Introduction to Activity Based Costing

Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the
traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns costs
to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products
that are actually demanding the activities.

Let's discuss activity-based costing by looking at two products manufactured by the same company. Product PQR is a
low volume item which requires certain activities such as special engineering, additional testing, and many machine
setups because it is ordered in small quantities. A similar product, Product XYZ, is a high-volume product—running
continuously—and requires little attention and no special activities. If this company used traditional costing, it might
allocate or "spread" all of its overhead to products based on the number of machine hours. This will result in little
overhead cost allocated to Product PQR, because it did not have many machine hours. However, it did demand lots of
engineering, testing, and setup activities. In contrast, Product XYZ will be allocated an enormous amount of overhead
(due to all those machine hours), but it demanded little overhead activity. The result will be a miscalculation of each
product's true cost of manufacturing overhead. Activity based costing will overcome this shortcoming by assigning
overhead on more than the one activity, running the machine.

Activity based costing recognizes that the special engineering, special testing, machine setups, and others are activities
that cause costs—they cause the company to consume resources. Under ABC, the company will calculate the cost of
the resources used in each of these activities. Next, the cost of each of these activities will be assigned only to the
products that demanded the activities. In our example, Product PQR will be assigned some of the company's costs of
special engineering, special testing, and machine setup. Other products that use any of these activities will also be
assigned some of their costs. Product XYZ will not be assigned any cost of special engineering or special testing, and
it will be assigned only a small amount of machine setup.

Activity based costing has grown in importance in recent decades because (1) manufacturing overhead costs have
increased significantly, (2) the manufacturing overhead costs no longer correlate with the productive machine hours or
direct labor hours, (3) the diversity of products and the diversity in customers' demands have grown, and (4) some
products are produced in large batches, while others are produced in small batches.

Activity based costing with two activities

Manufacturing overhead (Mfg) (also known as factory overhead, factory burden, production overhead) involves a
company's factory operations. It includes the costs incurred in the factory other than the costs of direct materials and
direct labor. This is the reason that manufacturing overhead is often classified as an indirect cost. Generally accepted
accounting principles require that cost of direct material cost, direct labor, and manufacturing overhead be considered
as the cost of products for valuing inventory and for determining the cost of goods sold. (Expenses that are outside of
the factory, such as selling, general and administrative expenses, are not product costs and are not inventoriable. They
are reported as expenses on the income statement in the accounting period in which they occur.) Examples of
manufacturing overhead include the depreciation or the rent on the factory building, depreciation on the factory
equipment, supervisors in the factory, the factory quality control department, factory maintenance employees, electricity
and gas for the factory, indirect factory supplies, etc. Because manufacturing overhead is an indirect cost, accountants
are faced with the task of assigning or allocating overhead costs to each of the units produced. This is a challenging
task because there may be no direct relationship. (For example, the property tax on the factory building is based on its
assessed value and not on the number of units produced. Yet the property tax must be assigned to the units
manufactured.)

Let's illustrate the concept of activity-based costing by looking at two common manufacturing activities: (1) the setting
up of a production machine for running batches of products, and (2) the actual production of the units of product. We
will assume that a company has annual manufacturing overhead costs of $2,000,000—of which $200,000 is directly
involved in setting up the production machines. During the year the company expects to perform 400 machine setups.
Let's also assume that the batch sizes vary considerably, but the setup efforts for each machine are similar. The cost
per setup is calculated to be $500 ($200,000 of cost per year divided by 400 setups per year). Under activity-based
costing, $200,000 of the overhead will be viewed as a batch-level cost. This means that $200,000 will first be
allocated to batches of products to be manufactured (referred to as a Stage 1 allocation), and then be assigned to the

This reading was recuperated on AccountingCoach PRO. Available in:

https://www.accountingcoach.com/activity-based-costing/explanation
https://www.accountingcoach.com/activity-based-costing/explanation/2
units of product in each batch (referred to as Stage 2 allocation). For example, if Batch X consists of 5,000 units of
product, the setup cost per unit is $0.10 ($500 divided by 5,000 units). If Batch Y is 50,000 units, the cost per unit for
setup will be $0.01 ($500 divided by 50,000 units). For simplicity, let's assume that the remaining $1,800,000 of
manufacturing overhead is caused by the production activities that correlate with the company's 100,000 machine
hours.

For our simple two-activity example, let's see how the rates for allocating the manufacturing overhead would look with
activity-based costing and without activity-based costing:

Next, let's see what impact these different allocation techniques and overhead rates would have on the per unit cost of
a specific unit of output. Assume that a company manufactures a batch of 5,000 units and it produces 50 units per
machine hour, here is how the cost assigned to the units with activity-based costing and without activity based costing
compares:

If a company manufactures a batch of 50,000 units and produces 50 units per machine hour, here is how the cost
assigned to the units with ABC and without ABC compares:

As the tables above illustrate, with activity-based costing the cost per unit decreases from $0.46 to $0.37 because the
cost of the setup activity is spread over 50,000 units instead of 5,000 units. Without ABC, the cost per unit is $0.40
regardless of the number of units in each batch. If companies base their selling prices on costs, a company not using
an ABC approach might lose the large batch work to a competitor who bids a lower price based on the lower, more
accurate overhead cost of $0.37. It's also possible that a company not using ABC may find itself being the low bidder
for manufacturing small batches of product, since its $0.40 is lower than the ABC model of $0.46 for a batch size of
This reading was recuperated on AccountingCoach PRO. Available in:
https://www.accountingcoach.com/activity-based-costing/explanation
https://www.accountingcoach.com/activity-based-costing/explanation/2
5,000 units. With its bid price based on manufacturing overhead of $0.40—but a true cost of $0.46—the company may
end up doing lots of production for little or no profit.

