Activity-Based Costing System

A presentation by
Ahmad Tariq Bhatti
FCMA, FPA, MA (Economics), BSc
Dubai, United Arab Emirates

Activity-Based Costing

Activity-Based Costing System 2

In contrast to traditional/absorption costing system, ABC system
first accumulates overheads costs for each organizational activity,
and then assigns the costs of the activities to the products,
services, or customers (cost objects) causing that activity.


During 1980’s, the limitations of absorption costing
system were felt with severity. Companies were looking
for a system that could reflect true product cost in order to
fight competition. The absorption costing system was
designed decades ago, when most companies produced
narrow range of products. Further, overhead costs were
small enough to make a big difference in the identification
of cost of a product. This criticism of absorption costing
led to generation of the idea of ABC system. David
Cooper and Robert Kaplan wrote articles on the idea of
ABC system in 1990 and 1992. The new system was
accepted widely and became reality of the day. Now ABC
system has become part of every management
accounting text book and being implemented the world
over.

ABC is a cost attribution to cost units on the basis of benefit received
from indirect activities.
-- Cima Official Terminology
An activity is an event that incurs costs.
A cost object is defined as anything for which a separate measure of
cost is desired/required.
An activity cost pool: The overheads cost allocated to a distinct type
of activity or related activities.
A cost driver is any factor or activity that has a direct cause and effect
relationship with the resources consumed.
Cost Unit: An item of production or a service for which it is useful to
have cost information.
Cost accounting: The process of identifying, analyzing, summarizing,
recording and reporting costs associated with business operations.
Direct costs: Those costs that are directly associated with the
manufacturing process.
Indirect/overheads costs: Those costs that are not directly
identifiable with a unit of production.


Direct Costing System
A system of costing the products where direct costs (also referred to as
variable costs) are assigned to products only. It reflects the contribution to
indirect costs. The system is considered appropriate for decision-making
purposes. It is recommended in the circumstances where indirect costs are a
low proportion of a company’s total costs.

Traditional or Absorption Costing System
It reflects full cost pertaining to a product. It is easy to use and, therefore, is
practiced widely. The allocation of overhead costs under the system is
based on a rate determined by either a percentage of direct labor cost or
number of labor hours worked or another. Therefore, the reported allocation
of overheads for a given product may be incorrect. It is the main defect of
absorption costing.

Activity-Based Costing System
It also reflects full cost pertaining to a product. ABC system establishes
relationships between overheads costs and activities so that we can
better allocate overheads costs. It reflects the more accurate use of
overheads costs based on their relevant activity levels achieved. The system
has eliminated the defects of traditional/absorption costing system.

Spreads overheads cost over entire product range. A single
overheads recovery rate (also known as predetermined overheads
rate or overheads absorption rate) is used to absorb total overheads
cost to all production. For instance,
For job order costing, overheads cost absorption rates are normally based on
direct labor cost or direct labor hours
For process costing, overheads cost absorption rates are normally based on
machine hours worked

Results of the defect:
Each product appeared to cost the same, as far as overheads cost is
concerned
Products with high profit margins subsidized products with low profit
margins
In-accurate cost accumulation led to inaccurate profit planning of
products
A product cannot compete in the market if its cost is not accurately
accumulated and reflected in costing records 7
Activity-Based Costing System

An overheads cost allocation
system that:
allocates overheads cost to
multiple activity cost pools and
assigns the activity cost pools
to products or services by
means of cost drivers that
represent the activities used.

Product
(A,B,C,D,…,N)

Cost Pools
(I,II,III,IV,V….,N)

Cost Drivers
(1,2,3,4,…N)

Activities
(1,2,3,4,…N)

Step 1 Identify Cost Objects i.e. Product A,B,C

Step 2 Identify direct costs i.e. Direct Materials, Direct Labor,
Direct expense

Step 3 Select the cost allocation bases to be used for
overheads cost i.e. # of set-ups, # of units, etc.

