Scribd
Upload
10 views

Managerial Accounting Session 4

Uploaded by

Jacquin
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
10 views

Managerial Accounting Session 4

Uploaded by

Jacquin
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 9

Managerial Accounting

ACTIVITY-BASED COSTING
Activity-based costing (ABC) is an approach for allocating overhead
costs. More specifically, ABC allocates overhead to multiple activity cost pools,
and it then assigns the activity cost pools to products and services by means of
cost drivers.
To understand the concept clearly, we must first define or give meaning
to certain terms:
1. Activity
- any event, action, transaction, or work sequence that incurs costs
when producing a product or providing a service.

2. Activity cost pool


- is the overhead cost attributed to a distinct type of activity (e.g.,
ordering materials or setting up machines).

3. Cost driver
- is any factor or activity that has a direct cause-effect relationship with
the resources consumed.

Comparing ABC with Traditional Costing

In traditional costing, overhead costs are allocated on a predetermined


rate based on Direct Labor Hours or Peso, while in activity-based costing,
overhead costs are allocated on activity cost pools by means of cost drivers.
Activity-based Costing
For the year 2020, Lewis Shoes and Sandals Corporation manufactured 200
units of limited edition shoes with the following costs:
Direct Materials - Php 40,000
Direct Labor - Php 20,000
There are 25 purchase orders per 100 units of shoes. One shoe takes about 0.50
hour machine time to manufacture, and for every 100 units of shoes, 2 employee needs to
supervise it.
- What is the attributable Overhead Costs to the 200 units of shoes? Total Product Cost?
Purchasing:
25 orders/100 units = 0.25 orders per unit
200 units x 0.25 orders/unit = 50 orders
50 order x Php 100/order = Php 5,000
Machining:
200 units x 0.50 hour/unit = 100 hours
100 hours x Php 100/hour = Php 10,000
Supervising:
200 units x 2 employees/100 units = 4 employees
4 employees x Php 1,000/employee = Php 4,000
Total Overhead Cost Attributable to the 200 units of exclusive edition shoes:
= Php 5,000 + Php 10,000 + Php 4,000
= Php 19,000 or Php 95 per shoe
Total Product Cost:
= Php 40,000 + Php 20,000 + Php 19,000
= Php 79,000 or Php 395 per shoe
In the previous example, we learn how to apply ABC in costing. Now let us try to
compare the costs assigned to the 200 units of shoes using Traditional Costing System.

Overhead Cost:

Php 200,000 / 300 machine hours = Php 667 per hour


- In traditional costing, overhead cost is often distributed/allocated using a
predetermined rate calculated by Overall Overhead Cost divided by number of Direct Labor
Hours (Machine Hours) or Direct Labor Cost.
- The predetermined rate here is Php 667 per hour.

200 units x 0.5 hour/unit = 100 hours


100 hours x Php 667/hour = Php 66,700

Traditional Costing Overhead Cost - Php 66,700


Activity-base Costing Overhead Cost - Php 19,000

Here we can see large discrepancy between traditional costing and ABC, this is
because traditional costing only recognizes machine hours as basis for computing
overhead cost, while in ABC, activity that incurs cost are recognized in computing and
allocating overhead cost such as purchasing and supervising. Therefore, ABC's allocation
of overhead cost, generally, is more accurate as compared to traditional costing.
Benefits of ABC

The primary benefit of ABC is more accurate product costing. Here’s why:

1. ABC leads to more cost pools being used to assign overhead costs to products.
Instead of one plantwide pool (or even departmental pools) and a single cost driver,
companies use numerous activity cost pools with more relevant cost drivers. Costs are
assigned more directly on the basis of the cost drivers used to produce each product.

2. ABC leads to enhanced control over overhead costs. Under ABC, companies can
trace many overhead costs directly to activities—allowing some indirect costs to be
identified as direct costs. Thus, managers have become more aware of their responsibility
to control the activities that generate those costs.

3. ABC leads to better management decisions. More accurate product costing should
contribute to setting selling prices that can help achieve desired product profi tability levels.
In addition, more accurate cost data could be helpful in deciding whether to make or buy a
product part or component, and sometimes even whether to eliminate a product.

Activity-based costing does not change the amount of overhead costs. What it
does do is allocate those overhead costs in a more accurate manner. Furthermore, if the
scorekeeping is more realistic and more accurate, 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:

1. ABC can be expensive to use.The increased cost of identifying multiple activities and
applying numerous cost drivers discourages many companies from using ABC. Activity-
based costing systems are more complex than traditional costing systems—sometimes
signifi cantly more complex. So companies must ask, is the cost of implementation greater
than the benefit of greater accuracy? Sometimes it may be. For some companies, there
may be no need to consider ABC at all because their existing system is sufficient. If the
costs of ABC outweigh the benefi ts, then the company should not implement ABC.

2. Some arbitrary allocations continue. Even though more overhead costs can be
assigned directly to products through ABC’s multiple activity cost pools, certain overhead
costs remain to be allocated by means of some arbitrary volume-based cost driver such as
labor or machine hours.

END

Reference: Managerial Accounting: Tools for Business Decision Making Sixth Edition by J.J. Weygandt PhD, CPA; P.P.
Kimmel PhD, CPA; and D.E. Kieso PhD, CPA

You might also like