Chapter 10

Activity-Based Costing (ABC)

 Reminder: Long-Term Decisions
• In the long term, we can adjust capacity resources
(buildings, equipment, skilled staff)
=> capacity costs (fixed costs) change with our decisions
• Capacity costs cannot be traced to “cost objects” (product
lines, customers, departments, etc) due to resource sharing
by cost objects
=> use cost allocation to estimate capacity costs for
individual cost objects
• To evaluate long-term decisions, we use
profit margin =
= contribution margin – allocated capacity costs
from “traditional” cost allocation
or activity-based costing (ABC)

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 Why ABC?
Activity-Based Costing (ABC) = cost allocation on
steroids
• Much more accurate than “traditional” allocations from Ch 9
• By 1990-s, many firms realized that traditional allocations
systematically distort capacity costs
underestimate true costs of overestimate true costs of
low-volume premium products high-volume basic products
(e.g., Lexus LC 500) (e.g., Camry)

=> bad decisions: drop profitable products, keep unprofitable

products, etc
• ABC resolved this problem
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 Why do we care?
• Capacity costs are HUGE (more than 40% of TC on average)
and MESSY (cannot be traced to cost objects)
• Without understanding these costs well, we do not even know
whether

MSRP
$92,000

is profitable or unprofitable
• ABC helps us understand capacity costs
=> can make MUCH better decisions for cost objects such as
product lines and customers

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 ABC: General Idea
1. Capacity costs are caused by capacity resources

capacity resources capacity costs in $

factory building
rent
office building

production equipment
depreciation
office equipment

labor supervisors
salaries
sales managers

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 ABC: General Idea
2. Firms use capacity resources to perform activities

activities capacity resources

factory building
assembly of
labor supervisors
finished products
prod. equipment

machine prod. support staff

set-ups tools

processing of sales office

customers’ orders sales staff

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 ABC: General Idea
=> activities drive capacity costs in the long term

activities capacity resources capacity costs in $

factory building
assembly of
labor supervisors
finished products
prod. equipment
rent, salaries,
prod. support staff depreciation,
machine
etc
set-ups tools

processing of sales office

customers’ orders sales staff

A CAUSAL VIEW OF COSTS (we analyze what exactly

causes our capacity costs => much more realistic estimates)
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 Designing an ABC system
Step 1: What are the main activities?

E.g.,
• assembly of the finished product using labor
• machining of components
• machine set-ups before each production batch
• processing of customers’ orders

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 Designing an ABC system
Step 2: What capacity resources are used for each activity?
How much do they cost?
Group these costs into cost pools based on activities.
Activities
assembly of machining of machine customer
Capacity resources products components set-ups orders
production labor supervisors    

machine maintenance staff    

production support staff    

sales staff    

floor space for assembly    

floor space for machines    

sales office space    

machine depreciation    
Total cost of capacity
set-up tools and supplies 
$50,000 
$40,000 
$30,000 
$70,000
resources in the cost pool
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 Designing an ABC system
Step 3: For each pool, choose the cost driver that has the
strongest causal relation with the costs in the pool
(to identify potential cost drivers, think about the underlying activity)

Underlying Activity for the Cost Pool

assembly of machining of machine customer
products components set-ups orders
Total cost in the cost pool $50,000 $40,000 $30,000 $70,000
direct machine number number of
Cost driver
labor $ hours of setups orders

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 Designing an ABC system
As an aside, why does the traditional allocation distort costs?

Underlying Activity for the Cost Pool

assembly of machining of machine customer
products components set-ups orders
Total cost in the cost pool $50,000 $40,000 $30,000 $70,000
Cost driver direct machine number number of
labor $ hours of setups orders
Cost driver % for:

90% 90% 60% 60%

10% 10% 40% 40%

Traditional allocation applies the DL percentages (90% and 10%)

to all four pools. In contrast, ABC uses the correct percentages.
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 Designing an ABC system
Step 4: Compute activity rates (aka allocation rates)

