ABC Costing

L3.
2 Activity-Based
Costing
Reference material: Braun

et al (2010) Managerial
Accounting Chapter 4
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 1
Real Case Based
1. Madison Dairy, faced major challenges, such as declining
profitability and small retailers were put out of business
by giants such as Wal-Mart, SuperValu, Target and Tysco.
The products previously reported as profitable such as
strawberry and mocha-almond were actually the least
profitable. Conversely, vanilla and chocolate, previously
thought to be break even, were actually profitable with
10% profit margin.
Madison’s previous conventional system has assigned
too much of overhead cost to vanilla and chocolate, the
high-volume products, based on direct labor cost.
(Boston: Harvard Business Press)
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
2. ATB Financial, a commercial bank based in Alberta,
Canada, offered 200 products and processed 12 million
transactions monthly for its 2 million customer accounts
in 160 branches. The existing cost system did not assign
the costs of these regional and corporate resources to
transactions, products, and customers.
An ATB project team developed an installed time driven
ABC system that could accurately calculate branch and
product profitability each month.
Within a year, the bank had identified nearly $2 mil in
annualized profit improvement in revenue and cost
reduction. (Boston: Harvard Biz Press)

3. WS Industries in Chennai, India supplies equipment such as
insulators, capacitors, circuit breakers, lightening arrestors
and transformers to company. As competition intensified in
the 1990s, the coy no longer can pass cost increase in the
form of higher price.
An ABC project team was formed mapping all processes &
activities into database, classifying each as either value
added or non-value added. The non-value added was
dropped in the firm continuous improvement project (CIP)
In the 1st three years, the coy completed 56 CIPs yielding
savings of US$300K and improving factory capacity from
9,000 to 11,700 metric tons per year.
(Boston: Harvard Business School Publishing)
Learning Objective 1
Develop and use departmental
overhead rates to allocate indirect
costs

Why and How do Companies Refine
their Cost Allocation Systems?
• Why refine?
– Mismatching resources
– Cost distortion
• Who can refine?

– Manufacturing operations
– Service companies and governmental agencies

Conventional -Plantwide Overhead Rate
Using one predetermined manufacturing

overhead cost rate for all operations
Predetermined MOH rate = Total estimated manufacturing overhead costs

Total estimated amount of the allocation base
MOH
Plantwide Actual Use of
Allocated to
Overhead Rate Allocation Base
One Unit
Elliptical $16 per DL hour × 10 DL hours = $160
Treadmill $16 per DL hour × 10 DL hours = $160

Conventional-Plantwide Overhead Rate
Using one predetermined manufacturing

overhead cost rate for all operations
Predetermined MOH rate = Total estimated manufacturing overhead costs

OR TOTAL OVERHEAD x 100 %

TOTAL LABOUR COST

Departmental Overhead Rates
Separate predetermined manufacturing
overhead rates for each department
Manufacturing Plant with $1,000,000 of total estimated MOH and 2

departments
Department A Department B
($400,000 of MOH) ($600,000 of MOH)
$400,000 ÷ departmental allocation base $600,000 ÷ departmental allocation base
yields a MOH rate for this department yields a MOH rate for this department
ONLY ONLY

• When to use
– Departments incur different amounts and types of MOH
– Different jobs or products use the department resources to a

different extent

Total Departmental Total
Departmental
Department Manufacturing Departmental
Overhead Rate
Overhead Costs Labor Hours
Dept. A $2 million 50,000 hrs $40/DL hour
Dept. B $5 million 250,000 hrs $20/DL hour
Dept. C $3 million 200,000 hrs $15/DL hour

TOTAL $10 million 500,000 hrs

Examples: Exhibit 4-8, 4-9 and 4-11
Actual Use of MOH
Departmental
Department Departmental Allocated to One
Overhead Rate
Allocation Base Elliptical
Machining $32 per DL hour × 1 DL hours = $32
Assembly $12 per DL hour × 9 DL hours = 108

Actual Use of MOH

Departmental
Department Departmental Allocated to One
Overhead Rate
Allocation Base Treadmill
Machining $32 per DL hour × 4 DL hours = $128
Assembly $12 per DL hour × 6 DL hours = 72

Plantwide
Departmental Overhead
Overhead Rate Amount of Cost
Rates MOH Allocation
MOH Allocation Distortion
(from Exhibit 4-10)
(from Exhibit 4-2)
Elliptical $ 160 $ 140 $20 overcosted
Treadmill $ 160 $ 200

