Activity-Based Costing: A

Tool to Aid Decision Making

Chapter Seven

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 Activity Based Costing (ABC)

ABC is a
ABC is designed to good supplement
provide more accurate to our traditional
cost system
ways of assigning I
agree!
indirect and support
service costs to
activities, processes,
products, customers

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 ABC differs from traditional costing

• Both manufacturing and non manufacturing

costs are allocated
• Use of several cost pools
• Different kinds of allocation base
• Allocation through capacity vs activity

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 Designing an ABC System

Cost Objects
(e.g., products
Activities
and
customers)

Consumption
of Resources

Cost

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 Designing an ABC System

Steps for Implementing ABC

❶ Identify and define activities and activity cost
pools.
❷ Trace costs to activities and cost objects.
❸ Assign costs to activity cost pools.
❹ Calculate activity rates.
❺ Assign costs to cost objects.
❻ Prepare management reports.

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 ❶Identify and Define Activities
and Activity Cost Pools

Unit-Level Batch-Level
Activity Activity

Manufacturing
companies typically
combine
their activities into five
classifications.

Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
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 ❶Identify and Define Activities
and Activity Cost Pools

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.
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 ❶Identify and Define Activities
and Activity Cost Pools

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

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 ❶Identify and Define Activities
and Activity Cost Pools

Two types of activity measures:

Transaction Duration
driver driver
Simple count
A measure
of the number
of the amount
of
of time
times an
needed
activity
for an activity.
occurs.
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 ❶Identify and Define Activities
and Activity Cost Pools

At Classic Brass, the ABC team, selected the following

activity cost pools and activity measures:

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 ❶Identify and Define Activities
and Activity Cost Pools

•• Customer
Customer Orders
Orders -- assigned
assigned allall costs
costs ofof 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 allall costs
costs ofof 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 allall 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.
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 ❷When Possible, Directly Trace Overhead
Costs to Activities and Cost Objects

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 ❸Assign Costs to Activity Cost Pools

At Classic Brass the following distribution of resource

consumption across activity cost pools is determined.

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

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 ❸Assign Costs to Activity Cost Pools

Indirect
Indirect factory
factory wages
wages $500,000
$500,000
Percent
Percent consumed
consumed byby customer
customer orders
orders 25%
25%
$125,000
$125,000

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 ❸Assign Costs to Activity Cost Pools

Factory
Factory equipment
equipment depreciation
depreciation $300,000
$300,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 20%
20%
$$ 60,000
60,000

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 ❸Assign Costs to Activity Cost Pools

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 ❹Calculate 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.
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 ❹Calculate Activity Rates

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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Shipping Overhead Costs
Materials Labor
Labor Costs

Traced
Traced Traced
Traced Traced
Traced

Cost
Cost Objects:
Objects:
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Shipping Overhead Costs
Materials Labor
Labor Costs

First-Stage Allocation

Order Customer
Customer Product
Product Customer
Customer Other
Size Orders
Orders Design Relations

Cost
Cost Objects:
Objects:
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Shipping Overhead Costs
Materials Labor
Labor Costs

First-Stage Allocation

Order Customer
Customer Product
Product Customer
Customer Other
Size Orders
Orders Design Relations

Second-Stage Allocations

$/MH
$/MH $/Order
$/Order $/Design
$/Design $/Customer
$/Customer

Cost
Cost Objects:
Objects: Unallocated
Unallocated
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
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 ❺Assigning Costs to Cost Objects

Let’s 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.
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.
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 ❺Assigning Costs to Cost Objects

The customer-level
cost is assigned to
customers directly;
it is not assigned to
products.

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 ❻Prepare Management Reports

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 ❻Prepare Management Reports

Customer Profitability Analysis

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 Product Margins

Traditional Cost Accounting System

400
400 units
units xx 0.5
0.5 MH/unit
MH/unit xx $50/MH
$50/MH == $10,000
$10,000

Predetermined manufacturing $1,000,000

= = $50/MH
overhead rate 20,000 MH
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 Differences Between ABC and
Traditional Product Costs
Product margins are different for four reasons:
❶ 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.
❷ 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.
❸ Traditional costing assigns only manufacturing costs to
products. ABC also assigns nonmanufacturing costs to
products.
❹ Traditional costing assigns all manufacturing costs to
products. The ABC system does not assign organization-
sustaining manufacturing costs to the products.
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 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.
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 Activity Based Management

• Upon analysis of product costs thru ABC

• Re-price products
• Substitute products
• Redesign products
• Improve processes and operations strategy
• Technology investment
• Eliminate products

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 End of Chapter 7

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