Full Costing – Activity Based
Costing Theory and Practice
Lecture 17
Chapter 9 continued
ACCTN101
ACCOUNTING FOR MANAGEMENT
PPTs to accompany Accounting at Work by Low et al
Learning Objectives
•Understand the limitations of traditional costing
methods.
•Define Activity-Based Costing (ABC) and its components.
•Learn how to apply ABC to allocate overhead costs
accurately.
•Compare ABC with traditional costing methods.
•Analyze the benefits and challenges of implementing
ABC.
•Apply ABC in a practical case study.
Recap of Traditional Costing
•Product Cost Elements:
• Direct Labor
• Direct Material
• Factory Overhead
•Overhead Allocation:
• Based on indirect allocation bases (e.g., labour hours, machine hours)
Traditional overhead allocation
Overhead costs are ABSORBED into product cost on the
basis of some indirect allocation base.
For example:
• number of units; or
• labour hours; or
• labour cost; or
• material cost; or
• machine hours
Limitations: Traditional overhead allocation
•Inaccurate product costing
•Ignores cost drivers and activities
•Not suitable for modern manufacturing
environments
Example: Traditional overhead allocation
• Assume a company allocates overhead based
on direct labor hours.
• Product A requires 2 hours of labor, while
Product B requires 4 hours.
• Overhead is allocated equally based on labor
hours, regardless of actual resource
consumption.
According to Cooper and
Kaplan:
Problems with traditional allocation basis:
❑ All managers these researchers visited, were not convinced their full
cost systems were adequate for product-related decisions.
❑ They found product costs were :
systematically distorted
(e.g. high volume products attracted too much
overhead)
Introduction to Activity-Based Costing (ABC)
Definition:
❑ ABC is a method of costing which identifies the factors which cause costs
whereupon these costs are charged to output based on the usage of those
factors.
Or ABC is a costing method that identifies activities as the main cost drivers
and allocates costs based on the consumption of these activities.
Introduction to Activity-Based Costing (ABC)
•Purpose:
• To provide more accurate product
costing
• To better understand cost behavior
and drivers
• To support better decision-making
Introduction to Activity-Based Costing (ABC)
Historical Context:
•Traditional costing methods were
developed in simpler manufacturing
environments.
•Modern manufacturing involves more
complex processes and diverse products.
•ABC was developed to address these
complexities.
Key Concepts of ABC
•Activities: Tasks performed to produce
products or services (e.g., machine setup,
material handling)
•Cost Pools: Groups of costs associated with
specific activities
•Cost Drivers: Factors that cause costs to be
incurred (e.g., number of setups, number of
purchase orders)
•Activity Rates: Cost per unit of activity (e.g.,
cost per setup, cost per purchase order)
Key Concepts of ABC
Example:
•Activity: Machine Setup
• Cost Pool: $100,000
• Cost Driver: Number of setups
• Activity Rate: $100,000 / 1,000 setups =
$100 per setup
Applying ABC: Step-by-Step
[Link] Activities and Cost Pools
Example: Material handling, machine setup,
engineering support
[Link] Activity Rates
Example: Total cost of material handling / Number of
purchase orders
[Link] Cost Drivers
Example: Number of purchase orders, number of
setups
[Link] Costs to Products
Example: Cost per purchase order x Number of
purchase orders for a product
Applying ABC: Step-by-Step
Detailed Example:
•Activity: Material Handling
• Cost Pool: $50,000
• Cost Driver: Number of purchase orders
• Activity Rate: $50,000 / 500 orders = $100 per order
•Product A:
• Number of Purchase Orders: 100
• Overhead Allocation: 100 orders x $100/order = $10,000
•Product B:
• Number of Purchase Orders: 200
• Overhead Allocation: 200 orders x $100/order = $20,000
Comparison with Traditional Costing
•Traditional Costing:
• Allocates overhead based on volume-related measures (e.g., direct labor
hours)
• Assumes all products consume overhead equally
•ABC:
• Allocates overhead based on activities and cost drivers
• Recognizes different products consume different activities
Comparison with Traditional Costing
•Example:
• Traditional Costing:
• Overhead cost per unit = Total Overhead / Total Units
• Product A: 100 units x $100/unit = $10,000
• Product B: 200 units x $100/unit = $20,000
• ABC:
• Product A: $10,000 (based on 100 purchase orders)
• Product B: $20,000 (based on 200 purchase orders)
Benefits and Challenges of ABC
•Benefits:
• More accurate product costing
• Better understanding of cost behavior
• Improved decision-making
• Enhanced profitability analysis
• Better resource allocation
Benefits and Challenges of ABC
•Challenges:
• Implementation can be complex and costly
• Requires detailed data collection and analysis
• May be difficult to identify all relevant
activities and cost drivers
• Requires ongoing maintenance and updates
Activity cost pools and allocation
For example:
Material Material storage Machine Machine
purchasing and issuing Set ups running
Activity Activity Activity Activity
cost pool 1 cost pool 2 cost pool 3 cost pool 4
Product 1 Product 2 Product 3
19
20 Example (from Text book)
Simple Difficult Complex
Volume (Units) 2,000 1,000 400
Direct Material Cost per unit
60 100 180
($)
Direct Labour Cost per unit
15 45 90
($)
Sales price per unit ($) 140 350 740
Traditional allocation determination of profitability
for
21 products
Simple Difficult Complex
Direct Material Cost per unit ($) 60 100 180
Direct Labour Cost per unit ($) 15 45 90
Overhead Cost per unit ($)
45 135 270
(300% DL)
Total Manufacturing Cost per unit 120 280 540
Sales price per unit ($) 140 350 740
Gross Profit 20 70 200
Gross Profit % 14% 20% 27%
RANK 3rd 2nd 1st
Page 240, Chapter 9
Determination of Overhead Cost – Using ABC and
Cost
23 Drivers
Activities $ Simple Difficult Complex Total
Machine running cost 48,300 8,000 5,000 800 13,800
Machine set-up cost 63,700 2,000 3,000 4,800 9,800
2 components parts per unit 6 components parts per unit 10 components parts per unit
Stores – material receipt and 2 x 2,000 units 6 x 1,000 units 10 x 400 units
handling cost*
28,000 4000 6000 4000 14,000
Packing & delivery cost 93,000 10 12 40 62
Engineering cost 100,000 5 5 15 25
$333,000
* No. of component parts (per unit) – need to know volume of production to determine level of activity.