Underlying Activity for the Cost Pool

assembly of machining of machine customer
products components set-ups orders
Total cost in the cost pool $50,000 $40,000 $30,000 $70,000
direct machine number of number of
Cost driver
labor $ hours setups orders

25,000 1,000 300 350

Total cost driver amount
DL$ hours setups orders

$50,000 $40,000 $30,000 $70,000

Activity rate
25,000 1,000 300 350
=$2 per =$40 per =$100 per =$200 per
DL$ hour setup order

After that, use the standard formulas to allocate costs to “cost

objects” (product lines, projects, customers, etc)
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 Allocating Costs to Cost Objects
Cost object X (e.g., product X or customer X) uses 10,000 DL$,
300 machine hours, 50 set-ups, and 50 customer orders.
allocated costs for X
= activity rate × number of cost driver units for X

Cost Activity Cost driver Cost allocated

Pool rate units for X to X
assembly of $2 per $2×10,000
10,000 DL$
products DL$ =$20,000
machining of $40 per $40×300
300 hrs
components hour =$12,000
$100 per $100×50
machine set-ups 50 setups
setup =$5,000
$200 per $200×50
customer orders 50 orders
order =$10,000
Total $47,000
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 Advantages of ABC
• Uses multiple cost pools and cost drivers to accurately
capture the consumption of capacity resources by cost
objects
• More accurate estimates than in “traditional” allocations

Disadvantages of ABC
• ABC requires a more detailed information system
• Implementing a detailed ABC system is costly and time-
consuming
 Should Apple implement an ABC system?  YES  NO
 Should Kia implement an ABC system?  YES  NO

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 Activity Based Management
How to use the information from ABC to better manage
products and customers

“In most companies, 20-30 percent of the business provides

most of the profits, while 30-40 percent of the customers
and products lose money. The key question is how to
identify which is which.”
HBS Working Knowledge for Business Leaders

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 Product Planning
• Should we keep or drop a product line?
• What price should we charge?
• Should we change the product mix?
ABC provides more accurate cost estimates
=> better product planning decisions

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 Product Planning: Target Costing
Product design choices affect subsequent production costs
=> can reduce future production costs through careful design
choices during product development

• Traditional approach
determine
design the price = costs +
production
product target profit margin
costs
• Target costing – a reverse approach

choose design the product

allowable cost =
price point and in a way that keeps
price point − target
key product production costs at
profit margin
features the allowable level
use ABC to estimate future production costs for various product design
choices

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 Example: A Very Very Bad Design Choice

In mid-1990s, GM made 139 different types of

hood hinges, versus just one type for Ford.
1. This design choice increased GM’s machine setup costs for
hinges by approximately
 +20%  double  ×139
2. This design choice increased GM’s handling costs for
hinges by approximately
 +20%  double  ×139
3. How can GM dramatically reduce the costs of hinges
through better design choices?

18 source: Atkinson, Kaplan, Matsumura, Young “Management Accounting”

 Customer Planning
• Many customers (40–50% on average) are unprofitable
• Use customer-level profit margin to assess customer profitability
and then decide what to do with the unprofitable customers.

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 Exercise: Customer Planning
  Customer A Customer B Variable costs are $10 per unit.
Units sold 100 100 From the ABC system,
Price per unit $15 $15 the activity rates are:
Number of orders 2 10 $30 per order,
Customer visits 1 2 $50 per customer visit,
Deliveries 3 10 $20 per delivery.

1. Compute the profit margin for each customer.

  Customer A Customer B
Revenue $1,500 $1,500
Variable costs 1,000 1,000
Contribution margin $500 $500
2. Customer B is
Allocated fixed unprofitable.
costs: What can we do?
Orders 2*$30=$60 10*$30=$300  charge B a higher price?
Customer visits 1*$50=$50 2*$50=$100
Deliveries 3*$20=$60 10*$20=$200  limit the number of
Profit margin  $330 ($100) orders/deliveries?
 charge a fee per
order/delivery?
20  “fire” customer B?
 Additional Exercises

