Session at IIM, Jammu
MBA- Term III
on
Activity Based Costing
March 9,2024
BY
DR.SAMEER GUPTA
PROFESSOR
THE BUSINESS SCHOOL
UNIVERSITY OF JAMMU
Analysis and Classification of
Costs
Costsmay be classified into different
categories depending upon the purpose:
1. Classification on the basis of behavior
2. Classification by Nature or Element
3. Functional Classification
4. Classification for managerial decisions
and control.
Classification by Nature or
Element
➢Direct Cost
➢Indirect Cost
COST
Material Labour Expenses
Direct Indirect Indirect
Direct
Direct Indirect
Overheads
Indirect Material
Indirect Labour
Indirect Expenses
Classification of Overheads
1. Functional Classification
2. Classification with regard to the
behavior of Expenditure
3. Element-wise classification
4. Classification according to nature of
Expenditure
1. Functional Classification of Overheads
Manufacturing : → Depreciation,
Factory heating/ lighting, fuel, Tools,
Insurance etc.
Administrative
Distribution
Selling
2. Classification with regard to
the behavior of Expenditure
Fixed Overheads
Variable Overheads
Semi-variable Overheads
3. Element-wise classification
Indirect Material
Indirect Labor
Indirect Expenses
4. Classification according to
nature of Expenditure
Salaries
Depreciation
Repairs
Maintenance
Powers etc.
Allocation and Apportionment
of Overheads to Cost Centres
After Classification, next step is
to
allocate and/or apportion overheads to
cost centres known as
Departmentalization (or Primary
Distribution of overheads)
Apportionment of Service cost centres
costs to Producing Cost Centres
(Secondary Distribution of Overheads)
Methods of Absorption
1. Rate per unit of Output or Production
2. Direct Wages (or Direct Labor cost )
3. Direct labor hours
4. Machine Hour Rate
5. Direct Material Cost Method
6. Prime Cost Method
7. Sale Price Method
Activity Based Costing (ABC)
An activity-based costing system (also
known as ABC System) is a two-stage
procedure for assigning overhead
costs → to products, which focuses on the
major activities performed in the production
process.
Activity Based Costing (ABC)
Activity-based
costing is
a costing method that
identifiesactivities in an
organization and
assigns the cost of each activity to
all products and services according
→ to the actual consumption by
each.
Activity Based Costing (ABC)
Moreover,Activity-Based Costing
(ABC) has been developed as a
more modern absorption costing
method to overcome the problems
of
under-costing
and over-costing and
To produce more Accurate Product
Costs.
ABC vis-à-vis Traditional
Activity based Costing (ABC) is a systematic, cause
& effect method of assigning the cost of activities to
products, services, customers or any cost object.
ABC is based on the principle that “products consume
activities”.
Traditional cost systems allocate costs based on
Direct labor,
Material cost,
Revenue or other simplistic methods.
As a result, traditional systems tend to over-cost high
volume products, services and customers and under-cost
low volume.
ABC vis-à-vis Traditional
In traditional absorption costing,
overheads are first assigned or related to Cost
Centers, (production and service centers) and
then to Cost Objects i.e., products or services.
But in Activity-based costing system,
overheads are related or assigned to activities or
grouped into Cost Pools
before they are related to Cost Objects i.e.,
products or services.
ABC vis-à-vis Traditional
Thus, the activity based system uses
Activities
instead of Functional Departments
(Cost Centers)
for absorbing overheads.
Important Terms in Activity-Based Costing
The operation of the ABC System involves
the use of the following terms:
Cost Object: It indicates an item for which
cost is calculated using the Activity-based
costing System.
For Example, a service, a customer or a
product.
Cost Driver: A cost driver is any Factor or
Force that causes a change in the cost of an
activity.
Cost Drivers
Cost driver may be divided into two parts:
(a) Resource Cost Driver :The quantity
measure of the resources used/consumed
by an activity is called Resource Cost
Driver.
It is used to assign the cost of a resource to
An Activity or Cost Pool.
(b) Activity Cost Driver: An Activity Cost Driver
is Really a measure of frequency and
Strength of Demand, set on tasks by Cost
Items.
Steps to Follow in Activity-Based Costing
Step 1: Identify the activities that consume
resources.
Step 2: Assign costs to activities.
Step 3: Identify the cost driver associated
with each activity.
A cost driver is a factor that causes, or
"drives" an activity's cost.
Steps to Follow in Activity-Based Costing
(Cont.)
