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Module 11 Activity Based Costing

The document discusses Activity Based Costing (ABC) and the Traditional Costing method. It provides an example comparing how overhead costs are allocated to products using each method for a furniture company. ABC allocates overhead using multiple cost pools and cost drivers, leading to more accurate product costs. Traditional costing uses a single predetermined overhead rate based on direct labor hours. The example shows ABC results in different overhead and production costs per unit for each product compared to traditional costing. While more accurate, ABC can also be more expensive to implement.

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Marjorie Nepomuceno
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512 views

Module 11 Activity Based Costing

The document discusses Activity Based Costing (ABC) and the Traditional Costing method. It provides an example comparing how overhead costs are allocated to products using each method for a furniture company. ABC allocates overhead using multiple cost pools and cost drivers, leading to more accurate product costs. Traditional costing uses a single predetermined overhead rate based on direct labor hours. The example shows ABC results in different overhead and production costs per unit for each product compared to traditional costing. While more accurate, ABC can also be more expensive to implement.

Uploaded by

Marjorie Nepomuceno
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Activity

Based Costing
(ABC)
PREPARED BY: CRISTOPHERSON A.
PEREZ, CPA
Activity Based Costing
Activity Based Costing allocates overhead to products based on the performance of activities, most often
multi-stage activity cost pools.
In the first stage, activities are identified. These activities are work performed or undertaken to produce
products such as number of setups, number of scheduling, number of orders, number of parts, number of
inspections, number of labor hours, number of designs, and etc.
These activities are used as cost drivers in computing overhead rates. Total factory overhead is then
allocated to activity cost pools. Cost per activity is divided by the activity driver’s practical capacity to arrive
at the overhead rate per activity.
In the second stage, overhead cost pool is traced to products using the pool rates computed in the first stage.
Thus, the overhead assigned to the product is computed as follows:

Applied overhead = Pool rate x actual activity usage


Traditional Costing Method
In a traditional cost system, the budgeted overhead cost is divided by the budgeted level of
activity to arrive at the pre-determined overhead rate.
The traditional basis of application bases are direct labor hours, direct labor costs, machine
hours or units produced.
Under this method, the larger the denominator, the smaller the pre-determined overhead rate;
therefore, the lesser the amount of overhead applied to the job.
Overhead cost is then applied to the products by multiplying the overhead rate by the actual
level of activity.
Illustration: ABC & Traditional
Method
Dragon Furniture Company has identified activity centers to which overhead costs are assigned. The
following data are available:
Activity Centers Costs Activity Drivers
Utilities P300,000 60,000 machine hours
Scheduling and setup 273,000 780 setups
Materials handling 640,000 1,600,000 lbs. of materials

The company’s products and other operating statistics follow:


Illustration: ABC & Traditional
Method
Products A B C
Prime costs P80,000 P80,000 P90,000
Machine hours 30,000 10,000 20,000
Number of setups 130 380 270
Pounds of materials 500,000 300,000 800,000
Number of units 40,000 20,000 60,000
produced
Direct labor hours 32,000 18,000 50,000

Requirement: Determine the production cost per unit using ABC and Traditional Costing (using
direct labor hours as cost driver).
SOLUTION: ABC METHOD
FIRST STEP: DETERMINE THE POOL RATES
SOLUTION: ABC METHOD
SECOND STEP: ALLOCATE THE OVERHEAD USING THE POOL RATES
SOLUTION: ABC METHOD
THIRD STEP: DETERMINE THE TOTAL COSTS OF EACH JOB

The manufacturing costs of each product are computed as below:

Cost element Product A Product B Product C


Prime Costs P80,000 P80,000 P90,000
Overhead 395,500 303,000 514,500
Total Costs P475,500 P383,000 P604,500
Divide by: Units 40,000 20,000 60,000
produced
Production cost P11.89 P19.15 P10.08
per unit
SOLUTION: TRADITIONAL METHOD
(USING DIRECT LABOR HOURS)
Under the traditional method of costing where factory overhead is allocated to products using direct
labor hours, the predetermined overhead rate is computed as follows:
Predetermined overhead rate = 1,213,000 (total overhead) / 100,000 DLH (total DLH) = P12.13 per DLH

Cost element Product A Product B Product C TOTAL


Overhead to A: 32,000 388,160
DLH x 12.13
Overhead to B: 18,000 218,340
DLH x 12.13
Overhead to C: 50,000 606,500
DLH x 12.13
Total Overhead Costs 388,160 218,340 606,500 1,213,000
SOLUTION: TRADITIONAL METHOD
(USING DIRECT LABOR HOURS)
To compute for the production cost per unit under the traditional method:

Cost element Product A Product B Product C

Prime Costs P80,000 P80,000 P90,000


Overhead 388,160 218,340 606,500
Total Costs P468,160 P298,340 P696,500
Divide by: Units 40,000 20,000 60,000
produced
Production cost P11.70 P14.92 P11.61
per unit
ADVANTAGES OF ABC
SYSTEMS
ABC is a more accurate product costing than traditional costing because:

1. ABC leads to more cost pools used to allocate overhead costs to products. Costs are allocated more
directly on a basis of the portion of multiple cost-driven activities that can be traced to each product.

2. ABC leads to enhanced control over overhead costs. Under ABC, many overhead costs can be traced
directly to activities; thus, some indirect costs become direct costs.

3. ABC leads to better management decisions. More accurate product costing should contribute to
setting selling prices that will achieve desired product profitability levels.
DISADVANTAGES OF ABC
SYSTEMS
1. ABC can be expensive to use. Many companies are discouraged from using
ABC because of the higher cost of identifying multiple activities and applying
numerous cost drivers.
2. Some arbitrary allocations continue.
REFERENCES:
Guerrero, P.P. (2014). Principles and Procedural Applications. GIC Enterprises & Co., Inc.

Rante, G.A. (2016). Cost Accounting. Millenium Books, Inc.

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