Traditional Costing Systems

• Product Costs
– Direct labor
– Direct materials
– Factory Overhead
• Period Costs
– Administrative expense
– Sales expense
Appear on the income
statement when
goods are sold, prior
to that time they are
stored on the balance
sheet as inventory.
Appear on the income
statement in the
period incurred.
Traditional Costing Systems
• Product Costs
– Direct labor
– Direct materials
– Factory Overhead
• Period Costs
– Administrative expense
– Sales expense
Direct labor and direct
materials are easy to
trace to products.
The problem comes
with factory
Traditional Costing Systems
• Typically used one rate to allocate overhead to
• This rate was often based on direct labor
dollars or direct labor hours.
• This made sense, as direct labor was a major
cost driver in early manufacturing plants.
Problems with Traditional Costing
• Manufacturing processes and the products
they produce are now more complex.
• This results in over-costing or under-costing.
– Complex products are not allocated an adequate
amount of overhead costs.
– Simple products get too much.
Today’s Manufacturing Plants
• Are more complex
• Are often automated
• Often make more than one product
• Use proportionately smaller amount of direct
• making direct labor a poor allocation base for
factory overhead.
When the manufacturing process is
more complex:
• Then multiple allocation bases should be
used to allocate overhead expense.
• In such situations, managers need to
consider using activity based costing


Activity Based costing is recent development in Cost
Accounting which attempts to absorb overheads into
product cost on more realistic basis.
ABC focusses on activities as fundamental cost
 An activity is a process or procedure that causes
work. In relation to ABC, we only mean activities of
support or service departments, such as material
handling, quality testing, inspection etc. Activities
consume resources.
 ABC differ from traditional system only in respect of
allocation of overheads or indirect cost.

Volume based allocation bases e.g
Labour-hours, machine hours
Cost Divers are used as
allocation bases e.g, Set-up
hours for set-up cost;
inspection hours for
allocating inspection cost;
testing hours for allocating
quality cost and so on..
Cost is allocated based on drivers .Cost drivers are factors
or transaction that are significant determinants of costs.
For e.g, purchasing departments cost depends on number of
purchase order placed, costs of warehousing depends upon
number of items in stock, machine set-up cost depends on
number of set-up per periods etc.
Machine set-up Number of production runs
Purchasing material Number of orders placed
Warehousing Items in stock
Material handling Number of parts
Inspection Inspection per item
packing Number of packing order
 In ABC, a cause and effect relationship is established.
Cost are allocated based on demands on resources.
Measurement of
Consumption of resources
ABC focusses on activities for cost management.
Traditional system focusses on cost – the effect rather
than on the cause –the activity
ABC Steps
• Overhead cost drivers are determined.
• Activity cost pools are created.
– A activity cost pool is a pool of individual costs
that all have the same cost driver.
• All overhead costs are then allocated to one of
the activity cost pools.
ABC Steps:
• An overhead rate is then calculated for each
cost pool using the following formula:
– Costs in activity cost pool/base
– The base is, of course, the cost driver
• Overhead costs are then allocated to each
product according to how much of each base
the product uses.
• Let’s illustrate the concept of activity based
costing by looking at two common
manufacturing activities: (1) the setting up of
a production machine for running batches of
products, and (2) the actual production of the
units of product.

