Activity Based Costing

Traditional System
• Relies on one cost pool and one cost driver.
– Sometimes two cost pools and two cost drivers.
• Consider the below example:
Ordinary Deluxe
    Product   Product
Units Produced   20,000   2,000
Variable Cost   Rs.   Rs.
Material   10   12
5 hrs @ 12 per 6 hrs @ 12 per
Labour hr 60 hour 72
Variable overhead 5 6
Variable Cost   75   90
         
Fixed production
overheads     Rs.224,000  
 Traditional System
• Traditional System may allocate fixed
production overheads based on labour hours.
• Total labour hrs = 20,000 * 5 + 2,000 * 6
= 112,000
• Overhead per labour hour = 224,000/112,000
= Rs.2
 Traditional System
• In such case the cost per unit will be as below:
Ordinary Deluxe
  Product Product
Variable Cost 75 90
Allocated production overheads 10 12
Cost per unit 85 102
 ABC
• Further information is as below:
– Overheads consists of following activities:
• Batch set up cost ( based on number of batches) =
90,000
• Material Handling costs (based on components
handled) = Rs.96,000
• Product Design (based on time consumption in
desiging) = Rs.38,000
 ABC
• Further information is as below:
– Overheads consists of following activities:
• Batch set up cost ( based on number of batches) = 90,000
– For Ordinary Product one batch consists of 2,000 units
– For deluxe product on batch consists of 100 units
• Material Handling costs (based on components handled) =
Rs.96,000
– Ordinary product requires 1 component per unit
– Deluxe product requires 2 components per unit
• Product Design (based on time consumption in designing) =
Rs.38,000
– Ordinary product is a low customization product and requires only
40 hrs. for designing etc. in a period
– Deluxe product is a highly customized and requires approx. 150 hrs
for designing in a period
 Traditional System
• This approach provides a good estimate of cost if:
– Overhead cost are relatively immaterial.
– Less diversity of products or identical products
– Less diversity in resource consumption by products
• However, in modern organizations with high
amount of automation, large number of product
lines, high diversity and customization of
products, traditional system may fail.
Activity Based Costing
 Overview
• Need good estimate of controllable costs to improve
quality of decisions
– Choices that we make when allocating costs determine the
validity of the estimated profit margin
– Activity based costing is a method to refine our allocation
and improve validity of estimate

• Activity based management is the process of taking

ABC data to improve the effectiveness of business
processes
– Focused on Customer
– Focused on Production
– Focused on Product concepts and design
Decisions When Allocating Costs
 Forming Cost pools
• Includes all costs
– Pre and post production
• Takes business process view
– A collection of activities
• Activities are the core building block of ABC systems
• Prepares activity map for each product
– Similarity to bill of materials and routing sheet
Activities at Parcel Service
 ABC
• Identify activities:
– Overheads consists of following activities:
• Batch set up cost ( based on number of batches) =
90,000 – Setting up batches
• Material Handling costs (based on components
handled) = Rs.96,000 – Handling componennts
• Product Design (based on time consumption in
desiging) = Rs.38,000 – Designing of product
 Cost Hierarchy
• The cost hierarchy broadens the principle of
variability
– Allows us to consider multiple activities

• The cost hierarchy recognizes four types of costs

– Unit-level costs
– Batch-level costs
– Product-level costs
– Facility-level costs
 Why the Cost Hierarchy?
• Allows us to compute a more accurate estimate of
costs
– Can extend concept to other “levels”
• Customer level costs, channel level costs,…

• However,
– Difficult to assign many costs to hierarchy categories
• Need finer data on operations
– Wrong classification of levels introduces errors in cost
estimation
Example: Deluxe Checks
 Forming Cost Pools
• Activities can pertain to any level in the activity
hierarchy
– Activities done for each unit, each batch, each
product or for the facility as a whole
• The corresponding cost pools will correspond to the
cost hierarchy
– Unit, batch, product and facility level cost pools
 Cost Pools
Cost
Cost Name for
Pool Underlying Activity
Hierarchy Cost Pool
Number
Assembly of products
1 Unit Level Labor related

Machine
2 Unit Level Machining of product components
related
Issue and process production orders Production
3 Batch Level
(including production scheduling) order related
Receive and process customer orders Customer
4 Batch Level
(including invoicing) order related
Product Provide production support Production
5
Level (includes design updates) support
Facility General
6 General Administration
Level administration
 ABC
• Apply cost hirerachy
– Overheads consists of following activities:
• Batch set up cost ( based on number of batches)
=90,000 – Setting up batches
• Material Handling costs (based on components
handled) = Rs.96,000 – Handling components
• Product Design (based on time consumption in
desiging) = Rs.38,000 – Designing of product
 Which Drivers to Choose?
• Activity based costing systems pick drivers that
correspond to activities
– Thus, we have unit, batch, product and facility
level drivers
• In contrast, traditional systems only employ
unit-level drivers
– Units, direct labor, machine hours.
 Cost Drivers