Step 4 Identify the overheads cost associated with the bases
selected

Step 5 Compute the rate per unit

Step 6 Compute overheads cost for allocation to products

Step 7 Compute costs of products

Departments

Activity Design Setup Shipping
Overheads Cost
Pool

Cost No. of No. of No. of
Allocation employees Setup Shipments
Base Hours

Cost
Objects Product A Product B Product C


Activity Cost
Activity Cost Drivers
Pools
a) Number of units
 Production b) Number of set-ups
c) Number electricity units consumed
a) Number of sales personnel
 Marketing b) Number of sales orders
a) Number of research projects
 Research &
b) Personnel hours spend on projects
Development c) Technical complexities of the projects
a) Number of service calls
 Customer Service b) Number of products serviced
c) Hours spend on servicing products
 Purchasing a) Number of purchase orders
 Material Handling a) Number of material requisitions

Intensity
Transaction Drivers
Drivers Duration
 Each overseas
Drivers purchase order
should be
 # of purchase orders
 # of customer orders  Set up hours weighted 1.5
processed  Inspection hours times of local
 # of inspections  Labor hours purchase order
 Production hours  Each overtime
performed
 # of set-ups  Loading hours hour shall be
charged as twice
undertaken
of the normal
wage hour

Activity Based Costing 13

I. Unit-level activities
The costs of direct materials, direct labor, and machine maintenance
are examples of unit-level activities.

II. Batch-level activities
are costs incurred every time a group (batch) of units is produced .
Purchase orders, machine setup, and quality tests are examples of
batch-level activities.

III. Product-line activities
Examples of product-line activities are engineering changes made in
the assembly line, product design changes, and warehousing and
storage costs for each product line.

IV. Facility support activities
The costs relating to the activities are administrative in nature and
include building depreciation, property taxes, plant security, insurance,
accounting, outside landscape and maintenance, and plant
management's and support staff's salaries.

Alpha Ltd. is manufacturing two products A and B. Both products
are manufactured on the same machines and undergo the same
processes. Here is the detail of budgeted data obtained for the two
products for the financial year ending on December 31, 20x1:

Description A B

Budgeted production quantity (units) 25,000 2,500
Number of purchase orders 400 200
Number of set-ups 150 100

Resources required/unit:
Direct material (AED.) 25 62.5
Direct labor (Hours) 10 10
Machine time (Hours) 5 5


Budgeted production overheads cost for the year have been calculated as
follows:
Description Amount (AED.)
 Volume related overheads cost 275,000
 Purchase related overheads cost 300,000
 Set-up related overheads cost 525,000
Total overheads cost 1,100,000
The budgeted labor rate is AED. 20 per hour.
The company’s present system is to absorb overheads by product
units using rates per labor hour. However, the company is
considering implementing a system of activity-based costing.
Following cost drivers for overheads are used.
 Volume related  Machine hours
overheads
 Purchase related  Number of purchase
overheads orders
 Set-up related overheadsCosting System
Activity-Based
 Number of set-ups 17

Requirements:
a) Calculate the unit costs for product A and B using:
i. The absorption costing system
ii. The proposed activity-based costing system
b) Compare the results in (i) and (ii) and explain the differences.

Solution:
The first step is to determine the overheads absorption rate or cost driver
rates for each activity. Then utilize these rates to data given for each
product.
Description A B Total
Production quantity 25,000 2,500
Direct labor hours required 250,000 25,000 275,000
AED.
Total production overheads 1,100,000


Description A B Total
Overhead absorption rate per labor hour (AED. AED. 4
1,100,000/275,000)
 Machine hours required 125,000 12,500 137,500
 Total purchase orders 400 200 600
 Total set-ups 150 100 250
Cost per cost driver
Volume related overheads cost AED.
275,000
Machine hours required 137,500
Volume related overheads/machine hour (AED. 275,000/137,500) AED. 2
Purchases related overheads cost AED.
300,000
Total purchase orders 600
Purchase related overheads / order (AED. 300,000/600) AED. 500
Set-ups related overheads cost AED.
525,000
Total set-ups 250

(a) (i) Unit cost working under traditional/absorption
costing system

Description of cost components A B

AED. AED.
Direct materials cost 25.00 62.50
Direct labor cost (AED. 20 x 10 labor 200.00 200.00
hours/unit)
Overheads (10 labor hours x AED. 4) 40.00 40.00
------------------ -----------------
Total cost per unit 265.00 302.50
========== ==========


