Activity Based Costing vs. Traditional Steps, Results Compared

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How to Use Activity Based Costing (ABC)

Activity Based vs Traditional Costing Step by Step, Compare Results
Business Encyclopedia ISBN 978-1-929500-10-9 Copyright © 2023 Solution Matrix Ltd All Rights Reserved
How to Use Activity Based Costing (ABC)

ABC vs Traditional Costing, Results Compared
Business Encyclopedia ISBN 978-1-929500-10-9
Copyright © 2023 Solution Matrix Ltd All Rights Reserved
What is Activity Based Costing?
Businesses move to Activity Based Costing to better understand the true costs of goods and
services.
Businesses that sell goods and services have a critical need to know their costs for producing and delivering
products, accurately. Accurate costing at the individual product level is essential for knowing which products
are earning profits and which are selling at a loss. This information can also be crucial for pricing, production
planning, and product protfolio management.
Tracking product costs is a task for the firm's cost accounts, most of whom rely on traditional costing
methods. Cost accountants know, however, that these methods sometimes deliver misleading information
about individual product costs. In cases where the company has reason to question the accuracy of product
cost figures, many firms turn to an alternative costing method: Activity-based costing.
Define Activity‐Based Costing ABC
Activity-Based Costing is a methodology for assigning costs to individual products, services, projects,
tasks, or acquisitions, based on…
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Activity Based Costing vs. Traditional Steps, Results Compared https://www.business-case-analysis.com/activity-based-costing.html
▪ The activities that go into them.

▪ Resources consumed by these activities.
By measuring activities and resources consumed by individual products, ABC methods essentially
convert the so-called indirect costs of traditional costing methods into direct costs.
Activity based costing attempts to measure the costs of products and services more accurately than traditional cost
accounting, [Photo: Ford Motor Company Assembly Line, Dearborn, Michigan, 1927]
Firms adopt activity-based-costing to better

understand the true costs of products and services
Activity based costing attempts to measure the costs of products and services more accurately than traditional cost
accounting, [Photo: Ford Motor Company Assembly Line, Dearborn, Michigan, 1927]
ABC contrasts with traditional costing (cost accounting), which sometimes assigns costs using somewhat
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arbitrary allocation percentages for overhead or the so-called indirect costs. As a result, ABC and traditional
cost accounting can estimate the cost of goods sold and gross margin very differently for individual
products. Contradictory and uncertain cost estimates can be a problem when management needs to know
precisely which products are profitable and which are selling at a loss.
What Are the Benefits of ABC?
The move from traditional costing to ABC is usually driven by a desire to understand the "true costs" of
individual products and services more accurately. Companies implement Activity Based costing to:
▪ Identify specific products that are unprofitable.
▪ Improve production process efficiency.
▪ Price products appropriately, with the help of accurate product cost information.
▪ Reveal unnecessary costs that become targets for elimination.
Firms that use ABC consistently to pursue these objectives are practicing Activity Based management
ABM.
ABC Impacts the Same Accounts, But With Different Mathematics
Note that the purpose of ABC is to provide information for decision support and planning. ABC by itself
usually has little or no impact on the structure of the firm's financial accounting reports (Income statement,
Balance sheet, or Cash flow statement). This impact is minimal because both ABC and traditional costing
ultimately assign costs to the same existing accounts. The two approaches merely use different mathematics
to do so.
Note especially, however, that ABC sometimes brings improvements in reported margins and profitability.
These outcomes follow when ABC reveals unnecessary or inflated costs, or when ABC shows where to
adjust pricing models, workflow process, or the product mix.
Explaining Activity Based Costing in Context
This article further defines, describes, and illustrates Activity Based costing using example calculations to
contrast ABC with traditional cost accounting. Examples appear in context with related terms from the fields
of budgeting, cost accounting, and financial accounting.
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Contents
▪ What is Activity Based costing ABC?
◦ Define Activity-Based Costing.
▪ Why do companies and organizations use Activity Based costing?
▪ How does Activity Based costing compare to traditional cost accounting?
▪ Traditional cost accounting for direct and indirect costs with allocation. How to apply traditional costing
(TC) in 5 steps. Example calculations and costing results.
◦ TC Step 1. Find total direct costs.
◦ TC Step 2. Find each product's direct labor and direct materials costs per unit.
◦ TC Step 3. Find total direct costs for each product unit.
◦ TC Step 4. Allocate to find indirect labor and materials costs.
◦ TC Step 5. Find product cost and gross margin cost per unit.
▪ Activity Based costing for direct and indirect costs. How to apply Activity Based costing ABC in 6 steps.
Example calculations and costing results.
◦ ABC Step 1. Find total direct costs.
◦ ABC Step 2. Find each product's direct labor and direct materials costs per unit.
◦ ABC Step 3. Find total direct costs for each product unit.
◦ ABC Step 4. Identify indirect activity pools, cost drivers, unit costs.
◦ ABC Step 5. Find per-unit indirect costs for each product.
◦ ABC Step 6. Calculate profitability for individual products.
▪ Comparing traditional and Activity Based costing: Advantages and disadvantages.
▪ What is Activity Based management ABM?
Related Topics
▪ For the accountant's role in assigning cost figures, see the article Accountant.
▪ The article Cost Object defines and explains the term "cost object."
▪ The article Direct and Indirect Labor Costs further explains the role of these terms in traditional cost
accounting.
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Why Do Companies and Organizations Move to ABC?

