Introduction to ABC Costing

The cost calculation model in a company is of utmost importance,

since it determines the viability of the business, and measures the degree of productivity and
efficiency in the utilization of resources.

The calculation of costs is also an unavoidable problem, as all

an organization or company needs to have reliable, timely information, or the
más exacta posible sobre el costo de sus productos, para de esta manera
make the right decisions.

The activity-based costing system, also known as ABC

(activity based costing) emerged in 1960 although its rise occurred from 1980.
promoters were Cooper Robin and Kaplan Robert, due to the difficulties and
irrelevancies presented by traditional cost calculation methods
(design methods between 1870–1920) that prioritize labor and do not give the
importance that costs have in contemporary production processes
indirect.

With traditional costing methodologies, costs are assigned to the

products in the field of units, that is to say it was supposed that the costs
depending on the production volume.

While in ABC costing this unit allocation is not limited but is

considers assignments to batches of products or infrastructure, what
it means establishing a differentiation between the different types of activities
that have been developed throughout the manufacturing process and identify the
the way each product has consumed these activities.

ABC Costing Definitions

The ABC costing system is based on the fact that a company to

producing requires carrying out activities that consume resources. From
this premise costs the activities and then the cost of them is
assigned to the different cost objects (products, services, etc.) that
demand these activities, this achieves greater precision in the
determination of costs and profitability.

Understanding a cost system as a mathematical model that

try to simulate the resource consumption in a transformation process, with
the purpose of knowing its cost.

Process
It is a set of interrelated tasks or activities that are carried out
a transformation, adding something to the object.
The activities are parts of the processes and do not include any decision making.
the decision is not worth breaking them down, they consume time and resources to
fulfill its function.

Cost allocation is done in two stages: first, the costs

from the resources is assigned to the activities, and in a second stage the
costs of the activities are assigned to the products using the drivers
of cost.

The cost driver quantifies an activity, and is a factor in the operation that
it allows to determine how much money activity is needed for the
transformation of the object to be costed. Each inductor is a measure of its
activity and must be defined in units of activity.
• Resources: All those means that contribute to production and
distribution of the goods and services that we produce and use.

DirectCost: In business terminology, it refers to all those

cost that can be directly associated with the production of a
product. Example: Direct Labor, Raw Material, etc.

Indirect Cost: These are costs that affect the production process.
in general of one or more products, so it cannot be assigned
directly to a single product without using any allocation criteria.
Example: Rental of an industrial warehouse or salary of personnel
administrative.

DEFINITIONOFABCCOSTINGMETHOD

The central idea of ABC is to identify the factors that originate the cost and
use them for a more precise determination of the same.

The Activity-Based Costing (ABC) method measures cost and performance.

of the activities, based on the use of resources, as well as organizing
the relationships of the Cost Center managers of the different
activities

PURPOSES OF COST ACCOUNTING

The purposes are:

1. Determine the cost of the inventories of manufactured products both per unit and
global, with a view to the presentation of the Financial Situation Statement.

2. Determine the cost of goods sold, in order to be able to calculate the

profit or loss in the respective period and be able to prepare the Income Statement.

3. Provide management with a useful tool for planning and control

systematic of production costs.
4. Serve as a source of cost information for economic studies and decisions
specials mainly related to long-term capital investments, such
as machinery replacement, plant expansion, manufacture of new
products, pricing of goods, etc

RELATION BETWEEN GENERAL ACCOUNTING AND COST ACCOUNTING

The two accounting systems must necessarily correlate for some accountants.
cost accounting is part of general accounting, for others it is a
independent accounting but with correlative links and common purposes.

Cost accounting provides the general accounting with the cost of the products.
elaborated, on the other hand, general accounting can execute its results with this.
Operations and obtain the required results

Dynamic costing system based on activities

Activity Based Costing (Dynamic Activity Costing System) was developed

as a method aimed at providing a solution to a problem that occurs in most of
companies that use the traditional costing system, reflected in the following:

The inability to report the costs of individual products at a reasonable level

of accuracy.

