FACULTY OF BUSINESS

ACCOUNTING SCHOOL

ACADEMIC REPORT:

ABC COSTING METHOD

COURSE:
MANAGEMENT ACCOUNTING

AUTHOR:
PAICO GUEVARA JEAN PIERRE ALEXANDER

TEACHER:
ANGEL LEONEL MIJA MEZA

Chiclayo - Perú
(2023)
 1

INDEX

INDEX ..................................................................................................................... 1

INTRODUCTION .................................................................................................... 2

DEVELOPMENT ……………………………………………………………………… ……. .3

THE NEW COST PARADIGMS .............................................................................. 3

4 COSTING METHOD .............................................................................................

PRINCIPLES OF THE ABC .................................................................................... 5

METHOD

ADVANTAGES AND DISADVANTAGES OF USING THE ABC .............................. 6

METHOD

1. Advantages of using the ABC ...................................................................... 6

method
2. Disadvantages of using the ABC ................................................................. 6
method
3. Comparative example .................................................................................. 7

STAGES OF COSTING SYSTEM ........................................................................... 8

1. INSTRUMENTATION OF ABC .................................................................... 8

2. ALLOCATION OF COSTS .......................................................................... 9
a. Stages for assignment ..................................................................... 9
b. Assignment factors .......................................................................... 10

MAIN ELEMENTS OF THE ABC ............................................................................ 10

MODEL

1. Conceptual scheme of an ABC .................................................................... 10

model
2. Practical scheme of the ABC ....................................................................... 10
model

IDENTIFICATION OF ACTIVITIES ......................................................................... 12

PRODUCT COSTING BY ACTIVITIES ................................................................... 12

ADVANTAGES OF ABC OVER TRADITIONAL SYSTEMS .................................... 13

14 COSTING ...........................................................................................................

1. Case No. 01 ................................................................................................ 14

RECOMMENDATIONS ........................................................................................... 17

CONCLUSIONS ..................................................................................................... 17

REFERENCES ....................................................................................................... 17
 2

INTRODUCTION

The international trade situation gives us a unique opportunity to grow and be able to
position the industry in Peru in the highest place.

Lines of promotion and support for exports are undoubtedly the added values that
businessmen expect to be able to compete with the different markets in the region, since
the Peruvian FTA is here and it is time to get ready to compete and grow sustained.

But to maintain sustained growth we must do things intelligently, intelligently based on

the needs of the market, and the market is going to ask us for good products at very
different prices. And under this premise we have no choice but to analyze our processes
very well and manage costs.

Cost management is the key and be very careful we are talking about cost management,
in these businesses the costs are dispersed throughout the production process: in labor,
in the consumption of raw materials and their waste, in the consumption of spare parts
and packaging material, depreciation, maintenance; In short, they are in the
organization's environment and are so sensitive that what we must do is know how to
live with them in our daily lives, since decisions cannot wait.

Yes it's correct! We must compete with Quality, times and precise costs , an interesting
challenge because then we will Strategically Manage our operating costs. And for this
we will use the ABC Costing methodology, since we not only want to know how much it
cost us to produce but also how much the profits amounted to and each of the different
action fronts that our companies have.

Below we present a report that defines and explains the activity-based costing system
compared to the traditional costing system. For your better understanding, examples are
shown as well as practical cases solved with these methods in industries.
 3

DEVELOPMENT

THE NEW COST PARADIGMS:

The Traditional Costing system selects as fundamental bases for the proration of costs
the volumes, machine hours, man hours or units produced, which are considered in this
traditional method as the original cause of the costs that must be charged to the products;
but these bases do not accurately reflect the resources consumed by the different
products or processes.

