Republic of Iraq

Ministry of Higher Education &Scientific Research

Wasit University
College of Administration & Economics
Accounting Department

Submitted to:
Professor
Dr. Abbas Nawar Khait Al-Musawi

By The Student:

Nagham Fouad Abbas

1443 A.H. 2021 A.D.

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 Contents
 Introduction
 What Is Activity-Based Costing (ABC)?
 Objectives of Activity Based Costing
 Designing an Activity-Based Costing (ABC) System
 How Activity-Based Costing (ABC) Works
 Cost Driver Analysis
 Cost Hierarchies
 Two-Dimensional ABC
 ABC in Service and Merchandising Companies
 Activity-based costing vs. traditional costing
 Benefits of Activity-Based Costing (ABC)
 Drawbacks of an ABC system
 Sources

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Introduction
Activity based costing (ABC) assigns manufacturing overhead
costs to products in a more logical manner than the traditional
approach of simply allocating costs on the basis of machine
hours. Activity based costing first assigns costs to the activities
that are the real cause of the overhead. It then assigns the cost of
those activities only to the products that are actually demanding
the activities.

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What Is Activity-Based Costing (ABC)?

Activity-based costing (ABC) is a costing method that

assigns overhead and indirect costs to related products and
services. This accounting method of costing recognizes the
relationship between costs, overhead activities, and
manufactured products, assigning indirect costs to products less
arbitrarily than traditional costing methods. However, some
indirect costs, such as management and office staff salaries, are
difficult to assign to a product.
[Link]
Based%20Costing%20(ABC)%3F

Objectives of Activity Based Costing

The objectives of Activity Based Costing are discussed below:
(The Institute of Cost and Works Accountants of India :2008
:408)
[Link] remove the distortions in computation of total costs as seen
in the traditional costing system and bring more accuracy in the
computation of costs of products and services.
[Link] help in decision making by accurately computing the costs
of products and services.
[Link] identify various activities in the production process and
further identify the value adding activities.
[Link] distribute overheads on the basis of activities.
[Link] focus on high-cost activities.

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[Link] identify the opportunities for improvement and reduction
of costs.
[Link] eliminate non value adding activities.
[Link]
~:text=PDF%20Available-,Activity%20Based%20Costing,-November%202019

Designing an Activity-Based Costing (ABC) System

There are three essential characteristics of a successful activity-
based costing implementation.
First, top managers must strongly support the ABC
implementation because their leadership is instrumental in
properly motivating all employees to embrace the need to
change.
Second, top managers should ensure that ABC data is linked to
how people are evaluated and rewarded. If employees continue
to be evaluated and rewarded using traditional (non-ABC) cost
data, they will quickly get the message that ABC is not
important and they will abandon it.
Third, a cross-functional team should be created to design and
implement the ABC system. The team should include
representatives from each area that will use ABC data, such as
the marketing, production, engineering, and accounting
departments. These cross-functional employees possess intimate
knowledge of many parts of an organization’s operations that is
necessary for designing an effective ABC system.
Furthermore, tapping the knowledge of cross-functional
managers lessens their resistance to ABC because they feel
included in the implementation process. Time after time, when

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accountants have attempted to implement an ABC system on
their own without top management support and cross-functional
involvement, the results have been ignored. (Garrison & Noreen &
Brewer,13th, p312)

How Activity-Based Costing (ABC) Works?

Activity-based costing (ABC) is mostly used in the

manufacturing industry since it enhances the reliability of cost
data, hence producing nearly true costs and better classifying the
costs incurred by the company during its production process.
This costing system is used in target costing, product
costing, product line profitability analysis, customer profitability
analysis, and service pricing. Activity-based costing is used to
get a better grasp on costs, allowing companies to form a more
appropriate pricing strategy.
The formula for activity-based costing is the cost pool total
divided by cost driver, which yields the cost driver rate. The cost
driver rate is used in activity-based costing to calculate the
amount of overhead and indirect costs related to a particular
activity.
The ABC calculation is as follows:
1. Identify all the activities required to create the product.
2. Divide the activities into cost pools, which includes all the
individual costs related to an activity such as
manufacturing. Calculate the total overhead of each cost
pool.
3. Assign each cost pool activity cost drivers, such as hours or
units.