What are the Reasons for Using Activity Based Costing?
The desire to improve costing accuracy moves business people to adopt ABC, mainly to get closer to the
true cost and true profitability of individual products and services. They move to Activity Based costing for
the same reasons to understand better the true costs and return on investment from projects, programs, or
other initiatives.
ABC pursues these objectives primarily by making direct costs out of many of the expenses that traditional
cost accounting treats as indirect costs. Examples below show how ABC does this.
Organizations that use ABC consistently and effectively are said to practice Activity Based management
(ABM). Here, managers turn to ABC to support decisions about pricing, adding or deleting items from the
product portfolio, choosing between outsourcing and in-house production, and evaluating process
improvement initiatives. For more on ABM, see the section below, "What is Activity Based management?"
The percentage of organizations currently using Activity Based costing varies significantly from industry to
industry. Various surveys in the period 2012-2018 report the highest rate of firms using ABC in
manufacturing (20%-50%), followed by financial services (15-25%), public sector (12-18%), and
communications (6-12%).
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Activity Based Costing vs. Traditional Cost Accounting

What Are the Differences? Do They Lead to Different Costing Results?
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Traditional costing typically

assigns values to "Indirect"
product or service costs with cost
allocation rules that can be
somewhat arbitrary. [Photo:
Norfolk & Western Railroad employees calculating, Roanoke, Virginia, ca. 1925]
The balance sheet compares the firms assets,

liabilities, and equities.
Traditional costing typically assigns values to "Indirect" product or service costs with cost allocation rules that can be somewhat
arbitrary. [Photo: Norfolk & Western Railroad employees calculating, Roanoke, Virginia, ca. 1925]
The different approaches and outcomes from ABC and traditional costing are most accessible for illustration
in the context of a product manufacturing example. However, the principles appearing here extend readily
to a wide range of other business settings.
Example: Traditional Cost Accounting vs. ABC
For example, consider a firm that manufactures automobile parts through a sequence of machine operations
on metal stock. In such settings, traditional cost accounting views "product production costs" as either direct
costs or indirect costs (or overhead).
Example Sources of Direct Costs
Traditionally, direct costs for such firms are costs they can assign to specific product units. In product
manufacturing, these might include direct materials and direct labor costs:
▪ Direct labor costs.
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These can include the cost for person minutes or person-hours per product unit for running production
machines.
▪ Direct materials.
Direct materials costs might include costs per product unit for metal stock, fasteners, and lubricants.
Example Sources of Indirect Costs
Traditionally, indirect costs for such firms are manufacturing overhead expenses they cannot assign directly
to specific product units. Instead, they allocate these costs to specific production runs, batches, or periods.
These might include indirect costs such as the following:
▪ Materials purchase order costs.

Firms typically do not order materials for each product unit, but instead, for entire batch runs. They may
also order supplies to cover a specific time span.
▪ Machine set up costs.

Manufacturing firms do not set up production machines for each product unit. They are set up instead for
the production run of each product model.
▪ Product packaging costs.

Manufacturers can sometimes package multiple product units in a single package. And, they may fill
numerous packages in a single packaging run.
▪ Machine testing and calibration costs.

Manufacturing firms perform these operations regularly and often, but not for each product unit.
▪ Machine maintenance and cleaning costs.

Firms usually perform these operations only after producing multiple product units.
Product Specific Cost Sources
For this example, consider a firm that manufactures and sells two product models, Model A and Model B.
Some aspects of A and B compare as Table 1 shows:
Products Compared Product A Product B
Selling Price Higher price Lower price
Materials purchased More materials purchase orders, smaller orders Fewer materials purchase orders, larger orders
Production Runs More production runs, smaller runs Fewer production runs, larger runs
Mach. Setups More machine setups Fewer machine setups
Packaging 1 Unit per package 4 Units per package
Direct labor More direct labor required Less direct labor required
Direct materials Higher direct materials cost Lower direct materials cost
Table 1. Product A and Product B compared.
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Direct Costs Are the Same in Traditional and Activity Based Costing
Management must estimate the profitability of each product to decide which products to produce and sell and
how to price them. These estimates, in turn, require an understanding of the full cost per unit of each product.
While the direct costs per unit are easy to find, the indirect costs are less noticeable. As a result, the firm will
have to uncover indirect product costs through a costing methodology—either traditional cost allocation or
Activity Based costing.
Direct costs are the same under both traditional costing and ABC. For direct costs, accountants measure a
product unit cost for each direct cost category. The two costing methods differ, however, in the way they
assign values to so-called indirect costs for products. Consequently, the two costing approaches sometimes
give entirely different pictures of the profitability of individual products.
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How to Use Traditional Costing

Calculate Direct and Indirect Costs in 5 Steps
Cost accountants can apply traditional costing methods to find total production costs for Products A and B in
Table 1 above. In one accounting period, the firm produces and sells
▪ 900,000 units of product A at $3.00 each.

