WEEK 5
REVIEW OF ACTIVITY-BASED COSTING
Study objectives:
1. Recognize the difference between traditional costing and activity-based costing.
2. Identify the steps in the development of an activity-based costing system.
3. Know how companies identify the activity cost pools used in activity-based
costing.
4. Know how companies identify and use cost drivers in activity-based costing.
5. Understand the benefits and limitations of activity-based costing.
6. Differentiate between value-added and non-value-added activities.
7. Understand the value of using activity levels to activity-based costing.
8. Apply activity-based costing to service industries.
9. Explain just-in-time (JIT) processing.
Traditional Costing and Activity-Based Costing
Often the most difficult part of computing accurate unit costs is determining the proper
amount of overhead cost to assign each product, service or job. For job order costing we
assumed the direct labor cost was the relevant activity base for assigning overhead
costs to a job and for process costing we assumed that machine hours are the relevant
activity base.
Activity-based costing (ABC) allocates overhead to multiple activity cost pools
and assigns the activity cost pools to products and services by means of cost drivers. In
ABC, an activity is any event, action, transaction, or work sequence that causes the
incurrence of cost in producing a product or providing a service. A cost driver is any
factor or activity that has a direct cause-effect relationship with the resources consumed.
ABC allocates overhead in a two-stage process: In the first stage, overhead costs are
allocated to activity cost pools, rather than to departments. Each is a distinct type of
activity. In the second stage, the overhead allocated to the activity cost pools is assigned
to products using cost drivers which represent and measure the number of individual
activities undertaken or performed to produce products or provide services.
Activity-based costing involves the following four steps:
a. Identify and classify the major activities involved in the manufacture of specific
products and allocate manufacturing overhead costs to the appropriate cost
pools.
b. Identify the cost driver that has a strong correlation to the costs accumulated in
the cost pool.
c. For each cost pool, compute the activity-based overhead rate per cost driver.
d. Assign manufacturing overhead costs for each cost pool to products, using the
overhead rates (cost per driver).
Unit Costs under ABC
A well-designed activity-based costing system starts with an analysis of the activities
performed to manufacture a product or provide a service. This analysis should identify all
resource-consuming activities. It requires a detailed, step-by-step walk through of each
operation, documenting every activity undertaken to accomplish a task.
After costs are allocated to the activity cost pools, the cost drivers for each cost pool
must be identified. The cost driver must accurately measure the actual consumption of
the activity by the various products. To achieve accurate costing, a high degree of
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correlation must exist between the cost driver and the actual consumption of the
overhead costs in the cost pool.
An activity-based overhead rate per cost driver is computed by dividing the total
estimated overhead per activity by the number of cost drivers expected to be used per
activity. The formula for this computation is as follows:
In assigning overhead costs, it is necessary to know the expected use of cost drivers for
each product. To assign overhead costs to each product, the activity-based overhead
rates are multiplied by the number of cost drivers expected to be used per product.
Benefits of ABC
The primary benefit of ABC is more accurate product costing because:
a. ABC leads to more cost pools.
b. ABC leads to enhanced control over overhead costs.
c. ABC leads to better management decisions.
Limits of ABC
Although ABC systems often provide better product cost data than traditional volume-
based systems, there are the following limitations:
a. ABC can be expensive.
b. Some arbitrary allocations continue.
When to use ABC
The presence of one or more of the following factors would point to possibly using ABC:
a. Product lines differ greatly in volume and manufacturing complexity.
b. Product lines are numerous, diverse, and require differing degrees of support
services.
c. Overhead costs constitute a significant portion of total costs.
d. The manufacturing process or the number of products has changed significantly.
e. Production or marketing managers are ignoring data provided by the existing
system and are instead using “bootleg” costing data or other alternative data
when pricing or making other product decisions.
Value-added versus Non-value-added activities
Activity-based management (ABM) is an extension of ABC from a product costing
system to a management function that focuses on reducing costs and improving
processes and decision making.
a. Value-added activities increase the worth of a product or service to customers.
