Chapter 8
Activity-Based Costing: A
Tool to Aid Decision Making
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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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It is ordinarily used as a
supplement to, rather
than as a replacement
for, the company’s usual
costing system.
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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. For example,
ABC systems can assign sales commissions, shipping costs,
and warranty repair costs to specific
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. This
is because ABC only assigns a cost to a product if decisions
concerning that product will cause changes
in the cost.
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How Costs are Treated Under
Activity–Based Costing
Level of complexity
ABC uses more cost pools than traditional cost systems that often
use a single plant wide overhead pool or just one overhead pool
per department.
Since more than one activity is often performed
within each
Activity–Based
Costing
department.
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.
Volume
measures
plus other
bases.
Bases usually
rely only on
volume
measures.
Traditional Costing
ABC
 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 labor hours.
Direct labor hours work
well when overhead
increases as direct
labor 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 labor hours.
Problems:
 In many processes, overhead is increasing
while direct labor is decreasing.
 Variety and complexity of products is increasing.
 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.
All overhead
costs are not related
to volume measures like
direct labor
hours.
ABC uses
volume as well as
other allocation bases not
related to the volume
of production.
 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.
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
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Identify and Define Activities
and Activity Cost Pools--Explanation
1. Unit-level activities are performed each time a unit is produced.
2. Batch-level activities are performed each time a batch is
handled or processed, regardless of how many units are in the
batch. e.g. setting up equipment and shipping customer orders.
3. Product-level activities relate to specific products and must be
carried out regardless of how many batches are run or units
produced and sold. For example, designing or advertising a
product.
4. Customer-level activities relate to specific customers and are
not tied to any specific product. For example, sales calls and
catalog mailings.
5. Organization-sustaining activities are carried out regardless of
which customers are served, which products are produced, how
many batches are run, or how many units are made. For
example, heating a factory and cleaning executive offices.
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Identify and Define Activities
and Activity Cost Pools
Activities
should only be
combined within a level
if they are highly
correlated.
Batch-level
Activities should not be
combined with unit-level
activities,
and so on
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When combining
activities, they should be
grouped together only at
the appropriate
level.
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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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$$
$
$ $
$
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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.
When All Activity takes the
same time
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Different amount of time
required toCopyright
perform
Activities
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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
• The indirect factory workers allocated twentyfive percent of their time to the customer orders
activity, forty percent of their time to the product
design activity, twenty percent of their time to
the order size activity, ten percent of their time
to customer relations, and five percent of their
time to the “other” activity.
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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
Labor
Shipping
Costs
Traced
Traced
Traced
Overhead Costs
Cost Objects:
Products, Customer Orders, Customers
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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
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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
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Unallocated
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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
$19/MH
$315/Order
$257/Design $3675/Customer
Cost Objects:
Products, Customer Orders, Customers
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Unallocated
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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.
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.
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For each activity
cost pool, the
amount of activity
consumed by the
product
(or
customer)
is
multiplied by the
activity rate to
arrive
at
the
amount
of
overhead
cost
applied to the
product
(or
customer).
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Assigning Costs to Cost Objects
The customer-level
cost is assigned to
customers directly;
it is not assigned to
products.
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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
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$
$
13
50
25
315
1,285
76
650
1,764
$ (1,114)
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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
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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.
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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.
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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.
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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.
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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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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.
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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.
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Appendix 8A: ABC Action Analysis
$125 per order × 1 orders = $125
Other entries in the table are computed similarly.
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Appendix 8A: ABC Action Analysis
Next, label each cost using an ease of adjustment
code:
• Green costs adjust more or less automatically to
changes in activity level without any action by
managers.
• Yellow costs can be adjusted to changes in activity
level, but it would require management action to
realize the change in cost.
• Red costs can be adjusted to changes in activity
level only with a great deal difficulty and with
management intervention.
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Appendix 8A: ABC Action Analysis
Action Analysis of Custom Compass Housing
Sales
Green costs
Direct materials
Shipping costs
Green margin
Yellow costs
Direct labor
Indirect factory wages
Factory utilities
Administrative wages and salaries
Office equipment depreciation
Marketing wages and salaries
Selling expenses
Yellow margin
Red costs
Factory equipment depreciation
Factory building lease
Administrative building lease
Red margin
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$
$
650
$
38
612
13
25
50
1,145
72
168
15
175
5
96
-
1,630
$ (1,018)
96
$ (1,114)
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End of Chapter 8
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Let’s move on to something else!
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I need some Help!
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THE END
THIS CHAPTER HAS
BEEN A MOUNTAIN-TOP
EXPERIENCE, BUT I’M
GLAD IT IS FINISHED!
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