Activity based costing ABC explained with an example

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SOURCE: https://www.business-case-analysis.com/activity-based-costing.html

This section presents an ABC version of the same product costing situation. The example shows how ABC and traditional costing can yield different indirect cost estimates for the same products. And, this means the two approaches can also estimate profitability differently. Finally, especially, however, that the example also shows clearly that ABC requires more data and more detailed analysis than the PVB allocation approach.

ABC costing for products A and B begins with the same summary table used for the traditional costing example above. Data for starting the analysis includes units produced and sold, sales revenues, and direct costs. The ABC example therefore begins with another copy of Table 2:

Direct costs under ABC

Products Compared

Product A Product B Total
1. Units produced & sold 900,000 2,100,000 3,000,000
2. Selling price / unit $3.00 $2.00
3. Direct labor cost / unit $0.50 $0.50
4. Direct materials cost / unit $0.75 $0.50
5. Sales revenues [ = 1 * 2 ] $2,700,000 $4,200,000 $6,900,000
Direct costs
6. Direct labor costs [ = 1 * 3 ] $450,000 $1,050,000 $1,500,000
7. Direct materials costs [ = 1 * 4 ] $675,000 $1,050,000 $1,725,000
8. Total Direct costs [ = 6 + 7 ] $1,125,000 $2,100,000 $3,225,000
Table 2 (second copy). Sales revenues and direct costs for Products A and B

Overhead or indirect costs under activity based costing

In ABC, the “indirect” or “overhead” cost contributors are viewed as “activity pools.”

Under activity based costing, an activity pool is the set of all activities required to complete a task, such as (a) process purchase orders, or (2) perform machine set ups.

In order to “cost”  activity pools, ABC identifies activity units that are cost drivers for each pool. The total cost of for the activity pool “process purchase orders,” for instance, is driven by the number of purchase orders processed, while the total cost for activity pool “perform machine set ups” is driven by the number of set ups.

Tables 5A and 5B, below show a cost driver (CD) unit cost for each activity pool: one machine set up, for instance, is found to require $1,500 in labor, materials, energy, and other resources.

Table 5A, moreover, shows the number of CD units (activity units) used for product A, while Table 5B shows these figures for product B. From the known cost of each CD unit, a total cost can be assigned for each product for each activity pool, as the rightmost columns of Tables 5A and 5B show.

In ABC, assigning cost totals to activity pools in this way, using cost driver units, is  stage-1 allocation, or batch-level allocation.

Product A activity units, activity pools, and cost drivers

Activity Pool

Cost Driver (CD)
Activity Units
CD
Unit Cost
Total Activity
Product A
Total Indir
Cost  (A)
17. Purchase orders No of purchase orders $1,800 75 $135,000
18. Machine set ups No of setups $1,500 150 $225,000
19. Product packaging No of product
packages packed
$0.20 900,000 $180,000
20. Machine testing
& calibration
No of tests $100 1,000 $100,000
21. Maintenance
& cleaning
No of batch runs $1,150 200 $230,000
Total $870,000
Table 5A. ABC Stage-1 allocation (batch level allocation) for product A: Activity pools, cost drivers, cost per cost driver unit, and total cost for these activities.

Product B activity units, activity pools, and cost drivers

Activity Pool

Cost Driver (CD) CD
Unit Cost
Total Activity
Product B
Total Indir
Cost  (B)
17. Purchase orders No of purchase orders $1,800 25 $45,000
18. Machine set ups No of setups $1,500 100 $150,000
19. Product
packaging
No of product
packages packed
$0.20 500,000 $100,000
20. Machine testing
& calibration
No of tests $100 2,000 $200,000
21. Maintenance
& cleaning
No of batch runs $1,150 50 $57,500
Total $552,500
Table 5B. ABC Stage-1 allocation (batch level allocation) for Product B: Activity pools, cost drivers, cost per cost driver unit, and total cost for these activities.

When each product’s activity pool cost totals are known, the analysts can then calculate the cost per product unit, as Table 5C shows. To find product unit costs, the analyst divides the activity pool cost totals by the number of product units. In ABC, the process of finding product unit costs is stage-2 allocation, or product level allocation.

Stage 2 allocation in ABC: Allocating activity pools to product units

Activity Pool

Total Indirect Cost
Product A
[From Table 5A]
Cost per product unit
Product A
Total Indirect cost Product B
[From Table 5B]
Cost per product unit
Product A
Total indirect cost
A+B
17. Purchase orders $135,000 $0.15 $45,000 $0.02 $180,000
18. Machine set ups $225,000 $0.25 $150,000 $0.07 $150,000
19. Product packaging $180,000 $0.20 $100,000 $0.05 $280,000
20. Machine testing
& calibration
$100,000 $0.11 $200,000 $0.09 $300,000
21. Maintenance
& cleaning
$230,000 $0.26 $57,500 $0.03 $57,500
Total $870,000 $0.97 $552,500 $0.26 $1,422,500
Table5C. Stage-2 allocation in ABC: Allocating activity pool costs to individual product units. The cost per product unit figures for product A and product B (second and fourth columns) derive d from the cost sums for each activity pool (first and third columns) divided by the number of product units produced and sold for each product (Table 2, line 1).

The total product unit costs for each product correspond to the total indirect costs for each product from the traditional costing approach.

Finding overhead costs per unit in ABC

Table 6 below shows how these costs contribute to the new version of profitability calculations for each product.

Products Compared

Product A Product B Total
22. Units produced and
sold  [Table 2, line 1]
900,000 2,100,000 3,000,000
23. Total direct costs
[Table 2, line 8]
$1,125,000 $2,100,000 $3,225,000
24. Total overhead costs
[Table 5C, line 21 ]
$870,000 $552,500 $1,422,500
25. Revenues per unit
[ Table 2, line 2 ]
$3.00 $2.00
26. Direct costs / unit
[ = 23 / 22 ]
$1.25 $1.00
27. Overhead costs / unit
[ = 24 / 22 ]
$0.97 $0.26
28. Gross profit / unit
[ = 25 −26 − 27 ]
$0.78 $0.26
29. Gross profit margin
[ = 28 / 25 ]
26.1% 36.8%
Table 6. Gross profit and gross margin calculation for each product, using activity based costing for indirect, or overhead costs.

Conclusions: Activity based costing example.

  • Estimated Indirect (overhead) cost per unit is quite different for each product, unlike the traditional costing example above where indirect costs per unit were the same for both products. This approach recognizes that product A uses more activity pool resources than product B.
  • On a per unit basis, ABC finds product B more profitable than product A. The gross margin rate of 36.8% for B compares with a gross margin of 26.1% for A.

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