AE 313 AB COSTING AND AB MANAGEMENT

Prepared by: Joseph R. Mendoza CPA, MBA

Product Cost Determination is one of the most important business activities since it has a direct impact on the revenue
generation of a firm. Product cost is used in pricing decision – determining the proper price on which to sell the product/s to
customers. Product cost determination is specifically designated as an accounting function. It is one of the primary uses of the cost
accounting system. However, its great impact on the overall well-being of the firm makes it a major concern for all managers.

Normally, product cost includes all manufacturing costs and excludes non-manufacturing costs such as research and development,
selling and administrative costs. Two of the most important cost concepts and classifications relevant to product costing are:
Cost According to Nature/Function Cost According to TRACEABILITY to Cost Object
A. Product B. Department
Direct materials P xx Direct Direct
Direct labor xx Direct Direct
Factory Overhead xx Indirect Direct/indirect
Total Product Costs Pxx Direct/indirect Direct/indirect
Gen. Administrative Costs xx
Selling Costs xx
Total Costs Pxx
Pricing decision can be based on product costs or total costs. In any instance, the problem lies on allocation of indirect costs, in case
the company manufactures more than 1 product.

COSTING Systems
1. TRADITIONAL (VOLUME based/ FUNCTIONAL Based) Costing - allocates indirect costs (factory overhead) based on only 1 cost
driver: the volume of operations or unit level of activity, which can either be:
A. INPUT factor of production – direct labor hours, machine hours, etc…
B. OUTPUT factor of production – units produced

Plant wide and Departmental Rates using unit-level drivers may not assign overhead costs accurately if:
A. the proportion of nonunit-level overhead costs to total overhead costs is large
B. the degree of product diversity is great

PRODUCT DIVERSITY occurs when products consume overhead activities in different proportions, because the products differ in
size, complexity, batch size and required set up time, among others. CONSUMPTION RATIO is the proportion of each activity
consumed by a product

Thus, allocation of indirect (overhead) costs using Traditional Costing approach leads to PEANUT BUTTER COSTING (broad
averaging) because the indirect costs are uniformly assigned or spread to the products, when in fact, the individual products use
those resources in a non-uniform way. Such allocation is very general because it does not consider other factors or variables that
caused the creation of indirect costs.

Inaccuracy of indirect costs allocation leads to CROSS SUBSIDIZATION – a condition in which wrong costing of one product causes
the wrong costing of the other products. Naturally, since indirect costs are allocated based on volume of operations, high volume
product lines will be overcosted ( ) and low volume product lines will be undercosted. ( )

 Distorted product costs can be a problem in extremely competitive environments. The series of effects of traditional costing is
shown below:
LOW Volume Product HIGH Volume Product
Indirect cost allocation
Product cost
Sales Price
Market share (Total Sales)
Profit

2. ACTIVITY BASED Costing (ABC) System is a system that focuses on various activities performed and collects costs on the basis of
the underlying nature and extent of those activities. ABC system approaches costs from the perspective that products do not
cause costs; they require activities, and the activities themselves are the causes of all costs incurred.
ABC system traces overhead costs to activities, and then traces costs to products. This method better provides managers with
cost information for product pricing, cost control and planning, and other purposes.
ABC focuses on attaching costs to products (goods/services) based on the activities performed to produce, perform, distribute or
support those products. Hence, it allocates indirect costs based on multiple activities called as cost drivers. Cost drivers (activity
measures) are activities which cause or generate cost. Since it drives the cost, it serves as the allocation base in an ABC system.

MAJOR COST DRIVERS

1. VOLUME of operations – can be output (units produced) or input (machine hours, labor hours) of production
2. COMPLEXITY of operations - as products become more complicated, having more parts and requiring more operations, cost
will increase even if total output will not increase.

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AE 313 AB COSTING AND AB MANAGEMENT
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3. DIVERSITY of operations – as the company increases the variety of product it offers, cost will increase even if total output
remains constant.

ACTIVITY COST POOL (ACTIVITY CENTER) – a bucket in which costs are accumulated that relate to single activity
measure in the ABC system. It is part of the production process for which management wants a separate reporting of the cost
activity involved. It can be related to the following level of activities.
1. UNIT level – performed each time a unit is produced.
2. BATCH level – performed each time a batch of goods is handled or processed.
3. PRODUCT level – performed as needed to support the production of each type of product.
4. PLANT (FACILITY/ORGANIZATION SUSTAINING) level – sustain a facility’s general manufacturing process.

