Activity Based Costing

Learning Outcome

• Discriminate between traditional and activity

based costing.
• Identify various cost drivers and illustrate
the process of Activity based costing.
 Poll from Previous Lecture

• Which of the following is NOT included

in the cost sheet?
A. Prime cost
B. Factory overheads
C. Selling and distribution expenses
D. Non-operating income
 Poll from Previous Lecture
The main purpose of preparing a cost
sheet is to:
A. Determine the selling price of a product
B. Record transactions for financial
accounting
C. Comply with tax regulations
D. Prepare cash flow statements
 Traditional/Conventional
Costing
• Total Cost = Material + Labour+ Overheads
• Overheads are allocated to the products on volume
based measures e.g. units produced
 Case Study
• Mr. John sold 100 Pizza and 100 burgers at
his ‘Fast food joint’ in the month of October.
• He purchased the pizza base for Rs. 20 per
unit and Bunn for Rs. 10 p.u.
• There is electricity bill of Rs. 2,000 for the
month of October.
• What will be the cost per pizza and
burger??
 Traditional costing system
Pizza (100 units) Burger (100 units)
Material cost 2000 1000
Electricity bill (Rs. 2000*100 units) / 1000 1000
200 units
Total cost 3000 2000

•Electricity bill is equally distributed amongst both

products on the basis of no. of units.
• But what if 800 units of electricity is used for making
100 Pizzas and 200 units of electricity is used for
making 100 burgers.

Is it fair to allocate cost equally???

Will this not distort the costing in the new
environment?

ABC provides an
Alternative.
 ABC technique
• Apportionment on the basis of electricity
units consumed for each product.
Pizza (100 units) Burger (100 units)
Material cost 2000 1000
Electricity bill (Rs. 2000*800/1000) (Rs. 2000*200/1000)
=1600 =400
Total cost 3600 1400

• It divides cost more proportionately and

fairly.
 Limitation of Conventional
costing System
• Focuses upon product costing by tracing
costs to the product and allocating costs
through cost centers.
• Methods of Allocation are inadequate to
prorate common costs.
• It can result into cost distortion i.e. either
under-costing of product or over-costing of
product.
 Activity-Based Costing (ABC)
Activity-based
Activity-based costing
costing (ABC)
(ABC) is
is aa costing
costing
method
method that
that assigns
assigns overhead
overhead and
and indirect
indirect costs
costs
to
to related
related products
products and
and services
services

Products Activities
Require Consume
Activities Resources

People
Manage
4-13
Activities
 Activity based costing
• Activity-based costing is a costing method
that identifies activities in an organization
and assigns the cost of each activity to all
products and services according to the
actual consumption by each.
• An activity is an event that incurs costs.
• A cost driver is any factor or activity that
has a direct cause and effect relationship
with the resources consumed.
Example of Cost Drivers
 ABC Steps
• Identification of main activities
• Overhead cost drivers are determined.
• Activity cost pools are created.
– A activity cost pool is a pool of individual costs
that all have the same cost driver.
• Charging the cost of activities to products
as per activity cost driver rate.
 Let’s work on an example . . .
• Management decides to install an ABC
system
Step-1: Identification of main activities

Activities
Payment of Payroll taxes Rs.1,000
Machine maintenance Rs.500
Purchasing Dept. labor paid Rs.4,000
Total
Fringe benefits Rs.2,000 overheads=
Purchasing Dept. Supplies Rs.250 Rs. 11,250

Equipment depreciation Rs.750

Electricity bill paid Rs.1,250

Unemployment insurance Rs.1,500
Step-2: Overhead Cost Drivers are
Determined:
• Management decides that all overhead
costs only have three cost drivers—
– Direct labor hours
– Machine hours
– Number of purchase orders
Base Product A Product B Total
Direct labor hours 400 600 1,000
Machine hours 100 150 250
Purchase orders 50 50 100
Step-3: All overhead costs are then allocated
to one of the activity cost pools.
Direct Labor
General Ledger
Payroll taxes Rs.1,000
Machine maintenance Rs.500
Purchasing Dept. labor Rs.4,000
Machine Hours
Fringe benefits Rs.2,000
Purchasing Dept. Rs.250
Supplies
Equipment depreciation Rs.750
# of Purchase Orders
Electricity Rs.1,250
Unemployment Rs.1,500
insurance

