Activity-Based
Costing Systems
Chapter 4
Traditional overhead allocation
system
Single predetermined rate is used to
allocate overhead to products
Easy to use
Assumes all overhead is correlated with the
activity base
Assumes all overhead costs are related to all
products
Does not consider the product’s consumption
of resources other than the base
An ideal system
Treat indirect costs like direct costs
Accurate assignment of the resources
consumed by the individual cost objects
Different types and amounts of overhead charged
to different cost objects
No allocation based on estimates
Not possible
Cost element shared by many cost objects
Cost element not related to cost objects
Not cost effective to trace accurately
Activity-based costing
Recognizes
Not all costs are related to the same cost
driver
Not all costs are incurred at the unit level
Unit level
Batch level
Product level
Customer level
Facility level
Activity-based costing
Recognizes
That activities are performed to produce or
support the cost object
Those activities consume resources
Can identify resources with the activities
Can identify the activities with the cost objects
Can be used for any cost object
Not GAAP for financial reporting
Activity-based costing
Traditional allocation method
Costs
Products
Activity-based allocation method
Costs
Activities
First stage
Products
Second stage
Implementation of an ABC system
Step 1 – Develop activity dictionary
List of activities related to the cost object
How precise?
Only major activities if purpose is better cost
information
More detailed if purpose is process
improvement
Will probably have an “other” activity
Implementation of an ABC system
Identify activities (cost pools)
Interview employees
Process flowcharts
Etc.
At which level do they occur?
Unit, batch, etc.
May not want to allocate facility level costs to
products
Implementation of an ABC system
How are the activities performed?
Inputs and outputs
What causes the activity to commence?
Production order, material requisition, etc.
What is the output of the activity?
Units produced, pieces assembled, time
consumed, etc.
How can the activity be measured?
Transactions, time, etc.
For use as possible cost drivers
Implementation of an ABC system
Step 2 – Determine the significant costs
related to each activity
Resources used
Employee time
Wages and benefits
Assets
Depreciation, taxes, insurance, etc.
Consumables
Supplies, utilities, maintenance, etc.
“Other”
Implementation of an ABC system
Exhibit 1
Alpha Manufacturing Company
First-stage allocation percentages
Material
handling
Indirect labor
10%
Indirect materials
Set-up
Assembly
Testing and
inspection
Rework
Packaging
Breaks and
meetings
5%
Other
Total
15%
5%
50%
5%
5%
5%
100%
20%
45%
20%
10%
5%
100%
Depreciation
15%
5%
25%
15%
10%
30%
100%
Insurance and taxes
10%
5%
30%
20%
5%
30%
100%
5%
5%
50%
5%
5%
30%
100%
25%
20%
5%
25%
100%
Utilities
Repairs and maintenance
Factory administration
Other
25%
10%
90%
100%
100%
100%
Implementation of an ABC system
Exhibit 2
Alpha Manufacturing Company
First-stage allocation
Indirect labor
Cost
$ 1,600,000
Material
Testing and
Breaks and
handling
Set-up
Assembly
inspection
Rework
Packaging
meetings
Other
Total
$ 160,000 $ 240,000 $
80,000 $ 800,000 $
80,000 $
80,000 $
80,000 $
80,000 $ 1,600,000
10%
15%
5%
50%
5%
5%
5%
5%
100%
Indirect materials
$
$
250,000
-
$
50,000 $
20%
112,500 $
45%
50,000 $
20%
25,000 $
10%
12,500 $
5%
-
75,000 $
15%
25,000 $
5%
125,000 $
25%
75,000 $
15%
50,000 $
10%
150,000 $
30%
-
22,500 $
10%
11,250 $
5%
67,500 $
30%
45,000 $
20%
11,250 $
5%
67,500 $
30%
-
40,000 $
5%
40,000 $
5%
400,000 $
50%
40,000 $
5%
40,000 $
5%
240,000 $
30%
-
43,750 $
25%
35,000 $
20%
8,750 $
5%
43,750 $
25%
-
0%
Depreciation
Insurance and taxes
Utilities
Repairs and maintenance
Factory administration
$
$
$
$
500,000
225,000
800,000
175,000
$ 1,250,000
$
$
$
$
$
43,750 $
25%
-
$
-
-
0%
Other
$
200,000
$
-
$ 5,000,000
$
$
341,250
$
-
0%
0%
Total
$
0%
-
$
0%
$
366,250
$
-
0%
-
$
0%
$
828,750
$
-
0%
-
$
0%
$ 1,045,000
$
-
0%
-
$
0%
$
215,000
$
0%
-
$
0%
$
593,750
$
$
250,000
100%
$
500,000
100%
$
225,000
100%
$
800,000
100%
$
175,000
100%
0%
$
-
0%
0%
$
-
0%
0%
$
-
0%
0%
$
0%
0%
125,000 $ 1,125,000 $ 1,250,000
10%
90%
100%
-
$
0%
$
-
0%
205,000
200,000 $
100%
$ 1,405,000
200,000
100%
$ 5,000,000
Implementation of an ABC system
Step 3 – Determine cost drivers and rates
What activity measures correlate with each
cost?
