Management Accounting Consultancy Report




Chapter 8 (including appendix) Activity Based Costing

For this topic you should be able to:

Recognise problems with traditional product costing systems

Describe the key features of activity-based costing (ABC)

Be able to use the ABC model to calculate product costs

Explain differences between product costs prepared under ABC and those under traditional costing

Recognise what types of organisations benefit from ABC and explain what these benefits are

Outline the impediments to introducing ABC and its limitations, and ways to overcome these.

Features of traditional product costing systems

Direct material and direct labour costs are traced to products

Overheads are aggregated into very large cost pools, sometimes for individual departments but often for the whole organisation (plant)

Manufacturing overhead costs are allocated to products using a predetermined overhead rate, either plant wide or departmental

Manufacturing overhead rate is calculated using some measures of production volume (for example direct labour hours or machine hours)

Non-manufacturing costs are not assigned to products

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Direct materials

Overhead costs

Indirect materials

Indirect labour

Production facility costs


Overhead cost pool

Plant-wide or departmental

Individual products or services

(cost objects)

Direct Labour




Traditional costing systems

(using volume based cost driver)

Last week’s lecture

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Failure to adapt to the changing business environment

Increasing levels of non-volume-driven manufacturing overhead costs

Increasing proportions of non-manufacturing costs

Problems with traditional product costing systems

Causes of changes in cost structures include:

Increased automation

Increasing product diversity and complexity

Increased emphasis on upstream and downstream areas of the value chain, for example, customer demand for improved service, quality, marketing and customer support

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Indicators of problems with a product costing system

Traditional product costing systems are likely to result in inaccurate product costs when:

product diversity increases

the proportion of direct labour costs decreases and the proportion of manufacturing overhead costs increases

the proportion of manufacturing overhead costs, not related directly to production volume, increases

non-manufacturing costs that are product-related become substantial

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Activity-based costing

A method that can be used to measure both the cost of cost objects and the performance of activities

Can help solve problems such as:

Distorted product costs

Poor cost control


A unit of work performed within the organisation

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Traditional approach (from week 6) …

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ABC approach

Resource Drivers



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Direct materials

Transport equipment costs

Testing materials cost pool

Allocated using number of materials tested

Individual products or services or other cost objects

Direct Labour

Overhead costs:


Allocate using activity cost drivers

Activity Based Costing (ABC)

Supervisors’ salaries

Inspectors’ salaries

Other resource costs

Inspection cost pool

Allocated using number of units inspected

Set-up machines cost pools

Allocated using number of set-ups

Trace or allocate using resource drivers

Activity cost pools:

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Be careful…

Do not confuse overhead costs with activity cost pools (see previous slide)

Overhead costs represent all the manufacturing (and/or non-manufacturing) costs of the organisation

These are allocated to activity cost pools using resource drivers

Activity cost pools are an amalgamation of the overhead costs that are used to carry out a particular activity.

These costs are then applied collectively to cost objects (for example, products) using a common activity cost driver

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Activity-based vs. traditional product costs

Traditional product costing is based on the use of volume-based cost drivers

Not all aspects of manufacturing overhead vary with production volume, for example fixed costs

Activity-based costing recognises both volume-based and non-volume-based cost drivers

In ABC, the quantity of activity drivers consumed by a product often depends on whether the activity is performed for each unit, batch or product line.

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Traditional costing treats all costs as unit level

Ignores product level and facility level costs

Also ignores batch size

Activity-based vs. traditional product costs

Units produced in large batches consume a relatively low cost per unit of batch costs

For example, imagine the setup cost per batch of units is $200 and in August 100 units were produced in each batch ….. Therefore, the setup costs per unit is $2

Scenario 1: In September, the units produced per batch increased to 300 due to higher consumer demand. However, despite the increase in batch size, it still costs $200 to setup the batch leading to a setup cost of $0.67 per unit

Scenario 2: In September, the setup cost per batch of units increased to $250 due to the introduction of more sophisticated machinery. However, despite the increased cost, 100 units per batch are still made leading to a setup cost of $2.50 per unit.

