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MAS-LECTURE NOTES ARMIN GLENN ARANETA, CPA

ACTIVITY BASED COSTING SYSTEM

Broad Averaging or “Peanut – Butter Costing” – describes a coasting 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 fat, use those resources in
non-uniform ways.

Product under-costing – a product consumes a high-level of resources but is reported to have a

low cost per unit.

Product over costing – a product consumes a low level of resources but is reported to have a
high cost per unit.

Product-cost-cross-subsidization – if a company under costs one of its products, it will over cot
at least one of its other products.

COSTING SYSTEM REFINEMENT – making changes to a simple costing system that

reduces the use of broad averages for assigning the cost of resources to cost objects and provides
better measurement of the cost of overhead resources used by different costs objects.

An activity based approach 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.

Activity Base costing (ABC) System – allocates overhead to multiple activities cost pools and
assigns the activity cost pools to products by means of cost drivers.

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.

Value-adding Activities – activities that are necessary (non-eliminable) to produce the products.

Non-value adding Activities – activities that do not make the product or service more valuable
to the customer.

BENEFITS OF ABC:

1. ABC leads to more cost pools.

2. ABC leads to enhanced control over overheads costs.
3. ABC leads to better management decisions.

FOUR DECISIONS FOR WHICH ABC INFORMATION IS USEFUL:

1. Pricing and product mix decisions,

2. Cost reduction and process improvement decisions,
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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.

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 activities.
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.

Hierarchy of Activity Levels

1. Unit-level Activities – are performed each time a unit is produced.

2. Batch-level Activities – performed each time a batch is handled or processed, regardless of
how many units are in the batch.
3. 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.
4. Customer-level Activities – relate to specific customers.
5. Organization-sustaining Activities – carried out regardless of which customers are served,
which product are produced, how many batches are run, or how many units are made.

STEPS FOR IMPLEMENTING ACTIVITY BASED COSTING

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

2. Assign overhead costs to activity cost pools.
3. Calculate activity rates.
4. Assign overhead costs to cost objects using the activity rates and activity measures.
5. Prepare management reports.
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Practice Problems:

Problem 1. ABC, cost hierarchy, service. Abbot Laboratories does heat testing (HT) and stress
testing (ST) on materials and operates at capacity. Under its current simple costing system, Abbot
aggregates all operating costs of P 1, 190, 000 into a single overhead cost pool.

Abbot calculates a rate per test-hour of P17 (1, 190, 000 / 70, 000 total test hours). HT uses 40,
000 test hours, and ST uses 30, 000 test hours. Bruno Mars, Abbot’s controller believes there is
enough variation in test procedures and cost structures to establish separate costing and billing
rates for HT and ST. The market for test services is becoming competitive. Without this
information, any miscosting and mispricing of its services could cause Abbot to lose business.
Mars divides Abbot’s costs into four-activity-cost categories.

A. Direct labor costs, P146, 000. These costs can be directly traced to HT, P100, 000 and
ST, P46, 000.
B. Equipment-related costs (rent, maintenance, energy, and so on), P350, 000. These
costs are allocated to HT and ST on the basis of test-hours.
C. Setup costs, P430, 000. These costs are allocated to HT and ST on the basis of the
number of setup hours required. HT requires 13, 600 set-up hours, and ST requires 3, 600
set-up hours.
D. Costs of designing tests, P264, 000. These costs are allocated to HT and ST on the
basis of the time required for designing the tests. HT requires 3,000 hours, and ST
requires 1, 400 hours.

Requirements:

1. Classify each activity cost as output unit-level, batch-level, product or service-sustaining, or

facility sustaining.
2. Calculate the cost per test-hour for HT and ST. Explain briefly the reasons why these numbers
differ from the P17 per test-hour that Abbot calculated using its simple costing system.

Problem 2. Plant-wide, department, and activity-cost rates. Parangal Trophies makes trophies
and plaques and operates at capacity. Parangal does large custom orders, such as the participant
trophies for the Gilas Pilipinas Bulilit Tournament. The controller has asked you to compare
plant-wide department, and activity-based cost allocation.

