Activity based costing

ACTIVITY-BASED
COSTING

Ankur Verma
Abhinav Parmar
McGraw-Hill/Irwin Arvinderpal
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

ACTIVITY BASED COSTING
Traditional costing system ABC System
1. Direct and indirect costs 1. The direct and indirect costs are
are allocated to process allocated to activities like
centres or major departments Purchases, Material handling,
Producing the goods, machine set
ups, Supervising production
workers, Inspecting finished goods,
Dispatching good to customers

2. Cost driver as base for 2.Cost driver as base for allocation
allocation of overheads is not of overheads is based on cause
based on cause and effect and effect relationship between
relationship overheads and the overhead
allocation base (the cost driver)
Stores deptt – Labour hours or
machine hours or units produced
3. There is only one cost 3. There are many allocation bases
driver Or OH allocation as per activity chosen and cause
and effect base relationship

1-2

Traditional, Volume-Based
Product-Costing System
• Aerotech produces three complex printed circuit
boards referred to as Mode I, Mode II, and Mode
III.
• The following information is obtained from
company records:

Mode I Mode II Mode III
Production:
Units 10,000 20,000 4,000
Runs 1 run of 10,000 4 runs of 10 runs of
units 5,000 units 400 units

1-3

Traditional, Volume-Based Product-Costing System

Additional information includes:

Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor 60.00 80.00 40.00
Budgeted manufacturing overhead $3,894,000

Direct labor (hr/board) 3 4 2
Setup time (hr/run) 10 10 10
Machine time (hr/board) 1 1.25 2
Manufacturing overhead is determined as follows
1-4

Units produced 10,000 20,000 4,000
Direct labor (hr/unit) 3 4 2
Total hours 30,000 80,000 8,000

Total hours required 118,000

Budgeted manufacturing overhead $3,894,000
= $33 per hour
Budgeted direct-labor hours 118,000

Direct labor (hr/unit) 3 4 2
Overhead rate per hour $ 33 $ 33 $ 33
Overhead per unit $ 99 $ 132 $ 66

1-5

With these product costs, Aerotech established
target selling prices (Cost × 125%).
Direct labor 60.00 80.00 40.00
Manufacturing overhead 99.00 132.00 66.00
Total $ 209.00 $ 302.00 $ 126.00

Cost per unit $ 209.00 $ 302.00 $ 126.00
Target selling price 261.25 377.50 157.50

209.00 x 1.25
1-6

Activity Based Costing System
(ABC)

ABC systems
follow a two-
stage procedure
to assign
overhead costs to
products.

1-7

(ABC)
ABC systems follow a
two-stage procedure
to assign overhead
costs to products.

Stage One
Identify significant
activities and assign overhead
costs to each activity in
proportion to resources used.
1-8

(ABC)
ABC systems follow a
two-stage procedure
to assign overhead
costs to products.

Stage Two
Identify cost drivers
appropriate to each activity
and allocate overhead to
the products.

1-9

ABC System

1. Identify major activities

activity consists of aggregation of tasks having common
characteristics)
e.g.
Activity: purchase of materials :

Tasks: receiving a purchase request, inviting quotations,
selecting supplier, placing orders, receiving material

1-10

2. Assigning costs to Activity Cost
Centers:
Cost incurred on these activities are
assigned to these Activity Cost Centers.

Direct costs are traced directly.

Indirect costs are assigned to activities on the
basis of cause and effect cost drivers.

1-11

There must be a cause - effect relationship
between the overheads to be allocated and the
allocation base otherwise inaccurate allocation
of overheads will occur.

For an example, it would be wrong to allocate
overheads of stores dept. on the basis of labor
hours.

It should be more appropriately based on number
of units handled or used in production process.

1-12

3. Selecting cost drivers for allocating costs
to cost objects

The costs accumulated for an activity cost centre
are then allocated to different cost objects.

For this, a separate activity cost driver or
allocation rate is used.

In ABC analysis, the tracing of overheads to cost
objects requires that cost behavior must be
understood so that appropriate cost drivers are
identified.

