Activity-Based Costing

Module 2
 Syllabus Objective

Compare and contrast activity-based costing (ABC) techniques

with traditional costing approaches
Traditional Costing Systems
Traditional costing systems, namely job order costing
and process costing were designed to provide unit
product cost mainly for external reporting purposes.

The traditional method of product costing attached

overhead costs to products and services based on a
predetermined overhead rate.

In the manufacturing sector, it is widely believed that

this rate tends to be inaccurate, especially in the high-
volume focused factory environment.
Deficiencies of Traditional Costing Systems

+ Under traditional costing systems, costs were distributed to

products by simplistic and arbitrary measures, usually direct
labour based, which did not represent the demands made by
each product on the firm’s resources.

+ When such distorted information represents the only

available data on product costs, the danger exists for
misguided decisions on product pricing, product
sourcing, product mix and responses to rival products.
Activity-Based Costing (ABC)
Activity 2
+ One of the best tools for
Activity 1 Activity 3
refining a costing system is
activity-based costing. Activity-
based costing (ABC) refines a
costing system by identifying
Product / Service
(Cost object)
individual activities as the
fundamental cost objects.
Activity-Based Costing (ABC)
+ ABC systems identify activities Activity 2

in all functions of the value Activity 1 Activity 3

chain, calculate costs of

individual activities, and assign
costs to cost objects such as
products and services on the Product / Service
(Cost object)
basis of the mix of activities
needed to produce each
product or service.
Activity-Based Costing (ABC)
+ An activity is an event, task, or
unit of work with a specified
purpose—for example,
designing products, setting up Painting
machines, operating machines,
and distributing products. More
informally, activities are verbs;
they are things that a firm does. Cutting
Activity – Based Costing (ABC)

+ Activity-based costing is ordinarily used as a supplement to,

rather than as a replacement for, a company’s usual
costing system. Most organizations that use activity-based
costing have two costing systems—the official costing system
that is used for preparing external financial reports and the
activity-based costing system that is used for internal decision
making and for managing activities.
Activity Based Costing (ABC)

ABC is designed to provide

ABC is a
managers with cost good supplement
to our traditional
information for strategic cost system
I agree!
and other decisions that
potentially affect capacity
and therefore affect fixed as
well as variable costs.
ABC vs. Traditional Costing Systems
Area ABC Traditional Costing
Cost accumulation By cost pools By departments
Cost of implementation Relatively expensive Relatively inexpensive
and maintenance
Control of costs Cost control is Cost control is undertaken on a
undertaken on a cross departmental basis.
functional basis, i.e.
based on the
organization as a whole.
Allocation bases Costs are allocated to Costs are allocated to products by
products and services using volume-based allocation
using cost drivers bases, e.g. units of production,
(activities). direct labour hours, machine hours.
Accuracy of information More accurate due to the Less accurate due to inability to
for management alignment of allocation align allocation bases with cost
decision-making. bases with cost drivers. drivers.
 Steps for Implementing ABC

1 2 3 4
Define activities, Trace costs to Calculate activity Use the activity
activity cost activities and rates rates to assign
pools and cost objects costs to cost
activity measures objects
Step 1: Define activities,
activity cost pools and
activity measures
How Costs are Treated Under ABC
ABC differs from traditional costing systems

Level of complexity
Activity–Based
Costing

Departmental
Overhead
Rates
Plantwide
Overhead
Rate

Number of cost pools

 ABC uses more cost pools.
How Costs are Treated Under ABC
ABC differs from traditional costing systems

Each ABC cost pool has its

own unique measure of activity.

Traditional cost systems usually rely

on volume measures such as direct labor
hours and/or machine hours to allocate
all overhead costs to products.

 ABC uses more cost pools.

 Activities

+ These are processes that consume substantial

resources to produce an output. The principal
function of an activity is to convert resources
(supplies, labour and technology) into output and
services.
How Costs are Treated Under ABC

Unit-Level Batch-Level
Activity Activity

Manufacturing
companies typically combine
their activities into five
classifications.

Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
 Unit- Level Activities
+ These are performed each time a
unit is produced. The costs
associated with unit-level activities
are those costs generated from the
use of resources on each individual
unit of a product or service.
Example: Direct materials, direct
labour, variable overheads
(traceable to the product).
 Batch Level Activities
These are activities performed each time a batch is handled or processed,
without reference to the number of units in the batch. The costs associated
with batch level activities are the costs related to the consumption of
resources at the group level that is related to a group of products or
services.

Costs at the batch level depend on the number of batches rather than on
the number of units produced or sold. Example: machine setup,
inspections, materials movement.
Product-Sustaining Activities
These relate to the product being
produced without reference to the number
of units or batch of the product being
produced.

Product-sustaining costs are costs relating

to the use of resources to support the
products or services.

Design costs, equipment maintenance and

product development are examples of
product-sustaining costs.
Customer-Level Activities
+ These relate to specific
customers and are not
tied to any specific
product. For example,
sales calls and catalogue
mailings would be
customer-level activities.
 Organization-Sustaining Activities
These are activities that are necessary for sustaining the
organization and do not relate to production.