• We will assume that a company has annual
manufacturing overhead costs of
$2,000,000—of which $200,000 is directly
involved in setting up the production
machines. During the year the company
expects to perform 400 machine setups. Let’s
also assume that the batch sizes vary
considerably, but the setup efforts for each
machine are similar.
• The cost per setup is calculated to be $500
($200,000 of cost per year divided by 400
setups per year). Under activity based costing,
$200,000 of the overhead will be viewed as
a batch-level cost. This means that $200,000
will first be allocated to batches of products to
be manufactured (referred to as a Stage 1
allocation), and then be assigned to the units
of product in each batch (referred to as Stage
2 allocation).
• For example, if Batch X consists of 5,000 units
of product, the setup cost per unit is $0.10
($500 divided by 5,000 units). If Batch Y is
50,000 units, the cost per unit for setup will
be $0.01 ($500 divided by 50,000 units). For
simplicity, let’s assume that the remaining
$1,800,000 of manufacturing overhead is
caused by the production activities that
correlate with the company’s 100,000
machine hours.
For our simple two-activity example, let's see how the rates for allocating the
manufacturing overhead would look with activity based costing and without activity
based costing:
Next, let's see what impact these different allocation techniques and
overhead rates would have on the per unit cost of a specific unit of output.
Assume that a company manufactures a batch of 5,000 units and it produces
50 units per machine hour, here is how the cost assigned to the units with
activity based costing and without activity based costing compares
If a company manufactures a batch of 50,000 units and
produces 50 units per machine hour, here is how the
cost assigned to the units with ABC and without ABC
• As the tables above illustrate, with activity based
costing the cost per unit decreases from $0.46 to
$0.37 because the cost of the setup activity is spread
over 50,000 units instead of 5,000 units.
• Without ABC, the cost per unit is $0.40 regardless of
the number of units in each batch.
• If companies base their selling prices on costs, a
company not using an ABC approach might lose the
large batch work to a competitor who bids a lower
price based on the lower, more accurate overhead
cost of $0.37.
• It’s also possible that a company not using
ABC may find itself being the low bidder for
manufacturing small batches of product, since
its $0.40 is lower than the ABC model of $0.46
for a batch size of 5,000 units.
• With its bid price based on manufacturing
overhead of $0.40—but a true cost of $0.46—
the company may end up doing lots of
production for little or no profit.
• Our example with just two activities
(production and setup) illustrates how the
cost per unit using the activity based costing
method is more accurate in reflecting the
actual efforts associated with production.
• As companies began measuring the costs of activities (instead
of focusing on the accountant’s departmental classifications),
they began using ABC cost information to practice activity
based management. For example, with the cost of setting up
a machine now being measured and discussed, managers
began to ask questions such as:
Why is the cost of setting up a production machine so expensive?
What can be done to reduce the setup cost?
If the setup costs cannot be reduced, are the selling prices
adequate to cover all of the company’s costs—including the
setup cost that was previously buried in the overall machine-
hour overhead rate?

When do we use ABC costing?
• When one or more of the following conditions are
• Product lines differ in volume and manufacturing
• Product lines are numerous and diverse, and they
require different degrees of support services.
• Overhead costs constitute a significant portion of total
• The manufacturing process or number of products has
changed significantly—for example, from labor
intensive to capital intensive automation.


• ABC system focus attention on activities rather than
products . Because activities of various department may be
combined and cost of similar activities ascertained, e.g
quality control, inspection, handling of material. If detailed
cost are kept by activities, the total company cost of each
activity can be obtained, analyzed, planned and controlled.

• Because cost are identified with activities and then
allocated to product or services, based on appropriate cost
drivers, more accurate product/service cost results.

• Managers manage activities and not products. Changes
in activities leads to changes in cost. Therefore, if activities
are managed well, costs will fall and resulting products
will be more competitive
• Allocating overheads cost to production based on single
cost drivers can result in an unrealistic product cost( as in
traditional costing). To manage activities better and to
make wiser economic decision, managers need to identify
the relationship of cause( activities) and effect( cost) . ABC
focusses on this aspect.
• ABC highlight problem area that deserve management’s
attention and more detailed analysis.


• ABC fails to encourage manager think about changing
work processes to make business more Competitive.
•ABC does not confirm to GAAP in some areas. For,
example ABC encourages allocation of non-product cost
as research and development to product cost . While
committed cost such as factory depreciation are not
allocated to product.
• Using ABC, for short-run decisions may sometimes
prove costly in long run. For ex, decision of lowering sales
order handling cost by reducing small order that generate
lower margin.
•ABC does not encourage the identification and removal
of constraints creating delay and excesses.
Additional Uses of ABC
• Activity Based Management (ABM)
– Extends the use of ABC from product costing to a
comprehensive management tool that focuses on
reducing costs and improving processes and
decision making.
• ABM classifies all activities as value-added or
– Value-added activities increase the worth of a
product or service to the customer.
• Example: Addition of a sun roof to an automobile.
– Non-value added activities don’t.
• Example: The cost of moving or storing the product
prior to sale.
The Objective of ABM . . .
• To reduce or eliminate non-value related
activities (and therefore costs).
• Attention to ABM is a part of continuous
improvement of operations and activities.
The End!