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. $40 undercosted 12
S4-3
Uncle Bruce Snack makes potato chips, corn chips, and
cheese puff using the 3 different production lines within
the same manufacturing plant.
Currently it uses a single plant wide overhead rate to
allocate its $3.5 mil of annual manufacturing overhead .
Of this amount, $1.8 mil is associated with potato chip
line, $1.0 mil associated with corn chip, and $0.7 mil
associated with cheese puff line.
The plant is currently running 17,500 machine hours;
11,250 in the potato chip line, 3,450 in the corn chip line,
and 2800 in the cheese puff line. It considers the machine
hours to e the cost driver of manufacturing overhead
cost.
S4-3: Compute Departmental
Overhead Rates
1. What is Uncle Bruce’s plant wide overhead rate?
Total estimated manufacturing overhead costs

Manufacturing overhead cost

Total machine hours ?
$3.5 million
17,500 machine hours = $200 per machine hr

S4-3 (continued)
2. Calculate the departmental overhead rates for
Uncle Bruce’s three production lines. Round all
answers to the nearest cent.
Overhead
Department Overhead Cost Machine Hours
Rate
Potato chips $1,800,000 11,250 MH ?
Corn chips $1,000,000 3,450 MH ?
Cheese puffs $ 700,000 2,800 MH ?

S4-3 (continued)
3. Which products had been overcosted by
the plantwide rate? Which products had
been undercosted by the plantwide rate?
Plantwide Rate = $200.00 per machine hour
Departmental Rate:
Potato Chips = $160.00
Corn Chips = 289.86
Cheese Puffs = 250.00

Develop and use activity-based costing
(ABC) to allocate indirect costs

Activity-Based Costing
• Allocates indirect costs to production
• Focuses on activities and costs of activities
• Separate allocation rate for each activity
Manufacturing
Activities
Machine Materials Fabricating Supervising Inspecting Packaging

set-up Handling Parts Assembly Products Products

Step 1:
• Identify & estimate indirect costs
Total Activity Cost
Activity MOH Costs for the Activity
Pool
Machine Set-up Indirect labor to set-up machines $80,000
Materials Handling Forklifts, gas, operators’ wages 200,000
Machine lease payments, electricity,
Fabricating Parts 300,000
repairs
Supervising Assembly Production engineers’ labor 150,000

Inspecting Testing equipment, inspection labor 170,000
Packaging Packaging equipment 100,000
$1,000,000
Steps 2 - 3: Compute cost allocation rate for each activity
Total Cost
Activity Allocation base Cost Allocation Rate
Pool
Machine Set-up Number of set-ups $80,000 $80,000 / 8000 = $10
200,000/ 400,000 = 0.50

Materials Handling Number of parts moved 200,000
per part
Fabricating Parts Machine hours 300,000 300,000/ 12,500 = $24
Supervising
Direct labor hours 150,000 150,000 / 50,000 = $3
Assembly
Inspecting Number of inspections 170,000 170,000 / 34,000 = $5
Packaging Cubic feet packaged 100,000 100,000 / 1,600,000 = 0.25

1,000,000

Step 4: Allocate overhead to the individual jobs
Info for
Product A
Step 5: Compute cost allocation rate for each activity
Step 6: Obtain quantity of allocation base used
Step 7: Allocate to the cost object
Actual Use of Activity
Activity Cost MOH Allocated
Activity Allocation Base (collected on
Allocation Rate to One object
job)
Machine Set-up $10 per set-up × 2 set ups = $20
Materials Handling $0.50 per part × 20 parts = 10
$24 per machine
Fabricating × 1 machine hour = 24
hour
Supervising
$3 per DL hour × 9 DL hours = 27
Assembly
Inspecting $5 per inspection × 3 inspections = 15
$0.25 per cubic
Packaging × 52 cubic feet = 13
foot
Total $109
Activity-Based Costing Steps
Product B (Steps 4 through 7)
Activity Cost Allocation Actual Use of Activity Allocation MOH Allocated

Activity
Rate Base (collected on job) to One object
Machine Set-up $10 per set-up × 4 set ups = $40

Materials
$0.50 per part × 26 parts = 13
Handling
Fabricating $24 per machine hour × 4 machine hour = 96
Supervising
$3 per DL hour × 6 DL hours = 18
Assembly
Inspecting $5 per inspection × 6 inspections = 30
Packaging $0.25 per cubic foot × 60 cubic feet = 15
Total $212
Examples of Cost Drivers
Activities: Cost Drivers:
Material purchasing # of purchase orders
Material handling # of parts
Production scheduling # of batches
Quality inspections # of inspections
Photocopying # of pages copied
Warranty service # of service calls

