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Chapter 11

ACTIVITY BASED COSTING(ABC)

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ABC defined:

a systematic costing method that uses activitiesto allocate factory overhead costs and otherindirect costs to products.

it can provide more accurate data on product

cost by using multiple cost drivers that reflectmore accurately the causes of incurred costs.

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ABC vs. Traditional Costing

Traditional Costing ABC Costing

Factory overhead costsare allocated toproducts by using asingle activity or costdriver (e.g. labor hours)

Also called peanut-butter costing

Factory overhead costsare allocated toproducts using severalactivities or cost driversthat are closely related

with the incurrence ofspecific factoryoverhead costs.

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Steps in Implementing ABC Costing

1. Perform PROCESS VALUE analysis identifying value-added vs. non value-addedactivities.

Value-added activities - non-eliminable activitythat incurs costs but increases the worth ofthe product to the customer. (e.g. engineering

designs modifications)

Non value-added activities increases the costof a product but do not increase its value to

customers. (e.g. materials handling and rework)

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Continued2. Identify cost drivers (activities), cost pools and

activity centers.

Cost driver particular activity that causes theincurrence of certain costs.

Cost pool a group of similar costs usuallyincreased or decreased by a single cost driver.

Activity center a unit of organization that

performs a set of tasks. It is a part of the productionprocess for which management wants a separatereporting of the cost of the activity involved.

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Level of activity centers can be classified into fourgeneral categories:

Unit-level activities performed each time a

unit is producedBatch-level activities performed each time a

batch of goods is handled or processed.

Product-level activities performed to support

production (sales) of specific product type.Facility-level activities performed to sustain a

facilitys manufacturing process

Continued

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Exercise: Activity Levels

1. Equipment set-up

2. Plant supervision

3. Prime costs4. Packaging and

shipment

5. Heating, lighting and

security6. Designing, changing

and advertising

7. Product order

processing

Batch-level

Facility-level

Unit-level

Batch-level

Facility-level

Product-level

Batch-level

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Continued.3. Calculate predetermined overhead rates for

each identified activity.

Predetermined overhead rate = Estimated

overhead costs / Estimated cost driver

Note: Estimated figures are used because actual figuresare not yet known at the start of the period.

4. Allocate overhead costs to the products on thebasis of predetermined overhead rates.

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Continued.

In summary, ABC is a two-stage allocationprocess. First, overhead costs are traced toactivities, then, overhead costs are allocated to

products on the basis of the activities performedby a particular product.