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Activity-based vs. traditional product costs

Traditional costing systems tend to overcost high-volume, relatively simple products and undercost low-volume, complex products

High-volume, simple products may use less activities

Low-volume, complex products may use more activities

Traditional costing does not recognise these differences

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An activity-based costing model

The costing view (ABC)

Measures the cost of activities

Assigns activity costs to cost objects (e.g. products)

Activity-based management view (ABM)

Provides information to manage activities, managing costs and other sources of customer value

Three types of cost drivers

Resource drivers (ABC)

Activity drivers (ABC)

Root-cause cost drivers (ABM)

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The ABC framework

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Activity-based costing terminology

Resource driver

A cost driver used to estimate the cost of resources (i.e. overhead costs) consumed by an activity

Activity driver

A cost driver used to estimate the cost of an activity consumed by the cost object

Bill of activities

Identifies the activities, the activity cost per unit of activity driver, the quantity of activity drivers consumed, and therefore, the cost of the activities consumed by the product




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The ABM framework

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Activity-based management terminology

Root-cause cost drivers

The underlying factors that cause activities to be performed and their costs to be incurred

Used to monitor and control what is happening in a business

Provide information about root causes of activities, their value to customers, and appropriate performance measures to use.

Can potentially be different to the activity driver

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The research department sends out blood samples for examination to an external pathology lab.

What is the cost driver of this activity?

For cost estimation purposes: Number of blood samples sent

For cost management purposes: Skill level of staff

Research Cost - $1.5 million – Pharmaceutical Company

Remember Week 2??

The costing view

Step one: Measuring the cost of activities

Use resource drivers to assign overhead costs to separate cost pools (for example, activity centres) for each activity

Determine the total cost for each type of activity

Step two: Assigning activity costs to products

Choose an appropriate activity driver for each activity

Calculate cost per unit of activity driver

Assign activity costs to cost objects using activity drivers

Prepare a bill of activities for each major product

Determine the total cost for each product (equals the cost of activities used to produce each product)

Total Cost of activity

Total quantity of its activity driver

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Activity-based hierarchy of costs and activities

Unit level activities

Performed for each unit of product

Batch level activities

Performed for each batch of product

Product level (or product-sustaining) activities

Performed for specific products or product families

Facility level (or facility-sustaining) activities

Required to support the business as a whole, not caused by any particular product (so arbitrary calculation may still be inevitable unfortunately)

Doesn’t matter if there are 100 or 150 units in the batch – same cost!

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The costing view: Bill of activities

Product: Hensley Tooth

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Lecture illustration

Yummy's Bakery makes a number of different cakes and pastries. Two of its best-selling products are the Lamington and the Vanilla Slice.

It has a budgeted overhead amount of $425,000 for the coming year. It anticipates 2,000 direct labour hours.

400 Lamingtons can be produced an hour. 500 Vanilla Slice can be produced an hour.

The prime cost for a Lamington is $0.30 and $0.50 for a Vanilla Slice.

On the next slide is a list of the main activities performed at Yummy and their annual costs. These costs represent an allocation of all the bakery’s overhead costs. They were allocated to activities using resource drivers.

Five potential activity cost drivers and the annual quantity of each activity driver are also listed.

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Lecture illustration contd….

Activity Activity Cost

Process Receivables $15,000

Process Payables $25,000

Program Production $28,000

Load mixer $14,050

Operate mixer $45,900

Clean mixer $6,900

Fill trays $16,000

Set up ovens $50,000

Bake cakes $130,000

Pack cakes $80,000

Activity cost drivers Quantity

Kg processed 200,000

No. batches 1,000

No. cakes produced 800,000

No. invoices 5,000

No. purchase orders 2,500


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Lecture illustration contd….

The data for the Lamington and the Vanilla Slice is as follows:





The bakery also spent $2,150 in development and testing costs, of which $860 was spent on developing the Lamington and $1,290 spent on developing the Vanilla Slice. The rent of the facility that makes the Lamingtons and Vanilla Slices is $12,000.