Cost Pool Cost Driver

1. Labor related Labor cost or Labor Hours

2. Machine related Machine hours

3. Production order related Number of production orders

4. Customer order related Number of customer orders

5. Production support Traced to each product line

6. Marketing support Subjective estimate

7. Warehousing % area occupied

 ABC
• Activity Cost Drivers
– Overheads consists of following activities:
• Setting up batches : No. of Setups
• Handling components : No. of components handled
• Designing of product: Time consumed in designing
 What Denominator Volume to Use?

• In traditional cost allocation

– Denominator volume = budgeted/actual volume
– All costs would be allocated
– No distinction between demand & supply of
capacity
• ABC de-links demand and supply
– Uses practical capacity as denominator volume
 Example

• Cost: $55,000, Capacity = 11,000 units

Budgeted usage :“A” uses 4,000 units; “B” uses 6,000
units.
• Traditional method
– Rate = $5.50 /unit;
A = $22,000, B = $33,000
• ABC’s approach
– Rate = $5 / unit
A = $20,000, B = $30,000, Unassigned = $5,000!
– Supply is 11,000 units & demand is 10,000 units
 What to do with Unassigned Cost?
• This is the cost of capacity not used
• ABC brings this cost to managerial action.
– Disposition depends on reason for the unused capacity
• If…
– True excess, get rid of capacity or re-deploy
– Accommodate variability in production, allocate to product
– Seasonal, allocate to product
– Peak load pricing, time of day pricing
– Customer related, allocate to customer
 Summary: Steps in ABC
• Identify all activities and pool like activities together
• Analyze accounts and assign costs from accounts to
cost pools to determine cost in each pool
• Determine driver for each pool
• Assign costs from pools to cost objects
 ABC
• Consider the earlier example:
Ordinary Deluxe
    Product   Product
Units Produced   20,000   2,000
Variable Cost   Rs.   Rs.
Material   10   12
5 hrs @ 12 per 6 hrs @ 12 per
Labour hr 60 hour 72
Variable overhead 5 6
Variable Cost   75   90
         
Fixed production
overheads     Rs.224,000  
 ABC
• Further information is as below:
– Overheads consists of following activities:
• Batch set up cost ( cost driver: No. of set ups) = 90,000
– For Ordinary Product one batch consists of 2,000 units
– For deluxe product on batch consists of 100 units
• Material Handling costs (Cost driver: No. of components) =
Rs.96,000
– Ordinary product requires 1 component per unit
– Deluxe product requires 2 components per unit
• Product Design (cost driver : No. of Hours consume for
designing) = Rs.38,000
– Ordinary product is a low customization product and requires only
40 hrs. for designing etc. in a period
– Deluxe product is a highly customized and requires approx. 150 hrs
for designing in a period
 ABC
ABC estimates will be as follows:

Ordinary Deluxe
  Product Product
Variable Cost 75.00 90.00
Batch set up 1.50 30.00
Material Handling Cost 4.00 8.00
Product Desiging 0.40 15.00
Total Cost (ABC) 80.90 143.00
Traditional Cost System Estimate 85.00 102.00
Pizzeria Gallery specializes in pizza making and delivery. Their two main products are Deluxe
Veggie and Veggie Supreme. The company is currently using Traditional cost system and
allocate cost based on number of pizzas. Total 12,000 deluxe veggie and 7,000 Veggie
Supreme were made in this period. The company plan to use activity-based costing using the
following data:
 Overhead costs:
Wages $48,000
Administrative $62,000
Total $110,000
 Resources are consumed as follows:
Activity Cost Pools
Pizza Making Delivery Other
Wages & Salaries 65% 20% 15%
Administrative 20% 30% 50%
 
Activity for the year is:

Activity Cost Pool Activity

Deluxe Veggie Veggie Supreme
Pizza Making 4,000 hours 3,500 hours
Delivery 11,000 deliveries 6,000 Deliveries
Other 50% 50%
 
What difference will it make to cost per pizza for both types of pizza.
 Advantages of ABC reports

• Captures the complexity of the production process

– Speaks the “language of the user”
• Highlights that not every cost is related to volume
– Volume is still the most important driver though
• Produces more accurate costs, enabling better decisions
• Total profit will not change by changing cost allocation
system
– Only the allocation of costs has changed