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Overview
• Better estimates of controllable costs
improve quality of decisions
➢ Choices that we make when allocating costs
determine the validity of the estimated profit margin
➢ Activity based costing is a method to refine our
allocation and improve validity of estimate

• Activity based management is the process of

taking ABC data to improve the effectiveness
of business processes
➢ Focused on Customer
➢ Focused on Production
➢ Focused on Product concepts and design

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 Decisions When Allocating Costs

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 Forming Cost pools
• Includes all costs
➢ Pre and post production
• Takes business process view
➢ Each process is a collection of activities
▪ Activities are the core building block of ABC
systems

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 Activities at United Parcel Service

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 Forming Cost Pools
• Activities can pertain to any level in the
activity hierarchy
➢ Activities done for each unit, each batch,
each product or for the facility as a whole
• The corresponding cost pools will
correspond to the cost hierarchy
➢ Unit, batch, product and facility level cost
pools
➢ For each cost pool, use corresponding level
of cost driver
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 Cost Pools at MKC
Cost
Cost Name for
Pool Underlying Activity
Hierarchy Cost Pool
Number
Assembly of products
1 Unit Level Labor related
(includes intricate carpentry)
Machine
2 Unit Level Machining of product components
related
Issue and process production orders Production
3 Batch Level
(including production scheduling) order related
Receive and process customer orders Customer
4 Batch Level
(including invoicing) order related
Product Provide production support Production
5
Level (includes design updates) support
Facility General
8 General Administration
Level administration

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 Which Pools to Allocate?
Cost
Pool Name Underlying Activity Controllable?
Number
1 Labor related Assembly of products Yes
Machine
2 Machining of product components Yes
related
Production Issue and process production orders
3 Yes
order related (including production scheduling)
Customer Receive and process customer
4 Yes
order related orders (including invoicing)
Production Provide production support
5 Yes (Mostly)
support (includes design updates)
Marketing Provide marketing support
6 Yes (Mostly)
support (includes trade shows)
7 Warehousing Warehouse products Yes
General
8 General Administration No
administration
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 Which Drivers to Choose?
• Activity based costing systems pick
drivers that correspond to activities
➢ Thus, we have unit, batch, product and
facility level drivers
• In contrast, traditional systems only
employ unit-level drivers
➢ Units, direct labor, machine hours.

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 ABC: Better Drivers
Time spent on repair.
Unit level Time needed varies in proportion with extent
activity of repair needed

Put car up on jacks.

Batch level
This activity is done once for each repair
activity
episode

Maintain specialized diagnostic equipment.

Product
This activity is done for the separate
level
machines required by each auto
activity
manufacturer.

Facility Building and office upkeep.

level This activity is common to all the repairs and
activity is required to sustain the business.

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 Test Your Knowledge!
The costs associated with a company’s security
department would be considered what type of
activity?
a) Unit level
b) Batch level
c) Customer level
d) Facility level

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 Better Drivers at MKC
Cost Pool Cost Driver
1. Labor related Labor cost

2. Machine related Machine hours

3. Production order related Number of production orders

4. Customer order related Number of customer orders

5. Production support Traced to each product line

6. Marketing support Subjective estimate

7. Warehousing % area occupied

8. General administration (Not allocated)

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 What Denominator Volume to Use?
• In Chapter 9…
➢ Denominator volume = actual volume
➢ All costs would be allocated
➢ No distinction between demand & supply of
capacity
• ABC de-links demand and supply
➢ Uses practical capacity as denominator
volume

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 Example
• Cost: $55,000,Capacity = 11,000 units
“A” uses 4,000 units; “B” uses 6,000 units.
• Traditional method
➢ Rate = $5.50 /unit;
A = $22,000, B = $33,000
• ABC’s approach
➢ Rate = $5 / unit
A = $20,000, B = $30,000, Unassigned = $5,000!
➢ Supply is 11,000 units & demand is 10,000 units

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 What to do with Unassigned
Capacity Cost?
• This is the cost of capacity not used
• ABC brings this cost to managerial action
➢ Disposition depends on reason for the unused
capacity
• If…
➢ True excess, get rid of capacity or re-deploy
➢ Accommodate variability in production, allocate to
product
➢ Seasonal, allocate to product
➢ Peak load pricing, time of day pricing
➢ Customer related, allocate to customer

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 Summary: Steps in ABC
• Identify all activities and pool like activities
together
• Analyze accounts and allocate costs from
accounts to cost pools to determine cost in
each pool
• Determine driver for each pool
• Determine rate using practical capacity
➢ Step 1 in any allocation process
• Assign costs from pools to objects
➢ Step 2 in any allocation process

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 Test Your Knowledge!
The greatest advantage associated with activity-
based costing is that:
a) it is easy to design and implement.
b) it allocates all overhead costs based on the
same cost driver.
c) it allows for multiple cost pools and multiple
cost drivers.
d) it allows for multiple cost pools but only a single
cost driver.

