Q2 principles shown here extend readily to



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Activity based costing ABC is an approach for assigning costs
to products, services, projects, tasks, or acquisitions, based on – activities
that go into them and resources consumed by these activities. ABC contrasts
with traditional costing (cost accounting),
which sometimes assigns costs using arbitrary allocation percentages for
overhead or the so-called indirect costs. It results in ABC and traditional
cost accounting can estimate cost of
goods sold and gross margin very
differently for individual products. Contradictory and uncertain cost estimates
can be a problem when management needs to know exactly which products are
profitable and which are selling at a loss.

Cost accounting specialists  know that traditional cost accounting can hide
or distort information on the costs of individual products and
services—especially where local cost allocation rules misrepresent actual
resource usage. As a result, the move to ABC is usually driven by a need to
understand the “true costs” of individual products and services more
accurately. Companies implement activity based costing in order to -identify
individual products that are unprofitable, improve production process
efficiency and price products appropriately, with the help of accurate product
cost information . It  reveals unnecessary
costs that can be eliminated. Firms that use ABC consistently to pursue these
objectives are practicing activity based management ABM.

The purpose of ABC is to provide information for decision support
and planning. ABC by itself usually has little or no impact on the structure of
the firm’s financial accounting reports (Income statement, Balance sheet, or
Cash flow statement). This is because both ABC and traditional costing
ultimately assign costs to the same existing accounts. The two approaches
simply use different mathematics to do so. But  ABC sometimes brings improvements in
reported margins and profitability. These outcomes follow when ABC reveals
unnecessary or inflated costs, or when ABC shows where to adjust pricing
models, work flow process, or the product mix.

The different methods and
outcomes from ABC and traditional costing are easiest
to illustrate in the context of a product manufacturing example. However,
the principles shown here extend readily to a wide range of other
business settings.

Example: Traditional Cost Accounting vs. Activity Based Costing

example, consider a firm that manufactures automobile parts through a
sequence of machine operations on metal raw material. In such settings,
traditional accounting views product production costs as either direct
costs or indirect costs (or overhead).

Sources of Direct Costs

Traditionally, direct costs for such firms are costs they can assign
to specific product units. In product manufacturing, these might include
direct materials and direct labor costs:

Direct labor costs – These can include the cost for person minutes or person
hours per product unit for running production machines.

Direct materials – Direct materials costs might include costs per product unit for
metal stock, fasteners, and lubricants. 

Sources of Indirect Costs

Traditionally, indirect costs for such firms are manufacturing overhead
costs they cannot assign directly to specific product units. Instead, they
allocate these costs to specific production runs, batches, or time
periods. These might include indirect costs such as the following:

Materials purchase order costs – Firms typically do not order materials for each product unit,
but rather, for entire batch runs. They may also order supply materials to
cover a specific time period.

Machine set up costs – Manufacturing firms do not set up production machines for each
product unit. They are set up instead for the production run of each product

Product packaging costs – Manufacturers can sometimes package multiple product units in a
single package. And, they may fill multiple packages in a single packaging run.

Machine testing and calibration costs – Manufacturing firms perform these operations
regularly and often, but not for each individual product unit.

Machine maintenance and cleaning costs – Firms normally perform these operations only
after producing multiple product units. 

Product Specific Cost Sources

this example, consider a firm that manufactures and sells two product models,
Model A and Model B. Some aspects of A and B compare as shown in Table 1:

 Table 1.  Product A and Product B compared.

