Activity-Based Costing—A Tool to Aid Decision Making

Lecture Notes

 Activity-based costing (ABC) refines a costing system by identifying individual activities as the
fundamental cost objects.
 An activity is an event, task, or unit of work with a specified purpose—for example, designing
products, setting up machines, operating machines, and distributing products.
 More informally, activities are verbs; they are things that a firm does.
 To help make strategic decisions,
 ABC systems identify activities in all functions of the value chain, calculate costs of individual
activities, and assign costs to cost objects such as products and services on the basis of the mix of
activities needed to produce each product or service.

Differences between ABC and Traditional Costing.

Manufacturing costs in ABC.

 In traditional costing systems, overhead costs are usually allocated to products using a single measure
of activity such as direct labor-hours. This approach assumes that overhead costs are highly correlated
with direct labor-hours. In other words, it is assumed that overhead costs move in tandem with direct
labor-hours. If this is not true, product and other costs will be distorted.
 Activity-based Costing (ABC) attempts to remedy these deficiencies of traditional costing systems.
They key concept in activity-based costing is that products (and customers) cause activities. These
activities result in the consumption of resources, which in turn result in costs. Consequently, if we
want to do a good job of assigned costs to products and customers, we must identify and measure the
activities that ink products and customers to costs.
 The distinction between manufacturing and non-manufacturing costs is critical in traditional costing
systems. This distinction is not important at all in activity-based costing. Like variable costing,
activity-based costing is concerned with how costs behave. And like variable costing, activity-based
costing is used in internal reports and is primarily intended to help managers in making decisions.
 Activity-based Costing differs from traditional costing in five major ways:
1. Non-manufacturing costs, as well as manufacturing costs, may be assigned to products.
2. Some manufacturing costs may be excluded from products. These are the costs of idle capacity
and organization-sustaining costs.
3. In activity-based costing, there are a number of activity cost pools. Each cost pool is associated
to product and other cost objects using its own unique measure of activity.
a. An activity is an event that causes consumption of overhead resources such as
processing a purchase order.
b. An activity cost pool is a “bucket” in which costs are accumulated that relate to a
single activity such as processing purchase orders.
4. The allocation bases in activity-based costing, (i.e., measures of activity) often differ frpm
those used in traditional costing systems.
5. The overhead rates in activity-based costing (which are called activity rates) maybe based on
the level of activity at capacity rather than on the budgeted level of activity.

Multiple overhead cost pools in ABC.

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 In traditional overhead costing systems, an entire plant may have a single overhead cost pool or each
production department may have a separate overhead cost pool. In nearly all cases, overhead costs
are applied to products using either direct labor-hours, direct labor cost, or machine-hours. In
activity-based costing, each major activity has its own separate overhead cost pool. An activity is
any event that causes the consumption of resources. The activities tracked in the ABC system may
cut across many departments and the measures of activity (i.e., allocation bases) may be quite
different from the traditional allocation bases.

Cost Hierarchy in Activity-Based Costing.

 Thousands of activities are carried out in most organizations. It would not be practical to track all of
them in an activity-based costing system. A great deal of simplification is necessary. Activities and
their costs must be combined to reduce the complexity and record-keeping requirements. One way to
simplify is to group activities into a hierarchy. Activities, and their costs, can be combined within
each level of the hierarchy into activity cost pools—hopefully with minimal loss in accuracy. The
levels in the hierarchy are as follows:

1. Unit-level activities. These activities are performed each time a unit is produced. For example,
providing power to run processing equipment is likely to be a unit-level activity.

2. Batch-level activities. These activities are performed each time a batch is handled or processed,
regardless of how many units are in the batch. For example, tasks such as placing purchase
orders, setting up equipment, and arranging for shipments to customers are batch-level
activities.

3. Product-level activities. These activities relate to specific products and typically must be
carried out regardless of how many batches or units of product are produced or sold. For
example, designing a product, advertising a product, and maintaining a product manager and
staff are all product-level activities.

4. Customer-level activities. These activities relate to specific customers and include sales calls,
catalog mailings, and general technical support not tied to any specific product.

5. Organization-sustaining activities. These activities are carried out regardless of which

products are produced, how many batches are run, or how many units are made. This category
includes cleaning executive offices, providing a computer network, arranging for loans,
preparing annual reports to shareholders, and so on.

