CHAPTER

Chapter 3
Activity-Based Costing
and Management
.
 Role of Volume-Based Costing

• Volume-based costing can be a strategic

good choice for some firms.
• It is appropriate generally when direct costs
are the major cost of the product or service
and activities supporting the production of
the product or service are relatively simple,
low-cost, and homogenous across different
product lines.
 Activity based costing
• we need to understand relationships among
resources, ACTIVITIES, and products or services.
• A good costing system identifies costs with
activities that consume resources and assign
resource costs to cost objects such as
products, services, or intermediate cost pools
based on activities performed for the cost
objects.
 Terms used in ABC
• These terms are:
• An activity is a specific task or action of work
done.
• An activity can be a single action or an aggregation
of several actions.
• For example:
• moving inventory from workstation A to work
station B is an activity that may require only one
action.
• Production set-up is an activity that may include
several actions.
• A resource is an economic element needed
or consumed in performing activities.
• Salaries and supplies, for example, are
resources needed or used in performing
manufacturing activities.
• A cost driver is a factor that causes or relates
to a change in the cost of an activity.
• A cost driver is either a resource consumption
cost driver or an activity consumption cost
driver.
• A resource consumption cost driver is a measure of the
amount of resources consumed by an activity.
• It is the cost driver for assigning a resource cost consumed by or
related to an activity to a particular activity or cost pool.
• Examples of resource consumption cost drivers are:

• the number of items in a purchase or sales order,

• changes in product design,

• size of factory buildings, and

• machine hours.
 Cont..

• An activity consumption cost driver

measures the amount of an activity performed
for a cost object.
• It is used to assign activity cost pool costs to cost
objects.
Examples :
• the number of machine hours in the
manufacturing of product X, or
• the number of batches used to manufacture
Product Y.
 What Is Activity-Based Costing?

• Activity-based costing (ABC) is a costing

approach that assigns resource costs to cost
objects such as products, services, or
customers based on activities performed for
the cost objects.
• The premise of this costing approach is that a
firm’s products or services are the results of
activities and activities use resources which
incur costs.
 What steps?
1. Identity major activities performed by the
business
2. Calculate the total cost of each activity over
the period (i.e. cost centre or cost pool)
3. Determine the cost driver for each activity.
Cost drivers are the factors which cause the
activity cost pool to increase
4. Calculate the cost driver rate (i.e. total cost
in a cost pool/ no. of cost driver)
5. Assign the cost-centre overheads to the
products according to their cost driver rates
10
 Step 1: Identify Resource Costs and Activities
• Most firms record resource costs in specific
accounts in the accounting system.
Examples of these accounts include:
• supplies, purchasing,
• materials handling,
• warehousing,
• office expenses,
• furniture and fixtures,
• buildings, equipment,
• utilities, and
• salaries and benefits.
• For example, a firm may use a single factory
supplies account for all supplies in its
operations that include several manufacturing
operations.
 Levels of Activities
• To identify resource costs for various activities, a firm
classifies all activities according to the way in which the
activities consume resources.
1. A unit-level activity is performed on each individual unit
of product or service of the firm. Examples include:
A. direct materials,
B. direct labor-hours,
C. inserting a component, and
D. inspecting every unit.
• A unit-level activity is volume-based.
• The resource consumption driver and the activity consumption
driver are most likely to be the same for unit level activities.
2. A batch-level activity is performed for each
batch or group of units of products or services.
• A batch has more than one unit of a product or
service.
• Examples:
• setting up machines,
• placing purchase orders,
• scheduling production, conducting
• inspections by batch,
• handling materials, and
• production.
3. A product-level activity supports the production of a
specific product or service.
Examples:
• designing products,
• administering parts required for products, and
• engaging in engineering changes to modify products.
4. A facility-level activity supports operations in general. These
activities are not caused by products or customer service needs
and cannot be traced to individual units, batches, or products.
Examples:
• providing security and safety,
• Performing maintenance of general purpose machines,
• managing the plant,
• incurring factory property taxes and
• insurance and closing of the books each month.
 Step 2: Assign Resource Costs to Activities

• Activity-based costing uses resource consumption cost

drivers to assign resource costs to activities.
• Typical resource consumption cost drivers include the
number of:
 labor hours for labor intensive activities;
 employees for payroll-related activities;
 setups for batch-related activities;
 moves for materials-handling activities;
 machine-hours for machine repair and maintenance; and
 square feet for general maintenance and cleaning activities .
 Activity
Activity Level
•

• Direct materials • Unit

• Direct labor-hours • Unit
• Machine-hours
• Unit
• Number of production
orders • Batch
• Number of special • Batch
components
 Resource Consumption Cost
Resource Driver

• Personnel • Number of workers

• Storeroom • Number of items picked for an order
• Engineers
• Materials management • Time worked
• Accounting • Time worked
• Research and development • Time worked
• Quality • Number of new codes developed
• Utilities • Time worked
• Square-footage
 Step 3: Assign Activity Costs to Cost Objects

