Ateneo de Zamboanga University

School of Management and Accountancy

Accountancy Department

LEARNING PACKET
COSMAN2 – Strategic Cost Management
Session 1, First Semester, SY 2020-21

LEARNING PACKET NO. 6 DATE: September 13,2020

TOPIC: Activity – Based Costing Week No.: 6
Session: 1

INTENDED LEARNING OUTCOME:

At the end of this learning units, the learners shall:

1.) Differentiate Activity-Based Costing system from Traditional Costing System

2.) Explain the steps needed to implement the Activity-Based Costing Process
3.) Identify the levels of cost and cost drivers

I. CONCEPT NOTES

3.1.1. Overview of Activity-Based Costing (ABC) System

Definition
Activity Based Costing (ABC) System – is a costing method that is designed to provide managers with
cost information for strategic and other decisions that potentially affect capacity and therefore
“fixed” as well as variable costs. It is a system in which multiple overhead cost pools are allocated
using bases that include one or more non-volume-related factors.
The System
The use of the ABC System means that a company develops an allocation system that matches its own
unique production process. The system 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.
Rationale behind the costing system: products consume activities; activities consume resources.
Most organizations that use ABC have two costing systems: the official costing system that is used for
preparing external financial reports (GPFS), and the ABC system that is used for internal decision
making and for managing activities.
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
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.
Limitations of ABC
1. ABC can be expensive
 2. Some arbitrary allocations continue
3. ABC data can easily be misinterpreted
3.1.2. ABC System vs Traditional 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.
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.
Comparisons Between the ABC and Traditional Costing Systems
Activity-Based Costing Traditional Costing
1. Assume that cost objects consume 1. Assume that cost objects consume
activities. resources.
2. Uses drivers at various levels 2. Uses volume-related allocation bases
3. Process-oriented 3. Structure-oriented
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 lines 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.
3.1.3. Levels of Costs and Cost Drivers
UNIT LEVEL
Unit Level Costs – the costs that inevitable increase whenever a unit is produced. They are the only
costs that can be assigned accurately in proportion to volume.
Unit Level Drivers – are measures of activities that vary with the number of units produced and sold.
They are proportional to the volume of output and the only volume-related allocation bases used
in ABC.
Unit Level Activities – are performed each time a unit is produced.
BATCH LEVEL
Batch Level Costs – costs caused by the number of batches produced and sold.
Batch Level Drivers – measures of activities that vary with the number of batches produced and sold.
Batch Level Activities – are performed each time a batch is handled or processed, regardless of how
many units are in the batch.
PRODUCT LEVEL
Product Level Costs – costs incurred to support the number of different products produced. They are
not necessarily influenced by the production and sale of one more batch or one more unit.
Product Level Drivers – measures of activities that vary with the number of different products
produced and sold.
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.
PLANT LEVEL
Plant Level Costs – costs of sustaining capacity at a production site.
Plant Level Drivers – measures of activities that relate to the entire plant/organization.
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.

EXAMPLES OF COSTS, DRIVERS, AND ACTIVITIES

Activities Costs Drivers
Unit  Cutting  Electricity costs (if electrically-  Direct labor hours
 Soldering powered machinery is used in  Direct labor cost
 Painting producing each unit)  Machine hours
 Assembling  Heating costs (if each unit is heat-  Direct material
 Packaging treated) weight
 Inspection labor (if each unit requires  Direct material cost
inspection)  Direct material pieces
 Total prime costs
 Units produced
Batch  Scheduling  Setup costs  Setups
 Setting up  Material handling costs  Setup hours
 Blending  Scheduler, setup personnel or material  Batches
 Moving handler labor costs  Production/work
orders
 Material requisitions
Product  Designing  Product design costs  Design changes
 Developing  Cost of patents  Design hours
 Prototyping  Salaries of designers and  Product numbers
 Advertising programmers  Part numbers
 Warehousing
Plant  Heating  Rent/lease cost  Square footage
 Lighting  Depreciation occupied
 Cooling  Property taxes  Kilowatt hours used
 Providing  Insurance on factory building
security

