CHAPTER 6:

ACTIVITY BASED
COSTING
 Traditional Costing Method

• Activity-based costing is the newest means of calculating how overhead expenses are allocated to
different products at the time of publication. The traditional allocation method requires the business to
pick one metric to use as a means to allot overhead costs. Generally, the business would try to select a
metric that is the underlying cause of overhead costs.
• For example, a business might choose direct labor hours as the allocation metric. The total overhead
expense would be divided by the total number of direct labor hours for the financial period. Using the
per-hour overhead rate, overhead cost would be applied to each item based on the number of direct
labor hours used in producing the good.
Key Terms
for Activity
Based
Costing
 Key Terms for Activity Based
Costing
Activity Cost Driver
• In activity-based costing (ABC), an activity cost driver influences the costs of labor,
maintenance, or other variable costs. Cost drivers are essential in ABC, a branch of
managerial accounting that allocates the indirect costs, or overheads, of an activity.
• Activity-based costing (ABC) is an accounting method that allocates both direct and
indirect costs to business activities.
• A cost driver simplifies the allocation of manufacturing overheads, such as the costs
of factory space and electricity.
• Management selects cost drivers based on the associated variables of the expense
incurred.
 Key Terms for Activity Based
Costing
Overhead
• Overhead refers to the ongoing business expenses not directly attributed
to creating a product or service.
• Overhead refers to the ongoing costs to operate a business but excludes
the direct costs associated with creating a product or service.
• Overhead can be fixed, variable, or a hybrid of both.
• There exist different categories of overhead, such as administrative
overhead, which includes costs related to managing a business.
• The income statement reports overhead expenses.
Activity
Based
Costing
• Activity-based costing (ABC) is a costing method that assigns overhead and
indirect costs to related products and services. This accounting method of costing
recognizes the relationship between costs, overhead activities, and manufactured
products, assigning indirect costs to products less arbitrarily than traditional
costing methods. However, some indirect costs, such as management and office
staff salaries, are difficult to assign to a product.
• Activity-based costing is an improved method for allocating overhead costs.
Instead of using one factor for cost allocation, this new method focuses on
different aspects of the production process and allocates the overhead based on
each product’s reliance on different overhead aspects. The first stage of allocation
determines the cost of each occurrence of an overhead event during the process.
The second stage allocates the cost of each occurrence to individual items
produced by the business.
How Activity-
Based Costing
(ABC) Works
 How Activity-Based Costing (ABC)
Works
• Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the reliability of
cost data, hence producing nearly true costs and better classifying the costs incurred by the company during its
production process.
• Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities
—to products and services.
• The ABC system of cost accounting is based on activities, which are considered any event, unit of work, or task
with a specific goal.
• An activity is a cost driver, such as purchase orders or machine setups.
• The cost driver rate, which is the cost pool total divided by cost driver, is used to calculate the amount of
overhead and indirect costs related to a particular activity.
• ABC is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy.
 How Activity-Based Costing (ABC)
Works

• This costing system is used in target costing, product costing, product line
profitability analysis, customer profitability analysis, and service pricing. Activity-
based costing is used to get a better grasp on costs, allowing companies to form a
more appropriate pricing strategy.
• The formula for activity-based costing is the cost pool total divided by cost driver,
which yields the cost driver rate. The cost driver rate is used in activity-based costing
to calculate the amount of overhead and indirect costs related to a particular activity.
 How Activity-Based Costing (ABC)
Works

The ABC calculation is as follows:

• Identify all the activities required to create the product.
• Divide the activities into cost pools, which includes all the individual costs related to an activity—
such as manufacturing. Calculate the total overhead of each cost pool.
• Assign each cost pool activity cost drivers, such as hours or units.
• Calculate the cost driver rate by dividing the total overhead in each cost pool by the total cost drivers.
• Divide the total overhead of each cost pool by the total cost drivers to get the cost driver rate.
• Multiply the cost driver rate by the number of cost drivers.
• As an activity-based costing example, consider Company
ABC that has a $50,000 per year electricity bill. The
number of labor hours has a direct impact on the electric
bill. For the year, there were 2,500 labor hours worked,
which in this example is the cost driver. Calculating the
cost driver rate is done by dividing the $50,000 a year
electric bill by the 2,500 hours, yielding a cost driver rate
of $20. For Product XYZ, the company uses electricity for
10 hours. The overhead costs for the product are $200, or
$20 times 10.
 How activity-
based costing and
a two-stage
product system
are related
How A Two-Stage Product Costing System Works.
• Let’s assume a manufacturing operation. Direct costs are assigned directly to
products or services. The basic approach in product costing is to allocate
manufacturing overhead costs in the cost pools that record manufacturing costs
and assign, or allocate, these costs to the products or services of interest by using
appropriate cost allocation bases or cost drivers.
How activity-based costing and a
two-stage product system are
related
 How activity-based costing and a two-
stage product system are related
• The first-stage cost objects (cost pools) are the overhead accounts (e.g., machine-related
costs and direct labor-related costs) captured by the cost accounting system.
• The two-stage approach separates plant, or manufacturing, overhead into two or more cost
pools based on the account in which the costs were recorded.
• The allocation in the first stage permits selection of multiple cost drivers that were used to
allocate costs to products.
• Another common choice for first-stage cost objects is to use departments or lines within
the plant.
• The allocation of overhead costs to departments is not as simple as it is when overhead
accounts are used because the costs are not necessarily recorded at the department level.
• In the second stage, cost pool costs are assigned to objects.
 Compute
product costs
using activity-
based costing
 Compute product costs using activity-
based costing

