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CHAPTER 2A:
ACTIVITY BASED COSTING
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OVERVIEW
What will you learn?

ACTIVITY BASED COSTING (ABC)

I. Overview of ABC

II. Compare absorption costing and ABC

III. Discussion about ABC

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I. OVERVIEW OF ABC
1. Definition

Activity based costing (ABC) is a method of costing which involves identifying the costs
of the main support activities and the factors that 'drive' the costs of each activity.
Support overheads are charged to products by absorbing cost based on the product's
usage of the factor driving the overheads.
A cost driver is a factor which has most influence on the cost of an activity.

Below is some cost drivers for overheads:

Overheads Cost driver

Production set-up costs Number of production set ups

Machine oil and machine repairs Number of machine hours

Supervisor salary Number of labor hours

Ordering costs: handling customer orders Number of orders

Materials handling costs Number of production runs

It is obvious that ABC is an extension of traditional absorption costing specifically

considering what causes each type of overhead category to occur. Each type of overhead
is absorbed using a different basis depending on the cost driver.
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I. OVERVIEW OF ABC
1. Definition

Example 1:
SAP Co manufactures 2 products X and Y. Total incurred overheads costs is
$31,000 which includes 2 categories namely supervisor salary costs and
materials handling costs. In order to unit cost for each product, it is necessary to
absorb overheads.
Under the traditional absorption costing, both supervisor salary and materials
handling costs are likely to be absorbed based on number of the labor hours.
However, under ABC, cost driver attached to the activities which causes
overheads is considered carefully. Thus, supervisor salary costs are absorbed
based on number of the labor hours, but materials handling costs are absorbed
based on number of production runs as production runs is factor which has most
influence on these cost, not labor hours is.
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I. OVERVIEW OF ABC
2. Steps in ABC

ABC is carried out through 5 steps:

Step 1: Identify an organisation's major supporting activities

Step 2: Identify overheads to each activities

Step 3: Identify cost driver of each activity

Step 4: Calculate a cost per unit of cost driver

Cost per unit of cost driver = Overheads (Step 2)/ Total units of cost drivers (Step 3)

Step 5: Charge overheads to each activity on the basis of number of cost driver
they use
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I. OVERVIEW OF ABC
2. Steps in ABC

Example 2 (Question):

Suppose that SAP Co manufactures four products, W, X, Y and Z. Output and cost
data for the period just ended are as follows.

Output Number of Material Direct labor Machine

units production runs cost per unit hours per hours per
in the period $ unit unit
W 10 2 20 1 1
X 10 2 80 3 3
Y 100 5 20 1 1
Z 100 5 80 3 3
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Direct labor cost per hour: $5.

Overhead costs $
Short-run variable costs 3,080
Set-up costs 10,920
Expediting and scheduling costs 9,100
Materials handling costs 7,700
30,800

Required: Prepare unit costs for each product using ABC.

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I. OVERVIEW OF ABC
2. Steps in ABC

Example 2 (Answer):

Step 1: Identify an organisation's major support activities

There are 4 major supporting activities namely short-run variable, set-up,
expediting and scheduling and material handling.
Step 2: Identify overheads to each activities
Overheads are allocated for 4 support activities as follows:
$
Short-run variable 3,080
Set-up 10,920
Expediting and scheduling 9,100
Materials handling 7,700

Step 3: Identify cost driver of each activity

Activity Cost driver

Short-run variable Machine hours
Set-up Number of production runs
Expediting and scheduling Number of production runs
Materials handling Number of production runs
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I. OVERVIEW OF ABC
2. Steps in ABC

Example 2 (Answer):

Step 4: Calculate a cost per unit of cost driver

Total of cost Cost per unit
Activity Cost driver Overheads
driver of cost driver
($) (units) ($)
Short-run
Machine hours 3,080 440 (*) 7
variable
Number of
Set-up 10,920 14 780
production runs

Expediting and Number of

9,100 14 650
scheduling production runs

Materials Number of
7,700 14 550
handling production runs

(*) Total machine hours = Machine hour per unit x Output units
= 1x10 + 3x10 + 1x100 + 3x100 = 440 hours
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I. OVERVIEW OF ABC
2. Steps in ABC

Example 2 (Answer):

Step 5: Charge overheads to each activity on the basis of number of cost driver
they use
W X Y Z
Activity $ $ $ $
Short-run variable 70 210 700 2,100
Set-up 1,560 1,560 3,900 3,900
Expediting and
scheduling 1,300 1,300 3,250 3,250
Materials handling 1,100 1,100 2,750 2,750
4,030 4,170 10,600 12,000

Thus, product costs per unit are as follows:

W X Y Z
$ $ $ $
Direct material costs (**) 200 800 2,000 8,000
Direct labour costs (***) 50 150 500 1,500
Overheads 4,030 4,170 10,600 12,000
Total costs 4,280 5,120 13,100 21,500
Units produced 10 10 100 100
Cost per unit 428 512 131 215

