No.2 Activity Based Costing

Activity Based Costing
Bachelor of Labour Education
Institute of Human Resource Advancement

University of Colombo
BLE 207(b) Costing and Auditing

RMRB Rajapakse – Senior Lecturer in Accounting
1
WHY PRODUCT COST INFORMATION
IS IMPORTANT
Three major objectives of product costing:

 stock valuation- for financial reporting purposes
 cost control- to compare actual and slandered cost
 decision making- make or buy decisions
2
Why product cost;………
 Thus, it is important to calculate cost of
product/services as ‘accurately’ as
possible.
 So, total cost (both variable and fixed-

overhead) to be taken in to account.
 Overhead cost is the most important cost

element which has to be kept under
proper control.
3
Traditional way of OH Cost allocation
 Identify the different OH cost elements / cost
drivers and estimate cost drivers’ volume (no.
of inspections, no. of set ups, no. of orders, units of
material used)
 Prepare overhead budget
 Allocate OH cost to each departments (allotment,
apportionment)
 Allocate service department OH cost to production
departments (only one rate is applied)
 Calculate the OH cost absorption rate
 Allocate OH cost to the particular product/ service
4
Traditional ways of departmental
cost allocation
 Adapted one or more of the following
basis to absorb all overheads
Labour hours / Labour cost
Machine hours/ Machine hours cost
Material cost / quantities
Prime cost
Number of units produced
5
Problems of Traditional Costing
(TC)
 TC developed early 1900s
Main characteristics of the cost behavior of this era
were:
* Direct cost took high proportion of product cost

* Relatively less supportive /service functions
* Labour based production (Low level of machinery
usage)
* Standard products – less diversified product /
product lines
* Slow rate of change in both production and
production methods
6
TC cont;
 Thus,
*OH cost added to the production cost

on the basis of production volume (on
one product volume)
*But it does not produce logical basis

for absorption of overhead costs since
it base on a selected single volume
7
TC cont;
 With the development of production

method (Automated, Computerized,
Diversified:
* OH cost takes much higher proportion

in cost structure
* Logical and accurate method for
absorption is identified
8
Activity Based Costing (ABS)
 Provides better/ improved information

about cost
 Shows relationship between overhead
and activities
 Focuses on activities rather than volume
 Absorbs overheads to product or
services on cost drivers
 Over comes limitation of traditional
product cost allocation methods
9
ABC cont;
 More accurate cost management
methodology
 More emphasis to keep proper

management over indirect expenses
(Overhead cost)
10
ABC - basic assumptions
 Cost objects consume activities
 Activities consume resources
Understanding this relationship is

important to manage overhead cost
successfully
11
Activity Based Costing (ABC)
THE 5-STAGE ABC PROCESS

1. Identify the different activities of the business.
2. Create cost pools by calculating the total cost of
each activity.
3. Identify a cost driver (i.e. a causation factor) for
each activity (Number of inspections, Number of set-ups).
4. Calculate the cost driver rate (i.e. the average cost
of one occurrence of the cost driver).
5. Attach the activity costs to products according to
their demand for each activity.
12
ABC steps in other way
1. Identify activities
2. Determine cost for each activity
3. Determine cost drivers
4. Collect activity data
5. Calculate product cost
13
When ABC use ?
 Overhead is comparatively high
 Products are diverse: complexity
 Competition is stiff / rigid
14
EXAMPLES OF COST DRIVERS
Cost activity pools Cost drivers
 Controlling quality • Number of inspections
 Setting up machinery • Number of set-ups
 Ordering materials • Number of orders
 Operating machinery • Number of M/C hours
 Using materials • Units of material used
Etc. Etc.
15
THE ABC MECHANISM
Activity Cost
cost pools driver rates
Buying raw Rs. ÷purchase x No. of

materials order orders
OVERHEAD Controlling Rs. ÷ inspection x No. of PRODUCT

quality inspections
EXPENSES cost
Operating Rs. ÷ machine x No. of

machinery hour machine hrs
Etc. Etc. Etc.

16
COST DRIVER RATES
Cost driver rate = Activity cost pool
Number of cost drivers
E.g. If the cost pool for ordering materials

(i.e. running the Purchasing Department)
totals Rs. 480,000 and 10,000 purchase
orders are raised,
CDR= Rs.480,000 =Rs.48 / order

10,000
17
Eg. From the following information, calculate
the cost driver rates
Activity cost pools Rs./year
 Controlling quality 50,000
 Setting up machinery 10,000
 Operating machinery 20,000
 Using materials 700,000
Products A B C
 No. of quality inspections 250 350 400
 No. of machine set-ups 10 25 15
 No. of machine hours 10,000 14,000 16,000
 Kg of material used 8,000 12,000 15,000
18
From the following information, Cont; …..
ABC PRODUCT COST?
Eg. A batch of 1,000 units of product

B causes 2 quality inspections, 3
machine set-ups, 2,000 machine
hours and the use of 200 kg of
material.
What is the activity-based product
cost of one unit of B?
19
LIMITATIONS OF ABC
 Some costs (e.g. heating, site security) will apply to

more than one cost pool, necessitating a subjective
apportionment base and loss of the causation link.
 Cost pools can have more than one cost driver which
may result in different product costs, e.g. the setting
up of machinery can use the number of set-ups or the
number of set-up hours.
 Activity-based costing systems are more complex and

resource-demanding/expensive than absorption
costing systems. They are probably not suitable for
companies whose products and markets are relatively
stable.
20

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Activity Based Costing

Bachelor of Labour Education

Institute of Human Resource Advancement

BLE 207(b) Costing and Auditing

Three major objectives of product costing:

 So, total cost (both variable and fixed-

 Overhead cost is the most important cost

* Direct cost took high proportion of product cost

*OH cost added to the production cost

*But it does not produce logical basis

 With the development of production

* OH cost takes much higher proportion

 Provides better/ improved information

 More emphasis to keep proper

 Cost objects consume activities

 Activities consume resources

Understanding this relationship is

THE 5-STAGE ABC PROCESS

 Products are diverse: complexity

 Competition is stiff / rigid

 Controlling quality • Number of inspections

 Setting up machinery • Number of set-ups

 Ordering materials • Number of orders

 Operating machinery • Number of M/C hours

 Using materials • Units of material used

Buying raw Rs. ÷purchase x No. of

OVERHEAD Controlling Rs. ÷ inspection x No. of PRODUCT

Operating Rs. ÷ machine x No. of

Etc. Etc. Etc.

E.g. If the cost pool for ordering materials

CDR= Rs.480,000 =Rs.48 / order

Eg. A batch of 1,000 units of product

 Some costs (e.g. heating, site security) will apply to

 Activity-based costing systems are more complex and

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