Activity-Based Costing

Activity-Based Costing
Traditional Costing Systems

• Often the most difficult part of computing
accurate unit costs is determining the proper
amount of overhead cost to assign to each
product, service, or job.
• Unlike direct materials and direct labor costs
which can usually be easily traced to the
product, overhead is an indirect or common
cost that generally cannot be traced to a
product.
Traditional Costing Systems
• In traditional costing a single predetermined
overhead rate was used throughout the year
to assign costs to products.
• We assumed that direct labor cost and
machine hours were the relevant activity
bases for the assignment of all overhead in job
order and process costing, respectively.
• Activity-based costing (ABC) allocates overhead to
multiple activity cost pools and assigns the activity
cost pools to production by means of cost drivers.
• In ABC, an activity is any event, action, transaction, or
work sequence that causes the incurrence of cost in
the production of a product or rendering of a service.
• A cost driver is any factor or activity that has a direct
cause/effect relationship with the resources
consumed.
• ABC first allocates costs to activities, and then
to the products based on each product’s use
of those activities.
• The reasoning behind ABC cost allocation is
simple: products consume activities;
activities consume resources.
Collecting ABC Data
• Interviews of the key employees in each of the
organizations support department and careful
review of each department’s records.
• Storyboarding is a procedure used to develop a
detailed process flow chart, which visually
represents activities and relationship among
the activities.
• Multidisciplinary ABC Project team to collect
information.
Collecting ABC Data
• Activity Dictionary and Bill of activity:
• Activity Dictionary has a complete listing of

activities identified and used in ABC analysis.
• Bill of activity for a product or service is a
complete listing of activities required for the
product or service produced.
• ABC allocates overhead in a two-stage

process:
– Overhead is allocated to activity cost pools,
each of which is a distinct type of activity,
– Overhead in the cost pools is assigned to
products using cost drivers which represent
and measure the number of individual activities
undertaken or performed to produce products
or render services.
• Not all products or services share equally in activities.
• The more complex a product’s manufacturing operation,
the more activities and cost drivers it is likely to have.
• If there is little or no correlation between changes in the
cost driver and consumption of the overhead cost,
inaccurate product costs are inevitable.
• The next slide shows an illustration of an activity-based
costing system with seven activity cost pools and
correlated cost drivers.
Activity-Based Costing System
Overhead Costs
Ordering
Setting Inspecting
and Assem- Super-
Up Machining and Painting
Receiving bling vising
Machines Cost Pool Testing Cost Pool
Materials Cost Pool Cost Pool Cost Pool
Cost Pool
Cost Pool
Numbe Numbe Numbe Numbe Numbe Direct

Machin
r of r of r of r of r of Labor
e Hours
POs Setups Parts Tests Parts Hours
Products
Illustration of Traditional Costing versus ABC
A simple case example will now be presented to compare

traditional costing and activity-based costing. It illustrates
the distortion that can occur in traditional overhead cost
allocation.
• Atlas Company products two automobile anti-theft devices, The Boot
and The Club. The Boot is a high-volume item, totaling 25,000 units
annually, while The Club is a low-volume item totaling only 5,000 units
a year. Both products require one hour of direct labor. Therefore,
annual direct labor hours are 30,000. Expected annual manufacturing
overhead costs are Rs.900,000. Thus, the predetermined overhead
rate is Rs 30 (900,000  30,000) per direct labor hour.
Unit Costs Under Traditional Costing
• The direct materials cost per unit is Rs.40 for The

Boot and Rs. 30 for The Club. The direct labor cost is
Rs.12 for each product.
• The computation of the unit cost for The Boot and
The Club under traditional costing is shown below:
Atlas Company
Products
Manufacturing Costs The Boot The Club
Direct material Rs.40 Rs.30
Direct labor 12 12
Overhead 30* 30*
Total unit cost Rs.82 Rs.72
*Predetermined overhead rate times direct labor hours (Rs. 30 x 1 hr. = Rs. 30)
Unit Costs under ABC
Activity-based costing involves the following steps:
1 Identify the major activities that pertain to the
manufacture of specific products and allocate
manufacturing overhead costs to activity cost pools.
2 Identify the cost drivers that accurately measure each
activity’s contributions to the finished product and
compute the activity-based overhead rate.
3 Assign manufacturing overhead costs for each activity
cost pool to products using the activity-based overhead
rates (cost per driver).
Identifying Activities
A well designed activity-based costing system starts with
an analysis of the activities performed to manufacture a
product. This analysis should identify all resource-
consuming activities.
• Atlas Company identified three activity cost pools:

setting up machines, machining, and inspecting.
Allocating Overhead to Cost Pools
After the activity cost pools are identified, overhead costs

