Activity-Based Costing: Source: Datar, S.M, Rajan, M.V, 2019, Horngren's Cost Accounting, A Managerial Emphasis

Activity-based costing
Source: Datar, S.M, Rajan, M.V, 2019, Horngren’s Cost Accounting, A Managerial Emphasis,
16th ed., Pearson Education South Asis PTE. LTD., Manila, Philippines.
Activity-based costing
● refines a costing system by identifying individual activities as the fundamental cost
objects
○ refined costing system - reduces the use of broad averages for assigning the cost of resources to cost
objects and provides a better measurement of the costs of indirect resources ● costs are first traced to
activities and then the products.
● uses cost-drivers to allocate costs
● focuses on activities performed to produce products or services
● activity - an event, task, or unit of work with a specified purpose
Fundamental cost objects
Costs of
● products
Activities Costs of activities
● services
● customers
determine all activities identify the costs of allocate the costs to
contributing to the these activities and specific products or
completion of the product their equivalent cost services using cost
or services indicators driver
ABC System
1. Direct-cost tracing
- costs are traceable directly to an activity
- ABC subdivides a single indirect cost pool into smaller cost pools related to the different activities
2. Indirect cost pools

- need to be expanded until each pool is homogenous or have similar cause-and-effect relationship with a
single cost driver that is used as the cost-allocation driver
3. Cost-allocation bases -
cost drivers
Cost hierarchies
● categorises various activity cost pools on the basis of the different types of cost drivers, cost-allocation bases, or
different degrees of difficulty in determining cause-and-effect relationships.
Output unit-level costs - costs of activities performed on each individual unit of a product or service. e.g. machine
operation costs
Batch-level costs - costs of activities related to a group of units of a product or service rather than each individual unit of
product or service.
e.g. set-up costs
Product-sustaining costs (service-sustaining costs) - cost to support individual products or services regardless of the number
of units or batches
e.g. design costs
Facility-sustaining costs - cannot trace to an individual product or service but supports the organisation as a whole
e.g. support functions (HR, accounting, administration)

Process
1 2
3 4
6 7
5
When to use ABC

● Significant amounts of indirect costs are allocated using only one or two cost pools
● All or most indirect costs are identified as output unit-level costs
● Products make diverse demands on resources because of differences in volume,
process, steps, batch size, or complexity
● Products that a company is well suited to make and sell show small profits; whereas
products that a company is less suited to make and sell show large profits
● Operations staff has a substantial disagreement with the reported costs of
manufacturing and marketing products and services
ABC Management
- method using ABC to improve customer satisfaction and profitability
Pricing and product-mix decisions
- ABC system provides information on the costs of making and selling diverse products
Cost reduction and process improvement decisions
- ABC systems focus on how and where to reduce costs
- ability to control cost drivers e.g. overtime hours, setup hours
Design decisions
- evaluate the effect of current product and process designs on cost activities and costs and to
identify new designs to reduce costs
Planning and managing activities
- managers use the calculated budgeted rate to plan, make decisions and manage activities
ABC in service and merchandising companies
● widely used in service and
merchandising companies, more of a Department Cost driver
strategic tool rather than an Human resource headcount per department

inventory valuation Operations function - number of calls received
● ABC systems provide better insight customer service (call center)
into the operations of the company

and provide better understanding of Accounting functional costs
individual processes
Information technology end users
● e.g. shared service centers cost
drivers Facilities and admin surface used (square meter)
Illustration
Family Supermarkets has decided to increase the size of its Memphis store. It wants information about the
profitability of individual product lines: soft drinks, fresh produce, and packaged food. FS provide the following data
for 2017 for each product line:
FS also provide the following information for 2017:
FS also provide the following information for 2017:
Total support cost to be allocated 360,000
1. Family Supermarkets currently allocates store support costs (all costs other than cost of goods sold) to
product line on the basis of cost of goods sold of each product line. Calculate the operating income and
operating income as a percentage of revenues for each product line.
2. If FS allocates store support costs (all costs other than cost of goods sold) to product lines using an ABC
system, calculate the operating income and operating income as a percentage of revenues for each product
line.
3. Comment on your answers in requirements 1 and 2.
Solution: 1. allocating using COGS

1 Identify the products.
Solution 2: allocating using ABC .

2. Identify the direct costs.
3. Select activities and cost allocation bases.
4. Identify indirect costs associated with each

allocation base.
6. Compute the indirect costs allocated to the products
7. Compute the total cost of the

products
5. Compute the rate per unit of each cost-allocation base
Comparing simple cost system vs ABC
ABC provides
6. Compute the indirectacosts
better understanding
allocated of the costs necessary to the delivery of products to the customers. It
to the products
presents the level of activity or the intensity of using the resources for each product line. So it gives the
company an in-depth understanding of how they can improve their costing strategies, usage of resources
activity per product x
and pricing.
allocation rate
Although the ranks as to how the product lines absorb the support costs are the same for ABC and
simple costing system, the impact may materially decrease or increase the product line’s bottomline,
depending on its cost structure and profitability.
Fresh produce has the highest revenue but ABC showed that it has the lowest operating profit margin. It
utilises a lot of resources and these are eating up the profit margin of the product line.
In order to generate a revenue like this for fresh produce, it has to incur the
highest delivery, shelf-stocking and customer support.

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Activity-based costing

2. Indirect cost pools

e.g. set-up costs

e.g. design costs

e.g. support functions (HR, accounting, administration)

When to use ABC

strategic tool rather than an Human resource headcount per department

into the operations of the company

Solution: 1. allocating using COGS

Solution 2: allocating using ABC .

3. Select activities and cost allocation bases.

4. Identify indirect costs associated with each

7. Compute the total cost of the

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