Product A sales revenues = $2,700,000.
▪ 2,100,000 units of product B at $2.00 each.

Product B sales revenues = $4,200,000.
To find product gross profits and profit margins, however, accountants will use traditional costing methods to
estimate total production costs per unit, and with that, gross profit margin per unit.
Traditional Costing
Step 1. Find Total Direct Costs
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Production machine operators

working directly on products are
direct labor. The total cost of
direct labor will be the same
under both ABC and traditional costing. [Photo: Railroad yard machine shop lathe operators, Duluth, Minnesota, 1920 ]
Direct costs are the same in traditional and

activity based costing.
Production machine operators working directly on products are direct labor. The total cost of direct labor will be the same
under both ABC and traditional costing. [ Photo: Railroad yard machine shop lathe operators, Duluth, Minnesota, 1920 ]
For this example, product manufacturing direct costs consist of direct labor costs and direct materials cost.
Step 1A. Find Total Direct Labor Cost for Each Product
The firm's accounting system carries general ledger T-accounts for each product's direct labor costs. For one
accounting period, these costs are:
Product A direct labor: $450,000

Product B direct labor: $1,050,000
Step 1B Find Total Direct Materials Cost for Each Product.
The accounting system also carries accounts for each product's direct materials costs. The ledger shows these
direct materials costs for the period:
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Product A direct materials: $675,000 Product B direct materials: $1,050,000
Traditional Costing
Step 2. Find Direct Labor and Direct Materials Costs per Unit
Workers assembling individual

product units are direct labor,
working with direct materials. [
Photo: Cable assembly, Western
Electric Hawthorne Works,
Cicero, 1925 ]
Assemblers working directly on products are

direct labor.
Workers assembling individual product units are direct labor, working with direct materials. [ Photo: Cable assembly, Western
Electric Hawthorne Works, Cicero, 1925 ]
The Manufacturing organization provides product unit counts. For the current period:
Product A: 900,000 units Product B 2,100,000 units
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Step 2A. Find Each Product's Direct Labor Cost per Unit
Product A Direct labor per unit: $450,000 / 900,000 = $0.50 / unit

Product B Direct labor per unit: $1,050,000 / 2,100,000 = $0.50 / unit
Step 2B Find Each Product's Direct Materials Cost per Unit
Product A direct materials per unit $675,000 / 900,000 = $0.75 / unit

Product B direct materials per unit: $1,050,00 / 2,100,000 = $0.50 / unit
Traditional Costing
Step 3. Find Each Product's Total Direct Costs Per Unit
The final step in finding product direct costs, Step 3, is

simply adding individual product direct labor cost to the
individual product direct materials cost. These figures
are the results of Step 2, above.
Product A Direct costs per unit calculate as $0.70 +

$0.50 = $1.25 / unit
Product B Direct costs per unit: $0.50 + $0.50 =
$1.00 / unit
Direct Cost Summary, Traditional Costing
Table 2 below shows the resulting direct costs for these

sales, along with the given per unit sales revenues: Final assembly and test of each product unit is direct
labor. Total Direct costs per unit is simply the sum of per-
unit costs for direct labor and direct materials. [Photo:
Final assembly and test, switching circuit, Western
Electric Hawthorne Works, Cicero, 1925]
Products Compared Product A Product B Total
1. Units produced & sold 900,000 2,100,000 3,000,000
2. Selling price/unit $3.00 $2.00
3. Direct labor cost/unit $50.0 $0.50
4. Direct materials cost/unit $0.75 $0.50
5. Sales revenues
$2,700,000 $4,200,000 $6,900,000
[=1*2]
Direct costs
6. Direct labor costs

$450,000 $1,050,000 $1,500,000
[=1*3]
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7. Direct materials costs

$675,000 $1,050,000 $1,725,000
[=1*4]
8. Total Direct costs

$1,125,000 $2,100,000 $3,225,000
[=6+7]
Table 2. Sales revenues and direct costs for Products A and B.
Traditional Costing
Step 4. Allocate to Find Indirect Labor and Materials Costs
Workers setting up or maintaining

production machines are usually
classified as indirect labor.
Lubricants, cleaning supplies, and
other materials they use for these
activities are classified as indirect materials. [Photo: Setting up a 50-caliber gun boring machine, US Naval Shipyard,
Washington DC 1917]
Assemblers working directly on products are

direct labor.
Workers setting up or maintaining production machines are usually classified as indirect labor. Lubricants, cleaning supplies, and
other materials they use for these activities are classified as indirect materials. [Photo: Setting up a 50-caliber gun boring
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machine, US Naval Shipyard, Washington DC 1917]
The company's cost accountants will also find cost totals for the period's production support activities. In
traditional cost accounting, these costs are known as overhead or indirect costs, as Table 3 shows.
The simple form of traditional cost accounting appearing here uses only the Total Indirect cost line from
Table 3. Traditionally, firms allocate this cost total to each product, A or B, based on proportional usage of a
given resource. The resource chosen for this purpose is usually one of the direct cost items. Note especially
that this approach is also called production volume-based (PVB) cost allocation, for obvious reasons.
Prod. A & B Indirect % of Total Indirect