ACTIVITY LEVEL ACTIVITY CENTER (ACTIVITY COST POOL) COST DRIVER

1. UNIT Level Machine related activities like cutting, milling and maintenance. Machine hours
Labor related activities Labor hours
Overall production activity Units produced

2. BATCH level Purchase order processing no. of orders processed

Production order processing no. of materials receipt
Equipment set ups, material handling, no. of set ups, set up hours
quality inspection no. or hours of inspections

3. PRODUCT level Product testing, parts inventory mgmt. No. of tests, testing hours
Product design Design hours, design changes

4. PLANT level Plant occupancy Floor area

ALLOCATION PROCESS
ABC system is normally a two-stage process of assigning indirect costs to products.
Stage 1: Establish the activity-cost pools and identify the activity in which the cost is most clearly related to.
Stage 2. Assign each cost to products based on their relative use or consumption of activity.

Indirect Costs reclassify Activity relate to Activity measures = Cost Allocation – based on consumption of activity
based on (Cost Pools) (cost drivers)

 A brief comparison on cost allocation under the 2 costing approaches are as follows:
TRADITIONAL Costing Activity Based Costing (ABC)
First stage: traces costs to plant or department traces costs to activities
Second stage assigns costs to products assigns costs to products
Cost tracing usually allocation-intensive emphasizes direct tracing and driver tracing
Activity (cos drivers) unit-level unit-level and nonunit-level

RELATED TERMS
ACTIVITY Rate = Total Cost in the Cost Pool . CONSUMPTION Rate = Activity level of a product in the cost pool
Total activity level in the cost pool Total activity level in the cost pool

 Thus, the 2 step allocation process of indirect costs under ABC for each cost pool can be viewed as follows:
Step 1 Activity Rate
Step 2 Activity Rate x Activity level of each product in the cost pool
Total Cost in the Cost Pool . x Activity level of a product in the cost pool
Total activity level in the cost pool

Alternatively, it can also be computed as: Total Cost in the cost pool x Consumption rate.
Total Cost in the Cost Pool Activity level of a product in the cost pool
Total activity level in the cost pool

ILLUSTRATIVE PROBLEM 1
JODI Company manufactures and sells different kinds of products. Data gathered from its records are as follows:
Factory overhead: P2,316,000 Total productions = 200, 000 units
Product A Product B Product C
Material cost/unit P40 P30 P20
Direct labor/hour P37.50 P34.50 P31.25
Direct labor hours/unit 1.75 1.25 .9
Units produced 12, 000 8, 000 180, 000

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AE 313 AB COSTING AND AB MANAGEMENT
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Upon further study, the factory overhead (FOH) is traced and assigned to the following activities:
Cost Drivers Total Cost Total No. Product A Product B Product C
Set ups P1,428,000 714 300 360 54
Baking 800,000 800 hrs 120 100 580
Customer orders 88,000 176 60 80 36
Total P2,316,000

REQUIRED:
1. FOH allocation for each product using the Traditional Costing and ABC system.
2. Cost per unit of each product using the Traditional Costing and ABC system.
3. Amount of cross subsidy for each product.

SUGGESTED ANSWERS:
Requirement #1:
TRADITIONAL Costing System
Product A Product B Product C Total
Units Produced 12,000 8,000 180,000 200,000
Labor hours/unit 1.75 1.25 .90
Total labor hours 21,000 10,000 162,000 193,000
FOH/hr (P2,316,000/193,000) P12 P12 P12
FOH Allocation P252,000 P120,000 P1,944,000 P2,316,000
Units Produced 12, 000 8, 000 180, 000
FOH allocation/unit P21.00 P15.00 P10.80

ACTIVITY BASED Costing (ABC) System

The rates per unit of cost driver and related allocation based on consumption are as follows:
Cost Drivers Total Cost Total No. Activity (Cost Driver) Rate
Set ups P 1,428,000 714 P2,000/set up
Baking 800,000 800 hrs P1,000/baking hr
Customer orders 88,000 176 P500/order

