U nive rs id a de do M in ho

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Topic 3: Activity Based Costing

Ofélia Pinto

U nive rs id a de do M in ho
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LEARNING OBJECTIVES 2

• Explain how broad averaging undercosts and overcosts cost objects

• Describe three guidelines for refining a costing system
• Distinguish between simple and activity-based costing systems
• Describe a four-part cost hierarchy
• Calculate the cost of cost objects using activity-based costing
• Evaluate the costs and benefits of implementing activity-based costing
systems

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 U nive rs id a de do M in ho
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Purposes of cost allocation 3

Assigning indirect costs to cost objects:

• these costs are not traced
• indirect costs often comprise a large percentage of total overall
costs.

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Broad averaging and its consequences

U nive rs id a de do M in ho
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Historically, firms produced a limited variety of goods while their indirect costs
were relatively small.
Allocating overhead costs was simple ‒ use broad averages to allocate costs
uniformly regardless of how they are actually incurred, for example:
‒ “peanut butter costing”.

The end-result:
• Over costing – a product consumes a low level of resources but is
reported to have a high cost per unit

• Under costing – a product consumes a high level of resources but is

reported to have a low cost per unit

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Broad averaging and its consequences
U nive rs id a de do M in ho
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Undercosting and overcosting

• Undercosting – a product consumes a high level of resources but is
allocated low costs per unit.
• Overcosting – a product consumes a low level of resources but is
allocated high costs per unit.

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Broad averaging and its consequences

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Product-cost cross-subsidization
The results of overcosting one product and undercosting another:
• are that the overcosted product absorbs too much cost, making
it seem less profitable than it really is
• the undercosted product is left with too little cost, making it
seem more profitable than it really is.

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Simple costing system at Realenz Ltd U nive rs id a de do M in ho
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Design, manufacturing and distribution processes:

Realenz Ltd manufactures two types of lenses: a complex lens, CL5;
and a simple lens, S3, for vehicle tail lights
• Production sequence:
‒ design outputs and processes
‒ manufacture lenses
‒ distribute lenses

CL5 is sold at $137

S3 is sold at $63 and a competitor is offering it to the supplier at $53
The supplier is menacing to stop orders of S3
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Simple costing system at Realenz Ltd U nive rs id a de do M in ho

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Simple costing system using a single indirect-cost pool

There are seven steps:
• identify the products that are the chosen cost objects
• identify the direct costs of the products
• select the cost-allocation bases to use for allocating indirect
(or overhead) costs to the products
• identify the indirect costs associated with each cost-allocation
base

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Simple costing system at Realenz Ltd U nive rs id a de do M in ho
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cont’d
• calculate the rate per unit of each cost-allocation base

• calculate the indirect costs allocated to the products

• calculate the total cost of the products by adding all direct and
indirect costs assigned to the products.

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Simple costing system at Realenz Ltd U nive rs id a de do M in ho

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 Realenz simple costing system
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Step 1: Cost objects. S3 and CL5

Step 2: Identify direct costs – Direct materials; direct manufacturing labor:
$2.595.000 (see next slide, $1.725.000 for S3 and $ 870.000 for CL5)
Step 3: Cost allocation basis: 39.750 direct labour hours
Step 4: Total indirect costs amount to $2.385.000
Step 5: Calculate rate per unit of cost allocation: $2.385.000/39.750 h = $60
Step 6: Indirect costs allocated: 30.000 hours to S3 and 9.750 hours to CL5
Step 7: Calculate total cost

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Simple costing system at Realenz Ltd

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 Refining a costing system
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A refined costing system:

• reduces the use of broad averages for assigning the cost of
resources to cost objects
• provides better measurement of the costs of indirect
resources used by different cost objects.

