BAB 2024 CH04 - Activity Based Costing

Chapter 4
Activity-Based
Costing
4-1
Activity-Based
Chapter 4 Costing
Learning Objectives
After studying this chapter, you should be able to:
[1] Recognize the difference between traditional costing and activity-based costing.
[2] Identify the steps in the development of an activity-based costing system.
[3] Know how companies identify the activity cost pools used in activity-based
costing.
[4] Know how companies identify and use cost drivers in activity-based costing.
[5] Understand the benefits and limitations of activity-based costing.
[6] Differentiate between value-added and non–value added activities.
[7] Understand the value of using activity levels in activity-based costing.
[8] Apply activity-based costing to service industries.
4-2
Preview of Chapter 4
4-3
Traditional Costing and Activity-Based Costing
Traditional Costing Systems

 It is impossible to determine exact or true cost of a product
or service.
 To improve management decisions, companies strive to
provide decision makers with the most accurate cost
estimates for better decisions making or improved
management decisions.
 “Accurate estimate of product cost “– when cost are
traceable directly to the product produced or service provided.
4-4 LO1 Recognize the difference between traditional costing and activity-based costing.

 Direct materials and direct labor costs are easiest to trace
through material requisition and payroll time sheet
 Overhead cost (indirect/common cost) – cannot be
easily or directly trace to individual product or services –
used estimates to assign overhead cost to products or
services
 Most difficult part of computing accurate unit costs is
determining the proper amount of overhead cost to be
assigned to each product, service or job.

 Allocates overhead using a single predetermined rate.
► Job order costing: direct labor cost may be the relevant
activity base.
► Process costing: machine hours may be the relevant
activity base.
 Assumption was satisfactory when direct labor was a

major portion of total manufacturing costs.
► Wide acceptance of a high correlation between direct
labor and overhead costs.

 Direct labor is still often the appropriate
basis for assigning overhead costs
when:
► Direct labor constitutes a significant part of
total product cost
► High correlation exists between direct labor
and changes in overhead costs
Illustration 4-1
Traditional one-stage
costing system
The Need for a New Approach

 Tremendous change in manufacturing and service
industries – advances in computerized system,
technological innovation, automation etc
 Decrease in amount of direct labor usage.
 Significant increase in total overhead costs due to
depreciation on expensive equipment, machinery,
utilities, repairs & maintenance.
 Inappropriate to use plant-wide predetermined
overhead rates when a lack of correlation exists.
 Companies that use overhead rates based on direct
labor when this correlation does not exist experience Illustration 4-1
Traditional one-stage
significant product – cost distortion. costing system
4-8
Activity-Based Costing
 Complex manufacturing processes may require multiple
allocation bases; this approach is called Activity-Based
Costing (ABC).
 Allocates overhead to multiple activity cost pools and
 Assigns the activity cost pools to products or services by

means of cost drivers.
 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. For
example: number of ordering or number of machine set-up
 The rational for ABC costing is that products consume

activities and activities consume resources.
 ABC allocates overhead costs in two stages:
Stage 1: Overhead costs are allocated to activity cost pools.
Example: Ordering materials, setting up
machines,
assembling products, inspection.
Stage 2: Assigns overhead allocated to the activity cost
pools to products, using cost drivers.
Cost drives measure the number of individual activities undertaken
or performed to produce product or services
Example: number of purchase order, number of machine hours,
number of employees
 The more complex a product’s manufacturing operation,

the more activities and cost drivers are likely to be present.
Reason behind ABC cost allocation

Products consume activities,
(Before a product is complete, it has to go through various making processes)
and
Activities consume resources.
(Processes need material/resources in making a product)
LO1: Recognize the differences between traditional costing and activity – based costing
4-12
LO 1: Recognize the differences between traditional costing and activity-based costing.

4-13
Activity-Based Costing Illustration 4-2

Activities and related cost drivers
Based on the above illustration
 Co. allocates overhead costs to activity cost pools
 Co. identified 4 activity cost pools – purchasing, storing,

machining & supervising.
 After costs are allocated to activity cost pools, uses cost

driver to determine the costs to assign to the individual
products (either Ab Bench or Ab Coaster) based on each
product use of each activity.
Based on the above illustration
Example: If Ab Bench require more activity by the purchasing

department as measured by the number of required purchase
orders, then more overhead cost from purchasing pool will be
allocated to Ab Bench) .
Illustration 4-3 below shows a more complex activity based

costing system with 7 activity pools for Casey Company that
manufactures 2 types of automotive jacks i.e. automobile scissors
jack and truck hydraulic jack.
Activity-Based Costing Illustration 4-3

ABC system design—Lift Jack Company
 ABC does not replace an existing job order or process

cost system.
 ABC does is to segregate overhead into various cost

pools to provide more accurate cost information.
 ABC, supplements – it does not replace – the traditional

cost system.
Example of ABC Versus Traditional 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).
4-19 LO2 Identify the steps in the development of an activity-based costing system.
Illustration:
 Atlas Company produces two products (abdominal trainers):
► Ab Bench: a high volume item with sales totaling 25,000 units annually.
► Ab Coaster: a low volume item with sales totaling 5,000 units annually.
 Each product requires 1 hour of direct labor.