Rate x Activity level Model A Model B Model C

Set up Costs P2,000 x (300; 360; 54) P600,000 P720,000 P108,000
Baking Costs P1,000 x (120; 100; 580) 120,000 100,000 580,000
Customer orders P500 x (60; 80; 36) 30,000 40,000 18,000
Total FOH Allocation P750,000 P860,000 P706,000
Units Produced 12,000 8, 000 180,000
FOH allocation/unit P62.50 P107.50 P3.922

Requirement #2
TRADITIONAL COSTING System
Product A Product B Product C
Direct Materials P40.000 P30.000 P20.000
Direct Labor 65.625 43.125 28.125
Factory OH 21.000 15.000 10.800
Product cost/unit P126.625 P88.125 P58.925

Activity Based Costing (ABC) System

Product A Product B Product C
Direct Materials P40.000 P30.000 P20.000
Direct Labor 65.625 43.125 28.125
Factory OH 62.50 107.50 3.922
Product cost/unit P168.125 P180.625 P52.047

Product A Product B Product C

Cost/Unit – Traditional Costing P126.625 P88.125 P58.925
Cost/Unit – ABC System (168.125) (180.625) (52.047)
Cross Subsidy/unit Over (under) stated (P41.50) (P92.50) P6.878

NOTE:
Using the premise that ABC is the correct (more accurate) costing system, the costs for low volume products (A and B) using
Traditional (Volume Based) Costing are understated and the costs of high volume product C is overstated. This is because under
Traditional Costing, all overhead costs are allocated based on only 1 cost driver: the volume of operations or unit level of activity,

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AE 313 AB COSTING AND AB MANAGEMENT
Prepared by: Joseph R. Mendoza CPA, MBA

ILLUSTRATIVE PROBLEM 2
Kaseph Inc. manufactures two kinds of products, ordinary named Faith and special named Love. Last year, it produced 47,000 units
of FAITH and 2, 000 units of LOVE, incurring a total overhead cost of P1,010,000. Kandi, the manager, was able to gather the
following related data:
Faith Love Total
Direct Materials P470,000 P 40,000 Unit level costs P 250,000
Direct labor (DL) P940,000 P 60,000 Batch level costs 400,000
DL hrs./ unit 1 1.5 Product level costs 360,000
Set up hours 60 40 Total overhead costs P1,010,000
Design hours 24 36
Purchase orders 50 25
Upon further investigation, it was found out that 80% of the batch level costs is due to the machine set ups made during the
production process. Under its former costing, all overhead costs are allocated to products based on direct labor hours.

REQUIRED:
1. Cost per unit of product faith and love under traditional costing and ABC system.
2. Amount of cross subsidy for each product.

SUGGESTED ANSWERS
Requirement #1:
TRADITIONAL Costing System
FAITH LOVE Total
Units Produced 47,000 2,000 49,000
Labor hours/unit 1 1.50
Total labor hours 47,000 3,000 50,000
FOH/hr (P1,010,000/50,000) P20.20 P20.20
FOH Allocation P949,400 P60,600 P1,010,000
Units Produced 47,000 2,000
FOH allocation/unit P20.20 P30.30
Direct Materials 10.00 P20.00
Direct Labor 20.00 30.00
Product cost/unit P50.20 P80.30

ACTIVITY BASED Costing System

The rates per unit of cost driver and related allocation based on consumption are as follows:
Cost Pools Total Cost Cost Drivers Total No. . Rate/unit .
Unit level costs P 250,000 Labor hours 50,000 hrs P5/hr
Batch level costs -80% 320,000 Set up hours 100 hrs P3,200/hr
Batch level costs -20% 80,000 Purchase orders 75 orders P1,066.67/order
Product level costs 360, 000 Design hours 60 hrs P6,000/hr
Total OH costs P1,010,000
FAITH LOVE
Unit level costs P5 x (47,000; 3,000) P235,000 P15,000
Batch level costs -80% P3,200 x (60; 40) 192,000 128,000
Batch level costs -20% P1,066.67 x (50; 25) 53,333 26,667
Product level costs P6,000 x (24; 36) 144,000 216,000
Total OH costs P624,333 P385,667
Units Produced 47,000 2,000
FOH allocation/unit P 13.28 P192.83
Direct Materials 10.00 20.00
Direct Labor 20.00 30.00
Product cost/unit P43.28 P242.83