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Refining a costing system

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Three principal reasons for the demand for refinements to

the costing system are:
– increase in product diversity
– Proliferation of products on the market
– increase in indirect costs
– Technology enhances decrease in direct costs and
increase in indirect costs
– competition in product markets
– Competition forces the need for more accurate
cost information

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 Refining a costing system
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Three guidelines for refining a costing system:

• direct-cost tracing
‒ identify as many direct costs as is economically feasible
• indirect-cost pools
‒ expand the number of indirect-cost pools into homogeneous
cost pools ‒ all of the costs have the same or a similar cause-
and-effect (or benefits-received) relationship with a single
cost driver that is used as the cost-allocation base
• cost-allocation bases
‒ for each activity cost pool, the cost driver is used as the cost-
allocation base.
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Activity-based costing systems U nive rs id a de do M in ho

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• Activity-based costing (ABC) refines a costing system by

identifying individual activities as the fundamental cost objects.
• An activity is an event, task, or unit of work with a specified
purpose.

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Activity-based costing systems U nive rs id a de do M in ho
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Cost hierarchies
A cost hierarchy categorises various activity cost pools on the
basis of the different types of cost drivers, or cost-allocation bases,
or different degrees of difficulty in determining cause-and-effect
relationships.
ABC uses a four-level cost structure to determine how far down the
production cycle costs should be pushed:
‒ output unit-level costs
‒ batch-level costs
‒ product-sustaining costs
‒ organisation-sustaining costs.
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Activity-based costing systems – U nive rs id a de do M in ho

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web link 18

• An explanation and video on ‘Activity-Based Costing’ can be

found at:
http://www.referenceforbusiness.com/management/A-
Bud/Activity-Based-Costing.html

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 Implementing activity-based costing at U nive rs id a de do M in ho
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Realenz Ltd 19

Figures 6-4 to 6-6 illustrate the following seven steps:

• identify the outputs that are the chosen cost objects
• identify the direct costs of the outputs
• select the activities and cost-allocation bases to use for allocating
indirect costs to the outputs
• identify the indirect costs associated with each cost-allocation base
• calculate the rate per unit of each cost-allocation base
• calculate the indirect costs allocated to the outputs
• calculate the total cost of the outputs by adding all direct and indirect
costs assigned to the outputs.
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Implementing activity-based costing at Realenz Ltd U nive rs id a de do M in ho

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Implementing activity-based costing at U nive rs id a de do M in ho

Realenz Ltd Realenz and ABC rate calculation:

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Implementing activity-based costing at Realenz Ltd U nive rs id a de do M in ho

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Comparing costing systems U nive rs id a de do M in ho
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U nive rs id a de do M in ho
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Comparing costing systems 24

• Each method is mathematically correct.

• Each method is acceptable.
• Each method yields a different cost figure, which will
lead to different gross margin calculations.
• Only overhead is involved. Total costs for the entire
firm remain the same, they are just allocated to
different cost objects within the firm.
• Selection of the appropriate method and drivers
should be based on experience, industry practices, as
well as a cost-benefit analysis of each option under
consideration.
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 U nive rs id a de do M in ho
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Comparing costing systems 25

A number of critical decisions can be made using this

information:
‒ should one product be ‘pushed’ over another?
‒ should one product be dropped?
Accounting for overhead costs is an imprecise
science. Accordingly, best efforts should be put
forward to arrive at a cost that is fair and reasonable.

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U nive rs id a de do M in ho
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Comparing costing systems 26

Rationale for selecting a more refined costing system:

• increase in product diversity
• increase in indirect costs
• advances in information technology
• competition in foreign markets.

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Implementing ABC systems U nive rs id a de do M in ho
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An ABC system is likely to provide the most benefits when:

• Significant amounts of indirect costs are allocated using only one or
two cost pools.
• All or most indirect costs are identified as output unit-level costs.
• Outputs make diverse demands on resources because of differences
in volume, process steps, batch size or complexity.
• Outputs that a company is well suited to make and sell show small
profits; whereas outputs that a company is less suited to produce and
sell show large profits.
• Operations staff have substantial disagreement with the reported costs
of manufacturing and marketing outputs.

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Implementing ABC systems

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• ABC is generally perceived to produce superior costing figures due to

the use of multiple drivers across multiple levels.
• ABC is only as good as the drivers selected, and their actual relationship
to costs. Poorly chosen drivers will produce inaccurate costs, even with
ABC.

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 Questions
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1. What is broad averaging and what consequences can it have on costs?

