based costing is a costing technique used to absorb overheads

into cost units.
• It is an alternative to traditional absorption costing which will usually
share overheads across all products based on a single cost driver
(usually machine or labour hours).
• Under it overheads are assigned to different products based on the
extent to which each product ‘drives’ or causes that cost.
• overhead costs are first allocated and apportioned to support- activity
cost centers- cost pools
• Cost drivers or factors that cause the costs in the activity cost centers
are identified
• Based on their rate of usage of the cost drivers, overhead costs are then
absorped into cost units

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 Activity Based Costing-
Reasons for development of ABC
• Overheads have become a huge proportion of total production costs
• Absorption was appropriate when manufactures produced only a
narrow range of products,products underwent similar operations and
consumed similar proportions of overheads and overheads were a
small fraction of total production costs.
• Rise in non-volume support activities due to AMT
• Rise in use of advanced manufacturing technology(AMT) has led to
the rise in non-volume support activities eg, production scheduling &
inspection, set up production runs which vary according to range and
complexity of products manufactured.
• Falling cost of information costs mean more complex system for
accumulating and analysing overheads can be used.

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 Activity Based Costing-
• Moreover ABC avoids the tendency for absoprtion costing to
charge larger overheads to high volume products which are
not compex and hence use less support actvities.
• Or low overheads to low volume products though they are
complex and use more support services.
• It is argued that a modern manufacturing environment
requires a more sophisticated and intelligent costing system.
• This costing system can be relatively time-consuming and
costly to implement but can be useful, if manufacturing
overhead expenditure is significant and a diverse product
range exists. ABC can also be applied to costing within service
industries.

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 Activity Based Costing-
 The steps to be followed are as follows:
• ๏ Identify the major ‘activities’ that give rise to overheads (e.g.
quality testing, ordering costs etc)- cost pools
• ๏ Determine what causes the cost of each activity – the cost
driver (e.g. number of inspections, number of orders)
• ๏ Calculate the total costs for each activity – the cost pools.
• ๏ Calculate a cost per cost driver.
• ๏ Allocate the overhead costs to products based on their usage
of cost driving activities.
• ๏ Calculate the overhead cost per unit for each item of output.

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 Activity Based Costing
 ABC Cost Hierarchy

• ABC costing classifies costs into the following categories.

• ๏ Unit level cost – are incurred with each unit of output -e.g. power
is used by factory machines each time a unit is produced.
• ๏ Batch level costs –increase with each ‘batch’ of output -e.g.
equipment set-up costs are incurred each time a new batch is
processed.
• ๏ Product Sustaining costs – this type of cost does not increase in
relation to batches or units produced but are necessary costs to
support particular product types – e.g. design costs.
• ๏ Facility level costs – General manufacturing overheads -these can
not easily be traced to production activity e.g. admin staff salaries.

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 ABC Example 1

• Una manufactures three products: A, B, and C. Data for the

period just ended is as follows:
• A B C
• Production (units) 20,000 25,000 2,000
• Sales price ( per unit) $20 $20 $20
• Material cost (per unit) $5 $10 $10
• Labour hours (per unit) 2 hours 1 hour 1 hour
(Labour is paid at the rate of $5 per hour)

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 Example 1
Overheads for the period were as follows:
• Set-up costs 90,000
• Receiving 30,000
• Despatch 15,000
• Machining 55,000
• $190,000
Cost driver data:
• A B C
• Machine hours per unit 2 2 2
• Number of set-ups 10 13 2
• Number of deliveries received 10 10 2
• Number of orders despatched 20 20 20

(a) Calculate the cost (and hence profit) per unit, absorbing all the overheads on the
basis of labour hours.
• (b) Calculate the cost (and hence profit) per unit absorbing the overheads using an
Activity Based Costing approach.
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 Solution-Absorption costing
 a) COST STATEMENT- Absorption Costing
• A B C
• $ $ $
• Material cost (per unit) 5 10 10
• Labour hours (per unit) W1 10 5 5
• Fixed overhead W2 5.67 2.84 2.84
• Full prod. cost 20.67 17.84
17.84
• Selling Price 20 20 20
• Profit /unit (0.67) 2.16 2.16

