ACTIVITY-BASED COSTING

Dr. Gabrielle Mae A. Bernas, CPA

A good mystery never fails to capture the imagination. Money is stolen
or lost, property disappears, or someone meets with foul play. On the
surface, what appears unremarkable to the untrained eye can turn out
to be quite a revelation once the facts and details are uncovered.
Getting to the bottom of the case, understanding what happened and
why, and taking action can make the difference between a solved case
and an unsolved one. Business and organizations are much the same.
Their costing systems are often mysteries with unresolved questions:
Why are we bleeding red ink? Are we pricing our products accurately?
Activity-based costing can help unravel the mystery and result in
improved operations, as LG Electronics discovers in the following slide.
 LG Electronics Reduces Costs and Inefficiencies Through Activity-Based Costing
LG Electronics is one of the world’s largest manufacturers of flatscreen televisions and
mobile phones. In 2009, the Seoul, South Korea-based company sold 16 million liquid crystal
display televisions and 117 million mobile phones worldwide.
To make so many electronic devices, LG Electronics spends nearly $40 billion annually on
the procurement of semiconductors, metals, connectors, and other materials. Costs for
many of these components have soared in recent years. Until 2008, however, LG Electronics
did not have a centralized procurement system to leverage its scale and to control supply
costs. Instead, the company had a decentralized system riddled with wasteful spending and
inefficiencies.
To respond to these challenges, LG Electronics hired its first chief procurement officer
who turned to activity-based costing (“ABC”) for answers. ABC analysis of the company’s
procurement system revealed that most company resources were applied to administrative
and not strategic tasks. Furthermore, the administrative tasks were done manually and at a
very high cost.
 The ABC analysis led LG Electronics to change many of its procurement practices and
processes, improve efficiency and focus on the highest-value tasks such as managing costs
of commodity products and negotiating with suppliers. Furthermore, the company
developed a global procurement strategy for its televisions, mobile phones, computers, and
home theatre systems by implementing competitive bidding among suppliers, standardizing
parts across product lines, and developing additional buying capacity in China.
The results so far have been staggering. In 2008 alone, LG Electronics reduced its
materials costs by 16%, and expects to further reduce costs by $5 billion by the end of 2011.
Most companies—such as Dell, Oracle, JP Morgan Chase, and Honda—offer more than
one product (or service). Dell Computer, for example, produces desktops, laptops, and
servers. The three basic activities for manufacturing computers are (a) designing computers,
(b) ordering component parts, and (c) assembly. The different products, however, require
different quantities of the three activities. For example, a server has a more complex design,
many more parts, and a more complex assembly than a desktop.
To measure the cost of producing each product, Dell separately tracks activity costs for
each product.
 Functional-Based Costing
Use a predetermined overhead rate which is calculated at the beginning of the year
(Overhead rate = Budgeted annual OH/Budgeted annual driver level)
In functional-based costing, only unit-level drivers are used to calculate overhead
rates. Unit-level drivers are factors that measure the demands placed on unit-level
activities by products. Unit-level activities are activities performed each and every
time a unit of a product is produced. The five most commonly used unit-level
drivers are:
1. Units produced 4. Machine hours
2. Direct labor hours 5. Direct material amount
3. Direct labor amount
 Limitations of Plantwide and Departmental
Rates
1. Non-Unit-Related Overhead Costs
The use of either plantwide rates or departmental rates assumes that a
product’s consumption of overhead resources is related strictly to and
proportional to the units produced.
Example: Setup and Engineering costs
2. Product Diversity
Product diversity means that products consume overhead activities in different
proportions. Product diversity is caused by the nature of the design and
manufacturing processes of products. One dimension of product diversity is
product complexity.
 Activity Rates: A Possible Solution
Instead of pooling the overhead costs in plant or departmental pools, rates are
calculated for each individual overhead activity. The rates are based on causal
factors that measure consumption (unit- and non-unit-level activity drivers).
Setting up equipment: $240,000/100 setups = $2,400 per setup
Machining: $200,000/90,000 machine hours = $2.22* per machine hour
Inspecting: 160,000/18,000 inspection hours = $8.89* per inspection hour
Moving materials: $120,000/300 moves = $400 per move

