Question

1. Why would an activity-based costing (ABC) system appeal to some companies, and what is the criterion for utilizing an ABC system?
2. Describe the advantages for using the ABC method versus a single plantwide rate or multiple departmental overhead rates; and specify any limitations that exist when using these conventional type overhead rates?
3. Provide an example of a company that would benefit from using an ABC system, and describe a few of the different activities they might use.

Answer 1

Activity Based Costing is a costing system in which costs are charged to the products based on the individual product's use of each activity. Costs are first traced to the activities and then are allocated to the products.

Following are the steps/ criteria for using Activity Based Costing:

A. Identification of Activities

Activities must be identified and all the supporting activities should be grouped together.

B. Analyzing the Activities:

We need to identify the process or activities which support a product.

C. Assigning the Costs

It involves assigning of costs to various activities.

D. Selecting appropriate Cost drivers:

The step involves identifying a factor which influences the cost.

E. Assign Cost of Activities to the products

Assign cost to each of the products depending on the number of activities used by the product.

Activity Based Costing appeals to some companies because of its several benefits which are listed below:

a. It is more accurate method of costing and leads to fair allocation of overheads

b. It helps in identifying the non value added activities so that the managers can eliminate them.

c. It helps in better customer and profitability analysis.

d. Pricing of the products is fair and correct because overheads are allocated on the basis of relevant cost drivers.

Single plant rate or multiple departmental rates being the traditional method of costing suffers from certain limitations which are as follows:

a. It does not offer accuracy in cost allocation

b. It does not takes into account non manufacturing costs.

c. Most of the factory overheads costs are allocated on the basis of just one factor i.e labor hours , machine hours etc.

Example: Let us take a company XYZ which produces 2 products A and B. Now let us take certain costs incurred by the company say : Factory maintenance $5000 , factory rent $ 4500, electricity $ 7000.

The direct labor hours used by Product A and B are 500 and 700 respectively.

Square Feet used :3000 Product A and 1750 Product B.

Machine hours for Product A and B are 350 and 450 respectively.

Now lets analyse the situation under traditional costing and activity based costing

Under traditional costing all the costs will be added and allocated on the basis of a common application rate

Total costs : 5000+4500+7000=16500

Total Labor Hours = 500+700=1200

Application rate = 16500/1200=13.75

Costs allocated to Product A : 13.75*500=6875

Costs allocated to Product B : 13.75*700=9625

Under activity Based Costing: Factory maintenance and factory rent are driven by the number of square feet used per product and electricity is driven by the machine hours.

Factory maintenance and factory rent costs = $5000+$4500=9500

Total square feet used = 3000+1750=4750

Rate = 9500/4750=2

Allocation of cost to Product A= 2*3000=6000

Allocation of cost to Product B=2*1750=3500

Similarly electricity costs will be allocated on the basis of machine hours

Total electricity costs = 7000

Machine Hours=350+450=800

Rate = 7000/800=8.75

Product A= 350*8.75=3062.5

Product B=450*8.75=3937.5

Therefor total costs allocated to products under ABC are as follows:

Product A: 6000+3062.5=9062.5

Product B: 3500+3937.5=7437.5

So ABC provides more accurate allocation of costs.

Different activities that can be used are:

Primary activities:The cost of primary activities (like use of indirect materials and consumables) may be correlated to number of units produced (i.e. on volume-basis).

Product Level activities: Activities like designing of the product, keeping technical drawings of product, advertising of a specific product are called product level. The cost of these activities is driven by the creation of a new product line and its maintenance.

Batch Level Activities: The cost of such activities is driven by the number of batches of units produced.