Hailey College of Banking & Finance

Management Accounting & Decision Making

Instructor: Iftikhar Ahmad
ACTIVITY BASED COSTING
Product costs include direct materials, direct labor, and overhead. It’s easy to determine the direct costs
for an individual product. They’re direct materials, direct labor, and variable overhead and increase each
time one more unit is produced. However, the indirect costs, fixed overhead, are much harder to assign
to individual products. In order to make good decisions on how to price products, whether to accept
special orders, whether to keep or drop a product line, etc., we need to have as accurate product costs as
possible.

The traditional method to allocate overhead to products was to use a pre-determined overhead rate
(POR) calculated with a driver denominator based on a volume-based activity such as direct labor hours
or machine hours, or even units produced. If you make only one kind of product, it really doesn’t matter
which of those you use because every unit produced will have the same amount of overhead allocated to
it. It’s rather like spreading peanut butter over all the units; they all get the same amount.

However, if you start producing many different kinds of products with varying degrees of complexity,
the one-size-fits-all method of allocating overhead can lead to greatly distorted costs of products. We
need another way of allocating overhead costs—hence, activity based costing (ABC). Activity-Based
Costing (ABC) is a cost accounting methodology that assigns costs to activities based on their use of
resources and assigns those costs to products or services based on their actual consumption of those
activities. ABC provides a more accurate understanding of the true cost of producing a product or
providing a service by identifying all of the costs associated with each activity involved in the
production or service process. This approach allows companies to better allocate costs and make
informed decisions regarding pricing, product mix, and process improvement. ABC can be particularly
useful for companies with complex production processes or diverse product lines where traditional
costing methods may not accurately reflect the true cost of production.

Over the past few years, we have come to realize that products don’t consume costs. Instead, they use
activities. ABC uses these activities to allocate overhead costs.

 The first step in ABC is to take the total pool of overhead costs and divide it into smaller pools
whose costs are incurred by common activities. There are four basic categories of activities:
(1) Unit-level activities occur each time one more unit of product it produced. Activities in this
category would include machine operation costs—utilities to operate the machines, maintenance,
or depreciation (units of production method).
(2) Batch-level activities occur each time a batch is produced, whether that batch is a few items
(a car) or thousands or items (a press run of one textbook). Activities in this category would
include setups, movement of materials, purchase orders, or number of inspections.
(3) Product-line activities occur for every type of product made. Activities in this category would
include design changes, advertisement of a product, dedicated product managers, or warehousing
for each product line.
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(4) Facility-support activities occur in order to have the capacity to produce. These are more
administrative, or general, in nature. These activities include providing computer networks,
accounting, property taxes, plant security, and human resource departments.

 Costs of activities in the unit-level, batch-level, and product-line categories can be allocated to
products based on the products’ consumption of those activities. On the other hand, facility-
support activities are not allocated to the products because their incurrence can’t be associated
with any particular product. These costs are common to all products.

 Once you have separated the overhead costs into cost pools associated with activities, look for an
appropriate cost driver to allocate the costs. Divide each pool’s costs by its appropriate cost
driver to find a POR. You may end up with 4-20 different cost pools and rates. Having too few
probably won’t give you as much information as you’d like. Having too many can also be
counterproductive—because you have too many to count, calculate, and pay attention to.

 Once you have your various POR’s, multiply each rate by the number of activities the products
use. Match the activity used to create the POR (the denominator activity) to the activity actually
used. Then total all the allocated costs to find the total OH for each product.

 Often we find that when one traditional volume-based driver is used to allocate overhead costs,
the high-volume less complicated product carries more of the costs than it truly has caused and is
cross-subsidizing (helping pay for the costs of) the low-volume, more customized products. Once
the costs are more accurately allocated, we find that we aren’t charging enough for the low-
volume items while we might be charging too much for our high-volume items. While we may
have thought our competitors were under-cutting our prices for the high volume items, in truth
we were more likely overcharging for ours. In essence, ABC allows us to get more accurate
information on production costs. With that information, we can make better decisions.

An activity-based costing (ABC) chart is a graphical representation of the costs associated with a
product or service using the activity-based costing methodology. It helps to identify and analyze the
various cost drivers associated with each activity that goes into producing a product or service. Here
is an example of an ABC chart:

Activity Cost Driver

Product design Number of design changes
Materials handling Number of material orders
Machine setup Number of machine setups
Assembly Number of units assembled
Quality inspection Number of inspections
Packaging Number of units packaged
Shipping Number of units shipped

In this example, the activity-based costing chart shows the costs associated with producing a
particular product, broken down by activity. The cost driver is the factor that influences the cost of
each activity, such as the number of design changes, material orders, machine setups, units
assembled, inspections, units packaged, and units shipped. By understanding the cost drivers for
each activity, a company can better allocate its resources and improve its profitability.
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Practice Questions

Question 1. Stow-n-Go makes standard and specialty briefcases. Standard briefcases are made from
leather lined with fabric and are a high-quality item that has sold well for many years. Standard
briefcases sell for $36 per unit. Last year the company expanded their product line to produce specialty
briefcases. These are made from fine synthetic materials, imprinted with the buyer’s name. Specialty
briefcases sell for $40 per unit. Most of the cutting and stitching is done by automated machines. These
machines are used to a much lesser degree on standard briefcases. The following are the current DM and
DL costs for the briefcases:

Standard Specialty
Units produced each month 10,000 2,500
Direct materials $20 $17.50
Direct labor 0.5 hr @ $12 $6 0.25 hr @ $12 $ 3.00

Currently, overhead is applied to products based on direct labor hours. They estimate total overhead
costs to be $101,250 and that a total of 5,625 direct labor hours will be worked.

