COST ELEMENTS AND

ACTIVITY BASED
COSTING (ABC)
ACC466
WAN MARDYATUL MIZA WAN TAHIR
 Topic outcome:
At the end of this topic, you should be able to:
 classify costs according to its function,
traceability and behavior
 calculate overhead absorption rate (OAR)
using traditional costing method (TCM)
 calculate overhead using activity based
costing (ABC) method
 justify the importance and limitation of both
method
 Introduction
There are 3 elements of cost:
Direct Materials Prime Cost
• Materials
Indirect Materials

Direct Labour
• Labour
Indirect Labour Overhead

Direct Expenses
• Expenses
Indirect Expenses

Overhead costs = indirect costs.

The costs cannot be charged directly to
costs units but must be shared equitably
between them
 Material

Fabric – RM30
Foam – RM400

1 unit of Sofa/Couch
Material cost:
RM500

Steel – RM50 Wood – RM20

 Costing for Material
First inFIFO Last inLIFO Weighted
• Material
First Out / stock
First Outmethods
pricing Average
Method

Oldest batch of stock Newest batch of stock

will be issued first until will be issued first until
fully issued. fully issued. Issue price is calculated at
Then, new batch of Then, older batch of average price after each
material purchases/receipts.
stock will be issued. stock will be issued. Issuance price is on average.
Lower cost of sales & Higher cost of sales & Average cost of sales &
higher profit. Lower profit. average profit.
 Costing for Material
Example : Record
 Labour

1 unit of Sofa/Couch
Wages/salary – RM50 Labour cost:
RM50
 Costing for Labour
REMUNERATION SCHEMES

Time based Scheme Premium

Output/ piecework or performance
schemes
Wages are paid based on based Scheme
number of hour worked. Time
Wages are paid based on number of units
allowance is
produced
set for a job

1.Basic Wages 1.Straight 1.Bonus

2.Overtime 2.Differential
Paid for the Piecework 3.Piecework with Paid on the basis
Extra hours Piecework
number of hours Paid based on guaranteed of time saved (the
worked from Paid based on minimum wages
worked (normal number of units difference between
normal working production levels
working hour) at a produced at a flat Minimum paid time allowed and
hours / basic produced
basic rate per hour rate time taken)
 Costing for Labour
Example : Record
 Overhead

Rental – RM1,000 per month Electricity bill –

RM200 per month

1 unit of Sofa/Couch
Overhead cost:
???

Depreciation –
Insurance – RM1,500 per month
RM500 per month
 Costing for Overhead

Direct material Cost per Unit

Prime cost of
Products Produced
Direct labour

TCM
Overhead
ABC
 CLASSIFICATION OF OVERHEAD
4 MAIN GROUPS

Cost incurred in production

Cost incurred in the
administration of the
organization
Eg: office salaries,
audit fees, stationery
expenses etc.
ADMINISTRATION
Cost incurred from the time
the product is completed
in the factory until it reaches
the customers.
Eg: transport charges
& packing costs
Eg: indirect materials,
Indirect factory wages,
Insurance of plant &
PRODUCTION
machinery, factory rent etc.
OVERHEAD
OVERHEAD
Cost incurred for the purpose
of selling goods to market &
SELLING securing orders.
OVERHEAD Eg :rent & rates for
sales dept, advertising
costs, traveling costs, market
DISTRIBUTION
research, salesmen
OVERHEAD
commission.
 Overhead absorb:
Traditional
method
Costing for
overhead
Activity Based
Costing (ABC)
 TRADITIONAL COSTING METHOD (TCM)
• Typically used one rate to allocate overhead to
products.
• This rate was often based on direct labor hour or
direct labor cost.
• This made sense, as direct labor was a major
cost driver in early manufacturing plants.
• Other basis normally use are machine hour and
production unit.
 STAGES IN TRADITIONAL METHOD
1. Identify whether it is a job order costing or
process costing
i. Job order - direct labour hour/cost is assumed to be
the relevant activity base.
ii. Process costing - machine hours is the relevant
activity base.
2. Compute(kira) overhead absorption rate (OAR) by
dividing total overhead cost with the basis
• Basis - direct labour hour/machine hour/production
unit
3. Calculate overhead per unit per product
• OAR x basis per unit per product
 TCM EXAMPLE

Overhead absorption rate (OAR)

= RM2,800,000 OAR:
(2 hours x 20,000 units) + (1.5 hours x 80,000 units) = Total overhead (RM)
= RM17.50 per DLH Total basis
Overhead cost per unit
Overhead cost per unit:
DE1 = RM17.50 x 2 hours = RM35 = OAR x basis per unit
DE2 = RM17.50 x 1.5 hours = RM26.25
ACTIVITY BASED COSTING (ABC)
• ABC is a process of identifying the costs of all
activities and allocating, applying, assigning or
tracing costs to product.
• The assumption of this method is that products
cause activities, activities cause costs and therefore
activity is related to product cost.
• This type of costing/ technique is highly debated to
be used in determining overhead as traditional
costing is perceived is inadequate and
unsophisticated to charge overhead.
 Activity Based Costing
Trace
overheads to
For each Cost Object
activity create
For each Cost Pool
activity
Identify identify Cost
activities Driver
 Example of cost driver
Cost pool Cost driver
(cost associated with each activity
are gathered together)
Material procurement No of orders
Material Handling No of material movements
Set ups No of set ups
Maintenance No of maintenance hours
Quality control No of inspections
Machinery (power, depreciation No of machine hours
etc)

