4
Activity-Based
Costing Systems
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
4-2
Learning Objective 1
4-3
Traditional Costing Systems
Traditional cost systems were created when
manufacturing processes were labor intensive.
A single company-wide overhead rate
based on direct labor hours may be
used to allocate overhead to products
in these labor intensive processes.
4-4
Traditional Costing Systems
In this example, overhead will be allocated to jobs
using direct labor hours. If total overhead is $120,
how much will be allocated to each job?
4-5
Traditional Costing Systems
Overhead Rate = $120 ÷ 8 direct labor hours
Overhead Rate = $15 per direct labor hour
Job 1 = 2 hours × $15 per hour = $30
Job 2 = 6 hours × $15 per hour = $90
4-6
Traditional Costing Systems
The company introduces
automated machinery. Total
overhead rises from $120 to
$420, while the labor time
needed for Job 2 falls from
6 hours to 1 hour. Now
allocate the $420 overhead
to the two jobs.
4-7
Traditional Costing Systems
Overhead Rate = $420 ÷ 3 direct labor hours
Overhead Rate = $140 per direct labor hour
Job 1 = 2 hours × $140 per hour = $280
Job 2 = 1 hour × $140 per hour = $140
4-8
Traditional Costing Systems
Is this a reasonable costing method?
Automation benefited only Job 2, but most of the
additional overhead cost was allocated to Job 1.
Clearly, we need to look for another cost driver.
4-9
Learning Objective 2
4-10
Activity-Based Costing (ABC)
A costing method that identifies the activities
performed within the organization as it delivers
its goods and services.
Products
Require
Activities
Activities
Consume
Resources
People
Manage
Activities
4-11
Activity-Based Costing (ABC)
A costing method that assigns costs to
products, based on the number of activities the
organization used in producing them.
Lot size
Design
time
Direct
labor
hours
Process
setups
Machine
hours
Customer
contact
4-12
Activity-Based Costing (ABC)
Both manufacturing
and nonmanufacturing
costs may be
assigned to
products.
ABC is a good
supplement
to our traditional
cost system.
A
B
Allocation bases
often differ from
traditional costing
systems.
C
Used in internal
decision making as well
as in inventory valuation
for external reporting.
4-13
ABC Compared with Traditional Costing
Activity-Based
Costing
Traditional
Costing
4-14
ABC Compared with Traditional Costing
Traditional Costing
Resource Costs
Directly traced
or allocated
Cost Pools:
Plants or
Departments
Predetermined
overhead
rate
Cost Objects
Activity-Based Costing
Resource Costs
Directly traced
or allocated
Cost Pools:
Activities or
Activity Centers
Cost driver
rates for
each activity
Cost Objects
4-15
Activity-Based Costing (ABC)
An Activity Cost
Pool is a
common way to
collect costs
that are related
to a specific
activity in the
ABC system.
Activity
Costs
$$
$
$ $
$
4-16
Four Steps in the ABC Process
 Identify and classify the activities
related to the company’s
products or services.
 Estimate the cost of each activity
identified in .
 Calculate a cost-driver rate for
each activity.
 Assign activity costs to products
using the cost-driver rate.
4-17
Learning Objective 3
4-18
 Identify and Classify Activities
UNIT-LEVEL ACTIVITIES
Resources acquired and activities performed for individual units of product.
BATCH-LEVEL ACTIVITIES
Resources acquired and activities performed for a group or batch of
similar products or services.
PRODUCT-LEVEL ACTIVITIES
Resources acquired and activities performed to produce and sell a specific
product or service.
CUSTOMER-LEVEL ACTIVITIES
Resources acquired and activities performed to serve specific customers.
FACILITY-LEVEL ACTIVITIES
Resources acquired and activities performed to provide general capacity to
produce goods or services.
4-19
 Identify and Classify Activities
TOP DOWN APPROACH
ABC teams of people from
top levels of management
generate the activity
dictionary.
RECYCLING
APPROACH
INTERVIEW OR
PARTICIPATIVE
APPROACH
Reuses documentation
of processes used for
other purposes.
ABC teams include or
interview operating
employees.
4-20
Learning Objective 4
4-21
 Estimate the Cost of Activities
The ABC teams should gather data on the costs of all
the activities identified in Step 1.
Examine
accounting
records for
recorded cost
information.
Ask employees
to indicate how
much time
they work on
various
activities.
4-22
 Calculate Cost-Driver Rates for
Activities
Two pieces of
information are
required to compute
the cost-driver rate:
Activity
Cost
÷
Activity
Volume
=
Cost-Driver
Rate
•Activity Cost
•Activity Volume
May Company has 4 employees in its Quality Control
Department. Salaries and costs for the department total
$360,000 per year. May produces 500,000 units of
product a year. What is the cost-driver rate per unit?
$360,000 ÷ 500,000 units = $.72 per unit
4-23
 Calculate Cost-Driver Rates for
Activities
MAY has a customer service center
where customers can call to ask
questions. Customers pay a fixed fee for
each call they make to the service center.
It costs MAY $1,260,000 a year to operate
the center. The center receives 120,000
calls per year. The center handles
1,000,000 minutes of calls.
What is the appropriate cost driver: total
minutes for all calls or number of calls?
What is the cost-driver rate?
4-24
 Calculate Cost-Driver Rates for
Activities
Since customers are charged “per call”, the
proper activity in this case is the number of
calls handled by the center.
The cost-driver rate would be:
$1,260,000 ÷ 120,000 units = $10.50 per call
4-25
 Calculate Cost-Driver Rates for
Activities
Cause and effect
relationship between
activity and costs
Based on resource’s
practical capacity to
support activities
Measurable
Appropriate
cost-driver
base
Predict or explain
an activity’s use
of resources
4-26
Practical Capacity Note
When estimating the
cost of an activity,
only the costs
associated with the
product should be
used (practical
capacity). The cost
of “unused capacity”
should not be
applied to products.
EXAMPLE
Suppose we rent a 1,000
square foot warehouse for
$1,000 per month. Only 800
sq. ft. are used to store
Product A. The rest of the
warehouse is “unused”.
How much rent cost should be
allocated to Product A?
4-27
Practical Capacity Note
80%, or $800
should be assigned
to Product A
20%, or $200 should
be assigned to
“unused capacity”
4-28
Learning Objective 5
4-29
 Assign Activity Costs to Products
1. Identify all
the activities
related to a
given product
or service.
2. Determine
how many
units of each
activity are
used per unit
of product.
3. Assign costs
to products
using the costdriver rates for
each activity.
4-30
 Assign Activity Costs to Products
Example: Yazz, Inc. produces 130,000 units of Product A
and 400,000 units for Product B. Using the following
cost information, how much overhead should be
allocated to Product A?
Cost-Driver
Activity
Cost-Driver Base
Rate
Factory Floor Space Square Footage
$ 50.000
Electricity
Kilowatts
$
0.050
Water
Gallons
$
0.160
Quality Control
Units Inspected
$
0.850
Packaging - Inner
Ounces of product $
0.025
Packaging - Outer
Boxes
$
1.250
Resources Used
by Product A
20,000 Sq. Ft.
15,000 KW
80,000 Gal.
135,000 Units
270,000 Oz.
135,000 Boxes
4-31
 Assign Activity Costs to Products
Cost-Driver
Activity
Base
Factory floor
Square
space
footage
Electricity
Kilowatts
Water
Gallons
Units
Quality control
inspected
Ounces of
Inner packaging
product
Outer packaging Boxes
Cost-Driver Resources Used
Cost
Rate
Assigned
by Product A
$
50.000
20,000 sq. ft. $ 1,000,000
$
$
$
0.050
0.160
0.850
15,000 kw.
80,000 gal.
135,000 units
$
$
$
750
12,800
114,750
$
0.025
270,000 oz.
$
6,750
$
1.250 135,000 boxes $ 168,750
Total Cost Assigned to Product A $ 1,303,800
4-32
Activity-Based Costing Example
Let’s look at an
example from the
Bilson Company.
4-33
Activity-Based Costing Example

