Chapter
8
Activity Based Costing:
A Tool to Aid Decision Making
Activity Based Costing (ABC)
The objective of
activity-based
costing is to
understand
overhead and the
profitability of
products and
customers.
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ABC is a
good supplement
to our traditional
cost system
I agree!
© The McGraw-Hill Companies, Inc., 2000
Activity Based Costing (ABC)
Activity-Based Costing
Both manufacturing
and nonmanufacturing
costs may be
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.
Irwin/McGraw-Hill
Overhead rates may
be based on activity
at capacity.
© The McGraw-Hill Companies, Inc., 2000
How Costs are Treated Under
Activity-Based Costing
Activity Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
Overhead Allocation
Irwin/McGraw-Hill
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Plantwide Overhead Rate
Companies tend to use direct labor
as the overhead allocation base.
Irwin/McGraw-Hill
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Departmental Overhead Rates
Finishing Department
Painting Department
Shipping Department
Irwin/McGraw-Hill
A two stage process is
necessary because costs
are allocated to departments
and then to products.
© The McGraw-Hill Companies, Inc., 2000
Departmental Overhead Rates
Stage One:
Costs assigned
to pools
Cost pools
Irwin/McGraw-Hill
Indirect
Labor
Indirect
Materials
Other
Overhead
Department
1
Department
2
Department
3
© The McGraw-Hill Companies, Inc., 2000
Departmental Overhead Rates
Stage One:
Costs assigned
to pools
Cost pools
Stage Two:
Costs applied
to products
Irwin/McGraw-Hill
Indirect
Labor
Indirect
Materials
Other
Overhead
Department
1
Department
2
Department
3
Products
© The McGraw-Hill Companies, Inc., 2000
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
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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 pools.
 Where possible, 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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© The McGraw-Hill Companies, Inc., 2000
Identifying Activity to Include
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
Irwin/McGraw-Hill
Organizationsustaining
Activity
Customer-Level
Activity
© The McGraw-Hill Companies, Inc., 2000
Identifying Activity to Include
Activity Cost Pool
is a “bucket” in
which costs are
accumulated that
relate to a single
activity in the ABC
system.
Irwin/McGraw-Hill
$$
$
$ $
$
© The McGraw-Hill Companies, Inc., 2000
The Mechanics of ABC
At Classic Brass, the ultimate cost objects are:
 Products,
 Customer orders, and
 Customers.
One overhead cost - shipping - can be traced
directly to customer orders.
The company’s overhead costs are shown on
the next slide.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
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
Irwin/McGraw-Hill
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., 2000
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Traced
$/DLH
Traced
Overhead Costs
Cost Objects:
Products, Customer Orders, Customers
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
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
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
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
Irwin/McGraw-Hill
Unallocated
© The McGraw-Hill Companies, Inc., 2000
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
Irwin/McGraw-Hill
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%
© The McGraw-Hill Companies, Inc., 2000
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
Indirect factory wages
$500,000
Percent consumed by customer orders
25%
$125,000
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
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
Factory equipment depreciation
$300,000
Percent consumed by customer orders
20%
$ 60,000
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
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
Irwin/McGraw-Hill
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., 2000
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.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
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
Irwin/McGraw-Hill
Customer
Order Size Relations
$ 380,000
÷ 20,000
$ 367,500
÷ 100
$
$
19
Other
$ 490,500
N/A
3,675
© The McGraw-Hill Companies, Inc., 2000
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:
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.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
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.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
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
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
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
$
650
1,764
(1,114)
1 design @ $1,285 per design
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
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
Irwin/McGraw-Hill
$
$
13
50
25
315
1,285
76
650
1,764
$ (1,114)
© The McGraw-Hill Companies, Inc., 2000
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
Irwin/McGraw-Hill
$
$
13
50
25
315
1,285
76
650
1,764
$ (1,114)
© The McGraw-Hill Companies, Inc., 2000
Product Margins
Traditional Cost Accounting System
Sales
Costs
Direct materials
Direct labor
Manufacturing overhead
Product margin
Predetermined manufacturing
=
overhead rate
Irwin/McGraw-Hill
Standard
Stanchions
$
13,600
$
(2,110)
(1,850)
(10,000)
(360)
$1,000,000
20,000 MH
Compass
Housing
$
650
$
(13)
(50)
(200)
387
= $50/MH
© The McGraw-Hill Companies, Inc., 2000
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
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
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.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
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.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
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.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
Custom Compass Housing
Sales
Green costs:
Direct materials
Shipping costs
Green margin
Yellow costs:
Direct labor
Indirect factory wages
Factory utilities
Administrative wages
Office equip. depreciation
Marketing wages
Selling expenses
Yellow margin
Red costs:
Factory equip. depreciation
Factory building lease
Admin. Building lease
Red margin
Irwin/McGraw-Hill
$
$
13
25
50.00
1,145.00
72.00
168.00
15.00
175.00
5.00
96
0
0
650
38
612
1,630
(1,018)
96
$ (1,114)
© The McGraw-Hill Companies, Inc., 2000
End of Chapter 8
Irwin/McGraw-Hill
I call this
quality
time!
© The McGraw-Hill Companies, Inc., 2000