Activity-Based Costing
Better Costing for Better Decisions
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Indirect Costs

Not easily and conveniently traceable to cost
objects

Cost element is shared among cost objects

Physically impossible to trace

Not cost effective to trace
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Indirect Costs

Need for allocation

Estimate product or activity cost


Increase awareness of indirect costs


What does it really cost?
Activities are not free
Plan more cost efficient operations

Now that we know what it costs, what should we do?
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Allocation of Indirect Costs

Typical allocation methods

Ability to bear

Fairness or equity

Benefits received

Cause and effect
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Traditional Allocation Method

Indirect costs allocated to cost object based
on the cost object’s consumption of some
measure of activity, usually labor hours
$10,000,000 total indirect cost
400,000 total labor hours
= $25 per hour rate
A product consuming 6 labor hours would be charged
$150 of indirect costs
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Criticisms of Traditional Overhead
Allocation

Assumes all overhead is volume-related

Factory-wide or departmental rates

All related to single activity measure

Departmental focus, not process focus

Focus on costs incurred, not cause of costs
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Activity-Based Costing

Purpose

Allocation of indirect costs based on causal
activities

Attempts to identify “direct” link between cost and cost
object

Results in better allocation

Does not provide “true” cost
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Activity-Based Costing

Traditional allocation method
Costs

Products
Activity-based allocation method
Costs
Activities
First stage
Products
Second stage
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Overview of ABC

Identifies activities required to produce the
product or service

Determines the cost of the activities

Allocates costs to the cost object based on
the object’s consumption of activities
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Levels of Cost Incurrence

Not all costs are volume-related

Unit level

Batch level

Product level

Facility level
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Operation of an ABC System


Assign costs to activity pools

First stage allocation

Identify the costs incurred to perform
various activities
Determine the measure of activity
best related to each cost pool

Cost drivers
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Operation of an ABC System

Determine rate per unit of activity

Assign costs to products/services based on
consumption of activities


Second stage allocation
Indirect costs are converted to direct costs
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Implementing ABC

Step 1 – Plan the system

What are the goals?

Inventory valuation

Process improvement

Foster active involvement

Assemble cross-functional team

Functional specialists
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Implementing ABC

Step 2 – Define, analyze activities and
resources

Decompose organization into elemental activities

Who does what, and why?

Interview employees

Determine resources

Determine inputs and outputs
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Implementing ABC

Gather statistics on activities

Inputs and outputs

Transaction, duration, intensity

For possible use as second-stage cost drivers
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Implementing ABC

Step 3 – Establish activity cost pools
and determine first stage allocation

First stage allocations assign costs to cost
pools

Requires costs to be re-categorized according
to why they are incurred, not by type

Drivers may be employee time, square footage,
etc.
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Implementing ABC

Step 4 – Determine second stage drivers and
assign costs to cost objects

Outputs of activity analysis may be second stage
drivers


Distance moved, times handled, machine hours, units,
etc.
Amount assigned to the cost object is the amount
of activity consumed times the rate per unit of the
activity
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When is ABC Most Useful?

High amounts of overhead cost

Multiple products

Complex products

Complex production system

Significant variation in volume between high
and low volume products
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When is ABC Most Useful?

Different products place different demands on
resources

Problems with current cost allocations due to
changes in products or processes

Better cost information is needed
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Activity-Based Management

Natural extension of ABC


Why are activities performed?

Are they necessary?

Are they consistent with organizational goals?
How are they performed?

Are they performed efficiently?

Can they be redesigned or eliminated?
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ABM for Process Improvement

Focus on problems, opportunities

Prioritize opportunities for improvement

Most critical

Greatest potential for cost savings
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ABM for Process Improvement

Determine and explain causes for problems
and opportunities


Cannot improve the system without first
understanding it
Select specific improvement projects
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ABM for Process Improvement

Use ABC/ABM data to test potential impact of
changes

Make changes

Iterate

Process of continual improvement
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Implications of ABC/ABM

Shifts focus from managing costs to
managing activities

Aids in recognizing, measuring and
controlling complexity

Promotes understanding of why costs
are incurred

Provides better cost allocation
information
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Implications of ABC/ABM

Useful for planning future operations

Fosters continuous improvement

Likely to meet with substantial
resistance

Analysis of why and how activities are
performed
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