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Activity Based Costing

Introduction to Activity Based Costing

Activity based costing (ABC) assigns manufacturing overhead costs to products in a
more logical manner than the traditional approach of simply allocating costs on the
basis of machine hours. Activity based costing first assigns costs to the activities that
are the real cause of the overhead. It then assigns the cost of those activities only to the
products that are actually demanding the activities.

Let's discuss activity based costing by looking at two products manufactured by the
same company. Product 124 is a low volume item which requires certain activities such
as special engineering, additional testing, and many machine setups because it is
ordered in small quantities. A similar product, Product 366, is a high volume product—
running continuously—and requires little attention and no special activities. If this
company used traditional costing, it might allocate or "spread" all of its overhead to
products based on the number of machine hours. This will result in little overhead cost
allocated to Product 124, because it did not have many machine hours. However, it did
demand lots of engineering, testing, and setup activities. In contrast, Product 366 will be
allocated an enormous amount of overhead (due to all those machine hours), but it
demanded little overhead activity. The result will be a miscalculation of each product's
true cost of manufacturing overhead. Activity based costing will overcome this
shortcoming by assigning overhead on more than the one activity, running the machine.

Activity based costing recognizes that the special engineering, special testing, machine
setups, and others are activities that cause costs-they cause the company to consume
resources. Under ABC, the company will calculate the cost of the resources used in
each of these activities. Next, the cost of each of these activities will be assigned only to
the products that demanded the activities. In our example, Product 124 will be assigned
some of the company's costs of special engineering, special testing, and machine setup.
Other products that use any of these activities will also be assigned some of their costs.
Product 366 will not be assigned any cost of special engineering or special testing, and
it will be assigned only a small amount of machine setup.

Activity based costing has grown in importance in recent decades because (1)
manufacturing overhead costs have increased significantly, (2) the manufacturing
overhead costs no longer correlate with the productive machine hours or direct labor

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hours, (3) the diversity of products and the diversity in customers' demands have grown,
and (4) some products are produced in large batches, while others are produced in
small batches.

Activity Based Costing with Two Activities

Let’s illustrate the concept of activity based costing by looking at two common
manufacturing activities: (1) the setting up of a production machine for running batches
of products, and (2) the actual production of the units of product.

We will assume that a company has annual manufacturing overhead costs of

$2,000,000—of which $200,000 is directly involved in setting up the production
machines. During the year the company expects to perform 400 machine setups. Let’s
also assume that the batch sizes vary considerably, but the setup efforts for each
machine are similar.

The cost per setup is calculated to be $500 ($200,000 of cost per year divided by 400
setups per year). Under activity based costing, $200,000 of the overhead will be viewed
as a batch-level cost. This means that $200,000 will first be allocated to batches of
products to be manufactured (referred to as a Stage 1 allocation), and then be
assigned to the units of product in each batch (referred to as Stage 2 allocation). For
example, if Batch X consists of 5,000 units of product, the setup cost per unit is $0.10
($500 divided by 5,000 units). If Batch Y is 50,000 units, the cost per unit for setup will
be $0.01 ($500 divided by 50,000 units). For simplicity, let’s assume that the remaining
$1,800,000 of manufacturing overhead is caused by the production activities that
correlate with the company’s 100,000 machine hours.

For our simple two-activity example, let's see how the rates for allocating the
manufacturing overhead would look with activity based costing and without activity
based costing:

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 With ABC Without ABC
Mfg overhead costs assigned to setups $200,000 $–0–
Number of setups 400 Not applicable
Mfg overhead cost per setup $500 $–0–

Total manufacturing overhead costs $2,000,000 $2,000,000

Less: Cost traced to machine setups 200,000 –0–
Mfg O/H costs allocated on machine hours $1,800,000 $2,000,000
Machine hours (MH) 100,000 100,000
Mfg overhead costs per MH $18 $20

$500 setup cost per

Mfg Overhead Cost Allocations $20 per MH
batch + $18 per MH

Next, let's see what impact these different allocation techniques and overhead rates
would have on the per unit cost of a specific unit of output. Assume that a company
manufactures a batch of 5,000 units and it produces 50 units per machine hour, here is
how the cost assigned to the units with activity based costing and without activity based
costing compares:

With ABC Without ABC

Mfg overhead for setting up machine $500 $–0–
No. of units in batch 5,000 Not applicable
Mfg O/H caused by Setup – Per Unit $0.10 Not applicable

Mfg overhead costs per machine hour $18 $20

No. of units produced per machine hour 50 50
Mfg O/H caused by Production – Per Unit $0.36 $0.40

Total Mfg O/H Allocated – Per Unit $0.46 $0.40

If a company manufactures a batch of 50,000 units and produces 50 units per machine
hour, here is how the cost assigned to the units with ABC and without ABC compares:

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 With ABC Without ABC
Mfg overhead for setting up machine $500 $–0–
No. of units in batch 50,000 Not applicable
Mfg O/H caused by Setup – Per Unit $0.01 Not applicable

Mfg overhead costs per machine hour $18 $20

No. of units produced per machine hour 50 50
Mfg O/H caused by Production – Per Unit $0.36 $0.40

Total Mfg O/H Allocated – Per Unit $0.37 $0.40

As the tables above illustrate, with activity based costing the cost per unit decreases
from $0.46 to $0.37 because the cost of the setup activity is spread over 50,000 units
instead of 5,000 units. Without ABC, the cost per unit is $0.40 regardless of the number
of units in each batch. If companies base their selling prices on costs, a company not
using an ABC approach might lose the large batch work to a competitor who bids a
lower price based on the lower, more accurate overhead cost of $0.37. It’s also possible
that a company not using ABC may find itself being the low bidder for manufacturing
small batches of product, since its $0.40 is lower than the ABC model of $0.46 for a
batch size of 5,000 units. With its bid price based on manufacturing overhead of
$0.40—but a true cost of $0.46—the company may end up doing lots of production for
little or no profit.