The Activity Based Costing methodology is based on the fact that a company to produce
products or services needs to carry out activities, which consume resources, so first the
activities are costed and then the cost of the activities. It is assigned to the different cost
objects (product, services, customer groups and regions, processes, etc.) that demand
these activities; In this way, much greater precision is achieved in the determination of
costs and the corresponding profitability.
 4

ABC COSTING METHOD:

ABC costing provides a methodology to track the costs of resources to specific activities,
and through these, cost processes, products, services, customers, suppliers and
distribution channels, and thus determine their profitability. In this sense, it helps
executives identify the costs and results of possible business alternatives, simulating
operational changes for effective decision making.

ABC costing is a strategic tool for decision making because it allows the company to:

 Know where you earn or lose money

 Understand how the cost of processes impacts profits
 Know where, how and why resources have not been well used

The process of assigning costs to activities and cost objects is supported by criteria
called "drivers" or cost generators, which explain the cause and effect relationship
between these elements. Therefore, the key concepts of ABC are :

1. Resources: Economic elements used or applied in carrying out activities. They

are reflected in the accounting of companies through concepts of expenses and
costs such as salaries, benefits, electricity, advertising, commissions, materials,
etc.

2. Activities: These are the tasks that an organization performs to produce,

distribute, market, charge the agreed price, etc., of a product or service. They
have the following characteristics:

 They suppose or give rise to specific knowledge or doing.

 They use a series of physical, human, and technological resources.
 They are homogeneous tasks from the point of view of their behavior, cost and
execution.
 They allow you to have a result (product).
 5

 They are focused on satisfying the needs of a specific client that can be internal
or external.

Examples of common activities in a company:

 Commissioning of machinery.
 Quality inspection.
 Reception of materials.
 Stock movement.
 Driving force consumption.
 Machine hours.
 Computing hours.
 Engineering changes.
3. Cost Objects : It is the reason for carrying out an activity. Includes
products/services, clients, projects, contracts, geographic areas, etc.

4. Cost generators or inducers : These are the factors or criteria for assigning
costs. Choosing a correct generator requires understanding the relationships
between resources, activities and cost objects.

 Resource Generators : These are the criteria or bases used to transfer costs
from resources to activities.

 Activity Generators: are the criteria used to transfer costs from an activity to
one or more cost objects. It is selected by considering how the activity is related
to the cost object and how the relationship can be quantified.

Como el número de la actividad mide los incrementos utilizados, el ABC

permite captar mejor los factores económicos subyacentes a la operación de
la empresa, lo que permite obtener costos de productos más exactos

PRINCIPLES OF THE ABC METHOD

The two fundamental ideas from which the methodology in question is based are:

1. Products do not consume costs but activities.

2. Activities are those that really consume resources. Costs are the quantified
expression of the resources consumed by activities.

It follows, first of all, that cost management should focus mainly on the activities that give
rise to them, leading to their optimal management generating a reduction in the costs
derived from them.
 6

Secondly, a cause/effect relationship must be established between the activities and the
products or services. It follows that the greater the consumption of activities corresponds
to the allocation of greater costs and vice versa.

Finally, and thirdly, we have the greatest objectivity in the allocation of costs, resulting
from knowing the resources consumed in each activity. Therefore , the imputation to the
product or service will be based on the activities that have been produced or consumed.

The ABC grants the possibility of analyzing the information not about the costs that have
been attributed based on a certain criterion, but to detect those unnecessary works that
should be the source of reduction or even elimination.

ADVANTAGES and DISADVANTAGES OF USING THE ABC METHOD

 ADVANTAGES OF USING THE ABC METHOD

We can summarize the advantages and benefits of applying ABC in the following points:

1. It allows research into the causes that give rise to the activities and, in turn, the
costs.
2. It does not pose difficulties for implementation in any type of organization.
3. It is compatible with the Total Costs method, or Full Costing , since in fact it is
based on the calculation of the total cost.
4. It allows its adaptation to both historical costs and standard costs.
5. Facilitates the elimination of those activities that do not generate value.
6. It allows the “a priori” calculation of activities that you wish to incorporate, as well
as the impact that they would produce if carried out.
7. It facilitates strategic decision-making, since it reveals the real level of
competitiveness of the company, as well as the possibilities of success or failure
compared to the competition.