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 Exercise: Choosing Cost Drivers
Choose the best cost driver for each pool
Cost pools Cost drivers
• salaries of machine maintenance staff (they A. direct labor hours
perform routine maintenance for machines every
10,000 hours) B. machine-hours
• engineering department costs (they design new C. # batches
products) D. # products
• production labor supervisors’ salaries designed
• salaries for production support workers (they set
up the machines before each production batch) E. # units sold
• billing department costs (they prepare customers’ F. # customer
invoices and make sure that customers pay on orders
time)
• warranty service staff salaries (they replace
defective items; on average, 1% of all units
shipped are defective)

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 cost pool activity rate allocated costs for A
Exercise: Allocating Costs using ABC
You have an ABC system with 3 pools.
"labor-related"
# cost driver units
total cost in
cost pool
"production setups" the pool
product A product B total
"labor-related"
“machine maintenance" $20,000 4,000 DL$ 6,000 DL$ 10,000 DL$
"production setups" $15,000 30 setups 20 setups 50 setups
“machine maintenance" $10,000 50 hours 150 hours 200 hours
Compute allocated costs for product A.

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 Exercise: Customer Profitability
  Customer A Customer B Variable costs are $5 per unit.
Units sold 100 100 From the ABC system,
Price per unit $15 $15 the activity rates are:
Number of orders 4 10 $60 per order,
Number of $80 per delivery.
deliveries 2 6
1. Compute the profit margin for each customer.
  Customer A Customer B
Revenue
VC
CM
Allocated FC:
Orders
Deliveries
Profit margin 

2. Should you get rid of one of the customers?  A  B

If yes, how much will this improve your profit in the long term?
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 Exercise: Cost Distortion in
Traditional Allocations
1. Suppose that General Motors (GM) uses a traditional cost
allocation. Is GM likely to underestimate or overestimate the
true capacity costs of these two vehicles?

Cadillac Escalade Chevy Silverado

(~30,000 units per year) (~600,000 units per year)

 underestimate  overestimate  underestimate  overestimate

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 (continued) Cost Distortion in
Traditional Allocations
2. After implementing ABC, is GM likely to find that these
vehicles are less profitable or more profitable than originally
thought?

Cadillac Escalade Chevy Silverado

(~30,000 units per year) (~600,000 units per year)

 less profitable  more profitable  less profitable  more profitable

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 Exercise: Traditional Allocation vs ABC
You make BLUE pens (a basic high-volume product) and PURPLE pens (a
low-volume niche product).
BLUE PURPLE Total
Sales volume (units) 99,000 1,000 100,000
Revenue $99,000 $5,000 $104,000
Direct materials $9,900 $100 $10,000
Direct labor $9,900 $100 $10,000
Contribution Margin $79,200 $4,800 $84,000
Fixed Costs $70,000
Profit $14,000
1. Traditional cost allocation: Compute allocated costs and profit
margins for BLUE and PURPLE, using DL$ as the cost driver.
allocation rate =
allocated costs for BLUE =
allocated costs for PURPLE =
profit margin for BLUE =
profit margin for PURPLE =
Based on these traditional estimates, is PURPLE a successful product?
 YES  NO
Should we trust these traditional estimates?  YES  NO
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 (continued) Traditional Allocation vs ABC
2. To implement ABC, you collected additional information about the
structure of your capacity costs:
# cost driver units
cost in
cost pool activity rate
pool
BLUE PURPLE
"labor related" $50,000 $5/DL$ 9,900DL$ 100DL$
"production setups" $15,000 $7,500/setup 1 1
"product support" $5,000 $2,500/product 1 1
Compute allocated costs and profit margins using ABC
BLUE PURPLE
allocated FC:
“labor-related” 5×9,900 = $49,500 5×100 = $500
“production setups” 1×7,500 = $7,500 1×7,500 = $7,500
“product support” 1×2,500 = $2,500 1×2,500 = $2,500
total FC $59,500 $10,500
profit margin 79,200 − 59,500 = 4,800 − 10,500 =
$19,700
Is PURPLE a successful product?  YES  NO  ($5,700)
HELL NO
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 “You can have
any color, as long
as it is black.”
WHY?

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