Chapter 8
Activity Based Costing:
A Tool to Aid Decision Making
Activity Based Costing (ABC)
ABC is designed to
provide managers
with cost
information for
strategic and other
decisions that
potentially affect
capacity and
therefore “fixed”
costs.
McGraw-Hill/Irwin
ABC is a
good supplement
to our traditional
cost system
I agree!
© The McGraw-Hill Companies, Inc., 2003
Activity Based Costing (ABC)
Both manufacturing
and nonmanufacturing
costs may be
assigned to
products.
A number
of cost pools each
allocated to a product
or cost object.
Some manufacturing
costs may be excluded
from product
costs.
Allocation bases often
differ from
traditional costing
systems.
McGraw-Hill/Irwin
Overhead rates may
be based on activity
at capacity.
© The McGraw-Hill Companies, Inc., 2003
How Costs are Treated Under
Activity-Based Costing
Activity Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
Overhead Allocation
McGraw-Hill/Irwin
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Plantwide Overhead Rate
Companies tended to use direct labor as
the overhead allocation base. There was a
belief that direct labor and overhead
costs were highly correlated.
McGraw-Hill/Irwin
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Departmental Overhead Rates
Finishing Department
Painting Department
Many companies have a system
in which each department has
its own overhead rate.
Shipping Department
McGraw-Hill/Irwin
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Departmental Overhead Rates
Stage One:
Costs assigned
to pools
Cost pools
McGraw-Hill/Irwin
Indirect
Labor
Indirect
Materials
Other
Overhead
Department
1
Department
2
Department
3
© The McGraw-Hill Companies, Inc., 2003
Departmental Overhead Rates
Stage One:
Costs assigned
to pools
Cost pools
Stage Two:
Costs applied
to products
McGraw-Hill/Irwin
Indirect
Labor
Indirect
Materials
Other
Overhead
Department
1
Department
2
Department
3
Products
© The McGraw-Hill Companies, Inc., 2003
Departmental Overhead Rates
Stage One:
Costs assigned
to pools
Cost pools
Stage Two:
Costs applied
to products
Indirect
Labor
Indirect
Materials
Other
Overhead
Department
1
Department
2
Department
3
Direct
Labor
Hours
Machine
Hours
Raw
Materials
Cost
Products
Departmental Allocation Bases
McGraw-Hill/Irwin
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Cost of Idle Capacity
Traditional Cost
Accounting
The predetermined
overhead rate is based
on budgeted activity.
This results in applying
overhead costs of
unused, or idle,
capacity.
McGraw-Hill/Irwin
Activity Based
Costing
Products are charged for
the costs of capacity
they use – not for the
costs of capacity they
don’t use.
© The McGraw-Hill Companies, Inc., 2003
Designing an ABC System
Cost Objects
(e.g., products
and customers)
Activities
Consumption
of Resources
Cost
McGraw-Hill/Irwin
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Designing of 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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
Identify and Define Activities
and Activity Cost Pools
Unit-Level
Activity
Batch-Level
Activity
A part of the production
process for which management
wants a separate reporting of the
costs of the activity involved.
Product-Level
Activity
McGraw-Hill/Irwin
Organizationsustaining
Activity
Customer-Level
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:
Activity Cost Pools at Classic Brass
Activity Cost Pool
Customer orders
Product design
Order size
Customer relations
Other
McGraw-Hill/Irwin
Activity Measure
Number of customer orders
Number of product designs
Machine-hours
Number of active customers
Not applicable
© The McGraw-Hill Companies, Inc., 2003
Identify and Define Activities
and Activity Cost Pools
Activity Cost
Pool is a “bucket”
in which costs are
accumulated that
relate to a single
activity measure
in the ABC
system.
McGraw-Hill/Irwin
$$
$
$ $
$
© The McGraw-Hill Companies, Inc., 2003
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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
Whenever Possible, Directly Trace
Overhead Costs to Activities and Cost Objects
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
McGraw-Hill/Irwin
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
© The McGraw-Hill Companies, Inc., 2003
Assign Costs to Activity Cost Pools
At Classic Brass the following distribution of resource
consumption across activity cost pools is determined.