In relation to point 5, it should be noted that multiple Western companies that audit their
activities have determined that between 50 and 70 percent of these activities are not
valued by their clients.

Este dato refleja la importancia que tiene el análisis de las actividades y el

valor agregado que las mismas generan.

 DISADVANTAGES OF USING THE ABC MODEL:

1. They focus excessive attention on cost management and optimization, neglecting

the systemic vision of the organization.
2. It requires greater effort and training to achieve adequate implementation.
3. The choice of generators is at the discretion, it takes a lot of experience to
determine them.
 7

4. ABC is a historical cost system, the excessive variability of future costs makes it
difficult to manage.
5. It consumes a large part of the resources in the design and implementation
phases.
6. Even if the costing is more precise, it is never possible to obtain the exact cost of
the products because there are effects or expenses incurred at the last minute
that cannot be divided appropriately.

 EXAMPLE:

Suppose that a customer A orders 10 units of a product worth S/.10 and another
customer B orders 100 units of the same product. The total cost of the ACTIVITY:
“RECEIVE ORDERS” is S/.400, the work for the person who receives these orders is
EXACTLY THE SAME in both cases. Traditional costing DOES NOT take this fact into
account. The ABC method does and the Cost/Unit result is very DIFFERENT.

PHASES TO IMPLEMENT THE ABC

The ABC costing model is a model that is based on the grouping into cost centers that
make up a value sequence of the products and services of the company's productive
activity. It focuses its efforts on the reasoning of adequately managing the activities that
cause costs and that are related through their consumption to the cost of the products.
The most important thing is to know the generation of costs to obtain the greatest
possible benefit from them, minimizing all factors that do not add value.

The activities are related in sets that form the total of the production processes, which
are ordered sequentially and simultaneously, in order to obtain the different cost states
that accumulate in production and the value that they add to each process.

Processes are defined as “The entire rational organization of facilities, machinery,

labor, raw materials, energy and procedures to achieve the final result . ” In the
 8

studies carried out on ABC, activities and processes are separated or described; the
most common are listed below:

Activities

 Homologize products
 Negotiate prices
 Classify suppliers
 Receive materials
 Plan production
 Expedite orders
 Check in
 Charge
 Design new products, etc.

Processes

 Shopping
 Sales
 Finance
 Staff
 Planning
 Research and development, etc.

To be operational from the point of view of efficiency, activities and processes need to
be homogeneous to measure them in operational functions of the products.

STAGES OF THE ABC COSTING SYSTEM

ABC costing system is based on two stages, the first loads overhead costs to activity-
based cost pools and the second uses a series of ratios based on cost drivers to assign
costs from the pools to product lines.

1. ABC INSTRUMENTATION

Having identified and established the activities, processes and factors that measure the
transformation of the factors, it is necessary to apply an operational cost phase to the
model since it is known that every activity and process consumes a cost, as well as the
products and services. consume an activity. In this model, costs directly affect raw
materials and labor compared to final products, distributing the rest among activities,
since on the one hand resources are consumed and on the other hand they are used to
obtain outputs.

As the activities have a direct relationship with the products, with the activity-based cost
system it is possible to transform the indirect costs with respect to the products into direct
 9

costs with respect to the activities, which leads to a more effective form of transformation.
of the cost of factors in the cost of products and services.

After carrying out the previous steps, the costs of the activities must be grouped
according to their level of causality for obtaining the products and services into:

 Activities at the internal level of the product (Unit level)

 Activities related to production orders (Batch - level)
 Activities related to product maintenance (Product level)
 Activities related to the maintenance of production (Product - sustaining)
 Activities related to research and development (Facility-level)
 Activities aimed at the continuous customer support process (Customers - level)

2. ALLOCATION OF COSTS

Activity-Based Costing (ABC) implies that each product must absorb not only direct
operating costs, but also the costs of operational and administrative support activities.
These costs are considered indirect and are assigned to products according to their
direct consumption in cost-generating activities. If the activities are directly related to the
production of products, they are treated as variable indirect costs and are allocated
according to the direct consumption of the product in the activity.