 There seven steps for implementing an activity-based costing system. The seven steps are listed
below:

1. Identify and define activities and activity pool.

2. Wherever possible, trace costs directly to activities and cost objects. For example, direct
materials and direct labor costs are often traced directly to products and are not included in the
activity-based costing system.
3. Assign costs to activity cost pools.
4. Calculate activity rates. These are like predetermined overhead rates in a traditional costing
system.
5. Measure the activities caused by products and other costs objects.
6. Assign costs to cost objects using the activity rates and measure of activity.
7. Prepare management reports.
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Mechanics of Activity-Based Costing.
 Once the activity cost pools and their activity measures have been defined, costs are allocated to the
activity cost pools.
 The costs in the activity cost pools are then divided by their activity measures to determine activity
rates.
 The activity rates are then used to assign costs to cost objects such as products and customers.
 For example, if a customer generates five orders and the activity rate for orders is RM15 per order,
then the customer would be assigned RM75 in order costs.
 The mechanics are fundamentally no different from the mechanics covered in topic 4 for applying
overhead to products. The main difference is that instead of one predetermined overhead rate, many
activity rates are used.

The process to understand the mechanic of activity-based costing

1. Prepare the first-stage allocation of costs to the activity cost pool.

a. Begin with a listing of the costs that will be included in the activity-based costing system
and the results of interviews with employees that indicate how these costs are to be
distributed across the activity cost pools. The interview results will indicate what
percentage of a specific cost such as indirect factory wages should be allocated to the first
activity cost pool, the second activity cost pool, and so on.
b. For example, supposed there is an activity cost pool for processing purchase orders. The
results of the interviews might indicate that 20% of the resources associated with office
staff wages are consumed in processing purchase orders. If the office staff wages are
RM200,000 per year, then 20% of RM200,000, or RM40,000, would be allocated to the
processing purchase orders cost pool.

2. Calculate the activity rates.

a. An activity rate is a cost per unit of activity. For example, the activity rate for machine set-
ups might be RM14 per machine set-up.
b. Supposed that 2,000 purchase orders are processed per year. If the office staff wages for
processing purchase orders are RM40,000, then the average cost of office staff wages for
processing purchase orders would be RM20 per purchase order. (RM40,000 / 2,000 =
RM20).
c. Activity rates are important in activity-based management. Activity rates for similar
activities can be compared across organizations or across different locations in the same
organizations. For example, the average cost of office staff wages for processing purchase
orders might be higher than RM20 at some locations in a company and lower at others. The
high locations may learn how to better process purchase orders by stud the techniques used
at the lower cost locations.

3. Prepare the second-stage allocation of costs to products, customers and other cost objects.

a. To allocate costs to products or other cost objects, multiply the cost object’s level of
activity by the activity rate.
b. For example, if a product requires two purchase orders and the activity rate is RM20 per
purchase order for office stage wages, it would be allocated RM40 (2 purchase orders @
RM20 per purchase order). Sum all of the costs of all of the activities associated with the
product to determine the total cost of the product.

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Product costs computed under activity-based costing and traditional costing systems differ for a number
of reasons. There are differences in what costs are allocated to product as well as in how they are
allocated. Focusing on how the costs are allocated, some general patterns emerge.
1. An activity-based costing system will typically shift costs away from high volume products that
are produced in small batches to low-volume products that are [produced in small batches.
Traditional costing systems apply batch-level and product level costs uniformly to all product
and the high-volume products absorbs the bulk of such costs. In an activity-based costing
system, such costs are assigned to the products that cause the costs rather than spreading them
uniformly over all products on the basis of volume,’

2. On a per-unit basis, the effect of the cost increases is usually much larger for low-volume
products than for high-volume products. The reason is that if x dollars are shifted from high-
volume products to low-volume products, the cost saving for the high-volume product is spread
over many units whereas the increase in costs for the low-volume products are spread over
relatively few units.

EXAMPLE 1:

Lambert Fabrication, Inc. is a manufacturing company that uses activity-based costing data for internal
decisions. The company has four activity cost pools, which are listed below:

Activity Cost Pool Annual Activity

Producing units………………………5,000 machine-hours
Processing orders…………………….1,000 orders
Customer support……………………..200 customers
Other…………………………………..Not applicable

The “Other” activity cost pool consists of the costs of idle capacity and organization-sustaining costs.
The company traces the costs of direct materials and direct labor to jobs (i.e., orders). Overhead costs-
both manufacturing and non-manufacturing-are allocated to jobs using the activity-based costing system.
The company’s overhead costs for the year are listed below:

Annual Overhead Costs

Indirect factory wages………………………..RM100,000
Other factory overhead………………………. 200,000
Selling and administrative overhead………… 400,000
Total overhead cost………………… RM700,000

To develop the company’s activity-based costing system, employees were asked how they distributed
their time and resources across the four activity cost pools. The results of those interviews appear below:

Results of Interviews of Employees

Distribution of Resource Consumption across Activities
Producing Processing Customer Other Totals
Units Orders Support
Indirect factory wages 40% 30% 10% 20% 100%
Other factory overhead 30% 10% 0% 60% 100%
Selling And Administrative Overhead 0% 25% 40% 35% 100%

