Activity-Based

Costing System
A presentation by

Ahmad Tariq Bhatti

FCMA, FPA, MA (Economics), BSc

Dubai, United Arab Emirates

Activity-Based Costing

Activity-Based Costing System

The
Concept

Activity-Based
Costing

In contrast to traditional/absorption costing system, ABC

system first accumulates overheads costs for each
organizational activity, and then assigns the costs of the
activities to the products, services, or customers (cost
objects) causing that activity.
Activity-Based Costing System

Origin

During 1980s, the limitations of absorption

costing system were felt with severity. Companies
were looking for a system that could reflect true
product cost in order to fight competition. The
absorption costing system was designed decades
ago, when most companies produced narrow
range of products. Further, overhead costs were
small enough to make a big difference in the
identification of cost of a product. This criticism of
absorption costing led to generation of the idea of
ABC system. David Cooper and Robert Kaplan
wrote articles on the idea of ABC system in 1990
and 1992. The new system was accepted widely
and became reality of the day. Now ABC system
has become part of every management
accounting text book
and being implemented the
Activity-Based Costing System
world over.

Definitions
ABC is a cost attribution to cost units on the basis of benefit
received from indirect activities.
-- Cima Official Terminology
An activity is an event that incurs costs.
A cost object is defined as anything for which a separate
measure of cost is desired/required.
An activity cost pool: The overheads cost allocated to a
distinct type of activity or related activities.
A cost driver is any factor or activity that has a direct cause
and effect relationship with the resources consumed.
Cost Unit: An item of production or a service for which it is
useful to have cost information.
Cost accounting: The process of identifying, analyzing,
summarizing, recording and reporting costs associated with
business operations.
Direct costs: Those costs that are directly associated with
the manufacturing process.
Indirect/overheads costs: Those costs that are not directly
identifiable with a unit of production.
Activity-Based Costing System

Related Concepts
Direct Costing System

A system of costing the products where direct costs (also referred to

as variable costs) are assigned to products only. It reflects the
contribution to indirect costs. The system is considered
appropriate for decision-making purposes. It is recommended in
the circumstances where indirect costs are a low proportion of a
companys total costs.

Traditional or Absorption Costing System

It reflects full cost pertaining to a product. It is easy to use and,
therefore, is practiced widely. The allocation of overhead costs
under the system is based on a rate determined by either a
percentage of direct labor cost or number of labor hours
worked or another. Therefore, the reported allocation of overheads
for a given product may be incorrect. It is the main defect of
absorption costing.

Activity-Based Costing System

It also reflects full cost pertaining to a product. ABC system
establishes relationships between overheads costs and
activities so that we can better allocate overheads costs. It
reflects the more accurate use of overheads costs based on their
relevant activity levels
achieved.Costing
The system
Activity-Based
System has eliminated the
defects of traditional/absorption costing system.

The Defect of Traditional

Costing System
Spreads overheads cost over entire product range. A single
overheads recovery rate (also known as predetermined
overheads rate or overheads absorption rate) is used to
absorb total overheads cost to all production. For instance,
For job order costing, overheads cost absorption rates are normally
based on direct labor cost or direct labor hours
For process costing, overheads cost absorption rates are normally
based on machine hours worked

Results of the defect:

Each product appeared to cost the same, as far as overheads
cost is concerned
Products with high profit margins subsidized products with low
profit margins
In-accurate cost accumulation led to inaccurate profit planning
of products
A product cannot compete in the market if its cost is not
accurately accumulated and reflected in costing records
Activity-Based Costing System

ABC System
An overheads cost allocation
system that:
allocates overheads cost
to multiple activity cost
pools and
assigns the activity cost
pools to products or
services by means of
cost drivers that
Activity-Based Costing System

Process
Product
(A,B,C,D,,N)
Cost Pools
(I,II,III,IV,V.,N)
Cost Drivers
(1,2,3,4,N)
Activities
(1,2,3,4,N)
Activity-Based Costing System

Design
& Implementation
Step
1
Step
2
Step
3

Identify Cost Objects i.e. Product A,B,C

Step
4
Step
5
Step

Identify the overheads cost associated with

the bases selected

Identify direct costs i.e. Direct Materials,

Direct Labor, Direct expense
Select the cost allocation bases to be used for
overheads cost i.e. # of set-ups, # of units,
etc.

