TOPIC 2

ACTIVITY-BASED COSTING (ABC)

PREVIEW OF PREVIOUS TOPIC
 Traditional Costing and Activity-Based Costing
Traditional costing systems
The need for a new approach
Activity-based costing

 Illustration of Traditional Costing

versus ABC
Unit costs under traditional costing
Unit costs under ABC
Comparing unit costs
ACTIVITY-BASED COSTING VERSUS
TRADITIONAL COSTING

Traditional Costing Systems

 Allocates overhead using a single predetermined
rate.
Job order costing: direct labor cost is assumed
to be the relevant activity base.
Process costing: machine hours is the relevant
activity base.

 Assumption was satisfactory when direct labor was

a major portion of total manufacturing costs.
Wide acceptance of a high correlation between
direct labor and overhead costs.
 Traditional Costing Systems:
Continued

 Direct labor is still often the appropriate basis

for assigning overhead costs when:
Direct labor constitutes a significant part of
total product cost
and
High correlation exists between direct labor and
changes in overhead costs.

Overhead Direct Labor Products

Costs Hours/Dollars
 Need for a New Approach
 Tremendous change in manufacturing and service
industries.

 Decrease in amount of direct labor usage.

 Significant increase in total overhead costs.

 May be inappropriate to use plant-wide

predetermined overhead rates based on direct labor
or machine hours when a lack of correlation exists.

 Complex manufacturing processes may require

multiple allocation bases; this approach is called
Activity-Based Costing (ABC).
 Activity-Based Costing (ABC)

 An overhead cost allocation system that allocates

overhead to multiple activity cost pools
and
 Assigns the activity cost pools to products or services
by means of cost drivers that represent the activities
used.
 Activity-Based Costing (ABC)
Terms
 Activity: any event, action, transaction, or work
sequence that causes a cost to be incurred in producing a
product or providing a service.

 Activity Cost Pool: a distinct type of activity.

For example: ordering materials or setting up machines.

 Cost Drivers: any factors or activities that have a direct

cause-effect relationship with the resources consumed.
The Logic Behind ABC

Products consume activities,

and
activities consume resources.
 Activity-Based Costing (ABC) – Continued

 ABC allocates overhead costs in two stages:

Stage 1: Overhead costs are allocated to activity

cost pools.

Stage 2: The overhead costs allocated to the cost

pools is assigned to products using cost
drivers.

 The more complex a product’s manufacturing

operation, the more activities and cost drivers likely
to be present.
Activities and Related Cost Drivers
ABC System Design – Lift Jack Company
 Traditional Costing vs ABC

 ABC does not replace an existing job

order/process cost system.

 ABC does segregate overhead into various

cost pools to provide more accurate cost
information.

 ABC, thus, supplements – it does not replace

– the traditional cost system.
 Traditional Costing vs ABC
An Illustration

 Atlas Company produces two automotive antitheft devices:

 The Boot: a high volume item with sales totaling 25,000 per year
 The Club: a low volume item with sales totaling 5,000 per year

 Each product requires 1 hour of direct labor

 Total annual direct labor hours (DLH) 30,000 (25,000 + 5000)
 Direct labor cost $12 per unit for each product

 Expected annual manufacturing overhead costs $900,000

 Direct materials cost:

 The Boot - $40 per unit
 The Club - $30 per unit
 Activity-Based Costing:
A Closer Look

More accurate product costing through:

 Use of more cost pools to assign overhead costs
 Enhanced control over overhead costs
 Better management decisions
Activity-Based Costing: A Closer Look
Limitations of ABC

 Can be expensive to use

 Some arbitrary allocations continue
 Activity-Based Costing:
A Closer Look
Use ABC When One or More of the Following Exist:
 Products differ greatly in volume/manufacturing complexity
 Products lines are
 Numerous
 Diverse
 Require different degrees of support services
 Overhead costs are a significant portion of total costs
 Significant change in manufacturing process or number of
products
 Managers ignore data from existing system and instead use
“bootleg” costing data
 Value-Added vs.
Non-Value-Added Activities
Study Objective 6

Activity Based Management (ABM):

 An extension of ABC from a product costing system to a

management function
that focuses on reducing costs and improving processes and
decision making
 A refinement of ABC used in ABM classifies activities as
either value-added or non-value-added.
 Value-Added vs.
Non-Value-Added Activities
Value-Added Activity
An activity that increases the worth
of a product or service such as:

