Activity Based Costing

Activity-Based Costing (ABC) – is a systematic costing method that mainly uses ‘activities’ as basis to allocate
overhead and indirect costs to products. ABC provides reliable data for product costing by using multiple cost drivers
that are more reflective of the actual causes of incurred overhead costs.

ABC vs TRADITIONAL COSTING

Under the traditional costing, overhead costs are allocated to products by using a single
Cost driver (usually labor hour). This costing is volume-based and suitable for labor-intensive, low-overhead
companies. Traditional costing (a.k.a peanut-butter costing) is simple and inexpensive to implement.
Under ABC, overhead costs are allocated to products using several cost drivers associated with the
identified cost pools. ABC is suitable for capital-intensive, product-diverse, and high-overhead companies. ABC
often leads to accurate product costing and elimination of non-value-added activities.

STEPS IN IMPLEMENTING ACTIVITY-BASED COSTINGh2

1. Identify cost drivers(activities), cost pools and activity centers.
 A cost driver is the particular activity that causes the incurrence of certain costs
 A cost pools is a group of costs usually associated with a common cost driver.
 An activity center is a unit of organization that performs a set of tasks. It is part of the
production process for which management wants a separate reporting of the costs of the
activity involved. Level of activity centers can be classified into four general categories:

Unit-level activities performed each time a unit is produced.

Batch-level activities performed each time a batch of goods is handled or processed.
Product-level activities performed to support production (sales) of specific product type.
Facility-level activities perform to sustain a facility’s manufacturing process.

2. Calculate predetermined overhead rates for each identified activity.

Predetermined overhead rate = estimated overhead costs ÷ estimated activity
level.
NOTE: Estimate figures are used because actual figures are not yet known at the start of the period.
3. Allocate overhead costs to the products on the basis of predetermined overhead rates.
In summary, ABC is a ‘two-stage’ allocation. First, overhead costs are traced to activities; then overhead
costs are allocated to products in proportion to their consumption of activities.

ACTIVITY – BASED MANAGEMENT (ABM) - integrates ABC with other concepts such as Total Quality
Management (TQM), process value analysis and target costing to produce a management system that
strives for excellence through cost reduction and continuous process improvement. An important goal of
ABM is to reduce or eliminate non-value-added activities and costs.
 VALUE-ADDED activities are necessary activities that incur costs but increase the perceived
value of a particular product to the customer. Example: engineering designs modification.
 NON-VALUE-ADDED activities are operations that are either (1) unnecessary or dispensable,
or (2) necessary, but inefficient and improvable. Example: rework of defective units.

BALANCED SCORECARD – is an approach to performance measurement that combines traditional

financial measures with non-financial performance measures. Balanced scorecard was created by David Norton and
Robert Kaplan in response to value-based management is a performance evaluation technique that focuses on
traditional financial measures.
FOUR PERSPECTIVES OF THE BALANCED SCORECARD
1. FINANCIAL perspective – measures reflecting financial performance.
Examples: profit, return on investment (RoI), revenue growth
2. CUSTOMER perspective – measures having a direct impact on customers.
Examples: customer satisfaction, customer retention, market share, customer complaints
3. LEARNING & GROWTH perspective – measures describing the company employee’s learning curve.
Examples: employee satisfaction, employee turnover, training and recreation
4. INTERNAL BUSINESS PROCESSES perspective – measures showing key business processes performance.
Examples: manufacturing cycle efficiency, product quality, productivity measures, throughput

COMPONENTS OF BALANCED SCORECARD

 STRATEGIC OBJECTIVES – a statement of what the strategy must achieve and what is critical to its
success.
 STRATEGIC INITIATIVES – key action programs required to achieve strategic objectives.
 PERFORMANCE MEASURES – describe how success in achieving the strategy will be measured.
  BASEKINE PERFORMANCE – the current level of performance for the performance measure.
 TARGETS – the level of performance or rate of improvement needed in the performance
measure.

Strategic objectives focus on WHAT is to be achieved. Strategic initiatives focus on HOW it will be
achieved. Performance measures, baseline performance and targets relate how it will be
MEASURED.
EXERCISES: ACTIVITY-BASED COSTING& BALANCED SCORECARD
1. Activity Levels
Determine the appropriate level for each of the following activities or costs. Indicate whether the
activity is unit-level (UL), batch-level (BL), product-level (PL), facility-level (FL) :
A) Equipment setups
B) Plant supervision
C) Prime costs
D) Packaging and shipments
E) Designing, changing and advertising
F) Heating, lighting, security
G) Product order processing

2. Traditional Costing vs. ABC

Ford Company incurs P 800,000 in manufacturing overhead costs. The company has been allocating
overhead to individual product lines based on direct labor hours.