Indirect Components
Materials purchasing $180,000 12.6%
Machine setups $375,000 26.4%
Product packaging $280,000 19.7%
Machine testing & calibration $300,000 21.1%
Machine maintenance & cleaning $287,000 20.2%
Total Indirect $1,422,500 100.0%
Table 3. Indirect cost components for Traditional Costing
Under PVB cost allocation, accountants allocate (apportion) the total indirect cost to Products A and B based
on factors such as the proportion of the total:
▪ Production machine time for each product.
▪ Direct labor costs for each product.
▪ Factory floor space for each product.
Other factors may also apply. For this example, the firm's accountants chose to allocate indirect costs
referring to direct labor costs.
The indirect cost total from Table 3 above is $1,422,500. The direct labor total (line 6 from Table 1) is
$1,500,000. From these figures, the firm allocates indirect labor cost to each product as a percentage of the
product's own direct labor cost:
Step 4A. Find Total Indirect Labor Costs as Percentage of Total Direct Labor
Indirect labor cost / direct labor cost ratio:

= $1,422,500 / $1,500,000
= 0.948 = 94.8%
▪ For product A, Direct labor costs are $450,00 (Table 2, line 6). The indirect cost allocation for A is
therefore 94.8% of this, or $426,750.
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▪ For product B, Direct labor costs are $1,050,000 (Table 2, line 6). The indirect cost allocation for B is
therefore 94.8% of this, or $995,750.
Table 4, below, shows how this allocation produces indirect cost estimates per unit. And, the table also shows
the conventional costing solutions for gross profit and gross margin for each product unit.
Step 4B. Find Indirect Cost Per Unit
Estimated Indirect cost per unit is the same for both products, $0.47 (Table 4, line 14). These two indirect
costs must be equal because both products use the same allocation rate (94.8%) applied to direct labor costs,
based on the same direct labor rate ($0.50/unit).
Product A Product B Total

Products Compared
9. Units produced and sold

900,000 2,100,000 3,000,000
[Table 2, line 1]
10. Total direct costs

$1,125,000 $2,100,000 $3,225,000
[Table 2, line 8]
11. Total indirect costs

$426,750 $995,750 $1,422,500
[allocation shown above]
12. Revenues per unit

$3.00 $2.00
[Table 2, line 2 ]
13. Direct costs/unit

$1.25 $1.00
[ = 10 / 9 ]
14. Indirect costs/unit

$0.47 $0.47
[ = 11 / 9 ]
15. Gross profit/unit

$1.28 $0.53
[ = 12 − 13 − 14 ]
16. Gross profit margin

42.5% 26.3%
[ = 15 / 12 ]
Table 4. Gross profit and gross margin calculation for each product, using
traditional cost accounting approaches for indirect costs.
Traditional Costing
Step 5. Find Product Cost Per Unit and Gross Margin Per Unit
Step 5 delivers individual product profitabilities for traditional costing.
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With the product revenue figures

and the individual product cost
figures from steps 1 - 4, the
accountant calculates individual
product profitabilities (gross
margins) [Photo: Bank Accountants, New York, 1930]
Step 5 delivers individual product profitabilities

for traditional costing.
With the product revenue figures and the individual product cost figures from steps 1 - 4, the accountant calculates individual
product profitabilities (gross margins) [Photo: Bank Accountants, New York, 1930]
To find product gross margins for Products A and B, the analyst calculates as line 16 of Table 4 above shows.
The result is that traditional cost accounting shows:
▪ Product A gross margin = 42.5%
▪ Product B gross margin = 26.3%.
On a per-unit basis, this traditional costing finds Product A more profitable than product B.
These Product profitability results are directly comparable with the profitabilities for products A and B found
in Step 6 of the Activity Based costing example below.

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How to Apply Activity Based Costing Direct, Indirect Costs

Calculate in 6 Steps
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This section presents an ABC version of the same product costing situation presented above as Traditional
Costing. The examples show how ABC and traditional costing can yield different indirect cost estimates for
the same products. This means the two approaches can also estimate product-specific profitability differently.
Finally, the examples show that ABC requires more data and a more detailed analysis than the traditional
PVB allocation approach.
Activity Based Costing

Step 1. Find Total Direct Costs
Direct costs are the same in activity based and traditional costing.
Production machine operators

working directly on products are
direct labor. The total cost of
direct labor will be the same
under both ABC and traditional
costing. [Photo: Production Lathe Operator, Leys Malleable Castings, Derbyshire 1930]
Direct costs are the same in activity based and

traditional costing.
Production machine operators working directly on products are

direct labor. The total cost of direct labor will be the same under both ABC and traditional costing. [Photo: Production Lathe
Operator, Leys Malleable Castings, Derbyshire 1930]
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ABC costing for products A and B begins with the starting data appearing above for the traditional costing
example. Data for starting the ABC analysis include:
▪ Units produced and sold.
▪ Sales revenues.
▪ Direct costs.
The ABC example, therefore, begins with Table 5 (an exact copy of Table 2 above).
Products Compared Product A Product B Total
1. Units produced & sold 900,000 2,100,000 3,000,000
2. Selling price/unit $3.00 $2.00
3. Direct labor cost/unit $50.0 $0.50
4. Direct materials cost/unit $0.75 $0.50
5. Sales revenues
$2,700,000 $4,200,000 $6,900,000
[=1*2]
Direct costs
6. Direct labor costs

