ACTIVITY

BASED
COSTING
MUHAMMAD AZEEM
VUGUIDE.TK
ROADMAP OF THE
PRESENTATION

 WHAT IS COST?
 IMPORTANCE OF TRUE PRODUCT COST
 METHODS OF CALCULATING COST
 IMPORTANTANCE OF ACTIVITY-BASED COSTING
 STEPS FOR IMPLEMENTING ACTIVITY-BASED
COSTING
 TRADITIONAL COSTING VS ACTIVITY-BASED
COSTING
 COST COLOURS
 LIMITATIONS OF ACTIVITY BASED COSTING
 SUMMARY
WHAT IS COST?
According To American Accounting
Association

WHY KNOWLEDGE OF TRUE

PRODUCT COST IMPORTANT?
 To discover opportunities for cost
improvements
 To prepare and actualize a business plan
 To improve strategic decision making
METHODS OF
CALCULATING COST

1. Direct costing

2. Traditional costing
3. Activity based costing
(ABC)
ACTIVITY-BASED
COSTING
 Activity-based costing is a method that is
designed to provide management with
cost information

 Activity-based costing is ordinarily used

as supplement

 Most organization that use Activity-based

costing have 2 costing systems
IN ACTIVITY-BASED
COSTING
 Non manufacturing as well as
manufacturing costs may be assigned to
product

Some manufacturing costs may be

excluded from product cost

 A number of overhead cost pools are

used each of which is allocated to
product
 The allocation basis often differ
from those used in traditional
costing system

 Overhead rates may be based

on level of activity
WHY ACTIVITY-BASED
COSTING IS IMPORTANT?

 Major advantage of using Activity-

based costing is that it avoids or
minimizes distortion in product
costing

 Activity-based costing generates

useful information
 Activity-based costing also
provides a clear metric for
improvement

 Activity-based costing
encourages management to
evaluate efficiency
STEPS FOR IMPLEMENTING
ACTIVITY-BASED COSTING

STEP 1: IDENTIFY AND DEFINE ACTIVITIES

AND ACTIVITY COST POOLS

STEP 2: DIRECTLY TRACE OVERHEAD COSTS

TO ACTIVITY AND COST OBJECTS

STEP3: ASSIGN COSTS TO ACTIVITY COST POOLS

STEP 4: CALCULATE ACTIVITY RATES

STEP 5: ASSIGN COST TO COST OBJECTS

STEP 6: PREPARE MANAGEMENT REPORT

 TRADITIONAL
COSTING
VS
ACTIVITY-BASED
COSTING
 TRADITIONAL ACTIVITY-BASED
COSTING COSTING

1. NON MANUFACTURING COSTS

Only manufacturing Products are assigned

costs are assigned to all overhead costs –
products manufacturing as well
as non manufacturing

2. MANUFACTURING COSTS

All manufacturing costs Products are assigned

are assigned to all overhead costs –
products manufacturing as well
as non manufacturing
 COST OF IDLE CAPACITY
TRADITIONAL ACTIVITY-BASED
COSTING SYSTEM COSTING SYSTEM

• Predetermined • Products are

overhead rates are charged for the
computed costs
Rate = ESTIMATED FOH of capacity they use
BASE
• The costs of idle
capacity are not
charged to products

 This results in
 This results in
• Applying idle capacity • more stable unit costs
costs to products • consistency with the
• Unstable unit product objective of assigning
costs
FLOW OF ACTIVITIES

ACTIVITY-BASED COSTING MODEL

TRADITIONAL COSTING SYSTEM
CONSUMPTION OF RESOURCES VS
CONSUMPTION OF ACTIVITIES
Activity-based costing assumes

Products consume activities

Activities consume resources

Traditional Costing assumes

cost objects consume resources

 STRUCTURE-ORIENTATION
VERSUS PROCESS-ORIENTATION
TRADITIONAL ACTIVITY-BASED
COSTING SYSTEM COSTING SYSTEM
• Traditional costing • ABC gathers
systems are more information from the
concerned about processes
the organizational • result
charts than the both capacity management
actual process and resource management
• result is known
capacity management
unknown
COST COLOURS
There are three colours used for cost
classification.

1. GREEN COLOUR COST:

 automatically adjusts with changes in
activity
 management action not required
EXAMPLE
 direct material cost
 shipping cost, etc.
2. YELLOW COLOUR COST:
 need to be adjusted with changes in
activity
 management action required
EXAMPLE
 direct labor cost
 indirect factory wages
 factory utilities

3. RED COLOUR COST:

 management action required to
adjust these costs
 difficult to change with activity
EXAMPLE
 Factory equipment depreciation
 Factory/Administration building lease
LIMITATIONS OF ACTIVITY
BASED COSTING
 Activity-based costing is more costly to
maintain than a traditional labor costing
system
 Activity-based costing does not have full
support of top management
 Activity-based costing can easily be
misinterpreted
 Organization using activity-based costing
have to maintain 2 cost systems
SUMMARY
 Activity-based costing estimates the
cost of sources consumed by cost
objects such as product and customers

 The approach taken in activity-based

costing assumes that cost objects
generate activities that in turn
consumes costly resources.
 Activities form the link between costs
and cost objects

 Activity-based costing is concerned

with overhead – both manufacturing
overhead and selling, general, and
administrative overhead