Activity Cost Pools
Customer Product
Order
Orders
Design
Size
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
Shipping costs **
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Customer
Relations
Other
Total
25%
20%
0%
0%
40%
0%
10%
0%
20%
60%
50%
0%
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%
**Not included because they are directly traced to customer orders.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
Assign Costs to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)
Activity
Customer
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
$ 125,000
Production Department
$
CostIndirect
Pools factory wages
Factory equipment depreciation
Product
Order
Customer
Factory utilities
Design
Sizelease Relations
Factory building
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
Other
80,000 $
400,000
50,000
60,000
Total
1,000,000
40,000
510,000
250,000
50,000
$
300,000
1,850,000
Indirect factory wages
$500,000
Percent consumed by customer orders
25%
$125,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
Assign Costs to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)
Activity
Customer
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
$ 125,000
60,000
Production Department
$
CostIndirect
Pools factory wages
Factory equipment depreciation
Product
Order
Customer
Factory utilities
Design
Sizelease Relations
Factory building
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
Other
80,000 $
400,000
50,000
60,000
Total
1,000,000
40,000
510,000
250,000
50,000
$
300,000
1,850,000
Factory equipment depreciation
$300,000
Percent consumed by customer orders
20%
$ 60,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
Assign Costs to Activity Cost 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
McGraw-Hill/Irwin
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
© The McGraw-Hill Companies, Inc., 2003
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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
Calculate Activity Rates
Computation of Activity Rates
Activity Cost Pools
Customer orders
Product design
Order size
Customer relations
Other
McGraw-Hill/Irwin
(a)
Total Cost
$ 315,000
257,000
380,000
367,500
490,500
(b)
Total Activity
1,000 orders
200 designs
20,000 MHs
100 customer
Not applicable
(a) ÷(b)
Activity Rate
$315 per order
$1,285 per design
$19 per MH
$3,675 per customer
Not applicable
© The McGraw-Hill Companies, Inc., 2003
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Traced
Traced
Traced
Overhead Costs
Cost Objects:
Products, Customer Orders, Customers
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Other
Cost Objects:
Products, Customer Orders, Customers
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
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
McGraw-Hill/Irwin
Unallocated
© The McGraw-Hill Companies, Inc., 2003
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 labor totals $1,850.
6. Shipping costs total $180.
McGraw-Hill/Irwin
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.
© The McGraw-Hill Companies, Inc., 2003
Assigning Costs to Cost Objects
Overhead Cost for the Standard Stanchions
Activity Cost Pools
Customer orders
Product design
Order size
Customer relations
(a)
Activity Rate
$
315
1,285
19
3,675
The customer-level
cost is assigned to
customers directly;
it is not assigned to
products.
McGraw-Hill/Irwin
(b)
Activity
2
0
200
N/A
(a) (b)
ABC Cost
$
630
3,800
Overhead Cost for the Custom Housing
Activity Cost Pools
Customer orders
Product design
Order size
Customer relations
(a)
Activity Rate
$
315
1,285
19
3,675
(b)
Activity
1
1
4
N/A
(a) (b)
ABC Cost
$
315
1,285
76
© The McGraw-Hill Companies, Inc., 2003
Prepare Management Reports
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
McGraw-Hill/Irwin
$
$
13
50
25
315
1,285
76
650
1,764
$ (1,114)
© The McGraw-Hill Companies, Inc., 2003
Prepare Management Reports
Customer Profitability Analysis
Windward Yachts
Product margins:
Standard stanchion
Custom compass housing
Total product margin
Less: Customer relations
Customer margin
McGraw-Hill/Irwin
$ 5,030
(1,114)
3,916
3,675
$ 241
© The McGraw-Hill Companies, Inc., 2003
Product Margins
Traditional Cost Accounting System
Sales
Costs
Direct materials
Direct labor
Manufacturing overhead
Product margin
Standard
Stanchions
$
13,600
$
(2,110)
(1,850)
(10,000)
(360)
Compass
Housing
$
650
$
(13)
(50)
(200)
387
400 units x 0.5 MH/unit x $50/MH = $10,000
Predetermined manufacturing
=
overhead rate
McGraw-Hill/Irwin
$1,000,000
20,000 MH
= $50/MH
© The McGraw-Hill Companies, Inc., 2003
Difference Between ABC and
Traditional Product Costs
Batch-level or productlevel costs will
ordinarily shift
overhead costs from
high-volume
products produced
in large batches to
low-volume products
produced in small
batches.
McGraw-Hill/Irwin
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.
© The McGraw-Hill Companies, Inc., 2003
Targeting Process Improvement
Activity-based costing can be
used to identify areas that would
benefit from process
improvements.
The theory of constraints
approach is a powerful tool for
targeting the area in an
organization whose improvement
will yield the greatest benefits.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
Limitations of ABC
ABC systems are a
major project requiring
substantial resources.
The benefits of
increased accuracy
must outweigh these
additional costs.
ABC produces
numbers, like product
margins, that are at
odds with numbers
produced by traditional
costing system. Some
managers find it
difficult to adjust to this
change.
ABC data can be misinterpreted and must
be used with care when making decisions.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2003
End of Chapter 8
McGraw-Hill/Irwin
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