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 4. Calculate the cost driver rate by dividing the total overhead
in each cost pool by the total cost drivers.
5. Divide the total overhead of each cost pool by the total cost
drivers to get the cost driver rate.
6. Multiply the cost driver rate by the number of cost
drivers. [Link]
w%20Activity-Based%20Costing%20(ABC)%20Works

Cost Driver Analysis

Companies engage in many activities that consume resources
and cause costs to be incurred. All activities have cost drivers,
defined in Chapter 2 as the factors that have direct cause and-
effect relationships to a cost. Many cost drivers can be identified
for an individual business unit. For example, cost drivers for
factory insurance are value of property, plant, and equipment;
number of accidents or claims occurring in a period; and
inventory size. Cost drivers are classified as either volume-
related (such as labor or machine hours) or nonvolume- related
(such as setups, work orders, or distance traveled), which
generally reflect the incurrence of specific transactions.
(Kinney. Raiborn 8th, p119)

Cost Hierarchies
A cost hierarchy categorizes various activity-cost pools on the
basis of the different types of
cost drivers or cost-allocation bases, or different degrees of
difficulty in determining cause and- effect (or benefits-received)
relationships. ABC systems commonly use a cost hierarchy

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with four levels that reflect the cost drivers of the activity-cost
pools:
(1) output unit–level costs,
(2) batch-level costs,
(3) product-sustaining costs, and
(4) facility-sustaining costs.
(Horngren, 17th, p177)

Two-Dimensional ABC

One way of picturing the relationship between ABC and ABM is

in terms of the two-dimensional ABC model depicted in Exhibit
5–11. the ABC system uses two-stage cost allocation to assign
the costs of resources to the firm’s cost objects, these cost
objects could be products manufactured, services produced, or
customers served. Now focus on the horizontal dimension of the
model. Depicted here is the process view that describes the
various processes by which work is accomplished in the
organization in terms of the activities that are the building
blocks of those processes. The left-hand side of Exhibit 5–11
depicts activity analysis, which is the detailed identification and
description of the activities conducted in the enterprise. Activity
analysis entails identification not only of the activities but also
of their root causes, the events that trigger activities, and the
linkages among activities. The right-hand side of Exhibit 5–11
depicts the evaluation of activities through performance
measures. And connecting them, in the center of the model, is
the activity cost information generated by ABC. This horizontal
view, comprising activity analysis and evaluation with an eye
toward the cost of the processes, is what we call activity-based
management.

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(Hilton,12th, p188)

ABC in Service and Merchandising Companies

The widespread use of ABC systems in service and

merchandising companies reinforces the idea that ABC systems
are used by managers for strategic decisions rather than for
inventory valuation. (Inventory valuation is fairly
straightforward in merchandising companies and not needed in
service companies.) Service companies, in particular, find great
value from ABC because a vast majority of their cost structure is
composed of indirect costs. After all, there are few direct costs
when a bank makes a loan or when a representative answers a
phone call at a call center. As we have seen, a major benefit of

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ABC is its ability to assign indirect costs to cost objects by
identifying activities and cost drivers. As a result, ABC systems
provide greater insight into the management of these indirect
costs than do traditional costing systems. The general approach
to ABC in service and merchandising companies is similar to the
ABC approach in manufacturing organizations. (Horngren, 17th,
p186)

Activity-based costing vs. traditional costing

ABC provides an alternative to traditional costing. Traditional

costing applies an average overhead rate to direct production
costs based on a cost driver (e.g., hours or volume). But, some
production-related activities use more overhead expenses than
others. As a result, traditional costing can give an inaccurate cost
of making each product. Traditional costing is simpler but less
specific than activity-based costing. You might consider going
with traditional costing if you only make a few products. You
may also use traditional costing for reporting externally (e.g., to
investors) and activity-based costing for reporting internally
(e.g., to managers).
[Link]
business/#:~:text=Activity-
based%20costing%20vs.%20traditional%20costing%C2%A0

Benefits of Activity-Based Costing (ABC)

Activity-based costing (ABC) enhances the costing process in

three ways.
First, it expands the number of cost pools that can be used to
assemble overhead costs. Instead of accumulating all costs in
one company-wide pool, it pools costs by activity.

