RESOURCE ALLOCATION

FROM TRADITIONAL
COSTING TO ABC
ASOC. PROF. SYED MOHD. GHAZALI WAFA
B. SYED ADWAM WAFA
GRADUATE SCHOOL OF BUSINESS
UNIVERSITI KEBANGSAAN MALAYSIA
Classifying Costs
By Behavior
Fixed
Variable
By Traceability
Direct
Indirect
By Function
Product
Period
2-4
Fixed Costs
Committed fixed costs are
required to maintain the current
service or production capacity to
fill previous legal commitments.
Discretionary fixed
costs are set at a
fixed amount each
year at the discretion
of management.
2-5
Total Cost Behavior With a
Single Unit Level Cost Driver
Total
costs
(Y)
Value of independent variable (X)
0
0
Fixed costs (a)
Variable costs (b)
Total costs
Y = a + bX
Variable costs are
layered on top of
fixed costs.
Slope, b =
Y
X
2-6
Equation for Total Costs
Y = a + bX
total costs vertical axis intercept
(an approximation of
FIXED COSTS)
slope (an
approximation of
variable COSTS PER
UNIT of X)
value of
independent
variable (UNITS)
2-7
Economists Curvilinear
Total Cost Pattern
Total
power
costs
Units produced
0
0
Normal
activity
range
Relevant range
for which linear
patterns are valid
Relevant Costs
Costs that can be eliminated (in whole or in
part) by choosing one alternative over
another are avoidable costs.
Avoidable costs are relevant costs.
Unavoidable costs include:
-Sunk costs.
-Future costs that do not differ between
the alternatives.
Unavoidable costs are never relevant.
How Costs are Treated:
Traditional to Activity-Based Costing
Overhead Allocation
Plantwide
Overhead
Rate
Departmental
Overhead
Rates
Activity Based
Costing
Traditional
Plantwide Overhead Rate
Companies tend to use direct labor
as the overhead allocation base.
A two stage process is
necessary because costs
are allocated to departments
and then to products.
Finishing Department
Shipping Department
Painting Department
Departmental Overhead Rates
Department
1
Department
2
Department
3
Cost pools
Indirect
Labor
Indirect
Materials
Other
Overhead
Stage One:
Costs assigned
to pools
Departmental Overhead Rates
Department
1
Department
2
Department
3
Cost pools
Stage One:
Costs assigned
to pools
Products
Stage Two:
Costs applied
to products
Departmental Overhead Rates
Indirect
Labor
Indirect
Materials
Other
Overhead
Department
1
Department
2
Department
3
Cost pools
Stage One:
Costs assigned
to pools
Products
Stage Two:
Costs applied
to products
Direct
Labor
Hours
Machine
Hours
Raw
Materials
Cost
Departmental Allocation Bases
Departmental Overhead Rates
Indirect
Labor
Indirect
Materials
Other
Overhead
Designing an ABC System
Cost Objects
(e.g., products
and customers)
Activities
Consumption
of Resources
Cost
Designing an ABC System
Steps for Implementing ABC
OIdentify and define activities and activity pools.
OWhere possible, trace costs to activities and cost
objects.
OAssign costs to activity cost pools.
OCalculate activity rates.
OAssign costs to cost objects.
OPrepare management reports.
Identifying Activity to Include
A part of the production
process for which management
wants a separate reporting of the
costs of the activity involved
Unit-Level
Activity
Batch-Level
Activity
Product-Level
Activity
Customer-Level
Activity
Organization-
sustaining
Activity
2-18
Manufacturing Cost Hierarchy
Unit level activities
Batch level activities
Product level activities
Facility level activities
2-19
Manufacturing Cost Hierarchy
Activity
Level Reason for Activity Examples of Activity Cost
Unit Performed for each
level unit product
produced or sold
Cost of raw materials
Cost of inserting a
component
Utilities cost of
operating equipment
Some costs of packaging
Sales commissions
2-20
Manufacturing Cost Hierarchy
Activity
Level Reason for Activity Examples of Activity Cost
Batch Performed for each
level batch of product
produced or sold
Cost of processing a
sales order
Cost of issuing and
tracking work order
Cost of equipment setup
Cost of moving batch
between workstations
Cost of inspection
2-21
Manufacturing Cost Hierarchy
Activity
Level Reason for Activity Examples of Activity Cost
Product Performed to support
level each different
product that can be
produced
Cost of product
development
Cost of product
marketing such as
advertising
Cost of specialized
equipment
Cost of maintaining
specialized equipment
2-22
Manufacturing Cost Hierarchy
Activity
Level Reason for Activity Examples of Activity Cost
Facility Performed to
level maintain general
manufacturing
capabilities
Cost of maintaining
general facilities
Cost of nonspecialized
equipment
Cost of real property
taxes
Cost of general
advertising
Cost of general
administration
2-23
Changing Composition of Total
Manufacturing Costs
Volume-Based Unit
Level Analysis
Activity-Based
Multiple-Level
Analysis
Variable--only one type of
variable cost is considered:
Unit level
Variable--many types of
variable cost drivers are
considered, including:
Unit level
Batch level
Product level
2-24
Volume-Based Unit
Level Analysis
Activity-Based
Multiple-Level
Analysis
Fixed--Costs that do not
vary with the number of
units
Fixed--costs that do not
respond to change in
variable cost drivers are
considered:
Facility level
Changing Composition of Total
Manufacturing Costs
2-25
Customer Cost Hierarchy
OUnit level activities
OOrder level activities
OCustomer level activities
OFacilities level activities
A merchandising organization or the sales
division of a manufacturing organization
might use the following hierarchy:
2-26
OUnit level activities
OOrder level activities
OCustomer level activities
OMarket segment level activities
OFacility level activities
An organization that sells to distinct
market segments might have the
following cost hierarchy:
Customer Cost Hierarchy
Cost Drivers Selection
The selection of activity cost drivers requires making
choices related to how to economize on the number of
activity cost drivers, how to isolate events (because
activities triggered by the same event often can use the
same activity cost driver), and whether to apply transaction
drivers, duration drivers, or intensity drivers.
Transaction drivers count how often an activity is
performed. Duration drivers represent the amount of time
required to perform an activity. Intensity drivers directly
charge for the resources used each time an activity is
performed. Also, rather than using intensity drivers, a
weighted index approach might be used to simulate an
intensity driver.

