Activity-Based Costing

Traditional Costing
Systems
Often the most difficult part of computing
accurate unit costs is determining the
proper amount of overhead cost to
assign to each product, service, or job.
Unlike direct materials and direct labor
costs which can usually be easily traced
to the product, overhead is an indirect
or common cost that generally cannot be
traced to a product.

Traditional Costing
Systems
In traditional costing a single
predetermined overhead rate
was used throughout the year to
assign costs to products.
We assumed that direct labor cost
and machine hours were the
relevant activity bases for the
assignment of all overhead in job
order and process costing,
respectively.

Traditional Costing
Systems
When overhead cost allocation systems were first
developed, direct labor made up a large part of total
manufacturing cost. It was widely accepted that there
was a high correlation between direct labor and the
incurrence of overhead cost. As a result, direct labor
became the most popular basis for overhead allocation.
A simplified (one-stage) traditional costing system relying
on direct labor to assign overhead is displayed below:
Overhead
Costs

Direct
Labor
Hours

Products

Traditional Costing
Systems
Even in todays environment, direct
labor is often the appropriate basis
for assigning overhead cost to
products.
It is appropriate when
direct labor constitutes a significant part
of total product cost, and
a high correlation exists between direct
labor and changes in the amount of
overhead costs.

The Need for a New Costing

System
Advances in computerized systems, technological
innovation, international competition, and
automation have changed the manufacturing
environment drastically. The amount of direct labor
used in many industries is now greatly reduced, and
total overhead costs have significantly increased.
Companies that continue to use plant wide
predetermined overhead rates based on direct labor,
where the correlation between direct labor and
overhead no longer exists, experience significant
product cost distortions.

The Need for a New Costing

System
Recognizing these distortions, many companies
now use machine hours as the overhead
allocation base in an automated manufacturing
environment.
But even machine hours may not suffice as the
sole plantwide basis for allocating all overhead.
If the manufacturing process is complex, then only
multiple allocation bases can result in more
accurate computations.
In such situations, managers need a new overhead
cost allocation method: activity-based costing.

Activity-Based Costing
Activity-based costing (ABC) allocates
overhead to multiple activity cost pools and
assigns the activity cost pools to production by
means of cost drivers.
In ABC, an activity is any event, action,
transaction, or work sequence that causes the
incurrence of cost in the production of a product
or rendering of a service.
A cost driver is any factor or activity that has a
direct cause/effect relationship with the resources
consumed.

Activity-Based Costing
ABC first allocates costs to activities,
and then to the products based on
each products use of those
activities.
The reasoning behind ABC cost
allocation is simple: products
consume activities; activities
consume resources.

Collecting ABC Data

Interviews of the key employees in each
of the organizations support department
and careful review of each departments
records.
Storyboarding is a procedure used to
develop a detailed process flow chart,
which visually represents activities and
relationship among the activities.
Multidisciplinary ABC Project team to
collect information.

Collecting ABC Data

Activity Dictionary and Bill of
activity:
Activity Dictionary has a complete
listing of activities identified and
used in ABC analysis.
Bill of activity for a product or
service is a complete listing of
activities required for the product or
service produced.

Activity-Based Costing
ABC allocates overhead in a twostage process:
Overhead is allocated to activity
cost pools, each of which is a distinct
type of activity,
Overhead in the cost pools is
assigned to products using cost
drivers which represent and measure
the number of individual activities
undertaken or performed to produce
products or render services.

Activity-Based Costing
Not all products or services share equally in activities.
The more complex a products manufacturing
operation, the more activities and cost drivers it is
likely to have.
If there is little or no correlation between changes in
the cost driver and consumption of the overhead
cost, inaccurate product costs are inevitable.
The next slide shows an illustration of an activitybased costing system with seven activity cost pools
and correlated cost drivers.

Activity-Based Costing
System
Overhead Costs
Ordering
and
Receiving
Materials
Cost Pool

Setting
Up
Machines
Cost Pool

Numbe
r of
POs

Numbe
r of
Setups

Products

Machining
Cost Pool

Assembling
Cost Pool

Inspecting
and
Testing
Cost Pool

Painting
Cost Pool

Supervising
Cost Pool

Machin
e Hours

Numbe
r of
Parts

Numbe
r of
Tests

Numbe
r of
Parts

Direct
Labor
Hours

Illustration of Traditional
Costing versus ABC
A simple case example will now be presented to
compare traditional costing and activity-based
costing. It illustrates the distortion that can occur
in traditional overhead cost allocation.
Atlas Company products two automobile anti-theft devices, The
Boot and The Club. The Boot is a high-volume item, totaling
25,000 units annually, while The Club is a low-volume item
totaling only 5,000 units a year. Both products require one hour
of direct labor. Therefore, annual direct labor hours are 30,000.
Expected annual manufacturing overhead costs are Rs.900,000.
Thus, the predetermined overhead rate is Rs 30 (900,000
30,000) per direct labor hour.

