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

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

Product cross-subsidization- if a company 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 for assigning the cost of resources to cost objects and provides better measurement of the costs of
overhead resources used by different cost objects.

An 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 a 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. pricing and product mix decisions,
2. cost reduction and process improvement decisions,
3. product design decisions, and
4. decisions for planning and managing activities.

LIMITATIONOFABC:
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. Product lines differ greatly in volume and manufacturing complexity.
2. Product fines are numerous, diverse, and require differing degrees of support services.
3. Overhead costs constitute a significant portion of total costs
4. The manufacturing process or the number of products has changed significantly.
5. Production or marketing managers are ignoring data provided by the existing system.

HIERARCY OF ACTIVITY LEVELS

Unit-level Activities - are performed each time a unit is produced.
Batch-level Activities - performed each time a batch is handled or processed, regardless of how many units are i n
the batch. --
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
Customer-level activities - relate to specific customers
Organization-sustaining activities - carried out regardless of which customers are served, which products are
produced, hew many batches are run, or how many units are made.

STEPS FOR IMPLEMENTING ACTIVITY-BASED COSTING:

1. Define activities, activity cost pools, and activity measures,
2. Assign overhead costs to activity cost pools.
3. Calculate activity rates.
4. Assign overhead costs to cost objects using the activity rates and activity measures.
5. Prepare management reports.

EXERCISES:
1. Zalucki Company plans to use activity-based costing to determine its product costs. It presently uses a single
plant wide factory overheated rate for allocating factory overhead to Products, based on direct labor hours. The
total factory overhead cost is as follows:

Department Factory Overhead

Production Support P1,225,000
Production (factory overhead only) __175,000
Total cost P1,400,000

The company determined that it performed four major activities in the Production Support Department. These
activities, along with their budgeted costs, are as follows.

Production Support Activities Budgeted Cost

Setup .......................................................................P 428,750
Production control ................................ 245,000
Quality control ........................................................ 183,750
Materials management ......................................... 367,500
Total ....................................................................... P1,225,000

Zaluckl Company estimated the following activity-base usage and units produced for each of its three products:

TV Computer Cell Phone Total

Number of units 10,000 2,000 50,000 62,000
Direct labor hours 25,000 10,000 140,000 175,000
Setups 80 40 5 125
Production orders 80 40 5 125
Inspections 35 40 0 75
Material requisitions 320 400 30 750

REQUIRED:
1. Determine the factory overhead cost for the TV, computer, and cell phone under the single plant wide factory
overhead rate method. Use direct labor hours as the activity base.
2. Determine the factory overhead cost for the TV, computer, and cell phone under activity-based costing.
3. Which method provides more accurate product costing? Why?

1. Factory overrhead cost.

TV Computer Cell Phone
Direct labor hours
x FOH rate per dlh
Total FOH

2. TV
ACTIVITY ACTIVITY BASE USAGE ACTIVITY RATE ACTIVITY COST
Setup
Production Control
Quality Control
Material Management
Production
Total factory overhead
 COMPUTER
ACTIVITY ACTIVITY BASE USAGE ACTIVITY RATE ACTIVITY COST
Setup
Production Control
Quality Control
Material Management
Production
Total factory overhead

CELL PHONE
ACTIVITY ACTIVITY BASE USAGE ACTIVITY RATE ACTIVITY COST
Setup
Production Control
Quality Control
Material Management
Production
Total factory overhead

2. Super Cool Inc. manufactures cooling units for commercial buildings. The price and cost of goods sold for each unit are as follows:
Price P 40,000 per unit
Cost of goods sold 25,500
Gross profit P15,000 per unit

In addition, the company incurs selling and administrative expenses of P160,400. The company wishes to assign these costs to its three
major customers, Golles University, Biggest Arena, and JE Hospital. These expenses are related to three major non-manufacturing
activities: customer service, project bidding, and engineering support. The engineering support is in the form of engineering
changes that are placed by the customer to change the design of a product. The activity cost pool and activity bases associated
with these activities are:

ACTIVITY ACTIVITY Activity Based

Cost Pool
Customer service P66,500 Number of service requests
Project bidding 34,500 Number of bids
Engineering support 59,400 Number of customer design changes
Total costs P160,400

Activity-base usage and unit volume Information for the three customers is as follows:
Gollies Biggest NE Total
University Arena Hospital
Number of service 110 35 45 190
requests
Number of bids 14 12 20 46
Number of customer 75 25 35 135
design changes
Unit volume 5 10 15 30

REQUIRED:
1. Determine the activity rates for each of the three nonmanufacturing activity pools.
2. Determine the activity costs allocated to the three customers, using the activity rates in (1).
3. Construct customer Profitability reports for the three customers, using the activity costs in (2). The reports
should disclose the gross profit and income from operations associated with each customer.
4. Construct customer profitability reports for the three customers, using the traditional costing system
where the company allocates non-manufacturing costs using the unit volume. The reports should
disclose the gross profit and income from operations associated with each customer.