2. Why should managers worry about product over costing or under costing?
3. What is a cost system refinement? Describe the three guidelines for refinement.
4. What is an activity based approach to designing a costing system?
5. Describe four levels of a cost hierarchy
6. Why is it important to classify costs into a cost hierarchy?
7. What are the key reasons for product cost differences between simple costing and ABC?
8. Describe four decisions for which ABC information is useful.
9. “Department indirect costs rates are never activity cost rates” Do you agree? Explain.
10. Describe four signs that help indicate when ABC systems are likely to provide the most
benefits.

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Lecture Illustration – Burrard Limited U nive rs id a de do M in ho

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Issues to address

1. Calculate the total cost per unit of Type X and Type Y using
the current plant wide rate (in which overheads are allocated
according to the machine hours).

2. Calculate the total cost per unit of Type X and Type Y using
Activity Based Costing.

3. Should management adopt an ABC system?

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Lecture Illustration – Burrard Limited U nive rs id a de do M in ho
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Things to note:

• Activities have already been identified

• Activity costs have already been allocated to activities

• Activity cost drivers have already been identified

• Normally management accountants would be involved in

these tasks

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Lecture Illustration – Burrard Limited U nive rs id a de do M in ho

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Things to note:

 Materials handling costs are batch level costs

◦ Hence activity driver is a batch level driver – no. of orders

 Machine set-up costs are batch level costs

◦ Hence activity driver is a batch level driver – no. of setups

 Machine operation costs are output unit level costs

◦ Hence activity driver is a unit level driver – MH’s

 Design costs are product sustaining costs

◦ Hence activity driver is a product level driver – design hours
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Lecture Illustration – Burrard Limited U nive rs id a de do M in ho
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Manufacturing overhead for the budget period is $14,400,000.

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Lecture Illustration – Burrard Limited U nive rs id a de do M in ho

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A further analysis of budgeted overheads has determined that four

activities are undertaken in relation to Type X and Type Y. Activities,
activity costs and activity cost drivers are as follows.

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Lecture Illustration – Burrard Limited: Part a) U nive rs id a de do M in ho
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Calculate the total cost per unit of Type X and Type Y using
the current plant wide rate.
Plant wide Allocation rate:
Budgeted manufacturing overhead
Machine Hours
$14.400.000
720.000 MH’s
= $20 per MH

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Lecture Illustration – Burrard Limited : Part a) U nive rs id a de do M in ho

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Total cost of Type X and Type Y – plantwide rate

Type X Type Y
Direct Materials $1,000,000 $ 500,000
Direct Labour 3,000,000 2,400,000
Manuf. O/H 2,400,000 12,000,000
(120,000 MH x $20) (600,000 MH x $20)

Total costs $6,400,000 $14,900,000

Number of units 500,000 200,000
Cost per unit $12.80 $74.50

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Lecture Illustration – Burrard Limited: Part b) U nive rs id a de do M in ho
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Calculate the total cost per unit of Type X and Type Y using
Activity Based Costing

Determine Activity Allocation Rates for each activity

 Materials handling (activity cost driver = no. of orders)

◦ $2,050,000/5,000 orders = $410 per order

 Machine set-up (activity cost driver = no. of set-ups)

◦ $1,250,000/800 setups = $1,562.50 per setup
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Lecture Illustration – Burrard Limited: Part b) U nive rs id a de do M in ho

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 Machine operation (activity cost driver = machine hours)

◦ $7,500,000/720,000 MH’s = $10.42 per MH

 Design (activity cost driver = design hours)

◦ $3,600,000/6,000 design hours = $600 per design hr

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Lecture Illustration – Burrard Limited: U nive rs id a de do M in ho
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Part b) 42

Type X Type Y

Direct Materials $1,000,000 $ 500,000

Direct Labour 3,000,000 2,400,000
Manuf. O/H (using ABC)

Materials handling 1,230,000 820,000

($410 x 3000) ($410 x 2000)
Machine set-up 781,250 468,750
($1562.50 x 500) ($1562.50 x 300)

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Lecture Illustration – Burrard Limited: U nive rs id a de do M in ho

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Part b) 43

Type X Type Y

Machine operation 1,250,000 6,250,000

($10.42 x 120,000) ($10.42 x 600,000)

Design costs 2,400,000 1,200,000

($600 x 4,000) ($600 x 2,000)
Total costs $9,661,250 $11,638,750
Number of units 500,000 200,000
Cost per unit $19.32 $58.19

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Lecture Illustration – Burrard Limited: Part c) U nive rs id a de do M in ho
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Should management adopt an ABC system?