Unit Costs Under Traditional

Costing
The direct materials cost per unit is Rs.40 for
The Boot and Rs. 30 for The Club. The direct
labor cost is Rs.12 for each product.
The computation of the unit cost for The Boot
and The Club under traditional costing is
shown below:
Atlas Company
Manufacturing Costs
Direct material
Direct labor
Overhead
Total unit cost

Products
The Boot
The Club
Rs.40
Rs.30
12
12
30*
30*
Rs.82
Rs.72

*Predetermined overhead rate times direct labor hours (Rs. 30 x 1 hr. = Rs. 30)

Unit Costs under ABC

Activity-based costing involves the following steps:
1 Identify the major activities that pertain to the
manufacture of specific products and allocate
manufacturing overhead costs to activity cost pools.
2 Identify the cost drivers that accurately measure each
activitys contributions to the finished product and
compute the activity-based overhead rate.
3 Assign manufacturing overhead costs for each
activity cost pool to products using the activitybased overhead rates (cost per driver).

Identifying Activities
A well designed activity-based costing system
starts with an analysis of the activities performed
to manufacture a product. This analysis should
identify all resource-consuming activities.

Atlas Company identified three activity cost

pools: setting up machines, machining, and
inspecting.

Allocating Overhead to Cost

Pools
After the activity cost pools are identified, overhead
costs are assigned directly to activity cost pools.

Atlas Companys activity cost pools, along

with with estimated overhead allocated to
each activity
cost pool are shown below:
Atlas Company
Activity Cost Pools
Setting up machines
Machining
Inspecting
Total

Estimated
Overhead
Rs.300,000
500,000
100,000
Rs.900,000

Identifying Cost Drivers

After costs are allocated to the activity cost pools, the
cost drivers for each activity cost pool must be
identified. To achieve accurate costing, a high degree of
correlation must exist between the activity cost driver
and the actual consumption of the activity cost pool.

The cost drivers identified by Atlas and their total

expected use per activity cost pool are shown below:
Atlas Company

Activity Cost Pools

Setting up machines
Machining
Inspecting

Cost Drivers
Number of setups
Machine hours
Number of inspections

Expected Use of
Cost Drivers
per Activity
1,500 setups
50,000 machine hours
2,000 inspections

Computing Overhead
Rates
Availability and ease of obtaining
data relating to the activity cost
driver is an important factor that
must be considered in its selection.
The activity-based overhead rate is
computed as shown below:
Estimated
Overhead per
Activity

Expected Use of
Cost Drivers per
Activity

Activity-based
Overhead Rate

Computing Overhead
Rates
Atlas Companys computations of
its activity-based overhead rates
are below:
Atlas Company

Activity Cost Pools

Setting up machines
Machining
Inspecting
Total

Estimated
Overhead
Rs.300,000
500,000
100,000
Rs.900,000

Expected Use of
Cost Drivers
per Activity
1,500 setups
50,000 machine hours
2,000 inspections

= Activity-Based

Overhead Rates
Rs.200 per setup
Rs.10 per machine hour
Rs.50 per inspection

Assigning Overhead Costs to

Products under ABC
In assigning overhead costs, it is necessary to know the
expected use of cost drivers for each product.

Because of its low volume, The Club requires

more setups and inspection than The Boot. The
expected
Atlas
Company use of cost drivers per product is shown
below:
Expected Use
Activity Cost Pools
Cost Drivers
Setting up machines
Number of setups
Machining
Machine hours
Inspecting
Number of inspections

of Cost Drivers
Expected Use of
per Product
Cost Drivers
The Boot
The Club
per Activity
500
1,000
1,500 setups
30,000
20,000
50,000 machine hours
500
1,500
2,000 inspections