► Total annual direct labor hours (DLH) 30,000 (25,000 + 5,000)
► Direct labor cost $12 per unit for each product
 Expected annual manufacturing overhead costs $900,000.

 Direct materials cost:
► Ab Bench - $40 per unit Required: Calculate unit costs
► Ab Coaster - $30 per unit under Traditional Costing & ABC.
Illustration: Traditional Costing
Manufacturing costs Ab Bench Ab Coaster

Direct materials $40 $30
Direct labor 12 12
Overhead 30 30
Total unit cost $82 $72
* Overhead rate = $900,000/30,000 DLH = $30 per DLH

Overhead = ($30 X 1 hr. = $30)
Since both products required one direct labor hours per unit, both products
are allocated overhead cost of $ 30.00 per unit under traditional costing.
Illustration: Activity Based Costing (ABC)
Identify and Classify Activities and Allocate

Overhead to Cost Pools (Step 1)
 Well designed activity-based costing starts with an analysis of
activities performed to manufacture a product or provide a
service.
 Analysis should identify all resource consuming activities - a
detailed step by step of each operations & documenting every
activity to accomplish the task.
 Overhead costs are assigned directly to the appropriate activity
cost pool
Identify and Classify Activities and Allocate

Overhead to Cost Pools (Step 1)
Example: Overhead costs directly associated to machine
setups (such as salaries, supplies, depreciation) would be
assigned to machine setups cost pool.
Illustration 4-4
4-23 LO3 Know how companies identify the activity cost pools used in activity-based costing.
Identify Cost Drivers (Step 2)

 Cost driver must accurately measure the actual consumption
of the activity by the various products.
 To achieve accurate costing, a high degree of correlation
must exist between cost driver & actual consumption of
overhead costs in the cost pool. Illustration 4-5
4-24 LO4 Know how companies identify and use cost drivers in activity-based costing.
Compute Overhead Rate (Step 3)

 Compute an activity-based overhead rate per cost driver.
 Use Estimated Overhead per activity
 Expected use of Cost Drivers per activity – the total expected use
of cost drivers for all product.
Illustration 4-6
Compute Overhead Rates (Step 3)

Illustration 4-7
Assign Overhead Cost to Products (Step 4)

 In assigning overhead costs, it is necessary to know the
expected use of cost drivers for each product.
 Because of its low volume, Ab Coaster requires more set-ups
and inspections than Ab Bench. Illustration 4-8

To assign overhead costs, Atlas multiplies the activity-based
overhead rates per cost driver (Ill. 4-7) by the number of cost
drivers expected to be used per product (Ill. 4-8).
Illustration 4-9

To assign overhead costs, Atlas multiplies the activity-based
overhead rates per cost driver (Ill. 4-7) by the number of cost
drivers expected to be used per product (Ill. 4-8).
Illustration 4-9
Comparing Unit Costs

Illustration 4-10
A likely consequence of the differences in assigning overhead is that

Atlas has been overpricing the Ab Bench and possibly losing market
share to competitors. It also has been sacrificing profitability by
underpricing the Ab Coaster.

Illustration 4-11
High volume Low volume

item with sales item with sales
totaling 25,000 totaling 5,000
units annually units annually

 Unit costs under traditional costing are significantly
distorted.
 Cost of producing “Ab Bench” is overstated by $13 per unit
($82 - $69) while cost of producing “Ab Coaster” is
understated by $65 per unit. ($137 - $72)
 Under ABC, overhead costs have shifted from high-volume
product (Ab Bench - $17) to the low-volume product (Ab
Coaster - $95).