are assigned directly to activity cost pools.
• Atlas Company’s activity cost pools, along with with
estimated overhead allocated to each activity cost pool
are shown below:
Atlas Company
Estimated
Activity Cost Pools Overhead
Setting up machines Rs.300,000
Machining 500,000
Inspecting 100,000
Total Rs.900,000
Identifying Cost Drivers
After costs are allocated to the activity cost pools, the cost
drivers for each activity cost pool must be identified. To
achieve accurate costing, a high degree of correlation must
exist between the activity cost driver and the actual
consumption of the activity cost pool.
• The cost drivers identified by Atlas and their total expected
use per activity cost pool are shown below:
Atlas Company
Expected Use of
Cost Drivers
Activity Cost Pools Cost Drivers per Activity
Setting up machines Number of setups 1,500 setups
Machining Machine hours 50,000 machine hours
Inspecting Number of inspections 2,000 inspections
Computing Overhead Rates
• Availability and ease of obtaining data

relating to the activity cost driver is an
important factor that must be considered in
its selection.
• The activity-based overhead rate is
computed as shown below:
Estimated Expected Use of
Activity-based
Overhead per
Activity
 Cost Drivers per
Activity
=
Overhead Rate
Computing Overhead Rates
• Atlas Company’s computations of its

activity-based overhead rates are below:
Atlas Company
Expected Use of
Estimated Cost Drivers
Activity Cost Pools
Setting up machines
Overhead
Rs.300,000
 per Activity
1,500 setups
= Activity-Based
Overhead Rates
Rs.200 per setup
Machining 500,000 50,000 machine hours Rs.10 per machine hour
Inspecting 100,000 2,000 inspections Rs.50 per inspection
Total Rs.900,000
Assigning Overhead Costs to Products under
ABC
In assigning overhead costs, it is necessary to know the

expected use of cost drivers for each product.
• Because of its low volume, The Club requires more setups and
inspection than The Boot. The expected use of cost drivers
per product is shown below:
Atlas Company
Expected Use
of Cost Drivers
Expected Use of
per Product
Cost Drivers
Activity Cost Pools Cost Drivers per Activity The Boot The Club
Setting up machines Number of setups 1,500 setups 500 1,000
Machining Machine hours 50,000 machine hours 30,000 20,000
Inspecting Number of inspections 2,000 inspections 500 1,500
ABC
To assign overhead costs to each product, the activity-
based overhead rates are multiplied by the number of cost
drivers expected to be used per product.
• The assignment of Atlas Company’s estimated annual
overhead cost to The Boot is shown below. Estimated
overhead assigned to The Club is shown on the next slide.
Atlas Company: The Boot
Expected Use Activity-Based
of Cost Drivers Overhead Cost
x = Assigned
Activity Cost Pools per Product Rates
Setting up machines 500 Rs.200 Rs.100,000
Machining 30,000 Rs. 10 300,000
Inspecting 500 Rs. 50 25,000
Total assigned costs (a) Rs.425,000
Units produced (b) 25,000
Overhead cost per unit (a)  (b) Rs.17
ABC
Atlas Company: The Club
Expected Use Activity-Based
of Cost Drivers Overhead Cost
x = Assigned
Activity Cost Pools per Product Rates
Setting up machines 1,000 Rs.200 Rs.200,000
Machining 20,000 Rs. 10 200,000
Inspecting 1,500 Rs. 50 75,000
Total assigned costs (a) Rs.475,000
Units produced (b) 5,000
Overhead cost per unit (a)  (b) Rs.95
• These data show that under ABC, overhead costs

are shifted from the high volume product (The
Boot) to the low-volume product (The Club).
ABC
This shift of overhead from high to low volume

products results in more accurate costing for two
reasons:
– Low-volume products often require more special handling,
such as setups. Thus, the low-volume product is
responsible for more overhead costs per unit than a high-
volume product.
– The overhead costs incurred by the low-volume product
often are disproportionate to a traditional allocation base
such as direct labor hours.
Comparing Unit Costs
Atlas Company
The Boot The Club

Traditional Traditional
Manufacturing Costs Costing ABC Costing ABC
Direct materials Rs.40 Rs.40 Rs.30 Rs. 30
Direct labor 12 12 12 12
Overhead 30 17 30 95
Total cost per unit Rs.82 Rs.69 Rs.72 Rs.137
The comparison shows that unit costs under traditional

costing are significantly distorted. The cost of producing
The Boot is overstated Rs.13 per unit and the cost of
producing The Club is understated Rs.65 per unit.
Comparing Unit Costs
• The differences in cost per unit are attributable
entirely to how manufacturing overhead is
assigned.
• A likely consequence of the differences is that
Atlas Company has been overpricing The Boot
and possibly losing market share to
competitors. In addition, it has been
sacrificing profitability by underpricing The
Club.

Activity-Based Costing

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Activity-Based Costing

Traditional Costing Systems

• Activity Dictionary has a complete listing of

• ABC allocates overhead in a two-stage

Numbe Numbe Numbe Numbe Numbe Direct

A simple case example will now be presented to compare

• The direct materials cost per unit is Rs.40 for The

• Atlas Company identified three activity cost pools:

After the activity cost pools are identified, overhead costs

• Availability and ease of obtaining data

• Atlas Company’s computations of its

In assigning overhead costs, it is necessary to know the

• These data show that under ABC, overhead costs

This shift of overhead from high to low volume

The Boot The Club

The comparison shows that unit costs under traditional

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