In the case of work orders, some costs are generated at specific times in the production
process and are assigned directly to the goods produced as a higher value of the work
order. The ABC system classifies costs into operational and support activities, and then
redistributes support costs and expenses to products according to the needs of the
production process.

Redistribution is carried out in two stages: direct allocation of costs and expenses, and
allocation of supporting costs and expenses to final products. ABC seeks greater
precision by first assigning costs to activities and then to products, using a cause-effect
approach. STAGES FOR ALLOCATION:

First Stage: In this stage. Costs are classified into a set of general costs or pool for
which variations can be explained by a single cost - driver.

Second Stage: In this stage, the per unit cost of each pool is assigned to the products.
It is done using the pool ratio calculated in the first stage and the measurement of the
assembly of resources consumed by each product. The calculation of the costs assigned
by each cost pool to each product is:

General costs applied = Pool ratios * Cost - driver units used

The total overhead costs allocated in this way are divided by the number of units
produced. The result is the unit cost of general production costs. Adding this cost to the
unit cost for materials and direct labor, the unit cost of production is obtained.
 10

A) ALLOCATION FACTORS

The allocation factors are directly related to the stages compared to their design and
operation. These factors are the choice of cost pools, the selection of means of
distributing overhead costs to the cost pools, and the choice of a cost - drivers for each
cost pool. These factors represent the basic mechanism of an ABC system.

MAIN ELEMENTS OF THE ABC MODEL

CONCETUAL SCHEME OF THE ABC MODEL

The ABC model uses a two-stage process to assign costs to objects:

1. Resources are assigned to activities according to their use.

2. The costs of activities are assigned to products or customers.

PRACTICAL SCHEME OF THE ABC MODEL

STEP 1: List of resources (Manufacturer)

The cost of the company's resources is obtained from the general accounting data.
Subsequently, those cost concepts with homogeneous behavior are grouped into cost
bags.

STEP 2: List of resources (Distributor)

Apply the same procedure described for the manufacturer in step 1.

STEP 3: Resource allocation factors

Given that the activities carried out by both the manufacturer and the distributor consume
company resources, it is necessary to identify the factors that measure said use of
resources, to know the cost of the activities.

STEP 4: Calculation of the cost of activities/sub-activities (critical)

First of all, we must point out those critical activities and sub-activities that are carried
out by the company.

STEP 5: Calculation of the cost of activities/sub-activities (on resource utilization)

Next, based on the use of each resource, what part of its cost is allocated to the different
sub-activities is calculated.

STEP 6: Calculation of the total cost of the activities/sub-activities

The cost of each sub-activity is obtained by adding the cost of each and every one of the
resources used to carry it out.

STEP 7: Identification of cost drivers

 11

The transfer of the cost of the activities to the cost objects is carried out through the use
of cost generators. When two or more activities, or several sub-activities within the same
activity, have the same cost generator, it is advisable to group them to simplify the
calculation process.

STEP 8: Calculation of the cost of products (Manufacturer)

The way to obtain the cost of products with the ABC model is through knowledge of the
activities that are required for their manufacturing or distribution.

STEP 9: Calculation of the cost of products (Distributor)

The way to obtain the cost of products with the ABC model through knowledge of the
activities required to obtain or distribute them.

STEP 10: Calculation of the cost of products

The cost attributable to each product will result from the aggregation of the cost of the
activities necessary to produce or distribute it, depending on whether we consider the
activity of a manufacturer or that of a distributor/logistics operator.

STEP 11: Cost allocation according to traditional accounting

Traditional accounting has to allocate costs based on more or less arbitrary criteria, such
as sales volume, percentage distribution, etc.

