Activity-Based Costing: A
Tool to Aid Decision Making
Chapter Eight
© 2006 McGraw-Hill Ryerson Ltd.
Learning Objectives
After studying this chapter, you should be able to:
1. Describe activity-based costing and how it differs
from a traditional costing system.
2. Assign costs to cost pools using a first-stage
allocation.
3. Compute activity rates for cost pools.
4. Assign costs to a cost object using a secondstage allocation.
© 2006 McGraw-Hill Ryerson Ltd.
Learning Objectives
After studying this chapter, you should be able to:
5. Prepare a report showing activity-based costing
product margins from an activity view.
6. Compare product costs computed using
traditional and activity-based costing methods.
7. (Appendix 8A) Prepare an action analysis report
using activity-based costing data and interpret
the report.
© 2006 McGraw-Hill Ryerson Ltd.
Activity Based Costing (ABC)
ABC is designed to
provide managers with
cost information for
strategic and other
decisions that
potentially affect
capacity and therefore
affect fixed as well as
variable costs.
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ABC is a
good supplement
to our traditional
cost system
I agree!
How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
Manufacturing
costs
Nonmanufacturing
costs
Traditional
product costing
ABC
product costing
 ABC assigns both types of costs to products.
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How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
Traditional
product costing
Nonmanufacturing
costs
Some
All
Manufacturing
costs
ABC
product costing
 ABC does not assign all manufacturing costs to products.
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How Costs are Treated Under
Activity–Based Costing
Level of complexity
“Best practice” ABC differs from traditional costing in five ways.
Activity–Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
Number of cost pools
 ABC uses more cost pools.
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How Costs are Treated Under
Activity–Based Costing
Number of
Allocation Bases
“Best practice” ABC differs from traditional costing in five ways.
Bases usually
rely solely on
volume
measures.
Traditional Costing
ABC
 ABC uses more allocation bases.
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Volume
measures
plus other
bases.
How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
The most commonly used allocation base
in traditional costing is direct labour hours.
Direct labour hours work
well when overhead
increases as direct
labour hours increase.
 ABC uses more allocation bases.
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How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
The most commonly used allocation base
in traditional costing is direct labour hours.
Problems:
 In many processes, overhead is increasing
while direct labour is decreasing.
 Variety and complexity of products is increasing.
 ABC uses more allocation bases.
© 2006 McGraw-Hill Ryerson Ltd.
How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
All overhead
costs are not related
to volume measures like
direct labour
hours.
ABC uses
volume as well as
other allocation bases not
related to the volume
of production.
 ABC uses more allocation bases.
© 2006 McGraw-Hill Ryerson Ltd.
How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
Traditional Costing
ABC
The predetermined
overhead rate is based
on budgeted activity.
This results in applying
all overhead costs
including unused, or
idle capacity costs to
products.
Products are charged
for the costs of
capacity they use – not
for the costs of
capacity they don’t
use. Unused capacity
costs are treated as
period expenses.
 ABC bases level of activity on capacity.
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Characteristics of Successful
ABC Implementations
Strong top
management support
Link to evaluations
and rewards
Cross-functional
involvement
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Designing an ABC System
Cost Objects
(e.g., products
and customers)
Activities
Consumption
of Resources
Cost
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Designing an ABC System
Steps for Implementing ABC
Identify and define activities and activity cost
pools.
Trace costs to activities and cost objects.
Assign costs to activity cost pools.
Calculate activity rates.
Assign costs to cost objects.
Prepare management reports.
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Identify and Define Activities
and Activity Cost Pools
Unit-Level
Activity
Batch-Level
Activity
Manufacturing
companies typically combine
their activities into five
classifications.
Product-Level
Activity
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Organizationsustaining
Activity
Customer-Level
Activity
Identify and Define Activities
and Activity Cost Pools
Activities
should only be
combined within a level
if they are highly
correlated.
When combining
activities, they should be
grouped together only at
the appropriate
level.
© 2006 McGraw-Hill Ryerson Ltd.
Identify and Define Activities
and Activity Cost Pools
An Activity Cost
Pool is a “bucket” in
which costs are
accumulated that
relate to a single
activity measure in
the ABC system.
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$$
$
$ $
$
Identify and Define Activities
and Activity Cost Pools
Two types of activity measures:
Transaction
driver
Duration
driver
Simple count
of the number of
times an activity
occurs.
A measure
of the amount
of time needed
for an activity.
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Identify and Define Activities
and Activity Cost Pools
At Classic Brass, the ABC team, selected the following
activity cost pools and activity measures:
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Identify and Define Activities
and Activity Cost Pools
• Customer Orders - assigned all costs of resources
that are consumed by taking and processing
customer orders.
• Product Designs - assigned all costs of resources
consumed by designing products.