Requirement #2
FAITH LOVE
Cost/Unit – Traditional Costing P50.20 P80.30
Cost/Unit – ABC System 43.28 P242.83
Cross Subsidy/unit Over (under) stated P6.92 (P162.53)

NOTE:
Again, using the premise that ABC is the correct (more accurate) costing system, the costs for low volume products (LOVE) using
Traditional (Volume Based) Costing are understated and the costs of high volume product (FAITH) is overstated. This is because
under Traditional Costing, all overhead costs are allocated based on only 1 cost driver: the volume of operations or unit activity level,

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AE 313 AB COSTING AND AB MANAGEMENT
Prepared by: Joseph R. Mendoza CPA, MBA

Traditional Costing vs. ABC

TRADITIONAL Costing ACTIVITY BASED Costing
1. Focus Controlling cost incurrence Controlling the cost driver.
2. Use Mainly for external reporting Mainly for internal use by management
3. Standard Follows GAAP. Overhead includes Does not follow GAAP. Overhead may also include
production costs only. non-production costs. Moreover, some production
costs may be excluded as product cost.
4. Allocation of indirect Based on only 1 cost driver under unit Based on multiple cost drivers under multiple levels of
(overhead) costs activity level activity
5. Overhead rates Based on budgeted level of activity Maybe based on level of capacity

Activity-Based Supplier Costing

 use of ABC system to identify the true costs of suppliers. ABC traces costs related to purchase, quality, reliability, and delivery
performance to specific suppliers.

Activity-Based Customer Costing

 Use of ABC system to trace costs to specific customers. The cost of serving different customers can affect pricing decisions and
profitability. Customer costing involves three steps:
1. Activities, such as order entry, shipping, and sales calls, are listed in an activity dictionary. Different levels include order level,
customer level, and channel level.
2. Cost of resources used is assigned to activities.
3. Cost of the activities is assigned to customers.
 the cost assignment summary below shows a comparison of customer costing and product costing:

Cost Assignment

Customer Costing Product Costing

List Customer Activities List Activities

Determine Cost of Activities Determine Cost of Activities

Group into Homogeneous Group into Homogeneous

Customer-Driven Cost Pools Cost Pools

Assign Costs to Customers Assign Costs to Products

INDICATORS of Need for ABC

 The factors that are commonly associated with the need to consider ABC are:
1. Product variety and product complexity. Mass customization refers to the relatively low cost mass production of products to the
unique specifications of individual customers. It requires the use of flexible manufacturing systems.
2. Direct labor is a small percentage of total costs
3. Sales are increasing but profits are declining
4. Marketing does not use costs reports for pricing decisions
5. Product-line profit margins are hard to explain
6. Line managers do not believe the product costs reports
7. Some products that have reported high profit margins are not sold by competitors

 ABC is useful in companies having the following characteristics:

1. Production of a wide variety of goods or performance of a wide variety of services.
2. High overhead costs that are not proportional to the unit volume of individual products.
3. Significant automation which made it more difficult to assign overhead to products using traditional direct labor or machine hour basis.
4. Profit margins that are difficult to explain
5. Hard to make products that show big profits and easy to make products that show loses.

CRITICISMS Against (DISADVANTAGES of) ABC

1. ABC implementation necessitates a considerable amount of time, cost and effort, not just in identifying and analyzing the cost
drivers and cost pools for proper cost allocation, but also in overcoming the barriers to change inside the organization. Significant
support is difficult to acquire especially when employees are used to traditional costing or old system of doing things.
2. ABC does not comply with GAAP. Thus 2 books (cost systems) must be maintained. One book for traditional costing for financial
accounting purposes and one book for ABC for management accounting (pricing decision and performance evaluation) purposes.
3. Companies desiring to implement ABC system must be aware that, while more accurate costing may be provided, ABC systems
are not always appropriate. For example, when cost – benefit analysis is applied, ABC is not useful to small companies or when
indirect costs (overhead) are relatively small or insignificant in amount. (see #!)

