Chapter
4
Activity Based Costing:
A Tool to Aid Decision Making
TRADITIONAL COSTING
Allocates Costs Company-wide at One Rate
 Allocates overhead using a single predetermined
overhead rate.
Historically based on gross profit or relative sales.
Now often on direct labor or machine hours.
Process costing: Usuallybased on machine hours.
 Allocation accurately shows profitability of the
company as a whole.
Problem: Profitability of individual products may
not accurately reflect the effort and costs incurred.
ACTIVITY BASED COSTING
(ABC)
Both manufacturing
and nonmanufacturing
overhead costs are
assigned to
products.
There are a number
of cost pools each of
which is allocated
using a unique
measure of activity.
Some manufacturing
costs may be excluded
from product
costs.
Allocation bases often
differ from
traditional costing
systems.
Overhead rates may
be based on activity
at capacity.
Overhead rates based on Activities
Activity 1
Activity 2
Activity 3
A two stage process is
necessary because costs
are allocated to activities
and then to products.
Activities and Related Cost Drivers
Activity Cost Pool
is a “bucket” in
which costs are
accumulated that
relate to a single
activity in the ABC
system.
$$
$
$ $
$
Designing an ABC System
Steps for Implementing ABC
 Identify and define activities, activity cost pools,
and cost drivers.
 Trace identifiable costs to activities.
 Allocate overhead costs to activity cost pools.
 Calculate activity rates based on expected total
use of cost drivers.
 Assign costs to products.
Designing an ABC System
Identifiable
(Indirect) Costs
Activities
(Cost Pools)
Amount of
Activity Used
Overhead Costs
Costs Applied
ABC Overhead Rates
Stage One:
Costs assigned
to activity pools
Cost pools
Indirect
Labor
Indirect
Materials
Other
Overhead
Activity
1
Activity
2
Activity
3
ABC Overhead Rates
Stage One:
Costs assigned
to activity pools
Indirect
Labor
Indirect
Materials
Other
Overhead
Cost pools
Activity
1
Activity
2
Activity
3
Setups
Machine
Hours
Inspections
ABC Overhead Rates
Stage One:
Costs assigned
to activity pools
Indirect
Labor
Indirect
Materials
Other
Overhead
Cost pools
Activity
1
Activity
2
Activity
3
Setups
Machine
Hours
Stage Two:
Costs applied
to products
Products
Inspections
Traditional Costing vs ABC
 ABC does segregate overhead into various cost
pools to provide more accurate cost information.
 ABC supplements – it does not replace – the
existing traditional job order/process cost system.
 Why? Variances (over/under applied) would
become very complex and not very meaningful.
Activities and Related Cost Drivers
The Mechanics of ABC
One overhead cost - shipping - can be traced
directly to customer orders.
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)
Production Department
Indirect factory wages
$
Factory equipment depreciation
Factory utilities
Factory building lease
Shipping costs traced to customer orders
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total overhead costs
500,000
300,000
120,000
80,000
$
400,000
50,000
60,000
1,000,000
40,000
510,000
250,000
50,000
$
300,000
1,850,000
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Traced
$/DLH
Traced
Products or Customers
Overhead Costs
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Customer
Orders
(# of Orders)
Product
Design
Order
Size
Customer
Relations
(Mach Hrs)
(# of Customers)
Products or Customers
Other
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Customer
Orders
Product
Design
Order
Size
Customer
Relations
Other
Second-Stage Allocations
$/Order
$/Design
$/MH
Products or Customers
$/Customer
Unallocated
Assigning Costs to Activity Cost Pools
Management at Classic Brass believes overhead should be
distributed as follows:
Activity Cost Pools
Customer Product
Orders
Design
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
Shipping costs traced to customer order
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Order
Size
Customer
Relations
Other
Total
25%
20%
0%
0%
40%
0%
10%
0%
20%
60%
50%
0%
N/A
10%
0%
0%
0%
5%
20%
40%
100%
100%
100%
100%
100%
15%
30%
0%
5%
0%
0%
10%
0%
0%
30%
25%
0%
40%
45%
100%
100%
100%
100%
20%
10%
10%
0%
0%
0%
60%
70%
10%
20%
100%
100%
Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption of
overhead, costs are assigned to activity pools.
Activity Cost Pools
Customer Product
Orders
Design
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
$ 125,000
Order
Size
Customer
Relations
Other
Total
$
Indirect factory wages
$500,000
Percent consumed by customer orders
25%
$125,000
500,000
Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption of
overhead, costs are assigned to activity pools.
Activity Cost Pools
Customer Product
Orders
Design
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
$ 125,000
60,000
Order
Size
Customer
Relations
Other
Total
$
Factory equipment depreciation
$300,000
Percent consumed by customer orders
20%
$ 60,000
500,000
300,000
Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption of
overhead, costs are assigned to activity pools.
