08 Activity-Based Costing A Tool To Aid Decision Making

11th Edition
Chapter 8
McGrawHill/Irwin
Copyright2006,TheMcGrawHillCompanies,Inc.
Activity-Based Costing: A
Tool to Aid Decision Making
Chapter Eight
McGrawHill/Irwin
Activity Based Costing (ABC)
ABC is designed to
provide managers with
cost information for
strategic and other
decisions that potentially
affect capacity and
therefore affect fixed as
well as variable costs.
McGrawHill/Irwin
ABC is a
good supplement
to our traditional
cost system
I agree!
How Costs are Treated Under

ActivityBased Costing
Best
Best practice
practice ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
Manufacturing
costs
Nonmanufacturing
costs
Traditional
product costing
ABC
product costing
ABC assigns both types of costs to products.

McGrawHill/Irwin

Best
Best practice
practice ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
Traditional
product costing
Nonmanufacturing
costs
Mo
st,
not but
all
Some
All
Manufacturing
costs
ABC
product costing
ABC does not assign all manufacturing costs to products.

McGrawHill/Irwin

Level of complexity
Best
Best practice
practice ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
ActivityBased
ActivityBased
Costing
Costing
Departmental
Departmental
Overhead
Overhead
Rates
Rates
Plantwide
Plantwide
Overhead
Overhead
Rate
Rate
Number of cost pools

ABC uses more cost pools.
McGrawHill/Irwin

Number of
Allocation Bases
Best
Best practice
practice ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
Volume
measures
plus other
bases.
Bases usually
rely solely on
volume
measures.
Traditional Costing
ABC
ABC uses more allocation bases.
McGrawHill/Irwin

Best
Best practice
practice ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
The
The most
most commonly
commonly used
used allocation
allocation base
base
in
in traditional
traditional costing
costing is
is direct
direct labor
labor hours.
hours.
Direct labor hours work
well when overhead
increases as direct
labor hours increase.

McGrawHill/Irwin

Best
Best practice
practice ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
The
The most
most commonly
commonly used
used allocation
allocation base
base
in
in traditional
traditional costing
costing is
is direct
direct labor
labor hours.
hours.
Problems:
In many processes, overhead is increasing
while direct labor is decreasing.
Variety and complexity of products is increasing.

McGrawHill/Irwin

Best
Best practice
practice ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
All overhead
costs are not related
to volume measures like
direct labor
hours.
ABC uses
volume as well as
other allocation bases not
related to the volume
of production.

McGrawHill/Irwin

Best
Best practice
practice ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
Traditional Costing
ABC
The predetermined
overhead rate is based
on budgeted activity.
This results in applying
all overhead costs
including unused, or
idle capacity costs to
products.
Products are charged

for the costs of
capacity they use not
for the costs of
capacity they dont
use. Unused capacity
costs are treated as
period expenses.
ABC bases level of activity on capacity.

McGrawHill/Irwin
Characteristics of Successful
ABC Implementations
Strong
Strong top
top
management
management support
support
Link
Link to
to evaluations
evaluations
and
and rewards
rewards
Cross-functional
Cross-functional
involvement
involvement
McGrawHill/Irwin
Designing an ABC System
Cost Objects
(e.g., products
and customers)
Activities
Consumption
of Resources
Cost
McGrawHill/Irwin
Designing an ABC System

Steps for Implementing ABC
Identify and define activities and activity cost
pools.
Trace costs to activities and cost objects.
Assign costs to activity cost pools.
Calculate activity rates.
Assign costs to cost objects.
Prepare management reports.
McGrawHill/Irwin
Identify and Define Activities

and Activity Cost Pools
Unit-Level
Activity
Batch-Level
Activity
Manufacturing
companies typically combine
their activities into five
classifications.
Product-Level
Activity
McGrawHill/Irwin
Organizationsustaining
Activity
Customer-Level
Activity

Activities
should only be
combined within a level
if they are highly
correlated.
When combining
activities, they should be
grouped together only at
the appropriate
level.
McGrawHill/Irwin

An Activity Cost
Pool is a bucket in
which costs are
accumulated that
relate to a single
activity measure in
the ABC system.
McGrawHill/Irwin
$$
$
$ $
$

Two types of activity measures:
Transaction
driver
Duration
driver
Simple count
of the number of
times an activity
occurs.
A measure
of the amount
of time needed
for an activity.
McGrawHill/Irwin

