Activity-Based

Costing Systems
Learning Objective 1
 Traditional Costing Systems

Traditional
Traditional cost
cost systems
systems were
were created
created when
when
manufacturing
manufacturing processes
processes were
were labor
labor intensive.
intensive.

A
Asingle
single company-wide
company-wide overhead
overhead rate
rate
based
based on on direct
direct labor
labor hours
hours may
may be
be
used
used to to allocate
allocate overhead
overhead to
to products
products
in
in these
these labor
labor intensive
intensive processes.
processes.
Traditional Costing Systems
Job 1 Job 2
Labor Hours 2 6

In
Inthis
thisexample,
example, overhead
overheadwill
will be
beallocated
allocatedto tojobs
jobs
using
usingdirect
direct labor
laborhours.
hours. IfIf total
total overhead
overheadis is$120,
$120,
how
howmuch
much will
willbe
beallocated
allocatedto toeach
each job?
job?
Traditional Costing Systems

Job 1 Job 2
Labor Hours 2 6
Overhead
$ 30 $ 90
Allocation

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
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.
Traditional Costing Systems

Job 1 Job 2
Labor Hours 2 1
Overhead
$ 280 $ 140
Allocation

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
Traditional Costing Systems

Job 1 Job 2
Labor Hours 2 1
Overhead
$ 280 $ 140
Allocation

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.
Learning Objective 2
Activity-Based Costing (ABC)

AA costing
costing method
method that
that identifies
identifies the
the activities
activities
performed
performed within
within the
the organization
organization as as itit delivers
delivers
its
its goods
goods and
and services.
services.

Products Activities
Require Consume
Activities Resources

People
Manage
Activities
Activity-Based Costing (ABC)

AA costing
costing method
method that
that assigns
assigns costs
costs toto
products,
products, based
based on
on the
the number
number of
of activities
activities the
the
organization
organization used
used inin producing
producing them.
them.

Process
Lot size Direct
setups
labor
hours

Design Machine Customer

time hours contact
 Activity-Based Costing (ABC)
Both
Both manufacturing
manufacturing
and
and nonmanufacturing
nonmanufacturing ABC
ABC isis aa good
good
costs
costs may
may be
be supplement
supplement
assigned
assigned to
to to
to our
our traditional
traditional
products.
products. cost
cost system.
system.
A
B C
Allocation
Allocation bases
bases Used
Used in
in internal
internal
often
often differ
differ from
from decision
decision making
making as as well
well
traditional
traditional costing
costing as
as in
in inventory
inventory valuation
valuation
systems.
systems. for
for external
external reporting.
reporting.
ABC Compared with Traditional Costing

Activity-Based
Activity-Based
Costing
Costing

i ty n
ex t io
pl nta
o m e its
C m e f
o f l e n
Traditional
Traditional l m B p e
Costing v e I of
Costing f
Le t o el
os ev
C L
 ABC Compared with Traditional Costing
Traditional Costing Activity-Based Costing
Resource Costs Resource Costs

Directly traced Directly traced

or allocated or allocated

Cost Pools: Cost Pools:

Plants or Activities or
Departments Activity Centers

Predetermined Cost driver

overhead rates for
rate each activity
Cost Objects Cost Objects
Activity-Based Costing (ABC)
Activity
An Activity Cost Costs
Pool is a
common way to $$
$
collect costs $ $
that are related $
to a specific
activity in the
ABC system.
 Four Steps in the ABC Process

Identify
Identify and
and classify
classify the
the activities
activities
related
related to
to the
the companys
companys
products
products oror services.
services.

Estimate
Estimate the
the cost
cost of
of each
each activity
activity
identified
identified in
in .
.

Calculate
Calculate aa cost-driver
cost-driver rate
rate for
for
each
each activity.
activity.

Assign
Assign activity
activity costs
costs to
to products
products
using
using the
the cost-driver
cost-driver rate.
rate.
Learning Objective 3
 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 p erformed to provide general capacity to
produce goods or services.
 Identify and Classify Activities

TOP
TOPDOWN
DOWNAPPROACH
APPROACH
ABC
ABCteams
teamsofof people
peoplefrom
from
top
toplevels
levelsof
of management
management
generate
generatethe
theactivity
activity
dictionary.
dictionary.

