Overview of
Activity-Based Cost Systems
for Management Control
ACCT7320, Dr. C. Bailey
5-1
Introduction
This presentation…
• describes how ABC systems help improve
pricing and product mix decisions.
• illustrates how ABC assists in cost
management decisions by improving
processes and product designs.
Note: ABC concerns mainly indirect
(overhead) costs!
5-2
Undercosting and Overcosting
Product undercosting:
A product consumes a relatively high level of
resources but is reported to have a relatively
low total cost.
Product overcosting:
A product consumes a relatively low level of
resources but is reported to have a relatively
high total cost.
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Undercosting and Overcosting
 Irene, Roberta, and Nancy are three bank customers.
 They require different activities from the bank:
• Irene banks exclusively at the ATM.
• Roberta visits the teller daily to make deposits,
withdrawals
• Nancy deposits foreign currency as well as calling
the branch frequently to ask currency rates.
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Undercosting and Overcosting
Traditional allocation bases might apply
branch overhead to accounts based on account
balances or equal amounts per account.
Irene (who never makes any demands on the
branch) will be overcosted and appear less
profitable than she should.
Roberta and Nancy may be undercosted and
appear more profitable than they are.
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Refining a Costing System
Guidelines for refining a costing system:
Direct-cost tracing – Classify as many of the
total costs as direct costs as is economically
feasible.
Indirect-cost pools – Expand the number of
cost pools until each of these pools is
homogeneous.
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Refining a Costing System
Cost-allocation basis – Identify the preferred
cost-allocation base for each indirect-cost
pool.
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Activity-Based Costing System
ABC calculates the costs of individual
activities and assigns costs to cost objects
such as products, services, or customers based
on the activities used to produce a product or
service, serve a customer, etc.
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Two-Step Allocation
Collect costs in general ledger and subsidiary
accounts (labor, material, services, deprec., etc)
Identify activity centers
Accumulate costs into activity center cost
pools
• cost driver
Allocate costs to products and services
• activity driver
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Activity-Based Costing System
Fundamental Cost Objects: Labor,
materials, etc. (All indirect to the
Product or Service)
Cost drivers
Other Indirect Costs of
product/svc (including
other non-ABC items)
Direct Costs
Cost of
Activity A
Other
Cost
drivers
Traced
Cost of
Activity B, etc.
Activity drivers
Cost of Product,
Service, Customer
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Examples of Activities
Activities at a Video Rental Store:
• Replace movies on shelves
• Ring sales:
Collect money
Sign receipt
Give copy
• Accept reservations, Hold, Call customer
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ABM
Activity Analysis
Value-added activity
 Increases worth of
product or service to a
customer
 Customer is willing to
pay for
Non-value-added activity
 Increases time spent on
product or service but
does not increase worth
 Unnecessary from
customer perspective
 Some can be eliminated
without affecting market
value or quality
 Business-value-added
activities are essential
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Activities of a
Milk Truck Delivery Person
Activity
Driving
Shelving
Paperwork
Waiting
Cost Driver
Time; miles; area of town
Time; number of packages;
categories of products
Time; types of customer
Type of customer?
5 - 13
Cost Hierarchies
A cost hierarchy is a categorization of costs
into different cost pools on the basis of the
different types of cost drivers (cost-allocation
bases) or different degrees of difficulty in
determining cause-and-effect relationships.
5 - 14
Cost Hierarchies
ABC systems commonly use a four-part cost
hierarchy to identify cost-allocation bases:
1 Output unit-level cost
2 Batch level costs
3 Product- (or service-)sustaining costs
4 Facility-sustaining costs
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Output Unit-Level Costs...
are resources sacrificed on activities
performed on each individual unit of product
or service.
• Energy
• Machine maintenance, repairs
(depreciation?)
• Labor
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Batch-Level Costs...
are resources sacrificed on activities that are
related to a group of units of product or service
• Setup hours to run a batch
• Procurement costs of placing an order
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Product-Sustaining...
or service-sustaining, costs are resources
sacrificed on activities to support individual
products or services.
• Design costs
• Engineering costs
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Facility-Sustaining Costs...
are resources sacrificed on activities that
cannot be traced to individual products or
services but support the organization as a
whole.
• General administration
• Rent
• Building security
5 - 19
Decision Usefulness of Cost Hierarchies
Different levels of cost drivers:
Level
Useful for Decisions Such As…
Output-unit
Batch
Shall we increase production, and at what price?
How often should we produce batches?
What base amount must we charge to set up a “run”,
regardless of the number a customer wants made?
Product/Service-Sustaining Should we continue to offer this service/product?
Facility-Sustaining
Shall we continue in business or dissolve it?
5 - 20
Major Differences,
Traditional Costing vs. ABC
Typical System
One or a few indirect
cost pools
Application base may
be a true cost driver
Application base often
financial (direct labor cost,
direct material cost, etc)
ABC
Many pools
Base more likely a
true cost driver
Bases likely to be
non-financial (# of parts,
number of operations,
hours of testing, etc.)
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Indicators that ABC Systems
May be Appropriate
significant amounts of indirect costs are
allocated using only one or two cost pools.
all or most costs are identified as output unitlevel costs (unlikely to be true!).
products make diverse demands on resources
because of differences in volume, process
steps, batch size, or complexity.
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Indicators that ABC Systems May be Appropriate,
continued...
products that a company is well-suited to
make and sell show small profits while
products for which a company is less suited
show large profits.
complex products appear to be very profitable
and simple products appear to be losing
money.
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Indicators that ABC Systems May be Appropriate,
continued…
operations staff have significant disagreements
with the accounting staff about the costs of
manufacturing and marketing products and
services.
automation makes it difficult to assign
overhead to products using direct labor or
machine hours
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Criticisms of ABC
Significant amount of time and cost to
implement
Must overcome barriers to change
Does not conform to GAAP
Does not promote total quality management
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ABC In Service And
Merchandising Companies
The general approach to ABC in the service
and merchandising areas is very similar to
the approach in manufacturing.
Costs are divided into homogeneous cost
pools and classified as output unit-level,
batch level, product, or service-sustaining
and facility sustaining costs.
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ABC In Service And
Merchandising Companies
The cost pools correspond to key activities.
Costs are allocated to products or customers
using activity drivers or cost-allocation bases
that have a cause-and-effect relationship with
the cost in the cost pool.
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End
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