• Order Size - assigned all costs of resources
consumed as a consequence of the number of units
produced.
• Customer Relations – assigned all costs associated
with maintaining relations with customers.
• Other – assigned all overhead costs that are not
associated with the other cost pools.
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When Possible, Directly Trace Overhead
Costs to Activities and Cost Objects
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Assign Costs to Activity Cost Pools
At Classic Brass the following distribution of resource
consumption across activity cost pools is determined.
**Not included because they are directly traced to customer orders.
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Assign Costs to Activity Cost Pools
Indirect factory wages
$500,000
Percent consumed by customer orders
25%
$125,000
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Assign Costs to Activity Cost Pools
Factory equipment depreciation
$300,000
Percent consumed by customer orders
20%
$ 60,000
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Assign Costs to Activity Cost Pools
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Calculate Activity Rates
The ABC team determines that Classic Brass will
have these total activities for each activity cost
pool . . .
 1,000 customer orders,
 200 new designs,
 20,000 machine-hours,
 100 customer relations activities.
Now the team can compute the individual
activity rates by dividing the total cost for
each activity by the total activity levels.
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Calculate Activity Rates
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Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labour
Shipping
Costs
Traced
Traced
Traced
Cost Objects:
Products, Customer Orders, Customers
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Overhead Costs
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labour
Shipping
Costs
Overhead Costs
First-Stage Allocation
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Cost Objects:
Products, Customer Orders, Customers
© 2006 McGraw-Hill Ryerson Ltd.
Other
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labour
Shipping
Costs
Overhead Costs
First-Stage Allocation
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Other
Second-Stage Allocations
$/MH
$/Order
$/Design
$/Customer
Cost Objects:
Products, Customer Orders, Customers
© 2006 McGraw-Hill Ryerson Ltd.
Unallocated
Assigning Costs to Cost Objects
Let’s take a look at how our system works
for just one customer – Windward Yachts.
Standard Stanchions (no design required)
1. 400 units ordered with 2 separate orders.
2. Each stanchion required 0.5 machine-hours.
3. Selling price is $34 each.
4. Direct materials total $2,110.
5. Direct labour totals $1,850.
6. Shipping costs total $180.
© 2006 McGraw-Hill Ryerson Ltd.
Custom Compass Housing (requires new design)
1. One order during the year.
2. Each housing required 4 machine-hours.
3. Selling price is $650 each.
4. Direct materials total $13.
5. Direct labour totals $50.
6. Shipping costs total $25.
Assigning Costs to Cost Objects
The customer-level
cost is assigned to
customers directly;
it is not assigned to
products.
© 2006 McGraw-Hill Ryerson Ltd.
Prepare Management Reports
Standard Stanchions
Sales
Cost:
Direct materials
Direct labour
Shipping costs
Customer orders
Product design
Order size
Product margin
$
13,600
$
8,570
5,030
$ 2,110
1,850
180
630
3,800
Custom Compass Housing
Sales
Cost:
Direct materials
Direct labour
Shipping costs
Customer orders
Product design
Order size
Product margin
© 2006 McGraw-Hill Ryerson Ltd.
$
$
13
50
25
315
1,285
76
650
1,764
$ (1,114)
Prepare Management Reports
Customer Profitability Analysis
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Product Margins
Traditional Cost Accounting System
400 units x 0.5 MH/unit x $50/MH = $10,000
Predetermined manufacturing
=
overhead rate
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$1,000,000
20,000 MH
= $50/MH
Differences Between ABC and
Traditional Product Costs
Product margins are different for four reasons:
 Traditional costing assigns design costs to both products
based on machine hours. ABC assigns product design
costs to a product only if product design work is required.
 Traditional costing assigns customer order costs, a batchlevel cost, using a unit-level allocation base, machine hours.
ABC assigns these batch-level costs using a batch-level
activity measure.
 Traditional costing assigns only manufacturing costs to
products. ABC also assigns nonmanufacturing costs to
products.
 Traditional costing assigns all manufacturing costs to
products. The ABC system does not assign organizationsustaining manufacturing costs to the products.
© 2006 McGraw-Hill Ryerson Ltd.
Differences Between ABC and
Traditional Product Costs
When batch-level and
product-level costs are present,
ABC will usually shift costs from high
volume products, produced in large batches,
to low volume products produced in small batches.
This cost shifting will usually have its
greatest impact on the per
unit cost of the low
volume products.
© 2006 McGraw-Hill Ryerson Ltd.
Targeting Process Improvement
Activity-based management is
used in conjunction with ABC to
identify areas that would benefit
from process improvements.
While the theory of constraints
approach discussed in Chapter 1 is a
powerful tool for targeting
improvement efforts, activity rates
can also provide valuable clues on
where to focus improvement efforts.