Our example with just two activities (production and setup) illustrates how the cost per
unit using the activity based costing method is more accurate in reflecting the actual
efforts associated with production. As companies began measuring the costs of
activities (instead of focusing on the accountant’s departmental classifications), they
began using ABC cost information to practice activity based management. For
example, with the cost of setting up a machine now being measured and discussed,
managers began to ask questions such as: Why is the cost of setting up a production
machine so expensive? What can be done to reduce the setup cost? If the setup costs
cannot be reduced, are the selling prices adequate to cover all of the company’s
costs—including the setup cost that was previously buried in the overall machine-hour
overhead rate?

Activity Based Costing with Four Activities

Let’s add two more activities to our example: procurement and material handling. The
costs of these two activities are not caused by—nor do they correlate with—machine
hours. Rather, we will assume that both of these activities are related to the physical

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weight of the direct material used in making the product.

The company determines that $300,000 of its annual manufacturing overhead is

associated with procurement and material handling. As a result, the company removes
$300,000 from the manufacturing overhead that will be allocated via machine hours,
and instead plans to allocate the $300,000 to the products based on the weight of the
materials used. The company expects that during the year it will procure and handle
3,000,000 pounds of material. Under activity based costing, the company will assign
$0.10 ($300,000 divided by 3,000,000 pounds) per pound of product weight to each unit
manufactured. The end result is that the heavier parts will not only have more direct
material cost, they will also be assigned more factory overhead than the lighter parts. By
assigning some manufacturing overhead to a product based on the product’s weight,
the remaining manufacturing overhead assigned via machine hours will be reduced.
These points are illustrated in the following table:

With ABC Without ABC

Mfg overhead costs assigned to setups $200,000 $–0–
Number of setups 400 Not applicable
Mfg overhead cost per setup $500 $–0–

Mfg O/H costs caused by procurement/handling $300,000 $–0–

Pounds of material in products 3,000,000 Not applicable
Mfg O/H per pound of product material $0.10 $–0–

Mfg O/H costs caused by producing the items:

Total manufacturing overhead costs $2,000,000 $2,000,000
Less: Cost traced to machine setups – 200,000 $–0–
Less: Costs traced to procurement/handling – 300,000 $–0–
Mfg costs to be allocated on machine hours $1,500,000 $2,000,000
Machine hours (MH) 100,000 100,000
Mfg overhead costs allocated per MH $15 $20

$500 setup
cost
per batch +
Mfg Overhead Cost Allocations $20 per MH
$0.10 per lb.
+
$15 per MH

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In the table below we can see how ABC would assign costs to the following:

1. A product that weighs 0.5 pound and is produced in a batch of 50,000 units at a
rate of 50 per hour.
2. A product that weighs 1.5 pounds and is produced in a batch of 50,000 units at a
rate of 50 per hour.
3. No activity based costing allocations—all manufacturing overhead costs are
allocated entirely via machine hours.

(1.) ABC (2.) ABC (3.) No ABC

Mfg overhead for setting up machine $500 $500 $–0–
No. of units in batch 50,000 50,000 Not applicable
Mfg O/H caused by Setup – Per Unit $0.01 $0.01 Not applicable

Mfg overhead costs per lb. of product $0.10 $0.10 Not applicable
Lbs of material in product 0.5 1.5 Not applicable
Mfg O/H caused by Weight – Per Unit $0.05 $0.15 Not applicable

Mfg overhead costs per machine hour $15 $15 $20

No. of units produced per machine hour 50 50 50
Mfg O/H caused by Production – Per Unit $0.30 $0.30 $0.40

Total Mfg O/H Allocated – Per Unit $0.36 $0.46 $0.40

If the manufacturing overhead costs are caused by a number of activities such as setup,
procurement, handling, and production, then using the activity based costing method of
determining costs will give you a result that is closer to the true costs. As you can see,
the product that weighs 0.5 pound is a assigned $0.36 of manufacturing overhead, while
the product weighing 1.5 pounds is assigned $0.46 of manufacturing overhead. Under
the traditional costing allocations the procurement and handling costs would be
assigned on production hours. Keep in mind that whenever manufacturers have a
diverse lineup of products, allocating costs on a single basis (such as machine hours)
will result in inaccurate per-unit manufacturing overhead costs.

Conclusion
Because the material covered here is considered an introduction to the topic of activity
based costing, there are many complexities not presented. You should always consult
with an accounting professional for assistance with your own specific circumstances.

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