$450,000 $1,050,000 $1,500,000
[=1*3]
7. Direct materials costs

$675,000 $1,050,000 $1,725,000
[=1*4]
8. Total Direct costs

$1,125,000 $2,100,000 $3,225,000
[=6+7]
Table 5. Sales revenues and direct costs for Products A and B. Table 5 are identical to Table 2, above.
In this ABC example, as well, Product manufacturing direct costs consist of direct labor costs and direct
materials cost.
ABC Step 1A. Find Total Direct Labor Cost for Each Product
From the firm's general ledger accounts, these costs for the period are:
Product A direct labor: $450,000 Product B direct labor: $1,050,000
ABC Step 1B Find Total Direct Materials Cost for Each Product.
The ledger shows these direct materials costs for the period:
Product A direct labor: $675,000 Product B direct labor: $1,050,000

Step 2. Find Direct Labor and Materials Costs per Unit
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Direct costs are the same in activity based and traditional costing.
Direct labor and direct materials

on the assembly Line. Costing of
direct materials and labor is the
same under ABC and Traditional
Costing. [Photo: Sand core molds
production line, Leys Malleable
Castings, Derbyshire 1928]
Direct costs are the same in activity based and

traditional costing.
Direct labor and direct materials on the assembly Line. Costing of

direct materials and labor is the same under ABC and Traditional Costing. [Photo: Sand core molds production line, Leys
Malleable Castings, Derbyshire 1928]
The Manufacturing organization provides these product unit counts for the period:
Product A: 900,000 units Product B 2,100,000 units
ABC Step 2A. Find Each Product's Direct Labor Cost per Unit
Product A Direct labor per unit: $450,000 / 900,000 = $0.50 / unit

Product B Direct labor per unit: $1,050,000 / 2,100,000 = $0.50 / unit
ABC Step 2B Find Each Product's Direct Materials Cost per Unit
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Product A direct materials per unit $675,000 / 900,000 = $0.75 / unit

Product B direct materials per unit: $1,050,00 / 2,100,000 = $0.50 / unit

Step 3. Find Total Direct Cost for Each Product Unit
For the final step in finding product direct costs, Step

Workers completing Final assembly and test are
3, is simply individual product direct labor cost to the
direct labor.
individual product direct materials cost. These
figures are the results of Step 2, above.
Product A Direct costs per unit calculate as $0.70 +

$0.50 = $1.25 / unit
Product B Direct costs per unit: $0.50 + $0.50 =

$1.00 / unit
Direct Cost Summary, Activity Based Costing
Table 5 above summarizes direct costs for these product

sales, along with the given per unit sales revenues
Labor for final assembly and test of each unit is direct

labor. Total Direct costs per unit is simply the sum of per-
unit costs for direct labor and direct materials. [Photo:
Radio final assembly and test, Emerson Radio and
Phonograph Corporation, New York, 1945]

Step 4. Identify indirect Activity Pools, Cost Drivers, Unit Costs.
Labor and materials that support the production line are classified as indirect
labor and meterials.
Labor that supports production

line operation and set up is
classified as indirect labor.
Lubricants, cleaning supplies, and
other materials for these activities
are classified as indirect
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materials. [Photo: Factory winch

workers, Philadelphia, 1920]
Labor and materials that support the production

line are classified as indirect labor and meterials.
Labor that supports production line operation and set up is

classified as indirect labor. Lubricants, cleaning supplies, and other
materials for these activities are classified as indirect materials.
[Photo: Factory winch workers, Philadelphia, 1920]
In ABC Step 4, the analyst Identifies Indirect (or Overhead) Activity Pools, Cost drivers, and Unit Costs. The
analyst, in other words, completes Stage 1 Allocation (or Batch Level Allocation).
In ABC, analysts view the indirect or overhead cost contributors as activity pools.
Activity Pools
Under Activity Based costing, an activity pool is the set of all activities necessary for completing a task, such
as (a) processing purchase orders, or (2) performing machine setups.
To cost activity pools, ABC identifies activity units that drive costs for each pool. For example:
▪ The total cost of for the activity pool Processing purchase orders is driven by the number of purchase
orders processed.
▪ The total cost for the activity pool Performing machine setups is driven by the number of setups.
Step 4A. Identify Activity Pools, Their Cost drivers (CDs), and Unit Cost
Tables 6 A and 6B, below, list 5 Indirect or Overhead Activity Pools in producing each product unit, their
cost drivers (CDs), and per-unit cost for each activity pool. For example:
▪ Activity Pool: Purchase orders. ▪ Activity. Pool: Machine test, calibration.

Cost Drover: Number of POs. Cost Driver: Number of tests.
Cost Driver Unit Cost: $1,800. Cost Drover Unit Cost: $100.
▪ Activity. Pool: Machine setup. ▪ Activity Pool: Maintenance, cleaning
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Cost Drover: Number of setups. Cost Driver: Number of batch runs.

