Advanced Cost and Management Accounting

(ACFN 621)

CHAPTER TWO

Activity Based Costing and Management

By: Mohammed G(Msc,

Assistant Professor)
Nov, 2022
Jimma, Ethiopia
Describe the purposes of cost management systems.
Explain the relationship among cost, cost object, cost
accumulation, and cost assignment.
Distinguish between direct and indirect costs.
Explain the major reasons for allocating costs.
Understand the main differences between traditional and
activity-based costing (ABC) systems and why ABC
systems provide value to managers.
Use activity-based management (ABM) to make strategic
and operational control decisions.
BY M.G Assi.prof. JU.ACFN 2
A cost management system (CMS) is a collection of
tools and techniques that identifies how management’s
decisions affect costs.
The primary purposes of a cost management system
are:
 To provide cost information for strategic management
decisions and operational control and
 For measures of inventory value and cost of goods sold
for financial reporting.

BY M.G Assi.prof. JU.ACFN

3
A cost is a sacrifice or giving up of resources for a
particular purpose.

Costs are frequently measured by the monetary units

that must be paid for goods and services.

Cost Object

A cost object (objective) is anything for which a separate

measurement of costs is desired.

Customers Service
BY M.G Assi.prof. JU.ACFN
Product Departments
4
Cost accounting is that part of the cost management system
that measures costs for the purposes of management
decision making and financial reporting.

Cost Collecting costs by some

accumulation: “natural” classification
such as materials or labor
Cost
assignment: Tracing costs to one or
more cost objectives 5
CA Cost
Material costs
accumulation
(metals)
Cost assignment
to cost objects

Machining Department Finishing Department

Activity Activity Activity Activity
1. Departments
Activity Activity Activity Activity

2. Activities Cabinets Cabinets

3. Products Desks Desks

Tables Tables
6
  Direct costs can be identified specifically and exclusively with a
given cost objective in an economically feasible way.

Indirect costs cannot be identified specifically and exclusively

with a given cost objective in an economically feasible way.
Cost Allocation
Cost allocation assigns indirect costs to cost objects, in proportion
to the cost object’s use of a particular cost-allocation base.

A cost-allocation base is some measure of input or output

that determines the amount of cost to be allocated to a
particular cost object.
BY M.G Assi.prof. JU.ACFN
7
An ideal cost-allocation base would measure how much of the
particular cost is caused by the cost objective.
Note the similarity of this definition to that of a cost driver—
an output measure that causes costs. Therefore, most
allocation bases are cost drivers.
Cost allocations support a company’s CMS that provides cost
measurements for strategic decision making, operational
control, and external reporting.

BY M.G Assi.prof. JU.ACFN

8
 Cost Allocation
 Four purposes of cost allocation:

 Predict economic effects of strategic and operational

control decisions.
 Provide desired motivation and feedback for
performance evaluation.
 Compute income and asset valuations for financial
reporting.
 Justify costs or obtain reimbursement.

BY M.G Assi.prof. JU.ACFN

9
Individual costs allocated to cost objects using a single cost-
allocation base.

1. Accumulate indirect costs for a period of time.

2. Select an allocation base for each cost pool, preferably a
cost driver, that is, a measure that causes the costs in
the cost pool.
3. Measure the units of the cost-allocation base used for each
cost object and compute the total units used for all
cost objects.
4. Multiply the percentage by the total costs in the cost pool
to determine the cost allocated to each cost object.
BY M.G Assi.prof. JU.ACFN
10
 Direct costs are physically traced to a cost object.

 Indirect costs are allocated using a cost-allocation base.

BY M.G Assi.prof. JU.ACFN

11
Some costs lack an identifiable relationship to a cost object.
Often it is best to leave such costs unallocated.

An unallocated cost for one company may be an allocated cost

or even a direct cost for another.

These unallocated costs are recorded but not assigned to any

cost object.

12
 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.
BY M.G Assi.prof. JU.ACFN
13
 Identify activities and assign indirect costs to those activities.

Central idea . . .
 Products require activities.
 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.
14
 There are three reasons why the reported product margins for the two
costing systems differ from one another.
1. Traditional costing allocates all manufacturing overhead to products.
ABC costing only assigns manufacturing overhead costs consumed
by products to those products.
2. Traditional costing allocates all manufacturing overhead costs using
a volume-related allocation base. ABC costing also uses non-volume
related allocation bases.
3. Traditional costing disregards selling and administrative expenses
because they are assumed to be period expenses. ABC costing
directly traces shipping costs to products and includes
nonmanufacturing overhead costs caused by products in the activity
cost pools that are assigned to products.
15
Most companies do not use ABC for external reporting
because.
External reports are less detailed than internal reports.
 It may be difficult to make changes to the company’s
accounting system.
ABC does not conform to IFRS, mainly because it
allocates also selling and administrative overheads to the
value of inventory