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AE 313 AB COSTING AND AB MANAGEMENT
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4. ABC in itself, does not promote total quality management (TQM) and continuous improvement. However, ABC and its related
management techniques can be implemented in conjunction with TQM, JIT and other techniques.
5. Pay-offs (benefits) from implementing ABC may not be immediate.

ADVANTAGES of ABC
1. Identify and monitor significant costs of technology and advertising, and assess their impact on performance.
2. Trace technology costs directly to products
3. Identify the activities that cause or drive costs. Management can make quality decisions by knowing the nature of each activity.
4. More accurate allocation of costs to various products leads to better pricing policy and Increased market share.
5. More accurate cost information helps the management to adapt productivity improvement approaches like TQM, business
process reengineering and others.
6. ABC can be used to measure the profitability of different product lines and or customer types.
7. Analyze the performance of activities, and the related problems, across business functions.
8. Helps the management to focus on value adding and eliminate non-value adding activities to reduce costs. Thus, management
becomes better stewards of organizational resources.
9. Promotes standards of excellence

Activity Based Management (ABM)

 refers to the use of ABC costing information to help management make decisions. Assigning the costs of an activity accurately
does not address the issue of whether or not the activity should be performed or whether it is being performed efficiently.
 ABC establishes relationships between overhead costs and activities so that we can better allocate overhead costs. ABM focuses
on managing activities to reduce costs.
 ABM focuses on process-value analysis which focuses on cost reduction instead of cost assignment. It emphasizes the
maximization of system wide performance instead of individual performance.

COMPONENTS of Process-value analysis

I. DRIVER analysis II: ACTIVITY analysis III: ACTIVITY PERFORMANCE MEASUREMENT
I. DRIVER analysis is the effort expended to identify those factors that are the root causes of activity costs. Once the root cause
of activity costs is known, then action can be taken to improve the activity.
II. ACTIVITY analysis - is the process of identifying, describing, and evaluating the activities an organization performs.
An ACTIVITY is an event, action, transaction, task or unit of work with a specified purpose. It can be a repetitive action performed
in fulfillment of business functions.
 ACTIVITY analysis produces the following outcomes:
a. What activities are performed? c. The time and resources required to perform the activities
b. How many people perform the activities? d. Determination of the value-added portion of the activities.
1. VALUE ADDED activities – activities that are necessary to achieve corporate objectives and remain in business. It increases
the worth of product and the customer is willing to pay for it. Examples: cutting, assembling, polishing,
Value-added COSTS are costs to perform value-added activities with perfect efficiency.

2. NON VALUE ADDING activities – are all activities other than those that are absolutely essential to remain in business. These
activities that do not make the product more valuable to the customer. It may be a necessary activity like moving materials
from/to stockroom or workstation and inspecting the quality of finished product. This activity is subject to continuous evaluation
and improvement. NVA can also be an unnecessary like wait or queue time, which needs to be reduced, if not eliminated.
Non-value-added costs are costs caused by either non-value-added activities, or the inefficient performance of value-added
activities.

All costs incurred for non-value adding activities Pxx

INEFFICIENCY Costs* incurred in performing value adding activities xx
Total Non-value added costs Pxx

Inefficiency costs can be viewed as excess (extra or unnecessary) costs incurred by not conforming to the standard level
of performing a value adding activity.

CATEGORIES of non-value-added activities

A. Scheduling - an activity that uses time and resources to determine when different products have access to processes (or
when and how many setups must be done) and how much will be produced.
B. Moving - an activity that uses time and resources to move materials, work in process, and finished goods from one
department to another.
C. Waiting - an activity in which materials or work in process use time and resources by waiting on the next process.
D. Inspecting - an activity where time and resources are spent on ensuring that the product meets specifications.
E. Storing—an activity that uses time and resources while a good or raw material is held in inventory.

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AE 313 AB COSTING AND AB MANAGEMENT
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 Activity analysis attempts to

a. identify and eliminate all unnecessary activities b. increase the efficiency of necessary activities.

 Activity analysis can reduce costs in four ways:

1. Activity ELIMINATION—eliminating non-value-added activities.
2. Activity SELECTION—choosing among different sets of activities caused by competing strategies.
3. Activity REDUCTION—decreasing the time and resources required by an activity. This approach to cost reduction
should be primarily aimed at improving the efficiency of necessary activities, or improving the non-value-added activities until
they can be eliminated. Reducing setup time is an example of improving the efficiency of a necessary activity.