Cost Driver Unit Cost: $1,500. Cost Driver Unit Cost: $1,150
▪ Activity. Pool: Product packaging.

Cost Driver: Number packed.
Cost Driver Unit Cost: $0.20.
▪ Activity Pool: Purchase orders.

Cost Drover: Number of POs.
Cost Driver Unit Cost: $1,800.
▪ Activity. Pool: Machine setup.

Cost Drover: Number of setups.
Cost Driver Unit Cost: $1,500.
▪ Activity. Pool: Product packaging.

Cost Driver: Number packed.
Cost Driver Unit Cost: $0.20.
▪ Activity. Pool: Machine test, calibration.

Cost Driver: Number of tests.
Cost Drover Unit Cost: $100.
▪ Activity Pool: Maintenance, cleaning

Cost Driver: Number of batch runs.
Cost Driver Unit Cost: $1,150
Step 4B. Calculate Activity Pool Costs for Each Product
Table 6A, moreover, shows the number of CD units (activity units) used for product A, while Table 6B shows
these figures for product B. From the given cost of each CD unit, calculate the total cost for each activity
pool, for each product.
For example, the Activity Pool "Purchase Orders" has a Cost Driver unit cost of $1,800. Product required 75
CD units for this activity. Total Product A indirect cost for this activity pool is thus
(75)($1,800) = $135,000
Completing these calculations completes Step 4, ABC Stage 1 Allocation (Batch Level Allocation). Tables
6A and 6B summarize Step 4 data and calculations.
Product A: Activity Units, Activity Pools, and Cost Drivers
Cost Driver (CD) CD Total Activity Total Indirect

Activity Pool Activity Units Unit Cost Product A Cost (A)
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17. Purchase orders No of purchase orders $1,800 75 $135,000
18. Machine setups No of setups $1,500 150 $225,000
No of product
19. Product packaging $0.20 900,000 $180,000
packages packed
20. Machine testing

No of tests $100 1,000 $100,000
& calibration
21. Maintenance
No of batch runs $1,150 200 $230,000
& cleaning
Total $870,000
Table 6A. ABC Stage-1 allocation (batch level allocation) for product A: Activity pools, cost drivers, cost per cost driver unit, and the total
cost for these activities.
Product B: Activity Units, Activity Pools, and Cost Drivers
Cost Driver (CD) CD Total Activity Total Indirect

Activity Pool Cost (B)
Unit Cost Product B
17. Purchase orders No of purchase orders $1,800 25 $45,000
18. Machine setups No of setups $1,500 100 $150,000
No of product
19. Product packaging $0.20 500,000 $100,000
packages packed
20. Machine testing

No of tests $100 2,000 $200,000
& calibration
21. Maintenance 50
No of batch runs $1,150 $57,500
& cleaning
Total $552,500
Table 6B. ABC Stage-1 allocation (batch level allocation) for Product B: Activity pools, cost drivers, cost per cost driver unit, and the total
cost for these activities.

Step 5. Find Per‐Unit Indirect Costs for Each Product
Production supervisors are indirect labor
22 of 35 08/06/2023, 03:25
Production supervisors are

classified as indirect
labor [Photo: Shipyard workers
and supervisor, Story Shipyard,
Ipswitch, Massachusetts, 1925].
Production supervisors are indirect labor
Production supervisors are classified as indirect labor [Photo:

Shipyard workers and supervisor, Story Shipyard, Ipswitch,
Massachusetts, 1925].
When each product's activity pool cost totals, the analyst

can then calculate the cost per product unit, as Table 6C shows.
To find product unit costs, the analyst divides the activity pool cost totals by the number of product units.
From Table 5, Line 1, the firm produced 900,000 units of Product A and 2,100,000 of Product B. With these
figures, the analyst calculates per-product unit costs that appear in the third and fifth columns of Table 6C.
For example:
For the activity pool Purchase orders (line 17 of Table 6C):
Product A Cost per Product Unit = $135,000 / 900,000 = $0.15

Product B Cost per Product Unit = $45,000 / 2,100,000 = $0.02
Stage 2 Allocation in ABC: Allocating Activity Pools to Product Units
Total Indirect Cost Cost per Total Indirect cost Cost per Total indirect
Activity Pool Product A product unit Product B product unit cost
[From Table 6A] Product A [From Table 6B] Product A A+B
17. Purchase orders $135,000 $0.15 $45,000 $0.02 $180,000
18. Machine setups $225,000 $0.25 $150,000 $0.07 $150,000
19. Product packaging $180,000 $0.20 $100,000 $0.05 $280,000
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20. Machine testing $100,000 $0.11 $200,000 $0.09 $300,000

& calibration
21. Maintenance $230,000 $0.26 $57,500 $0.03 $57,500

& cleaning
Total $870,000 $0.97 $552,500 $0.26 $1,422,500
Table6C. Stage-2 allocation in ABC: Allocating activity pool costs to individual product units. The cost per product unit figures for product A and
product B (second and fourth columns) derive d from the cost sums for each activity pool (first and third columns) divided by the number of
product units produced and sold for each product (Table 2, line 1).