(**) Direct material costs = Material cost per unit x Output

(***) Direct labor costs = Direct labor hours per unit x Output
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II. COMPARE ABSORPTION COSTING AND ABC

1. Example

Example 3 (Question):

Suppose that SAP Co manufactures four products, W, X, Y and Z. Output and cost
data for the period just ended are as follows.
Output Number of Material Direct labor Machine
units production runs cost per unit hours per hours per
in the period $ unit unit
W 10 2 20 1 1
X 10 2 80 3 3
Y 100 5 20 1 1
Z 100 5 80 3 3
14
Direct labor cost per hour: $5.
Overhead costs $
Short-run variable costs 3,080
Set-up costs 10,920
Expediting and scheduling costs 9,100
Materials handling costs 7,700
30,800
Required: Prepare unit costs for each product using absorption costing
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II. COMPARE ABSORPTION COSTING AND ABC

1. Example

Example 3 (Answer):

Absorption costing is a method of product costing, which is mentioned in chapter

1 Costing. Accordingly, the absorption rate for overheads based on direct labor
hours or machine hours.
Total direct labor hours = Total machine hours = 440 hours
OAR = $30,800/ 440 hours = $70/hour
So, product costs per unit are as follows:
W X Y Z
$ $ $ $
Direct material costs 200 800 2,000 8,000
Direct labour costs 50 150 500 1,500
Overheads
[OAR x Machine hours] 700 2,100 7,000 21,000
Total costs 950 3,050 9,500 30,500
Units produced 10 10 100 100
Cost per unit 95 305 95 305
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II. COMPARE ABSORPTION COSTING AND ABC

1. Example

Example 3 (Answer):

See that production costs per unit is significant difference between 2 methods.
Details are as follows:
Product Absorption costing ABC Difference per unit Difference in total
$ $ $ $
W 95 428 +333 +3,330
X 305 512 +207 +2,070
Y 95 131 +36 +3,600
Z 305 215 -90 -9,000

The difference is because of overheads absorbed to each product.

Overheads
Direct labor/
Output under Overheads
Product Machine hours Difference
units absorption under ABC
per unit
costing
$ $ $
W 10 1 700 4,030 +3,330
X 10 3 2,100 4,170 +2,070
Y 100 1 7,000 10,600 +3,600
Z 100 3 21,000 12,000 -9,000
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II. COMPARE ABSORPTION COSTING AND ABC

1. Example

Example 3 (Answer):

There are 2 main reasons for the distinction in overheads:

Overheads = Allocated criteria (1) x Cost per unit of allocated criteria (2)
(1) Allocated criteria: It is obvious that under absorption costing, there is only
allocated criteria namely machine hours but under ABC, there are 2 allocated
criteria for overheads activities namely machine hours and number of production
runs.
(2) Cost per unit of allocated criteria: each product uses criteria.
• Overheads will be lower for low-volume products (here, W and X) and
reverse, for Y and Z, overheads will be higher. (Low volume  Lower
number of production runs  Lower overhead costs)
• Overheads will be lower for smaller products (here W and Y, with just
one hour of work needed per unit) and reverse, for X and Z, overheads
will be higher. (Smaller products  Lower machine hours  Lower
overhead costs).
Due to which, production cost per unit is not accurate. When making pricing
decision for products W, X and Y, there is a risk that there is a loss as production
cost is determined too low.
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II. COMPARE ABSORPTION COSTING AND ABC

2. Comparative table

Thus, there are some differences between ABC and absorption costing:

Absorption costing ABC

• Allocate overheads based on the • Allocate overheads based on the

unique criterion, always labor hours number of cost driver that activity
or machine hours uses

• Easy to understand and calculate • Complicated, take time to

calculate. Sometimes, costs could
• Overheads are allocated outweigh benefits
unreasonably
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III. DISCUSSION ABOUT ABC

Benefits and limitations of ABC

Using ABC has some following benefits and limitations:

• Cost control and reduction by Limitations

the efficient management of
cost drivers • It is time consuming and
• Better costing information expensive
used to assist pricing decisions • It will be of limited benefit if
• Facilitate a good overhead costs are primarily
understanding of what drives volume related
overhead costs • The benefit is reduced if the
• A more realistic estimate of company is producing only
costs and profits which can be one product or a range of
used in a performance products with similar costs
appraisal • Complex situations may have
multiple cost drivers
Benefits

Therefore, ABC is suitable for larger organisations and the service sector. Details are as
follows:
• When production overheads are high relative to prime costs such as service sector
• When production overheads are high relative to prime costs
• When there are considerable differences in the use of resources by products
• Where consumption of resources is not driven by volume.