Products Compared

Product A

Product B


Higher price

Lower price

   Materials purchased

More materials purchase orders, smaller orders

Fewer materials purchase orders, larger orders


More production runs, smaller runs

Fewer production runs, larger runs

  Mach. Set

More machine set ups

Fewer machine set ups


1 Unit per package

4 Units per package


More direct labor required

Less direct labor required

  Direct  materials

Higher direct materials cost

Lower direct materials cost

Direct Costs Are the Same in traditional and
Activity Based costing

Management must estimate the profitability of each product in
order to decide which products to produce and sell and how to price them. This, in turn, requires an
understanding of the full cost per unit of each product. While the direct
costs per unit may be found, easily, the indirect costs are
less obvious. As a result, the firm will have to uncover product indirect costs
through a costing methodology—either traditional cost allocation or activity
based costing. Direct costs are the same under both traditional costing
and ABC. For direct costs, accountants measure a cost per product unit for
each direct cost category. The two costing methods differ, however, in the way
they assign indirect costs to products. Consequently, the two
costing approaches sometimes give quite different pictures of the profitability
of individual products. 

The following example explains the advantages of using


A company manufactures two products X and Y with the
following cost patterns.

Product X, $

Product Y, $

Direct Material



Direct Labour @ $5 per hour



Variable Production Overhead @ 6$ per hour






Production fixed overheads total $300,000 per month and
are absorbed on the basis of direct labour hours. Budgeted labour hours are
$25,000 per month. The following is the activity based analysis carried out by
the company


Product X

Product Y

Total Cost ($)





Material handling








Budgeted production of X is 1,250 units and Y is 4,000 units.

The company wants to make 20% profit on full production cost. Sale price is calculated using a full cost approach and
activity based costing.




1) Full cost approach

Product X, $

Product Y, $

Variable Cost



Fixed Production Overheads (300,000/25,000 = $12 per
labour hour)



Total Cost



Profit margin @20%



Sale Price



2) Activity based costing


Product X

Product Y

Total Cost ($)

Set-ups (30:20)




Material handling (30:20)




Inspection (880:3520)








Budgeted units



Overhead per unit




Product X

Product Y

Variable Cost



Production Overheads



Total Cost



Profit margin @20%



Sale Price



Conclusion – When
the results of both approaches are compared we can see a huge difference in
sales price. This means that the company was making a loss on sale of product X
while it was over charging for product Y, which could lead to customer
dissatisfaction and cause a drop in sales.







The three major influences on pricing decisions are – Customers,
Competitors and Costs .It is not necessarily true for all the time. For a
one-time-only special order, the relevant costs are only those costs that will
change as a result of accepting the order. In this case, full product costs
will rarely be relevant. It is more likely that full product costs will be
relevant costs for long-run pricing decisions. Four purposes of cost allocation
are as follows –

To provide information for economic decisions secondly To motivate
managers and other employees thirdly To justify costs or compute reimbursement
amounts and fourthly To measure income and assets

Activity-based costing helps managers in pricing decisions in two
ways – It gives managers more accurate product-cost information for making
pricing decisions. Secondly It helps managers to manage costs during value
engineering by identifying the cost impact of eliminating, reducing, or
changing various activities. Two alternative approaches to long-run pricing
decisions are the following:

Market-based pricing, an
important form of which is target pricing. The market-based method asks, “Given
what our customers want and how our competitors will react to what we do, what
price should we charge?

      2.     Cost-based pricing which asks, “What does
it cost us to make this product and, hence, what
price should we charge that will recoup our costs and achieve a target return
on investment?”

A target cost per unit is the estimated long-run cost per unit of
a product (or service) that, when sold at the target price, enables the company
to achieve the targeted operating income per unit Value engineering is a
systematic evaluation of all aspects of the value-chain business functions, with the objective of reducing costs
while satisfying customer needs. Value engineering via improvement in
product and process designs is a principal technique that companies use to
achieve target cost per unit. A value-added cost is a cost that customers
perceive as adding value, or utility, to a product or service. Examples are
costs of materials, direct labor, tools, and machinery. A non value-added cost
is a cost that customers do not perceive as adding value, or utility, to a
product or service. Examples of non value-added costs are costs of rework,
scrap, expediting, and break down maintenance. No. It is important to
distinguish between when costs are locked in and when costs are incurred
because it is difficult to alter or reduce costs that have already been locked
in. Cost-plus pricing is a pricing approach in which managers add a markup to
cost in order to determine price. Cost-plus
pricing methods vary depending on the bases used to calculate prices.