In a highly competitive environment, the more accurate the

cost information, the better the planning and decision making.
 Activity-Based Costing System
• Prime costs (direct materials and direct labor) are assigned in the same way for
functional-based as for activity-based costing systems, both using direct tracing
to products.
• Activity-based costing (ABC) system first traces overhead costs to activities and
then to products and other cost objects.
• An ABC system boasts the potential of generating more accurate product costs
than a functional-based costing system.
 Design Steps for an ABC System
1. Identify, define, and classify activities and key attributes.
2. Assign the cost of resources to activities.
3. Assign the cost of secondary activities to primary activities.
4. Identify cost objects and specify the amount of each activity
consumed by specific cost objects.
5. Calculate primary activity rates.
6. Assign activity costs to cost objects.
 1. Activity Identification, Definition, and Classification
• Identifying an activity is equivalent to describing action taken—usually by using an action
verb and an object that receives the action. A simple list of the activities identified is called
an activity inventory.
• Once an inventory of activities is taken, then activity attributes are used to define
activities. Activity attributes are nonfinancial and financial information items that describe
individual activities. An activity dictionary lists the activities in an organization along with
desired attributes. The attributes selected depend on the purpose being served.
• Activity classification facilitates the achievement of key managerial objectives such as
product or customer costing, continuous improvement, total quality management, and
environmental cost management. For example, for costing purposes, activities can be
classified as primary or secondary. A primary activity is an activity that is consumed by a
final cost object such as a product or customer. secondary activity is one that is consumed
by intermediate cost objects such as primary activities, materials, or other secondary
activities.
2. Assigning Costs of Overhead Resources to Activities
• The cost of an activity is simply the cost of the resources consumed by the activity.
Activities consume resources such as labor, materials, energy, and capital.
• The cost of these resources is found in the general ledger, but how much is spent on
each activity is not revealed. Resource costs must be assigned to activities using direct
and driver tracing.
• For labor resources, a work distribution matrix is often used. A work distribution matrix
simply identifies the amount of labor consumed by each activity and is derived from the
interview process (or a written survey).
2. Assigning Costs of Overhead Resources to Activities
• The cost of an activity is simply the cost of the resources consumed by the activity.
Activities consume resources such as labor, materials, energy, and capital.
• The cost of these resources is found in the general ledger, but how much is spent on
each activity is not revealed. Resource costs must be assigned to activities using direct
and driver tracing.
• For labor resources, a work distribution matrix is often used. A work distribution matrix
simply identifies the amount of labor consumed by each activity and is derived from the
interview process (or a written survey).
 3. Assigning Secondary Activity Costs to Primary
Activities
• Activities are classified as primary and secondary. If there are secondary activities, then
intermediate stages exist. In an intermediate stage, the cost of secondary activities is
assigned to those activities (or other intermediate cost objects) that consume their
output.
 4. Cost Objects and Bills of Activities
• Once the costs of primary activities are determined, these costs then can be assigned to
products or other cost objects in proportion to their usage of the activity, as measured
by activity drivers.
• Activity drivers measure the demands that cost objects place on activities. Most ABC
system designs choose between one of two types of activity drivers: transaction drivers
and duration drivers.
• Transaction drivers measure the number of times an activity is performed, such as the
number of treatments and the number of requests.
• Duration drivers measure the demands in terms of the time it takes to perform an
activity, such as hours of hygienic care and monitoring hours.
• With the drivers defined, a bill of activities can be created. A bill of activities specifies the
product, expected product quantity, activities, and amount of each activity expected to
be consumed by each product.
4. Cost Objects and Bills of Activities
 5. Activity Rates
• Primary activity rates are computed by dividing the budgeted activity costs by practical
activity capacity, where activity capacity is the amount of activity output (as measured
by the activity driver). Practical capacity is the activity output that can be produced if the
activity is performed efficiently.

