ACTIVITY BASED COSTING SYSTEM
Activity-based costing (ABC) is a costing method that is designed to provide managers with cost
information for strategic and other decisions that potentially affect capacity and therefore “fixed”
costs. ABC is ordinarily used as a supplement to, rather than as a replacement for the company’s usual
costing system.
Most organizations that use ABC have two costing systems- the official costing system that is used for
preparing external financial reports and the ABC system that is used for internal decision making and
for managing activities.
DESIGN OF AN ACTIVITY-BASED COSTING SYSTEM
The steps or activities required in designing an ABC system are
1. Process Value Analysis (PVA)
a) Analyze activities required to make the product or perform the service. This can be
done through the preparation of a flowchart detailing each in the manufacturing
process from the receiving of materials to the final inspection of the completed
product. This requires walking through an operation and documenting every activity
observed as well as the time involved. An activity is any event or transaction that is a
cost driver- that is, it causes the incurrence of cost in an organization.
b) Classify each activity as value-added or non-value added.
c) Identify ways either reduce or eliminate the non-value-added activities.
2. Identifying Activity Centers
An activity center can be defined as a part of the production process for which management
wants a separate reporting of the cost of the activity involved. Generally, the levels of activities
can be classified into four as follows:
a) Unit-level activities- which are performed each time a unit is produced.
b) Batch-level activities – which are performed each time a batch of goods is handled or
processed;
c) Product-level activities – which are performed as needed to support the production
of each different type of product
d) Facility-level activities – which simply sustain a facility’s general manufacturing
process.
3. Assign Cost to Activity Centers
Assign costs to the activity centers where they are accumulated while waiting to be applied to
products. Costs that are traceable to the activity center should be assigned directly to activity
centers. Other costs shared by two or more activity centers should be assigned according to
some cost driver that controls the utilization of the costs involved.
4. Select Cost Drivers
This involves assigning costs from the activity center to the product using appropriate cost
drivers. When selecting a cost driver, one must consider the following factors:
a) The case of obtaining data relating to the cost driver
b) The degree to which the cost driver measures actual consumption by products of the
activity involved.
Unit -Level Activities
Activity Centers Cost Drivers Traceable Costs
Machine-related activities, Machine- Hours Power costs
such as milling, cutting, and Labor-hours Maintenance costs
maintenance. Number of units of output Labor costs
Labor related activities Factory supplies
including fringe benefits Depreciation of general-use
machines and equipment
Depreciation of maintenance
equipment
Batch Level Activities
Activity Centers Cost Drivers Traceable Costs
Purchase order processing Number of orders processed Clerical costs
Production order processing Number of material receipts Supplies consumed
Equipment setups Pounds of material handled Labor set up costs
Material handling Number of setups Labor cost to handle material
Quality inspection Hours of setup time Depreciation of office, setup,
Number of inspections and material-handling
Hours of inspection time equipment
Quality control costs
Batch Level Activities
Activity Centers Cost Drivers Traceable Costs
Product testing Number of tests Testing facility costs
Parts inventory management Hours of testing time Parts administration costs
Product design Number of part types Parts carrying costs
Hours of design time Product engineering costs
Number of engineering change Design costs
orders
Facility Level Activities
Activity Centers Cost Drivers Traceable Costs
General Factory Machine hours Plant management salaries
Plant occupancy Labor-hours Plant deprecation
Personnel administration and Number of employees Property taxes & insurance
training* Hours of training time Personnel administration costs
Employee training costs
Work recreational facilities
*The costs of some of these activities may be traceable in part to the facility level and in part to other
activity centers at the unit level, product level, and batch level. Personnel administration and training
may be such an activity.
