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BM1915 ACTIVITY-BASED COSTING Peanut Butter Costing vs. Activity-Based Costing Peanut butter costing involves assigning (or spreading) overhead cost...

BM1915 ACTIVITY-BASED COSTING Peanut Butter Costing vs. Activity-Based Costing Peanut butter costing involves assigning (or spreading) overhead costs uniformly to cost objects using broad averages. However, this may result in the following: Product undercosting – A product consumes a high level of resources but is reported to have a low cost per unit. Product overcosting – A product consumes a low level of resources but is reported to have a high cost per unit. Product cost cross-subsidization – If one (1) product is undercost, it will overcost at least one (1) of other products. The company must make a change in the costing system to reduce the use of broad averages for assigning the cost of resources to cost objects. This is also done to provide a better measurement of the overhead costs used by different cost objects in order to prevent the following circumstances mentioned above. An activity-based approach refines a costing system by focusing on individual activities as fundamental cost objects. It uses the cost of these activities as the basis for assigning costs to products or services. Activity- based costing (ABC) system allocates overhead to multiple activity cost pools and assigns the activity cost pools to products using cost drivers. The following terms will be used in activity-based costing: Cost driver is a factor that causes a change in the cost pool for a particular activity. It is used as a basis for cost allocation and includes any factor or activity that has a direct cause–effect relationship. Activity cost pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system. Activity refers to any event, action, transaction, or work sequence that incurs costs when producing a product or providing a service. o Value-adding activities – activities that are necessary to produce the products o Nonvalue-adding activities – activities that do not make the product or service more valuable to the customer The presence of one (1) or more of the following factors indicates ABC as the superior costing system: Product lines differ greatly in volume and manufacturing complexity. Product lines are numerous and diverse, and require differing degrees of support services. 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 the data provided by the existing system. Hierarchy of Activity Levels (Garrison, Noreen, & Brewer, 2018) Traditional cost systems rely exclusively on allocation bases that are driven by the volume of production. On the other hand, activity-based costing defines five (5) levels of activity that do not largely relate to the volume of units produced. 1. Unit-level activities are performed each time a unit is produced. The costs of unit-level activities should be proportional to the number of units produced. For example, providing power to run processing equipment would be a unit-level activity because power tends to be consumed in proportion to the number of units produced. 03 Handout 1 *Property of STI  [email protected] Page 1 of 5  BM1915 2. Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, tasks such as placing purchase orders, setting up equipment, and arranging for shipments to customers are batch-level activities. These are incurred once for each batch (or customer order). Costs at the batch level depend on the number of batches processed rather than on the number of units produced, the number of units sold, or other measures of volume. For example, the cost of setting up a machine for batch processing is the same regardless of whether the batch contains one or thousands of items. 3. Product-level activities relate to specific products and must be typically carried out regardless of how many batches are run or units of product are produced or sold. For example, activities such as designing a product, advertising a product, and maintaining a product manager and staff are all product-level activities. 4. Customer-level activities relate to specific customers and include activities such as sales calls, catalog mailings, and general technical support that are not tied to any specific product. 