Week 7 Activity based costing
Problems with conventional product costing system
• Problems 1: Features of conventional product costing systems
– Direct material and direct labour costs are traced to products
– Manufacturing overhead costs are allocated to products using a predetermined
overhead rate (plant wide or departmental)
– Manufacturing overhead rate is calculated using some measure of production volume
– Non-manufacturing costs are not assigned to products
• Problems 2: Failure to adapt to the changing business environment
– Manufacturing overhead is increasing as a proportion of total manufacturing costs.
– Increasing levels of non-volume-driven manufacturing overhead costs.
– Increasing proportions of non-manufacturing costs.
– Causes of changes in costs include: increased automation, increasing product diversity,
increased customer demand for improved service, quality and customer support.
Indicators of Problems with a Product Costing System
– Conventional product costing systems are likely to result in inaccurate product costs
▪ the proportion of direct labour costs decreases.
▪ the proportion of manufacturing overhead costs increases.
▪ the proportion of manufacturing overhead costs, not related directly to production
▪ non-manufacturing costs that are product-related become substantial.
▪ product diversity increases.
• Problems 3: Costing in service firms:
– Service firms tend to use firm-wide, volume-based overhead rates
▪ Overhead costs are increasing and are increasingly non-volume driven.
– Customers are demanding a more diverse range of higher quality services
▪ Increases in service diversity and quality increase the level of non-volume-driven
▪ Service costs derived from conventional product costing systems may be inaccurate.
Activity based costing
A methodology that can be used to measure both the cost of cost objects and the
performance of activities.
Can help solve problems such as
– Distorted product costs
– Poor cost control Activity Based Costing Model:
The costing view
- measures the cost of activities & assigns activity costs to products.