Activity-Based

Costing
A Tool to Aid Decision
Making

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 Activity Based Costing (ABC)

ABC is designed to
provide managers with
cost information for It is ordinarily used as a
strategic and other supplement to, rather
decisions that potentially than as a replacement
affect capacity and for, the company’s usual
therefore affect fixed as
well as variable costs. costing system.
 

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 How Costs are Treated Under
Activity–Based Costing

“Best practice” ABC differs from traditional costing in five ways.

Manufacturing Non-manufacturing
costs costs

Traditional ABC
product costing product costing

 ABC assigns both types of costs to products. For example,

ABC systems can assign sales commissions, shipping costs,
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and warranty repair costs to specific products.
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 How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.

Manufacturing Non-manufacturing
costs costs

Some
Mo
st, b
All

not ut
all

Traditional ABC
product costing product costing

 ABC does not assign all manufacturing costs to products. This

is because ABC only assigns a cost to a product if decisions
concerning that product will cause changes
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in the cost.
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 How Costs are Treated Under
Activity–Based Costing
ABC uses more cost pools than traditional cost systems that often
use a single plant wide overhead pool or just one overhead pool
per department.
Since more than one activity is often performed within each
Activity–Based
department. Costing

Departmental
complexity

Overhead
Level of

Rates
Plantwide
Overhead
Rate

Number of cost pools

 ABC uses more cost pools.
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 How Costs are Treated Under
Activity–Based Costing

“Best practice” ABC differs from traditional costing in five ways.

Volume
Allocation Bases

measures
Bases usually plus other
Number of

rely only on bases.

volume
measures.

Traditional Costing ABC

 ABC uses more allocation bases.
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 How Costs are Treated Under
Activity–Based Costing

“Best practice” ABC differs from traditional costing in five ways.

The most commonly used allocation base

in traditional costing is direct labor hours.

Direct labor hours work

well when overhead
increases as direct
labor hours increase.

 ABC uses more allocation bases.

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 How Costs are Treated Under
Activity–Based Costing

“Best practice” ABC differs from traditional costing in five ways.

The most commonly used allocation base

in traditional costing is direct labor hours.

Problems:
 In many processes, overhead is increasing
while direct labor is decreasing.
 Variety and complexity of products is increasing.

 ABC uses more allocation bases.

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 How Costs are Treated Under
Activity–Based Costing

“Best practice” ABC differs from traditional costing in five ways.

ABC uses
volume as well as
other allocation bases not
All overhead related to the volume
costs are not related of production.
to volume measures like
direct labor
hours.

 ABC uses more allocation bases.

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 How Costs are Treated Under
Activity–Based Costing

“Best practice” ABC differs from traditional costing in five 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 don’t
use. Unused capacity
costs are treated as
period expenses.

 ABC bases level of activity on capacity.

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 Characteristics of Successful
ABC Implementations

Strong top
management support
Link to evaluations
and rewards

Cross-functional
involvement

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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

 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.

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 Identify 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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 Identify and Define Activities
and Activity Cost Pools--Explanation
1. Unit-level activities are performed each time a unit is produced.
2.  Batch-level activities are performed each time a batch is
handled or processed, regardless of how many units are in the
batch. e.g. inspection, setting up equipment and shipping
customer orders.
3. Product-level activities relate to specific products and must be
carried out regardless of how many batches are run or units
produced and sold. For example, designing or advertising a
product.
4. Customer-level activities relate to specific customers and are
not tied to any specific product. For example, sales calls and
catalog mailings.
5. Organization-sustaining activities are carried out regardless of
which customers are served, which products are produced, how
many batches are run, or how many units are made. For
example, heating a factory and cleaning executive offices.

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 Identify and Define Activities
and Activity Cost Pools

Activities
should only be
combined within a level
if they are highly
correlated.

When combining
Batch-level activities, they should be
Activities should not be grouped together only at
combined with unit-level the appropriate
activities, level.
and so on
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 Identify 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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 Identify and Define Activities
and Activity Cost Pools

Two types of activity measures:

Transaction Duration
driver driver

Simple count A measure

of the number of of the amount
times an activity of time needed
occurs. for an activity.
When All Activity takes the Different amount of time
same time required to perform Activities
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 Identify 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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 Identify and Define Activities
and Activity Cost Pools

• Customer Orders - assigned all costs of resources

that are consumed by taking and processing
customer orders.
• Product Designs - assigned all costs of resources
consumed by designing products.
• Order Size - assigned all costs of resources
consumed as a consequence of the number of units
produced.
• Customer Relations – assigned all costs associated
with maintaining relations with customers.
• Other – assigned all overhead costs that are not
associated with the other cost pools.
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 When Possible, Directly Trace Overhead
Costs to Activities and Cost Objects

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 Assign 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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 Assign Costs to Activity Cost Pools

• The indirect factory workers allocated twenty-

five percent of their time to the customer orders
activity, forty percent of their time to the product
design activity, twenty percent of their time to
the order size activity, ten percent of their time
to customer relations, and five percent of their
time to the “other” activity.