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a. Using the result of the interviews. Carry out the first-stage allocation of costs to the activity cost
pools.
b. Using the results of the first-stage allocation, compute the activity rates for each of the activity cost
pools. (activity rates are not computed for the “other” activity cost pool. These costs will not be
allocated to products of customers.)
c. Using the activity rates you derived in part (b) above, compute the total amount of overhead cost that
would be allocated to an order that requires 20 machine hours.
d. The order in part (c) above required RM685 in direct materials and RM975 in direct labor costs. The
revenue from the job was RM2,500. Prepare a report from an activity that shows the margin from the
order.
e. Using the activity rates, compute the total amount of overhead cost that would be allocated to a
customer who had two orders during the year requiring a total of 100 machine hours
f. The order in part (c) above required RM685 in direct materials and RM975 in direct labor costs. The
revenue from the job was RM2,500. Prepare a report from an activity view that shows the margin
from the order.

Solutions:

a.

Producing Processing Customer Other Totals

Units Orders Support
Indirect factory wages1 RM40,000 RM30,000 RM10,000 RM20,00 RM100,000
Other factory overhead2 60,000 20,000 0 120,000 200,000
Selling And Administrative
Overhead3 0 100,000 160,000 140,00 400,000
Total overhead cost RM100,000 RM150,000 RM170,000 RM280,000 RM700,000

Example: 30% of RM100,000 = RM30,000

Percentage of indirect factory wages attributable to processing orders according to the interview result.

Calculations:

Indirect factory wages1

Producing Units = 40% x RM100,000 = RM40,000

Processing Orders = 30% x RM100,00 = RM30,000
Customer Support = 10% x RM100,000 = RM10,000
Other = 20% x RM100,000 = RM20,000

Other factory overhead2

Producing Units = 30% x RM200,000 = RM60,000
Processing Orders = 10% x RM200,000 = RM20,000
Customer Support = 0% x RM200,000 = 0
Other = 60% x RM200,000 = 120,000

Selling And Administrative Overhead3

Producing Units = 0% x RM400,000 = 0
Processing Orders = 25% x RM400,000 = 100,000
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Customer Support = 40% x RM400,000 = RM160,000
Other = 35% x RM400,00 = RM140,000
b.

Computation of Activity Rates

Producing Processing Orders Customer

Units Support
Total activity 5,000 1,000 200
Machine-hours Orders Customers
Indirect factory wages1 RM8.00 RM30.00 RM50.00
Other factory overhead2 12.00 20.00 0.00
Selling And Administrative Overhead3 0.00 100.00 800.00
Total overhead cost RM20.00 RM150.00 RM850.00

Examples: RM30,000/1,000 orders = RM30.00 per order

Indirect factory wages allocated to the processing orders activity cost pool in the first-stage allocation
above.

Calculations:

Indirect factory wages1

Producing Units = RM40,000/5,000MH = RM8.00
Processing Orders = RM30,000/1,000 orders = RM30.00
Customer Support = RM10,000/200 customers = RM50.00

Other factory overhead2

Producing Units = RM60,000/5,000 MH = RM12.00
Processing Orders = RM20,000/1,000 orders = RM20.00
Customer Support = 0.00

Selling and Administrative Overhead3

Producing Units = 0.00
Processing Orders = RM100,000/1,000 orders = RM100.00
Customer Support = RM160,000/200 customers = RM800.00

c.
The Overhead Cost of an Order Requiring 20 Machine-Hours
Producing Processing Customer
Units Orders Support Total
Total activity 20 1 Not applicable
machine hours Orders
Indirect factory wages1 RM160.00 RM30.00 RM0.00 190.00
Other factory overhead2 240.00 20.00 0.00 260.00
Selling And Administrative 0.00 100.00 0.00 100.00
Overhead3
Total overhead cost RM400.00 RM150.00 RM0.00 RM550.00

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 Examples: RM30.00 per order x 1 order = RM30.00

Calculations:
Indirect factory wages1
Producing Units = 20 units x RM8.00 = RM160.00
Processing Orders = 1 order x 30 = RM30.00
Customer Support = 0 x 50 = RM0.00

Other factory overhead2

Producing Units = RM12 x 20 units = RM240.00
Processing Orders = RM20.00 x 1 order = RM20
Customer Support = RM0.00

Selling and Administrative Overhead3

Producing Units = RM0.00
Processing Orders = RM100.00 x 1 order = RM100
Customer Support = RM0.00

d.
Margin on the Order from an Activity View
Revenue RM2,500.00
Costs:
Direct materials RM685.00
Direct labor 975.00
Production units 400.00
Procession orders 150.00
Customer support 0.00 2,210.00
Margin RM290.00

e.