E4 -33B
Central Plain uses ABC to account for its chrome wheel manufacturing process. The
firm manager has identified 4 manufacturing activities that incur manufacturing
overhead costs: materials handling, machine set up, insertion of parts, and
finishing. The budgeted activity costs for the upcoming year and their allocation
bases are as follows:
hhhhmmmmmmmmmmmmmmmmmmmmmmmmmmmmmmmm
Activity Budget Mfg Overhead cost Allocation Base(cost driver)
mmmmmmmmmmmmmmmmmmmmmmmmmmmmmmmmmmm
Materials handling $ 5,600 Number of parts
Machine set up $ 6,400 Number of Set ups
Insertion of parts $ 39,200 Number of parts
Finishing $ 96,800 Finishing direct labor hour
TOTAL $ 148,000
Central Plain expects to produce 1,000 chrome wheels during the year. The wheels
are expected to use 2800 parts, 20 set up, consume 2200 hours of finishing time.
Job 420 use 250 parts, 3 set up, and use 130 hours of finishing time
Job 510 use 475 parts, 6 set up, and use 300 hours of finishing time.
E4 -33B
• Required to:
1. Compute the cost allocation rate for each
activity
2. Compute the manufacturing overhead cost
that should be assigned to job 420.
3. Compute the manufacturing overhead cost
that should be assigned to Job 510.

E4-33B: ABC Example
Step 1. Identify each activity
• Material handling
• Machine setup
• Insertion of parts
• Finishing
Step 2. Estimate the total indirect costs of each
activity
– Material handling ?
– Machine setup ?
– Insertion of parts ?
– Finishing ?
E4-33B (continued)
Step 3. Identify the allocation base for each

activity’s indirect costs (the primary cost driver)
Activity Budgeted cost Allocation base (cost driver)

Material handling $5,600 ?
Machine setup 6,400 ?
Insertion of parts 39,200 ?
Finishing 96,800 ?
Total $148,000

E4-33B (continued)
Step 4. Estimate the total quantity of each allocation base
Total Est. Est. Quant. of Cost Allocation

Activity Cost Base
Mat. handling $5,600 ÷ ?
Machine setups 6,400 ÷ ?
Insertion of parts 39,200 ÷ ?
Finishing 96,800 ÷ ?

E4-33B (continued)
Step 5. Compute cost allocation rate for each activity
Total Est. Est. Quant. of Cost Allocation

Activity
Cost Allocation Base Rate
Mat. handling $5,600 ÷ 2,800 parts ?
Machine setups 6,400 ÷ 20 setups ?
Insertion of parts 39,200 ÷ 2,800 parts ?
Finishing 96,800 ÷ 2,200 hrs ?

E4-33B (continued)
Step 6. Obtain actual quantity of each allocation base used by the cost
object (1,000 wheels)
Step 7. Allocate indirect costs to cost object (compute the manufacturing
overhead cost that should be assigned to Job 420)
Job 420
Material handling 250 parts ? ?

Machine setup 3 setups ? ?
Insertion of parts 250 parts ? ?
Finishing 130 finishing hours ? ?
Total

E4-33B (continued)
Step 7 (continued from prior slide): Allocate indirect costs to cost object (i.e.,
compute MOH cost that should be assigned to Job 510)
Job 510
Material handling 475 parts $ 2.00 ?

Machine setup 6 setups 320.00 ?
Insertion of parts 475 parts 14.00 ?
Finishing 300 finishing hours 44.00
?
Total ?

Cost Hierarchy

Cost Hierarchy Defined
• Unit-level activities – activities and cost incurred for every unit.
• Batch-level activities – activities and cost incurred for every batch,

regardless of the number of units in the batch. In one batch can
consists of many units. Eg Packaging into batches.
• Product-level activities – activities and cost incurred for a particular

product, regardless of the number of units or batches. Eg cost of R &
D, marketing cost.
• Facility-level activities – activities and cost incurred no matter how

many units, batches or products are produced in the plant. Eg. Cost of
depreciation, insurance, property tax, plant maintenance.

Summary - steps
How are overhead rates determined under ABC?
1 Identify the activities performed. (Activity)
2 Identify a cost driver for each activity. (cost driver)
3 Determine the cost of performing each activity.
(Cost pool)
4 Determine the number of units of the cost driver
made available by the resources committed to each
activity. (Total units of resources in each activity
area eg.hr, no.)
5 Activity overhead rate = Activity cost divide by the
number of cost driver units made available (activity
cost driver rate)
Example
A company produces a high volume product named HV and a
low volume product named LV. A team led by the
Management Accountant, was established to develop an
improved system of costing based on activities, products and
associated cost. Previously indirect overheads had been pre-
determined using direct labor cost. The results are shown
below:
HV LV Total
Production &
Sales (unit) 25000 5000 30,000
Unit cost data:
Direct material(RM) 25 20 725000
Direct labor (RM) 15 5 400000
Machine hours 1 2 35000
Continue
HV LV Total
Other operating data:
No. of setups 4 20 24
No. of deliveries 40 80 120
Overhead Costs:
Production processing RM 700,000
Machine setup RM 120,000
Delivery RM 180,000
Total RM 1,000,000
======
Demonstrate how product costs are calculated under ABC and
Traditional method and comments on the unit cost.
Understand the benefits and

limitations of ABC/ABM systems

Activity-Based Management
(ABM)
• Using ABC information to make decisions
– Pricing and product mix
– Cost cutting
– Planning and control

