Lesson 4Activity Based Costing- ABC

By,

C.A.Kankanamge

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Activity Based Costing- ABC

Learning Objectives :

At the end of the session :

1. Student should understand the Activity Based Costing ( ABC) Concepts

2. Students should compare traditional costing method with the ABC

3. Prepare cost sheet by using the ABC method

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Total Cost of Product/ Service Unit

• Direct Material Cost = xxxx

• Direct Labour Cost = xxxx

• Total Direct Cost / = xxxxx

Prime Cost

(+) Overhead Cost = xxxx

Total Cost = xxxxx

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Example : Traditional Costing Method

• 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

Total labor hrs. required

Standard: 2,000 units * 5 labor hours per unit

10,000

Luxury: 10,000 units * 4 labor hours per unit

40,000

Total Labor Hours 50,000 4

Standard Luxury

Direct Materials $25 $17

Direct Labor ($12 per hour)

$60 ($ 12 per hr x 5hrs)

$48 ($ 12 per hr x 4rs)

Costs for materials and labor cost for each table are provided below:

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• Manufacturing overhead costs total $800,000 every year. The breakdown of these costs among the company’s six activity cost pools is given below.

• The following six activities contribute to overall overhead costs.

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Estimated Manufacturing Overhead Cost

StandardLuxury

Total

Labor related $80,000 10,000 hrs 40,000hrs 50,000 hrs

Machine setups $150,000 3000 set ups

2,000set ups

5,000set ups

Parts administration $160,000 50parts 30parts 80parts

Production orders $70,000 100 orders 300 orders 400orders

Material receipts $90,000 150 receipts

600 receipts

750 recipts

General factory machine hours

$250,000 12,000hrs 28,000 hrs 40,000

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• Traditional Overhead Absorption Rate =

Total Budgeted Overhead

Total Labor hrs /Machine hrs

• Using the predetermined overhead rate approach with labor hours, the predetermined overhead rate is equal to $16 per labor hour ($800,000 / 50,000 labor hours). Using this information, we can design the total cost for each product.

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Unit Cost - Using Traditional ApproachStandard

Luxury

Direct materials $25 $17

Direct labor $60 $48

Manufacturing overhead applied:

Standard: 5 labor hours * $16 per labor hour

$80

Luxury: 4 labor hours * $16 per labor hour

$64

Unit product cost $165 $1299

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.

• The activities listed below are given in this example but companies usually break down the relevant activities.

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Activity-Based Costing

• Activity-based costing is a method of assigning indirect costs to products and services by identifying cost of each activity involved in the production process and assigning these costs to each product based on its consumption of each activity.

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Activity Cost Pools• An activity cost pool is an aggregate of all the costs

associated with performing a particular business task, such as making a particular product. By pooling all costs incurred in a particular task, it is simpler to get an accurate estimate of the cost of that task.

Cost Driver• Factor or variable which has a cause and effect

relationship with the total cost. The cost driver is the ’cause’, and the ‘total cost incurred’ is the effect of it.

• If we take an example of fuel cost of running a car, the cost driver (cause) would be ‘No. of Kms Run’, and the total cost (effect) would be ‘total cost of fuel’. The relationship is quite clear. Higher the no. of km run, higher would be the total cost of fuel.

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Formula – Overhead Rate Per Cost Driver

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Overhead Rate Per Cost Driver

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Example : Activity Cost Driver

ActivityCost

Driver (activity)

Overhead Cost

Estimated Units

Rate

Purchasing Materials

Pieces of materials

$ 200,000100,000 pieces

$ 2 per piece

Machine Setups

Machine setups

800,000 400 setups 2,000 per setup

InspectionsInspection hours

400,0004,000

inspect. hours

100per

inspect. hour

Running Machine

Machine hours

600,00020,000 mach. Hours

30per

machine hour

Total Overhead

$ 2,000,000 17

Methods used for Activity-Based Costing (Steps)

1. Identify the activities that consume resources and assign costs to those activities.

Purchasing materials would be an activity, for example.2. Identify the cost drivers associated with each activity. A cost driver is an activity or transaction that causes costs to be incurred. For the purchasing materials activity, the cost drivers could be the number of orders placed or the number of items ordered. Each activity could have multiple cost drivers.3.Compute a cost rate per cost driver unit. The cost driver rate could be the cost per purchase order, for example.4. Assign costs to products by multiplying the cost driver rate times the volume of cost driver units consumed by the product. For example, the cost per purchase order times the number of orders required for Product A for the month of December would measure the cost of the purchasing activity for Product A for December. 18

Activity Estimated MOHTotal per Activity

Overhead Rate

Labor related $80,000 50,000 hours $1.60 per labor hour

Machine setups $150,000 5,000 setups $30.00 per setup

Parts administration

$160,000 80 parts $2,000 per part

Production orders

$70,000 400 orders $175 per order

Material receipts $90,000 750 receipts $120 per receipt

General factory machine hours

$250,000 40,000 machine hours

$6.25 per machine hour

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• Next, for each product, we can use the calculated overhead rates to determine the overhead Cost.

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Standard Luxury

Activity Expected Activity

Overhead applied

Expected Activity

Overhead 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 per unit

$158.25 Overhead cost per unit

$48.3521

Unit Cost Card Using Activity-Based-Costing Approach

Standard Luxury

Direct materials $25 $17

Direct labor $60 $48

Manufacturing overhead applied:

Standard: $158.25

Luxury: $48.35

Unit product cost $243.25 $113.35

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Thank You.

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