• ABC Mobile Phone Company makes mobile phones. How much is the overhead
cost of each phone of each phone model? (PDA phones and simple phones)?
• Example Mobile Phone Company, 1 year of data:
• PDA phones – Phones manufactured in 1 year: 3,000 units
• Simple – Phones manufactured in 1 year: 7,000 units.
• Total Phones manufactured in 1 year ( PDA-phones + Simple-phones): $10,000
units.
• Overhead cost in 1 year:
• Machine maintenance costs: $400,000
• Quality control costs: $600,000
• Total overhead of firm (machine maintenance + quality control): $1,000,000
 Compute product costs using activity-
based costing
• Quantity of each overhead type:
• Number of machine hours used: 10,000 hours
• NOTE: The number of machine hours is the way we will count or
measure how much machine maintenance we did. We need to know
this because machine maintenance is part of the overhead.
• Quality inspections: 1,000 inspections
• NOTE: the number of quality inspections is the way we will count
or measure how much quality control we did. We need to know this
because quality control is part of the overhead.
 Compute product costs using activity-
based costing

• Quantity of each type of overhead used by each type of

phone:
• PDA phones: 5,500 machine hours and 650 quality
inspections.
• Simple phones: 4,500 machine hours and 350 quality
inspections.
Computations:
Traditional way (Estimation): total overhead cost/ number of phones
$1,000,000/10,000 = $100 for each phones.
(PDA and simple phones)
Activity based costing (Exact): break down the costs
Machine maintenance cost: Quality control cost
$400,000 $600,000
10,000 machine hours 1,000 inspections
 Compute product costs using
activity-based costing
Activity based costing: break down
the costs
Machine maintenance cost: Quality control cost:

• $400,000 • $600,000
• 10,000 machine • 1,000 inspections
hours • $600,000/1,000=$6
• $400,000/10,000=$4 00 for one
0 for machine hour inspection
 Compute product costs using activity-
based costing
Activity based costing

Machine maintenance cost: Quality control cost:

• Machine maintenance cost • Quality control cost:
$400,000 $600,000
• 10,000 machine hours: $40 • 1,000 quality inspections:
for 1 machine hours $600 for 1 inspections
 Compute product costs using activity-
based costing
Activity based costing
Machine maintenance cost:
Next is find the total machine maintenance
cost for PDA and Simple phones
• 5,500x$40 = $220,000 Total machine
maintenance cost for simple phones
• 4,500x$40 = $180,000 total machine
maintenance cost for simple phones
Quality control cost:
Next is find the total quality control
cost for PDA and Simple phones
• 650 quality inspections
650x$600 = $390,000
• 350 quality inspections for simple
phones
350x$600 = $210,000
 Compute product costs using activity-
based costing

Now we can compute the OVERHEAD cost for the PDA Phones:
• Machine maintenance cost for all PDA phones: $220,000
• Number of PDA phones made: 3,000 units (given)
• Machine maintenance cost for each PDA phones:
$220,000/3,000 = $73.33 for each PDA phones

• Quality control cost for all PDA phones: $390,000

• Number of PDA phones made: 3,000
• Quality control cost for each PDA phones:
• $390,000/3,000 phones = $130 for each PDA phones
 Compute product costs using activity-
based costing

Now that we have the overhead cost for machine

maintenance and quality control for PDA phone we can
now compute for the total overhead cost for PDA phone.
therefore...
• Total overhead cost for each PDA phone:
$73.33+$130 = $203.33 overhead cost for each PDA
phone
 Compute product costs using activity-
based costing

Next we can compute the OVERHEAD cost for the Simple Phones:
• Machine maintenance cost for all simple phones: $180,000
• Number of Simple phones made: 7,000 (Given)
• Machine maintenance cost for each simple phone:
• $180,000/7,000 = $25.71 for each simple phone