Pricing and Product Mix
Decisions
• Change the prices for products after
identifying the different total cost
• Decide to market the higher profitability
product
• Shift the product mix away from less
profitable products

Cutting Costs
• Analyze costs in value chain – Activities that added
value to firm’s product or service (include R&D,
design, production, purchases, marketing ,
distribution and customer service
• Value-engineering – Eliminating waste by
achieving efficient and effective processing.

Planning and Control Decisions
• Uses the costs of activities to create budgets
• Compare with actual activities to see if goals
are being met

Using ABC Outside of Manufacturing
• Merchandising & service: find the most
profitable product or service
• Manufacturers: allocate operating activities

Cost Benefit Test
• Do the benefits of adopting ABC/ABM exceed the
costs?
• Benefits are higher when:

– Accurate product cost information.
– Opportunities for cost savings results in an increase in
profits.
• Benefits are lower when:
– Many different products, many different types/amounts of
resources.
– High indirect costs.
– High and low volume products.

Costs of Adopting ABC
• Generally lower with
– accounting and information system expertise to develop
the system.
– information technology.
• Are companies glad they adopted ABC?

– 89% of the companies say that it was worth the cost.
– On the rise
– Not a cure-all, helps managers understand costs better

Signs The Old System May
Be Distorting Costs
• Cost system may need repair
when:
– Managers don’t understand costs and
profits
– The cost system is outdated

Barriers to Implementing ABC
There are some of the barriers to implementing ABC

systems in any organisation
• Lack of clear business purpose
• Lack of senior management commitment
• Delegating the ABC project to consultants
• Poor ABC model design
• Individual and organizational resistance to change

End of this Chapter

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L3.

Reference material: Braun

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 5

• Who can refine?

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 6

Using one predetermined manufacturing

Predetermined MOH rate = Total estimated manufacturing overhead costs

Elliptical $16 per DL hour × 10 DL hours = $160

Treadmill $16 per DL hour × 10 DL hours = $160

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 7

Using one predetermined manufacturing

Predetermined MOH rate = Total estimated manufacturing overhead costs

OR TOTAL OVERHEAD x 100 %

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 8

Manufacturing Plant with $1,000,000 of total estimated MOH and 2

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 9

– Different jobs or products use the department resources to a

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 10

Dept. A $2 million 50,000 hrs $40/DL hour

Dept. B $5 million 250,000 hrs $20/DL hour

Dept. C $3 million 200,000 hrs $15/DL hour

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 11

Machining $32 per DL hour × 1 DL hours = $32

Assembly $12 per DL hour × 9 DL hours = 108

Actual Use of MOH

Machining $32 per DL hour × 4 DL hours = $128

Assembly $12 per DL hour × 6 DL hours = 72

Elliptical $ 160 $ 140 $20 overcosted

Treadmill $ 160 $ 200

Total estimated manufacturing overhead costs

Manufacturing overhead cost

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 14

Corn chips $1,000,000 3,450 MH ?

Cheese puffs $ 700,000 2,800 MH ?

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 15

Plantwide Rate = $200.00 per machine hour

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 16

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 17

Machine Materials Fabricating Supervising Inspecting Packaging

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 18

Supervising Assembly Production engineers’ labor 150,000

Machine Set-up Number of set-ups $80,000 $80,000 / 8000 = $10

200,000/ 400,000 = 0.50

Fabricating Parts Machine hours 300,000 300,000/ 12,500 = $24

Inspecting Number of inspections 170,000 170,000 / 34,000 = $5

Packaging Cubic feet packaged 100,000 100,000 / 1,600,000 = 0.25

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 20

Activity Cost Allocation Actual Use of Activity Allocation MOH Allocated

Machine Set-up $10 per set-up × 4 set ups = $40

Packaging $0.25 per cubic foot × 60 cubic feet = 15

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 23

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.

Step 3. Identify the allocation base for each

Activity Budgeted cost Allocation base (cost driver)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 27

Total Est. Est. Quant. of Cost Allocation

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Total Est. Est. Quant. of Cost Allocation

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Material handling 250 parts ? ?

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Material handling 475 parts $ 2.00 ?

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. 31