3.1.4. Implementing Activity-Based Costing

Essential Characteristics of a Successful ABC Implementation
1. Top managers must strongly support the ABC implementation because their leadership is
instrumental in properly motivating all employees to embrace the need to change.
2. Top managers should ensure that ABC data is linked to how people are evaluated and rewarded.
3. A cross-functional team should be created to design and implement the ABC system.
Steps in Implementing ABC System
 Overhead Cost (Manufacturing and Non-Manufacturing)

First Stage Allocation

Unit-Level Batch-Level Product- Plant-Level

Driver Driver Level Driver Driver

Second Stage Allocation

Cost Objects

1. Define activities, activity cost pools, and activity measures.

Definitions:
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
The first major step in implementing an ABC system is to identify the activities that will form the
foundation for the system. This can be difficult, time-consuming, and involves a great deal of
judgment. A common procedure is for the individuals on the ABC implementation team to
interview people who work in overhead departments and ask them to describe their major
activities. Ordinarily, this results in a very long list of activities. Assign overhead costs to activity
cost pools,
2. Assign overhead costs to activity cost pools
First-Stage Allocation – the process of assigning functionally organized overhead costs derived
from a company’s general ledger to the activity cost pools. First-stage allocations are
usually based on the results of interviews with employees who have first-hand knowledge
of the activities.
3. Calculate activity rates.
The activity rates that will be used for assigning overhead costs to products and customers are
computed after doing the first stage allocation. The ABC team determined the total activity for
each cost pool that would be required to produce the company’s present product mix and to
serve its present customers.
Computation of activity rate:
Total activity cost
Activity rates =
Total activity
4. Assign overhead costs to cost objects using the activity rates and activity measures.
Second-Stage Allocation – in this allocation stage, activity rates are used to apply overhead costs
to products and customers.
5. Prepare management reports.
Sample Problem with Solution

Believing that its traditional costing system may be providing misleading information, an organization
is considering an activity-based costing approach (ABC). It now employs a full-cost system and has
been applying its manufacturing overhead on the basis of machine hours.

The organization plans on using 50,000 direct labor hours and 30,000 machine hours in the
coming year. The following data show the manufacturing overhead that is budgeted.
Activity Cost driver Budgeted Budgeted
Activity Cost
Materials handling Number of parts 6,000,000 P 720,000
handled
Setup costs Number of setups 750 315,000
Machining costs Machine hours 30,000 540,000
Quality Control Number of batches 500 225,000
Total manufacturing overhead cost P 1,800,000

Cost, sales, and production data for one of the organization's products for the coming year are as
follows:
Prime Costs:
Direct materials cost per unit P 4.40
Direct labor cost per unit (0.05 DLH @ 0.75
P15/DLH
Total prime cost per unit P 5.15

Sales and production data:

Expected sales 20,000 units
Batch size 5,000 units
Setups 2 per batch
Total parts per finished unit 5 parts
Machine hours required 80 MH per batch

1.) Compute the Product cost per unit using Traditional Costing

Total Overhead Cost / Budgeted Machine Hour = Overhead Cost/ Machine Hour
= 1,800,000 / 30,000
= P60 / machine Hour

Machine Hours Required for the product : 80 Machine hour per Batch
: 80 hours X 4 batches = 320 Hours

Total Overhead Required for the Product

320 Hours X P60 / machine hour = P19, 200

Cost of Overhead to be allocated per unit = P 19,200 / 20,000 units = P0.96

Direct Materials P 4.4

Direct Labor 0.75
Overhead Cost/Unit under Traditional Costing 0.96
Product Cost P 6.11
2.) Compute the Product cost per unit using Activity Costing

Budgeted Budgeted
Activity Cost driver Activity Cost Cost / Activity
Number of parts
Materials handling handled 6,000,000 P 720,000 P 0.12
Number of
Setup costs setups 750 315,000 420
Machining costs Machine hours 30,000 540,000 18
Number of
Quality Control batches 500 225,000 450
Total manufacturing
overhead cost P 1,800,000

