Colegio de San Gabriel Arcangel

Area E, City of San Jose del Monte, Bulacan

LEARNING MODULE IN STRATEGIC COST MANAGEMENT

Unit Title: ACTIVITY BASED COSTING
Duration: 3 hours
Introduction:
This module enables you to more accurately apportion overhead costs to specific
products; the aim being to associate elements of overhead cost to those products that
actually cause the cost. Activity Based Costing allows for the accumulation and
recovery of costs associated with the purchase, manufacture and sale of items,
resulting in improved accuracy in calculating product profitability.
Activity Based Costing is not another SYSPRO Inventory costing method (e.g. Average,
Standard, FIFO, LIFO and Last Cost), but rather, it provides you with a different method
of calculating these costs.
This module explains the merits and applications of activity-based costing and service
department costing It covers the activity-based costing in depth beginning with the initial
design of the system followed by an illustration of its applications. This module also
explains the allocation of overhead costs incurred by service department.

Objectives / Competencies:
At the end of the session, the learner will be able to:
1. Apply activity-based costing and activity-based management to service
organizations.
2. Expand the use of activity-based costing.

Pretest
Multiple choice. Select your answer by encircling the letter of the correct answer.
1. Activity-based costing first assigns costs to
a. Products b. Overhead
c. Activities d. Departments

2. The first step in applying the activity-based costing method is

a. Identifying the cost drivers
b. Computing a cost rate per cost driver
c. Identifying the activities that consume resources
d. Assigning costs to products

3. Which of the following is not a cost driver?

a. Materials handling b. Purchase orders

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 c. Computer time d. Number of items sold
4. ABC can be applied to
a. Plant activities
b. Administrative activities
c. Marketing activities
d. All of these

5. Which of the following statements is true?

a. The traditional approach to costing uses many different cost drivers
b. Costs that are indirect to products are by definition traceable directly to
products
c. Costs that are indirect to product are traceable to some activity
d. All of the above statements are tru

Lesson Proper / Course Methodology:

A. Introduction of New Lesson

Definitions:

Activity-based costing is using information about activities to manage many

aspects of an organization, and focuses on processes and on tasks and activities
within processes, rather than simply managing costs.
.
Activity-based costing is a method of assigning indirect costs, including non-
manufacturing overhead, to products and services. It first assigns costs to
activities, then to products based on each product’s use of activities. It is a
premise that products consume activities and activities consume resources.

Activity center – unit of organization that performs a set of tasks

Cost pool – means indirect cost pool, refer to groupings or aggregations of

costs, usually for subsequent analysis

Plantwide allocation – uses the entire plant as a cost pool. Then, allocate all
costs from that pool to product using a single overhead allocation rate, or one set
of rates, to all of the products of the plant, independent of the number of
departments in the plant.

Departmental allocation – each department is a separate cost pool, which

accumulates costs. Then using separate rates, or sets of rates, for each
department, allocate from each cost pool to products produced in that
department.

Cost driver – a factor that causes or drives an activity’s costs

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Cost pools group costs into either
a. Plants, which are entire factories, stores, banks and so forth
b. Departments within plants
c. Activity centers

Differences between Traditional and Activity-Based Costing (ABC)

Traditional ABC
Cost Pools One or a limited number Many, to reflect different
activities
Applied rate Volume-based, financial Activity-based, non-
financial
Suited for Labor-intensive, low Capital-intensive,
overhead companies product-diverse, high
overhead companies
Benefits Simple, inexpensive Accurate product
costing, eliminate non-
value added activities

Benefits of Activity-Based Costing

a. Improved product or service cost data
b. Improved decisions about pricing, service mixes and product strategies based
on more accurate cost information
c. Cost reduction by eliminating non-value added activities
d. Greater control of costs because of its focus on the behavior of costs at their
origination both short-term and long-term
e. More accurate evaluation of performance by programs and responsibility
center.

Steps in Activity-Based Costing

1. Identify the activities that consume resources, and assign costs to those
activities. Example: Purchasing of materials
2. Identify the cost driver(s) associated with each activity. Example: number of
orders is a cost driver in purchasing materials. Each activity could have
multiple cost drivers.
3. Compute a cost rate per cost driver unit. Example; The cost per purchase
order is a driver cost rate
4. Assign costs to products by multiplying the cost driver rate times the volume
of cost drivers consumed by the product. Example: Number of purchase
orders required for a particular product times the cost per purchase order

Example of Cost Drivers

a. Manufacturing
Labor hours or labor cost Number of customers
Machine hours Items produced or sold
Machine set-ups Flight hours
Kilos of materials handled Number of operations
Purchase orders Scrap/Rework orders
Quality inspections Computer time

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 Number of parts in a product Hours of testing time
Square footage Number of billing hours
Design time Number of vendors
Asset value

b. Non-Manufacturing
Number of hospital beds occupied
Number of take-offs and landing for an airplane
Number of rooms occupied in a hotel
Number of trips for a bus company
Number of kilometers driven

Computing a Cost Rate per Cost Driver

Estimated Indirect Cost

Predetermined Indirect Cost Rate=
Estimated Volume of the Allocation Base

Allocating Costs to Product

Costs are allocated to products by multiplying each cost driver’s rate by the
amount of cost driver activity used in making the product

Example Problem 1
Samantha Manufacturing, Inc. provided the following information for the month of
June 2020.
Units
Machine A produced 600
Machine B produced 1,000

Cost Drivers
Activities Machine A Machine B
Purchasing materials 600 packs 1,000 packs
Machine set-ups 10 set-ups 25 set-ups
Inspections 150 hours 200 hours
Running machines 500 hours 1,000 hours