Cost Driver Amount in Cost Pool Amount of Activity

Direct labor hours P 300,000 40,000
Number of batches 300,000 1,000
Number of shipments 200,000 500
Total overhead costs P 800,000

Product X Product Y
Direct labor hours 2,000 1,000
Number of batches 20 1,00
Number of shipments 2 150

REQUIRED:
Determine the overhead costs to be allocated to each product (X and Y) using:
A) Traditional costing (based on direct labor hours)
B) Activity-based costing (ABC)

3. Application of Overhead Costs

A) Jeep Company us based on direct labor hours toes a predetermined overhead rate based on
direct labor hours to apply manufacturing overhead last year are as follows:
Estimated Actual
Manufacturing overhead P 720,000 P 620,000
Direct labor hours 600,000 hrs. 550,000 hrs.

What was the manufacturing overhead for Jeepney Company for last year?
a. Over-applied by P 40,000 c. Over-applied by P 20,000
b. Under-applied by P 40,000 d. Under-applied by P 40,000

B) Peugeot Company uses activity-based costing to compute product costs for external reports. The
company has three centers and applies overhead using predetermined overhead rates for each
activity center. Estimated costs and activities for the current years are presented below:
Estimated Overhead Cost Expected Activity
Activity 1 P 18,000 1,200
Activity 2 P 57,600 2,400
Activity 3 P 97,200 3,600

Actual costs and activities for the current year were as follows:
Actual Overhead Cost Actual Activity
Activity 1 P 19,500 1,250
Activity 2 P 67,500 2,500
Activity 3 P 90,000 3,70
 What was the amount of overhead applied for Activity 2 during the year?
a. P 7,500 over-applied c. P 7,200 over-applied
b. P 7,500 under-applied d. P 7,200 under-applied

C) The most common treatment of under-applied and over-applied overhead costs is to close it out
to
a. P Work in process c. Cost of goods sold
b. Retained earnings d. Finished goods

4. Manufacturing Cycle Efficiency

Audi Company keeps careful track of time related to orders and their production. During the
most recent quarter, the following average times were recorded for each unit or order:
Inspection time 1 day
Process time 2 days
Move time 3 days
Queue time 4 days
Wait time 5 days
REQUIRED:
1) How long in days the manufacturing cycle time (throughput time)?
2) What is the manufacturing cycle efficiency ratio?
3) What percentage of the production time is spent on non-value-added activities?
4) How long in days is the delivery cycle time?
DELIVERY CYCLE
Start of Production Shipment of
Goods

Wait Time Process Time + Inspective Time + Move Time + Queue Time

Manufacturing Cycle Time (Throughput Time)

5. Quality Costs
A) What are the four categories of quality costs?
a. Internal failure, external failure, carrying and ordering costs
b. Prevention, appraisal, internal failure, and external failure costs
c. Product liability, warranty, appraisal, and training costs
d. Training, testing, failure, and conformance costs
B) Identify the two (2) CONFORMANCE COSTS (i.e., costs incurred to keep defective products from
falling into the hands of customers).
a. Prevention and appraisal costs
b. Prevention and internal failure costs
c. Appraisal and internal failure costs
d. Internal and external failure costs
6. Productivity Measures
Jaguar Company manufactures and sells a single product. The following information was made
available:
2017 2018
Unit sales (P 25 per unit) 10,000 15,000
Material usage 4,000 pounds 5,000 pounds
Material cost P 5 per pound P 10 per pound
Labor hours 2,000 hours 2,500 hours
Labor cost P 20 per hour P 25 per hour
A) Determine the operational partial productivity of DIRECT MATERIAL for (1) 2017 and (2) 2018.
a. (1) 2.50 (2) 3.00 c. (1) 0.25 (2) 0.24
b. (1) 5.00 (2) 6.00 d. (1) 0.50 (2) 0.30
B) Determine the operational partial productivity of DIRECT LABOR for (1) 2017 and (2) 2018.
a. (1) 2.50 (2) 3.00 c. (1) 0.25 (2) 0.24
b. (1) 5.00 (2) 6.00 d. (1) 0.50 (2) 0.30
C) Determine the financial partial productivity of DIRECTIVE MATERIAL for (1) 2017 and (2) 2018.
a. (1) 2.50 (2) 3.00 c. (1) 0.25 (2) 0.24
b. (1) 5.00 (2) 6.00 d. (1) 0.50 (2) 0.30
D) Determine the financial partial productivity of DIRECT LABOR for (1) 2017 and (2) 2018.
a. (1) 2.50 (2) 3.00 c. (1) 0.25 (2) 0.24
b. (1) 5.00 (2) 6.00 d. (1) 0.50 (2) 0.30
E) Determine the total productivity for 2017 as measured in both (1) units and (2) sales pesos.
a. (1) 0.667 (2) 16.667 c. (1) 1.667 (2) 41.67
b. (1) 0.167 (2) 4.167 d. (1) 6.667 (2) 166.
 ACTIVITY-BASED COSTING ANDBALANCED SCORECARD