Our example with just two activities (production and setup) illustrates how the cost per unit using the activity-based
costing method is more accurate in reflecting the actual efforts associated with production. As companies began
measuring the costs of activities (instead of focusing on the accountant's departmental classifications), they began
using ABC cost information to practice activity based management. For example, with the cost of setting up a machine
now being measured and discussed, managers began to ask questions such as:
Why is the cost of setting up a production machine so expensive?
What can be done to reduce the setup cost?
If the setup costs cannot be reduced, are the selling prices adequate to cover all of the company's costs—including
the setup cost that was previously buried in the overall machine-hour overhead rate?

Activity Based Costing with Four Activities

Let's add two more activities to our example: procurement and material handling. The costs of these two activities are
not caused by—nor do they correlate with—machine hours. Rather, we will assume that both of these activities are
related to the physical weight of the direct material used in making the product.

The company determines that $300,000 of its annual manufacturing overhead is associated with procurement and
material handling. As a result, the company removes $300,000 from the manufacturing overhead that will be allocated
via machine hours, and instead plans to allocate the $300,000 to the products based on the weight of the materials
used. The company expects that during the year it will procure and handle 3,000,000 pounds of material. Under activity-
based costing, the company will assign $0.10 ($300,000 divided by 3,000,000 pounds) per pound of product weight to
each unit manufactured. The end result is that the heavier parts will not only have more direct material cost, they will
also be assigned more factory overhead than the lighter parts. By assigning some manufacturing overhead to a product
based on the product's weight, the remaining manufacturing overhead assigned via machine hours will be reduced.
These points are illustrated in the following table:

In the table below, we can see how ABC would assign costs to the following:
1. A product that weighs 0.5 pound and is produced in a batch of 50,000 units at a rate of 50 per hour.
2. A product that weighs 1.5 pounds and is produced in a batch of 50,000 units at a rate of 50 per hour.
3. No activity-based costing allocations—all manufacturing overhead costs are allocated entirely via machine hours.

This reading was recuperated on AccountingCoach PRO. Available in:

https://www.accountingcoach.com/activity-based-costing/explanation
https://www.accountingcoach.com/activity-based-costing/explanation/2
If the manufacturing overhead costs are caused by a number of activities such as setup, procurement, handling, and
production, then using the activity-based costing method of determining costs will give you a result that is closer to the
true costs. As you can see, the product that weighs 0.5 pound is assigned $0.36 of manufacturing overhead, while the
product weighing 1.5 pounds is assigned $0.46 of manufacturing overhead. Under the traditional costing allocations
the procurement and handling costs would be assigned on production hours. Keep in mind that whenever
manufacturers have a diverse lineup of products, allocating costs on a single basis (such as machine hours) will result
in inaccurate per-unit manufacturing overhead costs.

Answer the following questions.

1. Activity based costing is considered to be a traditional costing method. True False
2. Under ABC, indirect manufacturing costs are predominantly assigned on the basis of direct machine hours.
True False
3. The cost to set up production equipment is best allocated directly to products via machine hours. True False
4. The cost to set up production equipment is best allocated directly to products via machine hours. True False
5. Setup cost is an example of a batch-level cost. True False
6. Manufacturing costs are often organized in the general ledger by function and department. When applying activity-
based costing, these manufacturing costs will be sorted by activities. True False
7. In activity-based costing, the manufacturing overhead cost per unit will depend partially on the number of units in
a batch. True False
8. If products are uniform and customers are similar in their demands, activity-based costing may not offer a
significant advantage over machine hours when assigning overhead. True False
9. A product with a high gross profit could be an unprofitable product. True False
10. Activity-based costing can be used to allocate SG&A expenses in order to assist management with pricing and
other marketing decisions. True False
11. Which of the following would not be included in a product's cost for inventory valuation for the financial statements?
Factory Supplies Quality Control Interest Expense
12. Which would be the least favorable basis for allocating manufacturing overhead for a factory with automated
equipment and a significant variation of services by its indirect labor?
ABC Direct Labor Hours Machine Hours
13. Which would be the most favorable basis for allocating manufacturing overhead for a factory with automated
equipment and a significant variation of services by its indirect labor?
ABC Direct Labor Hours Machine Hours
14. Activity-based costing will provide greater accuracy when allocating costs than a manufacturer's machine hours
when its products and customers are __________ diverse.
Less More
15. When using machine hours for allocating manufacturing overhead (instead of activity-based costing), a low-volume
item requiring a significant amount of special handling will be assigned too __________ manufacturing overhead.
Little Much
16. In ABC the assumption is that __________ use resources or cause costs. Activities Products

This reading was recuperated on AccountingCoach PRO. Available in:

https://www.accountingcoach.com/activity-based-costing/explanation
https://www.accountingcoach.com/activity-based-costing/explanation/2