At Classic Brass, the ABC team, selected the following
activity cost pools and activity measures:
Activity Cost Pools at Classic Brass

Activity Cost Pool
Customer orders
Product design
Order size
Customer relations
Other
McGrawHill/Irwin
Activity Measure
Number of customer orders
Number of product designs
Machine-hours
Number of active customers
Not applicable

Customer
Customer Orders
Orders -- assigned
assigned all
all costs
costs of
of resources
resources
that
that are
are consumed
consumed by
by taking
taking and
and processing
processing
customer
customer orders.
orders.
Product
Product Designs
Designs -- assigned
assigned all
all costs
costs of
of resources
resources
consumed
consumed by
by designing
designing products.
products.
Order
Order Size
Size -- assigned
assigned all
all costs
costs of
of resources
resources
consumed
consumed as
as aa consequence
consequence of
of the
the number
number of
of units
units
produced.
produced.
Customer
Customer Relations
Relations assigned
assigned all
all costs
costs associated
associated
with
with maintaining
maintaining relations
relations with
with customers.
customers.
Other
Other assigned
assigned all
all overhead
overhead costs
costs that
that are
are not
not
associated
associated with
with the
the other
other cost
cost pools.
pools.
McGrawHill/Irwin
When Possible, Directly Trace Overhead

Costs to Activities and Cost Objects
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)
Production Department
Indirect factory wages
$
Factory equipment depreciation
Factory utilities
Factory building lease
Shipping costs traced to customer orders
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total overhead costs
McGrawHill/Irwin
500,000
300,000
120,000
80,000 $
400,000
50,000
60,000
1,000,000
40,000
510,000
250,000
50,000
$
300,000
1,850,000
Assign Costs to Activity Cost Pools

At Classic Brass the following distribution of resource
consumption across activity cost pools is determined.
Activity Cost Pools
Customer Product
Order
Orders
Design
Size
Factory utilities
Shipping costs **
Selling expenses
Customer
Relations
Other
Total
25%
20%
0%
0%
40%
0%
10%
0%
20%
60%
50%
0%
10%
0%
0%
0%
5%
20%
40%
100%
100%
100%
100%
100%
15%
30%
0%
5%
0%
0%
10%
0%
0%
30%
25%
0%
40%
45%
100%
100%
100%
100%
20%
10%
10%
0%
0%
0%
60%
70%
10%
20%
100%
100%
**Not included because they are directly traced to customer orders.

McGrawHill/Irwin

Activity
Customer
Orders
Factory utilities
Selling expenses
Total
$ 125,000
$
CostIndirect
Poolsfactory wages
Product
Order
Customer
Factory utilities
Design
Sizelease Relations
Factory building
Selling expenses
500,000
300,000
120,000
Other
80,000 $
Total
1,000,000
40,000
400,000
50,000
60,000
510,000
250,000
50,000
$
300,000
1,850,000
Indirect
$500,000
Indirect factory
factory wages
wages
$500,000
Percent
25%
Percent consumed
consumed by
by customer
customer orders
orders
25%
$125,000
$125,000
McGrawHill/Irwin

Activity
Customer
Orders
Factory utilities
Selling expenses
Total
$ 125,000
60,000
$
CostIndirect
Poolsfactory wages
Product
Order
Customer
Factory utilities
Design
Sizelease Relations
Factory building
Selling expenses
500,000
300,000
120,000
Other
80,000 $
Total
1,000,000
40,000
400,000
50,000
60,000
510,000
250,000
50,000
$
300,000
1,850,000
Factory
$300,000
Factory equipment
equipment depreciation
depreciation
$300,000
Percent
20%
Percent consumed
consumed by
by customer
customer orders
orders
20%
$$ 60,000
60,000
McGrawHill/Irwin
Activity Cost Pools

Customer
Product
Orders
Design
Factory utilities
Selling expenses
Total
McGrawHill/Irwin
Order
Size
Customer
Relations
$ 125,000 $ 200,000 $ 100,000 $

60,000
180,000
12,000
60,000
60,000
15,000
-
20,000
-
40,000
-
50,000 $
120,000
12,500
-
Other
25,000 $
60,000
48,000
80,000
160,000
22,500
60,000
Total
500,000
300,000
120,000
80,000
400,000
50,000
60,000
50,000
25,000
150,000
25,000
250,000
5,000
35,000
10,000
50,000
$ 315,000 $ 257,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000
Calculate Activity Rates