The overhead cost allocated to a customer can be determined in exactly the same way as for an order.
The only difference is that customer support costs are also allocated along with the costs of producing
units and processing orders. (1 customer, 2 orders, 100 units)

Producing Processing Customer Total

Units Orders Support
Total activity 100 2 1
Machine -hours Orders Customer
Indirect factory wages RM800.00 RM60.00 RM50.00 RM910.00
Other factory overhead 1,200.00 40.00 0.00 1,240.00
Selling And Administrative Overhead 0.00 200.00 800.00 1,000.00
Total overhead cost RM2,000.00 RM300.00 RM850.00 RM3,150.00

Calculations:

Overhead rate
Indirect factory wages1 RM8.00 RM30.00 RM50.00
Other factory overhead2 12.00 20.00 0.00
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 Selling And Administrative Overhead3 0.00 100.00 800.00

Indirect factory wages

Producing Units = RM8.00 x 100 units = RM800
Processing Orders = RM30.00 x 2 orders = RM60
Customer Support = RM50.00 x 1 customer = RM50

Other factory overhead

Producing Units = RM12.00
Processing Orders = RM20.00
Customer Support = RM0.00

Selling And Administrative Overhead

Producing Units = RM0.00
Processing Orders = RM100.00
Customer Support = RM800.00

f.
The total at the bottoms of the columns in part (c) above are used to compute the margin on the
customer’s business from the activity view.

Margin on the Order from an Activity View

Revenue RM8,000.00
Costs:
Direct materials RM685.00
Direct labor 975.00
Production units 2,000.00
Procession orders 300.00
Customer support 850.00 8,400.00
Margin (RM400.00)

EXAMPLE 2:

Savvy Company manufactures 4,000 units of Product A and 20,000 of Product B each year. The
company uses direct labor-hours to assign overhead cost to products. The predetermined overhead rate
is:

Manufacturing overhead cost = RM900,000 = RM18/DLH

Direct labor hours 50,000

A Product A requires 2.5 DLH and Product B requires 2.0 DLH. According to the current cost system,
the costs to manufacture one unit of each product are:

Product A Product B
Direct materials RM36.00 RM30.00
Direct labor 17.50 14.00
Manufacturing overhead:
2.5 DLH x RM18/DLH 45.00
2.0 DLH x RM18/DLH 36.00
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 Total cost per unit RM98.50 RM80.00

Suppose, however, that overhead costs are actually caused by the five listed activities listed below:
Activity Traceable Cost
Machine setup RM255,000
Quality inspections 160,000
Production orders 81,000
Machine-hours worked 314,000
Materials receipts 90,000

Also suppose the following transaction data has been collected:

Number of Events or Transactions

Activity Total Product A Product B
Machine setup 5,000 3,000 2,000
Quality inspections 6,000 5,000 3,000
Production orders 600 200 400
Machine-hours worked 40,000 12,000 28,000
Materials receipts 750 150 600

These data can be used to develop overhead rates for each of the five activities:

Activity Costs Transactions Rate per

Transaction
Machine setup RM255,000 5,000 RM51/setup
Quality inspections 160,000 8,000 RM20/inspection
Production orders 81,000 600 RM135/order
Machine-hours worked 314,000 40,000 RM7.85/hour
Materials receipts 90,000 750 RM120/receipt

The overhead rates developed on the previous transparency can now be used to assign overhead costs to
products:
Product A
Activity Rate Transactions Amount
Machine setup RM51.00 3,000 RM153,000
Quality inspections 20.00 5,000 100,000
Production orders 135.00 200 27,000
Machine-hours worked 7.85 12,000 94,200
Materials receipts 120.00 150 18,000
Total Overhead (a) RM392,000
Number of units (b) 4,000
Overhead per unit (a)÷(b) RM98.05

Product B
Activity Rate Transactions Amount
Machine setup RM51.00 3,000 RM153,000
Quality inspections 20.00 5,000 100,000
Production orders 135.00 200 27,000
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 Machine-hours worked 7.85 12,000 94,200
Materials receipts 120.00 150 18,000
Total Overhead (a) RM507,800
Number of units (b) 20,000
Overhead per unit (a)÷(b) RM25.39

Product costs computed using the two different methods can now be contrasted:

Product costs using activity-based costing:

Product A Product B
Direct materials RM36.00 RM30.00
Direct labor 17.50 14.00
Manufacturing overhead 98.05 25.39
Total cost per unit RM151.55 RM69.39

Product costs using the old costing system:

Product A Product B
Direct materials RM36.00 RM30.00
Direct labor 17.50 14.00
Manufacturing overhead 45.00 36.00
Total cost per unit RM98.50 RM80.00

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