Chapter 36
Managerial Accounting
Activity-Based Costing
Prepared by Diane Tanner
University of North Florida
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Activity-Based Costing
 What is activity-based costing?
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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
divisions
Underlying Premises
Activities underlie costs.
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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
objects.
 Disadvantages of ABC
 Very expensive to implement
 No separation of fixed and variable costs which makes
incremental analysis difficult
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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
allocated.
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.
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Considerations of ABC
 Complete analysis requires allocation beyond
manufacturing costs to include
nonmanufacturing
 Activity can be measured on practical capacity,
actual capacity, or other estimate
 Practical capacity preferred over actual capacity
because
 Does not hide the cost of idle capacity within product
costs
 Gives a truer cost of activities used to produce the
product
ABC Implementation Issues
 After switching to ABC, companies may find
that only 10 to 15% of their products are
profitable
 Causes management to alter the product mix by
minimizing unprofitable products which causes
profits to increase
 Implementation mirrors the complexity of the
organization
 Complete conversion to ABC requires auditors
to accept the system when used for financial
reporting
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
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Overcosting and Undercosting
 Occurs due to broad, equal costs allocated to all
products
Undercosting
Overcosting
Overhead allocated under ABC
is greater than if traditional is
used
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
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ABC Vs. Traditional Costing Example
A complete walk through problem using Excel is
presented in a separate video.
The End
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