ACTIVITY BASED COSTING

LEARNING OBJECTIVES

By the end of the lecture you should be

able to:
1. Explain the shortcomings of traditional
overhead absorption/allocation methods.
2.Describe and explain the Activity Based
Costing (ABC) approach to overhead
absorption.
3.Compute products costs using ABC
approach and compare the costs with
 INTRODUCTION

The cost of a product or service is

information that is quite often
required by management for
various purposes, for example,
stock valuation, profit
measurement or decision making.

What is cost?
 Introduction (cont)
Cost is simply the aggregate of all the
expenses incurred in bringing a product to
its present condition and location.

Some expenses are directly traceable to
the cost object (direct costs), while some
are not (indirect costs or overheads).
The problem remains with production
overhead, which is not directly traceable,
should form part of the production cost of
a product.
Introduction(cont)
The process of allocating
production overheads to cost
units/cost objects is known as
overhead absorption.
There are two approaches to
overhead absorption; (i) traditional
approach (ii) Activity Based
Costing (ABC) approach.
 TRADITIONAL COST
ALLOCATION METHODS
Apportions the total production
overheads based on production volume.
Common absorption bases are number
of units, machine hours and direct
labour hours.
Under this approach, an organisation
can use either a (i) plant-wide
allocation method or a (ii) departmental
allocation method.
The department allocation method
uses separate cost pools for each
department.
Therefore a separate overhead
absorption rate for each department
is established.
ACTIVITY 1
PRODUCT A B

units produced 20 000 2000

Material cost/unit 10 12
Labour :A(5 hrs @ $12/H) 60
Labour B:(6 hrs @$12/hour) 72
Variable overhead A :(5 Hours 5
@$1/hour)
Variable overhead for B (6 6
Hours @$1/hour)
 Activity 1 (cont)
Budgeted fixed overheads for the period
amounted to $224 000
Required
Calculate the total full production cost and
the production cost per unit of each
product using labour hours to absorb
overheads.
 solution
Step 1-calculate overhead
absorption rate.
Step 2- determine the prime cost
Step 3-allocate overheads to
products using O.A.R as
calculated in step 1
Step 4- determine full production
The major drawback of the
traditional approach to overhead
absorption is that overhead is
absorbed into product cost on the basis
of production volume (measured
generally in machine hours, labour
hours, etc) regardless of the fact that
most of the overhead expenses may not
have been the result of that production
This, therefore, results in inaccurate
allotment of overhead cost with a
consequent effect on product pricing
and profitability or profit
measurement.
 ACTIVITY BASED COSTING
(ABC)
The modern approach called
Base Costin Activity (ABC)
dtraditional
g approach.
challenges this

takes into consideration the real
factors that cause overhead to
vary with production.
overheads accounts for
significant proportion of total
cost and a more accurate method
of apportionment is therefore,
required.
Using this approach would
require a different way of
classifying overhead cost, and the
Activity-based costing (ABC) rest
on this premise: Products require
activities; activities consume resources
and acquisition of resources causes
costs.
ABC therefore, assigns costs first to
activities, then to the products based on
each product’s use of activities
 Steps in ABC
Activity-based costing requires accountants to
follow four steps.
1.Identify the activities that consume
resources and assign costs to those activities
 Activity: an event, task, or unit of work with
a specified purpose,
 Activities can be classified into 4 categories
namely; unit level activities, batch level
activities, product level activities, and facility
level activities.
 2. Identify the cost driver(s)
associated with each activity.
A cost driver is a factor that
causes, or ‘‘drives,’’ an activity’s
costs.
The primary criterion for
selecting a cost driver is causal
relation. Choose a cost driver that
causes the cost.
 Activity 2

Match the following costs with their

appropriate cost drivers.
COSTS COST DRIVERS
1. Depreciation A.No. of set ups
2. Indirect labour B.No. of purchases
cost C.No. of product
3. Machine set up design
cost D.No. of inspections
4. Order placing E.Machine hours
cost F.Direct labour hours
3.Compute a cost driver rate for each
cost driver.
Cost driver rate=Indirect cost or
Overheads for each activity/Cost
driver volume.
4. Assign costs to products using
the cost driver rate
Multiply the cost driver rate by the
volume of cost drivers consumed
by the product.
 ACTIVITY 3
Continuing from data in Activity 2
above,
the following additional information is
provided;
The examination
Machine set-up of the fixed overheads
90,000
of $224,000 shows that they consist
costs of:
42,000
Depreciation 42,000
Inspection cost 50,000
Machining cost 224,00
Activity Levels are as follows;

Product A B
Number of set ups 10 20
Number of inspections 400 600
Number of machine hours 6500 350
0
Required
(a)Calculate the total production
cost per unit using ABC
(b) Compareprinciples
the cost per unit under
the Traditional approach and ABC
approach.
BENEFITS OF ABC COSTING

1) The complexity of manufacturing

has increased with wider product ranges,
shorter product life cycle all of which are
catered for by ABC with its multiple cost
drivers.
2)It facilitates a good understanding of
what drivers overhead costs.
3)It takes all overheads costs and so
takes management accounting
beyond its traditional factory floor
boundaries .
Drawbacks
Some measure of (arbitrary ) cost
apportionment may still be required at the
cost pooling stage for some items like
rent, rates, and building depreciation.
A single cost driver cannot explain the
cost behavior of all the items in its
associated pool.
Cost drivers applies only where costs
are caused by an activity that is measurable
in quantitative terms and which can be
The
end