The ABC team determines that Classic Brass will
have these total activities for each activity cost
pool . . .
1,000 customer orders,
200 new designs,
20,000 machine-hours,
100 customer relations activities.
Now
Now the
the team
team can
can compute
compute the
the individual
individual
activity
activity rates
rates by
by dividing
dividing the
the total
total cost
cost for
for
each
each activity
activity by
by the
the total
total activity
activity levels.
levels.
McGrawHill/Irwin
Calculate Activity Rates

Computation of Activity Rates
Activity Cost Pools
Customer orders
Product design
Order size
Customer relations
Other
McGrawHill/Irwin
(a)
Total Cost
$ 315,000
257,000
380,000
367,500
490,500
(b)
Total Activity
1,000 orders
200 designs
20,000 MHs
100 customer
Not applicable
(a) (b)
Activity Rate
$315 per order
$1,285 per design
$19 per MH
$3,675 per customer
Not applicable
Activity-Based Costing at Classic Brass

Direct
Materials
Direct
Labor
Shipping
Costs
Traced
Traced
Traced
Overhead Costs
Cost Objects:
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
McGrawHill/Irwin

Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Other
Cost Objects:
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
McGrawHill/Irwin

Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Other
Second-Stage Allocations
$/MH
$/Order
$/Design
Cost Objects:
$/Customer
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
McGrawHill/Irwin
Unallocated
Assigning Costs to Cost Objects

Lets take a look at how our system works
for just one customer Windward Yachts.
Standard Stanchions (no design required)
1. 400 units ordered with 2 separate orders.
2. Each stanchion required 0.5 machine-hours.
3. Selling price is $34 each.
4. Direct materials total $2,110.
5. Direct labor totals $1,850.
6. Shipping costs total $180.
McGrawHill/Irwin
Custom Compass Housing (requires new design)

1. One order during the year.
2. Each housing required 4 machine-hours.
3. Selling price is $650 each.
4. Direct materials total $13.
5. Direct labor totals $50.
6. Shipping costs total $25.
Assigning Costs to Cost Objects

Overhead Cost for the Standard Stanchions
Activity Cost Pools
Customer orders
Product design
Order size
Customer relations
(a)
Activity Rate
$
315
1,285
19
3,675
The customer-level
cost is assigned to
customers directly;
it is not assigned to
products.
McGrawHill/Irwin
(b)
Activity
2
0
200
N/A
(a) (b)
ABC Cost
$
630
3,800
Overhead Cost for the Custom Housing

Activity Cost Pools
Customer orders
Product design
Order size
Customer relations
(a)
Activity Rate
$
315
1,285
19
3,675
(b)
Activity
1
1
4
N/A
(a) (b)
ABC Cost
$
315
1,285
76
Prepare Management Reports

Standard Stanchions
Sales
Cost:
Direct materials
Direct labor
Shipping costs
Customer orders
Product design
Order size
Product margin
13,600
8,570
5,030
$ 2,110
1,850
180
630
3,800
Custom Compass Housing

Sales
Cost:
Direct materials
Direct labor
Shipping costs
Customer orders
Product design
Order size
Product margin
McGrawHill/Irwin
$
$
13
50
25
315
1,285
76
650
1,764
$ (1,114)
Prepare Management Reports
Customer Profitability Analysis

Windward
Windward Yachts
Yachts
Product
Product margins:
margins:
Standard
Standard stanchion
stanchion
Custom
Custom compass
compass housing
housing
Total
Total product
product margin
margin
Less:
Less: Customer
Customer relations
relations
Customer
Customer margin
margin
McGrawHill/Irwin
$$5,030
5,030
(1,114)
(1,114)
3,916
3,916
3,675
3,675
$$ 241
241
Product Margins
Traditional Cost Accounting System
Sales
Costs
Direct materials
Direct labor
Manufacturing overhead
Product margin
Standard
Stanchions
$
13,600
(2,110)
(1,850)
(10,000)
(360)
Compass
Housing
$
650
(13)
(50)
(200)
387
400
400 units
units xx 0.5
0.5 MH/unit
MH/unit xx $50/MH
$50/MH == $10,000
$10,000
Predetermined manufacturing
=
overhead rate
McGrawHill/Irwin
$1,000,000
20,000 MH
= $50/MH
Differences Between ABC and

Traditional Product Costs
Product margins are different for four reasons:
Traditional costing assigns design costs to both products
based on machine hours. ABC assigns product design

costs to a product only if product design work is required.
Traditional costing assigns customer order costs, a batch-
level cost, using a unit-level allocation base, machine hours.

