Activity Based Costing

Activity-Based Costing (ABC) – is a systematic costing method that mainly uses ‘activities’ as basis to allocate
overhead and indirect costs to products. ABC provides reliable data for product costing by using multiple cost drivers
that are more reflective of the actual causes of incurred overhead costs.

ABC vs TRADITIONAL COSTING

Under the traditional costing, overhead costs are allocated to products by using a single
Cost driver (usually labor hour). This costing is volume-based and suitable for labor-intensive, low-overhead
companies. Traditional costing (a.k.a peanut-butter costing) is simple and inexpensive to implement.
Under ABC, overhead costs are allocated to products using several cost drivers associated with the
identified cost pools. ABC is suitable for capital-intensive, product-diverse, and high-overhead companies. ABC
often leads to accurate product costing and elimination of non-value-added activities.

STEPS IN IMPLEMENTING ACTIVITY-BASED COSTINGh2

1. Identify cost drivers(activities), cost pools and activity centers.
 A cost driver is the particular activity that causes the incurrence of certain costs
 A cost pools is a group of costs usually associated with a common cost driver.
 An activity center is a unit of organization that performs a set of tasks. It is part of the
production process for which management wants a separate reporting of the costs of the
activity involved. Level of activity centers can be classified into four general categories:

Unit-level activities performed each time a unit is produced.

Batch-level activities performed each time a batch of goods is handled or processed.
Product-level activities performed to support production (sales) of specific product type.
Facility-level activities perform to sustain a facility’s manufacturing process.

2. Calculate predetermined overhead rates for each identified activity.

Predetermined overhead rate = estimated overhead costs ÷ estimated activity
level.
NOTE: Estimate figures are used because actual figures are not yet known at the start of the period.
3. Allocate overhead costs to the products on the basis of predetermined overhead rates.
In summary, ABC is a ‘two-stage’ allocation. First, overhead costs are traced to activities; then overhead
costs are allocated to products in proportion to their consumption of activities.

ACTIVITY – BASED MANAGEMENT (ABM) - integrates ABC with other concepts such as Total Quality
Management (TQM), process value analysis and target costing to produce a management system that
strives for excellence through cost reduction and continuous process improvement. An important goal of
ABM is to reduce or eliminate non-value-added activities and costs.
 VALUE-ADDED activities are necessary activities that incur costs but increase the perceived
value of a particular product to the customer. Example: engineering designs modification.
 NON-VALUE-ADDED activities are operations that are either (1) unnecessary or dispensable,
or (2) necessary, but inefficient and improvable. Example: rework of defective units.

BALANCED SCORECARD – is an approach to performance measurement that combines traditional

financial measures with non-financial performance measures. Balanced scorecard was created by David Norton and
Robert Kaplan in response to value-based management is a performance evaluation technique that focuses on
traditional financial measures.
FOUR PERSPECTIVES OF THE BALANCED SCORECARD
1. FINANCIAL perspective – measures reflecting financial performance.
Examples: profit, return on investment (RoI), revenue growth
2. CUSTOMER perspective – measures having a direct impact on customers.
Examples: customer satisfaction, customer retention, market share, customer complaints
3. LEARNING & GROWTH perspective – measures describing the company employee’s learning curve.
Examples: employee satisfaction, employee turnover, training and recreation
4. INTERNAL BUSINESS PROCESSES perspective – measures showing key business processes performance.
Examples: manufacturing cycle efficiency, product quality, productivity measures, throughput

COMPONENTS OF BALANCED SCORECARD

 STRATEGIC OBJECTIVES – a statement of what the strategy must achieve and what is critical to its
success.
  STRATEGIC INITIATIVES – key action programs required to achieve strategic objectives.
 PERFORMANCE MEASURES – describe how success in achieving the strategy will be measured.
 BASEKINE PERFORMANCE – the current level of performance for the performance measure.
 TARGETS – the level of performance or rate of improvement needed in the performance
measure.

Strategic objectives focus on WHAT is to be achieved. Strategic initiatives focus on HOW it will be
achieved. Performance measures, baseline performance and targets relate how it will be
MEASURED.
EXERCISES: ACTIVITY-BASED COSTING& BALANCED SCORECARD
1. Activity Levels
Determine the appropriate level for each of the following activities or costs. Indicate whether the
activity is unit-level (UL), batch-level (BL), product-level (PL), facility-level (FL) :
A) Equipment setups
B) Plant supervision
C) Prime costs
D) Packaging and shipments
E) Designing, changing and advertising
F) Heating, lighting, security
G) Product order processing

2. Traditional Costing vs. ABC

Ford Company incurs P 800,000 in manufacturing overhead costs. The company has been allocating
overhead to individual product lines based on direct labor hours.

Cost Driver Amount in Cost Pool Amount of Activity

Direct labor hours P 300,000 40,000
Number of batches 300,000 1,000
Number of shipments 200,000 500
Total overhead costs P 800,000

Product X Product Y
Direct labor hours 2,000 1,000
Number of batches 20 1,00
Number of shipments 2 150

REQUIRED:
Determine the overhead costs to be allocated to each product (X and Y) using:
A) Traditional costing (based on direct labor hours)
B) Activity-based costing (ABC)

3. Application of Overhead Costs

A) Jeep Company us based on direct labor hours toes a predetermined overhead rate based on
direct labor hours to apply manufacturing overhead last year are as follows:
Estimated Actual
Manufacturing overhead P 720,000 P 620,000
Direct labor hours 600,000 hrs. 550,000 hrs.

What was the manufacturing overhead for Jeepney Company for last year?
a. Over-applied by P 40,000 c. Over-applied by P 20,000
b. Under-applied by P 40,000 d. Under-applied by P 40,000

B) Peugeot Company uses activity-based costing to compute product costs for external reports. The
company has three centers and applies overhead using predetermined overhead rates for each
activity center. Estimated costs and activities for the current years are presented below:
Estimated Overhead Cost Expected Activity
Activity 1 P 18,000 1,200
Activity 2 P 57,600 2,400
Activity 3 P 97,200 3,600

Actual costs and activities for the current year were as follows:
 Actual Overhead Cost Actual Activity
Activity 1 P 19,500 1,250
Activity 2 P 67,500 2,500
Activity 3 P 90,000 3,70

What was the amount of overhead applied for Activity 2 during the year?
a. P 7,500 over-applied c. P 7,200 over-applied
b. P 7,500 under-applied d. P 7,200 under-applied

C) The most common treatment of under-applied and over-applied overhead costs is to close it out
to
a. P 7,500 over-applied c. P 7,200 over-applied
b. P 7,500 under-applied d. P 7,200 under-applied

4. Manufacturing Cycle Efficiency

Audi Company keeps careful track of time related to orders and their production. During the
most recent quarter, the following average times were recorded for each unit or order:
Inspection time 1 day
Process time 2 days
Move time 3 days
Queue time 4 days
Wait time 5 days
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