1. Activity Based Costing - ABC
Topic 5
Activity Based Costing - ABC
This chapter describes cost allocation and activity-based costing. It identifies managerial reports useful in directing a company’s activities. It also describes responsibility accounting, measuring departmental performance, and allocating common costs across departments.

2. Shortcomings of the Traditional Costing Approach
Volume-related cost absorption is based on correlation and is too simplistic. (
Advanced manufacturing technology (AMT) environments result in the increased importance of production overheads, e.g. depreciation of plant and machinery. They are a much larger proportion of total costs than in the past.

3. The ABC Causation Link Costs are incurred due to the performance of
operational activities.

4. Activity-Based Cost Allocation
Costing
Departmental
Overhead
Rates
Level of Complexity
Plant-wide
Overhead
Rate
Overhead Allocation

5. The ABC Mechanism Activity Cost cost pools driver rates
Buying raw RM/purchase  No. of
materials order orders
Overhead Controlling RM/inspection  No. of Product
quality inspections
expenses costs
Operating RM/machine  No. of
machinery hour machine hrs
Etc. Etc Etc.

6. Activity-Based Cost Allocation
In the ABC method,
we recognize that many
activities within a
department drive
overhead costs. A B C

7. Activity-Based Costing
Identify activities and assign indirect costs to those activities.
Central idea . . .
Products require activities.
Activities consume resources. A B C

8. Activity-Based Costing BenefitsP2
Activity-Based Costing Benefits
More detailed measures of costs.
Better understanding of activities.
More accurate product costs for . . .
Pricing decisions.
Product elimination decisions.
Managing activities that cause costs.
Benefits should always be compared to costs of implementation.

9. Identifying Cost DriversP2
Most cost drivers are related to either volume or complexity of production.
Examples: machine time, machine setups, purchase orders, production orders.
Three factors are considered in choosing a cost driver:
Causal relationship.
Benefits received.
Reasonableness.

10. Activity-Based Costing Procedures
Identify activities that consume resources.
Assign costs to a cost pool for each activity.
Identify cost drivers associated with each activity.
Compute overhead rate for each cost pool:
Assign costs to products:
Rate =
Estimated overhead costs in activity cost pool
Estimated number of activity units
Overhead Actual Rate Activity ×

11. Cost Driver Rates
Cost driver rate = Activity cost pool Number of cost drivers
E.g. If the cost pool for ordering materials (i.e. running the Purchasing Department) totals RM480,000 and 10,000 purchase orders are raised,
CDR = RM480,000 = RM48 /order ,000

12. Example 1: From the Following Information, Calculate the Cost Driver Rates:
Activity cost pools RM/year
Controlling quality   50,000
Setting up machinery   ,000
Operating machinery ,000
Using materials ,000
Products A B C
No. of quality inspections
No. of machine set-ups
No. of machine hours   , , ,000
Kg of material used   ,  12,000 15,000

13. Example 1: Solution Activity Cost driver rate
Controlling quality RM50,000 = RM50/inspection
1,000
Setting up machinery RM10,000 = RM200/set-up 50
Operating machinery RM20,000 = RM0.50/mh
40,000
Using materials RM700,000 = RM20/kg
35,000

14. Example Traditional Costing vs. ABC
PC Company manufactures a product in regular and deluxe models. Overhead is assigned on the basis of direct labor hours. Budgeted overhead for the current year is RM2,000,000. Other information:
First, determine the unit cost of each model using traditional costing methods.

15. Under Traditional Costing
The first thing we need to do is to determine the total direct labor hours. We then use that information to determine the overhead rate.
Overhead Estimated overhead costs
Rate Estimated activity =
Overhead RM2,000,000
Rate ,000 DLH =
= RM50 per DLH

16. Allocation OH to product Under Traditional Costing
Using our overhead rate, we can calculate the total unit cost of the deluxe and regular model.
Activity based costing will have a different overhead cost per unit. Let’s look at that.