Step 6. Calculate Profitability for Individual Products.
The Activity Based costing analyst aims to understand

Calculate total cost per unit
product costs accurately, and then understand individual
product profitability accurately. The aim, in other words,
is to find the true gross profit margins for individual
products.
Accountants calculate individual product profitability as

a gross margin based on product revenues and total
product production costs.
Table 7 below summarizes these figures, using direct

and indirect cost figures from ABC steps 1-5. Each table
row indicates the data source and calculation, if any. and
profitability calculations. Gross profit margins for
Products A and B appear in Row29.
Using the product revenue figures and the individual
product cost figures from ABC steps 1 - 5, the accountant
calculates individual product profitabilities (gross
margins) [Photo: Grace Kelly with NCR 3000 series
accounting calculator, 1950]
Product A Product B Total

Products Compared
22. Units produced and 900,000 2,100,000

3,000,000
sold [Table 5, line 1]
23. Total direct costs $1,125,000 $2,100,000 $3,225,000

[Table 5, line 8]
24. Total overhead costs $870,000 $552,500 $1,422,500

[Table 6C, bottom line total ]
25. Revenues per unit $3.00 $2.00

[ Table 5 line 2 ]
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26. Direct costs/unit $1.25 $1.00

[ = 23 / 22 ]
27. Overhead costs/unit $0.97 $0.26

[ = 24 / 22 ]
28. Gross profit/unit $0.78 $0.26

[ = 25 −26 − 27 ]
29. Gross profit margin 26.1% 36.8%

[ = 28 / 25 ]
Table 7. Gross profit and gross margin calculation for each product, using Activity Based costing for indirect, or overhead costs.
Conclusions: Activity Based Costing Example
First Conclusion
ABC finds different indirect (overhead) costs per unit for each product. ABC results are thus unlike the
traditional costing example above, where indirect costs per unit were the same for both products.
Second Conclusion
ABC analysis recognizes that product A uses more activity pool resources than product B.
Third Conclusion
On a per-unit basis, ABC finds product B more profitable than product A. The gross margin rate of 36.8%
for B compares with a gross margin of 26.1% for A.
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Comparing ABC and Traditional Costing

Advantages and Disadvantages to Each Approach
Costing Results from Two Approaches
Table 8 below shows the per-unit profitability estimates for each product from the examples above.
25 of 35 08/06/2023, 03:25
Product A Product B
Product Profitability (Gross Profit Margin)
Traditional cost allocation

42.5% 26.3%
(Production volume-based allocating)
Activity Based costing approach 26.1% 36.8%
Table8. Comparing profitability estimates from two different costing methods. Traditional costing shows product A more profitable than product
B. ABC based costing shows the reverse. These differences result from the different treatment of overhead costs.
Key Differences Between Costing Methods
The tables and examples above illustrate some critical differences between the costing methods:
Data and Analysis
▪ Activity Based costing requires detailed knowledge of the activities and resources that go into overhead
(or "indirect") support work.
▪ Traditional cost accounting (production volume-based allocation) requires only a total overhead cost and
a simple allocation rule.
Overhead Components and Products: Differentiation vs. Aggregation
▪ ABC recognizes that individual overhead components can be distributed differently for different
products. One product may consume relatively more maintenance resources, for instance, while another
product may consume relatively fewer maintenance resources, but relatively more for machine set up.
▪ Traditional cost accounting typically puts "overhead" components into fewer categories, or even a single
class, and uses a single allocation rate for all products.
Direct vs. indirect measurement
▪ Activity Based costing treats overhead costs essentially as direct costs, in that cost estimates reflect actual
cost driver usage for each product. These costs, in turn, can be reasonably be apportioned to individual
product units.
▪ In traditional cost accounting (production volume-based allocation), an accurate measure of total

overhead cost is accessible. However, in conventional costing the distribution of that total to individual
products is based on an indirect measure of that cost.
Costing Accuracy vs. the Cost of Costing
For the profitability figures appearing in Table 7 above, the Activity Based costing results may be taken as
the more accurate results—more closely reflecting the "true" production costs of products A and B—than the
profitability figures from the traditional costing approach. Whether or not the improved accuracy justifies the
26 of 35 08/06/2023, 03:25
higher expense of applying this costing method, however, is something management will have to investigate
and answer before committing to a comprehensive new approach to cost accounting.
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What is Activity Based Management?
Corporate officers and other high-level management responsible for strategy
Corporate Officers will choose