1-13

Identifying activities and cost drivers
depends upon type of activity, Volume related or not volume related
Major activity Associated costs Cost drivers

1. Processing orders for 1. Labor cost of 1. No. of purchase
Purchase of materials/ employees orders processed
Stores working in
purchase dept.
2. Handling materials and 2. Labor cost of 2. No. of materials and
Parts stores, depreciation parts requisitions
of machines used for
moving materials
3. Inspection of material and 3. Labor cost of 3. No. of receipts of
parts purchased inspection team, materials and parts
Depr. Of testing
equipments
4. Setting up production 4. Labor cost of 4. No. of set ups
procedures works involved in set-
ups and depr. of set
up equipments
1-14

Identifying activities and cost drivers
Depends upon type of activity, Volume related or not volume related
Major activity Associated costs Cost drivers

5. Producing the goods 5. Depreciation of 5. No. of machine hours
machines

6. Supervising production 6. Salary of assembly 6. No. of assembly
workers supervisors labor hours

7. Inspecting finished goods 7. Labor cost of 7. No. of inspections
inspectors and
depreciation of test
equipments

8. Dispatching good to 8. Labor cost of 8. No. of boxes packed
customers packing and cost of
Packing materials

1-15

Two Key Points

A large proportion of non- Product diversity
unit-level activities When the consumption
A unit-level cost driver, ratios differ widely
such as direct labor, between activities, no
machine hours, or single cost driver will
throughput, will not be accurately assign the
able to assign the costs resulting overhead costs.
of non-unit-level activities
accurately.

1-16

Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .

Degree of Behavioral
Correlation Effects

Cost of
Measurement

1-17

Direct versus Indirect Costs
Volume-Based Costing Activity-Based Costing
All production costs An effort is made to
except direct account for as many
materials and direct costs as possible as
labor are lumped direct costs of
together in one production.
overhead cost pool.

Indirect
Costs

1-18

Interviewing and Paper Trails
The information for ABC systems initially comes
from interviews with employees in the support
departments and a review of each department’s
records.

1-19

Storyboarding
A procedure used to develop a detailed
process flow chart, which visually represents
activities and the relationships among
activities.
Step These are the steps we
1 follow to build a
Step
memory board.
2
Step
3
Step
4

1-20

Machinery
cost pool

Maintenance Lubrication

Depreciation Electricity

Computer Support Calibration

1-21

Engineering
cost pool

Engineering salaries Engineering software

Engineering supplies Depreciation

1-22

Facility
cost pool

Plant depr. Property taxes

Plant mgmt. Insurance

Plant maint. Security

1-23

Overhead Costs
Total budgeted cost = $3,894,000 Identification
Activity
of Activity
must be
done on Activity Cost Pools
each unit Cost
produced. Pools
Product-
Unit Batch Sustaining Facility
Level Level Level Level

Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Activity Activities needed to support Activity required in order
performed an entire product line for the production
on each process to occur.
batch
produced.
1-24

Product-
Unit Batch Sustaining Facility
Level Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Receiving/Inspection
cost pool $200,000

Material-Handling
cost pool $600,000

Quality-Assurance
cost pool $421,000

Packaging/Shipping
cost pool $250,000

1-25

STAGE ONE

Various overhead
Maintenance Lubrication
costs related
to machinery Depreciation Electricity

Computer Support Calibration

Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1,212,600

1-26

STAGE TWO
Calculate Budgeted Machinery Costs = $1,212,600
the pool Budgeted Machine Hours 43,000
rate = $28.20/hour

Mode I: Mode II:
$28.20 per hr. $28.20 per hr.
1 hr. per unit 1.25 hr. per unit
Cost $28.20 per unit $35.25 per unit

Assignment
Mode III:
$28.20 per hr.
2 hr. per unit
$56.40 per unit

1-27

STAGE ONE
Total budgeted setup cost
Calculation of $20 per hour
total setup cost 10 hr. per setup
$200 cost per setup
15 production runs
$ 3,000 Total

Activity
cost Setup Cost Pool
pool Total budgeted cost = $3,000

1-28

STAGE TWO
Calculate Budgeted Setup Costs = $3,000
the pool Planned Production Runs 15 runs
rate = $200 per run