ABC assigns these batch-level costs using a batch-level
activity measure.
Traditional costing assigns only manufacturing costs to
products. ABC also assigns nonmanufacturing costs to

products.
Traditional costing assigns all manufacturing costs to
products. The ABC system does not assign organizationsustaining manufacturing costs to the products.
McGrawHill/Irwin
Differences Between ABC and

Traditional Product Costs
When batch-level and
product-level costs are present,
ABC will usually shift costs from high
volume products, produced in large batches,
to low volume products produced in small batches.
This cost shifting will usually have its
greatest impact on the per
unit cost of the low
volume products.
McGrawHill/Irwin
Targeting Process Improvement
Activity-based management is
used in conjunction with ABC to
identify areas that would benefit
from process improvements.
While the theory of constraints

approach discussed in Chapter 1 is a
powerful tool for targeting
improvement efforts, activity rates
can also provide valuable clues on
where to focus improvement efforts.
McGrawHill/Irwin
Activity-Based Costing and External Reporting
Most companies do not use ABC

for external reporting because . . .
1.
1. External
External reports
reports are
are less
less detailed
detailed than
than internal
internal
reports.
reports.
2.
2. ItIt may
may be
be difficult
difficult to
to make
make changes
changes to
to the
the companys
companys
accounting
accounting system.
system.
3.
3. ABC
ABC does
does not
not conform
conform to
to GAAP.
GAAP.
4.
4. Auditors
Auditors may
may be
be suspect
suspect of
of the
the subjective
subjective allocation
allocation
process
process based
based on
on interviews
interviews with
with employees.
employees.
McGrawHill/Irwin
ABC Limitations
Substantial resources
required to implement
and maintain.
Resistance to
unfamiliar numbers
and reports.
Desire to fully
allocate all costs
to products.
Potential
misinterpretation of
unfamiliar numbers.
Does not conform to

GAAP. Two costing
systems may be needed.
McGrawHill/Irwin
Appendix 8A: ABC Action Analysis

Conventional
Conventional ABC
ABC analysis
analysis does
does not
not
identify
identify potentially
potentially relevant
relevant costs.
costs. An
An
action
action analysis
analysis report
report helps
helps because
because it:
it:
Shows
Shows what
what costs
costs have
have been
been
assigned
assigned to
to aa cost
cost object.
object.
Indicates
Indicates how
how difficult
difficult itit would
would be
be to
to
adjust
adjust those
those costs
costs in
in response
response to
to
changes
changes in
in the
the level
level of
of activity.
activity.
McGrawHill/Irwin

Constructing an action analysis report
begins with the first-stage allocation
process. In addition to computing an
overall activity rate for each activity cost
pool, an activity rate is computed for each
type of overhead cost that is consumed
supporting a given activity.
Lets revisit the stage-one allocations
from the Classic Brass example that we
discussed earlier.
McGrawHill/Irwin
Activity Cost Pools
Customer Product Order Customer

Orders Design Size Relations Other
Total Activity
Customer
Orders
Factory utilities
Selling expenses
Total
$ 125,000
60,000
60,000
15,000
-
1,000
200 20,000
$
125 $ 1,000 $
5 $
FactoryActivity
equipmentCost
depreciation
60
9
Pools
Factory utilities
60
3
Product
Order
Customer
Design
Size
Relations
Other
General
Administrative
Department
60
100
2
15
$ 200,000 $ 100,000 $ 50,000 $ 25,000 $
180,000
60,000
Marketing
salaries
125
12,000 wages and
60,000
- 50
48,000Selling- expenses
5
80,000Total
$
315 $ 1,285 $ 19 $
20,000
-
40,000
-
120,000
12,500
-
160,000
22,500
60,000
100
N/A
500
-
Total
1,200
125
500,000
-
300,000
1,500
120,000
350
80,000
3,675
400,000
50,000
60,000
50,000
25,000
150,000
25,000
250,000
5,000
35,000
10,000
50,000
$ 315,000 $ 257,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000
$125,000 1,000 orders = $125 per order