(a) (ii) Unit cost working under Activity-Based Costing system

Description of cost components A B
AED. AED.
Direct materials cost 25.00 62.50
Direct labor cost 200.00 200.00
Volume related overheads cost (AED. 2 x 5 machine 10.00 10.00
hours/unit)
Purchases related overheads cost:
 Product A: [(AED. 500 x 400 Orders)/ 25,000 8
Units] 40
 Product B: [(AED. 500 x 200 Orders)/2,500 Units]
Set-up related overheads cost:
 Product A: [(AED. 2,100 x 150 Set-ups)/25,000 12.60
Units] 84.00
 Product B: [(AED. 2,100 x 100 Set-ups)/25,00 Units]
------- --------
Total cost per unit Activity-Based Costing System 255.60 396.50 21

(b) Difference in cost per unit under two systems.

Description A B
AED. AED.
Cost as per traditional costing system 265.00 302.50
Cost as per ABC costing system 255.60 396.50
Increase/(Decrease)  (9.40) 94.00
% change (3.55%) 31.07%

Explanation & Recommendation
Under Traditional Costing System, the cost of Product A is increased by AED. 9.40
per unit (i.e. 3.55%) and the cost of Product B is decreased by AED. 94 per unit
(i.e. 31.07%). These variances in cost per unit are because of inappropriate
absorption of overheads cost under Traditional Costing System. Therefore, ABC
system is highly recommended for the company, in order to book the correct
overheads cost for Products A and B.


XYZ Company makes a product AD that it sells to Alpha Company. The
company has ABC system in operation that it uses for internal decision
making. The company has two overheads departments, whose costs are
listed as below:
Description Amount (AED.)
Manufacturing overheads cost 500,000
Selling and administrative overheads cost 300,000
------------------
Total overheads costs 800,000
=========
The company's ABC system has the following activity cost pools and activity
drivers in place:
Activity Cost Pool Activity Drivers
 Assembling units  Number of units
 Processing orders  Number of orders
 Supporting customers  Number of customers
 Other  Not applicable


Costs assigned to other activity cost pool have no activity driver; they
consist of the costs of unused capacity and organization-sustaining costs -
neither of which are assigned to products, orders or customers.

XYZ Company distributes the costs of manufacturing overheads and of
selling and administrative overheads cost to the activity cost pools based on
employee information, the results of which are reported as below:

Assemblin Processing Supporting
Description Other Total
g Units Orders Customers
Manufacturing overheads 50% 35% 5% 10% 100%
Selling & administrative
10% 45% 25% 20% 100%
overheads
100
Total activity 1,000 units 250 orders -- --
customers


Required:
1. Perform the first stage allocation of overhead costs to the activity cost
pools.

2. Compute activity rates for the activity cost pools.

3. VB is one of the XYZ’s big customers. Last year VB ordered AD four
different times. VB ordered a total of 80 units of AD during the year.
Construct a table showing the overhead costs of these 80 units and
four orders. The price per unit charged to the customer is AED. 595.
The direct materials cost per unit is estimated at AED. 180 per unit and
direct labor cost per unit is AED. 50.


1. The first stage allocation of costs to the activity cost
pools appears as below:

Activity Cost Pools
Description of cost Assemblin Processing Supporting
Other Total
components g Units Orders Customers
AED. AED. AED. AED. AED.
Manufacturing Overheads
250,000 175,000 25,000 50,000 500,000
cost
Selling & admin. Overheads 30,000 135,000 75,000 60,000 300,000
cost

--------------- ---------------- --------------- ------------ ----------
Total cost 280,000 310,000 100,000 110,000 800,000
======= ======= ======= ====== ======