Mode I: (1 Run) Mode II: (4 Runs)
$200 per run $200 per run
10,000 units per run 5,000 units per run
Cost = $.02 per unit = $.04 per unit
Assignment
Mode III: (10 Runs)
$200 per run
400 units per run
= $.50 per unit

1-29

STAGE ONE
Various overhead Engineering salaries Engineering software
costs related
to engineering Engineering supplies Depreciation

Activity
cost Engineering Cost Pool

1-30

STAGE TWO
Allocate based Engineering Cost Pool
on engineering Total budgeted cost = $700,000
transactions

Mode I: Mode II:
25% × $700,000 45% × $700,000
10,000 units 20,000 units
Cost = $17.50 per unit = $15.75 per unit
Assignment
Mode III:
30% × $700,000
4,000 units
= $52.50 per unit

1-31

Exh.

STAGE ONE 5-9

Various overhead Plant depr. Property taxes
costs related
Plant mgmt. Insurance
to general
operations Plant maint. Security

Activity
cost Facility Cost Pool

1-32

Exh.

STAGE TWO 5-9

Calculate Budgeted Facilities Cost = $507,400
the pool Budgeted Direct-Labor Hours 118,000
rate = $4.30/hour

Mode I: Mode II:
$4.30 per hr. $4.30 per hr.
× 3 hr. per unit × 4 hr. per unit
Cost $12.90 per unit $17.20 per unit
Assignment
Mode III:
$4.30 per hr.
× 2 hr. per unit
$8.60 per unit

1-33

Other Overhead Costs
Re c e ivin g an d In s pe c t ion Cos t P ool
Board Ove rh e ad × % ÷ Un its = Cos t/Un it
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00

Mat e rial-Han dlin g Cos t P ool
Mode I $ 600,000 × 7% ÷ 10,000 = $ 4.20
Mode II 600,000 × 30% ÷ 20,000 = 9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50

Qu alit y-As s u ran c e Cos t P ool
Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10

P ac kagin g an d Sh ippin g Cos t P ool
Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
Mode III 250,000 × 66% ÷ 4,000 = 41.25

1-34

Other Overhead Costs
Re c e ivin g an d In s pe c t ion Cos t P ool
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00

Mat e rial-Han dlin g Cos t P ool
$14.82 Mode I
Mode II
$ 600,000
600,000
×
×
7%
30%
÷
÷
10,000
20,000
= $
=
4.20
9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50

Qu alit y-As s u ran c e Cos t P ool
Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10

P ac kagin g an d Sh ippin g Cos t P ool
Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
Mode III 250,000 × 66% ÷ 4,000 = 41.25

1-35

Product Cost from ABC
These are the new product costs when
Aerotech uses ABC.

Direct labor 60.00 80.00 40.00
Machinery
Setup
Engineering
Facilities
Other
Total

1-36

Product Cost from ABC
These are the new product costs when
Aerotech uses ABC.
Direct labor 60.00 80.00 40.00
Machinery 28.20 35.25 56.40
Setup 0.02 0.04 0.50
Engineering 17.50 15.75 52.50
Facilities 12.90 17.20 8.60
Other 14.82 23.57 212.85
Total $ 183.44 $ 261.81 $ 390.85

1-37

Distorted Product Costs
Both original and ABC target selling prices are
based on (Cost × 125%).

Mo de I Mo de II Mo de III To t a l
Tra dit io n a l co s t in g
$ 209.00 $ 302.00 $ 126.00
ABC co s t in g 183.44 261.81 390.85
u n it s 10,000 20,000 4,000
To t a l co s t s
Tra dit io n a l
ABC

1-38


Mo de I Mo de II Mo de III To t a l
Tra dit io n a l co s t in g209.00
$ $ 302.00 $ 126.00 NA
AB C co s t in g 183.44 261.81 390.85 n a
u n it s 10,000 20,000 4,000 n a
To t a l co s t s
Tra dit io n a l 2,090,000 6,040,000 504,000 8634000
AB C 1834400 5236200 1563400 8634000

1-39


Mo de I Mo de II Mo de III
Tra dit io n a l co s t in g $ 209.00 $ 302.00 $ 126.00
ABC co s t in g 183.44 261.81 390.85

Origin a l t a rget s ellin g p rice
ABC t a rget s ellin g p rice

.

