Activity-Based Costing - University of North Florida

Chapter 36
Managerial Accounting
Activity-Based Costing
Prepared by Diane Tanner
University of North Florida
Activity-Based Costing
 What is activity-based costing?
A system of allocating indirect costs to cost objects
Utilizes multiple cost pools
Is used with normal costing
Based on activities that drive costs rather than on volumebased denominators
 Primarily used to allocated manufacturing overhead
 Sometimes used to allocate support department costs to
Underlying Premises
Activities underlie costs.
Comparing ABC and Traditional Costing
 Advantages of ABC over traditional costing
 ABC results in more accurate costing.
 ABC helps managers control costs better.
 ABC considers the fact that only products that use
particular resources are assigned costs.
 ABC mitigates overcosting and undercosting of cost
 Disadvantages of ABC
 Very expensive to implement
 No separation of fixed and variable costs which makes
incremental analysis difficult
Setting Up an ABC System
 Step 1: Determine the cost object.
 Step 2: Form cost pools.
 The costs of performing a particular activity are
grouped into a cost pool.
 All costs in a pool should have the same cause.
 Step 3: Select a cost driver that has a causeand-effect relationship with the costs to be
How to Perform ABC
Step 1: Calculate the rate for each cost pool.
Estimated Cost / Estimated Activity = Rate
Step 2: Multiply each cost pool rate times the
respective actual activity to determine
allocated costs.
Step 3: Total up the allocated costs from step 2.
This results in the applied overhead cost.
Step 4: Add the allocated costs to the direct costs
of each cost object to obtain the total cost of
each cost object.
Considerations of ABC
 Complete analysis requires allocation beyond
manufacturing costs to include
 Activity can be measured on practical capacity,
actual capacity, or other estimate
 Practical capacity preferred over actual capacity
 Does not hide the cost of idle capacity within product
 Gives a truer cost of activities used to produce the
ABC Implementation Issues
 After switching to ABC, companies may find
that only 10 to 15% of their products are
 Causes management to alter the product mix by
minimizing unprofitable products which causes
profits to increase
 Implementation mirrors the complexity of the
 Complete conversion to ABC requires auditors
to accept the system when used for financial
Activity-Based Management
 A tool in which managers analyze activities that cause
indirect costs of products or services
 Goal is to improve efficiency and effectiveness of the
activities in order to reduce costs
 Serves as the basis for numerous process
improvement programs of companies
 Helps focus managerial attention on what is most
important among the activities performed to create
value for customers
Overcosting and Undercosting
 Occurs due to broad, equal costs allocated to all
Overhead allocated under ABC
is greater than if traditional is
Overhead allocated under ABC
is less than if traditional is used
A product consumes a relatively
high level of resources but is
reported to have a relatively
low total cost
A product consumes a relatively
low level of resources but is
reported to have a relatively
high total cost
ABC Vs. Traditional Costing Example
A complete walk through problem using Excel is
presented in a separate video.
The End