ACTIVITY BASED COSTING
Learning Objectives
Discuss the importance of unit costs
Describe the functional-based costing
approach
Explain why functional-based costing
approaches may produce distorted costs
Explain how an activity-based costing system
works
Learning Objectives (continued)
Provide a detailed description of how
activities can be grouped into
homogeneous sets to reduce the
number of activity rates.
Describe the role of activity-based
costing for organizations with only one
product, homogeneous products, or a
JIT structure.
Costing Review
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The unit cost is the total cost associated with the
units produced divided by the number of units
produced
A functional-based costing system assigns costs
using only unit level drivers (those tied directly to
production such as machine hours or units
produced)
A predetermined overhead rate is calculated and
used to allocate expenses
An activity-based costing system isolates costs by
activities (such as taking orders, shipping, etc.)
that are not necessarily related to unit-level
drivers
Signs that a functional based costing
system is providing inaccurate data
The outcome of bids is difficult to explain.
Competitors’ prices appear unrealistically
low.
Products that are difficult to produce show
high profits.
Operational managers want to drop products
that appear profitable.
Symptoms of an Outdated Functional
Cost System (continued)
The company has a highly profitable niche all
to itself.
Customers do not complain about price
increases.
Some departments are using their own
accounting system.
What Gave Rise to ABC?
In the early 1980’s:
Direct labor becoming a smaller percentage
of total manufacturing cost
Cost (overhead) allocations based on direct
labor became increasingly inaccurate
Traditional cost accounting systems valued
inventory for external reporting purposes
Increasing pressures on product costing
Types of Allocation
Plant-wide Allocation
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simplest method
entire plant = cost pool
note: the term plant is used, but doesn’t have to be
a plant; can be hospital, school, store etc.
Departmental Allocation
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a separate cost pool for each department
Activity Centers

a cost pool for each part of a company that performs
some easily described activity
Which Allocation Method to Use?
Decision based on cost-benefit

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Plant-wide methods cost the least but provide the
least information
Maintaining cost pools by activity center costs the
most but provides the most information
Do the benefits justify the costs?
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Is the data needed attainable?
What is the cost of collecting data?
What is the cost of processing more data?
Factors That Impair Accuracy of Functional Rates
Non-unit- related OH costs

Activities that are not performed each time a
unit of product is produced
 Machine Setups (occur for each batch)
 Costs increase for each additional setup, not an
additional unit of product
Product Diversity

Different products consume overhead
activities in different proportions
 Labor intensive products vs. machine intensive
Benefits of an ABC System
ABC provides:
more detailed measures of costs than plantwide or departmental allocation methods
more accurate product costs for marketing
decisions

pricing; products to keep; products to discontinue
better information to production managers
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costs of each activity
identifies previously unknown cost drivers
vehicle to promote teamwork among
accounting, production, marketing,
management
4 Steps of Activity-Based-Costing
 Identify activities that consume resources and
assign costs to those activities
 Identify cost driver(s) associated with each
activity

cost driver = factor that causes or “drives” an
activity’s costs
 Compute a cost rate per unit (of cost driver)
 Assign costs to products

Multiply the cost driver rate times the volume
(amount) of cost driver units consumed by
product
4 Steps of ABC - Example
Identify activities & assign costs to those activities
 Purchasing materials
 Accounting costs related to purchasing
Identify cost driver(s) associated with each activity

Number of orders
Compute a cost rate per unit (of cost driver)

Processing costs per purchase order
Assign costs to products
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Costs/purchase order x # of orders for October
More About the 4 Steps of ABC
Step 1:
Identify activities and assign costs to those
activities
 Most interesting and challenging step
 Requires people understand all of the activities
required to make the product
 Managers attempt to identify those activities
that have the greatest impact on costs
More on the 4 Steps of ABC Cont’d
Step 2:
Identify cost driver(s) associated with each
activity

Examples of cost drivers
Miles driven Pages typed
Flight hours Computer time
Rework OrdersCustomers served
Machine setups
Number of surgeries
Quality inspections
How to Decide Which Driver to Use?
Causal Relation
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Choose cost driver that causes costs
Not always feasible as indirect costs are generally not
causally linked to a cost object
Benefits Received
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Choose cost driver so that costs are assigned in
proportion to the benefits received
Reasonableness
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Costs that can not be linked based on causality or
benefits received
More on the 4 Steps of ABC (Cont)
Step 3: Compute a cost rate per unit (of cost
driver)
Predetermined indirect cost (driver) rate:
Estimated indirect cost
Estimated activity driver
Step 4: Assign costs to products
Cost driver rate x volume (amount)
consumed by product = Costs assigned
Belring, Inc.
– Activity Usage
Cordless
Regular
Total
Units produced per year 10,000
100,000
110,000
$78,000
$738,000
$816,000
10,000
90,000
100,000
5,000
45,000
50,000
Production runs
20
10
30
Number of moves
60
30
90
Prime costs
Direct labor hours
Machine hours
Belring, Inc. – Additional OH Cost Data
Activity
Setups
Material handling
Machining
Testing
Total
Activity Cost
$120,000
60,000
100,000
80,000
$360,000
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Belring, Inc. – Activity Rates
Activity rates are computed below:
Setup rate:
$120,000/30 =$4,000 per run
Material-handling rate: $60,000/90 = $666.67 per move
Machining rate:
$100,000/50,000 = $2 per MH
Testing rate:
$80,000/100,000 = $0.80 per DLH
Belring, Inc. – Activity-Based Costing
Unit Cost Computation
Prime costs
Overhead costs:
Setups
Material handling
Machining
Testing
Total mfg. costs
Units produced
Unit cost
Cordless
$ 78,000
Regular
$ 738,000
80,000
40,000
10,000
8,000
$216,000
 10,000
$ 21.60
40,000
20,000
90,000
72,000
$ 960,000
 100,000
$
9.60
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ABC - Not an Easy Process
Conversion to ABC takes a lot of time and resources
General process:
 Interview employees
 Collect data
 on time, activities, resources, activity attributes
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Build initial model of ABC system
Cost-out the activities
Test model
Prepare analysis; Report to management;
Implementation
Just-in-time Manufacturing
Having only as much as you need only
when you need it
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eliminate waste by not keeping excess
moves costs to suppliers
allows for easier product costing because
there is less to cost and the costs that are
present are easier to trace to products