Additional Data Machine A Machine B

Direct materials per unit P500 P800
Direct labor per unit P100 P180

Factory overhead is applied at the rate of 150% based on direct labor cost. The
estimated overhead for June 2020, amounts to P360,000

Overhead estimates for 2020

Activity Cost driver Estimated No. of Estimated
cost driver units overhead costs
Purchasing No. of packs 20,000 packs P 500,000
materials
Machine set-ups No. of set-ups 400 set-ups 2,000,000
Inspections Inspection hours 4,000 hours 800,000
Running Machine hours 20,000 hours 1,000,000
machines
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 Total estimated overheads P4,300,000
Required: Compute the following:

1. Pre-determined annual overhead rates for activity-based costing

Activity Cost driver Estimated No. Estimated Cost

of cost driver overhead costs Driver
units Rate
Purchasing No. of packs 20,000 packs P 500,000 P25.00
materials
Machine set- No. of set-ups 400 set-ups 2,000,000 P5,000
ups
Inspections Inspection 4,000 hours 800,000 P200
hours
Running Machine hours 20,000 hours 1,000,000 P50
machines
Total estimated overheads P4,300,000

2. Overhead costs assigned to Machine A and Machine B using Activity-Based

Costing
Cost Drivers
Activities Machine A Allocated Machine B Allocated
Cost Cost
Purchasing 600 packs x 25 15,000 1,000 packs x 25,000
materials 25
Machine set-ups 10 set-ups x 50,000 25 set-ups x 125,000
5,000 5,000
Inspections 150 hours X 30,000 200 hours x 40,000
200 200
Running 500 hours x 50 25,000 1,000 hours x 50,000
machines 50
P120,000 P240,000

Overhead Cost 120,000 / 600 P200 240,000 / P240

per unit 1,000

3. Cost per unit of Machine A and Machine B using Activity-Based Costing

Additional Data Machine A Machine B
Direct materials per unit P500 P800
Direct labor per unit 100 180
Factory Overhead 200 240
Total Mfg. Cost per Unit P800 P1,220

4. Cost per unit of Machine A and Machine B using Traditional approach

Additional Data Machine A Machine B
Direct materials per unit P500 P800
Direct labor per unit 100 180
Factory Overhead (100 x 150%) 150 (180 x 150%) 270
Total Mfg. Cost per Unit P750 P1,250

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Example Problem 2
Star Company incurs about P430,000 in manufacturing overhead costs each
month. The company works about 100,000 direct labor hours (dlh)per month, so
the average overhead cost per dlh is P4.30. The following are the data regarding
cost pools and drivers:

Cost driver Amount in Pool Amount of Activity

Direct labor hours P260,000 100,000
Number of batches 140,000 500
Engineering/design changes 30,000 120
Total overhead costs P430,000

You are to analyze two product lines using the existing method of allocating
overhead cost based on DLH and using activity-based rates. Bikes are the main
line that the company makes in large batches, while helmets are a specialty line
that only a few customers buy. The following are the data regarding the two
product lines.

Bikes Helmets
Direct labor hours 1,600 400
Number of batches 4 10
Engineering/design changes 2 12

Required:
1. Compute the overhead to be allocated to each line based on DLH.
Bike = 1,600 x P4.30 = 6,880
Helmet = 400 x P4.30 = 1,720
2. Compute the overhead to be allocated to each line using the 3 drivers.
Cost driver Amount in Pool Amount of Cost Driver
Activity Rate
Direct labor hours P260,000 100,000 P 2.60
Number of batches 140,000 500 280
Engineering/design 30,000 120 250
changes
Total overhead costs P430,000

Bikes Helmets
Direct labor hours 1,600 x 2.60 P4,160 400 x 2.60 1,040
Number of batches 4 x 280 1,120 10 x 280 2,800
Engineering/design 2x 250 500 12 x 250 3,000
changes
Total Allocated P5,780 P6,840
Overhead Cost

3. Comment the differences between your results in requirements 1 and 2.

Example Problem 3
Sherie Manufacturing has four categories of overhead. The 4 categories and
expected overhead costs for each category for next year are listed below.

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 Maintenance P200,000 Set-ups P250,000
Material handling 40,000 Inspection 310,000

At present overhead is applied using predetermined overhead rate, based on

budgeted direct labor hours. One hundred thousand (100,000) direct labor hours
are budgeted for the next year.

The plant manager submitted a bid for a proposed job, which are based on full
manufacturing cost plus 20%. Estimates for the proposed job are as follows:

Direct materials P15,000 No. of inspections 10

Direct labor (1,000 hours) P20,000 No. of set-ups 2
No. of material moves 12 No. of machine hours 300

In the past, full manufacturing cost has been calculated by allocating overhead
using a volume-based cost driver, direct labor hours. The plant manager has
heard of a new way of applying overhead that uses cost pools and cost drivers.

Expected activity for the four activity-based cost drivers that would be used are:

Machine hours 20,000 Set-ups 2,500

Material moves 1,600 Quality inspections 5,000

Required:
1. Using direct labor hours,
a. Determine the amount of overhead that would be allocated to the
proposed job
b. Determine the total cost of the proposed job
c. Determine the company’s bid if the bid is based on full manufacturing cost
plus 25%
2. If activity-based costing is used,
a. Determine the amount of overhead that would be applied to the proposed
job
b. Determine the total cost of the proposed job
c. Determine the company’s bid if the bid is based on full manufacturing cost
plus 25%

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