17. Activity-Based CostingP2
Activity-Based Costing
PC Company plans to adopt activity-based costing. Using the following activity center data, determine the unit cost of the two products using activity-based costing.
The first step is to determine each activity and to assign costs to each activity. Note that the total overhead cost of $2,000,000 has been assigned to each of the activity centers. We next need to determine the cost driver for each activity center, and the units of activity each activity center uses.

18. ABC-OH cost for activityP2 ?
We then total the units of activity used in each activity center. Our goal is to determine a rate for each activity center.
400 deluxe regular = 1,200 total

19. Activity-Based CostingP2
We divide the activity overhead cost by the units of activity for each activity center to determine the rate for each activity center. For instance, Purchasing has $84,000 in cost, and there were a total of 1,200 orders. Dividing $84,000 by 1,200 orders, we get a rate of $70 per order.

20. Allocation OH to product under Activity-Based Costing
Now we will use the rates and the units of activity consumed in each activity center by each model to determine the amount of overhead to allocate to each model.

21. Allocation OH to product under Activity-Based Costing
In Purchasing, 400 orders were issued for the Deluxe Model, and we allocate the purchasing costs at $70 per order. This means that $28,000 of the purchasing costs are allocated to the Deluxe Model. Similarly, we find that $56,000 of purchasing costs are allocated to the Regular Model.
Now let’s complete the table.
Let’s complete the table.

22. Activity-Based CostingP2
Here’s the completed table.

23. Activity-Based Costing
Total overhead = RM720,000 + RM1,280,000 = RM2,000,000 Recall that RM2,000,000 was the original amount of overhead assigned to the products using traditional overhead costing.

24. Activity-Based Costing
Using the information from the table, we can determine the manufacturing overhead per unit of each model.

25. Traditional Costing vs. ABC
The unit costs determined under traditional costing are different from the unit costs determined under ABC costing.
This result is not uncommon when activity-based costing is used. Many companies have found that low-volume, specialized products have greater overhead costs than previously realized.

26. Costs and Cost Drivers in Activity-Based Costing
Exh.
21-6
Here are some typical cost pools and cost drivers that can be used in Activity-Based Costing

27. Joint Costs
A single cost incurred in producing or purchasing two or more different products.
Similar to an indirect expense since it is shared among more than one cost object.
Example: The cost of crude oil is a joint cost for many petrochemical products.
Joint costs are incurred to produce multiple products from one process. Joint costs cannot be traced directly to any one of the multiple products. They are common to all products made from the joint process, so we allocate the joint costs to each of the joint products from the joint process.

28. Joint Costs and Their Allocation
Part I
Joint costs are allocated based on a physical measure such as weight or they are allocated based on relative sales value of the products. We have two products from the animal, hamburger meat and steak. If we allocate the joint costs of feeding and caring for the animal based on weight, which of the two products would receive the largest cost allocation?
Part II
A greater portion of the animal’s weight is hamburger meat, so a greater portion of the joint cost would be allocated to hamburger meat.
If we allocate the joint costs of raising the animal to the two products based on weight, which product would receive the largest cost allocation?
Hamburger, because there is more of it.

29. Joint Costs and Their Allocation
Part I
If we allocate the joint costs of feeding and caring for the animal based on sales value of the two products, which product would receive the largest cost allocation?
Part II
Even though the amount of steak weighs less, it sells for much more per pound. The total sales value of steak would be more than the total sales value of the hamburger meat. So, steak would receive a greater portion of the allocated joint cost.
If we allocate the joint costs of raising the animal to the two products based on sales value, would the steak receive a greater portion of the cost allocation?
Yes, steak has a higher sales value than hamburger.

30. Value Basis Allocation of Joint Costs
Product One Sales value = RM80,000
RM200,000 Joint Cost
Product Two Sales value = RM200,000
Here we see a single process that produces three products. The process has a joint cost of two hundred thousand dollars. Each product has a known sales value and we will allocate the joint costs based on sales value.
Product Three Sales value = RM120,000
Allocate the RM200,000 joint cost based on sales value.