Activity cost drivers Quantity used

No. batches 100

No. purchase orders 200

No. invoices 500

Kg processed 30,000

No. cakes produced 100,000


Activity cost drivers Quantity used

No. batches 200

No. purchase orders 800

No. invoices 1,000

Kg processed 50,000

No. cakes produced 100,000

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Lecture illustration contd…


Using traditional costing, with direct labour hours as a cost driver, calculate the product cost for the Lamington and Vanilla Slice.

Select an appropriate driver for each of the activities identified.

Calculate cost per unit of activity driver for the activities listed.

Use the information in parts 2 and 3 to determine a cost per unit for the Lamington and Vanilla Slice.

After all this: Reflect on the difference of calculating product costs using

this method and what we did last week!

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Lecture illustration solution

Question One

Budgeted overhead $425,000

Budget volume of cost driver 2,000 DLHrs

Predetermined overhead rate $212.50 per DLH

Lamington Vanilla Slice

400 produced/ hour = 0.0025 DLHrs 500 produced/ hour = 0.002 DLHrs

per unit per unit

Applied overhead $0.53 Applied overhead $0.43

plus prime cost $0.30 plus prime cost $0.50

Total cost $0.83 Total cost $0.93

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Lecture Illustration Solution (cont’d)

Question Two

Activity Activity Driver

Process Receivables No. invoices

Process Payables No. purchase orders

Program Production No. batches

Load Mixer No. batches

Operate Mixer Kg processed

Clean Mixer No. batches

Fill Trays No. cakes produced

Set up Ovens No. batches

Bake Cakes No. batches

Pack Cakes No. cakes produced

Cake Driver – get it?!

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Lecture illustration solution

Question Three

Activity Activity Cost Activity Driver Quantity Cost/unit of activity driver

Receivables $15,000 No. invoices 5000 $

Payables $25,000 No. purchase orders 2500 $

Program Production $28,000 No. batches 1000 $

Load Mixer $14,050 No. batches 1000 $

Operate Mixer $45,900 Kg processed 200000 $

Clean Mixer $6,900 No. batches 1000 $

Fill Trays $16,000 No. cakes produced 800000 $

Set up Ovens $50,000 No. batches 1000 $

Bake Cakes $130,000 No. batches 1000 $

Pack Cakes $80,000 No. cakes produced 800000 $

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Question Four

Activity Activity Driver Cost/unit of Lamington quantity Annual Cost

activity driver

Process Receivables No. invoices $3.00 500 $1,500

Process Payables No. purchase orders $10.00 200 $2,000

Program Production No. batches $28.00 100 $2,800

Load Mixer No. batches $14.05 100 $1,405

Operate Mixer Kg processed $0.23 30,000 $6,885

Clean Mixer No. batches $6.90 100 $690

Fill Trays No. cakes produced $0.02 100,000 $2,000

Set up Ovens No. batches $50.00 100 $5,000

Bake Cakes No. batches $130.00 100 $13,000

Pack Cakes No. cakes produced $0.10 100,000 $10,000

Develop and Test $ 860

Rent $6,000


Production volume 100,000

Overhead cost/unit $0.52

Prime cost per unit $0.30

Total cost per Lamington $0.82

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Question Four

Activity Activity Driver Cost/unit of Vanilla Slice Annual Cost

activity driver quantity

Process Receivables No. invoices $3.00 1,000 $ 3,000

Process Payables No. purchase orders $10.00 800 $ 8,000

Program Production No. batches $28.00 200 $ 5,600

Load Mixer No. batches $14.05 200 $ 2,810

Operate Mixer Kg processed $0.23 50,000 $11,475

Clean Mixer No. batches $6.90 200 $ 1,380

Fill Trays No. cakes produced $0.02 100,000 $ 2,000

Set up Ovens No. batches $50.00 200 $10,000

Bake Cakes No. batches $130.00 200 $26,000

Pack Cakes No. cakes produced $0.10 100,000 $10,000

Develop and Test $ 1,290

Rent $ 6,000


Production volume 100,000

Overhead cost/ unit $0.88

Prime cost per unit $0.50

Total Cost per Vanilla Slice $1.38

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Lecture illustration solution

Compare costs

Lamington Vanilla Slice Traditional $0.83 $0.93

Activity Based $0.82 $1.38

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When to use ABC?