2. The activity rates for the activity cost pools are:

Activity Cost Pools Total Cost Total Activity Activity Rate
AED. Units AED.
Assembling units 280,000 1,000 280 per unit
Processing orders 310,000 250 1,240 per order
Supporting
100,000 100 customers 1,000 per customer … (c)
customers
3. The overheads cost for the four orders of a total of 80
units of ASD would be computed as follows:
Activity Cost Pools Total Cost Total Activity Activity Rate
AED. AED.
Assembling units 280 per unit 80 units 22,400 …. (a)
Processing orders 1,240 per order 4 units 4,960 …. (b)
Supporting customers 1000 per customer Not applicable


4. The product and customer margin can be computed as
follows:
AD Product Margin: AED. AED.
Sales (AED. 595 per unit 80 units) 47,600
Cost:
Direct materials cost (AED. 180 per unit 80
14,400
units)
Direct labor cost (AED. 50 per unit 80 units) 4,000
Volume related overhead (a) 22,400
Order related overhead (b) 4,960 45,760
-------------------
AD Product Margin for the order 1,840
==========
Customer Profitability Analysis – XYZ Co.
Product margin 1,840
Less: Customer support overhead (above) 1,000
---------------
Profit 840
========

1. ABC system provides accurate costing of products/services.
2. Management has better understanding overheads cost.
3. The system utilizes unit cost rather than total cost unlike
absorption costing system.
4. ABC system integrates well with Six Sigma and other
continuous improvement programs.
5. The in-depth study of overheads cost under ABC system
makes all wastages visible to management and all non-
value added activities known to them. Thus, better controls
can be exercised on them.
6. It supports performance management and scorecards.
7. The system enables costing of processes, supply chains,
and value streams.
8. ABC system helps in benchmarking other products.

1. Implementing ABC system requires a big budget initially.
2. After implementation, the maintenance of the system is costly. Data
concerning numerous activity measures must be collected , checked, and
entered into the system on regular basis.
3. ABC system produces numbers such as product margins that are different
from the profits produced by traditional costing system. Management may
be double minded as they are used to work with traditional costing system,
as a requirement for external reporting.
4. ABC system generated data can be misinterpreted and must be used
with care when used in making decisions. Costs assigned to products,
customers and other cost objects are only potentially relevant.
5. Reports generated by ABC system do not conform to Generally
Accepted Accounting Principles (GAAP). Consequently, an organization
involved in ABC should have two cost systems - one for internal use and
one for preparing external reports.


The initiative to implement ABC system must be strongly
supported by the management. The workings involve a
tremendous job of making inquiries from employees.

The design and implementation of ABC system should be
the responsibility of a cross functional team of technicians.
Normally, the team would include representatives from
accounting, finance, IT, marketing, production and
engineering departments.

Services of an ABC system consultant must be hired in order
to prevent the wastage of resources and time.

Selection of ABC software that could implement and
automate the processing of the system should be made upon
expert advice. We have given a list of ABC system softwares
as Appendix A.

No. Software Website
http://www.acornsys.com
1 TDABC
2 SAS® Activity-Based Management ww.sas.com
http://www.cashfocus.com
3 ABC Focus activity based costing software
http://www.prismata.com
4 Prismata
http://www.mrdashboard.com
5 Activity Based Costing For EXCEL
Activity Based Costing – Workforce http://www.workforcesoftware.co
6 m
Software
http://africa.syspro.com
7 SYSPRO Activity Based Costing
http://www.business.com
8 Activity Based Costing/Management Software
http://www.algsoftware.com.au
9 ABC/M systems
http://www.acornsys.com
10 Acorn Systems
http://costperform.co.uk
11 CostPerform, UK
ACTIVITY BASED COSTING ANALYSIS http://www.xjtek.com
12 SIMULATION MODEL
http://www.enlighten-
13 Enlighten Software software.com
14 Prodacapo ABM Activity-Based Costing System http://www.prodacapo.com/abm 33

Cost & Management Accounting by Colin Drury, 5/e
Cost Accounting by Horngren /Datar /Foster, 11/e
Managerial Accounting by Hilton and Platt
Managerial Accounting by Weygandt / Kieso / Kimmel,
2/e
Cima Official Terminology


A presentation by
Ahmad Tariq Bhatti
FCMA, FPA, MA (Economics), BSc
Dubai, United Arab Emirates
Contact
at.bhatty@gmail.com


Activity-Based Costing System

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