Compute the rate per unit

Compute overheads
cost for allocation to
Activity-Based Costing System
products

10

Allocation Stage
Departments
Activity
Overheads Cost
Pool

Design

Setup

Shipping

Cost
Allocation
Base

No. of
employees

No. of
Setup
Hours

No. of
Shipments

Cost
Objects

Product A

Product B

Product C

Activity-Based Costing System

11

Cost Pools & Cost

Drivers
Activity Cost
Pools
Production
Marketing
Research &
Development
Customer Service
Purchasing
Material Handling

Activity Cost
Drivers
a) Number of units
b) Number of set-ups
c) Number electricity units
consumed
a) Number of sales personnel
b) Number of sales orders
a) Number of research projects
b) Personnel hours spend on projects
c) Technical complexities of the
projects
a) Number of service calls
b) Number of products serviced
c) Hours spend on servicing products
a) Number of purchase orders
a) Number of material requisitions

Activity-Based Costing System

12

Types of Cost Drivers

Transaction
Drivers
# of purchase orders
# of customer
orders processed
# of inspections
performed
# of set-ups
undertaken

Duration
Drivers

Set up hours
Inspection hours
Labor hours
Production hours
Loading hours

Activity Based Costing

Intensity
Drivers
Each overseas
purchase order
should be
weighted 1.5
times of local
purchase order
Each overtime
hour shall be
charged as
twice of the
normal wage
hour
13

Levels of Activities
I.

Unit-level activities
The costs of direct materials, direct labor, and machine
maintenance are examples of unit-level activities.

II. Batch-level activities

are costs incurred every time a group (batch) of units is
produced . Purchase orders, machine setup, and quality tests
are examples of batch-level activities.

III. Product-line activities

Examples of product-line activities are engineering changes
made in the assembly line, product design changes, and
warehousing and storage costs for each product line.

IV. Facility support activities

The costs relating to the activities are administrative in nature
and include building depreciation, property taxes, plant
security, insurance, accounting, outside landscape and
maintenance, and plant management's and support staff's
salaries.
Activity-Based Costing System

14

Cost Ascertainment

Activity-Based Costing System

15

An Illustrative Model
Alpha Ltd. is manufacturing two products A and B. Both
products are manufactured on the same machines and
undergo the same processes. Here is the detail of
budgeted data obtained for the two products for the
financial year ending on December 31, 20x1:
Description

25,000

2,500

Number of purchase orders

400

200

Number of set-ups

150

100

Direct material (AED.)

25

62.5

Direct labor (Hours)

10

10

Budgeted production quantity (units)

Resources required/unit:

Machine time (Hours)

Activity-Based Costing System

16

DATA (Continues)
Budgeted production overheads cost for the year have been
calculated as follows:
Description
Amount
(AED.)
Volume related overheads cost

275,000

Purchase related overheads cost

300,000

Set-up related overheads cost

525,000

Total
overheads
cost rate is AED. 20 per
1,100,000
The
budgeted labor
hour.
The companys present system is to absorb overheads by
product units using rates per labor hour. However, the
company is considering implementing a system of
activity-based costing.
Following cost drivers for overheads are used.
Volume related
Machine hours
overheads
Purchase related
overheads

Number of purchase
orders

Activity-Based Costing
System
Set-up related
Number
of set-ups

17

Solution
Requirements:
a) Calculate the unit costs for product A and B using:
i. The absorption costing system
ii. The proposed activity-based costing system
b) Compare the results in (i) and (ii) and explain the differences.

Solution:
The first step is to determine the overheads absorption rate or
cost driver rates for each activity. Then utilize these rates to
data given for each product.
Description
A
B
Total
Production quantity

25,000

2,500

Direct labor hours required

250,00
0

25,000

275,000
AED.

Total production overheads

Activity-Based Costing System

1,100,000
18

Solution
Description

Overhead absorption rate per labor hour (AED.

1,100,000/275,000)

Machine hours required

Total
AED. 4

125,000

12,500

137,500

Total purchase orders

400

200

600

Total set-ups

150

100

250

Cost per cost driver

Volume related overheads cost

AED.
275,000

Machine hours required

137,500

Volume related overheads/machine hour (AED.

275,000/137,500)

AED. 2

Purchases related overheads cost

AED.
300,000

Total purchase orders

600

Purchase related overheads / order (AED.

300,000/600)

Activity-Based Costing System

Set-ups related overheads cost

AED. 500
AED.

19

Solution
(a) (i) Unit cost working under
traditional/absorption costing system
Description of cost components

AED.

AED.