Measurable
Statistically or logically have a cause-and-effect
relationship with the cost
Predict or explain the consumption of
resources with reasonable accuracy
Based on practical capacity for the activity
Unused capacity is its own “activity”
Implementation of an ABC system
Exhibit 3
Alpha Manufacturing Company
Driver base quantities
Job
Driver base
Pounds moved
A
B
C
D
E
Total
410
9,600
90
5,700
2,000
17,800
10
60
6
44
40
160
3,500
108,000
800
54,000
21,700
188,000
Number of tests performed
14
120
10
90
31
265
Rework hours
80
400
30
48
42
600
Cubic feet of packaged goods
30
1,100
5
385
280
1,800
4,000
85,000
500
34,000
26,500
150,000
350
12,000
50
4,500
3,100
20,000
Set-up hours
Pieces assembled
Total direct labor hours
Number of units produced
Implementation of an ABC system
Exhibit 4
Alpha Manufacturing Company
Driver rate calculations
Activity
Material handling
Activity cost
$
Driver base
341,250 Pounds moved
Set-up
366,250 Set-up hours
Assembly
828,750 Pieces assembled
Testing and inspection
1,045,000 Number of tests performed
Driver quantity
Driver rate
17,800
$
160
$
188,000
$
265
$
3,943.40 per test performed
600
$
358.33 per rework hour
1,800
$
329.86 per cubic foot packaged
1.37 per direct labor hour
Rework
215,000 Rework hours
Packaging
593,750 Cubic feet of packaged goods
Breaks and meetings
205,000 Total direct labor hours
150,000
$
1,405,000 Number of units produced
20,000
$
Other
Total
$ 5,000,000
19.17 per pound moved
2,289.06 per set-up hour
4.41 per piece assembled
70.25 per unit produced
Implementation of an ABC system
Step 4 – Assign costs to cost objects
Determine the amount of each activity
consumed by the cost object
Multiply by the rate for that activity
Total the activity costs for each cost object
Divide total by quantity of the cost object to
determine unit cost
Implementation of an ABC system
Exhibit 5
Alpha Manufacturing Company
Second-stage allocation
Job A
Activity
Driver rate
Material handling
$
Set-up
$
Assembly
$
Testing and inspection
$
Rework
Packaging
10
22,891
3,500
3,943.40 per test performed
$
$
Breaks and meetings
$
1.37 per direct labor hour
Other
$
Job D
Cost
assigned
60
137,344
15,429
108,000
14
55,208
358.33 per rework hour
80
329.86 per cubic foot packaged
30
70.25 per unit produced
5,700
6
13,734
476,090
800
120
473,208
28,667
400
9,896
1,100
4,000
5,467
350
24,588
$
44
100,719
3,527
54,000
10
39,434
90
143,333
30
10,750
48
362,847
5
1,649
385
85,000
116,167
500
683
34,000
12,000
843,000
50
3,513
4,500
350
$
$
$
Activity
quantity
2,000
$ 2,736,034
485.73
Job E
Cost
assigned
109,277
170,004
$
Activity
quantity
1,725
$
$
Activity
quantity
90
Units in job
Cost per unit
Job C
Cost
assigned
184,045
4.41 per piece assembled
$
Activity
quantity
9,600
2,289.06 per set-up hour
410
Job B
Cost
assigned
7,860
Total job cost
19.17 per pound moved
Activity
quantity
Cost
assigned
17,800
40
91,563
160
366,250
238,045
21,700
95,659
188,000
828,750
354,906
31
122,245
265
1,045,000
17,200
42
15,050
600
215,000
126,997
280
92,361
1,800
593,750
46,467
26,500
36,217
150,000
205,000
316,125
3,100
217,775
20,000
1,405,000
$ 1,309,735
12,000
50
4,500
228.00
$ 1,500.31
291.05
$
Activity
quantity
38,343
75,015
$
Total
Cost
assigned
$
709,212
3,100
$
228.78
$
341,250
$ 5,000,000
Advantages of ABC
Better allocation of costs
Not perfect
Useful for estimating costs of future
projects
Can be extended to activity-based
management
“Now that we know what it costs, how can we
do it more efficiently?”
Advantages of ABC
Cost object can be anything
Product
Service
Process
Customer
Employee
Location
Etc.
Advantages of ABC
Aids in recognizing, measuring and
controlling complexity
Promotes understanding of why costs are
incurred
Shifts focus from managing costs to
managing activities
When to use ABC
High proportion of indirect costs
Complex products or processes
High volume vs. low volume products
Diverse indirect costs
Cost accounting system hasn’t evolved
Distrust of current system
Different products place different demands on
resources
Disadvantages of ABC
Costly to implement
Costly to maintain
Likely to meet substantial resistance
Not the “real” system
“Why do you want to know what I do?”