When overhead costs are a significant proportion of total cost, and a large part of overhead is not directly related to production volume

When the business has a diverse product range, and an individual product’s use of resources differs from its use of volume-based cost drivers

When production activity involves diverse batch sizes and product complexity

Proportion of product-related costs such as research and development, customer support and so on are increasing relative to manufacturing costs

There are likely to be high costs associated with making inappropriate decisions, based on inaccurate product costs

The cost of designing, implementing and maintaining the ABC system is relatively low due to sophisticated IT support

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When to use ABC – four key questions

1. Does the organisation make more than one product?

2. Does the organisation make multiple products using different processes?

3. Does the organisation have a high proportion of non-unit level costs?

4. Are overheads a significant proportion of total costs?

The organisation should definitely use ABC!









If an organisation makes one product, overhead cost per unit is simply total overhead costs divided by units produced.

If different products are made using similar processes, then the overhead costs relating to those processes will be largely identical, negating the need for ABC.

If most overhead costs are unit based, then overhead drivers will probably be volume-based drivers – traditional costing systems are usually able to capture these reasonably effectively

Though the organisation exhibits all the prior characteristics aligned with ABC use, if overhead costs are not significant then the implementation of ABC potentially outweighs the benefits

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Different forms of ABC

Simple approach: allocates manufacturing overhead costs to products

ABC system for indirect costs: allocates manufacturing overhead costs and non-manufacturing costs to products

Comprehensive system: allocates all product-related costs, except direct materials, to products and is used for activity management

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Which costs should be included in an ABC system?

Depends on the purpose of the system, which depends on the needs of management and on the problems that need to be addressed.

A decision to include activity-based management (ABM) in an ABC system will influence the range of costs included in the system, as well as the type of cost drivers identified

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Variations in forms of ABC

Actual (past) or budgeted costs are analysed

Cost objects, other than products, are included

For example, the costs of using particular suppliers or the cost of servicing particular customers

Implementation of ABC is a one-off project or an ongoing system

ABC is used to cost just one part of a business, with other parts relying on more traditional methods

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Impediments to introducing ABC

The benefits of ABC can be significant but the take-up rate has been relatively slow. Why?

Lack of awareness of ABC

Uncertainty about the potential benefits of ABC

Concerns about the extensive resources required to implement ABC

Resistance to change from managers and employees

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Impediments to introducing ABC

Behavioural issues in implementing activity-based costing

ABC may require substantial changes to:

The way businesses are managed

The type of data that is collected

Collection and analysis procedures

Implementation requires the time and effort of many people across the organisation (not just accountants!)

These changes can be perceived as threatening and therefore may be resisted

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Overcoming impediments of ABC

ABC must be accompanied by a change management plan that takes into account the extent of change needed and the personalities involved

Bottom-up change management (as opposed to top-down) may give employees some degree of ownership of any changes caused by ABC

Management must be seen as committed to the change process, but also willing to let their employees play a major role in developing and implementing ABC.

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Limitations of activity-based costing

Facility level costs

When a high level of facility level costs is allocated to products, an arbitrary element enters the product cost

These costs bear no obvious relationship to products

In lecture illustration: rent was split equally between products. Could we do better? Allocate based on square footage used to make products? Is that feasible/necessary?

Use of average costs in decision making

Batch, product level and facility level costs that have been divided by the number of units produced (as in lecture illustration) can lead to product costs that are of limited use for decision making if there is any element of customisation

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Limitations of activity-based costing


The cost of updating an ABC system can be very high although it may be needed to avoid producing outdated, irrelevant information

The level of complexity increases when the system is used for both activity management and product costing

Activity-based management requires extensive and detailed analysis of costs and activities

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Limitations of activity-based costing

ABC can be difficult to implement in service firms

High levels of facility costs, so potential for many arbitrary allocations

Individual activities are difficult to identify because they are non-repetitive

A non-repetitive production environment makes it difficult to identify service outputs (so what is the cost object?)

Despite these issues, ABC is used in many major Australian service organisations

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Some of the slides contained in this presentation were adapted from:

PowerPoint slides to accompany Management Accounting: Information for managing and creating value 8e

Copyright © 2018 McGraw-Hill Australia Pty Ltd

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