 Consequence of the difference in assigning overhead is
that the product ‘Ab Bench’ has been over-pricing and
possibly losing market share to competitors and has
sacrificing profitability by under-pricing ‘Ab Coaster’.
Two reasons
 Low-volume products often require more special handling
(E.g: more machine setups and inspections) than high-volume
products. Low-volume product frequently responsible for more
overhead costs per unit than high-volume product.
 Assigning overhead using ABC will usually increase the cost
per unit for low-volume products (decrease cost per unit for
high-volume products) as compared to traditional overhead
allocation. Therefore, traditional cost drivers as direct labor
hours are usually not appropriate for assigning overhead costs
to low-volume products.
Example
Casey Company has five activity cost pools and two products. It
expects to produce 200,000 units of its automobile scissors jack and
80,000 units of its truck hydraulic jack. Having identified its activity cost
pools and the cost drivers for each cost pool, Casey Company
accumulated the following data relative to those activity cost pools and
cost drivers.
Example
Using the above data, do the following.
a. Prepare a schedule showing the computations of the activity-

based overhead rates per cost driver.
b. Prepare a schedule assigning each activity’s overhead cost to the

two products.
c. Compute the overhead cost per unit for each product.
d. Comment on the comparative overhead cost per unit.
Example
a. Prepare a schedule showing the computations of the activity-based overhead rates per cost driver.
Example
b. Prepare a schedule assigning each activity’s overhead cost to the two products.
4-38 LO4
Example
c. Compute the overhead cost per unit for each product.
d. Comment on the comparative overhead cost per unit.

These data show that the total overhead assigned to 80,000 hydraulic
jacks exceeds the overhead assigned to 200,000 scissors jacks. The
overhead cost per hydraulic jack is $34.25. It is only $12.80 per
scissors jack.
Activity-Based Costing: A Closer Look
Benefits of ABC
More accurate product costing through:
 Use of more cost pools to assign overhead costs.
Costs can be assigned more directly on the basis of the
cost drivers used to produce each product.
 Enhanced control over overhead costs. Able to trace
many overhead costs directly to activities (allowing some
indirect costs to be identified as direct cost) and control the
activities that generate those costs.
4-40 LO5 Understand the benefits and limitations of activity-based costing.

Benefits of ABC
More accurate product costing through:
 Better management decisions. Accurate product costing
contribute to setting selling price that achieved desired
profitability levels. Able to decide whether to make or buy a
product or even whether to eliminate a product.
 Does not changed the amount of overhead cost -
Allocate those overhead costs in a more accurate manner
and able to better understand cost behavior and overall
profitability.

Limitations of ABC
 Can be expensive to use. Identifying multiple activities
and applying numerous cost drivers resulted in increase
cost. Discourages company of using ABC. Must weight the
benefits & cost when implementing ABC. If cost of ABC
outweigh the benefits, than should not implement ABC.
 Some arbitrary allocations continue. Even though
overhead cost can be assigned directly to products
through ABC’s multiple activity cost pools, certain
overhead costs remain to be allocated by means of
arbitrary volume-based cost driver such as labor and
machine hours

When to Use ABC
Factors to consider:
1. Product lines differ in volume and manufacturing complexity.
2. Product lines are numerous and diverse, requires different

degree of support services
3. Overhead costs constitute a significant portion of total costs.
4. Manufacturing process or the number of products has changed

significantly – labor to capital intensive due to automation.
5. Production or marketing managers are ignoring data provided

by the existing system instead using other alternative data
when making pricing decision.
Value-Added Versus Non–Value-Added Activities

Activity Based Management (ABM):
An extension of ABC from a product costing system to a

management function that focuses on reducing costs and
improving processes and decision making.
A refinement of ABC used in ABM classifies activities as either
► Value-added activities
► Non–value-added activities
4-44 LO6 Differentiate between value-added and non–value-added activities.


Company’s operation activity that increases the perceived
worth of a product or service such as:
Manufacturing Company Service Company

Engineering design Performing surgery
Machining services Legal research
Assembly Delivering packages
Painting


An activity that adds cost to, or increases the time spent
on, a product/service without increasing its market value such
as:
Manufacturing Company Service Company

Repair of machines Taking appointments
Storage of inventory Reception
Moving of inventory Bookkeeping and billing
Building maintenance Traveling
Inspections Ordering supplies
Inventory Control Advertising

Classification of Activity Level
 To achieve greater accuracy in overhead cost allocation

– recognize 4 different levels of activities
 Developed specific activity cost pools and their related
cost drivers.
 Provides managers a structured way about the
relationships between activities and the resources they
consume.
4-47 LO7 Understand the of value of using activity level in activity-based costing.