1-40


Tradition al cos tin g $ 209.00 $ 302.00 $ 126.00
ABC cos tin g 183.44 261.81 390.85

Origin al targe t s e llin g price 261.25 377.50 157.50
ABC targe t s e llin g price 229.30 327.26 488.56

The selling price of Mode I and II are reduced
and the selling price for Mode III is increased.
[$209.00 × 1.25] [$183.44 × 1.25]

1-41

Can you identify any problems Aerotech is likely
to face as a result of this distortion?
Tradition al cos tin g $ 209.00 $ 302.00 $ 126.00
ABC cos tin g 183.44 261.81 390.85
Cos t dis tortion pe r u n it 25.56 40.19 (264.85)
Un its produ ce d 10,000 20,000 4,000
Total cos t dis tortion 255,600 803,800 (1,059,400)

Traditional costing understates the cost
of complex, low volume products.

1-42

Indicators of Need for ABC
Direct labor is a Product-line profit
small percentage margins are hard
of total costs to explain

Line managers do not
Sales are increasing,
believe the product
but profits are declining.
costs reports

Some products that
Marketing does not
have reported high
use costs reports for
profit margins are not
pricing decisions
sold by competitors
1-43

The use of
ABC costing
information
to help
management
make decisions

1-44

Activity-based costing establishes relationships
between overhead costs and activities so that
we can better allocate overhead costs.
Activity-based management focuses
on managing activities to reduce costs.

1-45

Cost Assignment View

Resource costs

Activities

Cost Objects
1-47

Cost Assignment View

Resource costs
Process View
Activity Analysis Activity Evaluation

Root Activity Performance
Causes Triggers Activities Measures

Cost Objects
1-48

Activities

Nonvalue-
added
activities
Unnecessary Necessary

Reduce or Continually Evaluate
Eliminate and Improve
1-49

1. Identify Activities.
2. Identify Non-Value-Added Activities.
3. Understand Activity Linkages, Root Causes,
and Triggers.
Inspect Rework
Specify Select Receive Produce
finished defective
parts vendor parts goods
goods products

4. Establish Performance Measures.
5. Report Non-Value-Added Costs.

1-50

Process time

Inspection time Storage time

Move time Waiting time

1-51

Customer profitability analysis uses
activity-based costing to determine
the activities, costs, and profit associated
with serving particular customers.

1-52

Required
special
packaging.
Orders Demand
small fast
quantities. service.

Often
Orders
changes
frequently.
orders.

A costly
1-53

Cost Drive
Customer-Related Activities Cost Driver Base Rate
Order processing Purchase orders $ 150
Sales contacts (phone calls, faxes, etc.) Contacts 100
Sales visits Visits 1,000
Shipment processing Shipments 200
Billing and collection Invoices 160
Design/engineering change orders Design changes 4,000
Special packaging Units packaged 40
Special handling Units handled 60

A company may use these customer
related costs to help determine the
profitability of each customer.

1-54

No materials are purchased and no products
are manufactured until they are needed.

The primary goal of a
JIT production system is
to reduce or eliminate
inventories at every
stage of production.

1-55

Smooth, uniform production rate
Pull method of production
Purchase is small lot sizes
Quick, inexpensive setups
High quality materials
Effective preventive maintenance
Teamwork
Multiskilled workers

1-56

Long-term
contracts with
suppliers.

Only a few Parts delivered
suppliers. in small lots.

Grouped Minimal
payments to inspection of
vendor. materials.