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 Accounts to Cost Pools: MKC
Expense
Cost Pool Supervisory Supplies, General Total
staff tools, jigs, Administrative

1. Labor related $458,171 $237,500 $1,425,000

2. Machine related $229,329 $1,950,000
3. Production order related $600,000
4. Customer order related $750,000
5. Production support 395,000 220,671 $615,671
6. Marketing support 150,000 $675,000
7. Warehousing $225,000
8. General admin 462,500 $862,500
Total $853,171 $450,000 $850,000 $7,103,171

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 Step 1: Calculating Rates
Total Cost in Practical
Cost Pool Cost Driver Activity Rate
Pool Capacity
$0.30 per labor
Labor related Labor cost $1,425,000 $4,750,000
$
150,000 $13.00 per
Machine related Machine hours $1,950,000
machine hours machine hour
Number of $600.00 per
Production order related production $600,000 1,000 orders production
orders order
Number of
$500.00 per
Customer order related customer $750,000 1,500 orders
customer order
orders
Traced to each
Production support $615,671 n/a n/a
product line
$6,750 per
Subjective
Marketing support $675,000 100% percent of
estimate
support
$2,250 per
% area
Warehousing $225,000 100% percent area
occupied
occupied
General administration Not applicable $862,500 n/a n/a

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 Step 2: Determine Product cost
1. 3. 6. 7. 8.
Cost Pool Labor Production Marketing Warehousing General
related order related support admin
Production
Activity driver Labor cost N/A % area N/A
orders
$600 per $6,750 per
$0.30 per $2,250 per % of
Activity Rate: production percent of N/A
labor $ area
order support
Driver units
$1,807,400 200 30% 45%
for Silver line
Allocated
$542,220 $120,000 $202,500 $101,250
cost

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 Reporting ABC data
• ABC product cost reports contain more detail than
reports under traditional product costing systems
• These reports report different elements of the cost
hierarchy in separate lines
• A sample report might have:

Revenues
- Unit level costs
- Batch level costs
- Product level costs
- Facility level costs
= Profit margin

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 Category Detail Driver volume Activity Rate Cost

Revenue 225,925 feet $47.00 $10,618,475

Variable costs Direct materials 225,925 feet $23.00 $5,196,275
Direct labor 225,925 feet $8.00 $1,807,400
Variable selling 225,925 feet $1.40 $316,295 $7,319,970
Contribution margin $3,298,505
Unit-level costs $1,807,400
Labor related $0.30 $542,220
labor $
45,185 machine
Machine related $13.00 $587,405 $1,129,625
hours
Batch-level costs Production 200 production
$600.00 $120,000
support orders
300 customer
Customer support $500.00 $150,000 $270,000
orders
Product-level costs Production
n/a Traced $184,500
support
Marketing
30% of support $6,750,000 $202,500
support
Warehousing 45% of area $2,250,000 $101,250 $488,250
Facility-level costs General admin n/a n/a
Profit margin $1,410,630

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 Advantages of ABC reports
• Captures the complexity of the production
process
➢ Speaks the “language of the user”
• Highlights that not every cost is related to
volume
➢ Often, volume is still the most important driver
• Produces more accurate costs, enabling better
decisions
➢ Avoids cross-subsidization
• Total profit will not change by changing cost
allocation system
➢ Only the allocation of costs has changed

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 Exercise 10.30
Computing cost of activity (LO2).
The University Credit Union (UCU) has engaged your services
to determine the cost of its various activities. The following data
are available for a representative branch.
Process Process Balance Other
Total Cost
Deposits Checks Inquiries Activities
Tellers 30% 40% 10% 20% $150,000
Assistant manager 10% 10% 5% 75% 75,000
Managers 2% 3% 5% 90% 90,000

The average branch processes 600,000 deposits and

1,250,000 check transactions each year.
Required:
Compute the cost per deposit and the cost to process a check.

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