 Failure to recognize this classification of activities is
one of the reason that volume based cost allocation
(traditional costing system) causes distortion in product
pricing
LO7 Understand the value of using activity levels in activity-based costing

4-48
Classification of Activity Levels
ABC activities levels:

1. Unit-level activities
2. Batch-level activities
3. Product-level activities
4. Facility-level activities
4-49 LO7 Understand the value of using activity levels in activity-based costing.
1. Unit-level activities
Performed for each unit of production. Example: installation
automobile parts – frame, body, engine, tires. Amount of
installation performed increases with each additional unit of
cars installed with the parts.
2. Batch-level activities
Performed for each batch of product rather than each unit.
Example: “setup” activities to produce a batch –
reprogramming robotics, performing quality control for each
batch. Amount of time spent to set-up machines/quality
control increases with the number of batches produced.
3. Product-level activities
Performed every time a new type of product is produced.
Example: designing the product, creating & testing prototype
models, create metal dies & casts used to make the product.
Amount of time spent on designing, testing activities
increases with the number of products the Co. produces.
4. Facility-level activities
To support or sustain an entire production process. Example:
facility supervision, plant maintenance, factory building
insured & maintenance. These costs do not vary as a
function of the number of units, batches or products.
Classification
of Activity
Levels
Illustration 4-13
4-52 LO7

 Allocating all overhead costs by unit-based cost drivers
can send false signal to managers.
 Gives mistaken impression that these costs vary with
the number of units – if costs by batch-, product-, or
facility-level are divided by the number of units
produced.
 Resources consumed by batch-, product-, and facility-
level supporting activity do not vary at the unit level nor
can managers control cost at the unit level.
4-53 LO7 Understand the value of using activity level in activity-based costing.
 Number of activities performed at batch level goes up

as the number of batches rises – not by the number of
units within the batches changes
 Number of product-level activity performed depends on
the number of different products – not on how many
units or batches are produced.

 Facility-sustaining activity costs are not dependent
upon the number of products, batches, or units
produced.
 But Co. can control batch-, product-, and facility-level
costs only by modifying batch-, product-, and facility-
level activities .
Example
Morgan Toy Company manufactures six primary product lines in its

Morganville plant. As a result of an activity analysis, the accounting
department has identified eight activity cost pools. Each of the toy
products is produced in large batches, with the whole plant devoted to one
product at a time. Classify each of the following activities as either unit-
level, batch-level, product-level, or facility-level:
Product-level a. Engineering design,
Batch-level b. Machine setup,
Product-level c. Toy design,
Facility-level d. Interviews of prospective

employees,
Example
Morgan Toy Company manufactures six primary product lines in its
Morganville plant. As a result of an activity analysis, the accounting
department has identified eight activity cost pools. Each of the toy
products is produced in large batches, with the whole plant devoted to one
product at a time. Classify each of the following activities as either unit-
level, batch-level, product-level, or facility-level:
Batch-level e. Inspections after each setup,
Unit-level f. Polishing parts,
Unit-level g. Assembling parts,
Facility-level h. Health and safety.
Activity-Based Costing in Service Industries
No different than in Manufacturing company

Overall objective: Identify key cost-generation activities
and keep track of quantity of activities performed for each
service provided.
 General approach is to identify activities, cost pools, and
cost drivers.
 Labeling of activities as value-added or non-value-
added.
 A larger proportion of overhead costs are company-wide
costs that cannot be directly traced to specific services
provided by the company.
4-58 LO8 Apply activity-based costing to service industries.
Traditional Costing Example

Public accounting firm of Check and Doublecheck prepares the
following condensed annual budget.
Illustration 4-14
4-59 LO8
Traditional Costing Example

Under traditional costing Check and Doublecheck would
compute applied overhead and operating income as:
Illustration 4-15

Activity-Based Costing Example

Check and Doublecheck distributes its estimated annual
overhead costs of $600,000 to several activity cost pools.
Illustration 4-16


Assigning overhead in a service industry
Illustration 4-17


Comparison of traditional costing with ABC in a service
company.
Illustration 4-18


 Comparison shows that assignment of overhead cost
under traditional costing is distorted.
 Total cost assigned to perform the audit is greater
under traditional costing by $12,800 ($70,000 -
$57,200).
 Profit margin is significantly lower. Traditional costing
understates the profitability of the audit.

JUST-IN-TIME PROCESSING
 Traditionally, continuous process manufacturing is based

on just-in-case philosophy: Inventories of raw materials
are maintained just in case some items are of poor quality
or key supplier is shut down by a strike.
 This philosophy resulted in a “push approach” - raw
materials are pushed through each process and results in
buildup of extensive manufacturing inventories
 Switched to just-in-time (JIT) processing. Receive raw
materials just in time for the use in production. Complete
sub-assembly parts just in time for use in finished goods,
and complete finished goods just in time to be sold.
4-65 LO9 Explain just-in-time (JIT) processing.