4. Activity SHARING—increasing the efficiency of activities by using economies of scale. An example is designing a product
to use components already used in other products. By using existing components, activities associated with these
components, such as design and machine tooling, are not duplicated.

BUSINESS VALUE ADDED ACTIVITY is an activity that is necessary for the operation of a firm but for which a customer would not
want to pay. A PROCESS MAP is a detailed flowchart that indicates every step that goes into making a product or providing a service.
A VALUE CHART is a visual representation that identifies the stages and the time spent in those stages from the beginning to the end
of a process.

The entire processing time of a firm is usually composed of four types, namely:
1. Processing time – the actual time it takes to perform the functions necessary to produce a product.
2. Inspection time – the time taken to perform quality control activities.
3. Transfer (moving) time – the time consumed in moving parts or products from one place to another.
4. Idle (Queue) Time – time spent in storing inventory or waiting at a production operation for processing.

Only the first one is value added time, the rest are non-value added time.

III. ACTIVITY PERFORMANCE MEASUREMENT can be financial or nonfinancial.

 Three dimensions of activity performance measures are:
A. EFFICIENCY—focuses on the relationship of activity inputs and activity outputs. For example, activity efficiency is
improved by producing the same activity output with less input.
B. TIME —longer times usually result in more resource consumption and less ability to respond to customer demands. Cycle
time is the length of time it takes to produce a unit of output from start to finish (time/units produced). Velocity is the
number of units of output that can be produced in a given period of time (units produced/time)
C. QUALITY—concerned with doing the activity right the first time it is performed

 The 3 steps (components) above determine WHAT activities are being done, WHY they are being done, and HOW well they are
done. Understanding the root causes of activities provides the opportunities to manage activities so that costs can be reduced.

Using ABM to Eliminate Non-Value Added Activities and Costs

1. Identify Activities and then the non-value added activities
2. Understand the activity linkages, root causes and triggers
Specify Select Receive Produce Inspect Rework
parts Vendor parts goods defective ones
fi i h d d
3. Establish performance measures and report non-value added costs

QUALITY COST MANAGEMENT

 Improved quality can increase profits in two ways: 1. by increasing customer demand 2. by decreasing costs.
QUALITY COSTS are costs that are incurred because poor product quality exists or may exist.

CATEGORIES of quality-related activities

1. CONTROL activities - activities performed by an organization to prevent or detect poor quality (because poor quality may exist).
Control activities consist of prevention and appraisal activities.
CONTROL (CONFORMANCE) costs are the costs of performing control activities in order to keep defective products from falling
into the hands of customers. It is divided into:
A. PREVENTION costs – are incurred to prevent poor quality. Examples: quality training programs; quality engineering; quality
planning and reporting; quality audits; quality circles; systems development, statistical process control activities; supplier
evaluation and selection; technical support given to suppliers; field trials; design reviews.

B. APPRAISAL costs – costs incurred in activities to determine whether products and services are conforming to requirements or
customer needs. The main objective is to prevent nonconforming goods from being shipped to customers.

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Examples: inspection/testing of incoming materials, maintenance of test equipment, process control monitoring, packaging
inspection; supervising appraisal activities; process acceptance (sampling goods in process to see if the process is in control
and producing non-defective goods) product acceptance (sampling finished goods to determine if the finished goods meet an
acceptable quality level); outside endorsements.

2. FAILURE activities—activities performed by an organization or its customers in response to poor quality (poor quality does exist)
FAILURE (NON CONFORMANCE) costs are the costs of performing failure activities because defects are produced despite efforts
to prevent it. It is divided into:
C. INTERNAL failure costs are incurred because products or services do not meet requirements and the defect is discovered
before the external sale. Examples: cost of scrap, spoilage, rework costs, downtime caused by quality problems, disposal of
defective products; re-inspection; retesting; design changes.

D. EXTERNAL failure costs are incurred because products fail to meet requirements after delivery to customers.
Examples include: repair costs; warranty claims, recall costs, product liability lawsuits, lost sales because of poor product
performance; returns and allowances because of poor quality; customer dissatisfaction; lost market share