• The final step is to assign costs of activities or activity cost pools to cost
objects based on the appropriate activity consumption cost drivers.
• Outputs are the cost objects for which firms or organizations perform
activities.
• Typical outputs for a cost system are products and services; however,
outputs also can include customers, projects, or business units.
• For example:the outputs of an insurance company may be:
• individual insurance policies sold to customers,
• claims processed,
• types of policies offered,
• insurance agents, or divisions or subunits of the company.
• Firms use activity consumption cost drivers to assign activity costs to cost
objects.
Typical activity consumption cost drivers
are:
• purchase orders,
• receiving reports,
• inspection reports or hours,
• parts stored,
• payments,
• direct labor-hours,
• machine-hours, and setups and
• manufacturing cycle time.
A Comparison of Volume-Based and
Activity-Based Costing
• ABC company produces and sells two
secure communication systems, product A
and Product B.
• the company has the following operating
data for the two products:
 AW SZ
Production volume 5,000 20,000
Selling price $400.00 $200.00
Unit direct materials and labor $200.00 $ 80.00
Direct labor-hours 25,000 75,000
Direct labor-hours per unit 5 3.75
Activity-Based Costing
In using an activity-based costing, HBT has identified the following activities, budgeted costs, and activity
consumption cost drivers:

Activity Budgeted Cost Activity Consumption Cost Driver

Engineering $ 125,000 Engineering hours
Setups 300,000 Number of setups
Machine running 1,500,000 Machine-hours
Packing 75,000 Number of packing orders
Total $2,000,000

HBT also has gathered the following operating data pertaining to each of its products:

AW SZ Total
Engineering hours 5,000 7,500 12,500
Number of setups 200 100 300
Machine-hours 50,000 100,000 150,000
Number of packing orders 5,000 10,000 15,000

The firm has a total budgeted overhead of $2,000,000.

 Instructions
1. Using the existing traditional costing system,
a. Determine the company’s manufacturing
overhead rate
b. Determine the budgeted costs and profit
margin of the two products
2. Which product is under-costed and by how
much? Which product is over-costed and by
how much?
Volume-Based Costing
The volume-based costing system that the firm uses assigns factory overhead (OH) based on direct labor-
hours (DLH). Since the firm budgeted 100,000 direct labor hours for the year, the overhead rate per
direct labor hour is $20 per direct labor hour.
Total overhead $2,000,000
Total DLH 25,000 + 75,000 = 100,000
Overhead rate per DLH $ 20.00

Since the firm uses 25,000 direct labor hours to manufacture 5,000 units of A,
the factory overhead assigned to A is $500,000 in total and $100 per unit:

Total OH assigned to A $20 × 25,000 = $500,000

Number of units of A 5,000
Factory overhead per unit of A $ 100.00

The factory overhead for B is $1,500,000 in total and $75 per unit since the firm
spent 75,000 direct labor hours to manufacture 20,000 units of B:

Total OH assigned to B $20 × 75,000 =

Number of units of B $1,500,000
Factory overhead per unit of B 20,000
$ 75.00
Activity-Based Costing
Using the gathered data, the cost driver rate for each activity consumption cost driver is calculated as follows:
I

(1) (2) (3) (4) = (2)/(3)

Activity Consumption Activity Activity
Cost Driver Cost Consumption Rate
Engineering hours $ 125,000 12,500 $ 10
Number of setups 300,000 300 1,000
Machine-hours 1,500,000 150,000 10
Number of packing orders 75,000 15,000 5

Factory overhead costs are assigned to both products by these calculations:

AW (5,000 units)
(1) (2) (3) (4) = (2) × (3) (5)
Activity Consumption Activity Total Overhead
Cost Driver Rate Activities Overhead Per Unit
Engineering hours $ 10 5,000 $ 50,000 $ 10
Number of setups 1,000 200 200,000 40
Machine-hours 10 50,000 500,000 100
Number of packing orders 5 5,000 25,000 5
Overhead cost per unit $775,000 $155
 SZ (20,000 units)
(1) (2) (3) (4) = (2) × (3) (5)

Activity Consumption Activity Total Overhea

d
Cost Driver Rate Activities Overhead Per Unit

Engineering hours $ 10 7,500 $ 75,000 $ 3.75

Number of setups 1,000 100 100,000 5.00
Machine-hours 10 100,000 1,000,000 50.00
Number of packing orders 5 10,000 50,000 2.50

Overhead cost per unit $1,225,000 $61.25

class exercise
Martin Ltd. Manufactures tow products. Product A is a high-
Volume product while Product B is a low-volume product.
Details of production are shown as follows:
Product A Product B
Materials cost per unit $130 $130
Direct Labour cost per hour $50 $50
Direct machine hour per unit 4 hrs 4 hrs
Direct labour hour per unit 2 hrs 2 hrs
Output 10 100
No. of purchase orders 3 4
No. of set up 40 80
Overhead costs are shown as follows: $
Factory power 6600
Machinery set-up costs 4800
Materials handling and dispatch 2100
total overheads 13,500 28
• Required
Calculate the product costs using:
(a) Absorption costing based on machine
hour ( allocate overhead cost based on
machine hour)
(b) Activity-based costing

29
(a) Absorption costing based on machine
hour
Product A Product B
$ $
Direct Materials 130 130
Direct labour 100 100
Overheads
($13500*4/440) 123 123
Product cost per unit 353 353
4*10+100*4 2*50

30
 (b) Activity based Costing
Product A Product B
$ $
Direct Materials 130 130
Direct labour 100 100
Overheads
Factory power
(6600*4/440) 60 60
Machinery set-up cost
(4800*40/120*1/10) 160
(4800*80/120*1/100) 32
Materials handling & dispatch
(2100*3/7*1/10) 90
(2100*4/7*1/100) 12
Product cost per unit 540 334 31
End Of Chapter Three