BY M.G Assi.prof. JU.ACFN 16

Customer Orders - assigned all costs of resources that are consumed by taking and
processing customer orders.
Design Changes - assigned all costs of resources consumed by customer requested design
changes
Order Size - assigned all costs of resources consumed as a consequence of the number of
units produced.
Customer Relations – assigned all costs associated with maintaining relations with
customers.
Other – assigned all organization-sustaining costs and unused capacity costs 17
 The Benefits of ABC:
More detailed measures of costs.
Better understanding of activities.
More accurate product costs for . . .
Pricing decisions.
Product elimination decisions.
Managing activities that cause costs.
Benefits should always be compared to
costs of implementation.
BY M.G Assi.prof. JU.ACFN
18
Identifying Cost Drivers ;

Most cost drivers are related to either volume or complexity of

production.
Examples: machine time, machine setups, purchase orders,
production orders.

Three factors are considered in choosing a cost driver:

Causal relationship.
Benefits received.
Reasonableness.

19
 Identify activities that consume resources.
 Assign costs to a cost pool for each activity.
 Identify cost drivers associated with each activity.
 Compute overhead rate for each cost pool:

Assign costs to products:

Actual direct labor hours worked x Predetermined

overhead rate
20
 Albert Shoes Company calculates its predetermined overhead
rate on the basis of annual direct labor hours. At the
beginning of year 2021, the company estimated that its total
manufacturing overhead cost would be Br.268,000 and the
total direct labor cost would be 40,000 hours. The actual total
manufacturing overhead incurred for the year was Br.247,800
and actual direct labor hours worked during the year were
42,000.
 Required:
a. Calculate Albert’s predetermined overhead rate for the year 2021.
b. Find the amount of manufacturing overhead cost that Albert would
have applied to its units of product.
21
 The estimated operating and cost data for three different
companies is given below:

 The allocation bases used by above three companies for

computing their predetermined overhead rates are:
• Company A: Direct labor hours
• Company B: Machine hours
• Company C: Direct materials cost
 Required: Compute predetermined overhead rate for each
of the above three companies. 22
 Traditional costing is a costing method used to allocate
overhead costs based on a single cost driver according to the
consumption of a volume of production resources.
 This single cost driver can be based on machine hours, labor
hours etc. and is used for all the different activities.
ABC is generally perceived to produce superior costing
figures due to the use of multiple drivers across multiple
levels.
ABC is only as good as the drivers selected, and their
actual relationship to costs. Poorly chosen drivers will
produce inaccurate costs, even with ABC.
BY M.G Assi.prof. JU.ACFN 23
BY M.G Assi.prof. JU.ACFN
24
BY M.G Assi.prof. JU.ACFN
25
 Let’s look at an
 example comparing
traditional costing
with ABC.
We will start with
traditional costing.

BY M.G Assi.prof. JU.ACFN

26
Pearl Company manufactures a product in regular and
deluxe models. Overhead is assigned on the basis of
direct labor hours. Budgeted overhead for the current
year is Birr2,000,000. Other information:
Deluxe Regular
Model Model
Direct Material Br 150 Br 112
Direct Labor Cost 16 8
Direct Labor Time 1.6 hours 0.8 hours
Expected Volume (units) 5,000 40,000

First, determine the unit cost of each model using traditional costing
methods.
BY M.G Assi.prof. JU.ACFN 27
 Direct
Labor Hours
Deluxe Model 5,000 units @ 1.6 hours 8,000
Regular Model 40,000 units @ 0.8 hours 32,000
Total Direct Labor Hours (DLH) 40,000

Overhead Estimated overhead costs

=
Rate Estimated activity
Overhead Birr2,000,000
Rate 40,000 DLH = Birr50 per DLH

BY M.G Assi.prof. JU.ACFN 28

 ABC will have different
overhead per unit. Deluxe Regular
Model Model
Direct Material Br 150 Br 112
Direct Labor 16 8
Manufacturing Overhead
Br 50 per hour × 1.6 hours 80
Br 50 per hour × 0.8 hours 40
Total Unit Cost Br 246 Br 160

BY M.G Assi.prof. JU.ACFN

29
Pear Company plans to adopt activity-based costing.
Using the following activity center data, determine the
unit cost of the two products using activity-based
costing.

Overhead
Activity Cost Cost for Units of Activity
Center Driver Activity Deluxe Regular
Purchasing Orders Br 84000 400 800
Scrap Rework Orders 216,000 300 600
Testing Tests 450,000 4,000 11,000
Machine Related Hours 1,250,000 20,000 30,000
Total Overhead Br 2000000
BY M.G Assi.prof. JU.ACFN 30
 Activity-Based Costing
Overhead Units
Activity Cost Cost for of
Center Driver Activity Activity Rate
Purchasing Orders Br 84000 1,200
Scrap Rework Orders 216,000 900
Testing Tests 450,000 15,000
Machine Related Hours 1,250,000 50,000
Total Overhead Br 2000000