Other entries in the table are computed similarly.
McGrawHill/Irwin

Action Analysis Cost Matrix for Standard Stanchions
Activity Cost Pools
Customer Product
Orders Design
Total activity for stanchions
Factory utilities
Selling expenses
Total
2
$
250 $
120
120
30
-
100
10
630 $
Order Customer
Size Relations
200
$ 1,000
1,800
600
400
$ 3,800
Total
N/A
$ 1,250
1,920
600
520
30
100
10
$ 4,430
$125 per order 2 orders = $250

McGrawHill/Irwin

Action Analysis Cost Matrix for Custom Compass Housing
Activity Cost Pools
Customer Product
Orders Design
Total activity for compass housing
Factory utilities
Selling expenses
Total
1
$
Order Customer
Size Relations
125 $ 1,000 $
60
60
60
100
15
50
125
5
315 $ 1,285 $
4
20
36
12
8
76
Total
N/A
$ 1,145
96
72
168
15
175
5
$ 1,676
$125 per order 1 orders = $125

McGrawHill/Irwin

Next,
Next, label
label each
each cost
cost using
using an
an ease
ease of
of adjustment
adjustment
code:
code:
Green
Green costs
costs adjust
adjust more
more or
or less
less automatically
automatically to
to
changes
changes in
in activity
activity level
level without
without any
any action
action by
by
managers.
managers.
Yellow
Yellow costs
costs can
can be
be adjusted
adjusted to
to changes
changes in
in activity
activity
level,
level, but
but itit would
would require
require management
management action
action to
to
realize
realize the
the change
change in
in cost.
cost.
Red
Red costs
costs can
can be
be adjusted
adjusted to
to changes
changes in
in activity
activity
level
level only
only with
with aa great
great deal
deal difficulty
difficulty and
and with
with
management
management intervention.
intervention.
McGrawHill/Irwin

Action Analysis of Custom Compass Housing
Sales
Green costs
Direct materials
Shipping costs
Green margin
Yellow costs
Direct labor
Factory utilities
Selling expenses
Yellow margin
Red costs
Red margin
McGrawHill/Irwin
650
38
612
13
25
50
1,145
72
168
15
175
5
96
-
1,630
$ (1,018)
96
$ (1,114)
End of Chapter 8
McGrawHill/Irwin

08 Activity-Based Costing A Tool To Aid Decision Making

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11th Edition

Activity Based Costing (ABC)

How Costs are Treated Under

ABC assigns both types of costs to products.

How Costs are Treated Under

ABC does not assign all manufacturing costs to products.

How Costs are Treated Under

Number of cost pools

How Costs are Treated Under

How Costs are Treated Under

ABC uses more allocation bases.

How Costs are Treated Under

ABC uses more allocation bases.

How Costs are Treated Under

ABC uses more allocation bases.

How Costs are Treated Under

Products are charged

ABC bases level of activity on capacity.

Designing an ABC System

Designing an ABC System

Identify and Define Activities

Identify and Define Activities

Identify and Define Activities

Identify and Define Activities

Identify and Define Activities

Activity Cost Pools at Classic Brass

Identify and Define Activities

When Possible, Directly Trace Overhead

Assign Costs to Activity Cost Pools

**Not included because they are directly traced to customer orders.

Assign Costs to Activity Cost Pools

Assign Costs to Activity Cost Pools

Assign Costs to Activity Cost Pools

Activity Cost Pools

$ 125,000 $ 200,000 $ 100,000 $

Calculate Activity Rates

Calculate Activity Rates

Activity-Based Costing at Classic Brass

Activity-Based Costing at Classic Brass

Activity-Based Costing at Classic Brass

Assigning Costs to Cost Objects

Custom Compass Housing (requires new design)

Assigning Costs to Cost Objects

Overhead Cost for the Custom Housing

Prepare Management Reports

Custom Compass Housing

Prepare Management Reports

Customer Profitability Analysis

Differences Between ABC and

Traditional costing assigns design costs to both products

based on machine hours. ABC assigns product design

Traditional costing assigns customer order costs, a batch-

level cost, using a unit-level allocation base, machine hours.

Traditional costing assigns only manufacturing costs to

products. ABC also assigns nonmanufacturing costs to

Traditional costing assigns all manufacturing costs to

Differences Between ABC and

Targeting Process Improvement

While the theory of constraints

Activity-Based Costing and External Reporting

Most companies do not use ABC

Does not conform to

Appendix 8A: ABC Action Analysis