Bilson, Inc. manufactures and sells 5,000 units of
Product A (deluxe model), and 25,000 units of Product B
(standard model) each year.

Product A requires 3.0 direct labor hours (DLH) and
Product B requires 2.5 DLH to produce.

Employing a traditional costing system, Bilson assigns
overhead cost to products using direct labor hours.

The predetermined overhead rate is:
Mfg. overhead cost
Direct labor hours
=
$1,550,000
77,500
=
$20/DLH
4-34
Activity-Based Costing Example
Bilson’s unit product costs using
traditional costing are:
Direct material
Direct labor
Manufacturing overhead
3.0 DLH × $20/DLH
2.5 DLH × $20/DLH
Total unit product cost
Product A
$ 40.00
30.00
Product B
$ 29.00
25.00
60.00
$ 130.00
50.00
$ 104.00
Bilson marks its products up by 50 percent and allocates
its $500,000 customer service costs based on revenue.
4-35
Activity-Based Costing Example
$130.00 × 1.50
Traditional Costing
Product A
Volume
Sales Price
Product B
5,000
$ 195.00
Sales Revenue
Direct Material
$
Direct Labor
Overhead
Gross Margin
$
Customer Service Costs
Product operating income
$ 156.00
$
40.00
30.00
60.00
65.00
25,000
$
$
975,000
200,000
150,000
300,000
325,000
100,000
225,000
$
$
29.00
25.00
50.00
52.00
$ 3,900,000
725,000
625,000
1,250,000
$ 1,300,000
400,000
$ 900,000
$975,000 ÷ ($975,000 +$3,900,000) × $500,000
4-36
Activity-Based Costing Example
Sales of Product A have increased steadily since introduction,
but company income has declined. Management at Bilson is
unhappy with the traditional costing system and they have
decided to try activity-based costing.
In addition, management has
observed that the cost of direct
labor is relatively stable.
Since labor does not behave
like a unit-level cost, labor will
be combined with overhead and
the total conversion cost
will be assigned using ABC.
4-37
Activity-Based Costing Example
The total conversion cost is:
Traditional overhead
Labor (77,500 hours @ $10)
Total
In addition, management has
observed that the cost of direct
labor is relatively stable.
Since labor does not behave
like a unit-level cost, labor will
be combined with overhead and
the total conversion cost
will be assigned using ABC.
$1,550,000
775,000
$2,325,000
4-38
Activity-Based Costing Example
Management has identified the following five activities
and costs in the production of its two products:
Activity
Machine setups
Quality inspections
Production orders
Machine-hours worked
Material receipts
Total
Total conversion cost
Cost
$ 800,000
450,000
225,000
650,000
200,000
$ 2,325,000
4-39
Activity-Based Costing Example
The following transaction data has been
complied by management of Bilson:
Activity
Machine setups
Quality inspections
Production orders
Machine-hours worked
Material receipts
Total
5,000
9,000
600
50,000
800
Product A
3,000
6,000
200
15,000
150
Product B
2,000
3,000
400
35,000
650
4-40
Activity-Based Costing Example
These data can be used to develop predetermined
cost-driver rates for each of the five activities:
Activity
Costs
Machine setups
$ 800,000
Quality inspections
450,000
Production orders
225,000
Machine-hours worked
650,000
Material receipts
200,000
Total
$ 2,325,000
Total
Transactions
5,000
9,000
600
50,000
800
Rate per
Transaction
$
160.00
50.00
375.00
13.00
250.00
per
per
per
per
per
setup
inspection
order
hour
receipt
$ 800,000 ÷ 5,000 Machine setups = $160.00 per setup
4-41
Activity-Based Costing Example
The activity-based overhead rates we just calculated
can be used to assign conversion costs to Bilson’s
two products.
Product A
Activity
ABC Rate
Machine setups
$ 160.00
Quality inspections
50.00
Production orders
375.00
Machine-hours worked
13.00
Material receipts
250.00
Total overhead assigned
Number of units produced
Conversion per unit
Transactions
3,000
6,000
200
15,000
150
Amount
$ 480,000
300,000
75,000
195,000
37,500
$ 1,087,500
÷
5,000
$217.50
4-42
Activity-Based Costing Example
The activity-based overhead rates we just calculated
can be used to assign conversion costs to Bilson’s
two products.
Product B
Activity
ABC Rate
Machine setups
$160.00
Quality inspections
50.00
Production orders
375.00
Machine-hours worked