1-57

• Activity based costing in service industry
• As useful as in mfg. industry
• Mangers want more detailed and accurate
information about the cost of producing
products and services they are selling
• Airlines, ins co, banks, hospitals, fin service
firms, hotels railroads,
• Air France, American express, Bank of
America, DHL, Fed Ex, US postal service
1-58

ABC at service companies:
Identifying
Activities Activity cost pools Cost drivers
Classification of activities at
• Unit level :
• batch level,
• product sustaining level,
• facility (general operations) level

1-59

Bajaj Allianze General Insurance Co. Ltd
Claims Department
Classification of activities at
• Unit level : Entering initial claim into computer
• batch level: moving a batch of claims from one
processing step to the next
• product sustaining level: maintenance of the
medical service provider network ( physicians,
hospitals )
• facility (general operations) level: general
administration of claims business unit

1-60

• ABC at Delaware medical centre (Primary Care
Unit- OPD)
• Patient Appointment
• New routine extended complex
• Continuing routine extended complex
• Every appointment needs
• Regd. nurse 1 : vital signs/preparing patient for
Primary health care professional
• PHCP 1: physician / intern / resident doctor or
nurse practitioner

1-61

• ABC team identified :
• Activities cost drivers
Physician time Physician minutes with patient
Practitioner nurse time P-Nurse minutes with patient
Intern or resident time Intern minutes with patient
Regd. Nurse time Regd. Nurse minutes with patient
Clerical time: new patients New patient visits
Clerical time : continuing Continuiing patient visits
Billing Billing lines (items on a bill)
Facility Patient visits (both new and continuing)

1-62

• Activity : physician time
• Cost driver : physician minutes with patient
• Cost cost driver rate PV driver activity no. of activity
• pool qty Type qty cost visits cost /p
• 960000 240000 4 R 80000 320000 8000 $40
• E 100000 400000 5000 $80
• C 60000 240000 2000 $120

• Activity Nurse Practitioner time
• Cost driver : NP minutes with patient
• 90000 30000 3 R 12000 36000 1200 $30
• E 10000 30000 500 $60
• C 8000 24000 320 $75

1-63

• Activity : intern or resident time
• Cost driver : intern or resident minutes with patient
• 412500 125000 3.30 R 40000 132000 4000 $33
• E 50000 165000 2500 $66
• C 35000 115500 1000 $115

• Activity : Rgd. nurse time
• Cost driver : RN minutes with patient
• 281980 245200 1.15 R 132000 151800 13200 $11.50
• E 80000 92000 8000 $11.50
• C 33200 38180 3320 $11.50

1-64

• Activity : Clerical time –new patients
• Cost driver : New patients number
• 135300 12300 11.00 R 7200 79200 7200 $11
• E 3000 33000 3000 $11
• C 2100 23100 2100 $11

• Activity : Cleical time – continuing patients
• Cost driver : cont. patients number
• 61100 12220 5.00 R 6000 30000 6000 $5
• E 5000 25000 5000 $5
• C 1220 6100 1220 $5

1-65

• Activity : Billing
• Cost driver : Billing lines on a bill
• 38480 76960 0.50 R 26400 13200 13200 $1.00
• E 24000 12000 8000 $1.50
• C 26560 13280 3320 $4.00

• Activity : Facility
• Cost driver : number of new plus cont. patients visits
• 245200 24520 10.00 R 13200 132000 13200 $10
• E 8000 80000 8000 $10
• C 3320 33200 3320 $10

1-66

• Costing of service
• 1. Each patient sees either a physician or PN or
intern or resident – not all four
• 2. each patient is either a new patient or a
continuing patient and not both.
• 3. to compute cost of particular appointment, we
should select only one of primary health care
professionals, and select one of the two clerical
time categories –new or continuing.
• 4. finally since every appointment involves RN ,
billing, and use of primary care unit facility, all of
these activities must be included in the cost
calculation.

1-67

• Cost of extended appointment for a new patient
seeing a nurse practitioner
• Activity Cost
• Nurse practitioner time
• RN time
• Clerical time –new patients
• Billing
• Facility
• Total 94.00

1-68

• Cost of extended appointment for a new patient
seeing a nurse practitioner
• Activity cost
• Nurse practitioner time 60.00
• RN time 11.50
• Clerical time –new patients 11.00
• Billing 1.50
• Facility 10.00
• Total 94.00

1-69

Activity based costing

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