400 deluxe + 800 regular = 1,200 total

BY M.G Assi.prof. JU.ACFN

31
 Overhead Units
Activity Cost Cost for of
Center Driver Activity Activity Rate
Purchasing Orders Br 84000 1,200 Br 70 per order
Scrap Rework Orders 216,000 900 Br 240 per order
Testing Tests 450,000 15,000 Br 30 per test
Machine Related Hours 1,250,000 50,000 Br 25 per hour
Total Overhead Br 2000000

Rate = Overhead Cost for Activity ÷ Units of Activity

BY M.G Assi.prof. JU.ACFN

32
 Deluxe Model Regular Model
Actual Cost Actual Cost
Units of Allocated Units of Allocated
Activity Rate Activity to Product Activity to Product
Purchasing Br 70/order 400 ? 800 ?
Scrap Rework Br 240/order 300 ? 600 ?
Testing Br 30/test 4,000 ? 11,000 ?
Machine Related Br 25/hour 20,000 ? 30,000 ?
Total Overhead ? ?

33
 Deluxe Model Regular Model
Actual Cost Actual Cost
Units of Allocated Units of Allocated
Activity Rate Activity to Product Activity to Product
Purchasing Br 70/order 400 Br 28000 800 Br 56000
Scrap Rework Br240/order 300 ? 600 ?
Testing Br 30/test 4,000 ? 11,000 ?
Machine Related Br 25/hour 20,000 ? 30,000 ?
Total Overhead ? ?

Cost Allocated to Product = Actual Units of Activity × Rate

Let’s complete
BY M.G Assi.prof. JU.ACFN the table.
34
 Deluxe Model Regular Model
Actual Cost Actual Cost
Units of Allocated Units of Allocated
Activity Rate Activity to Product Activity to Product
Purchasing Br 70/order 400 Br 28000 800 Br 56000
Scrap Rework Br 240/order 300 72,000 600 144,000
Testing Br 30/test 4,000 120,000 11,000 330,000
Machine Related Br 25/hour 20,000 500,000 30,000 750,000
Total Overhead Br 720000 Br 1280000

Cost Allocated to Product = Actual Units of Activity × Rate

35
BY M.G Assi.prof. JU.ACFN
 Deluxe Model Regular Model
Total overhead = Birr720,000 + Birr1,280,000 = Birr2,000,000
Actual Cost Actual Cost
Recall that Birr2,000,000 was Unitsthe
of original
Allocatedamount
Unitsof
of overhead
Allocated
assigned to the products
Activity Rate using traditional
Activity overhead
to Product costing.
Activity to Product
Purchasing Br 70/order 400 Br 28000 800 Br 56000
Scrap Rework Br 240/order 300 72,000 600 144,000
Testing Br 30/test 4,000 120,000 11,000 330,000
Machine Related Br 25/hour 20,000 500,000 30,000 750,000
Total Overhead Br 720000 Br 1280000

Cost Allocated to Product = Actual Units of Activity × Rate

BY M.G Assi.prof. JU.ACFN

36
Overhead Costs Assigned to Products:
Deluxe Model Br 720,000 ÷ 5,000 units = Br 144 per unit
Regular Model Br 1,280,000 ÷ 40,000 units = Br 32 per unit

Deluxe Regular
Model Model
Direct Materials Br 150 Br 112
Direct Labor 16 8
Manufacturing Overhead 144 32
Total Unit Cost Br 310 Br 152

BY M.G Assi.prof. JU.ACFN 37

 Traditional Costing ABC
Deluxe Regular Deluxe Regular
Model Model Model Model
Direct materials Br 150 Br 112 Br 150 Br 112
Direct labor 16 8 16 8
Overhead 80 40 144 32
Total cost Br 246 Br 160 Br 310 Br 152

This result is not uncommon when activity-based costing is used. Many

companies have found that low-volume, specialized products have greater
BY M.G Assi.prof.overhead
JU.ACFN costs than previously realized.
38
 ABM is using the output of an activity-based cost
accounting system to aid strategic decision
making and to improve operational control.

A value-added cost is the cost of an activity that

cannot be eliminated without affecting a product’s
value to the customer.

Nonvalue-added costs are costs that can be

eliminated without affecting a product’s value to
the customer.
Benchmarking is the continuous process of comparing
products, services, and activities to the best industry
standards.

Benchmarking is a tool to help an organization measure its

competitive posture. Benchmarks can come from within the
organization, from competing organizations, or from other
organizations having similar processes.
 The initial stages in ABM are the same as for ABC, so these
should be familiar from earlier studies:
1. Identify the activities that the organization performs
2. Calculate the cost of each activity
3. Identify the activity cost driver for each activity. 

BY M.G Assi.prof. JU.ACFN

41
 The following points reflect the importance of the ABM:

 The findings of the ABM analysis can serve as the data

for forecasting models and budgets. Thus, we can say
that ABM can assist the management in getting a better
idea of future business prospects.

 Since ABM helps to make value-generating activities

more efficient, this, in turn, improves the customer
experience.
PUT THIS KNOWLEDGE TO WORK!

43