Assigning Overhead Costs to

Products under ABC
To assign overhead costs to each product, the activitybased overhead rates are multiplied by the number of
cost drivers expected to be used per product.
The assignment of Atlas Companys estimated annual
overhead cost to The Boot is shown below. Estimated
overhead assigned to The Club is shown on the next
slide.
Atlas
Company: The Boot
Expected Use
of Cost Drivers
per Product
Activity Cost Pools
500
Setting up machines
30,000
Machining
500
Inspecting
Total assigned costs (a)
Units produced (b)
Overhead cost per unit (a) (b)

Activity-Based
Overhead
Rates
Rs.200
Rs. 10
Rs. 50

Cost
Assigned
Rs.100,000
300,000
25,000
Rs.425,000
25,000
Rs.17

Assigning Overhead Costs to

Products under ABC
Atlas Company: The Club
Expected Use
of Cost Drivers
per Product
Activity Cost Pools
1,000
Setting up machines
20,000
Machining
1,500
Inspecting
Total assigned costs (a)

Activity-Based
Overhead
Rates
Rs.200
Rs. 10
Rs. 50

Cost
Assigned
Rs.200,000
200,000
75,000
Rs.475,000

Units produced (b)

5,000

Overhead cost per unit (a) (b)

Rs.95

These data show that under ABC,

overhead costs are shifted from the
high volume product (The Boot) to the
low-volume product (The Club).

Assigning Overhead Costs to

Products under ABC
This shift of overhead from high to low
volume products results in more accurate
costing for two reasons:
Low-volume products often require more special
handling, such as setups. Thus, the low-volume
product is responsible for more overhead costs
per unit than a high-volume product.
The overhead costs incurred by the low-volume
product often are disproportionate to a traditional
allocation base such as direct labor hours.

Comparing Unit Costs

Atlas Company

Manufacturing Costs
Direct materials
Direct labor
Overhead
Total cost per unit

The Boot
Traditional
Costing
Rs.40
12
30
Rs.82

ABC
Rs.40
12
17

The Club
Traditional
Costing
Rs.30
12
30

ABC
Rs. 30
12
95

Rs.69

Rs.72

Rs.137

The comparison shows that unit costs under traditional

costing are significantly distorted. The cost of
producing The Boot is overstated Rs.13 per unit and the
cost of producing The Club is understated Rs.65 per
unit.

Comparing Unit Costs

The differences in cost per unit are
attributable entirely to how
manufacturing overhead is assigned.
A likely consequence of the differences
is that Atlas Company has been
overpricing The Boot and possibly losing
market share to competitors. In
addition, it has been sacrificing
profitability by underpricing The Club.

 A Company manufacturing two

products furnishes the following data
for a year:
Product
Annual
Total
Total no. Of Total no. Of
output
(units)

machines
hours

purchase
orders

set ups

5000

20000

160

20

6000

120000

384

44

The annual overhead are as follows:

Volume related activity costs Rs. 5,50,000
Set up related activity costs Rs. 8,20,000
Purchase related activity costs Rs. 6,18,000
You are required to calculate the over head cost per
unit of each product A & B based on:
Traditional method of charging overhead
ABC Method

 Industrial Tools Ltd. produces four products A, B, C

and D. The following information is related to a
particular period: A
Particulars
B
C
D
Outputs(units)

100

200

500

2000

o. Of production runs

20

No. Of set ups

Labour hour per unit

Machine hour per unit

Material cost per unit (Rs.) 100

300

200

400

Direct Labour hour cost

(Rs.)

25

25

25

Rs.

Possible cost
drivers

25

Support department
costs
Set-up costs

1,00,000

No. Of set ups

Material handling costs

93,000

No. Of production
runs

Production scheduling
costs
Calculate
the total

77,500

No. Of production
runs of the
each

cost per unit for

Otherproducts
variable costs
37,500
four
using ABC.

Labour hours

Benefits of ABC
The primary benefit of ABC is more accurate
product costing because:
ABC leads to more cost pools used to assign
overhead costs to products. Instead of one pool
and one driver, numerous activity cost pools with
more relevant cost drivers are utilized.
ABC leads to enhanced control over
overhead costs. Many overhead costs can be
traced directly to activities. Thus, managers
become more aware of their responsibility to
control the activities that generate costs.

Benefits of ABC
ABC leads to better management decisions.
More accurate product costing helps in setting
selling prices and in deciding to whether make or
buy components.
Activity-based costing does not, in and of itself,
change the amount of overhead costs, but it does
in certain circumstances allocate those costs in a
more accurate manner. And, if the score-keeping
is more realistic, more accurate, and better
understood, managers should be able to better
understand cost behavior and overall profitability.

