LECTURE 5: Activity-Based Costing

ACC 422: MANAGERIAL ACCOUNTING

BS Operations Management
Learning Objectives:
1. Understand the basic approach in activity-based costing and how
it differs from conventional costing;
2. Compute activity rates for an activity – based costing system;
3. Compute product costs using activity – based costing; and
4. Contrast the product costs computed under activity-based costing
and conventional costing methods.
Activity-Based Costing (ABC)
▪ ABC is a technique that attempts to assign overhead
costs more accurately to products.
▪ ABC uses a number of allocation bases for assigning
costs to products. Each allocation base in an activity-
based costing system represents a major activity that
causes overhead costs.
▪ An activity in ABC is an event that causes the
consumption of overhead resources.
Activity-Based Costing (ABC)
❑ Examples of activities:
▪ Setting up machines
▪ Admitting patients to a hospital
▪ Scheduling production
▪ Performing blood tests at a clinic
▪ Billing customers
▪ Maintaining equipment
▪ Ordering materials or supplies
▪ Stocking shelves at a store
▪ Meeting with clients at a law firm
▪ Preparing shipments
▪ Inspecting materials for defects
▪ Opening an account at the bank
Activity-Based Costing (ABC)
▪ Activity cost pool – is a cost bucket in which
costs related to a particular activity measure are
accumulated.
▪ Activity measure – expresses how much of the
activity is carried out and is used as the
allocation base for assigning overhead costs to
products and services.
▪ Activity rate – an overhead rate in ABC system
Examples of Activities and Activity Measures
in Manufacturing Companies
Level Activities Activity Measures
Unit – level Processing units on machines Machine hours
Processing units by hand Direct labor hours
Consuming factory supplies Units produced
Batch – level Processing purchase orders Purchase orders processed
Processing production orders Production orders processed
Setting up equipment Number of setups; setup hours
Handling materials Pounds of material handled;
number of times material moved
Product – level Testing new products Hours of testing time
Administering parts inventories Number of part types
Designing products Hours of design time
Facility - level General factory administration Direct labor hours
Plant building and ground Direct labor hours
Hierarchy of Activities
▪ Unit – level activities – are performed each
time a unit is produced. The cost of unit-level
activities should be proportional to the number
of units produced.

▪ Example: Providing power to run processing equipment is unit-level activity because

power tends to be consumed in proportion to the number of units produced.
Hierarchy of Activities
▪ Batch – level activities – consists of tasks that
are performed each time a batch is processed,
such as processing purchase orders, setting up
equipment, packing shipments to customers, and
handling material.
▪ Cost at the batch level depend on the number of
batches processed rather than on the number of
units produced.

▪ Example: The cost of processing a purchase order is the same no matter how many
units of an item are ordered.
Hierarchy of Activities
▪ Product – level activities – (product –
sustaining activities) relate to specific products
and typically must be carried out regardless of
how many batches or units of the product are
manufactured.

▪ Example: It include maintaining inventories for parts of a product, issuing

engineering change notices to modify a product to meet a customer’s specifications,
and developing special test routines when a product is first placed into production.
Hierarchy of Activities
▪ Facility – level activities – (organization –
sustaining activities) are carried out regardless of
which products are produced, how many batches
are run, or how many units are made.

▪ Example: Facility-level costs include items such as factory management salaries,

insurance, property taxes and building depreciation.
.
Using Activity-Based Costing
▪ Comtek Inc.’s Basic Data

The ABC team gathered basic information relating to the

company’s two products. For the current year, the
company’s budget provides for selling 50,000 Phone
systems and 200,000 GPS systems. Both products require
two direct labor hours to complete. Therefore, the
company plans to work 500,000 direct labor (DLHs)
during the current year.
Using Activity-Based Costing
Phone: 50,000 units x 2 DLHs per unit 100,000
GPS: 200,000 units x 2 DLHs per unit 400,000
Total direct labor hours 500,000