Rate Calculations:
Treating patients: $103,070/30,000 = $3.44 per treatment
Providing hygienic care: $87,056/16,000 = $5.44 per hour of care
Responding to requests: $154,112/80,000 = $1.93 per request
Monitoring patients: $135,762/200,000 = $0.68 per monitoring hour
6. Product
Costing
 Time-Driven ABC Systems
• In the time-driven ABC systems, managers estimate the resource demands imposed by
each product rather than assign resource costs first to activities and then to products.
• For each type of overhead resource, only two parameters are estimated: the cost per
time unit of supplying resource capacity and the unit times of consumption of resource
capacity by products.
 Estimating the Cost per Time Unit of Capacity
• The first step in the time-driven ABC approach is to estimate the practical capacity of the
resources supplied as a percentage of the theoretical capacity.

For example, if an employee or machine is available to work 40 hours per week, the
practical capacity is 32 to 34 hours per week. Typically 85 percent is used for machines
(allowing 15 percent for maintenance, repair, and scheduling fluctuations) and 80 percent
is used for people (allowing 20 percent of their time for breaks, arrival and departure,
communication, and training). Thus if the theoretical capacity of each sales worker at
Sound Electronics is approximately 10,560 minutes per month (22 days/month × 8
hours/day × 60 minutes/hour), the practical capacity at 80 percent of theoretical is
estimated at 8,500 minutes per month per employee, or 340,000 minutes for all 40
employees. Therefore, the cost per minute of supplying capacity is $0.59
($200,000/340,000, rounded to the nearest cent).
 Estimating the Unit Times of Activities
• After calculating the cost per time unit of supplying resources to the business activities,
the next step in the time-driven ABC approach is to determine the time it takes to carry
out one unit of each kind of activity.
• In contrast to the traditional ABC model, which concerns the percentage of time an
employee spends doing an activity (e.g., performing credit checks), the time-driven ABC
approach asks how long it takes to complete one unit of that activity (e.g., the time
required to perform one credit check).

In the sales department at Sound Electronics, it takes an

employee 15 minutes to handle an inquiry, 30 minutes to
perform a credit check, and 47 minutes to process an order.
 Deriving Cost Driver Rates
• The cost driver rates can now be calculated by multiplying the two input variables: cost
per time unit of capacity and the unit times of activities.
For Sound Electronics, the cost driver rates are $8.85 (15 × $0.59) for handling
inquiries, $17.70 (30 × $0.59) for performing credit checks, and $27.73 (47 ×
$0.59) for processing customer orders. These cost driver rates can now be
applied to assign costs to individual customers as transactions occur.
Note that these rates are lower than those estimated using traditional ABC method ($10 for
handling inquiries, $20 for performing credit checks, and $33 for processing purchase orders).
The reason for this difference is that practical capacity is often not achieved productively. The
time-driven ABC analysis in Exhibit 4-18 reveals that only 86 percent of the practical capacity
(293,000 of the 340,000 minutes) of the resources supplied during the month has been used for
productive work, and hence, only about 86 percent of the total expenses of $200,000 were
expected to be assigned to customers during this period.
 Analyzing and Reporting Costs
• Time-driven ABC systems enable managers to report overhead costs on an ongoing basis
in a way that reveals both the costs of a business’s activities as well as the time spent on
them.
Practice Problem
Littell Lamp Company is noted for its full line of quality lamps. The company operates one
of its plants in Green Bay, Wisconsin. That plant produces two types of lamps: classical
and modern. Jean Marquez, the president of the company, recently decided to change
from a unit-based, traditional costing system to an activity-based costing system. Before
making the change companywide, she wanted to assess the effect on the product costs of
the Green Bay plant. This plant was chosen because it produces only two types of lamps;
most other plants produce at least a dozen.
To assess the effect of the change, the following data have been gathered (for simplicity,
assume one process):
Lamp Quantity Prime Costs Machine Hours Material Moves Setups
Classical 400,000 P800,000 81,250 300,000 100
Modern 100,000 P150,000 43,750 100,000 50
Amount — P950,000 P500,000* P900,000 P600,000

Compute the unit cost of each lamp using an activity-based costing approach