The company is considering using activity-based costing. The following information has been gathered:

Activity Cost Pool Activity Measure Estimated Expected Activity

OH Cost
Standard Specialty Total
Purchasing Number of orders $12,000 82 118 200
Material handling Number of receipts 15,000 116 184 300
Production orders and setup Setup hours 20,250 50 200 250
Inspection Inspection hours 16,000 300 500 800
Frame assembly Assembly hours 8,000 800 800 1,600
Machine related Machine hours 30,000 5,000 5,000
$101,250

Required:
a. What is the unit cost and gross profit for each product using the current DLH to apply overhead?
b. What is the unit cost and gross profit for each product using ABC to apply overhead?
c. What are your recommendations?

Question 2.
Shah, Inc. makes three types of sunglasses: Nerds, Stars and Fashions. Shah, Inc. presently applies
overhead using a pre-determined rate based on direct labor hours. A consultant recommended that Shah,
Inc. switch to activity-based costing. Management decided to try ABC and identified the following
activities, cost drivers and estimated costs for year 2 for each activity center.
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Activity Recommended cost Estimated

driver Costs (Rs.) Cost driver units
Production setup Number of production runs 30,000 100
Order processing Number of orders 50,000 200
Materials handling Pounds of materials used 20,000 8,000
Equipment depreciation Machine hours 60,000 10,000
and maintenance
Quality management Number of inspections 50,000 440
Packing and shipping Number of units shipped 40,000 20,000
Total estimated overhead

The company estimated 5,000 labor hours would be worked in year 2. assume the following activities
occurred in February of year 2:

Nerds Stars Fashions

Number of units produced 1,000 units 500 units 400 units
Direct materials costs Rs. 4000 Rs. 2500 Rs. 2000
Direct labor hours 200 hours 150 hours 87 hours
Number of orders 8 orders 8 orders 4 orders
Number of production runs 1 runs 2 runs 6 runs
Pounds of material 400 pounds 200 pounds 200 pounds
Machine hours 400 hours 200 hours 200 hours
Number of inspections 10 inspections 10 inspections 10 inspections
Units shipped 1000 units 500 units 300 units
Direct labor costs are Rs. 20 per hour.
Required:
1. Compute an overhead allocation rate for each of the cost drivers recommended by the consultant
and for direct labor.
2. Compute the production costs for each product for February using the cost drivers recommended
by the consultant.

Question 3.
Asad Corporation manufactures a variety of special packaging boxes use in the pharmaceutical industry.
The company’s Lahore plant is semi-automated, but the special nature of the boxes requires some
manual labor, the controller has chosen the following activity cost pools, cost drivers, and pool rates for
the Lahore plant’s product costing system.

Activity cost pool Overhead Cost driver Budgeted level

cost (Rs.) for cost driver
Purchasing storage and material handling 1000,000 Raw material costs Rs. 2500,000
Engineering and product design 500,000 Hours in the design 12,500 hours
department
Machine setup costs 350,000 Production runs 2500 runs
Machine depreciation and maintenance 1500,000 Machine hours 375,000 hours
Factory depreciation, taxes, insurance and 1000,000 Machine hours 375,000 hours
utilities
Other manufacturing overhead costs 750,000 Machine hours 375,000 hours
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Two recent production orders had the following requirements.

5,000 units of Box-R220

Director labor hours: 65 hours
Raw material cost: Rs. 75,000
Hours in design department: 75 hours
Production runs: 15 runs
Machine hours 75 hours
Required:
1. Calculated the pool rates each activity.
2. Compute the total overhead that should be assigned to the above production orders.

Question 4
A company manufactures two products, P and Q. Monthly data relating to production and sales are as
follows.
Product P Product Q
Direct material cost per unit Rs. 15 Rs. 20
Direct labor hours per unit 1 hour 2 hour
Direct labor cost per unit Rs. 20 Rs. 40
Sales demand 100 units 950 units

Production overheads are Rs. 200,000 each month and are absorbed on a direct labor hour basis. The
overhead absorption rate is Rs. 100 per direct labor hour.

The management accountant has produced a report on the potential value of ABC as a preferred
alternative to the traditional absorption costing system and has found that there are five main areas of
activity that can be said to consume overhead costs.
The management accountant has gathered the following monthly information:

Activity Total cost Cost driver Total Product Product

Rs. Number P
Q
Setting up 20,000 Number of setups 4 1 3
Machining 80,000 Machine hours 2,000 100 1,900
Order handling 20,000 Number of orders 4 1 3
Quality control 20,000 Number inspections 5 1 4
Engineering 60,000 Engineering hours 1,000 500 500

Required:
1. Calculate the costs, in total and per unit, for product P and product Q, using ABC.
2. Calculate the costs, in total and per unit, for product P and product Q, using plant-wide rate.
3. Explain why these two product-costing systems result in such widely differing costs. Which
system do you recommend? Why?
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Question 5.