Parangal Trophies
Budgeted Information
For the Year Ended November 30, 2015

Forming Department Trophies Plaques Total

Direct materials P13, 000 P11, 250 P24, 250
Direct labor 15, 600 9, 000 24, 600
Overhead Costs:
Setup 12, 000
Supervision 10, 386
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Assembly Department Trophies Plaques Total

Direct materials P2, 600 P9, 375 P11, 975
Direct labor 7, 800 10, 500 18, 300
Overhead Costs:
Setup 23, 000
Supervision 10, 960

Other information:
Setup costs vary with the number of batches processed in each department. The budgeted
number of batches for each product line in each department is as follows:
Trophies Plaques
Forming Department 40 116
Assembly Department 43 103

Supervision costs vary with direct labor costs in each department.

Requirements:

1. Calculate the budgeted cost of trophies and plaques based on a single plant-wide overhead
rate, if total overhead is allocated based on total direct costs.
2. Calculate the budgeted cost of trophies and plaques based on departmental overhead rates,
where forming department, and assembly department overhead costs are allocated based on total
direct costs of the assembly department.
3. Calculate the budgeted cost of trophies and plaques based if Parangal allocates overhead costs
in each department using activity-based costing.
4. Explain how the disaggregation of information could improve or reduce decision quality.

Problem 3. Sasakyan Mo’to Inc., (SM) designs, manufactures, and sells automotive parts. It has
three main operating departments: design, engineering, and production.

Design - the design of parts, using computer-aided design (CAD) equipment.

Engineering - the prototyping of parts and testing of their specifications.
Production - the manufacture of parts.

For many years, SM had long-term contracts with major automobile assembly companies. These
contracts had large production runs. SM’s costing system allocates variable manufacturing
overhead on the basis of machine hours. Actual variable manufacturing overhead costs for 2015
were P308, 600. SM had three contracts in 2015, and its machine hour used in 2015 was assigned
as follows:
Saiyo Motors 120
Sakanya Motors 2, 800
Saakin Motors 1, 080
4, 000
Requirements:

1. Compute the plant wide variable manufacturing overhead rate for 2015.
2. Compute the variable manufacturing overhead allocated to each contract in 2015.
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Problem 4. (Continuation of Problem 3). The controller of Sasakyan Mo’to Inc., (SM) decides to
interview key managers of the Design, Engineering, and Production departments. Each manager
is to indicate the consensus choice among departmental personnel of the cost driver of variable
manufacturing overhead costs for his or her department. Summary data are:

Department Variable Manufacturing Cost Driver

Overhead in 2015
Design P 39, 000 CAD design- hours
Engineering 29, 600 Engineering-hours
Production 240, 000 Machine-hours

Details pertaining to usage of these cost drivers for each of the three 2015 contracts are:

Department Cost Driver Saiyo Sakanya Saakin

Design CAD design- hours 110 200 80
Engineering Engineering-hours 70 60 240
Production Machine-hours 120 2, 800 1, 080

Requirements:

1. What is the variable manufacturing overhead rate for each department in 2015?
2. What is the variable manufacturing overhead allocated to each contract in 2015 using
department variable manufacturing overhead rates?

Problem 5. Tutuldok Company produces mathematical and financial calculators. Data related to
the two products is presented below:
Mathematical Financial
Annual production in units 50, 000 100, 000
Direct material costs P 150, 000 P 300, 000
Direct manufacturing labor costs 50, 000 100, 000
Direct manufacturing labor hours 2, 500 5, 000
Machine hours 25, 000 50, 000
Number of production runs 50 50
Inspection Hours 1, 000 500

Both products pass through Department 1 and Department 2. The department’s combined
manufacturing overhead costs are:

Machining costs P 375, 000

Setup costs 120, 000
Inspection costs 105, 000

Requirements:

1. Compute the cost per unit of product if the company will use the traditional full cost system.
2. Compute the cost per unit of product if the company will use the ABC system.
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Problem 6. Producer Company makes two products, A and Z. A is being introduced this period,
whereas Z has been in production for two years. For the period about to begin, 1, 000 units of
each product are to be manufactured. Assume that the only relevant overhead item is the cost of
engineering change orders; that A and Z are expected to require eight and two change orders; that
A and Z are expected to require 2 and 3 machine hours, respectively; and that the cost of a
change order is P 600. If Producer applies engineering change order costs on the basis of
machine hours, the cross subsidy per unit arising from this peanut butter-costing approach is:

a. P 1.20 c. P 3.60
b. P 2.40 d. P 4.80

“Never let go of your dreams.”

END