MODULE 2
Management Advisory Services 2
SESSION TOPIC 2 : Activity-Based Costing and Activity-Based Management
LEARNING OUTCOMES:
The following specific learning objectives are expected to be realized at the end of the session:
1. Full understanding of the Philippine Standards on auditing
2. Preparation of an audit plan
KEY POINTS
Traditional costing Activity based costing Activity center Cost driver
CORE CONTENT
Introduction:
This module covers the discussion of
a. Traditional costing;
b. Activity based costing.
IN-TEXT ACTIVITY
Traditional Costing Method
Under the traditional costing system, cost assigned to products or services are estimated.
The best estimate o cost is when the costs are directly traceable to the product produced or services rendered.
Direct material and direct labor costs are the easiest to trace directly to the product by verifying material requisition forms
and payroll time sheets.
Activity Based Costing
An allocation method that measures a variety of different factory activities and their relationship to overhead costs.
Using an ABC costing system means that a company develops an allocation system that matches its own unique
production process.
ABC costing is designed to take into account all the different costs that compose a company's total overhead and
distribute these costs as accurately as possible to products.
The first procedure in establishing an ABC System is to identify the activities that cause the overhead costs to be incurred.
A list of individual activities may be quite lengthy so activities are often group into activity centers or activity cost pools. For
example, (1) ordering materials, (2) inspection, (3) setting up the machine and (4) assembling.
The overhead costs allocated to the different activity centers are collected into cost drivers or cost pools.
Illustration
King Company produces two products, Product XX and Product YY. Product XX is a high volume item totaling
50,000 units annually while Product YY is a low volume item totaling only 10,000 units per year. Both products require one
hour of direct labor to complete. Estimated annual manufacturing overhead costs is P3,600,000.
The direct materials cost per unit is P80 for product XX and P60 for Product YY with direct labor cost for both
products at P24 per unit.
Using Traditional Costing
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Unit Cost Under ABC
To compute the unit costs under ABC, the following three procedures are to be used:
Identify the major activities that pertain to the manufacture of specific products and allocate manufacturing overhead costs
to activity centers.
Identify the cost drivers that accurately measure each activity's contribution to the finished product and compute the
activity-based overhead rate .
Allocate manufacturing overhead costs for each activity centers to products using the activity-based overhead rates (cost
per driver).
Identifying Activities and Allocating Overhead to Activity Centers
This requires a detailed analysis of the activities performed to manufacture the product. For example, King
Company identified three activity center: setting up machines, machining and inspecting.
After the activity centers are identified, estimated overhead costs are allocated directly to each activity centers as
shown below:
Activity Centers Estimated Overhead
Setting up machines P1,200,000
Machining 2,000,000
Inspecting 400,000
Total 3,600,000
Identifying Cost Drivers and Computing Overhead Rates
Activity Centers Cost Drivers Expected use of cost drivers per activity
Setting up machines Number of setups 3,000 set ups
Machining Machine hours 100,000 machine hrs
Inspecting Number of inspections 4,000 inspections
Activity-based Overhead Rates:
Setting up machines - 1.2M/3,000 set ups = 400 per set up
Machining - 2M/100K machine hours = 20 per machine hr
Inspecting - 400K/4,000 inspections = 100 per inspection
Usage of Cost driver per product:
Cost driver XX YY Total
Number of set ups 1,000 2,000 3,000
Machine hours 60K 40K 100K
Inspecting 1,000 3,000 4,000
Advantages of ABC
ABC leads to more cost pools used to allocate overhead costs to products. Costs are allocated more directly on a basis of
the portion of multiple cost-driven activities that can be traced to each product.
ABC leads to enhanced control overhead costs. Under ABC, many overhead costs can be traced directly to activities, thus
some indirect costs become direct costs.
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ABC leads to better management decisions. More accurate product costing should contribute to setting selli ng prices that
will achieve desired product profitability levels.
Disadvantages of ABC
ABC can be expensive to use. Many companies are discouraged from using ABC because of higher cost of identifying
multiple activities and applying numerous costs driver.
Some arbitrary allocations continue. Even though more overhead costs can be assigned directly to products through
multiple activity cost pools, some overhead costs remain to be allocated by means of some arbitrary volume-based cost
driver such as labor or machine hours.
SESSION SUMMARY
Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities—to
products and services.
The ABC system of cost accounting is based on activities, which are considered any event, unit of work, or task with
a specific goal.
An activity is a cost driver, such as purchase orders or machine setups.
The cost driver rate, which is the cost pool total divided by cost driver, is used to calculate the amount of overhead
and indirect costs related to a particular activity.
SELF-ASSESSMENT
Assignment : Computation of traditional and activity based costing
Quiz : Problem on activity-based costing
REFERENCES
Refer to the references listed in the syllabus of the subject.
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