ABC COST DRIVERS
Activity
Transaction
Driver
Duration Driver Intensity Driver
MACHINE
MAINTENANCE
# of machines Machine hours

Actual times for various
maintenances of various machines
MACHINE SETUP # of setups Setup hours
Actual times for various setups for
various machines
QUALITY CONTROL # of inspections Inspection hours
Actual times for various
inspections for various controls
MATERIAL
ORDERING
# of orders Ordering hours
Actual times for various orders for
various materials
PRODUCTION
SCHEDULING
# of runs Scheduling hours
Actual times for various runs for
various schedules
WAREHOUSING # of bins, aisles Picking hours

Actual times for various parts for
various warehousing activities
ENGINEERING
DESIGN
# of engineers
# of designs
Engineering hours
Actual times for various
engineering designs
Traditional Costing
Addison Company
Addison Company has two products: A and B.
Annual production and sales are 800 units of
Product A and 700 units of Product B. The
company has traditionally used direct labor-
hours as the basis for applying all manufacturing
overhead to products. Product A requires 0.2
direct labor hours per unit and Product B
requires 0.6 direct labor hours per unit. The total
estimated overhead for next period is $71,286.

To Calculate:

a. The predetermined overhead rate under the
traditional costing system.

b. The overhead cost per unit of Product B under the
traditional costing system.
Predetermined Overhead Rate
Total Direct Labor-Hours:
Product A: 800 units .2 DLHs per unit 160 DLHs
Product B: 700 units .6 DLHs per unit 420 DLHs
Total 580 DLHs
Predetermined overhead rate:
= $71,286 580 DLHs = $122.91
Total overhead cost applied to Product B using traditional
costing: $122.9069 420 DLHs = $51,621 (rounded)
Overhead cost per unit = $51,621 700 units = $73.74
ie: $122.9069 x .6 = $73.74

Addisonss Change to ABC System
The company is considering switching to an activity-based costing system for
the purpose of computing unit product costs for external reports. The new
activity-based costing system would have three overhead activity cost
poolsActivity 1, Activity 2, and General Factory--with estimated overhead
costs and expected activity as follows:
Expected Activity
Activity Cost Pool Estimated Product A Product B Total
Overhead Costs
Activity 1 $20,272 300 500 800
Activity 2 29,380 800 500 1,300
General Factory 21,634 160 420 580
Total $71,286
(Note: The General Factory activity cost pool's costs are allocated on the basis of
direct labor hours) : A = {800 x 0.2}; B = {700 x 0.6}

To Calculate:
a. The predetermined overhead rate (i.e.,
activity rate) under the activity-based
costing system.
b. The overhead cost per unit of Product B
under the activity-based costing system.

The overhead activity rate and overhead cost per unit of Product B under the
ABC system :

(a) (b) (a) (b)
Activity Cost Pool Estimated Cost Estimated Activity Activity Rate
Activity 1 $20,272 800 $25.34
Activity 2 $29,380 1,300 $22.60
General Factory $21,634 580 $37.30

Total Cost of Product B:
(a) (b) (a) (b)
Activity Cost Pool Activity Rate Activity ABC Cost
Activity 1 $25.34 500 $12,670
Activity 2 $22.60 500 11,300
General Factory $37.30 420 15,666
$39,636
Overhead cost per unit = $39,636 700 units = $56.62 per unit (rounded)

CABIO COMPANY
CABIO COMPANY manufactures two products, Product C and Product D.
The company estimated it would incur $119,100 in manufacturing
overhead costs during the current period. Overhead currently is applied to
the products on the basis of direct labor hours. Data concerning the
current period's operations appear below:
Product C Product D
Estimated volume 400 units 3,000 units
Direct labor hours per unit 1.20 hours 1.30 hours
Direct materials cost per unit $4.00 $22.80
Direct labor cost per unit $12.00 $13.00

Compute the predetermined overhead rate under the current method, and
determine the unit product cost of each product for the current year.
Change to ABC System
The company is considering using an activity-based costing system to
compute unit product costs for external financial reports instead of its
traditional system based on direct labor hours. The activity-based costing
system would use three activity cost pools. Data relating to these activities
for the current period are given below:
Expected Activity
Estimated
Overhead
Activity Cost Pool Costs Product C Product D Total
Machine setups $ 10,440 60 120 180
Purchase orders 78,000 820 1,180 2,000
General factory 30,660 480 3,900 4,380
Total $119,100

Determine the unit product cost of each product for the current period
using the activity-based costing approach.