Examples include engineering design, machining, assembly, painting, and
packaging.
b. Non-value-added activities are product- or service-related activities that simply
add cost to, or increase the time spent on, a product or service without increasing
its market value. Examples include repair of machines, the storage of inventory,
the moving of raw materials, assemblies, and finished product; building
maintenance; inspections; and inventory control. Examples for service
enterprises might include taking appointments, reception, bookkeeping, billing,
traveling, ordering supplies, advertising, cleaning, and computer repair.
The purpose of ABM is to reduce or eliminate the time and cost devoted to non-value-
added activities.
Classification of Activity Levels
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The recognition that some activity costs are not driven by output units has led to the
development of a classification of ABC activities, consisting of four levels. The four levels
are classified and defined as follows:
a. Unit-level activities. Activities performed for each unit of production.
b. Batch-level activities. Activities performed for each batch of products
rather than each unit.
c. Product-level activities. Activities performed in support of an entire
product line, but are not always performed every time a new unit or batch of
products is produced.
d. Facility-level activities. Activities required to support or sustain an entire
production process.
Activity-Based Costing in Service Industries
The general approach to identifying activities, activity cost pools, and cost drivers is the
same for service companies and for manufacturers. Also, the labeling of activities as
value-added and non-value-added, and the attempt to reduce or eliminate non-value-
added activities as much as possible is just as valid in-service industries as in
manufacturing operations.
Implementation of activity-based costing in service industries is sometimes more difficult
because there is a larger proportion of overhead costs which are company-wide costs
that cannot be directly traced to specific services provided by the company.
Just-in-Time Processing
Just-in-time (JIT) manufacturing is dedicated to having the right amount of materials,
products, or parts at the time they are needed. Under JIT processing, raw materials are
received just in time for use in production, subassembly parts are completed just in time
for use in finished goods, and finished goods are completed just in time to be sold.
A primary objective of JIT is to eliminate all manufacturing inventories. Inventories are
considered to have an adverse effect on net income because they tie up funds and
storage space that could be made available for more productive purposes.
There are three important elements in JIT processing:
a. A company must have dependable suppliers who are willing to deliver on short
notice exact quantities of raw materials according to precise quality
specifications. This may even include multiple deliveries within the same day.
b. A multiskilled work force must be developed.
c. A total quality control system must be established throughout the manufacturing
operations.
The major benefits of implementing JIT processing are:
a. Manufacturing inventories are significantly reduced or eliminated.
b. Product quality is enhanced.
c. Rework costs and inventory storage costs are reduced or eliminated.
d. Production cost savings are realized from the improved flow of goods through the
processes.
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ACTIVITY 1
(Write your answers using sheet/s of yellow pad paper to be submitted next Monday, October 12,
at the beginning of the class before the examination.)
EXERCISE 1
Carson Company manufactures a single product. Annual production costs incurred in
the manufacturing process are shown below for the production of 2,000 units. The
Utilities and Maintenance are mixed costs. The fixed portions of these costs are ₱200
and ₱400, respectively.
Costs Incurred
Production in Units 2,000 4,000
Production Costs
a. Direct Materials ₱ 4,000 ?
b. Direct Labor 16,000 ?
c. Utilities 1,000 ?
d. Rent 3,000 ?
e. Indirect Labor 4,600 ?
f. Supervisory Salaries 1,500 ?
g. Maintenance 900 ?
h. Depreciation 2,500 ?
Instructions
Calculate the expected costs to be incurred when production is 4,000 units. Use your
knowledge of cost behavior to determine which of the other costs are fixed or variable.
EXERCISE 2
1. Make a journal about Activity-based costing (ABC).
Sources:
Cabrera & Cabrera / Management Accounting Concepts and Application, 2017 Edition
Hilton / Managerial Accounting, 9th Edition
IMA / Standards of Ethical Conduct for Management Accountants,
[Link]
Kieso & Waygandt / Managerial Accounting, 4th Edition
Roque, Rogelio S. / Reviewer in Management Advisory Services, 2016 Edition
End of Week 5
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