Activity Cost Pools
Customer Product
Orders
Design
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
Order
Size
Customer
Relations
Other
Total
$ 125,000
60,000
-
$ 200,000
12,000
-
$ 100,000
180,000
60,000
-
$ 50,000
-
$ 25,000
60,000
48,000
80,000
$
500,000
300,000
120,000
80,000
60,000
15,000
-
20,000
-
40,000
-
120,000
12,500
-
160,000
22,500
60,000
400,000
50,000
60,000
50,000
5,000
$ 315,000
25,000
$ 257,000
$ 380,000
150,000
35,000
$ 367,500
25,000
10,000
$ 490,500
250,000
50,000
$ 1,810,000
Computation of Activity Rates
The ABC team has determined that Classic
Brass has the following total activities for each
activity cost pool . . .
 1,000 customer orders,
 200 new designs,
 20,000 machine-hours
 100 customers.
Now the team can compute the individual
activity rates.
Simplified Approach to ABC
After the first-stage allocation is complete, computation
of activity rates for each activity cost pool can be
simplified as follows:
Computation of the Activity Rates
Customer
Product
Orders
Design
Costs from firststage allocation $ 315,000 $ 257,000
Total activity
÷ 1,000
÷ 200
Cost per unit
of activity
$
315 $
1,285
Customer
Order Size Relations
$ 380,000
÷ 20,000
$ 367,500
÷ 100
$
$
19
3,675
Other
$ 490,500
N/A
Computation of Activity Rates
Activity Cost Pools
1,000
Orders
200
Designs
20,000
machine100
hours
Customers
Production Department
Indirect factory wages
$
125
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Indirect factory wages
Office equipment depreciation
Administrative building lease
Number of orders
Marketing Department
Indirect factory wages/order
Marketing wages and salaries
Selling expenses
Total
$
315
Other
Customer
Orders
$ 125,000
÷
1,000
$
125
Computation of Activity Rates
Activity Cost Pools
1,000
Orders
Production Department
Indirect factory wages
$
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
$
125
60
-
200
Designs
$
1,000
60
-
60
15
100
-
50
5
315
125
1,285
-
$
20,000
machine100
hours
Customers
$
5
9
3
$
2
1,200
125
-
$
19
500
-
$
1,500
350
3,675
Other
N/A
Assigning Costs to Cost Objects
Let’s take a look at how our system works for just
one customer - Windward Yachts.
 Windward ordered two products - Stanchions and
custom compass housings. Here are the details:
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 labor totals $1,850.
6. Shipping costs total $180.
Assigning Costs to Cost Objects
Let’s take a look at how our system works for just
one customer - Windward Yachts.
 Windward ordered two products - Stanchions and
customer compass housings. Here are the details:
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 labor totals $50.
6. Shipping costs total $25.
Assigning Costs to Cost Objects
Overhead cost of two orders for standard stanchions.
Activity Cost Pools
2 Orders
Production Department
Indirect factory wages
$
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
No new
design
200
machine
hours
N/A
Total
250
$125 per order × 2 orders = $250
Assigning Costs to Cost Objects
Overhead cost of two orders for standard stanchions.
Activity Cost Pools
No new
design
2 Orders
Production Department
Indirect factory wages
$
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
$
250
120
-
$
-
200
machine
hours
$
1,000
1,800
600
-
N/A
$
-
Total
$
1,250
1,920
600
120
30
-
-
400
-
-
520
30
100
10
630
-
3,800
-
100
10
4,430
$
$
$
$
Assigning Costs to Cost Objects
Overhead cost of one order for custom compass housing.
Activity Cost Pools
1 Order
1 new
design
Production Department
Indirect factory wages
$
125
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
$125 per
Marketing Department
Marketing wages and salaries
Selling expenses
Total
4 machine
hours
N/A
Total
order × 1 order = $125
Assigning Costs to Cost Objects
Overhead cost of one order for custom compass housing.
Activity Cost Pools
1 new
design
1 Order
Production Department
Indirect factory wages
$
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
$
125
60
-
$
1,000
60
-
60
15
100
-
50
5
315
125
1,285
-
$
4 machine
hours
$
20
36
12
N/A
$
8
$
76
$
-
Total
$
1,145
96
72
-
168
15
-
175
5
1,676
$
Product Margins
Standard Stanchions
Sales
Cost:
Direct materials
Direct labor
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 labor
Shipping costs
Customer orders
Product design
Order size
Product margin
$
$
13
50
25
315
1,285
76
650
1,764
$ (1,114)
Product Margins
Standard Stanchions
Sales
Cost:
Direct materials
Direct labor
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
Windward Yachts
Cost:
Product margins:
Direct materials
Standard stanchion
5,030
Direct$labor
Custom compass housing
(1,114)
Shipping
costs
Customer
orders
Total product margin
3,916
Product design
Less: Customer relations
3,675
Order size
Customer margin
$ 241
Product margin
$
$
13
50
25
315
1,285
76
650
1,764
$ (1,114)
Example
Traditional Using Machine Hours
 Total Production Dept O/H
$1,000,000
Total Machine Hours
20,000
Overhead Allocation/Machine Hour
$50/hr.
