ACTIVITY BASED COSTING SYSTEM

BROAD AVERAGING OR PEANUT-BUTTER COSTING describes a costing approach that

uses broad averages for assigning (or spreading, as in spreading peanut butter) the cost of
resources uniformly to cost objects when the individual products or services, in fact, use those
resources in non-uniform ways.

Product undercosting
-

a product consumes high level of resources but is reported to have a low cost per unit.

Product overcosting
-

a product consumes a low level of resources but is reported to have high cost per unit.

Product-cost cross-subsidization
-

if accompany undercosts one of its products, it will overcost at least one of its other
products.

COSTING SYSTEM REFINEMENT - making changes to a simple costing system that reduces
the use of broad averages assigning the cost of resources to cost objects and provides better
measurement of the costs of overhead resources used by different cost objects.

Activity-based approach
-

refines a costing system by focusing on individual activities as the fundamental cost

objects. It uses the cost of these activities as the basis for assigning costs to other cost
objects such as products or services.

ACTIVITY BASED COSTING (ABC) SYSTEM allocates overhead to multiple activity cost pools
and assigns the activity cost pools to products by means of cost drivers.

Cost driver
-

a factor that causes a change in the cost pool for a particular activity. It is used as a basis
for cost allocation; any factor or activity that has a direct cause-effect relationship.

Activity
-

any event,action,transaction, or work sequence that incurs costs when producing a

product or providing a service.

Activity Cost Pool

-

a bucket in which costs are accumulated that relate to as single activity measure in the
ABC System.

VALUE-ADDING ACTIVITIES activities that are necessary (non-eliminable) to produce the

products
NON-VALUE ADDING ACTIVITIES activities that do not make the product or service more
valuable to the customer.

BENEFITS OF ABC:
1. ABC leads to more cost pools
2. ABC leads to enhanced control over overhead costs
3. ABC leads to better management decisions
FOUR DECISIONS FOR WHICH ABC INFORMATION IS USEFUL:
1.
2.
3.
4.

pricing and product mix decisions,

cost reduction and process improvement decisions,
product design decisions,and
decisions for planning and managing activities.

LIMITATIONS OF ABC:
1. ABC can be expensive
2. Some arbitrary allocations continue

WHEN TO SWITCH TO ABC The presence of one or more of the following factors indicates
ABC as the superior costing system:
1.
2.
3.
4.
5.

Product lines differ greatly in volume and manufacturing complexity.

Product lines are numerous, diverse, and require differing degrees of support services.
Overhead costs constitute a significant portion of total costs
The manufacturing process or the number of products has changed significantly.
Production or marketing managers are ignoring data provided by existing system.

HIERARCY OF ACTIVITY LEVELS

1. Unit-level Activities performed each time a unit is produced.
2. Batch-level Activities performed each time a batch is handled or processed, regardless of
how many units are in the batch.
3. Product-level Activities relate to specific products and typically must be carried out
regardless of how many batches are run or units of product are produced or sold.
4. Customer-level Activities relate to specific customers

5. Organization-sustaining Activities carried out regardless of which customers are served,

which products are produced, how many batches are run, or how many units are made.

STEPS FOR IMPLEMENTING ACTIVITY-BASED COSTING:

1.
2.
3.
4.
5.

Define activities, activity cost pools, and activity measures.

Assign overhead costs to activity cost pools.
Calculate activity rates.
Assign overhead costs to cost objects using the activity rates and activity measures.
Prepare management reports.

EXERCISES:

1. Dioniso Manufacturing uses a normal costing system. Budgeted overhead for the coming
year is P2,160,000. Expected actual activity is 72,000 direct labor hours. During the year,
Dionisio worked a total of 70,000 direct labor hours and actual overhead totaled
P2,300,000.
REQUIRED:
a. Compute the predetermined overhead rate for Dionisio Manufacturing.
b. Compute the applied overhead.
c. Compute the overhead variance, and label the variance as underapplied or overapplied
overhead.

2. Various activities at Ning Corporation, a manufacturing Company, are listed below:

Activities
Level of Activity
a. Direct labor workers assemble a product.
Unit
b. Products are designed by engineers.
Product
c. Equipment is set up.
Batch
d. Machines are used to shape and cut materials.
Unit
e. Monthly bills are sent out to regular customers.
Customer
f. Materials are moved from the receiving dock to production lines.
Batch
g. All completed units are inspected for defects.
Unit
REQUIRED:
Classify each activity as a unit-level, product-level, batch level, or customer-level activity.
Provide an example of an example of an activity measure for each activity.

3. Lakadlang Corporation makes two types of hiking boots Xtreme and the Pathfinder. Data
concerning these two product lines appear below:
Product Data
Xtreme
Pathfinder
Selling price per unit
P140.00
P99.00
Direct materials cost per unit
72.00
53.00
Direct labor cost per unit
24.00
12.00
Direct labor hours per unit
2 hrs
1
hr

Estimated annual production

20,000 units

80,000

units
The company has a traditional costing system in which manufacturing overhead is applied
to units based on direct labor hours. Data concerning manufacturing overhead and direct
labor hours for the upcoming year appear below:
Estimated total manufacturing overhead
Estimated total direct labor hours

P1,980,000
120,000 DLH

REQUIRED:
a. Compute the product margins for the Xtreme and Pathfinder products under the
companys traditional costing system.
b. The company is considering replacing its traditional costing system with an activitybased costing system that would assign its manufacturing overhead to the following
four activity cost pools ( the Other cost pool includes organization-sustaining costs and
idle capacity costs):
Estimated
Expected Activity
Activities

Activity measures

Supporting direct labor

80,000
120,000
Batch setups
200
100

DLH
# of setups

Xtreme

Pathfinder

P 783,600

Total
40,000

495,000

300

Product sustaining
1
2

number of products

Other
n/a

Overhead Costs

602,400

99,000
n/a

n/a

Total manufacturing overhead

P 1,980,000

c. Compute the product margins for the Xtreme and Pathfinder products under the
activity-based costing system.
d. Prepare quantitative comparison of the traditional and activity-based cost assignments.
Explain why the traditional and activity-based cost assignments differ.
4. Actibase Company, a large wholesaler of grocery and household products, has been
implementing ABC in several functions. The Shipping Department, which averages about
P1,252,000 in monthly costs, is now ready for analysis. The controller is interested in
attributing shipping costs to two principal types of customers, supermarkets and
convenience stores, but wonders whether it is worthwhile to use ABC. Actibase has been
using peso volume of orders to evaluate customers and the controller believes this
practice is probably working well.

The controllers assistant worked up the following data using very rough, preliminary
estimates to see whether a more careful study might be likely to produce results
significantly different from the current method.
Cost Pool/Driver
Peso volume of orders
12,000,000
Number of customers
560
Number of orders
1,360
Number of stocks
6,400
Total shipping costs

Amount in Pool

Amount of Activity
P 492,000
360,000
160,000
240,000
P 1,252,000