Manufacturing Company Service Company

engineering design performing surgery
machining legal research services
assembly delivering packages
painting
packaging
 Value-Added vs.
Non-Value-Added Activities
Non-Value-Added Activities
An activity that adds cost to, or increases the time
spent on, a product/service without increasing its
market value such as:
Manufacturing Company Service Company
Repair of machines Taking appointments
Storage of inventory Reception
Moving of raw materials, Bookkeeping/billing
assemblies, and finished goods Traveling
Building maintenance Ordering supplies
Inspections
Inventory Control
 CLASSIFICATION OF
ACTIVITY LEVELS

 Unit-level activities:
Performed for each unit of production
 Batch-level activities:
Performed for each batch of product
 Product-level activities:
Performed in support of an entire product line, but
not always performed every time a new unit or
batch is produced
 Facility-level activities:
Required to support or sustain an entire production
process
 Hierarchy of Activity Levels
Four Levels Types of Activities
Unit-Level Activities Machine-related:
Drilling, cutting, milling
Labor-related
Assembling, painting
Batch-Level Activities Equipment setups
Purchase ordering
Inspection
Material handling
Product-Level Activities Product design
Engineering changes
Facility-Level Activities Plant management
salaries
Plant depreciation
Property taxes
Utilities
Cost Drivers
Machine Hours
Direct labor hours/cost
Number of setups/setup time
Number of purchase orders
Number of inspections or
inspection time
Number of material moves
Number of product designs
Number of changes
Number of employees
managed
Square footage
Square footage
Square footage
 Activity-Based Costing
in Service Industries

Similarities with Manufacturing Firms

 Overall objective:
Identify key cost-generation activities and keep track of quantity
of activities performed for each service provided

 General approach is to identify activities, cost pools, and

cost drivers

 Labeling of activities as value-added or non-value-added

 Reduction of non-value-added activities

 Activity-Based Costing
in Service Industries

Major difficulty to implementing

ABC:

A larger proportion of overhead

costs are company-wide costs
that cannot be directly traced to
specific services.
 Summary of Study Objectives
 Recognize the difference between traditional and activity-based
costing.
Traditional system allocates overhead to products using
predetermined unit-based output rate.
ABC allocates overhead to activity cost pools and assigns cost
to products using cost drivers.

 Identify the steps in the development of an activity-based

costing system.
Step 1: Identify the major activities and allocate the overhead costs
to cost pools.
Step 2: Identify the cost driver highly correlated to the cost pool.
Step 3: Compute the overhead rate per cost driver.
Step 4: Assign cost pools to products or services using the overhead
rates.
 Summary of Study Objectives
 Know how companies identify cost pools used in ABC.
Analyze each operation or process, document and time every task, action, or
transaction.

 Know how companies identify and use cost drivers in ABC.

Cost drivers identified for assigning activity cost pools must:
 Accurately measure the consumption of the activity
 Have related data easily available.

 Understand the benefits and limitations of ABC

Benefits:
 Enhanced control over overhead costs
 Better management decisions
Limitations:
 Higher costs accompany multiple activity centers and cost
drivers
 Some costs must still be allocated arbitrarily
 Summary of Study Objectives
 Differentiate between value-added and non-value-added activities.
Value-added activities increase the worth of a product or service.
Non-value-added activities add cost to, or increase the time spent on, a
product or service without increasing its market value.

 Understand the value of using activity levels in ABC

Activities may be classified as:
 Unit-level
 Batch-level
 Product-level
 Facility-level

Failure to recognize this classification can result

in distorted product costing.
 Summary of Study Objectives

 Apply ABC to service industries.

Same objective – improved costing of services
provided.
The general approach to costing is also the
same:
 analyze operations
 identify activities
 accumulate overhead costs by activity
cost pools
 identify and use cost drivers to assign
cost to services
 Appendix
Just-In-Time Processing (JIT)
A processing system dedicated to having the
right amount of materials, products, or parts
arrive as they are needed, thereby reducing
the amount of inventory.
Just-In-Time Processing

100 pairs of Send rubber and

sneakers... shoe laces directly
got it! to the factory.

Sales Order
Received
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Cu st o mer
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Goods Manufactured hipped t
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 JIT Processing
Objective of JIT:
Eliminate all manufacturing inventories

Elements of JIT:
 Dependable suppliers
 Multi-skilled work force
 Total quality control system

Benefits of JIT:
 Reduced inventory
 Enhanced product quality
 Reduced rework and storage costs
 Savings from improved flow of goods