ACTIVITY BASED COSTING

Activity-based costing (ABC) is based upon two principles. First, activities consume resources. Second, these
resources are consumed by products, services, or other cost objectives (output). ABC allocates overhead costs to
products on the basis of the resources consumed by each activity involved in the design, production, and distribution
of a particular good. This is accomplished through the assignment of costs to homogeneous cost pools that represent
specific activities and then the allocation of these costs, using appropriate cost drivers, to the product. ABC may be
used in conjunction with either job order or process costing systems.

Central to ABC are the activities performed to fulfill organizational objectives (producing products or services for
customers). Activities may be value-added or non-value-added.

Value-added activities are those which customers perceive as increasing the worth of a product or service and for
which customers are willing to pay. They include only production activities.

Non-value-added activities increase the cost of a product but do not increase its value to customers. Examples
include materials handling and rework. Packaging is required for some products such as milk or potting soil, but it
may be non-value-added for other products such as books (it is also costly and takes up huge amounts of landfill
space). Thus, these activities may be eliminated and/or restructured without customers perceiving a decline in the
value of the product/service. An activity (process) map is a flowchart which indicates all activities involved in the
production process and identifies both value-added and non-value-added activities.

Cost drivers are those activities which have a direct cause and effect relationship to the incurrence of a particular cost.

Unit-level costs are those costs that can be directly apportioned to volume. These costs may include such activities as
direct labor hour costs, directly attributable material costs, and costs per machine operating hour. Traditional costing
uses only variable and fixed or total overhead cost pools and views cost drivers at the output unit level, wherein
costs are allocated based on labor hours, machine hours, etc.

Batch-level costs are those costs that can be directly apportioned to the batch-run. For this type of cost, certain
activities are consumed in direct proportion to the number of batch-runs for each product. These batch-level costs
may include set-up, ordering, material handling, and transportation costs. Some costs though, such as setup costs,
vary at the batch level (batch-level costs) and should be spread over the units in the batch to which they relate (not
machine hours).

Product-level costs are those costs that can be directly apportioned to the product, which assumes that certain
activities are consumed to develop or permit production of different products. These product-level costs may
include such activities as research and development (R&D), parts and material acquisition and inventory costs,
technical administration, and specialized pre-production safety and manufacturing training. Product-sustaining
(process-level) costs such as engineering change orders should be assigned to the products for which the orders were
issued.

Facility-level costs cause problems in an ABC environment because these costs are associated with the sustainment
of a general manufacturing process. These facility-level costs may include such activities as travel costs, directors’
fees, and general administration and can include a large segment of the estimated product cost. Facility-sustaining
costs incurred at the organizational level support operations and can only be arbitrarily assigned to products.

As shown by the following table, ABC uses both transaction-related (e.g., purchase orders) and volume-related (e.g.,
machine hours) cost drivers. Traditional product costing tends to use only volume-related cost drivers.

Activity Cost driver

Purchase of materials Number of purchase transactions
Receiving Number of shipments received
Disbursing Number of checks issued
Setup costs Number of setups or setup hours
Machining Number of machine hours
Repair costs Number of machine hours engineering
Changes to products Number of engineering change notices

The activities listed above are all examples of direct activities which can be traced to an output or service. In contrast,
indirect activities such as human resources are not directly attributable to output. The cost of indirect activities may
be allocated or simply labeled as non-traceable.

Problem 1

The Juneau plant produces two calculators and has two production departments: assembly and packaging.
Information for the products is given below:

Deluxe Regular Total

Units produced 20,000 200,000 220,000
 Prime costs ₱160,000 ₱1,500,000 ₱1,660,000
Direct labor hours 20,000 160,000 180,000
Number of setups 60 40 100
Machine hours 10,000 80,000 90,000
Inspection hours 2,000 16,000 18,000
Number of moves 180 120 300

The following table presents activity information about the departments and products:

Assembly Packaging Total

Direct labor hours:
Deluxe 10,000 10,000 20,000
Regular 150,000 10,000 160,000
Total 160,000 20,000 180,000
Machine hours:
Deluxe 2,000 8,000 10,000
Regular 8,000 72,000 80,000
Total 10,000 80,000 90,000

Overhead Costs:
Setting equipment ₱120,000 ₱120,000 ₱240,000
Moving material 60,000 60,000 120,000
Machining 20,000 180,000 200,000
Inspection 16,000 144,000 160,000
Total ₱216,000 ₱504,000 ₱720,000

Requirements:
1. Compute the predetermined overhead rate for each department if Assembly uses labor hours and Packaging
uses machine hours.
2. Calculate the unit cost for each product if departmental overhead rates are used. (Round answer to the nearest
centavo.)
3. Compute the predetermined plant-wide overhead rate based on direct labor hours.
4. Calculate the unit cost of each product if a plant-wide overhead rate is used. (Round answer to the nearest
centavo.)
5. Calculate the overhead rates for each overhead activity.
6. Calculate the unit cost of each product if activity rates are used to assign overhead. (Round answer to the
nearest centavo.)

Problem 2

Kare Foods Company specializes in the production of frozen dinners. The first of the two operating departments
cooks the food. The second is responsible for packaging and freezing the dinners. The dinners are sold by the case,
each case containing 25 dinners. Two support departments provide support for Kare’s operating units: Maintenance
and Power. Budgeted data for the coming quarter are given below. The company does not separate fixed and
variable costs.

Support Departments Producing Departments

Particulars Packaging
Maintenance Power Cooking
and Freezing
Overhead Costs ₱340,000 ₱200,000 ₱75,000 ₱55,000
Machine Hours ---------- 40,000 40,000 20,000
Kilowatt Hours 20,000 ---------- 100,000 80,000
Direct Labor Hours ---------- ---------- 5,000 30,000

The predetermined rate for Cooking is computed on the basis of machine hours; direct labor hours are used
for Packaging and Freezing. The prime costs for one case of standard dinner total ₱16. It takes two machine hours to
produce a case of dinners in the Cooking Department and 0.5 direct labor hour to process a case of standard dinners
in the Packaging and Freezing Department. Recently, the Air Force has requested a bid on a three-year contract that
will supply standard frozen dinners to Minuteman missile officers and staff on duty in the field. The locations of the
missile sites were remote, and the Air Force had decided that frozen dinners were the most economical means of
supplying food to personnel on duty. The bidding policy of Kare Foods is full manufacturing costs plus 20%.
Assume that the lowest bid of the other competitors is ₱48.80 per case.

1. Kare’s Bid Price using direct method.

2. Kare’s Bid Price using step method.
3. Kare’s Bid Price using reciprocal method.