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 Assign Costs to Activity Cost Pools

Indirect factory wages $500,000

Percent consumed by customer orders 25%
$125,000

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 Assign Costs to Activity Cost Pools

Factory equipment depreciation $300,000

Percent consumed by customer orders 20%
$ 60,000

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 Assign Costs to Activity Cost Pools

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 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 the team can compute the individual

activity rates by dividing the total cost for
each activity by the total activity levels.
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 Calculate Activity Rates

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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

Traced Traced Traced

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

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

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

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

Second-Stage Allocations

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

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

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

Second-Stage Allocations

$19/MH $315/Order $257/Design $3675/Customer

Cost Objects:
Unallocated
Products, Customer Orders, Customers
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 Assigning 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) For each activity
1. 400 units ordered with 2 separate orders. cost pool, the
2. Each stanchion required 0.5 machine-hours. amount of activity
3. Selling price is $34 each. consumed by the
4. Direct materials total $2,110. product (or
5. Direct labor totals $1,850. customer) is
6. Shipping costs total $180. multiplied by the
Custom Compass Housing (requires new design) activity rate to
1. One order during the year. arrive at the
2. Each housing required 4 machine-hours. amount of
3. Selling price is $650 each. overhead cost
4. Direct materials total $13. applied to the
5. Direct labor totals $50. product (or
6. Shipping costs total $25. customer).
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 Assigning Costs to Cost Objects

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

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 Prepare Management Reports

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

Custom Compass Housing

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

Customer Profitability Analysis

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 Product Margins

Traditional Cost Accounting System

400 units x 0.5 MH/unit x $50/MH = $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:
 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 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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 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.
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 Activity-Based Costing and External Reporting

Most companies do not use ABC

for external reporting because . . .
1. External reports are less detailed than internal
reports.
2. It may be difficult to make changes to the company’s
accounting system.
3. ABC does not conform to GAAP.
4. Auditors may be suspect of the subjective allocation
process based on interviews with employees.

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 ABC Limitations

Substantial resources Resistance to

required to implement unfamiliar numbers
and maintain. and reports.

Desire to fully Potential

allocate all costs misinterpretation of
to products. unfamiliar numbers.

Does not conform to

GAAP. Two costing
systems may be needed.
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 Activity-Based Management

The use of
activity analysis
to help
management
make decisions

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 Activity-Based Management

Activity-based costing establishes relationships

between overhead costs and activities so that
we can better allocate overhead costs.
Activity-based management focuses
on managing activities to reduce costs.

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Two-Dimensional ABC and Activity-
Based Management

Cost Assignment View

Resource costs
Process View
Activity Analysis Activity Evaluation

Root Activity Performance

Causes Triggers Activities Measures

Cost Objects
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Two-Dimensional ABC and Activity-
Based Management

Cost Assignment View

Assign resource
costs to activity Resource costs
cost pools.

Root Activity Performance

Causes Triggers Activities Measures

Assign activity
costs to cost
objects using Cost Objects
cost drivers.
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 Elimination of Non-Value-Added
Costs

Activities

Analysis and
Classification
Nonvalue- Value-
added added
Activities Activities
Reduce or Continually Evaluate
Eliminate
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and Improve
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Using ABM to Eliminate Non-Value-
Added Activities and Costs
Identify Activities.
Identify Non-Value-Added Activities.
Understand Activity Linkages, Root Causes, and
Triggers.


Specify Select Receive Produce
Inspect Rework
finished defective
parts vendor parts goods
goods products

Establish Performance Measures.

Report Non-Value-Added Costs.

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 Customer Profitability Analysis

Customer profitability analysis uses

activity-based costing to determine
the activities, costs, and profit associated
with serving particular customers.

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 Customer Profitability Analysis

Required
special
packaging.
Orders Demand
small fast
quantities. service.

Often
Orders
changes
frequently.
orders.

A costly customer
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 Customer Profitability Analysis

Cost Drive
Customer-Related Activities Cost Driver Base Rate
Order processing Purchase orders $ 150
Sales contacts (phone calls, faxes, etc.) Contacts 100
Sales visits Visits 1,000
Shipment processing Shipments 200
Billing and collection Invoices 160
Design/engineering change orders Design changes 4,000
Special packaging Units packaged 40
Special handling Units handled 60

A company may used theses customer

related costs to help determine the
profitability of each customer.

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 Customer Profitability Analysis

Customer Profitability
Cumulative Operating Income as a % of Total

125.0%

100.0%
Operating Income

75% of actual operating income

75.0%

50% of actual operating income

50.0%

25% of actual operating income

25.0%

0.0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

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 Achieving Cost Reduction

Activity Activity
Reduction Selection

Reduce
Non-Value-Added
Costs
Activity Activity
Sharing Elimination

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