13.00
Material receipts
250.00
Total overhead assigned
Number of units produced
Conversion per unit
Transactions
2,000
3,000
400
35,000
650
Amount
$ 320,000
150,000
150,000
455,000
162,500
$ 1,237,500
÷
25,000
$
49.50
4-43
Activity-Based Costing Example
The activity-based overhead rates we just calculated
can be used to assign conversion costs to Bilson’s
two products.
Product B
Activity
ABC Rate
Transactions
Amount
Machine setups
$160.00
2,000
$ 320,000
Quality inspections
50.00
3,000
150,000
Production orders
375.00
400
150,000
Machine-hours worked
13.00
35,000
455,000
Material receipts
250.00
650
162,500
Total overhead assigned
$ 1,237,500
Total
conversion
assigned
to Product A
$ 1,087,500
Number
of units
produced
÷
25,000
Total
conversionper
assigned
1,237,500
Overhead
unit to Product B
$
49.50
Total overhead
$ 2,325,000
4-44
Activity-Based Costing Example
Let’s compute the product cost for A and B
using our ABC overhead rates:
Activity Based Costing
Direct materials
Conversion
Total unit product cost
These amounts did not
change as a result of
using ABC.
Product A
$ 40.00
217.50
$ 257.50
Product B
$ 29.00
49.50
$ 78.50
4-45
Activity-Based Costing Example
Now compare the unit product costs using the
traditional costing system and our ABC system.
Costing Method
Activity-based costing
Traditional costing
Product A
$ 257.50
130.00
Product B
$ 78.50
104.00
Remember, we used one overhead
rate based on direct labor hours.
4-46
Activity-Based Costing Example
Now compare the unit product costs using the
traditional costing system and our ABC system.
Costing Method
Activity-based costing
Traditional costing
Product A
$ 257.50
130.00
Product B
$ 78.50
104.00
Adopting activity-based costing usually results
in a shift of batch-level and product-level
overhead costs from high-volume standard
products to low-volume, more complex products.
4-47
Activity-Based Costing Example
Now compare the unit product costs using the
traditional costing system and our ABC system.
Costing Method
Activity-based costing
Traditional costing
Product A
$ 257.50
130.00
Product B
$ 78.50
104.00
Can you see how different allocation
methods might lead to making
different management decisions?
4-48
Activity-Based Costing Example
Based on these results Bilson also decides to use ABC to assign
its $500,000 customer service costs. The applicable activity is
number of customer consultations. Customers buying Product A,
the deluxe model, require more consultations than those buying
Product B, the standard model.
Cost per consultation = $500,000 ÷ 125,000 consultations = $4.00
4-49
Activity-Based Costing Example
No change in sales price
ABC Costing
Product A
Volume
Sales Price
Product B
5,000
$ 195.00
Sales Revenue
Direct Material
$ 40.00
Conversion
217.50
Gross Margin
$ (62.50)
Customer Service Costs
Product operating income
25,000
$ 156.00
$
975,000
200,000
1,087,500
$ (312,500)
200,000
$ (512,500)
$
$
29.00
49.50
77.50
$ 3,900,000
725,000
1,237,500
$ 1,937,500
300,000
$ 1,637,500
Let’s compare product income using traditional and ABC costing.
4-50
4-50
Volume
Sales Price
Product A
Product B
5,000
$ 195.00
Sales Revenue
Direct Material
$ 40.00
Conversion
217.50
Gross Margin
$ (62.50)
Customer Service Costs
Product operating income
25,000
$ 156.00
$
975,000
200,000
1,087,500
$ (312,500)
200,000
$ (512,500)
$
$
Product A
Volume
Sales Price
29.00
49.50
77.50
Product B
5,000
$ 195.00
Sales Revenue
Direct Material
$
Direct Labor
Overhead
Gross Margin
$
Customer Service Costs
Product operating income
25,000
$ 156.00
$
40.00
30.00
60.00
65.00
$ 3,900,000
725,000
1,237,500
$ 1,937,500
300,000
$ 1,637,500
ABC
Costing
$
$
975,000
200,000
150,000
300,000
325,000
100,000
225,000
$
$
29.00
25.00
50.00
52.00
$ 3,900,000
725,000
625,000
1,250,000
$ 1,300,000
400,000
$ 900,000
Traditional
Costing
4-51
Learning Objective 6
4-52
Product Profitability
Should Bilson
drop Product A?
Should Bilson
increase the price
of Product A?
Now that we have
measured product
costs accurately,
we see how profitable
each product really is.
Should Bilson
reduce the price
of Product B?
4-53
Product Profitability