25.00

62.50

Direct labor cost (AED. 20 x 10 labor

hours/unit)

200.00

200.00

Overheads (10 labor hours x AED. 4)

40.00

40.00

Direct materials cost

----------------- ----------------Total cost per unit

265.00

302.50

=======
===

=======
===

Activity-Based Costing System

20

Solution
(a) (ii) Unit cost working under Activity-Based Costing
system
Description of cost components

Direct materials cost

Direct labor cost
Volume related overheads cost (AED. 2 x 5

AED.

AED.

25.00

62.50

200.00

200.00

10.00

10.00

machine hours/unit)

Purchases related overheads cost:

Product A: [(AED. 500 x 400 Orders)/ 25,000
Units]
Product B: [(AED. 500 x 200 Orders)/2,500
Units]
Set-up related overheads cost:
Product A: [(AED. 2,100 x 150 Setups)/25,000 Units]
Product B: [(AED. 2,100 x 100 Set-ups)/25,00
Units]
Activity-Based Costing System

8
40

12.60
84.00

-------

--------

21

Solution
(b) Difference in cost per unit under two
systems.
Description

AED.

AED.

Cost as per traditional costing system

265.00

302.50

Cost as per ABC costing system

255.60

396.50

Increase/(Decrease)

(9.40)

94.00

(3.55%)

31.07%

% change

Explanation & Recommendation

Under Traditional Costing System, the cost of Product A is increased by
AED. 9.40 per unit (i.e. 3.55%) and the cost of Product B is decreased by
AED. 94 per unit (i.e. 31.07%). These variances in cost per unit are
because of inappropriate absorption of overheads cost under Traditional
Costing System. Therefore, ABC system is highly recommended for the
company, in order to book the correct overheads cost for Products A and
B.
Activity-Based Costing System

22

Illustration
XYZ Company makes a product AD that it sells to Alpha
Company. The company has ABC system in operation that it
uses for internal decision making. The company has two
overheads departments, whose costs are listed as below:

Amount
(AED.)
Manufacturing overheads cost
500,000
Sellingand administrative overheads cost
300,000

-----------------Total overheads costs

800,000
=========
The company's ABC system has the following activity cost pools and
activity drivers in place:
Description

Activity Cost Pool

Activity Drivers

Assembling units
Processing orders

Number of units
Number of orders
Number of customers

Supporting customers
Other

Not applicable

Activity-Based Costing System

23

Illustration
Costs assigned to other activity cost pool have no activity
driver; they consist of the costs of unused capacity and
organization-sustaining costs - neither of which are assigned to
products, orders or customers.
XYZ Company distributes the costs of manufacturing overheads
and of selling and administrative overheads cost to the activity
cost pools based on employee information, the results of which
Supportin
are reported as below:
Description
Manufacturing overheads
Selling& administrative
overheads
Total activity

Assembli Processin
g
Other Total
ng Units g Orders Customer
s
50%
35%
5%
10% 100%
10%

45%

1,000 units 250 orders

Activity-Based Costing System

25%
100
customers

20% 100%
--

-24

Illustration
Required:
1. Perform the first stage allocation of overhead costs to the
activity cost pools.
2. Compute activity rates for the activity cost pools.
3. VB is one of the XYZs big customers. Last year VB ordered
AD four different times. VB ordered a total of 80 units of AD
during the year. Construct a table showing the overhead costs
of these 80 units and four orders. The price per unit charged
to the customer is AED. 595. The direct materials cost per unit
is estimated at AED. 180 per unit and direct labor cost per unit
is AED. 50.

Activity-Based Costing System

25

Solution
1. The first stage allocation of costs to the
activity cost pools appears as below:

Activity Cost Pools

Description of cost
components

Manufacturing
Overheads cost
Selling& admin.
Overheads cost

Supportin
Assembli Processin
g
Other
ng Units g Orders Customer
s
AED.
AED.
AED.
AED.

Total
AED.

