ABC SYSTEM- Activity based costing system is a methodology to

identify each and every activity of a organization and assigning cost

to each activity. assigns manufacturing overhead costs to products
in a more logical manner than the traditional approach of simply
allocating costs on the basis of machine hours. Activity based
costing first assigns costs to the activities that are the real cause of
the overhead. It then assigns the cost of those activities only to the
products that are actually demanding the activities.
Activity based costing follows a two-stage procedure to assign
overhead costs to products.
STAGE ONE: Identify significant activities and assign overhead costs to each
activity in proportion to resources used. It includes cost hierarchy,
which is as follows
Unit level- This type of activity must be done for each unit of
production. Example, machine related activities.
Batch level- these activities must be performed for each
level of batch produced, rather than each unit.
Product-sustaining level- this category includes activities
that are needed to support an entire product line, rather than
a unit or a batch of product.
Facility level- facility level activities are required in order for
the entire production process to occur. Example, factory.

STAGE TWO: Identify cost drivers appropriate to each activity and allocate
overhead to the products.
To get a better understanding of the two stages, we can use an
example of Patio Grill company.
The costs and necessary details are given the chat below.

Overhead costs
Total budgeting costs- 4,896,000$

Activit
y
Cost
Pools

UNIT LEVEL

BATCH LEVEL

Product-sustaining level

Machine related
cost pool
$1,242,000

Setup cost
pool$210,000

Engineering design cost

pool
$130,000

Facility level
Facility cost pool
$2,300,000

Purchasi
ng cost
pool$300,000
Materialhandling
cost pool
$340,000
Quality
Assurance
cost pool
$110,000

These are the various activities that are identified in Patio Grill
Company in stage one and in stage two, each activitys cost drivers
are identified for each cost pool.

Activity

Activity
cost pool

Cost
driver

Cost
Pool
driver
rate
quantity

Machine $1242000 Machine 230000

hours
Related

Product Cost
line
driver
quantity
for
product
line
$5.40 Std
100000
Del
Ult
total

96000
34000
230000

Activity
cost for
product
line

Product
line
production
volume

$540000 10000

$54

518100 8000
183600 2000
1242000

64.80
91.80

ABC CALCULATIONS
First we will calculate pool rate for the machine related activity.
FORMULA Activity cost pool / Cost driver quantity = pool rate
Substituting the values in the equation
$ 1242000/230000 = $5.40
Now well compute the total activity cost for each product line
Product line

Pool rate

STD
DEL
ULT

$5.40
$5.40
$5.40

Cost driver
quantity for
each product
line
100000
96000
34000

Activity
cost
per
unit of
product

Activity cost for

each product
line
540000
518400
183600

Lastly the product cost per unit for each product line will be
calculated
FORMULA- Activity cost per product line/product line production
volume

Product line
STD
DEL
ULT

Activity cost for

each product
line
$540,000
518,000
183600

Product line
production
volume
10000
8000
2000

Activity cost
per unit of
product
$54
64.80
91.80

AIM OF ABC SYSTEM

. With ABC, a company can soundly estimate the cost elements of

entire products ACTIVITIES and services. That may help inform a
company's decision to either:
Identify and eliminate those products and services that are
unprofitable and lower the prices of those that are overpriced
(product and service portfolio aim)
Or identify and eliminate production or service processes that are
ineffective and allocate processing concepts that lead to the very
same product at a better yield (process re-engineering aim).
In a business organization, the ABC methodology assigns an
organization's resource costs through activities to the products and
services provided to its customers. ABC is generally used as a tool for
understanding product and customer cost and profitability based on the
production or performing processes. As such, ABC has predominantly
been used to support strategic decisions such as pricing, outsourcing,
identification and measurement of process improvement initiatives.