INTERVIEW
INTERVIEW OR
OR
RECYCLING
RECYCLING PARTICIPATIVE
PARTICIPATIVE
APPROACH
APPROACH APPROACH
APPROACH
Reuses
Reusesdocumentation
documentation ABC
ABCteams
teamsinclude
includeor
or
of
of processes
processesused
usedfor
for interview
interviewoperating
operating
other
otherpurposes.
purposes. employees.
employees.
Learning Objective 4
 Estimate the Cost of Activities

The
TheABC
ABCteams
teamsshould
shouldgather
gatherdata
data on
on the
the costs
costsof
ofall
all
the
theactivities
activities identified
identified in
inStep
Step1.1.

Examine
Examine
accounting Ask
Askemployees
employees
accounting to
records toindicate
indicatehow
how
recordsfor
for much
muchtime
time
recorded
recordedcost
cost they
theywork
workonon
information.
information. various
variousactivities.
activities.
 Calculate Cost-Driver Rates for
Activities
Two
Twopieces
piecesofof
information
informationareare
required
requiredto tocompute
compute
the
thecost-driver
cost-driverrate:
rate:
Activity Cost
Activity Cost
Activity Volume
Activity Volume

May
MayCompany
Companyhas has44employees
employeesin inits
itsQuality
QualityControl
Control
Department.
Department.Salaries
Salariesand
andcosts
costs for
for the
thedepartment
department total
total
$360,000
$360,000per
peryear.
year. May
Mayproduces
produces500,000
500,000units
unitsof
of
product
product aayear.
year. What
Whatis isthe
thecost-driver
cost-driver rate
rateper
perunit?
unit?
$360,000
$360,000500,000
500,000 units
units== $.72
$.72per
perunit
unit
 Calculate Cost-Driver Rates for
Activities
MAY
MAYhas hasaacustomer
customer service
servicecenter
centerwhere
where
customers
customerscancan call
call to
to ask
askquestions.
questions.
Customers
Customerspaypayaafixed
fixedfee feefor
foreach
each call
call
they
theymake
maketoto the
theservice
servicecenter.
center.ItIt costs
costs
MAY
MAY$1,260,000
$1,260,000aa year
year to to operate
operatethe the
center.
center. The
Thecenter
center receives
receives120,000
120,000calls
calls
per
per year.
year. The
Thecenter
center handles
handles1,000,000
1,000,000
minutes
minutesof of calls.
calls.
What
Whatis
isthe
theappropriate
appropriatecost
cost driver:
driver:total
total
minutes
minutesfor
forall
all calls
callsor
ornumber
numberof of calls?
calls?
What
What isis the
thecost-driver
cost-driver rate?
rate?
 Calculate Cost-Driver Rates for
Activities
Since
Sincecustomers
customersarearecharged
chargedper
percall,
call,the
the
proper
proper activity
activityin
inthis
thiscase
caseis
isthe
thenumber
numberof of
calls
callshandled
handledby bythe
thecenter.
center.
The
Thecost-driver
cost-driver rate
ratewould
would be:
be:
$1,260,000
$1,260,000 120,000
120,000 units
units==$10.50
$10.50per
per call
call
 Calculate Cost-Driver Rates for
Activities
Cause and effect
relationship between Measurable
activity and costs
Appropriate
cost-driver
base
Based on resources Predict or explain
practical capacity to an activitys use
support activities of resources
 Practical Capacity Note

When
Whenestimating
estimatingthe the
cost EXAMPLE
EXAMPLE
cost of
of anan activity,
activity,
only
onlythethecosts
costs Suppose
Supposewe werent
rentaa1,000
1,000
associated
associatedwith withthe
the square
squarefootfootwarehouse
warehousefor for
product
productshould
shouldbe be $1,000
$1,000per permonth.
month. Only
Only800
800
used
used (practical
(practical sq.
sq.ft.
ft.are
areused
usedto
tostore
store
capacity).
capacity). TheThecost
cost Product
ProductA. A. The
Therest
restof
ofthe
the
of
ofunused
unusedcapacity
capacity warehouse
warehouseis isunused.
unused.
should
shouldnot not be
be How
Howmuch
muchrentrentcost
costshould
shouldbe be
applied
appliedto to products.
products. allocated
allocatedto toProduct
ProductA?A?
Practical Capacity Note