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Second, it creates new bases for assigning overhead costs to
items such that costs are allocated based on the activities that
generate costs instead of on volume measures, such as machine
hours or direct labor costs.
Finally, ABC alters the nature of several indirect costs, making
costs previously considered indirect such as depreciation,
utilities, or salaries traceable to certain activities. Alternatively,
ABC transfers overhead costs from high-volume products to
low-volume products, raising the unit cost of low-volume
products.
[Link]
0Activity-Based%20Costing%20(ABC)

Drawbacks of an ABC system

Before implementing this type of costing method, consider the
cons:
Complex
Activity-based costing is more complicated than traditional
costing. Instead of general overhead costs and production-
related activities, you need to be specific.
How much time is Employee A spending on Activity XYZ?
What about electricity—how should you split up utility costs by
activity?
Getting into the weeds can make it difficult to track data without
an elaborate (and tried and true) system. Not to mention, some

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businesses don’t have the job positions and resources to manage
an ABC system.
Not 100% accurate
Unfortunately, there isn’t a costing method that gives you a
completely accurate breakdown of your costs. So, although an
ABC system is more accurate and detailed than traditional
costing, it isn’t 100% accurate.
For example, the ABC system requires employees to track how
much time they spend on each activity (e.g., research,
production, etc.). Your employees might miscalculate or even
exaggerate their time spent working on an
activity.
[Link]
business/#:~:text=Drawbacks%20of%20an%20ABC%20system%C2%A0

Demonstration Problem
Potter Inc. manufactures wizard figurines. All figurines are
approximately the same size, but some are plain ceramic
whereas others are “fancy,” with purple leather capes and a
prism_ headed wand. Management is considering producing
only the fancy figurines because they appear to be substantially
more profitable than the ceramic figurines. Th e company’s total
production overhead is $5,017,500. Some additional data follow:
Ceramic Fancy
Revenues $15,000,000 $16,800,000
Direct costs $8,250,000 $8,750,000
Production (unit 1,500,000 350,000
Machine hours 200,000 50, 000
Direct labor hours 34,500 153,625
Number of inspections 1,000 6,500

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Required:
a. Potter Inc. has consistently used machine hours to allocate
overhead. Determine the profitability of each line of figurines,
and decide whether the company should stop producing the
ceramic figurines.
b. Th e cost accountant has determined that production overhead
costs can be assigned to separate cost pools. Pool #1 contains
$1,260,000 of overhead costs for which the most
appropriate cost driver is machine hours; Pool #2 contains
$2,257,500 of overhead costs for which the most appropriate
cost driver is direct labor hours; and Pool #3 contains
$1,500,000 of overhead costs for which the most appropriate
cost driver is number of inspections. Compute the overhead cost
that should be allocated to each type of figurine using this
methodology.
c. Discuss whether the company should continue to manufacture
both types of figurines.

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Sources: -

1-Managerial Accounting, Ray H. Garrison, D.B.A., CPA, Thirteenth

Edition.

2-Cost Accounting a Managerial Emphasis, Horngren, Seventeenth

Edition Global Edition.

3-Managerial Accounting Creating Value in a Dynamic Business

Environment, Ronald W. Hilton, Twelfth Edition

4-Cost Accounting Foundations and Evolutions, Michael R. Kinney,

Cecily A. Raiborn, Eighth Edition.

5-Activity-Based Costing (ABC)

[Link]
Based%20Costing%20(ABC)%3F

6-Objectives of Activity Based Costing

[Link]
e-,Activity%20Based%20Costing,-November%202019

7-How Activity-Based Costing (ABC) Works?

[Link]
Based%20Costing%20(ABC)%20Works

8-Activity-based costing vs. traditional costing

[Link]
business/#:~:text=Activity-based%20costing%20vs.%20traditional%20costing%C2%A0

9-Benefits of Activity-Based Costing (ABC)

[Link]
Based%20Costing%20(ABC)

10-Drawbacks of an ABC system

[Link]
business/#:~:text=Drawbacks%20of%20an%20ABC%20system%C2%A0

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