 Managers at companies often look for better
ways to figure out the cost of their products. The company has three possible
methods that can be used to allocate overhead costs to products—plant wide
allocation, department allocation, and activity-based allocation (called
activity-based costing).  The
choice of an allocation method depends on how managers decide to group overhead
costs and the desired accuracy of product cost information. Groups of overhead
costs are called cost pools. For
example, Hewlett Packard’s printer
production division may choose to collect all factory overhead costs in one
cost pool and allocate those costs from the cost pool to each product using one
predetermined overhead rate. Or company may choose to have several cost pools
(perhaps for each department, such as assembly, packaging, and quality control)
and allocate overhead costs from each department cost pool to products using a
separate predetermined overhead rate for each department. In general, the more
cost pools used, the more accurate the allocation process.

Plantwide Allocation

 The plantwide
allocation method uses one predetermined overhead rate to allocate
overhead costs. Regardless of the approach used to
allocate overhead, a predetermined overhead rate is established for each cost
pool. The predetermined overhead rate is calculated as follows –  When activity-based costing is used, the
denominator can also be called estimated cost driver activity. One cost pool accounts for all overhead costs, and
therefore one predetermined overhead rate is used to apply overhead costs to
products. where one predetermined rate—typically based on direct labor
hours, direct labor costs, or machine hours—was used to allocate overhead
costs. Using SailRite Company as an example, assume annual overhead costs are
estimated to be $8,000,000 and direct labor hours are used for the plantwide
allocation base. Management estimates that a total of 250,000 direct labor
hours are worked annually. These estimates are based on the previous year’s
overhead costs and direct labor hours and are adjusted for expected increases
in demand the coming year. The predetermined overhead rate is $32 per direct
labor hour (= $8,000,000 ÷ 250,000 direct labor hours). Thus,  products are charged $32 in overhead costs
for each direct labor hour worked.

Department Allocation

the managers at a Company prefer a more accurate approach to allocating
overhead costs to its two products. As a result, they are considering using the
department allocation approach. The department
allocation approach is similar to the plantwide approach except that cost
pools are formed for each department rather than for the entire plant, and a
separate predetermined overhead rate is established for each department. But,
total estimated overhead costs will not change. Instead, they will be broken
out into various department cost pools. This approach allows for the use of
different allocation bases for different departments depending on what drives
overhead costs for each department. For example, the Hull Fabrication
department at SailRite Company may find that overhead costs are driven more by
the use of machinery than by labor, and therefore decides to use machine hours
as the allocation base. The Assembly department may find that overhead costs
are driven more by labor activity than by machine use and therefore decides to
use labor hours or labor costs as the allocation base.

Assume that SailRite
is considering using the department approach rather than the plantwide approach
for allocating overhead. The cost pool in the Hull Fabrication department is
estimated to be $3,000,000 for the year, and the cost pool in the Assembly
department is estimated at $5,000,000. The  total estimated overhead cost is still
$8,000,000 (= $3,000,000 + $5,000,000). Machine hours (estimated at 60,000
hours) will be used as the allocation base for Hull Fabrication, and direct
labor hours (estimated at 217,000 hours) will be used as the allocation base
for Assembly. Thus two rates are used to allocate overhead (rounded to the
nearest dollar) as follows:

Hull Fabrication department rate: $50 per machine hour
(= $3,000,000 ÷ 60,000 hours)
Assembly department rate: $23 per direct labor hour (=
$5,000,000 ÷ 217,000 hours)

products going through the Hull Fabrication department are charged $50 in
overhead costs for each machine hour used. Products going
through the Assembly department are charged $23 in overhead costs for
each direct labor hour used.






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