STEP 12: Comparative profitability analysis: ABC vs. Traditional Accounting

The profitability analysis of the products considering the costs provided by an ABC
system yields very different results than those obtained using traditional methods. For
example: the manufacturer loses a lot of money with product <<C>> and its most
profitable product is <<B>>, while accounting across the entire range of products,
consequently, products that are subsidiaries by others and, the decisions are wrong
based on profitability.

IDENTIFICATION OF ACTIVITIES

In the ABC model, the process of identifying activities begins with the appropriate
location of those that add value in the production processes. After specifying and
grouping these activities, work units, cost transmitters and transformation relationships
are established to measure the productivity of inputs and efficiently transmit costs to
outputs.

The detailed study of the sequence of activities and processes, along with their
associated costs, provides the organization's management with valuable information
about the critical points of the value chain. This facilitates the implementation of
continuous improvements in the value creation process. Identifying the causal factors of
 12

activities allows us to apply efficiency drivers, which are key elements to improve quality,
reduce deadlines, optimize core activities and reduce costs.

PRODUCT COSTING BY ACTIVITIES: GENERAL DESCRIPTION

The main difference lies in the nature and number of cost bases used, with ABC being
more precise by taking advantage of cause-effect relationships. It can be tested using
cost formulas for each activity and applying bases with a high reliability index. ABC often
uses more bases than the traditional system, providing greater accuracy in product
costing.

From the management perspective, the ABC system not only provides accurate
information on the cost of products, but also detailed information on the cost and
performance of activities and resources. This allows managers to make more informed
decisions, focusing on activities that can generate cost savings and improving
organizational efficiency. In short, ABC goes beyond simply assigning costs to products,
providing a more complete view of the organization's performance and efficiency.

Figure: Activity-based costing: Cost distribution in 2 stages

 13

The ability of an ABC system to provide strategic elements for judgment and process
improvement is of utmost importance and must be considered from an accounting point
of view.

ADVANTAGES OF ABC OVER TRADITIONAL SYSTEMS

As an alternative solution to the problems posed by traditional costing methods, the so-
called ACTIVITY-BASED COSTING emerged. The allocation of costs by this method
also occurs in two stages where the first also consists of accumulating the CIF by cost
centers with the difference that not only are more centers used than in traditional
methods but they take another name: they are called ACTIVITIES. In the second stage,
costs are assigned to jobs according to the number of activities required to be completed.
The activity cost accounting approach to cost management divides the business into
activities. An activity describes what the company does, the way time is consumed and
the outputs of the processes. The main function of an activity is to convert RESOURCES
(materials, labor, technology) into outputs.

Historically, costs have been charged to products like this:

Actually, in order to produce a product, some costs (RESOURCES) are needed, but
these resources are not consumed by the products but rather by activities that are carried
out to be able to produce them. The product consumes ACTIVITIES and the activities in
turn consume resources. It should be noted that under this system, products are not only
susceptible to costing, but also everything that consumes activities.

All the resources of a company are focused on producing something, then all the
resources must be assigned to that something and not only what is related to production.

PRACTICAL CASE SOLVED WITH ABC COSTING

CASE Nº 01: ABC COSTING, DETERMINATION OF THE PRODUCT COST

MADERERA WALYS SA has identified the activity centers to which manufacturing costs
are assigned. The amounts for this cost pool and its respective cost drivers for the year
20X6 are as follows:

Activity Centers Costs (S/.) Cost Drivers

Public services 300000 60000 machine hours
Equipment preparation
273000 780 enlistments
(readiness)
Material handling 640000 1600000 pounds of metal

PRODUCTS
 14

TO b c
direct costs S/. 80000 S/. 80000 S/. 90000
Machine hours 30000 10000 20000
Number of enlistments 130 380 270
Pounds of materials 500000 300000 800000
Number of units produced 40000 20000 60000
Direct labor hours 32000 18000 50000

A. Determine the unit cost of each product using the appropriate cost drivers for the
indirect manufacturing costs of each item.
B. Calculate the unit cost of each product using conventional traditional costing.
C. Determine the selling price of each product based on the ABC cost system and
traditional costing.