The price of Product A, the deluxe model, should
probably be increased. Customers who buy
deluxe models may buy based on features
instead of price.
The price of Product B, the standard model, may
be too high. Customers who buy standard
models are price sensitive. Decreasing
the price would increase volume,
possibly resulting in more income.
4-54
Customer Profitability
What are the costs and
benefits of serving
specific customers?
Service calls
Buy/sell orders
Order changes
Activity-based analysis can
be used to track the costs
of serving customers and
those customers’ contribution
to company profits.
4-55
Estimating Costs of New Products


Apply ABC analysis of present
product lines to proposed new
products.
This is valid as long as the
activities involved with the new
products are similar to those for
the present products.
4-56
Learning Objective 7
4-57
ABC in Service and Merchandising
Companies
The process is exactly the same as for manufacturing!
 Identify and classify the activities
related to the company’s products or
services.
 Estimate the cost of each activity
identified in .
 Calculate a cost-driver rate for each
activity.
 Assign activity costs to products using
the relevant cost-driver rates.
4-58
ABC– Benefits and Limitations

More accurate and informative
product costs lead to better pricing
decisions.

The activities driving costs are more
accurately measured.

Managers gain easier access to the
relevant costs.
An ABC system is very expensive
to develop and implement, and
very time-consuming to maintain.
4-59
When Should a Company Use ABC?

Indirect costs are significant in proportion to direct costs.

Goods are complex, requiring many inputs and processes.

Complex, low-volume products are profitable while
standard, high-volume products are not.

Different departments believe costs are assigned
inaccurately.

The company loses bids it thought were low, and wins bids
it thought were high.

Operations have changed significantly, but the costing
system has not changed.

Introduction of new models result in higher sales, apparent
profits per unit, but an overall income decline.
4-60
End of Chapter 4