Activity based costing (ABC)
ABC is a costing method that is designed to provide managers with cost information for strategic
and other decisions that potentially affect capacity and therefore "fixed cost". It is used to
determine product costs for special management reports. This system is ordinarily used as a
supplement to the company's usual costing system. Most organizations that use ABC system
have two costing systems--the official costing system that is used for preparing external financial
reports and the activity based costing system that is used for internal decision making and for
managing activities.
In activity based costing:
 Non-manufacturing as well as manufacturing costs may be assigned to products.
 Some manufacturing costs may be excluded from product costs.
 A number of overhead cost pools are used, each of which is allocated to products
and other costing objects using its own unique measure of activity.
 The allocation bases often differ from those used in traditional costing system.
 The overhead rates or activity rates may be based on the level of activity at
capacity rather than on the budgeted level of activity.
These differences from traditional cost accounting systems can dramatically impact the apparent
costs of products and the profitability of products and customers.
First, the initiative to implement activity based costing must be strongly supported by top
management.
Second, the design and implementation of activity based costing system should be the
responsibility of a cross functional team rather than of the accounting department. The team
should include representatives from each area that will use the data provided by the activity
based costing system.
Ordinarily, this would include representatives from marketing, production, engineering and top
management as well as technically trained accounting staff. An outside consultant who
specializes in activity based costing system serve as an advisor to the team.
Implementation of activity based costing system must be initiated by top management due to two
reasons. First, without leadership from top management, some managers may not see any reason
to change. Second, if top managers do not support the ABC system and continue to play the
game by the old rules, their subordinates will quickly get the message that ABC is not important
and they will abandon the ABC initiative. Time after time, when accountants have attempted to
implement an ABC system on their own with top-management support and active cooperation
from other managers, the results have been ignored.
For designing and implementing activity based costing system, management should carefully
study the existing cost accounting system and review the articles in professionals and trade
journals.
The following chart explains the general structure of activity based (ABC) costing model.
The Activity Based Costing Model
Cost Objects
(e.g., products and customers)

Activities

Consumption of Resources

Cost
Usually, company's traditional cost accounting system adequately measures the direct
material and direct labor costs of products since these costs are directly traced to products. In
most of the organizations activity based costing study is usually concerned solely with the other
costs of the company - manufacturing overhead and selling, general, and administrative costs.
The activity based costing implementation team should carefully plan about implementing
activity based costing. Implementation process may be broken down into the following six basic
steps.
Steps for implementing activity based costing system:
1. Identify and define activities and activity cost pools.
2. Wherever possible, directly trace costs to activities and cost objects.
3. Assign costs to activity cost pools.
4. Calculate activity rates.
5. Assign costs to cost objects using the activity rates and activity measures.
6. Prepare management reports.
The activity based costing systems, described by Robin Cooper and Robert Kaplan in the 1980's
and 1990's, has attracted much attention. These systems identifies the major activities of a
facility's production process and then classifies these activities into one of the following
categories:




Unit-level activities;
Batch-level activities;
Product-sustaining level activities
Facility-sustaining level activities.
The unit-level activities are performed each time a unit of a product is produced. The number of
times unit-level activities (such as drilling holes and inspecting every part) are performed varies
according to the number of units produced.
The batch-level activities are performed each time a batch of goods is produced. The number of
times batch-level activities (such as setting up a machine) are performed varies according to the
number of batches made. The costs of these activities can be assigned to individual batches but
they are fixed regardless of the number of units in the batch.
Product-sustaining activities are performed as needed to support the production of each
different type of product. Examples of product-sustaining activities are maintaining product
specifications, performing engineering change notices and developing special testing routines.
These costs can be assigned to individual products but are not proportional to the number of units
or batches produced.
Facility-sustaining activities support a facility's general manufacturing process. Examples of
facility-sustaining activities are lighting and cleaning the facility, facility security and managing
the facility.
The costs of the unit-level, batch-level and product-sustaining level activities are attributed to
products based on each product's consumption of those activities. The costs of facility-sustaining
activities are allocated to products arbitrarily or treated as period costs.
Ferris Corporation makes a single product - a fire resistant 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 whose costs are listed
below:
Manufacturing overhead
Selling and administrative overhead
$500,000
$300,000
Total overhead costs
$800,000
The company's activity based costing system has the following activity cost pools and activity
measures:
Activity Cost Pool
Assembling units
Processing orders
Supporting customers
Other
Activity Measures
Number of units
Number of orders
Number of customers
Not applicable
Costs assigned to the "other" activity cost pool have no activity measure; they consist of the costs
of unused capacity and organization-sustaining costs - neither of which are assigned to products,
orders or customers.
Ferris Corporation distributes the costs of manufacturing overhead and of selling and
administrative overhead to the activity cost pools based on the feedback from employees
interviewed, the results of which are reported below:
Distribution of Resource Consumption Across Activity Cost Pools
Assembling Processing
Supporting
Other
Units
Orders
Customers
Manufacturing overhead
50%
35%
5%
10%
Selling and administrative overhead
10%
45%
25%
20%
Total activity
1,000 units
250 orders 100 customers
--
Total
100%
100%
--
Required:
1. Perform the first stage allocation of overhead costs to the activity cost pools.
2. Compute activity rates for the activity cost pools.
OfficeMart is one of the Ferris Corporation's customers. Last year OfficeMart ordered filing
cabinets four different times. OfficeMart ordered a total of 80 cabinets during the year. Construct
a table showing the overhead costs of these 80 units and four orders.
Solution:
1.
The first stage allocation of costs to the activity cost pools appears below:
Activity Cost Pools
Assembling
Units
Manufacturing overhead
$250,000
Selling and admin. overhead
30,000
Total activity
$280,000
Processing
Orders
$175,000
135,000
Supporting
Customers
$25,000
75,000
Other
Total
$50,000
60,000
$500,000
300,000
$310,000
$100,000
$110,000
$800,000
2. The activity rates for the activity cost pools are:
Activity Cost Pools
Assembling units
Processing orders
Supporting customers
Total Cost
$280,000
$310,000
$100,000
Total Activity
1,000 units
250 units
100 customers
Activity Rate
$280 per unit
$1,240 per order
$1,000 per customer
3. The overhead cost for the four orders of a total of 80 filing cabinets would be computed as follows:
Activity Cost Pools
Assembling units
Processing orders
Supporting customers
Total Cost
$280 per unit
$1,240 per order
$1000 per customer
Total Activity
80 units
4 units
Not applicable
Activity Rate
$22,400
$4,960
4. The product and customer margin can be computed as follows:
Filing Cabinet Product Margin:
Sales ($595 per unit × 80 units)
Cost:
Direct materials ($180 per unit × 80 units)
Direct materials ($50 per unit × 80 units)
Volume related overhead (above)
Order related overhead (above)
$47,600
$14,400
4,000
22,400
4,960
45,760
$1,840
==========
Customer Profitability Analysis - OfficeMart
Product margin (above)
Less: Customer support overhead (above)
$1,840
1,000
$840
Advantages of Activity Based Costing System:
Activity based costing system has the following main advantages / benefits:
1. More accurate costing of products/services, customers, distribution channels.
2. Better understanding overhead.
3. Easier to understand for everyone.
4. Utilizes unit cost rather than just total cost.
5. Integrates well with continuous improvement programs.
6. Makes visible waste and non-value added activities.
7. Supports performance management and scorecards
8. Enables costing of processes, supply chains, and value streams
9. Activity Based Costing mirrors way work is done
10. Facilitates benchmarking
Disadvantages or Limitations of Activity Based Costing System:
Activity based costing system help managers manage overhead and understand profitability of
products and customers and therefore is a powerful tool for decision making. However activity
based costing has a number of limitations or disadvantages.
These limitations or disadvantages are briefly discussed below:
1. Implementing an ABC system is a major project that requires substantial resources. Once
implemented an activity based costing system is costly to maintain. Data concerning
numerous activity measures must be collected, checked, and entered into the system.
2. ABC produces numbers such as product margins, that are odds with the numbers produced
by traditional costing systems. But managers are accustomed to using traditional costing
systems to run their operations and traditional costing systems are often used in performance
evaluations.
3. Activity based costing data can be easily misinterpreted and must be used with care when
used in making decisions. Costs assigned to products, customers and other cost objects are
only potentially relevant. Before making any significant decision using activity based costing
data, managers must identify which costs are really relevant for the decisions at hand.
4. Reports generated by this system do not conform to generally accepted accounting
principles (GAAP). Consequently, an organization involved in activity based costing should
have two cost systems - one for internal use and one for preparing external reports.