Additional Data:

Before installing the ABC costing system, the company used a conventional costing
system and assigned manufacturing overhead costs to products using direct labor hours.
Product prices are estimated based on 120% of their cost.

DEVELOPMENT:

A. We calculate the unit cost of each product using the appropriate cost drivers for
the indirect manufacturing costs of each item.

Public service Material Material handling

preparation
Total Activity 300000 273000 640000
Cost
Total Base 60000 780 1600000
Activity
Activity Index 5 350 0.40

ABC COSTING SYSTEM

Activity Index Activity Cost

Activity Usage
(S/.) (S/.)
PRODUCTS A
direct costs 80000
Indirect manufacturing
costs
 15

Public services 30000 5 150000

Equipment preparation
130 350 45500
(readiness)
Material handling 500000 0.40 200000
Activity cost 475500
Units produced 40000
Unit cost 11.89

Activity Index Activity Cost

Activity Usage
(S/.) (S/.)
PRODUCTS B
direct costs 80000
Indirect manufacturing
costs
Public services 10000 5 50000
Equipment preparation
380 350 133000
(readiness)
Material handling 300000 0.40 120000
Activity cost 383000
Units produced 20000
Unit cost 19.15

Activity Index
Activity Usage Activity Cost (S/.)
(S/.)
C PRODUCTS
direct costs 90000
Indirect manufacturing
costs
Public services 20000 5 100000
Equipment preparation
270 350 94500
(readiness)
Material handling 800000 0.40 320000
Activity cost 604500
Units produced 60000
Unit cost 10.08

B. Calculation of the unit cost of each product using conventional traditional costing.

TRADITIONAL COSTING SYSTEM

PRODUCTS
 16

TO b c
direct costs 80000 80000 90000
Indirect manufacturing costs
Product A 388160
(1213000/100000)*32000
Product B 218340
(1213000/100000)*32000
Product C 605500
(1213000/100000)*32000
Total cost 468160 298340 696500
Units produced 40000 20000 60000
Cost per unit 11.70 14.92 11.61

C. Determination of the price of each product based on the ABC cost system and
traditional cost

Price ABC SYSTEM TRADITIONAL SYSTEM

versus
Product cost Sale price Product Cost Sale price
Cost
PRODUCT A 120% 11.89 26.15 11.70 25.75

PRODUCT B 120% 19.15 42.13 14.92 32.82

PRODUCT C 120% 10.08 22.17 11.61 25.54

RECOMMENDATIONS:

1. Identify unnecessary activities, that is, those that are not essential for the
operation of the organization or those not appreciated by customers.

2. Analyze significant activities to detect areas of opportunity to achieve

improvements.

3. Compare similar activities with other companies or areas of the same entity.

CONCLUSIONS

1. It must be taken into account that the ABC is established with a management
philosophy, in which all the individuals that make up the company must
participate, from the operational to the strategic, since by having all the productive
sectors covered, it takes the company to achieve COMPETITIVENESS
compared to entities that carry out the same activity.

2. ABC efficiently serves to obtain information about processes and activities,

improving the efficiency of operations and facilitating the flow of information for
decision making. The ABC method made a very important contribution to
 17

Management Accounting, it should not be considered only as a cost system, but

as company management.

3. The ABC concept involves more process personnel, giving rise to a greater link
to activities between departments. Although it should be noted that all company
employees, whether accountants or not, must know the system.

4. This cost system is applicable to different types of companies (productive and

service companies).

5. They allow costs to be calculated more accurately.

REFERENCES

 Cost accounting : A managerial approach. Authors : Charles T. Horngren,

George Foster, Srikant M. Datar . Edition 12. Pearson Education Publishing,
2007. Pages: 141-153

 Activity-based costing. Available at:

http://www.loscostos.info/costeoabc.html

 ABC, ABM, ABB COSTS - Tools to increase profitability and business

competitiveness. Author: MrioApaza Meza. Edition 2006-lima. Pages: 67-343
18