Facility- sustaining costs are those costs that support

the organization ad a whole and cannot be traced to
any product or service.

These costs include accountants’ salaries, general

managers’ salaries and building depreciation.

These costs cannot be assigned to individual products

or services because of the lack of any relationship
between them and the products and services provided.
 Activity 1 - Classify
activity costs
Rochelle Jordan Company manufactures seat belts. Classify each of the following
activity costs of the seat belt company as either unit level, batch level, product
level or facility level.
Plant management

Facility-Sustaining
Drilling

Unit-level
Painting

Unit-level
Machine setups

Batch-level
Product Design

Product-sustaining
Cutting

Unit-level
Inspection

Batch-level
Inventory Management

Product-sustaining
How Costs are Treated Under ABC

An event that causes the

Activity consumption of overhead
resources.

A “cost bucket” in which

Activity costs related to a particular
Cost Pool activity measure are
accumulated.
$$
$
$ $
$
How Costs are Treated Under ABC

The term cost driver

is also used to refer
Activity
to an activity
Measure
measure.

An allocation base
in an activity-based
costing system.
Cost Driver/ Activity
Measure
+ A cost driver is equivalent to a predetermined
factory overhead allocation base and should
be chosen on the basis that it has the greatest
influence on the cost behaviour of overheads.
For example, if, during the production process,
Product A uses twice as much floor space as
Product B, it should be charged with twice as
much maintenance cost.
Examples

Cost driver Activity Cost Pool

No. of customer orders Customer orders

No. of product designs Product design

 A list of possible cost drivers is
presented below. For each of the
Activity 2 following activity cost pools, select
the most appropriate cost driver.
Cost driver Cost Pool

a) Engineering hours 1) Machine set-up

b) Set-ups 2) Ordering and receiving
c) Machine hours 3) Packaging and shipping
d) Number of subassemblies 4) Engineering design
e) Boxes 5) Machining

f) Orders 6) Assembly
Activity 3
Suggest a suitable cost driver for each of the activities.
 Placing orders

+ Number of orders
Customer Service

+Number of customers
+Dollar volume of sales
Training employees

+Number of employees
Wrapping packages

+ Number of packages
Janitorial and maintenance

+ Square feet occupied

Advertising and marketing

+ Number of advertisements/ ad campaigns

 Step 2: Trace costs to
activities and cost objects
Activity-Based Costing (ABC)

+ In the traditional costing systems, only

manufacturing costs are traced to products, but in
activity-based costing, both manufacturing and non-
manufacturing costs are traced to products.
Activity-Based Costing (ABC)

+ In the ABC system, some overheads can be traced directly

to the cost object. For example, shipping costs can be
traced directly to customer orders. Other overhead costs
that cannot be directly traced to products, customer
orders are assigned to cost objects using the ABC system.
 Activity 4 Activity % of time on
each activity
+ A consultant was hired to
implement an activity-based Treating patients 30%

costing system at the Ridge Responding to requests 17%

County Hospital. On examining
the nursing department and
Monitoring patients 15%
conducting interviews with the
nursing staff, the consultant Distributing medication 20%
identified the following activities
and the percentage of time that Writing up charts 18%
nurses spent performing the
activity.
Activity 4 Activity % of time
on each
activity
+ On examining the Treating patients 30%
payroll file of Ridge Responding to requests 17%
County Hospital, it
Monitoring patients 15%
showed that the total
nursing cost for one Distributing medication 20%
month was Writing up charts 18%
$1,500,000. Trace the
overheads to the cost
pools.
 Activity % of time on

Nursing cost Treating patients

each activity
30%
$1,500,000 Responding to requests 17%
Monitoring patients 15%
Distributing medication 20%
Writing up charts 18%

Activity Cost assigned to

activity
Treating patients 30% x $1,500,000 450,000
Responding to requests 17% x $1,500,000 255,000
Monitoring patients 15% x $1,500,000 225,000
Distributing medication 20% x $1,500,000 300,000
Writing up charts 18% x $1,500,000 270,000
$1,500,000
Step 3:
Calculate
activity rates
Activity Rate

𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚 𝑹𝒂𝒕𝒆
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜𝑡𝑎𝑙 𝑚𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑖𝑛𝑔 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 (𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦)
=
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜𝑡𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 𝑜𝑟 𝑐𝑜𝑠𝑡 𝑑𝑟𝑖𝑣𝑒𝑟
Cost pool Overhead cost Activity Total
measure/ Cost
driver
Patient treatment $450,000 No. of patients 15,000 patients

Request $255,000 No. of requests 50,000 requests

response
Patient $225,000 No. of labour 25,000 labour
monitoring hours hours
Medication $300,000 No. of 20,000
distribution prescriptions prescriptions

Chart write up $270,000 No. of charts 15,000 charts

$1,500,000
Cost pool Overhead cost Activity Total
measure/ Cost
driver
Patient treatment $450,000 No. of patients 15,000 patients