80%, or $800 20%, or $200 should

should be assigned be assigned to
to Product A unused capacity
Learning Objective 5
 Assign Activity Costs to Products

1.
1.Identify
Identifyall
all 2.
2.Determine
Determine 3.
3.Assign
Assign costs
costs
the
theactivities
activities how
howmany
many to
to products
products
related
relatedtotoaa units
units of
of each
each using
using the
thecost-
cost-
given
givenproduct
product activity
activityare
are driver
driverrates
ratesfor
for
or
orservice.
service. used
used per
per unit
unit each
eachactivity.
activity.
of
of product.
product.
 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?
 Assign Activity Costs to Products
Activity-Based Costing Example

Lets look at an
example from the
Bilson Company.
 Activity-Based Costing Example

Bilson,
Bilson, Inc.
Inc.manufactures
manufacturesandandsells
sells5,000
5,000units
unitsof
of
Product
ProductAA(deluxe
(deluxe model),
model), and
and25,000
25,000units
unitsof
of Product
Product BB
(standard
(standardmodel)
model)each
eachyear.
year.
Product
ProductAArequires
requires3.0
3.0direct
directlabor
labor hours
hours(DLH)
(DLH) and
and
Product
Product BBrequires
requires2.5
2.5DLH
DLHto toproduce.
produce.
Employing
Employingaatraditional
traditional costing
costingsystem,
system,Bilson
Bilsonassigns
assigns
overhead
overheadcostcostto
toproducts
productsusing
usingdirect
directlabor
labor hours.
hours.
The
Thepredetermined
predeterminedoverhead
overheadrate
rateis:
is:
Mfg. overhead cost $1,550,000
= = $20/DLH
Direct labor hours 77,500
Activity-Based Costing Example

Bilsons unit product costs using

traditional costing are:
Product A Product B
Direct material $ 40.00 $ 29.00
Direct labor 30.00 25.00
Manufacturing overhead
3.0 DLH $20/DLH 60.00
2.5 DLH $20/DLH 50.00
Total unit product cost $ 130.00 $ 104.00

Bilson marks its products up by 50 percent and allocates

its $500,000 customer service costs based on revenue.
 Activity-Based Costing Example

$130.00 1.50
Traditional Costing
Product A Product B
Volume 5,000 25,000
Sales Price $ 195.00 $ 156.00

Sales Revenue $ 975,000 $ 3,900,000

Direct Material $ 40.00 200,000 $ 29.00 725,000
Direct Labor 30.00 150,000 25.00 625,000
Overhead 60.00 300,000 50.00 1,250,000
Gross Margin $ 65.00 $ 325,000 $ 52.00 $ 1,300,000
Customer Service Costs 100,000 400,000
Product operating income $ 225,000 $ 900,000

$975,000 ($975,000 +$3,900,000) $500,000

 Activity-Based Costing Example
Sales
Salesofof Product
ProductAAhave
have increased
increasedsteadily
steadily since
sinceintroduction,
introduction,
but
butcompany
companyincome
income has
hasdeclined.
declined.Management
Management at atBilson
Bilsonisis
unhappy
unhappywith
withthe
thetraditional
traditionalcosting
costingsystem
systemandandthey
theyhave
have
decided
decided to
totry
tryactivity-based
activity-based costing.
costing.