Step 4: Compute a cost rate per cost driver
unit.
Step 5: Assign costs to products by
multiplying the cost driver rate times the
volume of cost drivers consumed by the
product.
Labor Hours vs. Activity-Based Approach
XYZ Company manufactures and sells two types
of tables: Standard and Luxury.
Annual sales, direct labor hours, and total direct
labor hours per year are provided below:
Annual Sales X Labor Hours per unit Total labor hours
Standard: 2,000 units * 5 labor
10,000
hours per unit
Luxury: 10,000 units * 4 labor hours
40,000
per unit
Total Labor Hours 50,000
Costs for materials and labor for each
table are provided below:
Standard Luxury
Direct Materials $25 $17
Direct Labor
$60 $48
($12 per hour)
Manufacturing Overhead Costs Total $800,000
Every Year.
The breakdown of these costs among the
company’s Six Activity → Cost Pools is given
below:-
Estimated
Standard Luxury Total
MOH
1. Labor Related $80,000 10,000 40,000 50,000
2. Machine Setups $150,000 3000 2,000 5,000
3. Parts Administration $160,000 50 30 80
4.Production Orders $70,000 100 300 400
5.Material Receipts $90,000 150 600 750
6. General Factory
Machine Hours
$250,000 12,000 28,000 40,000
Total $800,000
Using the predetermined
overhead rate approach
with
Labor Hours, the predetermined
Overhead Rate is equal to
=$800,000/50,000 Labor Hours
= $16 per Labor Hour
Using thisinformation, we can design a
cost card for each product.
Unit Cost Card Using
Labor Approach
Luxur
Standard
y
Direct materials $25 $17
Direct labor $60 $48
Manufacturing overhead
applied:
Standard: 5 labor hours * $16
$80
per labor hour
Luxury: 4 labor hours * $16 per
$64
labor hour
Activity-Based Approach to Determine Overhead
Using the activity-based costing approach,
we can determine overhead rates for each activity that is
relevant to production.
Estimated
Activity MOH
Total per Activity Overhead Rate
1. Labor Related $80,000 50,000 hours $1.60 per labor hour
2. Machine Setups $150,000 5,000 setups $30.00 per setup
3. Parts
$160,000 80 parts $2,000 per part
Administration
4.Production
$70,000 400 orders $175 per order
Orders
5.Material Receipts $90,000 750 receipts $120 per receipt
6. General Factory 40,000 machine
$250,000 $6.25 per machine hour
Machine Hours hours
Next, for each product, we can use the calculated
Overhead Rates
to determine the Overhead Numbers:
Standard Luxury
Expected Overhead Expected Overhead
Activity
Activity applied Activity applied
Labor-related 10,000 $16,000 40,000 $64,000
Machine setups 3,000 $90,000 2,000 $60,000
Part administration 50 $100,000 30 $60,000
Production orders 100 $17,500 300 $52,500
Material receipts 150 $18,000 600 $72,000
General factory machine hours 12,000 $75,000 28,000 $175,000
Total $316,500 $483,500
Units produced 2,000 Units produced 10,000
Overhead cost Overhead cost
per unit
$158.25 per unit
$48.35
Unit Cost Card Using
Activity-Based Approach
Standard Luxury
Direct materials $25 $17
Direct labor $60 $48
Manufacturing overhead applied:
Standard
(: 5 labor hours * $16 per labor hour = $80)
$158.25
Luxury
(: 4 labor hours * $16 per labor hour= $64)
$48.35
Unit product cost $243.25 $113.35
Benefits of Activity-Based Costing
Activity-based costing (ABC) can affect the
cost distribution process in three ways:
The allocation of overhead costs is more
accurate and precise as they are separated
and grouped into pools based on the
number of activities.
To simplify, rather than calculating the
indirect expenses of the company by
pooling all costs together, ABC pools costs
based on activity.
Benefits of Activity-Based Costing (Cont.)
Activity-based costing tracespreviously
untraceable costs, such as depreciation, to
particular activities.
The ABC method can also
change the unit cost of Low-volume Products
→by transferring overhead costs from High-
Volume Products.
Benefits of Activity-Based
Costing (Cont.)
By comparing the first unit cost card
(i.e., when manufacturing overhead is applied based on just
one variable: direct labor hours) and
the second unit cost card
(i.e., when manufacturing overhead is applied based on
several important activities),
we can see that the unit product cost for each
product is generally similar.
However, the activity-based approach is the
more specific and precise way that companies will
allocate their manufacturing overhead costs.