The inability to provide useful information for the management of the company
for the purposes of controlling operations.

Traditional costing systems base the costing process on the product. This
because it is assumed that each element of the product consumes the resources in
based on the production volume, however, diversity is not taken into account
products in terms of size, design, or complexity. There is also no ...
direct relationship between production volume and cost consumption.

In contrast, the ABC costing system bases the costing process on the activities of the
company, meaning that costs are traced from activities to products,
based on the demand for products for activities during the process of
production.
Traditional cost Activity-based costing

Divide the organization's expenses into administration and sales costs.

manufacturing costs, which are allocated to the products.
allocated to the products in expenses of
administration and sales, which are
period expenses
It usually uses only one criterion The expenses of the cost centers are
of the allocation of indirect costs to be carried a the activities of
the cost centers, which department, which are then
It is generally not reviewed with associates directly related to the products.
frequency.
Uses normally only association criteria, uses various association factors.
distribution of manufacturing costs aiming to achieve the most accurate cost and
the products, generally hours as precise as possible.
man, machine hours worked or
produced volumes.
Facilitates a departmental view of the costs through
company costs, making activities difficult, making it possible
cost reduction actions. better direct the actions where
the company's resources are really
consumed.

The importance of a dynamic activity-based costing system is that it

considered as a strategic tool that supports decision-making in the
company, allowing to identify in which activity is where you win or lose
money, what is the impact of the cost of processes on profits, as well as having a
greater control of resources, and thus be able to know when, where, and why
The resources incurred are not being used properly.

Exercise No. 1 on Absorption Costing and ABC (Activity-Based Costing)

in Activities)

CASE: RABIT SHOES

RABBIT SHOES is a medium-sized company dedicated to

production and marketing of footwear for: ladies, gentlemen and
children, known as Z-D, Z-C, and Z-N.
All its sales take place in Peru and currently the company
It has 160 workers.

Sales last year were S/. 1,200,000

Since its inception in the year 2000, its executives apply the Cost per
Absorption, Direct Costing and also assigns its CIF (Indirect Costs)
Manufacturing Overheads), based on the Direct Labor Hours,
consumed in the manufacturing of each shoe.

The owner of the organization is evaluating the possibility of applying

ABC costing, that is, to implement a Cost System that is
based on the Activities, which improve the current one, which is based on the
Production Volume.

The following data for the last year is available:

1. Data on produced units, sold, and cost elements (See

Table No. 1
 TABLE No. 1

CONCEPT Z-D Z-C Z-N TOTALS

Units produced and 20 pairs 50 pairs 10 pairs
sold
Direct Materials Cost of S/. 5 $20 $ 50
unit
Cost of MOD per unit S/. 5 $15 S/. 10
CIF $2000
Hours MOD/Unit 10 Hrs 15 hours 5 Hrs 1000 Hours

2. The CIF amounts to $2000 and have been incurred by

three Cost Centers, which are Engineering, Manufacturing, and Warehouse
Dispatch, according to the data shown in the following Table Nº2

FRAME No. 2

COST CENTER CIF

1. ENGINEERING $300

2. MANUFACTURING S/. 1,050

3. WAREHOUSE AND S/. 650

DISPATCH

3. The Activities and Cost Drivers have been analyzed.

respective and the CIF by Activity (See Table No. 3)

TABLE NO. 3

ACTIVITIES INDUCTORS CIF

1. DESIGN MODELS Number of design orders $300
2. PREPARE Number of Hours of
S/. 150
Machinery preparation
3. MACHINING Number of Machine Hours $ 900
4. RECEIVE Number of receptions
$400
MATERIALS
5 DISPATCH Number of shipments to customers
$250
PRODUCTS
TOTAL CIF S/.
2000
4. In addition, the data concerning the number of has been gathered.
Inductors (Activity Measurement) of each Activity presented
in the following Table No. 4:

TABLE No. 4
CONCEPT Z-D Z- C Z- N
A. Number of Orders of 2 3 1
Design.
B. Number of Hours of 5 5 5
Preparation
C. Number of Machine Hours 20 30 10
D. Number of Receipts. 5 10 5
E. Number of Shipments to 5 15 5
Clients

It is requested:

Cost the products using the Traditional Costing System and ABC.