. JIT manufacturing is dedicated to having the right amount of materials,

parts, or products just as they are needed.
Illustration 4A-1

 JIT strives to eliminate inventories using a pull approach in

manufacturing.
 Begins with customer placing an order with the company
which starts the process of pulling the product through the
manufacturing process.
 Objective is a smooth continuous flow in manufacturing
process, with no buildup of inventories at any point.

Objective of JIT Processing

 To eliminate all manufacturing inventories.
► Inventories are considered to have an adverse effect on net
income because they tie up funds and storage space that
could be made available for more productive purposes.
Elements of JIT Processing

 Dependable suppliers.
 Multi-skilled work force.
 Total quality control system.

Elements of JIT Processing

 Dependable suppliers.
► Suppliers that are dependable. Willing to deliver on short
notice exact quantities of materials, and at specified work
stations. Online computer linkage between the company and
its suppliers facilitates this arrangement
 Multi-skilled work force.

► Workers must be multi-skilled in order to operate and
maintain several different types of machines
 Total quality control system.

► Establish total quality control throughout the manufacturing
operations, means no defects. Continuous monitoring by
both employees and supervisors at each work station is
required.

Benefits of JIT Processing

 Significant reduction or elimination of manufacturing
inventories.
 Enhanced product quality.
 Reduction or elimination of rework costs and inventory
storage costs.
 Production cost savings from the improved flow of goods
through the processes.

Accounting Benefits of JIT

 Elimination of separate raw materials and work-in-
process inventory accounts.
 Maintained one account – “Raw and In-process
inventory”
 All materials and conversion costs are charged to this
account and reduction (or elimination) of in-process
inventories resulted to simpler computation of equivalents
units of production

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Chapter 4

Traditional Costing Systems

Traditional Costing Systems

Traditional Costing Systems

 Assumption was satisfactory when direct labor was a

Traditional Costing Systems

The Need for a New Approach

 Allocates overhead to multiple activity cost pools and

 Assigns the activity cost pools to products or services by

 Activity Cost Pool: a distinct type of activity. For

 Cost Drivers: any factors or activities that have a direct

 The rational for ABC costing is that products consume

 The more complex a product’s manufacturing operation,

Reason behind ABC cost allocation

LO 1: Recognize the differences between traditional costing and activity-based costing.

Activity-Based Costing Illustration 4-2

Based on the above illustration

 Co. allocates overhead costs to activity cost pools

 Co. identified 4 activity cost pools – purchasing, storing,

 After costs are allocated to activity cost pools, uses cost

Based on the above illustration

Example: If Ab Bench require more activity by the purchasing

Illustration 4-3 below shows a more complex activity based

Activity-Based Costing Illustration 4-3

 ABC does not replace an existing job order or process

 ABC does is to segregate overhead into various cost

 ABC, supplements – it does not replace – the traditional

1. Identify and classify the activities involved in the manufacture

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

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

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

 Each product requires 1 hour of direct labor.

 Expected annual manufacturing overhead costs $900,000.

Illustration: Traditional Costing

Manufacturing costs Ab Bench Ab Coaster

* Overhead rate = $900,000/30,000 DLH = $30 per DLH

Illustration: Activity Based Costing (ABC)

Identify and Classify Activities and Allocate

Identify and Classify Activities and Allocate

Identify Cost Drivers (Step 2)

Compute Overhead Rate (Step 3)

Compute Overhead Rates (Step 3)

Assign Overhead Cost to Products (Step 4)

Assign Overhead Cost to Products (Step 4)

Assign Overhead Cost to Products (Step 4)

Comparing Unit Costs

A likely consequence of the differences in assigning overhead is that

Comparing Unit Costs

High volume Low volume

Comparing Unit Costs

Comparing Unit Costs

Using the above data, do the following.

a. Prepare a schedule showing the computations of the activity-

b. Prepare a schedule assigning each activity’s overhead cost to the

c. Compute the overhead cost per unit for each product.

d. Comment on the comparative overhead cost per unit.

c. Compute the overhead cost per unit for each product.

d. Comment on the comparative overhead cost per unit.

4-40 LO5 Understand the benefits and limitations of activity-based costing.

4-41 LO5 Understand the benefits and limitations of activity-based costing.

4-42 LO5 Understand the benefits and limitations of activity-based costing.

2. Product lines are numerous and diverse, requires different

3. Overhead costs constitute a significant portion of total costs.