Phone GPS
Direct materials 90 50
Direct labor (10/DLH) 20 20
Direct Labor Hours as a Base
▪ The company’s estimated manufacturing overhead costs
for the current year totaled P10M.
Estimated total manufacturing overhead cost
Predetermined overhead rate =
Estimated total amount of the allocation base

P10,000,000
=
500,000 direct labor hours

= P20 per direct labor hour

Direct Labor Hours as a Base
▪ Using this rate, the ABC team computed the unit
product costs:
Phone GPS
Direct materials ₱ 90 ₱ 50
Direct labor ₱ 20 ₱ 20
Manufacturing overhead (2 DLHs x 20 per DLH) ₱ 40 ₱ 40
Unit product cost ₱ 150 ₱ 110
 Computing Activity Rates
COMTEK’S ACTIVITY-BASED SYSTEM

Expected Activity
Activity Cost Pools and Activity Estimated Overhead
Phone GPS Total
Measures Cost
Labor-related (Direct labor hours) ₱ 800,000 100,000 400,000 500,000
Machine related (machine hours) ₱ 2,100,000 300,000 700,000 1,000,000
Machine setups (setups) ₱ 1,600,000 3,000 1,000 4,000
Production orders (orders) ₱ 3,150,000 800 400 1,200
Parts administration (part types) ₱ 350,000 400 300 700
General factory (machine hours) ₱ 2,000,000 300,000 700,000 1,000,000
₱ 10,000,000
Computing Activity Rates

Activity Cost Pools and Activity Estimated Overhead Total Expected

Activity Rates
Measures Cost Activity
Labor-related (Direct labor hours) ₱ 800,000 500,000 DLHs ₱ 1.60 per DLH
Machine related (machine hours) ₱ 2,100,000 1,000,000 MHs ₱ 2.10 per MH
Machine setups (setups) ₱ 1,600,000 4,000 setups ₱ 400.00 per setup
Production orders (orders) ₱ 3,150,000 1,200 orders ₱ 2,625.00 per order
Parts administration (part types) ₱ 350,000 700 part types ₱ 500.00 per part type
General factory (machine hours) ₱ 2,000,000 1,000,000 MHs ₱ 2.00 per MH
Computation of Overhead Cost
per Unit of Product
Phone GPS
Activity Cost Pools and Activity Expected Expected
Activity Rates Amount Amount
Measures Activity Activity
Labor-related (Direct labor hours) ₱ 1.60 100,000 ₱ 160,000 ₱ 400,000 ₱ 640,000
Machine related (machine hours) ₱ 2.10 300,000 ₱ 630,000 ₱ 700,000 ₱ 1,470,000
Machine setups (setups) ₱ 400.00 3,000 ₱ 1,200,000 ₱ 1,000 ₱ 400,000
Production orders (orders) ₱ 2,625.00 800 ₱ 2,100,000 ₱ 400 ₱ 1,050,000
Parts administration (part types) ₱ 500.00 400 ₱ 200,000 ₱ 300 ₱ 150,000
General factory (machine hours) ₱ 2.00 300,000 ₱ 600,000 ₱ 700,000 ₱ 1,400,000
Total overhead costs assigned ₱ 4,890,000 ₱ 5,110,000
Number of units produced ₱ 50,000 ₱ 200,000
Overhead cost per unit ₱ 97.80 ₱ 25.55
Comparison of Unit Product Cost

Activity - Based Costing Direct Labor Costing

Phone GPS Phone GPS
Direct materials ₱ 90.00 ₱ 50.00 ₱ 90.00 ₱ 50.00
Direct labor ₱ 20.00 ₱ 20.00 ₱ 20.00 ₱ 20.00
Manufacturing overhead ₱ 97.80 ₱ 25.55 ₱ 40.00 ₱ 40.00
Unit product cost ₱ 207.80 ₱ 95.55 ₱ 150.00 ₱ 110.00
THANK YOU! ☺