CHAPTER 4

ACTIVITY BASED
COSTING
By: Kasahun N.(M.Sc.)
 Traditional Costing Systems
 Product Costs Direct labor and direct

 Direct labor materials are easy to trace

to products.
 Direct materials
 Factory Overhead
The problem comes with
factory overhead.
 Factory overhead Includes all manufacturing costs except
direct materials and direct labor like:
 Maintenance wages/supplies
 Production supervision & expenses
 Depreciation expense of manufacturing assets
  Rent expense for buildings/machinery
 Electricity for manufacturing
 Insurance expense for manufacturing

 In traditional costing direct labor is still often the appropriate basis

for assigning overhead costs.
 Traditional cost systems were created when manufacturing
processes were labor intensive.
 A single company-wide overhead rate based on direct labor hours
may be used to allocate overhead to products in these labor intensive
processes.
 example: in this example overhead will be allocated to jobs using
direct labor hours. If total overhead is $120, how much will be
allocated to each job?
Job 1 Job 2
Labor Hours 2 6

 Overhead Rate = $120 ÷ 8 direct labor hours

= $15 per direct labor hour
 Job 1 = 2 hours × $15 per hour = $30
 Job 2 = 6 hours × $15 per hour = $90
Job 1 Job 2
Labor Hours 2 6
Overhead
$ 30 $ 90
Allocation
 The company introduces automated machinery. Total overhead
rises from $120 to $420, while the labor time needed for Job 2 falls
from 6 hours to 1 hour. Now allocate the $420 overhead to the two
jobs.
 Overhead Rate = $420 ÷ 3 direct labor hours
= $140 per direct labor hour
 Job 1 = 2 hours × $140 per hour = $280
 Job 2 = 1 hour × $140 per hour = $140
Job 1 Job 2
Labor Hours 2 1
Overhead
$ 280 $ 140
Allocation
 Is this a reasonable costing method?

 Automation benefited only Job 2, but most of the additional

overhead cost was allocated to Job 1. Clearly, we need to look for
another cost driver.
Today’s Manufacturing Plants
 Are more complex
 Are often automated
 Often make more than one product
 Use proportionately smaller amount of direct labor
 making direct labor a poor allocation base for factory overhead.
 In such situations, managers need to consider using activity based
costing (ABC).
 Activity-Based Costing (ABC)
Terms
 Activity: any event, action, transaction, or work sequence that
causes a cost to be incurred in producing a product or providing a
service.
 Activity Cost Pool: a distinct type of activity. For example: ordering
materials or setting up machines.
 Cost Drivers: any factors or activities that have a direct cause effect
relationship with the resources consumed.
The Logic Behind ABC
Products consume activities,
and
activities consume resources.
 ABC allocates overhead costs in two stages:
Stage 1: Overhead costs are allocated to activity cost pools.
Stage 2: The overhead costs allocated to the cost pools is
assigned to products using cost drivers.
 The more complex a product’s manufacturing operation, the more
activities and cost drivers likely to be present.

Traditional Costing vs ABC

 ABC does segregate overhead into various cost pools to provide
more accurate cost information.
 ABC, thus, supplements – it does not replace – the traditional cost
system.
Activities and Related Cost Drivers
 Activity-Based Costing Involves the following four steps.

1. Identify and classify the activities involved in the manufacture

of specific products, and allocate overhead to cost pools.

2. Identify the cost driver that has a strong correlation to the

costs accumulated in the cost pool.

3. Compute the activity-based overhead rate for each cost driver.

4. Assign overhead costs to products, using the overhead rates

determined for each cost pool (cost per driver).
Example:
 Atlas Company produces two automotive antitheft devices:
 The Boot: a high volume item with sales totaling 25,000 per
year
 The Club: a low volume item with sales totaling 5,000 per year
 Each product requires 1 hour of direct labor
 Total annual direct labor hours (DLH) 30,000 (25,000 + 5000)
 Direct labor cost $12 per unit for each product
 Expected annual manufacturing overhead costs $900,000
 Direct materials cost:
 The Boot - $40 per unit
 The Club - $30 per unit
 Unit Costs Under Traditional Costing
Products
Manufacturing Costs The Boot The Club
Direct Materials $40 $30
Direct Labor 12 12
Overhead 30* 30*
Total unit cost $82 $72

 Predetermined overhead rate: $900,000/30,000 DLH = $30 per

DLH
 Overhead = predetermined overhead rate times direct labor hours

($30 X 1 hr. = $30)

 Unit Costs Under ABC
Step 1: Identify and Classify Activities and Allocate Overhead to
Cost Pools

Activity Cost Pools Estimated Overhead

Setting up machines………….$300,000

Machining…………….………500,000
Inspecting…………….………100,000
Total ………………….………$900,000
 Step 2: Identify Cost Drivers

Expected Use

of Cost Drivers
Activity Cost Pools Cost Drivers Per Activity

Setting up machines…… Number of setups………… 1,500

Machining…………… Machine hours…………… 50,000
Inspecting…………… Number of ……………… 2,000

Inspections
 Step 3: Compute Overhead Rates

Formula for Computing Activity-Based Overhead Rate:

Estimated Overhead Per Activity
Activity-Based Overhead Rate =
Expected Use of Cost Drivers Per Activity

Expected Use
Estimated of Cost Drivers Activity-Based
Activity Cost Pools Overhead Per Activity Overhead Rates
Setting up machines $300,000 1,500 setups $200 per setup
Machining 500,000 50,000 machine hrs. $ 10 per mach. hour
Inspecting 100,000 2,000 inspections $ 50 per inspection
Total $900,000
 Step 4: Assign Overhead Costs to Products
Part 1: Expected Use of Cost Driver Per Product
Expected Use
of Cost Drivers
per Product
Expected Use
Activity Cost of Cost Drivers
Pools Cost Driver Per Activity The Boot The Club
Setting up Number of

machines setups 1,500 setups 500 1,000

Machining Machine hours 50,000 hours 30,000 20,000
Inspecting Number of
inspections 2,000 inspections 500 1,500
 Step 4: Assign Overhead Costs to Products
Part 2: Assign Cost Pools to Products
The Boot
Expected Use of Activity-Based
Activity Cost Drivers X Overhead = Cost
Cost Pools per Product Rates Assigned
Setting up machines 500 $200 $100,000
Machining 30,000 10 300,000
Inspecting 500 50 25,000
Total costs assigned $425,000
Units produced 25,000

Overhead cost per unit $17

 The Club

Expected Use of Activity-Based

Activity Cost Drivers X Overhead = Cost
Cost Pools per Product Rates Assigned
Setting up machines 1,000 $200 $200,000
Machining 20,000 10 200,000
Inspecting 1,500 50 75,000
Total costs assigned $475,000
Units produced 5,000

Overhead cost per unit $95

 Traditional vs. ABC

The Boot The Club

Traditional Traditional
Manufacturing Costs Costing ABC Costing ABC
Direct Materials $40 $40 $30 $30
Direct Labor 12 12 12 12
Overhead 30 17 30 95
Total Cost per Unit $82 $69 $72 $137

Overstated Understated
$13 $65

 Therefore if its in traditional costing the company will loose its

market share because the boot is expensive and the company loose
its profit because the club is understated.
End of The
Class!!!