Activity-based costing
1
Introduction



In the past, overhead costs were relatively
small, and the problems arising from
inappropriate overhead allocations were not
so significant
But nowadays, factories are highly automated,
resulting in increasing depreciation charges,
maintenance cost and machinery set-up cost
Errors in overhead absorption may seriously
affect the management decisions
2

The Activity-based costing (ABC) system is
developed to provide better approach for
assigning overheads to products and
computing product costs
3
Limitation of traditional costing

Traditional systems adopt volume-related
allocation bases e.g. direct labour hour and
machine hour. However, different resources
are used in non-volume related support
activities e.g. materials ordering, machinery
set-up, production scheduling and first-item
inspection
4

Traditional systems allocate overheads to
products in proportion to their production
volumes. High overheads are allocated to the
high-volume products. As a result, the highvolume simple products may be over-costed
while the low-volume complex products may
be under-costed
5
Introduction to Activity-based costing

The activity-based costing system asserts
that products create demand for activities and
activities bring about the costs to be incurred
6
What steps?
1.
2.
3.
4.
5.
Identity major activities performed by the
business
Calculate the total cost of each activity over
the period (i.e. cost centre or cost pool)
Determine the cost driver for each activity.
Cost drivers are the factors which cause the
activity cost pool to increase
Calculate the cost driver rate (i.e. total cost
in a cost pool/ no. of cost driver)
Assign the cost-centre overheads to the
products according to their cost driver rates
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Example
8
Martin Ltd. Manufactures tow products. Product A is a highVolume product while Product B is a low-volume product.
Details of production are shown as follows:
Product A Product B
Materials cost per unit
$130
$130
Direct Labour cost per hour
$50
$50
Direct machine hour per unit
4 hrs
4 hrs
Direct labour hour per unit
2 hrs
2 hrs
Output
10
100
No. of purchase orders
3
4
No. of set up
40
80
Overhead costs are shown as follows:
Factory power
Machinery set-up costs
Materials handling and dispatch
$
6600
4800
2100
13500
9

Required
Calculate the product costs using:
(a) Absorption costing based on machine
hour
(b) Activity-based costing
10
(a) Absorption costing based on machine
hour
Direct Materials
Direct labour
Overheads
($13500*4/440)
Product cost per unit
Product A
$
130
100
Product B
$
130
100
123
353
123
353
4*10+100*4
11
(b) Activity based Costing
Product A
$
130
100
Direct Materials
Direct labour
Overheads
Factory power
(6600*4/440)
60
Machinery set-up cost
(4800*40/120*1/10)
160
(4800*80/120*1/10)
Materials handling & dispatch
(2100*3/7*1/10)
90
(2100*4/7*1/100)
Product cost per unit
540
Product B
$
130
100
60
32
12
334
12
Objective
Allocation
of
overhead
Traditional
Activity based
Ensure
Focus
all
overheads are
absorbed into the
total production cost
The product cost
enable the
production cost and
stock valuation
 the basis volumerelated criteria e.g.
machine hours and
direct labour hours
on the
activities incurred
Assign to each
product only those
costs that would be
avoided if the
production was
discontinued
The basis of nonvolume-related
activities e.g. the no.
of purchase order,
production runs and
deliveries
13
Traditional
Assignment Overheads cost
of overhead are assigned to
each department
Activity based
Overheads
are
assigned to the cost
centre for each
activities
Adoption of  a single
Numerous cost
overhead
absorption rates is drivers are used for
rate
used
different activities
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Cost driver analysis


Traditional costing systems assume that all
overheads increase in proportion to the
number of units produced
In a complex manufacturing environment, a
greater number of cost drivers are used for
cost accumulation
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Unit-level activities
Batch-level activities
Production
-level activities
Costs are incurred for each unit
Produced. For example,
•Direct materials
•Direct labour
•Factory power
Costs are incurred for each batch
produced. For example,
•Purchase orders
•Production runs
•Number of inspection
Costs are incurred to support a product
Types or process. For example,
•Engineering change orders
•Product development
•Process design
•Test routines
Cost per unit
Cost per unit in batch
Cost per unit in batch
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Advantages of Activity-based costing



More realistic cost assignment
Better decision-making
Better control over cost
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Limitation of Activity-based costing



Difficult to apportion common costs
Difficult to implement
Inconsistent with the generally accepted
accounting principles (GAAP)
18