Notes for Week 5
Activity Based Costing and Service Cost Allocation
ACTIVITY BASED COSTING (ABC)
It allocates overhead costs to multiple activity cost pools and assigns the activity cost pools to products by means
of cost drivers. Cost drivers triggers a change in the cost of an activity. It is used a basis for cost allocation; any
factor of activity that has a direct cause-effect relationship. Activity cost pool is a bucket in which costs are
accumulated that relate to a single measure in ABC system.
ACTIVITY BASED MANAGEMENT (ABM)
Activity-Based Management is focused on the analysis of the entity’s activities that affects the production greatly.
In ABM, we eliminate activities that are nonvalue-adding.
Nonvalue-adding activities are activities that add costs to the production process or increase production time but
does not add any ‘value’ to the product.
When nonvalue-adding activities are eliminated without reduction of product quality, production time and costs
related to it are also eliminated. Thus, it helps increase profitability
On another perspective, ABM assist also in determining the activities that greatly help the production process that can
increase the ‘value’ of a product or service.
PROBLEM 1
Solution:
Activity Based Solution:
Benefits of Activity-Based Costing






Provides realistic costs of manufacturing for specific products
Allocates manufacturing overhead more accurately to products and processes that use the activity.
Identifies inefficient processes and targets for improvement
Determines product profit margins more precisely
Discovers which processes have unnecessary and wasted costs
Offers better understanding and justification of costs in manufacturing overhead
Limitations of Activity-Based Costing






Collection and preparation of data is time-consuming
Costs more to accumulate and analyze information
Source data isn’t always readily available from normal accounting reports
Reports from ABC don’t always conform to generally accpeted accounting principles and can’t be used
for external reporting
Data produced by ABC may conflict with managerial performance standards previously established
from traditional costing methods.
May not be as useful for companies where overhead is small in proportion to total operating costs.
When to switch to ABC?





Product lines differ greatly in volume and manufacturing complexity.
Product lines are numerous, diverse, and require differing degrees of support service
Overhead costs constitute a significant portion of total costs
The manufacturing process or the number of products has changed significantly
Production or marketing managers are ignoring data provided by the existing system.
SERVICE DEPARTMENT COSTS
Service or support department is a unit in an organization that contributes in a very indirect way to the conversion
of raw materials to finished goods. They are, however and still, at whatever little it may be, involved in producing
goods.
These department are the purchasing department, personnel department, warehousing department and maintenance
department. Since these departments support the production process, the costs incurred in these departments should
be allocated to the production departments to determine the cost of a product for proper decision-making.
METHODS OF ALLOCATION SERVICE DEPARTMENT COSTS:
Direct Method
Direct allocation of service costs to the production department.
It is applicable for entities whose service departments directly provide services to the production departments and
there is no or very little service provision of one service department to another service department
Sequential Method (Step Method)
The cost of the initially-ranked service department affects the cost of the secondarily-ranked service department before
allocation of costs to the production department.
It is applicable for entities whose one service department is also a recipient of a service from another service
department, alongside provision of services to the production departments.
Algebraic Method (Reciprocal Method)
The use of mathematical cost functions to allocate service costs for departments that provide services to each other.
It is applicable for entities whose service departments reciprocally provide services to each, as well as to the production
departments.
PROBLEM ON SERVICE ALLOCATION
DIRECT METHOD:
STEP METHOD:
ALGEBRAIC METHOD: