ACTIVITY BASED

COSTING
DPA30073 COST & MANAGEMENT ACCOUNTING
1
DEFINITION OF ABC
◦ Costing method whereby overhead costs are assigned to activities.
◦ ABC is the concept that products consumes activities.
◦ Activities may be known as processes, tasks or functions for a certain period
of time & for production purposes.
◦ Activities consumes resources to produce goods or provide services.
◦ Resources are subject to processes or activities performed by the labour force
& machines of the business.
◦ Activities consume resources such as material, time, services & information.
BASICS OF THE ABC SYSTEM
1. Recognize a few classifications of major activities & pooling
oCost pools are the groups of OH costs of various categories which the costs
can be associated with the activities.
oExample: inspection costs, machining costs & setting up costs.
BASICS OF THE ABC SYSTEM
2. Establishing the cost drivers.
oCost driver or activity driver is the unit of an activity that cause the change of
an activity cost.
oA cost driver is any activity that causes a cost to be incurred.
oA cost driver rate is the rate of OH expressed in terms of units of activities
that will be charged to the products & services.
BASICS OF THE ABC SYSTEM
3. Cost driver rate is predetermined rate for each cost pool.
Cost driver rate = Cost pool
Basis of activity driver
4. Application of costs to products & services. Once the cost driver rate is
calculated, this must be multiplied by the consumption rate of the product
concerned.
5. The total derived will then be divided by the volume of products or services .
BASICS OF THE ABC SYSTEM
◦ The more a product uses the activity, the more costs have to bear.
◦ The higher the volume of units, the higher the costs will be charged.
◦ ABC assists in providing information for other reasons like outsourcing, capital
expenditures & operational efficiency.
◦ Operational efficiency is the level at which the resources & activities being used
efficiently.
BASICS OF THE ABC SYSTEM
◦ Cost driver refers to the activity that drives rate is the measurement of such
consumption per unit of measurement.
◦ Allocation of OH is required to provide full cost of producing a product or providing a
service.
◦ ABC is useful for pricing decisions & identifying cost activities.
DESIGNING ABC

Involves identification of activities or process into

distinct cost pools that certain OH items are collected
under various categories.
There are a few steps for designing ABC system in a
production process.
STEPS FOR DESIGNING ABC

Identify activities
& cost
classification

Once processes
are distinguished,
Trace costs to the
the new costs
pools
must be
calculated.

Total up the costs

Relate activities
& show the new
to the cost drivers
costs under the
& to the rate
new classification
EXAMPLE
◦ The budgeted manufacturing OH costs of B-Best factory for the year 2018 are as follows:

OH cost pools RM Cost drivers Total usage of Usage of drivers

drivers for product M

Purchasing 570,000 No. of orders 300 150

Setting up 95,000 No. of set ups 950 400
machine
Quality control 230,000 No. of checks 2,000 1,200

Total 895,000
EXAMPLE
◦ In the last five years, the business used the basis of direct labour hours to charge overheads. In
the year 2018, the budgeted direct labour hours is 100,000 and the budgeted production of
Product M is 10,000 units.
◦ Required:
a) Calculate the appropriate absorption rates using traditional & ABC methods.
b) What is the product cost per unit if the direct materials cost is RM50 per unit & direct
labour is 2 hours per unit at RM15 per hour, under traditional and ABC methods?
 solution ◦ Product cost for Product M

a) OAR
Element of cost Traditional ABC

Traditional:
Direct materials 50 50

RM895,000 Direct labour 30 30

100,000 direct labour hours Overheads 17.9 (8.95 x 2dlh) 28.5 (1900 x
150/10,000)
= RM8.95 per DLH Purchasing
ABC:
4 (100 x
 Purchasing : 400/10,000) Setting
RM1,900 per order (570,000 / 300) up machine

 Setting up machine :
RM100 per set-up (95,000 / 950) 13.8 (115 x
1,200/10,000)
 Quality control : Quality control
RM115 per check (230,000 / 2,000)
Cost per unit 105.9 111.3
COMPARISON TRADITIONAL & ABC
◦ TRADITIONAL
◦ OH items listed & assigned to various
production & service.
◦ OH rate on basis of absorption is calculated to
arrive at one amount of OH charge.
◦ Cost behavior is not shown since the OH
linked to the cost centres.
◦ Two levels of activity, facility level & unit
level.
◦ ABC
◦ OH items listed & assigned to activities
termed as cost pools.
◦ Activities or cost drivers used to determine the
cost of the cost objects.
◦ The use of cost behavior is more realistic
because the OH are linked with the cost
drivers.
◦ Various level of cost hierarchy are identified
unit level, batch level, product level & facility.
ADVANTAGES OF ABC

Mgmt have better Provides better

Pricing & decision
control over the incentive to link
making improved
items charged activities

Mgmt have a
Activities that do
better Budget are better
not add value are
understanding of prepared
identified
costs
LIMITATIONS OF ABC

Cost driver ABC might

Classificatio is just costly to
n of OH is arbitrary & implement
subjective not be as change
accurate takes place
BENEFITS OF ABC
Highlight products, services, divisions, activities that are not performing &
leading to losses.
Facilities using more of the inputs for products & divisions that produce
higher profits.
Exercises controls over the costs.
Facilitates fairer pricing of products & services on per unit basis.