# Activity-Based Costing

Activity-based costing is a method of assigning indirect costs to products and services which involves finding cost of each activity involved in the production process and assigning costs to each product based on its consumption of each activity.

Activity-based costing is more refined approach to costing products and services than the traditional costing method. It involves the following steps:

• Identification of activities involved in the production process;
• Classification of each activity according to the cost hierarchy (i.e. into unit-level, batch-level, product level and facility level);
• Identification and accumulation of total costs of each activity;
• Identification of the most appropriate cost driver for each activity;
• Calculation of total units of the cost driver relevant to each activity;
• Calculation of the activity rate i.e. the cost of each activity per unit of its relevant cost driver;
• Application of the cost of each activity to products based on its activity usage by the product.

## Cost Hierarchy

The first step in activity-based costing involves identifying activities and classifying them according to the cost hierarchy. Cost hierarchy is a framework that classifies activities based the ease at which they are traceable to a product. The levels are (a) unit level, (b) batch level, (c) product level, and (d) facility level.

Unit level activities are activities that are performed on each unit of product. Batch level activities are activities that are performed whenever a batch of the product is produced. Product level activities are activities that are carried out separately for each product. Facility level activities are activities that are carried out at the plant level. The unit-level activities are most easily traceable to products while facility-level activities are least traceable.

## Example

Alex Erwin started Interwood, a niche furniture brand, 10 years ago. He ran the business as a sole proprietorship. While he has 50 skilled carpenters and 5 salesmen on his payroll, he has been taking care of the accounting by himself. Now, he intends to offer 40% of the ownership to public in next couple years, and is willing to make changes and has hired you as the management accountant to organize and improve the accounting systems.

Interwood's total budgeted manufacturing overheads cost for the current year is $5,404,639 and budgeted total labor hours are 20,000. Alex applied traditional costing method during all of the 10 years period, and based the pre-determined overhead rate on total labor hours. Interwood's sofa range includes the 2-set, 3-set and 6-set options. Platinum Interiors recently placed an order for 150 units of the 6-set type. The order is expected to be delivered in 1 month time. Since it is a customized order, Platinum will be billed at cost plus 25%. You are not a fan of traditional product costing system. You believe that the benefits of activity-based costing system exceeds its costs, so you sat down with Aaron Mason, the chief engineer, to identify the activities which the firm undertakes in its sofa division. Next, you calculated the total cost that goes into each activity, identified the cost driver that is most relevant to each activity and calculated the activity rate. The results are summarized below: ActivityA (in$)Relevant Cost DriverBC=A/B (in $) Production of components2,313,132Machine hours25,00093 Assembly of components1,231,312Number of labor hours20,00062 Packaging213,123Units5,00043 Shipping231,230Units5,00046 Setup costs34,243Number of setups240143 Designing123,132Designer hours1,000123 Product testing24,234Testing hours50048 Rent1,234,233Labor cost$1,645,64475%

Once the order was ready for packaging, Aaron gave you a summary of total cost incurred and a statement of activities performed (also called the bill of activities) as shown below:

Order No: 15X2013
Customer: Platinum Interiors
Units: 150
Type: 6 unit
Amounts in $Cost of direct materials25,000 Cost of purchased components35,000 Labor cost15,600 ActivityRelevant Cost DriverActivity Usage Production of componentsMachine hours320 Assembly of componentsNumber of labor hours250 PackagingUnits150 ShippingUnits150 Setup costsNumber of setups15 DesigningDesigner hours70 Testing Testing hours22 RentLabor cost4500 ### Part A Calculate the total cost of the order and the invoice value of the order based on traditional costing system. Solution In the traditional costing system, cost equals materials cost plus labor cost plus manufacturing overheads charged at the pre-determined overhead rate. The pre-determined overhead rate based on direct labor hours =$5,404,639/20,000 = $270 per labor hour The actual number of labor hours spent on the order is 250. Once we have this data, we can estimate the manufacturing overheads and the total cost as follows:  Direct materials 25,000 Purchased components 35,000 Labor cost 15,600 Manufacturing overheads ($270 × 250) 67,500 Total cost under traditional product costing system 143,100

Platinum is billed at cost plus 25%, so the amount of sales to be booked would amount to $178,875 (=$143,100 × 1.25).

### Part B

You know activity-based costing is a more refined approach. Now, since you have all the data needed, calculate the order cost using activity based costing.

Solution

In activity-based costing, direct materials cost, cost of purchased components and labor cost remains the same as in traditional product costing. However, the value of manufacturing overheads assigned is more accurately estimated. The following worksheet estimates the manufacturing overheads that should be assigned to the order of Platinum Interiors:

(A)(B)(A × B)
ActivityActivity RateActivity UsageActivity Cost Assigned
Production of components9332029,760
Assembly of components6225015,500
Packaging431506,450
Shipping461506,900
Setup costs143152,145
Designing123708,610
Product testing48221,056
Rent75%15,60011,700
82,121

Total cost of the order is hence:

US$Direct materials25,000 Purchased components35,000 Labor cost15,600 Manufacturing overheads82,121 Total cost under activity-based costing157,721 Based on the more accurate estimation of the order cost, the invoice should be raised at$197,150 (=$157,721 × 1.25) instead of$178,875 calculated under traditional product costing system.

The example highlights the importance of correct estimation of the product cost and the usefulness of activity-based costing in achieving that goal.

Written by Obaidullah Jan, ACA, CFAhire me at