Allocation of costs using cost drivers: machine running
Machine running cost pool
cost pool $48,300/ 13,800 machine hours
= $3.50 per machine hour
cost driver 8,000 hrs 5,000 hrs 800 hrs
@ @ @
$3.50 $3.50 $3.50
products S D C
$28,000/2000 units $17,500/1000 units $2,800/400 units
= $ 14 per unit = $ 17.50 per unit = $ 7 per unit
24
Allocation of costs using cost drivers: machine set up costs
Machine set up cost pool
cost pool $ 63,700 / 9,800 set ups
= $6.50 per set up
cost driver
2,000 3,000 4,800
@ @ @
$6.50 $6.50 $6.50
products S D C
$13,000/2000 units $19,500/1000 units $31,200 /400 units
= $ 6.50 per unit = $ 19.50 per unit = $ 78 per unit
25
Allocation of costs using cost drivers: store costs
Stores cost pool
$ 28,000 / 14,000 parts
cost pool = $ 2.00 per part
cost driver 4,000 6,000 4,000
@ @ @
$2 $2 $2
S D C
products $8,000 /2000 units $12,000 /1000 units $ 8,000 /400 units
= $ 4 per unit = $ 12 per unit = $ 20 per unit
26
Allocation of costs using cost drivers: packing and delivery
Packing & Delivery
cost pool $ 93,000 / 62 deliveries
= $1,500 per delivery
cost driver 10 12 40
@ @ @
$1,500 $1,500 $1,500
S D C
products $15,000 /2000 units $18,000 /1000 units $60,000 /400 units
= $ 7.50 per unit = $ 18 per unit = $ 150 per unit
27
Allocation of costs using cost drivers: Engineering Cost
Engineering cost pool
cost pool $ 100,000 / 25 runs
= $4,000 per run
cost driver 5 5 15
@ @ @
$4,000 $4,000 $4,000
S D C
products $20,000 /2000 units $20,000 /1000 units $60,000 /400 units
= $ 10 per unit = $ 20 per unit = $ 150 per unit
28
Example – ABC Approach
Costs per unit Simple Difficult Complex
Direct Material Cost 60.00 100.00 180.00
Direct Labour Cost 15.00 45.00 90.00
Machine running cost 14.00 17.50 7.00
Machine set-up cost 6.50 19.50 78.00
Stores – material receipt and handling 4.00 12.00 20.00
cost
Packing & delivery cost 7.50 18.00 150.00
Engineering cost 10.00 20.00 150.00
Total Cost per unit $117.00 $232.00 $675.00
Sales price per unit $140.00 $350.00 $740.00
Gross Profit $23 $118 $65
Gross Profit % 16.4% 33.7% 8.8%
Rank 2nd 1st 3rd
Comparison between the Traditional allocation
and ABC approaches
Simple Difficult Complex
Sales price $140 $350 $740
Traditional approach:
Total cost $120 $280 $540
Gross Profit $20 $70 $200
Gross Profit % 14% 20% 27%
Ranking: 3rd 2nd 1st
ABC approach
Total cost $117 $232 $675
Gross Profit $23 $118 $65
Gross Profit % 16.4% 33.7% 8.8%
Ranking: 2nd 1st 3rd
Case Study and Comparison
Ruiz Company produces snowmobiles and riding mowers. The
company’s total estimated factory overhead of $1,600,000 is
assigned to each activity as shown in Exhibit 11.
Setup consists of changing tooling in machines
in preparation for making a new product.
Estimated Activity Costs
Ruiz Company produces snowmobiles and riding mowers. The
company’s total estimated factory overhead of $1,600,000 is
assigned to each activity as shown in Exhibit 11.
Engineering changes consist of processing changes in
design or process specifications for a product.
Activity Rates
Activity Rates
Overhead
Allocation
Overhead
Allocation
Dangers of Product Cost Distortion
Using an inappropriate factory overhead allocation method can
lead to distorted product costs.
Dangers of Product Cost Distortion
Ruiz Company uses a single predetermined factory
overhead rate to allocate factory overhead to the
riding mower and snowmobile. The estimated
factory overhead was allocated using direct labor
hours. The overhead rate for Ruiz is as follows:
Estimated Total Factory
Predetermined Factory Overhead Costs
Overhead Rate
=
Estimated Activity Base
Predetermined Factory $1,600,000 = $80
Overhead Rate = 20,000 direct labor hours
Dangers of Product Cost Distortion
As a result of using a single predetermined factory overhead rate,
$800 was allocated to each snowmobile and riding mower.
Comparing the single rate with the ABC method in the chart below
shows how a single-rate method can distort costs.
Key Takeaways:
•Traditional costing methods can distort
product costs.
•ABC focuses on activities and cost drivers
for accurate cost allocation.
•Implementing ABC requires careful
planning and data collection.