Limitations of ABC
Although ABC systems often provide better product cost
data than traditional volume-based systems, there are
limitations.
ABC can be expensive to use. ABC systems are
more complex than traditional costing systems. There
is a cost to identifying multiple activities and applying
numerous cost drivers.
Some arbitrary allocations continue. Even though
more overhead costs can be assigned directly to
products, certain overhead costs remain to be allocated
by means of some arbitrary volume-based cost driver.

When to Switch to ABC

The presence of one or more of the following factors
indicates ABC as the superior costing system:
Product lines differ greatly in volume and manufacturing
complexity.
Product lines are numerous, diverse, and require differing
degrees of support services.
The manufacturing process or the number of products
has changed significantly.
Production or marketing managers are ignoring data
provided by the existing system, and are instead using
alternative data in making decisions.

When to Switch to ABC

The redesign and installation of a new
product-costing system is a significant
decision that requires considerable
cost and a major effort to accomplish.
Therefore, financial managers need to
be very cautious and deliberative
when initiating changes in costing
systems.

Activity-Based
Management
Activity-based management
(ABM) is an extension of ABC from a
product costing system to a
management function that focuses
on reducing costs and improving
processes and decision making.
A refinement of activity-based
costing used in ABM is the
classification of activities as either
value-added or nonvalue-added.

Value-Added versus NonvalueAdded Activities

Value-added activities increase the worth
of a product or service to customers.
They involve resource usage and related
costs that customers are willing to pay for.
Value-added activities are the functions of
actually manufacturing a product or service.
Examples include engineering design,
machining, assembly, painting, and
packaging.

Value-Added versus NonvalueAdded Activities

Nonvalue-added activities are production- or
service-related activities that simply add cost
to, or increase the time spent on, a product or
service without increasing its market value.
Examples include the repair of machines,
storage of inventory, moving of materials,
maintenance, and inspections.
Identifying and labeling activities as value-added
or nonvalue-added is part of the analysis of
operations, the first step, in an ABC system.

Value-Added versus NonvalueAdded Activities

Not all activities labeled nonvalue-added
are totally wasteful, nor can they be totally
eliminated.
For example, although inspection is a
nonvalue-added activity from a customers
perspective, few companies would
eliminate their quality control functions.
Similarly, moving and waiting time is
nonvalue-added, but it would be impossible
to completely eliminate.

Value-Added versus NonvalueAdded Activities

Nevertheless, because mangers recognize
the non-value-added characteristic of
these activities, they are motivated to
minimize them as much as possible.
Attention to such matters is part of the
growing
practice
of
activity-based
management which helps managers
concentrate
on
continuous
improvement
of
operations
and
activities.

Hierarchy of Activity
Levels
The recognition that not all activity costs are driven by
output units has led to the development of a
hierarchy of ABC activities:
Unit-level activities are performed for each unit of
production. (Ex.: materials)
Batch-level activities are performed for each batch
of products. (Ex.: setups)
Product-level activities are performed in support of
an entire product line. (Ex.: design)
Facility-level activities are required to support or
sustain an entire production facility. (Ex.: security)

Hierarchy of Activity
Levels
Failure to recognize this hierarchy of activities is
one of the reasons that volume-based cost
allocation causes distortions in product costing.
The resources consumed by batch-, product-,
and facility-level supporting activities do not
vary at the unit-level, and cannot be controlled
at the unit-level. Dividing these types of costs
by the number of units produced gives the
mistaken impression that these costs vary with
the number of units.

Just-in-Time Processing
Many firms have switched from a traditional
just in case approach to production to justin-time (JIT) processing.
JIT minimizes inventory storage and waiting
time, which are non value-added activities.
Under JIT processing, raw materials are
received just in time for use in production,
sub-assembly parts are completed just in
time for use in finished goods, and finished
goods are completed just in time to be sold.

Objective of JIT
Processing
A primary objective of JIT is to
eliminate all manufacturing
inventories.
JIT strives to do this by using a pull
approach to production, instead of
the traditional push approach
which often results in the buildup of
extensive inventories.

Elements of JIT
Processing
The three important elements in JIT processing
are:
Dependable suppliers willing to deliver exact
quantities of materials that meet precise
quality specifications on short notice.
A multi-skilled work force.
A total quality control system (which means
no defects) throughout all manufacturing
operations.