 Are costs allocated more accurately under the ABC system?
 First issue: Are total products costs materially different under
each system? YES
◦ (if not, use conventional system as it is a simpler system)
Type X Type Y
Conventional System $12.80 $74.50
ABC System $19.32 $58.19
51% higher 22% lower
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Lecture Illustration – Burrard Limited: U nive rs id a de do M in ho

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Part c) 45

Why are total costs different under each system?

• Because overhead has been allocated using different cost pools

and cost drivers

• Conventional system allocated ALL overhead costs in one cost

pool using only one unit based cost driver - machine hours

• ABC system uses four activity cost pools and four different cost
drivers for different activities

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Lecture Illustration – Burrard Limited: U nive rs id a de do M in ho

Part c)
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Conventional system allocated ALL overhead costs using

machine hours
• This assumes ALL overhead is caused by machine hour usage

• This is very unlikely

– Will design costs change as machine hours change? – NO
– Materials handling, machine setups? – NO

Therefore, COSTS ARE NOT ALLOCATED ACCURATELY

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Lecture Illustration – Burrard Limited: Part c) U nive rs id a de do M in ho

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ABC system uses different cost drivers for different activities

These cost drivers represent a more accurate cause of costs
• i.e. they represent the cause and effect relationship
between the activity and the cost

Therefore, COSTS WILL BE ALLOCATED MORE

ACCURATELY
• The final product cost will more accurately represent the
TRUE resource usage per product

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Lecture Illustration – Burrard Limited: Part c) U nive rs id a de do M in ho
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ABC system is more appropriate for costing X and Y because:

The four activity cost pools don’t have the same cause (driver)
 if they did, a conventional system would be appropriate

The two products use the activities differently per unit of product

◦ E.g. Machine set-ups

 Type X uses 1 setup for every 1000 units on
average (500,000 units/500 setups)
 Type Y uses 1 setup for every 667 units on average
(200,000 units/300 setups)
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Lecture Illustration – Burrard Limited: U nive rs id a de do M in ho

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Part c) 49

Therefore setup costs per unit are not the same for each unit of
product

◦ Type X: Setup cost per unit = $1.56 ($1,562.50/1,000 units)

◦ Type Y: Setup cost per unit = $5.21 ($1,562.50/667 units)

 This means a unit-based activity cost driver is NOT appropriate

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But what if all activity costs were caused by one U nive rs id a de do M in ho
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cost driver – Machine Hours 50

Determine Activity Allocation Rates for each activity (rounded)

 Materials handling (activity cost driver = MH’s)
 $2,050,000/720,000 MH’s= $2.85 per MH

 Machine set-up (activity cost driver = MH’s)

 $1,250,000/720,000 MH’s = $1.74 per MH

 Machine operation (activity cost driver = MH’s)

 $7,500,000/720,000 MH’s = $10.42 per MH

 Design costs (activity cost driver = MH’s)

 $3,600,000/720,000 MH’s= $5.00 per MH
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But what if all activity costs were caused by one U nive rs id a de do M in ho

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cost driver – Machine Hours 51

 Total activity cost per MH is:

$2.85 +$1.75 + $10.42 + $5.00 = $20.00 (rounded)
◦ This is the same as the plantwide allocation rate of $20 per MH

 Therefore
◦ Conventional systems can be used IF all activities have the SAME
cost driver
 This cost driver should be used in the conventional system
◦ As conventional systems are usually simpler, less expensive than
ABC systems, cost benefit analysis would suggest the use of the
conventional costing system in this situation
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 Next week
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• Topic 4 - Customer profitability analysis

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