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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 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

000 machine hours.000. For example.000 of manufacturing overhead is caused by the production activities that correlate with the company’s 100. the cost per unit for setup will be $0.000 –0– $2.10 Without ABC $–0– Not applicable Not applicable Mfg overhead costs per machine hour No.46 $0. of units produced per machine hour Mfg O/H caused by Production – Per Unit $18 50 $0.000.000 200.40 . For our simple two-activity example. of units in batch Mfg O/H caused by Setup – Per Unit $500 5.000 $18 $2.000 100.allocation).000 Without ABC $–0– 400 Not applicable $500 $–0– Total manufacturing overhead costs Less: Cost traced to machine setups Mfg O/H costs allocated on machine hours Machine hours (MH) Mfg overhead costs per MH $2. the setup cost per unit is $0.000 units).01 ($500 divided by 50.000 100.000 units. let’s assume that the remaining $1.800.000 $20 Mfg Overhead Cost Allocations $500 setup cost per batch + $18 per MH $20 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.000 units).000 units of product.000 $0.800.10 ($500 divided by 5. if Batch X consists of 5.000. For simplicity. Assume that a company manufactures a batch of 5. here is how the cost assigned to the units with activity based costing and without activity based costing compares: With ABC Mfg overhead for setting up machine No.36 $20 50 $0.000 units and it produces 50 units per machine hour. let's see how the rates for allocating the manufacturing overhead would look with activity based costing and without activity based costing: With ABC Mfg overhead costs assigned to setups Number of setups Mfg overhead cost per setup $200.000 $1. If Batch Y is 50.40 Total Mfg O/H Allocated – Per Unit $0.

000 units.01 Without ABC $–0– Not applicable Not applicable Mfg overhead costs per machine hour No.40 regardless of the number of units in each batch.46—the company may end up doing lots of production for little or no profit.40 is lower than the ABC model of $0.000 $0.000 units instead of 5. here is how the cost assigned to the units with ABC and without ABC compares: With ABC Mfg overhead for setting up machine No. they began using ABC cost information to practice activity based management. of units in batch Mfg O/H caused by Setup – Per Unit $500 50. more accurate overhead cost of $0.000 units. With its bid price based on manufacturing overhead of $0.46 for a batch size of 5. For example. with activity based costing the cost per unit decreases from $0. the cost per unit is $0. It’s also possible that a company not using ABC may find itself being the low bidder for manufacturing small batches of product. Without ABC.If a company manufactures a batch of 50. with the cost of setting up a machine now being measured and discussed.37.46 to $0.37 $0. As companies began measuring the costs of activities (instead of focusing on the accountant’s departmental classifications).40 As the tables above illustrate. since its $0. 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? .36 $20 50 $0. of units produced per machine hour Mfg O/H caused by Production – Per Unit $18 50 $0.37 because the cost of the setup activity is spread over 50.40—but a true cost of $0. 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. 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. If companies base their selling prices on costs. 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.000 units and produces 50 units per machine hour.40 Total Mfg O/H Allocated – Per Unit $0.

000 3.000 – 300.000 $0.Activity Based Costing with Four Activities Activity Based Costing with Four Activities Let’s add two more activities to our example: procurement and material handling.000 $1.000 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.10 $–0– Not applicable $–0– Mfg O/H costs caused by producing the items: Total manufacturing overhead costs Less: Cost traced to machine setups Less: Costs traced to procurement/handling Mfg costs to be allocated on machine hours Machine hours (MH) Mfg overhead costs allocated per MH $2. These points are illustrated in the following table: With ABC Mfg overhead costs assigned to setups Number of setups Mfg overhead cost per setup $200.000 of its annual manufacturing overhead is associated with procurement and material handling. the company will assign $0.000 divided by 3.000 from the manufacturing overhead that will be allocated via machine hours. The company determines that $300.000.000.000 $–0– $–0– $2.000 pounds of material. we will assume that both of these activities are related to the physical weight of the direct material used in making the product. The company expects that during the year it will procure and handle 3.000 to the products based on the weight of the materials used.000.000 100. the company removes $300. they will also be assigned more factory overhead than the lighter parts. and instead plans to allocate the $300.10 per lb. + $15 per MH $20 per MH .10 ($300.000 $15 $2.000. The costs of these two activities are not caused by—nor do they correlate with—machine hours. the remaining manufacturing overhead assigned via machine hours will be reduced.000 $20 Mfg Overhead Cost Allocations $500 setup cost per batch + $0. By assigning some manufacturing overhead to a product based on the product’s weight.000 100.000 400 $500 Without ABC $–0– Not applicable $–0– Mfg O/H costs caused by procurement/handling Pounds of material in products Mfg O/H per pound of product material $300.000.000.000 – 200. As a result.500. Under activity based costing. Rather.

In the table below we can see how ABC would assign costs to the following: 1. of units in batch Mfg O/H caused by Setup – Per Unit $500 50.5 pounds is assigned $0. of product Lbs of material in product Mfg O/H caused by Weight – Per Unit $0.40 If the manufacturing overhead costs are caused by a number of activities such as setup. 2. A product that weighs 0.36 $0. handling.36 of manufacturing overhead.05 $0. Under the traditional costing allocations the procurement and handling costs would be assigned on production hours. .) No ABC $–0– Not applicable Not applicable Mfg overhead costs per lb.000 $0.5 $0.5 pound is assigned $0.46 $0. allocating costs on a single basis (such as machine hours) will result in inaccurate per-unit manufacturing overhead costs.) ABC $500 50. procurement.46 of manufacturing overhead. As you can see. and production. the product that weighs 0.10 1.01 (3.5 pound and is produced in a batch of 50. of units produced per machine hour Mfg O/H caused by Production – Per Unit $15 50 $0. Keep in mind that whenever manufacturers have a diverse lineup of products.000 $0.000 units at a rate of 50 per hour.40 Total Mfg O/H Allocated – Per Unit $0.5 pounds and is produced in a batch of 50. (1.15 Not applicable Not applicable Not applicable Mfg overhead costs per machine hour No.10 0. then using the activity based costing method of determining costs will give you a result that is closer to the true costs. while the product weighing 1. 3.5 $0.) ABC Mfg overhead for setting up machine No.000 units at a rate of 50 per hour.30 $15 50 $0. A product that weighs 1. No activity based costing allocations—all manufacturing overhead costs are allocated entirely via machine hours.30 $20 50 $0.01 (2.