Expected sales 20,000 units

Batch size 5,000 units
Number of Batches ( 20,000/5,000) 4 batches

Activity Cost Driver Transaction Cost /Activity Total Cost

Materials
Handling Total parts per finished unit 5 parts 0.12 12000
Setup
Costs Setups 2 per batch 420 3360
Machinin 80 MH per
g Costs Machine hours required batch 18 5760
Quality
Control Number of Batches 4 batches 450 1800
Total 22920
Overhead Cost /Unit ( 22,920/2,000 units) 1.146

Direct Materials 4.4

Direct Labor 0.75
Overhead Cost/Unit under ABC Costing 1.146
Product Cost 6.296 or 6.30

II. CHECKING FOR UNDERSTANDING

Problem 1
Carpenter Inc. designs industrial tooling parts and makes the molds for those parts. The following
activities take place when the company creates a new mold. Classify each cost as unit level (U), batch
level (B), product/process level (P), or organizational level (O).

a. Consultation with equipment manufacturer on design specifications

b. Engineering design of mold
c. Creating mold
d. Moving materials from warehouse for test quantity
e. Direct materials for test quantity to judge conformity to design specifications
f. Inspecting test quantity
g. Preparing design specification changes based on test molds
h. Depreciating small kiln used solely for test quantities
i. Depreciating manufacturing building

Problem 2
Torri Manufacturing Corporation has a traditional costing system in which it applies manufacturing
overhead to its products using a predetermined overhead rate based on direct labor-hours
(DLHs). The company has two products, B40W and C63J, about which it has provided the
following data:

B40W C63J
Direct materials per unit ......... P34.90 P63.70
Direct labor per unit.................. P20.80 P62.40
Direct labor-hours per unit .... 0.80 2.40
Annual production ..................... 35,000 15,000

The company’s estimated total manufacturing overhead for the year is P2,656,000 and the
company’s estimated total direct labor-hours for the year is 64,000.

The company is considering using a variation of activity-based costing to determine its unit
product costs for external reports. Data for this proposed activity-based costing system appear
below:

Estimated Overhead
Activities and Activity Measures Cost
Assembling products (DLHs)............... P1,216,000
Preparing batches (batches) ................ 480,000
Milling (MHs) ............................................. 960,000
Total............................................................... P2,656,000

Activities B40W C63J Total

28,00 36,00 64,00
Assembling products ........ 0 0 0
Preparing batches .............. 2,304 2,496 4,800
Milling ..................................... 1,088 2,112 3,200

Required:

1. Determine the unit product cost of each of the company's two products under the traditional
costing system.
2. Determine the unit product cost of each of the company's two products under activity-based
costing system.

Problem 3
The Kamienski Cleaning Brigade Company provides housecleaning services to its clients. The
company uses an activity-based costing system for its overhead costs. The company has provided
the following data from its activity-based costing system.

Activity Cost Pool Total Total Activity

 Cost
Cleaning ................... P185,752 21,700 hours
Job support ............. 171,532 6,100 jobs
Client support ........ 15,124 760 clients
Other ......................... 240,000 Not applicable
Total........................... P612,408

The “Other” activity cost pool consists of the costs of idle capacity and organization-sustaining
costs.
One particular client, the Whiddon family, requested 15 jobs during the year that required a total
of 60 hours of housecleaning. For this service, the client was charged P1,170.

Required:

a. Using the activity-based costing system, compute the customer margin for the Whiddon family.
Round off all calculations to the nearest whole cent.
b. Assume the company decides instead to use a traditional costing system in which ALL costs are
allocated to customers on the basis of cleaning hours. Compute the margin for the Whiddon
family. Round off all calculations to the nearest whole cent.

