ACTIVITY BASED COSTING & SERVICE COST ALLOCATION

PREPARED BY: RONNELSON PASCUAL, CPA,MBA,CTT,MRTAX

INTENDED LEARNING OUTCOMES

1. Define and explain activity-based costing and its difference with traditional overhead costing.
2. Explain the cost accumulation procedures applied in activity-based costing system.
3. Determine the costs to be charged to the product using activity-based costing system.
4. Explain the rationale behind service cost allocation and its importance.
5. Determine the appropriate service cost allocation method to be applied.
6. Allocate service department costs using direct method, sequential method, and algebraic
method.
TRADITIONAL COSTING

Broad Averaging or Peanut Butter Costing System describes a costing approach that
uses broad averages for assigning the cost of resources uniformly to cost objects when
the individual products or services, in fact, use those resources in non-uniform ways.

The name comes from how peanut butter is spread - uniformly over an entire piece of
bread.
POSSIBILITIES OF 'OVERCOSTING’ AND 'UNDERCOSTING’

If a company undercosts one product, it will overcost at least one of its products. (product
cost cross-subsidization)

Product under costing happens when a product consumes high level of resources but is
allocated with lower costs than what it should be.

Product over costing happens when a product consumes low level of resources but is
allocated with higher costs than what it should be.
ACTIVITY-BASED COSTING SYSTEM

Activity Based Costing System allocates overhead costs to multiple activity cost
pools and assigns the activity cost pools to products by means of cost drivers.

Cost driver triggers a change in the cost of an activity. It is used a basis for cost
allocation; any factor of activity that has a direct cause-effect relationship.

Activity cost pool is a bucket in which costs are accumulated that relate to a single
measure in ABC system.
ACTIVITY-BASED COSTING SYSTEM

Activity Cost Pools Activity Cost Drivers

Purchasing Department Number of Purchase Orders

Receiving Department Number of Purchase Orders

Materials Handling Number of Materials Requisitions

Setup Number of Machine Setups Required

Inspection Number of Inspections

Engineering Department Number of Engineering Change Orders

Personnel processing Number of Employees Hired or Laid Off

Supervisors Number of Direct Labor Hours

ACTIVITY-BASED MANAGEMENT

Activity-Based Management is focused on the analysis of the entity's activities that affects the
production greatly. In ABM, we eliminate activities that are nonvalue-adding.

Nonvalue-adding activities are activities that add costs to the production process or increase
production time but does not add any 'value' to the product.

When nonvalue-adding activities are eliminated without reduction of product quality, production
time and costs related to it are also eliminated. Thus, it helps increase profitability.

On another perspective, ABM assist also in determining the activities that greatly help the
production process that can increase the 'value' of a product or service.
PROBLEM 1
The following cost information has been established by the accounting department of Baby Manufacturing Company:
PROBLEM 1 (QUESTIONS)

In this problem, assume that:

1. Produced and sold 2,500 units each of all products.
2. Selling Prices are: P800 for Product X, P820 for Product Y and P810 for Product Z
3. No beginning and ending work-in-process and finished goods inventory.

Requirement:
1. Compute for the product cost under traditional costing.
2. Compute for the product cost under activity-based costing.
PROBLEM 1 (SOLUTIONS) – TRADITIONAL COSTING
PROBLEM 1 (SOLUTIONS) – ABC (ACTIVITY-BASED-COSTING)
PROBLEM 1 (SOLUTIONS) – ABC (ACTIVITY-BASED-COSTING)
PROBLEM 1 (SOLUTIONS) – ABC (ACTIVITY-BASED-COSTING)
PROBLEM 1 (SOLUTIONS) – TRADITIONAL VS ABC (ACTIVITY-BASED-
COSTING)
BENEFITS OF ACTIVITY-BASED COSTING

1. Provides realistic costs of manufacturing for specific products.

2. Allocates manufacturing overhead more accurately to products and processes that use the
activity.
3. Identifies inefficient processes and targets for improvement.
4. Determines product profit margins more precisely.
5. Discovers which processes have unnecessary and wasted costs.
6. Offers better understanding and justification of costs in manufacturing overhead.
LIMITATIONS OF ACTIVITY-BASED COSTING

• Collection and preparation of data is time-consuming.

• Costs more to accumulate and analyze information.
• Source data isn't always readily available from normal accounting reports.
• Reports from ABC don't always conform to generally accepted accounting principles and can't
be used for external reporting.
• Data produced by ABC may conflict with managerial performance standards previously
established from traditional costing methods.
• May not be as useful for companies where overhead is small in proportion to total operating
costs.
WHEN TO SWITCH TO ABC?

• Product lines differ greatly in volume and manufacturing complexity.

• Product lines are numerous, diverse, and require differing degrees of support service.
• Overhead costs constitute a significant portion of total costs.
• The manufacturing process or the number of products has changed significantly.
• Production or marketing managers are ignoring data provided by the existing system.
SERVICE DEPARTMENT COSTS

Service or support department is a unit in an organization that contributes in a very indirect way
to the conversion of raw materials to finished goods. They are, however and still, at whatever
little it may be, involved in producing goods.

These departments are the purchasing department, personnel department, warehousing

department, and maintenance department. Since these departments support the production
process, the costs incurred in these departments should be allocated to the production
departments to determine the cost of a product for proper decision-making.
SERVICE DEPARTMENT COSTS
Methods of allocation service department costs:
WHAT IS THE BEST METHOD TO USE?
The proper method to use in service cost allocations depend on how these service departments
provide their services to other service departments and to the production departments.

 The direct method is applicable for entities whose service departments directly provide
services to the production departments and there is no or very little service provision of one
service department to another service department.

 The sequential method is applicable for entities whose one service department is also a
recipient of a service from another service department, alongside provision of services to the
production departments.

 The algebraic method is applicable for entities whose service departments reciprocally
provide services to each other, as well as to the production departments.
PROBLEM 2
 Marites Manufacturing has four departments. Assembly department and finishing department
make up the production departments while cafeteria and maintenance department make up
the service departments.
 The overhead cost of the cafeteria is allocated based on the number of employees while the
overhead cost of the maintenance department is based on the estimated overhead for the
period.
 In determining the predetermine overhead rates, the assembly department uses direct labor
hours and the finishing department uses machine hours. The following information is made
available:
DIRECT METHOD
SEQUENTIAL METHOD
ALGEBRAIC METHOD
ALGEBRAIC METHOD
- END OF SLIDE –

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