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 Solution
•  
Workings
A B C
W1. Labour hours (per unit) 2 x $5 1 x $5 1x $5
W2. Fixed overhead absorbed $2.836 1x $2.836 1x $2.836

Total overheads $190,000

A: 20,000 X2 40,000
B: 25,000 X 1 25,000
C: 20,000 X 1 2,000
67,000 Hours
OAR= = $2.836/ Hr

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 solution

• Cost Statement- ABC

• A B C
• $ $ $
• Material cost (per unit) 5 10 10
• Labour hours (per unit) 10 5 5
• Fixed overhead 3.90 3.79 8.63
• Full prod. cost 18.90 18.79 23.63
• Selling Price 20 20 20
• Profit /unit 1.10 1.21 (3.63)

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 solution

• Workings

Total A B C
• Set-up costs 90,000 =3600 36,000 46,800 7,200
• Receiving 30,000 =1364 13,640 13,640 2,728
• Despatch 15,000 =250 5,000 5,000 5,000
• Maschining 55,000 =0.585 23,406 29,250 2,340

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 Example 2
Q. Suppose that Cooplan manufactures four products, W, X, Y and Z. Output and cost
data for the period just ended are as follows:
Output Production Material/U Direct Maschine
units runs no. NIT labour hrs
W 10 2 20 1 1
X 10 2 80 3 3
Y 100 5 20 1 1
Z 100 5 80 3 3

• Direct labour cost per hour: GHS5

• Overhead costs GHS
• Short run variable costs 3,080
• Set-up costs 10,920
• Expediting and scheduling costs 9,100
• Materials handling costs 7,700
30,800

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 Activity Based Costing-

• Required:
• Prepare unit costs for each product using:
• (a) Conventional absorption costing
• (b) ABC
• Assume that in the traditional absorption costing system,
overheads are absorbed based on direct labour hrs.

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 solution
Solution-Absorption costing
• Using a conventional absorption costing approach the absorption
rate for overheads based on direct labour hours or machine
hours is: GHS30,800 ÷ 440 hours = GHS70 per direct labour. The
product costs would be as follows.
W X Y Z Total
GHS GHS GHS GHS

Direct material 200 800 2,000 8,000

Direct labour 50 150 500 1,500
overheadUnits 700 2,100 7,000 21,000
950 3,050 9500 30,500 44,000
Produced 10 10 100 100
Costs per unit 95 305 95 305

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 Solution -Activity Based Costing-
• It will be assumed that:
• the number of production runs is the cost driver for set-up
costs, expediting and scheduling costs and materials handling
costs;
• and that machine hours are the cost driver for short-run
variable costs. Product costs per unit are as follows:
W X Y Z Total
Direct material 200 800 2000 8000
Direct labour 50 150 500 1500
Short run overheads(W1) 70 210 700 2100
Set-up Costs(W2) 1560 1560 3900 3900
Expedition &Scheduling costs(W3) 1300 1300 3250 3250
Material handling cost(W4) 1100 1100 2700 2750
4280 5120 13,100 21,500 44,000
Units produced 10 10 100 100
Cost per unit 428 512 131 215

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 Solution-Activity Based Costing-

Workings
• W1. GHS3,080 ÷ 440 machine hours = GHS7 per machine hour
• W2. GHS10,920 ÷ 14 production runs = GHS780 per production run
• W3. GHS9,100 ÷ 14 production runs = GHS650 per production run
• W4. GHS7,700 ÷ 14 production runs = GHS550 per production run

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 Activity Based Costing-
Product Absoprtion ABC Difference/unit Diffrence -total
costing
W 95 428 333 3330
X 305 512 207 2070
Y 95 131 36 3600
Z 305 215 -90 -9000

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 Activity Based Costing-

• These figures might suggest that the traditional volume-based absorption

costing system is flawed, because the low-volume products W and X are not
being charged with a ‘fair share’ of the costs of overhead support activities.
• More specifically, traditional absorption costing may be unsatisfactory for
two main reasons.
• (a) It under-allocates overhead costs to low-volume products (here, W and
X) and over-allocates overheads to higher-volume products (here Z in
particular).
• (b) It under-allocates overhead costs to smaller-sized products (here W and
Y with just one hour of work needed per unit) and over allocates overheads
to larger products (here X and particularly
• Z). ABC addresses these problems, and arguably produces a more ‘realistic’
or ‘satisfactory’ cost