5. Organization-sustaining activities are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. This category includes activities such as heating the factory, cleaning executive offices, providing a computer network, arranging for loans, preparing annual reports to shareholders, and so on. Cost Allocation Procedure Using ABC System Steps for Implementing Activity-Based Costing 1. Identify and classify major activities and assign overhead costs to activity cost pools. 2. Identify the cost driver that has a strong correlation to the costs accumulated in each cost pool and the total amount of cost driver usage. 3. Calculate activity-based overhead rates for each cost pool. 4. Assign overhead costs to cost objects using the activity rates determined for each cost pool. The figure below shows the steps in implementing the activity-based costing system: Figure 1. Steps in implementing an ABC system 03 Handout 1 *Property of STI  [email protected] Page 2 of 5  BM1915 ILLUSTRATION: Faith Manufacturing Company submitted the following production reports for January of the current year. Units Produced Machine A 1,000 Machine B 1,600 Cost Driver Units Activities Product A Product B Purchasing materials 1,200 packs 2,000 packs Machine setups 20 setups 50 setups Inspections 300 hours 400 hours Running machines 1,000 hours 2,000 hours Additional data: Product A Product B Direct materials per unit P800 P1,200 Direct labor per unit P200 P360 Manufacturing overhead is applied at the rate of 150% based on direct labor cost. The estimated overhead for January 201A amounts to P720,000. Overhead estimates for 201A: Activity Cost Driver Estimated No. of Cost Estimated Overhead Driver Units Costs Purchasing materials No. of packs 40,000 packs P1,000,000 Machine setups No. of setups 800 set pus 4,000,000 Inspections Inspection hours 8,000 hours 1,600,000 Running machines Machine hours 40,000 hours 2,000,000 Total Estimated Overhead P8,600,000 Step 1. Identify and classify major activities and assign overhead costs to activity cost pools. Activities Estimated Overhead Costs Purchasing materials P1,000,000 Machine setups 4,000,000 Inspections 1,600,000 Running machines 2,000,000 Step 2. Identify the cost driver that has a strong correlation to the costs accumulated in each cost pool and the total amount of cost driver usage. Activities Cost Driver Estimated No. of Cost Driver Units Purchasing materials No. of packs 40,000 packs Machine setups No. of setups 800 setups Inspections Inspection hours 8,000 hours Running machines Machine hours 40,000 hours 03 Handout 1 *Property of STI  [email protected] Page 3 of 5  BM1915 Step 3. Calculate activity-based overhead rates for each cost pool. 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑝𝑒𝑟 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑦 − 𝑏𝑎𝑠𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑟𝑎𝑡𝑒 = 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑢𝑠𝑒 𝑜𝑓 𝑐𝑜𝑠𝑡 𝑑𝑟𝑖𝑣𝑒𝑟 𝑝𝑒𝑟 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 Activity cost pools Cost calculations Purchasing materials 𝑃1,000,000 = 𝑷𝟐𝟓 𝒑𝒆𝒓 𝒑𝒂𝒄𝒌 40,000 Machine setups 𝑃4,000,000 = 𝑷𝟓, 𝟎𝟎𝟎 𝒑𝒆𝒓 𝒔𝒆𝒕𝒖𝒑 800 Inspections 𝑃1,600,000 = 𝑷𝟐𝟎𝟎 𝒑𝒆𝒓 𝒊𝒏𝒔𝒑𝒆𝒄𝒕𝒊𝒐𝒏 𝒉𝒐𝒖𝒓 8,000 Running machines 𝑃2,000,000 = 𝑷𝟓𝟎 𝒑𝒆𝒓 𝒎𝒂𝒄𝒉𝒊𝒏𝒆 𝒉𝒐𝒖𝒓 40,000 Step 4. Assign overhead costs to cost objects using the activity rates determined for each cost pool. Product A Product B Total Purchasing materials A (1,200 x P25) P30,000 B (2,000 x P25) P50,000 P80,000 Machine setups A (20 x P5,000) 100,000 B (50 x P5,000) 250,000 350,000 Inspections A (P300 x P200) 60,000 B (400 x 200) 80,000 140,000 Running machines A (1,000 x P50) 50,000 B (2,000 x 50) 100,000 150,000 TOTAL P240,000 P480,000 P720,000 Overhead cost per unit of Product A using ABC (P240,000/1,000) = P240 Overhead cost per unit of Product B using ABC (P480,000/P1,600) = P300 The total cost per unit for each product line using ABC is as follows: Product A Product B Direct materials P800 P1,200 Direct labor 200 360 Overhead 240 300 Total manufacturing cost P1,240 P1,860 03 Handout 1 *Property of STI  [email protected] Page 4 of 5  BM1915 On the other hand, the following are the total cost per unit using peanut butter costing or the traditional approach: Product A Product B Direct materials P800 P1,200 Direct labor 200 360 Overhead – 150% of direct labor cost 300 540 Total manufacturing cost P1,300 2,100 References: Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2018). Managerial accounting (16th Ed.). New York: McGraw- Hill Education. Payongayong, L. S. (2016). Management services. Manila: Polytechnic University of the Philippines. 03 Handout 1 *Property of STI  [email protected] Page 5 of 5