Product Margins
Traditional Cost Accounting System
Sales
Costs
Direct materials
Direct labor
Manufacturing overhead
Product margin
Predetermined manufacturing
=
overhead rate
Standard
Stanchions
$
13,600
$
(2,110)
(1,850)
(10,000)
(360)
$1,000,000
20,000 MH
400 units x 0.5 MH/unit x $50/MH = $10,000
Compass
Housing
$
650
$
(13)
(50)
(200)
387
= $50/MH
Comparison of Unit Costs
Traditional vs ABC
Standard
Stanchion
Traditional
Costing
Sales
Manufacturing Costs
Direct Materials
Direct Labor
Overhead
Total Cost per Product
ABC
Compass
Housing
Traditional
Costing
ABC
$ 13,600
$ 13,600
$ 650
$ 650
2,110
1,850
10,000
13,960
2,110
1,850
4,610
8,570
13
50
200
263
13
50
1,701
1,764
Overstated
$5,390
Understated
$1,438
Comparison of Unit Costs
Traditional vs ABC
Standard
Stanchion
Traditional
Costing
Sales
Manufacturing Costs
Direct Materials
Direct Labor
Overhead
Total Cost per Product
Product Margin
ABC
Compass
Housing
Traditional
Costing
ABC
$ 13,600
$ 13,600
$ 650
$ 650
2,110
1,850
10,000
13,960
2,110
1,850
4,610
8,570
13
50
200
263
13
50
1,701
1,764
5,030
387
(1,114)
(360)
Difference Between ABC and
Traditional Product Costs
ABC will ordinarily shift
batch-level and
product-level
overhead costs from
high-volume
products produced in
large batches to lowvolume products
produced in small
batches.
Difference Between ABC and
Traditional Product Costs
Under ABC both
manufacturing and
nonmanufacturing
costs may be
assigned to products.
Organizationsustaining costs and
the costs of idle
capacity are not
assigned to products.
Ease of Adjustment
Costs that adjust automatically to changes in activity:
 Direct materials.
 Shipping.
Costs that could be adjusted to changes in activity:
 Direct labor.
 Factory utilities.
 Administrative wages and salaries.
 Office equipment depreciation.
 Marketing wages and salaries.
 Selling expenses.
Costs that are difficult to adjust to changes in activity:
 Factory equipment depreciation.
 Factory building lease.
 Administrative building lease.
Custom Compass Housing
Sales
Variable costs:
Direct materials
Shipping costs
Green margin
Semi - Variable costs:
Direct labor
Indirect factory wages
Factory utilities
Administrative wages
Office equip. depreciation
Marketing wages
Selling expenses
Yellow margin
Fixed costs:
Factory equip. depreciation
Factory building lease
Admin. Building lease
Red margin
$
$
13
25
50
1,145
72
168
15
175
5
96
0
0
650
38
612
1,630
(1,018)
96
$ (1,114)
Simplified Approach to ABC
Standard Stanchions:
Sales
Costs:
Direct materials
Direct labor
Shipping costs
Customer orders (2)
Product design
Order size (200)
Product margin
$
$
13,600
$
8,570
5,030
2,110
1,850
180
630
3,800
2 orders @ $315 per order
Simplified Approach to ABC
Custom Compass Housing
Sales
Costs:
Direct materials
Direct labor
Shipping costs
Customer orders (1)
Product design
Order size
Product margin
$
$
13
50
25
315
1,285
76
1 design @ $1,285 per design
$
650
1,764
(1,114)
Simplified Approach to ABC
Customer margin for Windward Yachts is shown below:
Customer Profitability Analysis
Product margins:
Standard stanchion
$
Custom compass housing
Total product margins
Less: Customer relations
Customer margin
5,030
(1,114)
3,916
(3,675)
241
Activity-Based Costing
Use ABC When One or More of the Following Exist:
 Products differ greatly in volume/manufacturing complexity
 Products lines are
Numerous
Diverse
Require different degrees of support services
 Overhead costs are a significant portion of total costs
 Significant change in manufacturing process or number of
products
 Managers ignore data from existing system and instead use
“bootleg” costing data
Value-Added vs.
Non-Value-Added Activities
Value-Added Activity
An activity that increases the worth
of a product or service such as:
Manufacturing Company
engineering design
machining
assembly
painting
packaging
Service Company
performing surgery
legal research services
delivering packages
Value-Added vs.
Non-Value-Added Activities
Non-Value-Added Activities
An activity that adds cost to, or increases the time
spent on, a product/service without increasing its
market value such as:
Manufacturing Company
Service Company
Repair of machines
Storage of inventory
Moving of raw materials,
assemblies, and finished goods
Building maintenance
Inspections
Inventory Control
Taking appointments
Reception
Bookkeeping/billing
Traveling
Ordering supplies
End of Chapter 4
I call this
quality
time!