Problem 4
Wyeth Corp. has decided to implement an activity-based costing system for its in-house legal department.
The legal department’s primary expense is professional salaries, which are estimated for associated
activities as follows:

Reviewing supplier or customer contracts (Contracts) P270,000

Reviewing regulatory compliance issues (Regulation) 375,000
Court actions (Court) 862,500

Management has determined that the appropriate cost allocation base for Contracts is the number of
pages in the contract reviewed, for Regulation is the number of reviews, and for Court is number of hours
of court time. For 2010, the legal department reviewed 450,000 pages of contracts, responded to 750
regulatory review requests, and logged 3,750 hours in court.

a. Determine the allocation rate for each activity in the legal department.
b. What amount would be charged to a producing department that had 21,000 pages of contracts
reviewed, made 27 regulatory review requests, and consumed 315 professional hours in court services
during the year?
c. How can the developed rates be used for evaluating output relative to cost incurred in the legal
department? What alternative does the firm have to maintaining an internal legal department and how
might this choice affect costs?

Problem 5
Leopold & Olney LLP has 5 partners and 12 staff accountants. The partners each work 2,100 hours per
year and earn P350,000 annually. The staff accountants each work 2,600 hours per year and earn
P80,000 annually. The firm’s total annual budget for professional support available to partners and staff
accountants is P312,750. The firm also spends P125,100 for administrative support that is used only by
the partners.
a. Assume that total support cost is considered a unit-level cost based on number of work hours. What is
the support rate per labor hour?
b. If an audit engagement requires 60 partner hours and 220 staff accountant hours, how much
professional support cost would be charged to the engagement using the rate determined in (a)?
c. Assume that support costs are considered batch-level costs based on number of work hours. What are
the support rates per labor hour? (Round to the nearest cent.)
d. If an audit engagement requires 60 partner hours and 220 staff accountant hours, how much support
cost would be charged to the engagement using the rates determined in (c)?

V. INDEPENDENT LEARNING

CASE 1
The following costs are incurred in a fast-food restaurant that relies on computer-controlled equipment
to prepare customers’ food. Classify each cost as unit level (U), batch level (B), product/process level (P),
or organizational level (O):
a. Maintenance of the restaurant building
b. Refrigeration of raw materials
c. Cardboard boxes for food order
d. Store manager’s salary
e. Electricity expense for the pizza oven
f. Wages of employees who clear and clean tables
g. Depreciation on equipment
h. Property taxes
i. Oil for the deep-fat fryer (changed every four hours)
j. French fries

CASE 2
Perioto Inc. currently charges manufacturing overhead costs to products using machine hours. However,
company management believes that the use of ABC would provide more realistic cost estimates and, in
turn, give the company an edge in pricing over its competitors. Perioto’s accountant and production
manager have provided the following budgeted information for 2011, given a budgeted capacity of
1,000,000 machine hours:

Type of Manufacturing Cost Cost Amount

Electric power P 500,000

Work cells 3,000,000

Material handling 1,000,000

Quality control inspections 1,000,000

Machine setups 350,000

Total budgeted overhead costs P5,850,000

Type of Manufacturing Cost Activity Drivers

Electric power 200,000 kilowatt hours

Work cells 300,000 square feet

Material handling 200,000 material moves
Quality control inspections 50,000 inspections

Machine setups 25,000 setups

A national construction company approached Pete Lang, the VP of marketing, about a bid for 2,500 doors.
Lang asked the cost accountant to prepare a cost estimate for producing the 2,500 doors; he received the
following data:

Direct material cost P 50,000

Direct labor cost P150,000
Machine hours 5,000
Direct labor hours 2,500
Electric power—kilowatt hours 500
Work cells—square feet 1,000
Number of material handling moves 20
Number of quality control inspections 15
Number of setups 6

Source: Adapted from Nabil Hassa, Herbert E. Brown, and Paul M. Saunders, “Management Accounting
Case Study: Beaver Window Inc.,” Management Accounting Campus Report (Fall 1990). Copyright
Institute of Management Accountants, Montvale, NJ.

a. What is the predetermined overhead rate if the traditional measure of machine hours is used?
b. What is the manufacturing cost per door as presently accounted for?
c. What is the manufacturing cost per door under the proposed ABC method?
d. If the two cost systems will result in different cost estimates, which cost accounting system is
preferable as a pricing base and why?