3. Various types of costs at Ning Corporation, a manufacturing Company, are listed below
a. Direct labor.
b. Purchase orders.
c . Direct materials.
d . Engineering change orders.
e. S e t u p .
f. Inspection.
g. Building depreciation.
h. Plant or division manager's salary
 i. Product development
j. Movement.

Required:
Classify each cost as a unit-level cost, product/process-level cost, batch-level cost, or organizational/faculty-level
cost activity.

4. Lakadlang Corporation makes two types of hiking boots - Xtreme and the Pathfinder. Data concerning these
two product lines appear below:

Product Date
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 hours 1 hour
Estimated annual protection 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 P1,980,000

Estimated total direct labor hours 120,000 DLH

REQUIRED
1. Compute the product margins for the Xtreme and the Pathfinder products under the company's traditional costing
system.

2. The company is considering replacing its traditional costing system with an activity-based coting system that would assign
its manufacturing overhead to the following our activity cost pools (the Other cost pool includes organization-sustaining
costs and idle capacity costs):

Estimated Expected Activity

Overhead
Activities Activity measures Costs Xtreme Pathfinder Total
Supporting direct labor DLH ₱783,600 ₱40,000 ₱80,000 ₱120,000
Batch Setup # of setups 495,000 200 100 300
Product sustaining number of products 602,400 1 1 2
Other 99,000 n/a n/a n/a
Total manufacturing overhead ₱1,980,000

Compute the product margins for the Xtreme and the Pathfinder products under the activity-based costing system.

5. Bydalake Resto is a popular restaurant located near Taal lake in Batangas. The owner of the restaurant has been
trying to better understand costs at the restaurant and has hired a student intern to conduct an activity-based costing
study. The intern, in consultation with the owner, identified three major activities and then completed the first-
stage allocations of costs to the activity cost cools. The results appear below:

Activity Cost Pool Activity Measure Total TotalActivity

Serving a Party of dines Number of parties served P 33,000 6,000 parties
Serving a diner Number of diners served 138,000 15,000 diners
Serving drinks Number of drinks ordered 24,000 10,000 drinks

The above costs include all the costs of the restaurant except for organization-sustaining costs such as rent,
property taxes, and top management salaries.

A group of diners who ask to sit at the same table are counted as a party. Some costs, such as the costs of cleaning
linen, are the same whether one person is at the table or the table is full. Other costs, such as washing dishes,
depend on the number of diners served

Prior to the activity-based costing study, the owner knew very little about the costs of the restaurant. She knew
that the twat cost for the month (including organization-sustaining costs) was P240,000 and that 15,000 diners
had been served. Therefore. The average cost per diner was P16.
REQUIRED:
1. According to the activity-based costing system, what is the total cost of serving each of the following parties
of diners'
a. A party of four diners who order three drinks in total.
b. A party of two diners who do not order any drinks.
c. A one diner who orders two drinks.

2. Convert the total costs you computed in (1) above to costs per diner. In other words, what is the average
cost per diner for serving each of the following parties?
a. A party of four diners who order three drinks in total
b. A party of two diners who do not order any drinks.
c. A lone diner who orders two drinks.

6. Wonder drugs Corporation (WC) decides to apply ABC analysis to three product lines: analgesics, vitamins,
and antacids. It identifies four activities and activity-cost rates for each activity as:
Ordering P100 per purchase order
Delivery P80 per delivery
Shelf-stocking P20 per hour
Customer support and assistance P0.20 per item sold

The revenues, cost of goods sold, store support costs, and activity-area usage of the three product lines are:
Analgesics Vitamins Antacids
Financial Data:
Revenues ₱57,000 ₱63,000 ₱52,000
Cost of goods shall 38,000 47,000 35,000
Store Support 11,400 14,100 10,500

Under its previous costing system. Wonderdrugs allocated its support costs to products at the rate of 30% cost of goods
sold.

REQUIRED.
1. Use the previous costing system to prepare a product line profitability report for Wonderdrugs.
2. Use the ABC system to prepare a product fine profitability report for Wonderdrugs.
3. What new insight does the ABC system in requirement 2 provide to Wonderdrugs managers?

7. Palmores Company has identified the following overhead activities, cost, and activity drivers for next year:
Creamed Items ExpectedCosts ActivityDriver Expected
Setup costs P480,000 Number of setups 1,200
Ordering costs 60,000 Number of orders 3,000
Machine costs 600,000 Machine how, 75,000
Power 40,000 Kilowatt hours 20,000

Assume, for simplicity, that each activity corresponds to a process. The following two jobs were completed during the
year:
JOB 101 J0B 102
Direct materials P 1,500 P 1,700
Direct labor (P90 per direct labor hour) 2,700 4,500
Units completed 80 50
Number of setups 3 2
Number of orders 2 3
Machine hours 90 60
Kilowatt hours used 150 80

The company's normal activity Is 20,000 direct labor hours.

REQUIRED:
a. Determine the unit cost for each job using direct labor hours to apply overhead
b. Determine the unit cost for each job using the four activity drivers.