Which overhead costs do you think

are driven by direct labor hours?
All overhead costs are then allocated to one of
the activity cost pools.
Direct Labor
General Ledger
Payroll taxes Rs.1,000 Rs.1,000
2,000
Machine maintenance Rs.500
1,500
Purchasing Dept. labor Rs.4,000 Rs.4,500
Machine Hours
Fringe benefits Rs.2,000
Purchasing Dept. Rs.250
Supplies
Equipment depreciation Rs.750
# of Purchase Orders
Electricity Rs.1,250
Unemployment Rs.1,500
insurance

Overhead driver by direct labor

hours
 Activity cost pool
Direct Labor
General Ledger
Payroll taxes Rs.1,000 Rs.1,000
2,000
Machine maintenance Rs.500
1,500
Purchasing Dept. labor Rs.4,000 Rs.4,500
Machine Hours
Fringe benefits Rs.2,000
Purchasing Dept. Rs.250 Rs. 500
750
Supplies
1,250
Equipment depreciation Rs.750 Rs.2,500
# of Purchase Orders
Electricity Rs.1,250
Unemployment Rs.1,500
insurance

Which overhead costs are

driven by machine hours?
 Activity cost pool
Direct Labor (1000 hrs.)
General Ledger
Payroll taxes Rs.1,000 Rs.1,000
2,000
Machine maintenance Rs.500
1,500
Purchasing Dept. labor Rs.4,000 Rs.4,500
Machine Hours (250 hrs.)
Fringe benefits Rs.2,000
Purchasing Dept. Rs.250 Rs. 500
750
Supplies
1,250
Equipment depreciation Rs.750 Rs.2,500
# of Purchase Orders (100)
Electricity Rs.1,250
Unemployment Rs.1,500 Rs.4,000
insurance 250
Rs.4,250
And finally, which overhead costs are
driven by # of purchase orders?
 Step-4: Allocation of cost as per activity cost
driver rate
Base Product A Product B
(4500*400/1000) (4500*600/1000)
Direct labor hours (400:600) =1800 =2700

(2500*100/250) (2500*150/250)
Machine hours(100:150) =1000 =1500

(4250*50/100) (4250*50/100)
Purchase orders(50:50) =2125 =2125

Total 4925 6325

The actual overhead allocated was Rs.4,925 + Rs.6,325 = Rs. 11,250
overhead applied.
 POLL
Which of the following is the different concerning ABC costing
when compared to traditional cost?
A.In ABC costing batch-level costs are applied to products using unit-
level bases
B.In an ABC costing system costs are only assigned to products that
actually required work that gave rise to a particular cost
C.Traditional costing and ABC costing usually yield very similar product
costs
D.Under traditional costing, batch level costs are shifted from high-
volume products to low volume products
 Same Problems Traditional Method

• Okay, so what if we had allocated the

overhead in this company using traditional
cost accounting allocation.
• Let’s assume the base is direct labor hours.
• What would be the amount allocated to
each product?
 Calculation
General Ledger

Payroll taxes Rs.1,000

•The total
Machine maintenance Rs.500
amount of
overhead is
Purchasing Dept. Rs.4,000 Rs.11,250.
labor
Fringe benefits Rs.2,000 •Total direct
Purchasing Dept. Rs.250 labor hours are
Supplies
1,000 and it is
Equipment Rs.750
depreciation
used for
allocation
Electricity Rs.1,250
purpose.
Unemployment Rs.1,500
insurance
 Calculation

• Allocating overhead using direct labour

hours only under traditional costing:
– Product A: Rs. 11,250 x 400 hours / 1000
hours = Rs.4,500
– Product B: Rs. 11,250 x 600 hours / 1000
hours = Rs.6,750

Total overhead applied 4500+6750= Rs.11,250

 Comparison
Product A Product B Total

Traditional Rs.4,500 Rs.6,750 Rs.11,250

Method
Activity Based Rs.4,925 Rs.6,325 Rs.11,250
Costing

Difference -Rs.425 Rs.425 -0-

Which is more accurate?

ABC Costing!
 Question
• Using the Activity-Based Costing method,
what is the total overhead cost allocated to
Product P2?
 POLL
In activity based costing, a cost driver is:

A)an overhead cost

B)a direct product cost
C)Are source consuming activity that causes
overheads
D)a variable cost
 POLL
In activity-based costing, some
manufacturing costs may be excluded from
product costs.

A)True
B)False
 POLL
Activity-based costing:
a) Uses a plant-wide overhead rate to assign
overhead
b) Is not expensive to implement
c) Typically applies overhead costs using
direct labor-hours
d) Uses multiple cost drivers
 PLACEMENT BASED QUESTIONS

• Give an example of how a manufacturing company might

use ABC to improve its operations.

• How can ABC be applied in a service industry?

• How does ABC support lean management or continuous

improvement practices?
THANK YOU!!