Chapter 7 : Activity Based Costing System
Introduction:
 Costing systems help management estimate costs and accurately charge customers.
 There are two types of Product Costing Systems
o Job Costing System
o Process Costing System
 The Nature of Product determine which system will be used.
 The following figure illustrate the process of estimating costs in both systems.
Allocation Rate
= $0.5 Per DLH
Chapter 7 : Activity Based Costing System
Q1: What is Activity-Based Costing?

The following Figure illustrate the Traditional Overhead Cost Allocation System

The following Figure illustrate the ABC Cost Allocation System
Chapter 7 : Activity Based Costing System
Q2: What Are Activities, and How Are They Identified?
Activity:
Type of task or function performed in an organization
Activity Identification:
*
*
*
Track the use of resources
Use the cost hierarchy
Grouping homogeneous costs
Cost Hierarchy
* Organization-sustaining activities
* Facility-sustaining activities
* Customer-sustaining activities
* Product-sustaining activities
* Batch-level activities
* Unit-level activities
Q3: What Process Is Used to Assign Costs in an ABC System?
ABC Procedures:
1. Identify the relevant cost object
2. Identify activities
3. Assign (trace and allocate) costs to activity based cost pools
4. For each ABC cost pool, choose a cost driver
5. For each ABC cost pool, calculate an allocation rate
Allocation
Rate
=
Estimated Activity Cost
Estimated Volume of Cost Driver
6. For each ABC cost pool, allocate activity costs to the cost object
Allocation = Allocation Rate × Actual Volume of Activity
Chapter 7 : Activity Based Costing System
Alternative Allocation Rates ( Types of Rates)
*
Past cost rate: Use past costs and past volumes
*
Estimated rate: Use estimated costs and estimated volumes
*
Supply-based rate: Use estimated costs and practical capacity
Selection of Cost Drivers
*
Cause-and-effect relationship between cost driver and activity costs
*
Judgment in choosing and evaluating potential cost drivers
Exercises
1.
BCH Corporation produces and sells two types of sofa pillows: plain and fancy. Currently,
BCH uses a traditional costing system with direct labor hours as the allocation base. Actual
hours for 20x3 were 20,000. In anticipation of developing an activity-based costing system,
BCH has identified the following cost pools and activities associated with pillow production:
Estimated Costs Actual Costs
Activity
Driver
for 20x4
for 20x3
Material cutting
Number of cuts
$16,000
$13,665
Sewing machine setups Number of setups
27,000
24,800
Factory maintenance
Number of direct labor hours 15,000
17,000
$58,000
$55,465
Direct costs for a plain sofa pillow are $1.25 for material and $2.00 for direct labor (15 minutes
@ $8.00 per hour). Direct costs for a fancy sofa pillow are $1.50 for material and $4.00 for
direct labor (30 minutes @ $8.00 per hour). In 20x4, BCH expects to make 8,000 Plan pillows
and 10,000 fancy pillows. Those output levels will require 5 setups for Plan pillows and 10
setups for fancy pillows. For the material cutting activity, the number of cuts is estimated at
10,000 for each type of pillow.
a. Calculate the cost per unit for each type of pillow under traditional costing
b. Calculate the cost per unit for each type of pillow under ABC
c. Under traditional costing, which type of pillow cross-subsidizes the other pillow? Explain.
Fact Sheet :
Direct Material Cost
Direct Labor Cost
DLH
Units Produced
Number of Setups
Number of Cuts
Plan
$ 1.25
$ 2.00
15 minutes
8,000
5
10,000
Fancy
$ 1.50
$ 4.00
30 minutes
10,000
10
10,000
Chapter 7 : Activity Based Costing System
Solution:
a. Calculate the cost per unit for each type of pillow under traditional costing
Plain sofa
$ 1.25
2.00
2.07
5.32
Direct Material
Direct Labor
Applied (allocated) overhead
Allocation Rate
=
=
Fancy sofa
$ 1.50
4.00
4.15
9.65
= $8.29 Per DLH
Direct labor hours for Plan pillows = 8,000 x 0.25 = 2,000
Direct labor hours for fancy pillows = 10,000 x 0.50 = 5,000
Total direct labor hours
= 7,000
Applied Overhead = Allocation Rate × Actual Volume of Activity
Plan = $8,29 × ¼ = $2.07
Fancy = $8,29 × ½ = $4.14
b. Calculate the cost per unit for each type of pillow under ABC
Direct Material
Direct Labor
Applied (allocated) overhead
Plain sofa
$ 1.25
2.00
2.66
5.91
Allocation Rates:
Estimated
Estimated
Allocation
Volume of Cost
Costs
Rates
Driver
Material cutting
$16,000 20,000 Cute
$ 0.8 Per Cute
Sewing machine setups
27,000 15
Setup
$1,800 Per Setup
Factory maintenance
15,000 7,000 DLH
$2.14 Per DLH
Activity
Fancy sofa
$ 1.50
4.00
3.67
9.17
Chapter 7 : Activity Based Costing System
Applied Overhead:
Activity
Material cutting
Sewing machine setups
Factory maintenance
Total Applied overhead
÷ Units Produced
Plain Sofa
$ 8,000 $ 0.8 × 10,000
9,000 $ 1,800 × 5
4,280 $ 2.14 × 2,000
$ 21,280
8,000
$2.66
Fancy
Sofa
$ 8,000 $ 0.8 × 10,000
18,000 $ 1,800 × 10
10,700 $ 2.14 × 5,000
$ 36,700
10,000
3.67
c. Under traditional costing, which type of pillow cross-subsidizes the other pillow?
Explain.
Under traditional costing, the plain pillows allocation ($5.32) was a little less than half of
the allocation for fancy pillows ($9.65). The difference between the two is $4.33. Under
ABC the difference was only $3.26 ($5.91 - $9.17). Therefore, fancy was cross-subsidizing
plain, that is, plain was not assigned as much overhead cost as it should have been