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 Activity Based Costing-

Merits of ABC
• Easy to use
• The complexity of manufacturing has increased, with wider product
ranges, shorter product life cycles and more complex production
processes. ABC recognises this complexity with its multiple cost drivers.
• (b) In a more competitive environment, companies must be able to
assess product profitability realistically. ABC facilitates a good
understanding of what drives overhead costs.
• (c) In modern manufacturing systems, overhead functions include a lot
of non-factory-floor activities such as product design, quality control,
production planning and customer services. ABC is concerned with all
overhead costs and so it can take management accounting beyond its
'traditional' factory floor boundaries.

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 Activity Based Costing-

• Criticisms of ABC
• (a) Cost apportionment may still be required at the cost pooling stage for shared items of cost such
as rent, rates and building depreciation. Apportionment can be an arbitrary way of sharing costs.
• (b) A single cost driver may not explain the cost behaviour of all items in a cost pool. An activity
may have two or more cost drivers.
• (c) Unless costs are ‘driven’ by an activity that is measurable in quantitative terms, cost drivers cant
be established
• (d) There must be a reason for using a system of ABC. ABC must provide meaningful product costs
or extra information that management will use. If management is not going to use ABC
information for any practical purpose, a traditional absorption costing system would be simpler to
operate and just as good.
• (e) The cost of implementing and maintaining an ABC system can exceed the benefits of ‘improved
accuracy’ in product costs.
• (f) Implementing ABC is often problematic, due to problems with understanding activities and their
costs.
• (g) ABC is an absorption costing system. Absorption costing has only limited value for
management accounting purposes.

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 Activity Based Costing-practice question
• A company manufactures two products, L and M, using the same equipment and similar processes. An extract of
the production data for these products in one period is shown below.
• L M
• Quantity produced (units) 5,000 7,000
• Direct labour hours per unit 1 2
• Machine hours per unit 3 1
• Set-ups in the period 10 40
• Orders handled in the period 15 60

• Overhead costs GHS

• Relating to machine activity 220,000
• Relating to production run set-ups 20,000
• Relating to handling of orders 45,000
• 285,000
• Required
• Calculate the production overheads to be absorbed by one unit of each of the products using the following costing
methods.
• (a) A traditional costing approach using a direct labour hour rate to absorb overheads
• (b) An activity based costing approach, using suitable cost drivers to trace overheads to products

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 Activity Based Costing-

 ABC and decision making

• Many of ABC's supporters claim that it can assist with decision making in a number of ways.
• It provides accurate and reliable cost information.
• It establishes a long-run product cost. It provides cost data which may be used to evaluate
different ways of delivering business.
It is particularly suited to the following types of decision:
• Pricing, where selling prices are derived by adding a profit mark-up to cost
• Promoting or discontinuing products or parts of the business, since ABC may help
management to identify activity costs that may be either incurred or saved
• Developing new products or new ways to do business, because ABC focuses attention on the
support activities that would be required for the new product or business procedure. Note,
however, that an ABC cost is not a variable cost.
• ABC is a form of absorption costing that seeks to charge overheads to products on a more ‘fair’
basis than traditional absorption costing. An ABC cost is therefore not a relevant cost for
decision-making purposes. ABC attempts to relate the incidence of costs to the level of
activities undertaken.

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 Activity Based Costing

• Conclusion
• Activity based costing (ABC) is an alternative to traditional absorption
costing as a method of costing.
• ABC involves the identification of the factors (cost drivers) which ‘cause’ or
‘drive’ the costs of an organisation's major activities.
• Overheads are allocated and apportioned to activity cost centres or ‘cost
pools’. From these activity cost centres, the overhead costs are then
absorbed into the product costs on the basis of their usage of the activity.
• The absorption rate for each activity is a rate per unit of the relevant cost
driver. – For activity costs that seem to relate to the volume of production,
the cost driver will be volume-related (labour or machine hours). – For
activity costs that do not seem to relate to production volume, a different
cost driver is identified, such as the number of production runs or number of
orders received

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