ABC and Activity Based
Management only when confident
the gain in costing accuracy justifies ABC implementation costs. [Photo: High-level management meeting. Image by H.
Armstrong Roberts, February 1930.]
Corporate officers and other high-level

management responsible for strategy
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Corporate Officers will choose ABC and Activity Based Management only when confident the gain in costing accuracy justifies
ABC implementation costs.[Image: High-level management meeting. Photo by H. Armstrong Roberts, February 1930.]
Organizations that use Activity Based costing results consistently for decision support and planning are
practicing Activity Based management ABM.
For example:
Pricing Decisions. The heart of the firm's business strategy is a business model specifying margins the firm
expects and needs to earn. With accurate knowledge of product costs, the firm can set prices more accurately
to achieve target margins.
Budgetary Planning. To create an operating budget for the next budge cycle, the firm must anticipate future
product costs accurately. ABC shows how indirect product costs depend on production volume for each
product, more accurately than traditional cost allocation methods. If the firm can predict future production
volume accurately, it can also budget future costs accurately.
Adoption of ABC and ABM
A few firms began using ABC in the mid-1970s. In the years since then, the percentage of companies and
other organizations using ABC increased more or less continuously, but slowly. Nearly five decades after
ABC first appeared, however, the majority of companies and organizations in all industries still do not use
Activity Based costing, and still do not practice Activity Based management.
Implementing Activity Based Management ABM
Regarding implementation, Activity Based costing requires
▪ Complete details on activities that go into specific products, services, and tasks.
▪ Complete details on the resources these activities consume (time, labor, and other goods and services).
Implementation in large, complex organizations is therefore a labor-intensive and data-intensive undertaking.

However, ABC and ABM are becoming more approachable to many companies as a result of two ongoing
trends.
▪ Firstly, recent improvements in costing software.
▪ Secondly, the increasing availability of data from complex, comprehensive software systems, such
as enterprise resource planning (ERP) systems, manufacturing resource planning (MRP) systems, and
customer relationship management (CRM) systems.
ABM Started in Manufacturing
When a few firms moved to ABC in the 1970s, the benefits of ABC were most apparent in product
manufacturing settings, as the two numerical examples above show. From the start, it was clear that in such
28 of 35 08/06/2023, 03:25
settings, the ABC is superior to traditional cost accounting for the purposes of:
▪ Identifying truly profitable and truly unprofitable products.
▪ Finding and eliminating unnecessary costs.
▪ Identifying and distinguishing between true value-add activities and non-value add activities.
▪ Pricing products so as to achieve acceptable margins.
Activity Based Management: Moving Beyond Manufacturing
Increasingly, however, the value of more accurate costing has become more widely appreciated, leading to
the application of this methodology for the purposes of:
▪ Budgeting and financial planning.
Organizations can anticipate overhead costs and funding needs with greater accuracy and more certainty
under ABC.
▪ Human capital management.
Firms can now direct human resources into more profitable activities under ABC.
▪ Performance measurement.
Managers can evaluate the performance of individuals, groups, projects, initiatives, and programs, with
more certainty and accuracy when they know their true costs through ABC.

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Business Case Website

How to Use Activity Based Costing (ABC)

How to Use Activity Based Costing (ABC)

What is Activity Based Costing?

Deﬁne Activity‐Based Costing ABC

▪ The activities that go into them.

Firms adopt activity-based-costing to better

What Are the Beneﬁts of ABC?

▪ Identify specific products that are unprofitable.

▪ Improve production process efficiency.

▪ Reveal unnecessary costs that become targets for elimination.

ABC Impacts the Same Accounts, But With Diﬀerent Mathematics

Explaining Activity Based Costing in Context

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▪ What is Activity Based costing ABC?

◦ Define Activity-Based Costing.

▪ Why do companies and organizations use Activity Based costing?

▪ How does Activity Based costing compare to traditional cost accounting?

◦ TC Step 1. Find total direct costs.

◦ TC Step 3. Find total direct costs for each product unit.

◦ TC Step 4. Allocate to find indirect labor and materials costs.

◦ ABC Step 1. Find total direct costs.

◦ ABC Step 5. Find per-unit indirect costs for each product.

◦ ABC Step 6. Calculate profitability for individual products.

▪ Comparing traditional and Activity Based costing: Advantages and disadvantages.

▪ What is Activity Based management ABM?

Why Do Companies and Organizations Move to ABC?

Business Case Templates

Activity Based Costing vs. Traditional Cost Accounting

Traditional costing typically

The balance sheet compares the firms assets,

Example: Traditional Cost Accounting vs. ABC

Example Sources of Direct Costs

▪ Direct labor costs.

Example Sources of Indirect Costs

▪ Materials purchase order costs.

▪ Machine set up costs.

▪ Product packaging costs.

▪ Machine testing and calibration costs.

▪ Machine maintenance and cleaning costs.

Product Speciﬁc Cost Sources

Products Compared Product A Product B

Selling Price Higher price Lower price

Mach. Setups More machine setups Fewer machine setups

Packaging 1 Unit per package 4 Units per package

Table 1. Product A and Product B compared.

Financial Metrics Pro

How to Use Traditional Costing

▪ 900,000 units of product A at $3.00 each.

▪ 2,100,000 units of product B at $2.00 each.

Production machine operators

Direct costs are the same in traditional and

Product A direct labor: $450,000

Step 1B Find Total Direct Materials Cost for Each Product.

Product A direct materials: $675,000 Product B direct materials: $1,050,000

Workers assembling individual

Assemblers working directly on products are

Product A: 900,000 units Product B 2,100,000 units

Product A Direct labor per unit: $450,000 / 900,000 = $0.50 / unit

Step 2B Find Each Product's Direct Materials Cost per Unit

Product A direct materials per unit $675,000 / 900,000 = $0.75 / unit

The final step in finding product direct costs, Step 3, is