Benefits of JIT Processing

The major benefits of JIT processing
are:
Manufacturing inventories are
significantly reduced or eliminated.
Product quality is enhanced.
Rework costs and inventory storage
costs are reduced or eliminated.
Production cost savings are realized
from the improved flow of goods
through the process.

Customer Profitability
Analysis

Customer profitability
analysis
Customer profitability analysis identifies
customer service activities and cost drivers
and determines the profitability of each
customer or customer group.
Here, customer service includes all
activities to complete the sale and satisfy
the customer, including advertising, sales
calls, delivery, billing, collections, service
calls, inquiries, and other forms of customer
service.

Customer profitability analysis

allows managers to:

Identify most profitable customers.

Manage each customers costs-to-serve.
Introduce profitable new products and services.
Discontinue unprofitable products, services, or
customers.
Shift a customers purchase mix toward highermargin products and service lines.
Offer discounts to gain more volume with low
costs-to-serve customers.
Choose types of after-sale services to provide.

 A good understanding of the

profitability of a firms current and
potential customers can help firms
improve overall profits and become
more competitive.
This begins with an analysis of the
cost to serve the customer.

Customer Cost Analysis

Not all customers require similar activities
either before or after the sale. Examples
of customer-specific activities include:
Order processing costs.
Billing, collection, and payment
processing costs.
Accounts receivable and carrying costs.
Customer service costs.
Selling and marketing costs

 Customer cost analysis is the

process of identifying the activities
and cost drivers related to servicing
customers.
Traditionally these costs are hidden
in the customer support, marketing,
and sales function.
ABM can help managers to
understand their costs to serve
customers.

Case Analysis
Patio Grill Company uses activity-based
costing to allocate overhead costs to its
customers.
The company has determined the
following cost pools): Order processing,
sales contacts, sales visits, shipment
processing and billing and collection.
The company has budgeted the following
amount of overhead cost and activity rate
for each cost pools.

Cost Pools

Budgeted Activity Budgeted Activity

Activity Rate (Rs)
Cost Pool(Rs)
Drivers

Order processing

2,400,000

12,000 orders

200 per order

Sales contacts

1,260,000

9,000 contacts

140 per contact

Sales visit

54,750

365 visits

150 per visit

Shipment
processing

1,056,000

4,800 shipments

220 per shipment

Billing and
collection

3,648,000

4,560 Invoices

800 per Invoice

Total

8,418,750

The activity rates shown in the table

above can be used to perform
customer cost and customer profit
analyses.

The following data pertains to five

customers of the company.

Cost of goods
sold

Customer101 Customer102 Customer103 Customer104 Customer105

Rs.150

Rs.340

Rs.1,100

Rs.180

Rs.760

Order
processing

Sales
contacts

Sales visit

12

Shipment
processing

Billing and
collection

Overhead costs are allocated among the customers

based on their activity-consumption rates. The table
below summarizes the cost of each customer:

Customer101 Customer102 Customer103 Customer104 Customer105

Order
processing

200

200

400

200

200

Sales
contacts

280

420

560

140

280

Sales visit

300

1,050

1,800

150

600

Shipment
processing

660

1,540

440

Billing and
collection

800

2,400

800

800

1580

2330

6700

1290

2320

Total

Assume that Company generated the following revenues for

each customer: Let's perform the Customer profitability
analysis:
Patio Grill company
Customer Profitability Report
For the Period Ending ........

Revenues
Less: costs of
goods sold
(a)Gross Profit

Customer101 Customer102 Customer103 Customer104 Customer105

Rs. 2,400
150

Rs.4,825
340

Rs. 13,240
1,100

Rs.1,260
180

Rs.4,530
760

2250

4485

12140

1080

3770

Order
processing

200

200

400

200

200

Sales
contacts

280

420

560

140

280

Sales visit
Shipment
processing
Billing and
collection
(b)Total
Customer
costs
Net profit (a-b)
Profit /
Revenues

300
0

1,050
660

1,800
1,540

150
0

600
440

800

2,400

800

800

1580

2330

6700

1290

2320

670
28%

2,155
45%

5,440
41%

(210)
(17%)

1,450
32%

 As we can see, customer102 and

customer103 provided the highest
return on sales while customer104
resulted in the lowest (actually,
negative) return.
Based on this analysis, Patio Grill
company may conclude that it is more
profitable to have customers providing
high revenues compared to customers
providing low revenues as return on
sales appears to be directly correlated
with revenue amounts.