In
Inaddition,
addition,management
managementhas has
observed
observedthat thatthe
thecost
cost of
ofdirect
direct
labor
labor isisrelatively
relativelystable.
stable.
Since
Sincelabor
labor does
doesnot
notbehave
behave
like
likeaaunit-level
unit-levelcost,
cost,labor
labor will
will
be
becombined
combinedwith withoverhead
overheadand and
the
thetotal
totalconversion
conversion cost
cost
will
willbe
beassigned
assignedusing
usingABC.
ABC.
 Activity-Based Costing Example
The
Thetotal
totalconversion
conversioncost
costis:
is:
Traditional
Traditionaloverhead
overhead $1,550,000
$1,550,000
Labor
Labor(77,500
(77,500hours
hours@ @ $10)
$10) 775,000
775,000
Total
Total $2,325,000
$2,325,000

In
Inaddition,
addition,management
managementhas has
observed
observedthat thatthe
thecost
cost of
ofdirect
direct
labor
labor isisrelatively
relativelystable.
stable.
Since
Sincelabor
labor does
doesnot
notbehave
behave
like
likeaaunit-level
unit-levelcost,
cost,labor
labor will
will
be
becombined
combinedwith withoverhead
overheadand and
the
thetotal
totalconversion
conversion cost
cost
will
willbe
beassigned
assignedusing
usingABC.
ABC.
 Activity-Based Costing Example

Management has identified the following five activities

and costs in the production of its two products:
Activity Cost
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 conversion cost

 Activity-Based Costing Example
The following transaction data has been
complied by management of Bilson:

Activity Total Product A Product B

Machine setups 5,000 3,000 2,000
Quality inspections 9,000 6,000 3,000
Production orders 600 200 400
Machine-hours worked 50,000 15,000 35,000
Material receipts 800 150 650
 Activity-Based Costing Example

These data can be used to develop predetermined

cost-driver rates for each of the five activities:
Total Rate per
Activity Costs Transactions Transaction
Machine setups $ 800,000 5,000 $ 160.00 per setup
Quality inspections 450,000 9,000 50.00 per inspection
Production orders 225,000 600 375.00 per order
Machine-hours worked 650,000 50,000 13.00 per hour
Material receipts 200,000 800 250.00 per receipt
Total $ 2,325,000

$ 800,000 5,000 Machine setups = $160.00 per setup

 Activity-Based Costing Example

The activity-based overhead rates we just calculated

can be used to assign conversion costs to Bilsons
two products.
Product A
Activity ABC Rate Transactions Amount
Machine setups $ 160.00 3,000 $ 480,000
Quality inspections 50.00 6,000 300,000
Production orders 375.00 200 75,000
Machine-hours worked 13.00 15,000 195,000
Material receipts 250.00 150 37,500
Total overhead assigned $ 1,087,500
Number of units produced 5,000
Conversion per unit $217.50
 Activity-Based Costing Example

The activity-based overhead rates we just calculated

can be used to assign conversion costs to Bilsons
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
Number of units produced 25,000
Conversion per unit $ 49.50
 Activity-Based Costing Example

The activity-based overhead rates we just calculated

can be used to assign conversion costs to Bilsons
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
Number assigned
of units to Product A
produced $ 1,087,500 25,000
Total conversionper
Overhead assigned
unit to Product B 1,237,500 $ 49.50
Total overhead $ 2,325,000
Activity-Based Costing Example

Lets compute the product cost for A and B

using our ABC overhead rates:

Activity Based Costing Product A Product B

Direct materials $ 40.00 $ 29.00
Conversion 217.50 49.50
Total unit product cost $ 257.50 $ 78.50

These amounts did not

change as a result of
using ABC.
 Activity-Based Costing Example

Now compare the unit product costs using the

traditional costing system and our ABC system.

Costing Method Product A Product B

Activity-based costing $ 257.50 $ 78.50
Traditional costing 130.00 104.00

Remember, we used one overhead

rate based on direct labor hours.
 Activity-Based Costing Example

Now compare the unit product costs using the

traditional costing system and our ABC system.

Costing Method Product A Product B

Activity-based costing $ 257.50 $ 78.50
Traditional costing 130.00 104.00

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.
 Activity-Based Costing Example

Now compare the unit product costs using the

traditional costing system and our ABC system.