• Quality control costs for all simple phones: $210 ,000

• Number of simple phones made: 7,000
• Quality control cost for each simple phone:
• $210,000/7,000 = $30 for each simple phone
 Compute product costs using activity-
based costing

And now that we have the overhead cost for machine

maintenance and quality control for Simple phone we can
now compute for the total overhead cost for Simple phone.
Therefore…

• Total overhead cost for each Simple phone:

$25.71+$30 = 55.71 overhead cost for each simple
phone
Compare Activity-
based Product
Costing to
Traditional
Department
Product Costing
Methods.
 Compare Activity-based Product
Costing to Traditional Department
Product Costing Methods

Comparing traditional costing and activity based costing (ABC) from the
result of computation.
Traditional costing: (more on estimation)
Overhead cost of PDA phone: $100 per phone
Overhead cost of simple phone: $100 per phone

Activity based costing: (more exact)

Overhead cost of PDA phone: $203.33 per phone (much higher)
Overhead cost of simple phone: $55.71 per phone (much lower)

For detailed step by step procedure:

Part 1: https://www.youtube.com/watch?v=PcjxRe4EsuY
Part 2: https://www.youtube.com/watch?v=xLb0onIVzmM
 Compare Activity-based Product
Costing to Traditional Department
Product Costing Methods

• Traditional costing adds an average overhead rate to

the direct costs of manufacturing products and is best
used when the overhead of a company is low
compared to the direct costs of production.
• Activity-based costing identifies all of the specific
overhead operations related to the manufacture of
each product.
 Compare Activity-based Product
Costing to Traditional Department
Product Costing Methods

Traditional Costing
Traditional costing adds an average
overhead rate to the direct costs of
manufacturing products. The overhead rate
gets applied on the basis of a cost driver,
such as number of labor hours required to
make a product.
 Compare Activity-based Product
Costing to Traditional Department
Product Costing Methods

Pros and Cons of Traditional Costing

• Traditional costing is best used when the overhead of a

company is low compared to the direct costs of production. It
gives reasonably accurate cost figures when the production
volume is large, and changes in overhead costs do not create
a substantial difference when calculating the costs of
production. Traditional costing methods are inexpensive to
implement.
 Compare Activity-based Product
Costing to Traditional Department
Product Costing Methods

Pros and Cons of Traditional Costing

• Companies usually use traditional costing for external reports, because

it is simpler and easier for outsiders to understand. However, it does not
give managers an accurate picture of product costs because the
application of overhead burden rates is arbitrary and applied equally to
the cost of all products. Overhead costs are not allocated to the products
that actually consume the overhead activities.
• The traditional costing method is best used for manufacturers that only
make a few different products.
 Compare Activity-based Product Costing to
Traditional Department Product Costing Methods

Activity-Based Costing
• Activity-based costing identifies all of the specific overhead
operations related to the manufacture of each product. Not all products
require the support of all overhead costs, so it is not reasonable to
apply the same overhead costs to all products
• Accountants created the ABC method to solve the problems of
inaccuracy that result from the traditional costing approach. Managers
needed more accurate costing methods to determine which profits
were actually profitable and which were not.
 Compare Activity-based Product Costing to
Traditional Department Product Costing Methods

Activity-Based Costing

• A fundamental difference between traditional costing and

ABC costing is that ABC methods expand the number of
indirect cost pools that can be allocated to specific products.
The traditional method takes one pool of a company’s total
overhead costs to allocate universally to all products.
 Compare Activity-based Product Costing to
Traditional Department Product Costing Methods

Pros and Cons of Activity-Based Costing

• Activity-based costing is the most accurate, but it is also the most difficult and
costly to implement. It is more suited to businesses with high overhead costs
that manufacture products, rather than companies that offer services.
• Companies that manufacture a large number of different products prefer an
activity-based system because it gives more accurate costs of each product. With
activity-based allocation of overhead costs, it is easier to identify areas where
expenses are being wasted on unprofitable products.
 Compare Activity-based Product Costing to
Traditional Department Product Costing Methods

Pros and Cons of Activity-Based Costing

• Deciding between traditional or activity-based costing is not easy. Your choice

should depend on the purpose of the reporting and who will see the information.
Managers need accurate product costs and prefer to use an activity-based
accounting system. Even though this system is more costly, it provides better
information that will enable managers to make more profitable decisions in the
long-term.
• For external reporting, companies still use the traditional costing system, but it
is becoming obsolete as outsiders demand more accurate information about
businesses.
 GROUP 5
1 2 3 4

GALIVO, COCHING, MENDOZA, TAY C O ,

A LY S S A SHIELA JEDIDIAH JAFET
J A N E T. MAE BENJAMIN
THANK Any
Question???

YOU!!!