Note that in a traditional costing system all of these production overheads would be
absorbed on production volume measured as direct labour/machine hours/unit
production (basis).
 STAGES IN ABC
1. Identify the major activities that take place in an
organization.
2. Determining the cost driver to each major
activity.
3. Compute cost driver rate by dividing activities
with cost driver. Cost driver rate (CDR) for each activity
= Overhead cost per activity (RM)
Total cost driver per activity

4. Assigning the cost of activities to products

according to the product’s demand for activities
Cost activity per product
= CDR x Cost driver per product
 ABC EXAMPLE

TOTAL
4,000
60,000
1,200
1,200
100,000
Overhead per unit: 2,800,000
Activity Cost Driver Rate DE1 (RM) DE2 (RM)

Purchasing RM280k/4k = RM70 RM70x1.8k = 126,000 RM70x2.2k = 154,000

Machining RM1,200k/60k = RM20 RM20x20k = 400,000 RM20x40k = 800,000

Assembly RM600k/1.2k = RM500 RM500x300 = 150,000 RM500x900 = 450,000

Quality control RM330k/1.2k = RM275 RM275x400 = 110,000 RM275x800 = 220,000

Finishing RM390k/100k = RM3.90 RM3.90 x20k = 78,000 RM3.90x80k = 312,000

Total overhead per product 864,000 1,936,000

Overhead cost per unit RM864k/20k = RM43.20 RM1,936k/80k = RM24.20

 Product/Production cost per unit
TCM ABC
DE1 DE2 DE1 DE2
Direct material RM80 RM65 RM80 RM65
Direct labour RM20 x 2 hours RM20 x 1.5 hours RM20 x 2 hours RM20 x 1.5 hours
= RM40 = RM30 = RM40 = RM30
Overhead RM35 RM26.25 RM43.20 RM24.20
Total cost per RM155 RM121.25 RM163.20 RM119.20
unit

SELLING PRICE = COST + Example DE1 profit Margin 20% Example DE1 profit Markup 20%
PROFIT Profit = Cost x 20/80 Profit = Cost x 20/100
= RM155 x 20/80 = RM155 x 20/100
Profit can be expressed as = RM38.75 = RM31
Margin or Markup Selling price Selling price
= RM155 + RM38.75 = RM155 + RM31
Margin is on Selling price = RM193.75 = RM186
Markup is on Total Cost
 Comparison between TCM and ABC
product cost
TCM ABC
Production overhead Allocate all production Allocates production
overheads to cost object or overhead cost that is only
products. consumed by particular
products (more accurate).
Basis Allocate overheads using Allocate overhead using
one single basis. multiple cost driver (basis)
based on activity.
Non production overhead Ignore any non production ABC include overhead cost
overhead costs (period (including non production
cost). overhead) which is caused
by the products in the
activity cost pools that are
assigned to the product.
 Advantages & disadvantages of traditional
method
• Advantage/importance
– Easy to implement- just need a space and a good filing system
• Disadvantage/limitations
– Not as accurate as ABC systems-this system results in significant
under-costing and over-costing when costs of performing all of
the diverse activities will be contained in one cost pool and will be
divided by single basis.
– outdated costing system in many companies because
manufacturing companies now use machines and computers for
much of their production, instead of labour.
– lead to bad management decisions because it excludes certain
non-manufacturing costs.
Advantages & disadvantages of activity based costing
method
• Advantages/importance
– Applies multiple cost drivers to ascertain a more reliable product
cost
– Provides an opportunity to trace the costs to the activities that
cause the costs.
– This method eliminates allocating irrelevant costs to a product.
– include an easy interpretation of cost for internal management,
the ability to enable benchmarking and a greater understanding
of overhead costs.
• Criticism/limitation
– Difficult to determine the most appropriate cost driver
– Implementation involves high expertise and high costs
– Uses large amount of historic data and may restrict future
decision
 ABC in Service Industry
The same steps used in manufacturing organizations can also be used in
service organizations. To understand how ABC could be used in a service
organization, let’s look at how ABC can be used to determine the cost of loan
products at a financial institution.
Imagine you are the chief financial officer of Five Star Bank. You are interested
in implementing an activity-based costing system to evaluate the cost of
different loan products, such as auto loans and home equity loans, offered by
the bank. Let’s look at how five steps of activity-based costing might work when
evaluating the cost of bank loans.
Step 1. Identify costly activities.
Processing loans includes activities such as meeting with customers, reviewing
customer applications, and running credit reports.
Step 2. Assign overhead costs to the activities identified in step 1.
Costs assigned to the activity of reviewing customer applications include items
such as wages of personnel reviewing applications, depreciation of computer
equipment used to review online applications, and supplies needed for the
review process.
 ABC in Service Industry
Step 3. Identify the cost driver for each activity.
Activity cost drivers are shown as follows:
Activity Cost Driver
Meeting with customers Hours of meeting time
Reviewing customer applications Number of applications reviewed
Running credit reports Number of credit reports run

Step 4. Calculate a predetermined overhead rate (aka CDR) for each activity.
This is done by dividing estimated overhead costs for each activity by the estimated
cost driver activity. For the activity meeting with customers, this calculation results in
a rate per hour of meeting time. For the activity reviewing customer applications, the
calculation results in a rate per application reviewed, and for running credit reports, a
rate per credit report run.
Step 5. Allocate overhead costs to products.
Overhead is allocated, or applied, to products (auto loans and home equity loans in
this example) based on the use of each activity’s cost driver. If a loan officer reviews
30 auto loan applications, an amount equal to the rate per application reviewed times
30 applications is allocated to the auto loans product.
(Source - https://courses.lumenlearning.com/acctmgrs/chapter/3-5-using-activity-based-costing-abc-and-activity-based-management-abm-in-service-organizations/)