2. Create Comparative Tables of the results obtained with the application of each
Costing System, identifying Hidden Profits or Losses, for:
Unit Cost of Finished Products.
CIF per unit of product.
Total CIF by Product.

SOLUTION

COSTING OF PRODUCTS USING THE SYSTEMS

TRADITIONAL DE COSTING.
1.1 Calculation of the CIF Allocation Rate (in this case the base
of assignment: DIRECT LABOR HOURS - MOD).

A. CIF RATE = CIF / MAN HOURS = S/. 2000 / 1000 MAN HOURS
= S/. 2 for Hours Machine.

PRODUCTS RATE CIF HOURS MOD CIF PER PRODUCT

Z-D $2 X 10 S/. 20 (a)
Z-C $2 X 15 = S/. 30 (b)
Z-N S/. 2 X 5 = S/. 10 (c)
B. ASSIGNMENT DE CIF A THE PRODUCTOS:

1.3 Calculation of the Unit Cost of Finished Products with the

Traditional Costing System.

COST ELEMENTS Z-D Z- C Z-N

Direct Materials S/. 5 $20 S/. 50
Direct Labor S/. 5 S/. 15 $10
Manufacturing Indirect Costs (CIF) S/.
20 S/. 30 S/. 10
(a) (b) (c)
COSTO UNITARIO DE PRODUCTOS/.30S/.65S/.70
FINISHED

2.

2.1 Determination of the number of Activity Inductors, Total and by

Product (Volume of Activity)

VOLUME OF ACTIVITY
INDUCTOR ACTIVITIES TOTAL Z-D Z- C Z-
N
DESIGN Number of Orders of
6 2 3 1
MODELS design
PREPARE Number of Hours of
15 5 5 5
MACHINERY preparation
MACHINE Number of Hours of
60 20 30 10
Machine
RECEIVE Number of receptions
20 5 10 5
MATERIALS
DISPATCH Number of shipments to
25 5 15 5
PRODUCTS clients

2.2 Calculate the Cost of each Activity (CIF by Inductor)

To calculate the Cost (CIF) by Activity, the following will be used
formula:

Activity Cost = Total CIF of the Activity / Total Number of

Inductors of the Activity

Design S/. 6 orders S/. 50 by Order

300 Models
Prepare S/ 15 Hours S/. 10 per hour
150 Machine
Machining S/ 60 Hours $15 per Hour
900
Receive S/. / 20 S/. 20 Receipts.
400 Receptions Materials
Dispatch S/. 25 Shipments S/ 10 for Shipping
250 Products

2.3 Calculation of the Unit Cost of Finished Product with ABC:

2.3.1 Cost Unitary from Z-D:

DIRECTS:
RESOURCES COST UNITS COST
UNITARY TOTAL
Materiales Directos $5 20 pairs S/
100
Direct Labor S/. 5 20 pairs S/. 100
TOTAL COSTS S/. 10 20 pairs
$200
DIRECT
INDIRECTS:
ACTIVITY MEASURE OF COST OF CIF
ACTIVITY ACTIVITY
Design Models 2 Orders of
$50 S/. 100
Design
Prepare Machinery 5 hours of
$10 $50
Preparation
Machining 20 Hours
S/. 15 S/. 300
Machine
Receive materials 5 Receipts S/. 20 $100
Dispatch Products 5 Shipments to
$10 S/. 50
Clients
TOTAL CIF S/. 600
TOTAL COST of Z-D $800
NUMBER DE
20
UNITS
UNIT COST
OF THE PRODUCT S/. 40
FINISHED

The same process is done for products Z-C and Z-N.