250,000

175,000

25,000

50,000 500,000

30,000

135,000

75,000

60,000 300,000

-------------- ----------------------------- ------------ ----------

Total cost

280,000 310,000 100,000

===== Costing
=====
Activity-Based
System=====

110,00 800,00
0
0
====

26

=====

Solution
2. The activity rates for the activity cost pools
are:
Activity Cost
Pools

Assembling units
Processing orders
Supporting
customers

Total Cost
AED.
280,000
310,000
100,000

Total
Activity
Units
1,000
250
100
customers

Activity Rate
AED.
280 per unit
1,240 per order
1,000 per customer
(c)

3. The overheads cost for the four orders of a

total of 80 units of ASD would be computed as
follows:
Total

Activity Cost Pools

Assembling units
Processing orders
Supporting
customers

Total Cost

AED.
280 per unit
1,240 per order
1000 per customer

Activity
80 units
4 units
Not
applicable

Activity-Based Costing System

Activity Rate
AED.
22,400 . (a)
4,960 . (b)

27

Solution
4. The product and customer margin can be
computed as follows:
AD Product Margin:
Sales (AED. 595 per unit 80
units)
Cost:
Direct materials cost (AED. 180 per
unit 80 units)
Direct labor cost (AED. 50 per unit 80
units)
Volume related overhead (a)
Order related overhead (b)

AED.

AED.

47,600

14,400

4,000

22,400
4,960

45,760
-----------------1,840
=======
===

AD Product Margin for the order

Customer Profitability Analysis

XYZ Co.
Product margin
Less: Customer support overhead
Activity-Based Costing System
(above)

1,840

1,000

28

Advantages
1. ABC system provides accurate costing of
products/services.
2. Management has better understanding overheads
cost.
3. The system utilizes unit cost rather than total cost
unlike absorption costing system.
4. ABC system integrates well with Six Sigma and
other continuous improvement programs.
5. The in-depth study of overheads cost under ABC
system makes all wastages visible to management
and all non-value added activities known to them.
Thus, better controls can be exercised on them.
6. It supports performance management and
scorecards.
7. The system enables
costing of processes, supply
Activity-Based Costing System
chains, and value streams.

29

Disadvantages
1. Implementing ABC system requires a big budget initially.
2. After implementation, the maintenance of the system is costly.
Data concerning numerous activity measures must be collected ,
checked, and entered into the system on regular basis.
3. ABC system produces numbers such as product margins that are
different from the profits produced by traditional costing system.
Management may be double minded as they are used to work
with traditional costing system, as a requirement for external
reporting.
4. ABC system generated data can be misinterpreted and must be
used with care when used in making decisions. Costs assigned to
products, customers and other cost objects are only potentially
relevant.
5. Reports generated by ABC system do not conform to
Generally Accepted Accounting Principles (GAAP).
Consequently, an organization involved in ABC should have two
cost systems - one forActivity-Based
internal use
and one for preparing external30
Costing System
reports.

Implementation
The initiative toChallenges
implement ABC system must be
strongly supported by the management. The
workings involve a tremendous job of making
inquiries from employees.

The design and implementation of ABC system

should be the responsibility of a cross functional team
of technicians. Normally, the team would include
representatives from accounting, finance, IT,
marketing, production and engineering departments.
Services of an ABC system consultant must be hired
in order to prevent the wastage of resources and
time.
Selection of ABC software that could implement and
automate the processing of the system should be
made upon expert advice. We have given a list of
Activity-Based
System
ABC system softwares
asCosting
Appendix
A.

31

Appendix A:
ABC Softwares

Activity-Based Costing System

32

Software Detail
No
.
1
2
3
4
5

Software

Website

TDABC

http://www.acornsys.com

SASActivity-Based Management

ww.sas.com
http://www.cashfocus.com

ABC Focus activity based costing software

Prismata

http://www.prismata.com

Activity Based Costing For EXCEL

Activity Based Costing Workforce
Software

http://www.mrdashboard.com

SYSPRO Activity Based Costing

http://africa.syspro.com

Activity Based Costing/Management

Software

http://www.business.com

ABC/M systems
Acorn Systems
CostPerform, UK

http://www.algsoftware.com.a
u
http://www.acornsys.com

ACTIVITY BASED COSTING ANALYSIS

SIMULATION MODEL

http://www.xjtek.com

Enlighten Software
Prodacapo ABM

http://www.enlighten-softwar
e.com
http://www.prodacapo.com/a
bm
33

9
10
11
12
13
14

Activity-Based Costing System

http://www.workforcesoftware
.com

http://costperform.co.uk

References
Cost & Management Accounting by Colin
Drury, 5/e
Cost Accounting by Horngren /Datar /Foster,
11/e
Managerial Accounting by Hilton and Platt
Managerial Accounting by Weygandt / Kieso /
Kimmel, 2/e
Cima Official Terminology

Activity-Based Costing System

34

Thank you!

The
End.

A presentation by

Ahmad Tariq
Bhatti
FCMA, FPA, MA (Economics), BSc

Dubai, United Arab Emirates

Contact
[email protected]

Activity-Based Costing System

35