Activity-Based
Costing
Managerial Accounting, ADA
Instructor
Mehriban Ahmadova
Introduction
• Activity-based costing (ABC) is a costing method that is designed to
provide managers with cost information.
• It is a process that assigns overhead to products based on the various
activities that drive overhead costs.
• It is used as a supplement to, not as a replacement for usual costing system.
• Official costing system used for external reporting and ABC for internal
reporting.
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Outline
1.
2.
3.
4.
Review P.O.R. under traditional allocation method.
Cost drivers.
Activity-based costing calculation.
Traditional vs ABC systems.
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Review P.O.R. under traditional
allocation method
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1/4 Review P.O.R. under traditional allocation method
Calculate P.O.R. and total cost #1
• Component categories under traditional allocation
• Product or job cost = direct materials + direct labor + manufacturing
overhead
• Estimated total manufacturing overhead costs
• Overhead application rate based on estimated overhead costs and a
estimated level of activity (see formula (3.1))
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜𝑡𝑎𝑙 𝑚𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑖𝑛𝑔 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑐𝑜𝑠𝑡
𝑃. 𝑂. 𝑅. =
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜𝑡𝑎𝑙 𝑎𝑙𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛 𝑏𝑎𝑠𝑒
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1/4 Review P.O.R. under traditional allocation method
Calculate P.O.R. and total cost #2
• The materials and labor costs per unit for three different recorders
produced by Musicality Manufacturing:
• Musicality determines the overhead rate based on direct labor hours. At
the beginning of the year, the company estimates total overhead costs to
be $2,500,000 and total direct labor hours to be 1,250,000.
1. What is the predetermined overhead rate?
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1/4 Review P.O.R. under traditional allocation method
Calculate P.O.R. and total cost #3
1. What is the predetermined overhead rate?
Estimated Annual Overhead Costs
Estimated Annual Activity
$2,500,000
1,250,000 direct labor hours
$2,500,000 Estimated Overhead_______ = $2.00 per direct labor hour
1,250,000 Estimated Direct Labor Hours
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1/4 Review P.O.R. under traditional allocation method
Calculate P.O.R. and total cost #4
The total direct labor hours estimated for the solo product is 350,000 direct
labor hours; for the band product is 400,000 direct labor hours: for the
orchestra product is 500,000 direct labor hours. Number of units produced
are solo – 140,000, band – 100,000, orchestra – 250,000
2. Calculate overhead cost per unit for all of the products.
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1/4 Review P.O.R. under traditional allocation method
Calculate P.O.R. and total cost #5
3. Combine overhead cost per unit with direct materials per unit and
direct labor cost per unit.
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1/4 Review P.O.R. under traditional allocation method
Calculate P.O.R. and total cost #6
Sale price was set as follows: solo - $20, band - $25, orchestra - $30.
Number of units sold are: solo – 150,000 units, band – 110,000 units,
orchestra – 200,000 units.
4. Calculate gross profit per unit for each product.
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1/4 Review P.O.R. under traditional allocation method
Calculate P.O.R. and total cost #7
Sale price was set as follows: solo - $20, band - $25, orchestra - $30.
Number of units sold are: solo – 150,000 units, band – 110,000 units,
orchestra – 200,000 units.
4. Calculate gross profit for each product.
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Cost Drivers & Cost Pools
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2/4 Cost Drivers
Identify Cost Drivers
• Cost driver: the reason a cost occurs
• In a labor-intensive environment, direct labor hours or dollars are a driver
of cost. In a machine intensive environment, machine hours are a cost
driver.
• Identify cost drivers:
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Activity-based costing calculation
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3/4 Activity-based costing
MOH Allocation: History
• Historical perspective on determination of manufacturing overhead
allocation
• Much of production historically was labor based, making labor hours or
labor dollars a good match for overhead allocation.
• Increased used of machines makes machine hours an appropriate cost
driver.
• Both labor hours and machine hours are easily measured.
• Establishing an activity-based costing system
• Technology has allowed for more detailed measurement of the many costs
that make up overhead in many industries.
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3/4 Activity-based costing
5-step ABC process
1.
2.
3.
4.
5.
Identify activities performed, activity cost pools and activity measures
Assign overhead costs to cost pools
Calculate activity rates for each cost
Allocate activity rates to cost objects (products, services)
Calculate unit product costs/prepare management reports
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3/4 Activity-based costing
Illustration: Classic Brass
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3/4 Activity-based costing
Illustration: Classic Brass: step 1
• At Classic Brass, the ABC team, in consultation with top managers,
selected the following activity cost pools and activity measures
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3/4 Activity-based costing
Illustration: Classic Brass: step 2
• The first-stage allocation in an ABC system is the process of assigning
functionally organized overhead costs derived from a company’s general
ledger to the activity cost pools.
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3/4 Activity-based costing
Illustration: Classic Brass: step 2
• First-stage allocations are usually based on the results of interviews with
employees who have first-hand knowledge of the activities.
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3/4 Activity-based costing
Illustration: Classic Brass: step 2
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3/4 Activity-based costing
Illustration: Classic Brass: step 3
• Activity rates =
$𝑎𝑠𝑠𝑖𝑔𝑛𝑒𝑑 𝑡𝑜 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 𝑝𝑜𝑜𝑙
𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑙𝑒𝑣𝑒𝑙
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3/4 Activity-based costing
Illustration: Classic Brass: ABC
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3/4 Activity-based costing
Illustration: Classic Brass: step 4
• In the second-stage allocation, activity rates are used to apply overhead
costs to products and customers.
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3/4 Activity-based costing
Illustration: Classic Brass: step 4
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3/4 Activity-based costing
Illustration: Classic Brass: step 4
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3/4 Activity-based costing
Illustration: Classic Brass: step 5
• Given information:
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3/4 Activity-based costing
Illustration: Classic Brass: step 5
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3/4 Activity-based costing
Illustration: Classic Brass: step 5
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Traditional vs ABC systems
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4/4 Traditional vs ABC systems
Overhead in Traditional vs ABC
Costing
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4/4 Traditional vs ABC systems
Traditional vs ABC Systems
Traditional Costing
Activity-Based Costing
Advantages
Advantages
All manufacturing costs are classified as material, labor, or
overhead and assigned to products.
There are multiple overhead cost pools, and each has an
individual measure of activity.
All manufacturing costs are considered to be part of the
product cost.
The allocation bases, or measures of activity, are often
different from those used in traditional allocation.
There is only one overhead cost pool and a single measure
of activity.
Both nonmanufacturing costs and manufacturing costs may
be assigned to products.
Disadvantages
Disadvantages
The use of the single cost driver does not allocate overhead as Some manufacturing costs may be excluded from product
accurately as using multiple cost drivers.
costs.
The use of the single cost driver may overallocate overhead
to one product and underallocate overhead to another
product.
It is more expensive.
By allocating product costs to inventory, this method is
acceptable for generally accepted accounting principles
(GAAP).
An ABC system takes much more to implement and operate.
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