Illustrative Problem I
Naga Company manufactures 4,000 units of Product L and 20,000 units of Product R each year. The
company currently uses direct labor hours to assign overhead costs to products. Product L requires
2.5 DLH and Product R requires 2.0 DLH to produce.
Presently, Naga Company uses a plantwide overhead allocation rate. Using this method, the unit
product cost is:
Product L Product R
Direct Material P36.00 P30.00
Direct labor 17.50 14.00
Manufacturing overhead
2.5 DLH x P18/DLH 45.00
2.0 DLH x P18/DLH 36.00
Total unit product cost P98.50 P80.00
Management at Naga believes that overhead costs are actually caused by the following five
activities:
Activity Traceable Cost
Machine Setups P255,000
Quality inspections 160,000
Production orders 81,000
Machine-hours worked 314,000
Material receipts 90,000
Total P900,000
The following transaction data have been compiled by the management of Naga:
Activity Total Product L Product R
Machine setups 5,000 3,000 2,000
Quality inspections 8,000 5,000 3,000
Production orders 600 200 400
Machine-hours worked 40,000 12,000 28,000
Material receipts 750 150 600
These data can be used to develop overhead rates for each of the five activities:
Activity Cost Cost function
Machine setups P255,000 5,000 P51 per setup
Quality inspections 160,000 8,000 20 per inspection
Production orders 81,000 600 135 per order
Machine-hours worked 314,000 40,000 7.85 per hour
Material receipts 90,000 750 120 per receipt
The activity based overhead rates that were just calculated can be used to assign overhead costs to
Naga’s two products.
Product L Product R
Activity ABC RATE TRANSACTIONS AMOUNT TRANSACTIONS AMOUNT
Machine setups P51.00 3,000 P153,000 2,000 102,000
Quality 20.00 5,000 100,000 3,000 60,000
inspections
Production orders 135.00 200 27,000 400 54,000
Machine-hours 7.85 12,000 94,200 28,000 219,800
worked
Material receipts 120.00 150 18,000 600 72,0000
Total overhead P392,200 P507,800
assigned
Number of units ÷ 4,000 ÷20,000
produced
Overhead per unit P98.05 P25.39
Now compare the unit product costs using the old costing system and ABC System
Costing method Product L Product R
Activity-based costing P151.55 P63.39
Old costing system 98.50 80.00
Illustrative Problem II
San Juan Company produces two products, Product KK and GG, and uses a costing system in which all
overhead is accumulated in a single cost pool and allocated based on machine hours. The company’s
management has decided to implement ABC because a cost study has revealed significant amounts of
overhead cost related to setup activity and design activity. The number of setups and the number of
design hours will be the activity drivers for the two new cost pools, and machine hours will continue
as the base for allocating the remaining overhead. Selected information follows the San Juan
Company’s most recent year of operations:
Product KK Product GG Total
Units Produced 500 15,500 16,000
Direct material cost:
Per unit P200 P20
Per Total P100,000 P310,000 P410,000
Machine Hours 3,000 47,000 50,000
Direct labor cost P50,000 P350,000 P400,000
Setups 120 80 200
Design hours 6,000 4,000 10,000
Overhead:
Set-up related P250,000
Design-related 350,000
Other 900,000
Total Overhead P1,500,000
Required:
1. Compute the total and pre-unit costs reported for the two products by the existing costing
system.
2. Compute the total and per-unit costs reported for the two products by the ABC system.
TRADITIONAL COSTING
Product KK Product GG
Direct Materials P100,000 P310,000
Direct Labor 50,000 350,000
Overhead: 90,000 1,410,000
P1,500,000/50,000 x 3000
P1,500,000/50,000 x 47,000
Total Cost P240,000 P2,070,000
Divided by units produced 500 15,500
Total cost per unit P480 P133.55
ABC COSTING
Product KK Product GG
Direct Materials P100,000 P310,000
Direct Labor 50,000 350,000
Overhead: Set up related
P250,000/200 x 120 150,000
P250,000/200 x 80 100,000
Design related
P350,000/10,000 x 6,000 210,000
P350,000/10,000 x 4,000 140,000
Others:
P900,000/50,000 x 3,000 54,000
P900,000/50,000 x 47,000 846,000
Total Cost P564,000 P1,746,000
Divided by units produced 500 15,500
Total cost per unit P112.80 P112.65