Rapid City Radiology, Inc. manufactures chemicals used in radiological systems. The controller has
established the following activity cost pools and drivers.

Budgeted
Overhead Budgeted Level
Activity Cost Pool Cost (Rs) Cost Driver for Cost Driver

Machine setups 1,000,000 Number of setups 250

Material handling 300,000 weight of raw material 75,000 Ib.
Hazardous waste 100,000 weight of hazardous chemical used 10,000 Ib.

Quality control 300,000 Number of inspections 2,000

Other overheads costs 800,000 Machine hours 40,000
Total 2,500,000

An order for 1,000 boxes of radiological development chemicals has the following production
requirements.

Machine setups 6 setups.

Raw material 9,000 pounds
Hazardous material 9,000 pounds
Inspections 2,100 inspections
Machine hours 500 machine hour

Required:
1. Compute the total overhead that should be assigned to the development-chemical order using
ABC.
2. What is the overhead cost per box of chemicals using ABC?
3. Suppose Rapid City Radiology, Inc. were to use a single predetermined overhead rate based on
machine hours. Compute the rate per hour.
4. Under the approach in requirement (3), how much overhead would be assigned to the
development-chemical order?
a. In total.
b. Per box of chemicals.
5. Explain why these two product-costing system result in such widely differing costs. Which
system do you recommend? Why?

Question 6
National Bank of Pakistan is examining the profitability of its Premier Account, a combined savings and
checking account. Depositors receive 7% annual interest rate on their average deposit. NBP earns an
interest rate spread of 3% (the difference between the rate at which it lends money and the rate it pays
depositors) by lending money for home loan purposes at 10%. Thus, NBP will gain Rs.60 on interest
spread if depositor has given an average Premier Account balance of Rs.2,000’i.e. Rs.2,000*30%=
Rs.60.
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The Premier Account allows depositors unlimited use of services such as deposits, withdrawals,
checking accounts, and foreign currency drafts. Depositors with Premier Account balances of Rs.1,000
or more receive unlimited free use of services. Depositors with minimum balances of less than Rs.1,000
pay Rs.20 per month service fee for their Premier Account.

NBP recently conducted an activity-based costing study of its services. It assessed the following costs
for six individual services. The use of these services in the current year by three customers is as follows:

Particulars Activity-based Cost Ali Waqar Hassan

Per transaction (Rs)

Deposits/Withdrawals with tellers 2.50 40 50 5

Deposits/Withdrawals at ATM 0.80 10 20 16
Prearranged monthly Deposits/Withdrawals 0.50 0 12 60
Written Bank checks 8.00 9 3 02
Foreign currency drafts 12.00 4 1 06
Inquiries about account balances 1.50 10 18 09
Average Premier Account balances for the current year Rs.1,100 Rs.800 Rs.25,000

ASSUME Ali and Hassan always maintain a balance above Rs.1,000, whereas Waqar has a balance
below Rs.1,000.

Required:
1. Compute the current year profitability of Ali, Waqar and Hassan’s Premier Accounts at NBP.
2. What evidence is there of cross-subsidization among the three Premier Accounts?

Question 7
Moubeen, Inc. manufactures two types of medical devices, Device A and Device B, and applies
overhead on the basis of direct-labor hours. Anticipated overhead and direct-labor time for the upcoming
accounting period are Rs. 710,000 and 20,000 hours, respectively. Information about the company’s
products follows.

Device A :
Estimated production volume, 2,500 units
Direct-material cost, Rs. 30 per unit
Direct labor per unit, 3 hours at Rs. 15 per hour
Device B:
Estimated production volume, 3,125 units
Direct-material cost, Rs. 45 per unit
Direct labor per unit, 4 hours at Rs. 15 per hour

Moubeen’s overhead of Rs. 710,000 can be identified with three major activities: order processing
(Rs.120,000), machine processing (Rs. 500,000), and product inspection
(Rs.90,000). These activities are driven by number of orders processed, machine hours worked, and
inspection hours, respectively. Data relevant to these activities follow.

Orders Machine Hour Inspection

Processed Worked Hours
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Device A 350 23,000 4,000
Device B 250 27,000 11,000
Total 600 50,000 15,000

Management is very concerned about declining profitability despite a healthy increase in sales volume.
The decrease in income is especially puzzling because the company recently undertook a massive plant
renovation during which new, highly automated machinery was installed-machinery that was expected
to produce significant operating efficiencies.

Required:
1. Assuming use of direct-labor hours to apply overhead to production, compute the unit
manufacturing costs of the Device A and Device B if the expected manufacturing volume is
attained.
2. Assuming activity-based costing, compute the unit manufacturing costs of the Device A and
Device B products if the expected manufacturing volume is attained.