WRAP-UP EXERCISES (MULTIPLE-CHOICE)

1. Activity-based costing (ABC) can be applied to
a. Selling overheads c. Manufacturing overheads
b. Administrative overheads d. All of the choices
2. Which of these situations is most likely to use traditional costing rather than ABC?
a. High-overhead operations c. Labor-intensive production
b. Product-diverse companies d. Capital-intensive production
3. Which of the following is least likely classified as a unit-level activity?
a. Peso sales c. Direct labor hours
b. Production volume d. Number of inspections
4. A major objective of activity-based management (ABM) is to reduce or eliminate
a. Value-added activities c. Labor-intensive activities
b. Non-value-added activities d. Capital-intensive activities
5. In activity-based costing, which of the following would be considered as a value-added activity?
a. Repair of machines c. Storage and warehousing
b. Engineering design d. Bookkeeping and accounting
6. Ferrari Company produces two products in a single factory. The controller has determined total
overhead costs to be P 480,000: P 140,000 of which relates to material moves,
P 150,000 relates to testing and the remainder is related to labor time.
Product A1 Product B2
Production 10,000 2,000
Material moves (total) 100 40
Product tests (total) 250 125
Direct labor hours per unit 1 5
Under activity-based costing (ABC), how much is product A1’s overhead cost per unit?
a. P 40.00 c. P 24.00
b. P 29.50 d. P 12.00
7. What is the most important purpose of a balanced scorecard?
a. Develop strategy c. Develop cause-and-effect linkages
b. Measure performance d. Set priorities
8. Which of the following is NOT one of the four perspectives of the balanced scorecard?
a. Investment in resources perspective c. Customer perspective
b. Learning and growth perspective d. Financial perspective
9. Process time + inspection time + queue time (during production process) =
a. Wait time c. Throughput time
b. Delivery cycle time d. Lead time
10. What is the correct formula for manufacturing cycle efficiency (MCE) ratio?
a. Value-added time ÷ Throughput time c. Throughput time ÷ Delivery cycle time
b. Value-added time ÷ Lead time d. Non value-added time ÷ Throughput time
11. It considers direct materials as the only variable cost of production process and treats all the other
costs of production as relatively fixed.
a. Throughput accounting c. Process value analysis
b. Backflush costing d. No such thing
12. Throughout contribution is equal to
a. Sales – material costs c. Sales – conversion costs
b. Sales – material and labor costs d. Sales – material and conversion costs
13. A quality cost incurred to detect individual units that do not conform to specifications is an example
of
a. Prevention cost c. Internal failure cost
b. Appraisal cost d. External failure cost
14. Which of these statements is FALSE regarding failure costs?
a. Internal failure costs result from identification of defects during the appraisal process.
b. It is generally better to incur internal failure costs than to incur external failure costs.
c. Internal failure costs include scrap, rejected products, rework and downtime.
d. External failure costs are generally classified as value-added costs.
15. Following are items included in the quality cost report prepared for Maserati Company for
the last month:
Employee training cost P 50,000
Product testing P 20,000
Equipment maintenance P 80,000
Rework upon inspection P 25,000
 a. Prevention cost is P 130,000 c. External failure cost is P 20,000

b. Appraisal cost is P 25,000 d. Internal failure cost is P 105,000

16. Which of the following scenarios is considered as counter-productive?

a. Same outputs, fewer inputs c. More outputs, fewer inputs
b. More outputs, same inputs d. Fewer outputs, same inputs