Patient Treatment

$450,000
𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑟𝑎𝑡𝑒 =
15,000 𝑝𝑎𝑡𝑖𝑒𝑛𝑡𝑠
= $30 𝑝𝑒𝑟 𝑝𝑎𝑡𝑖𝑒𝑛𝑡
Cost pool Overhead cost Activity measure/ Total
Cost driver

Request response $255,000 No. of requests 50,000 requests

Request Response

$255,000
𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑟𝑎𝑡𝑒 =
50,000 𝑟𝑒𝑞𝑢𝑒𝑠𝑡𝑠
= $5.10 𝑝𝑒𝑟 𝑟𝑒𝑞𝑢𝑒𝑠𝑡
Cost pool Overhead cost Activity measure/ Total
Cost driver
Patient monitoring $225,000 No. of labour hours 25,000 labour
hours

Patient Monitoring

$225,000
𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑟𝑎𝑡𝑒 =
25,000 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟𝑠
= $9 𝑝𝑒𝑟 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟
Cost pool Overhead cost Activity measure/ Total
Cost driver
Medication $300,000 No. of prescriptions 20,000
distribution prescriptions

Medication Distribution

$300,000
𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑟𝑎𝑡𝑒 =
20,000 𝑝𝑟𝑒𝑠𝑐𝑟𝑖𝑝𝑡𝑖𝑜𝑛𝑠
= $15 𝑝𝑒𝑟 𝑝𝑟𝑒𝑠𝑐𝑟𝑖𝑝𝑡𝑖𝑜𝑛
Cost pool Overhead cost Activity measure/ Total
Cost driver
Chart write up $270,000 No. of charts 15,000 charts

Chart Write-Up

$270,000
𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑟𝑎𝑡𝑒 =
15,000 𝑐ℎ𝑎𝑟𝑡𝑠
= $18 𝑝𝑒𝑟 𝑐ℎ𝑎𝑟𝑡
 Step 4:Use the activity rates
to assign costs to cost objects
 Assigning Overheads

𝑂𝐻 𝑎𝑝𝑝𝑙𝑖𝑒𝑑 𝑜𝑟 𝑎𝑠𝑠𝑖𝑔𝑛𝑒𝑑
= 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑟𝑎𝑡𝑒 × 𝐴𝑐𝑡𝑢𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 𝑜𝑟 𝑐𝑜𝑠𝑡 𝑑𝑟𝑖𝑣𝑒𝑟
+ During the month of August the hospital recorded the
following.
Activity measure/ Total
Cost driver
No. of patients 1,250 patients
No. of requests 4,100 requests
No. of labour hours 2,080 labour hours
No. of prescriptions 1,650 prescriptions
No. of charts 1,250 charts

Using the activity rates calculated, determine the overhead

to be applied for the month of August.
Activity measure/ Total
Activity Rates
Cost driver
Patient treatment $30 per patient
No. of patients 1,250 patients
Request response $5.10 per request
No. of requests 4,100 requests
Patient monitoring $9 per labour hour
No. of labour hours 2,080 labour hours
Medication distribution $15 per prescription
No. of prescriptions 1,650 prescriptions
Chart write-up $18 per chart
No. of charts 1,250 charts

𝑂𝐻 𝑎𝑝𝑝𝑙𝑖𝑒𝑑 𝑜𝑟 𝑎𝑠𝑠𝑖𝑔𝑛𝑒𝑑
= 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑟𝑎𝑡𝑒 × 𝐴𝑐𝑡𝑢𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 𝑜𝑟 𝑐𝑜𝑠𝑡 𝑑𝑟𝑖𝑣𝑒𝑟

$
Patient treatment ($30 x 1,250) 37,500
Request response ($5.10 x 4,100) 20,910
Patient monitoring ($9 x 2,080) 18,720
Medication distribution ($15 x 1,650) 24,750
Chart write-up ($18 x 1,250) 22,500
Total OH applied/ assigned 124,380
Total Cost
Under ABC the total cost of a product or service
is determined by summing the total direct cost
incurred and the overhead applied or assigned.
$
Direct materials xxx
Direct labour xxx
Direct expenses xxx
Overhead applied (Activity rate x Actual xxx
amount of activity measure/ cost driver)
Total cost xxx
During the month of August the hospital also
incurred the following costs:
Direct materials $65,000
Direct labour $116,000
Direct expenses $16,000

Required: Calculate the total cost incurred for

the month.

Recall: OH applied - $124,380

 Ridge County Hospital - August
$ $
Direct materials 65,000
Direct labour 116,000
Direct expenses 16,000
Patient treatment ($30 x 1,250) 37,500
Request response ($5.10 x 4,100) 20,910
Patient monitoring ($9 x 2,080) 18,720
Medication distribution ($15 x 1,650) 24,750
Chart write-up ($18 x 1,250) 22,500
Total OH applied/ assigned 124,380
Total cost $321,380