Costing Method Product A Product B

Activity-based costing $ 257.50 $ 78.50
Traditional costing 130.00 104.00

Can you see how different allocation

methods might lead to making
different management decisions?
 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.
Product A Product B Total
Sales Volume 5,000 25,000
Consultations per
Unit Sold 10 3
Total Consultations 50,000 75,000 125,000
Cost per Consultation $ 4.00 $ 4.00
Cost per Product $ 200,000 $ 300,000 500,000

Cost per consultation = $500,000 125,000 consultations = $4.00

 Activity-Based Costing Example
No change in sales price

ABC Costing
Product A Product B
Volume 5,000 25,000
Sales Price $ 195.00 $ 156.00

Sales Revenue $ 975,000 $ 3,900,000

Direct Material $ 40.00 200,000 $ 29.00 725,000
Conversion 217.50 1,087,500 49.50 1,237,500
Gross Margin $ (62.50) $ (312,500) $ 77.50 $ 1,937,500
Customer Service Costs 200,000 300,000
Product operating income $ (512,500) $ 1,637,500

Lets
Letscompare
compareproduct
productincome
incomeusing
usingtraditional
traditionaland
andABC
ABCcosting.
costing.
4-49

Product A Product B
Volume 5,000 25,000
Sales Price $ 195.00 $ 156.00
ABC
Sales Revenue $ 975,000 $ 3,900,000
Direct Material $ 40.00 200,000 $ 29.00 725,000 Costing
Conversion 217.50 1,087,500 49.50 1,237,500
Gross Margin $ (62.50) $ (312,500) $ 77.50 $ 1,937,500
Customer Service Costs 200,000 300,000
Product operating income $ (512,500) $ 1,637,500

Product A Product B
Volume 5,000 25,000
Sales Price $ 195.00 $ 156.00

Sales Revenue $ 975,000 $ 3,900,000

Traditional
Direct Material $ 40.00 200,000 $ 29.00 725,000 Costing
Direct Labor 30.00 150,000 25.00 625,000
Overhead 60.00 300,000 50.00 1,250,000
Gross Margin $ 65.00 $ 325,000 $ 52.00 $ 1,300,000
Customer Service Costs 100,000 400,000
Product operating income $ 225,000 $ 900,000
Learning Objective 6
 Product Profitability
Should Bilson
drop Product A?

Should Bilson Should Bilson

increase the price reduce the price
of Product A? of Product B?

Now that we have

measured product
costs accurately,
we see how profitable
each product really is.
 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.
 Customer Profitability
Service calls
What are the costs and
benefits of serving
Buy/sell orders
specific customers?

Order changes

Activity-based analysis can

be used to track the costs
of serving customers and
those customers contribution
to company profits.
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.
Learning Objective 7
ABC in Service and Merchandising
Companies
The process is exactly the same as for manufacturing!

Identify and classify the activities

related to the companys 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.
 ABC Benefits and Limitations
More
More accurate
accurate and
and informative
informative
product
product costs
costs lead
lead to
to better
better pricing
pricing
decisions.
decisions.
The
The activities
activities driving
driving costs
costs are
are more
more
accurately
accurately measured.
measured.
Managers
Managers gaingain easier
easier access
access toto the
the
relevant
relevant costs.
costs.

An
AnABCABC system
system is
is very
very expensive
expensive
to
to develop
develop and
and implement,
implement, and
and
very
very time-consuming
time-consuming to to maintain.
maintain.
 When Should a Company Use ABC?
Indirect
Indirectcosts
costsare
aresignificant
significantin
in proportion
proportion to
todirect
direct costs.
costs.
Goods
Goodsareare complex,
complex, requiring
requiringmany
many inputs
inputs and
andprocesses.
processes.
Complex,
Complex, low-volume
low-volumeproducts
products are areprofitable
profitablewhile
while
standard,
standard, high-volume
high-volume products
productsare arenot.
not.
Different
Differentdepartments
departmentsbelieve
believe costs
costsare
areassigned
assigned
inaccurately.
inaccurately.
The
Thecompany
companyloses
losesbids
bidsititthought
thought were
werelow,
low,and
andwins
winsbids
bids
itit thought
thoughtwere
werehigh.
high.
Operations
Operationshave havechanged
changed significantly,
significantly, but
but the
thecosting
costing
system
system hashasnot
notchanged.
changed.
Introduction
Introductionof ofnew
newmodels
modelsresult
resultin
inhigher
highersales,
sales, apparent
apparent
profits
profitsper
per unit,
unit, but
butan
anoverall
overallincome
incomedecline.
decline.
The End