© 2006 McGraw-Hill Ryerson Ltd.
Activity-Based Costing and External Reporting
Most companies do not use ABC
for external reporting because . . .
1. External reports are less detailed than internal
reports.
2. It may be difficult to make changes to the company’s
accounting system.
3. ABC does not conform to GAAP.
4. Auditors may be suspect of the subjective allocation
process based on interviews with employees.
© 2006 McGraw-Hill Ryerson Ltd.
ABC Limitations
Substantial resources
required to implement
and maintain.
Resistance to
unfamiliar numbers
and reports.
Desire to fully
allocate all costs
to products.
Potential
misinterpretation of
unfamiliar numbers.
Does not conform to
GAAP. Two costing
systems may be needed.
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Review Problem
Activity-Based Costing
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Review Problem
Ferris Corporation makes a single product – a fireresistant commercial filing cabinet – that it sells to office
furniture distributors. The company has a simple ABC
system that it uses for internal decision making. The
company has two overhead departments, for which the
costs are listed below:
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Review Problem
The company’s ABC system has the following
activity cost pools and activity measures:
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Review Problem
Costs assigned to the Other activity cost pool
have no activity measure; they consist of the
costs of unused capacity and organizationsustaining costs – neither of which are assigned
to products, orders, or customers.
Ferris Corporation distributes the costs of
manufacturing overhead and selling and
administrative overhead to the activity cost
pools based on employee interviews, the results
of which are reported on the next slide:
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Review Problem
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Review Problem
1. Perform the first-stage allocation of overhead costs to
the activity cost pools as in Exhibit 8-5.
2. Compute activity rates for the activity cost pools as in
Exhibit 8-6.
3. OfficeMart is one of Ferris Corporation’s customers,
Last year, OfficeMart ordered filing cabinets four
different times. OfficeMart ordered a total of 80 filing
cabinets during the year. Construct a table as in
Exhibit 8-9 showing the overhead costs of these 80
units and four orders.
© 2006 McGraw-Hill Ryerson Ltd.
Review Problem
4. The selling price of a filing cabinet is $595. The cost
of direct materials is $180 per filing cabinet, and direct
labour is $50 per filing cabinet. What is the product
margin on the 80 fling cabinets ordered by
OfficeMart? How profitable is OfficeMart as a
customer? See Exhibit 8-10 for an example of how to
complete this report.
© 2006 McGraw-Hill Ryerson Ltd.
Appendix 8A: ABC Action Analysis
Conventional ABC analysis does not
identify potentially relevant costs. An
action analysis report helps because it:
• Shows what costs have been
assigned to a cost object.
• Indicates how difficult it would be to
adjust those costs in response to
changes in the level of activity.
© 2006 McGraw-Hill Ryerson Ltd.
Appendix 8A: ABC Action Analysis
Constructing an action analysis report
begins with the first-stage allocation
process. In addition to computing an
overall activity rate for each activity cost
pool, an activity rate is computed for each
type of overhead cost that is consumed
supporting a given activity.
Let’s revisit the stage-one allocations
from the Classic Brass example that we
discussed earlier.
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Appendix 8A: ABC Action Analysis
$125,000 ÷ 1,000 orders = $125 per order
Other entries in the table are computed similarly.
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Appendix 8A: ABC Action Analysis
$125 per order × 2 orders = $250
Other entries in the table are computed similarly.
© 2006 McGraw-Hill Ryerson Ltd.
Appendix 8A: ABC Action Analysis
$125 per order × 1 orders = $125
Other entries in the table are computed similarly.
© 2006 McGraw-Hill Ryerson Ltd.
Appendix 8A: ABC Action Analysis
Next, label each cost using an ease of adjustment
code:
• Green costs adjust more or less automatically to
changes in activity level without any action by
managers.
• Yellow costs can be adjusted to changes in activity
level, but it would require management action to
realize the change in cost.
• Red costs can be adjusted to changes in activity
level only with a great deal difficulty and with
management intervention.
© 2006 McGraw-Hill Ryerson Ltd.
Appendix 8A: ABC Action Analysis
Action Analysis of Custom Compass Housing
Sales
Green costs
Direct materials
Shipping costs
Green margin
Yellow costs
Direct labor
Indirect factory wages
Factory utilities
Administrative wages and salaries
Office equipment depreciation
Marketing wages and salaries
Selling expenses
Yellow margin
Red costs
Factory equipment depreciation
Factory building lease
Administrative building lease
Red margin
© 2006 McGraw-Hill Ryerson Ltd.
$
$
650
$
38
612
13
25
50
1,145
72
168
15
175
5
96
-
1,630
$ (1,018)
96
$ (1,114)
End of Chapter 8
© 2006 McGraw-Hill Ryerson Ltd.