Chapter:3

Activity-Based Costing
and
Activity-Based Management

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 Background
 Recall that factory overhead is applied to
production in a rational systematic manner, using
some type of averaging. There are a variety of
methods to accomplish this goal.
 These methods often involve trade-offs between
simplicity and realism.

Simple Methods Complex Methods

Unrealistic Realistic

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Broad Averaging
 Historically, firms produced a limited variety of
goods while their indirect costs were relatively
small.
 Allocating overhead costs was simple: use broad
averages to allocate costs uniformly regardless of
how they are actually incurred.
 Peanut-butter costing
 The end-result: overcosting and undercosting

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Over and Undercosting
 Overcosting—a product consumes a low
level of resources but is allocated high
costs per unit.
 Undercosting—a product consumes a high
level of resources but is allocated low
costs per unit.

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Cross-subsidization
 The results of overcosting one product and
undercosting another.
 The overcosted product absorbs too much cost,
making it seem less profitable than it really is.
 The undercosted product is left with too little
cost, making it seem more profitable than it really
is.

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implement activity-based costing, a seven-step procedure
Step 1: Identify the products that are the chosen cost objects.

Step 2: Identify the direct costs of the products.

Step 3: Select the activities and cost-allocation bases to use for

allocating indirect costs to the products.

Step 4: Identify the indirect costs associated with each cost-allocation

base (activity).

Step 5: Compute the rate per unit of each cost-allocation base

(activity) used to allocate indirect costs to the products.

Step 6: Compute the indirect costs allocated to the products.

Step 7: Compute the total costs of the products by adding all direct
and indirect costs assigned to the products.

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 Example(1)
Salma manufactures produces two products which provides the following information:
Deluxe Standard
 Direct material $ 40000 $ 70000
 Direct Labor $ 60000 $ 30000
 ABC costing information:
 Cost Pool Overhead Costs Activity-cost driver
 Materials handling $ 45,000 90,000 orders
 Machine maintenance $300,000 15,000 maintenance hours
 Setups hours $270,000 45,000 setups hours
 Inspections $105,000 21,000 inspections
 Total O. H. costs $720,000
 The above activities are used by two products as follows:
Deluxe Standard
 Materials handling 20,000 orders 40,000 orders
 Machine maintenance 5,000 maintenance h 6,000 maintenance h.
 Setups hours 10,000 setups h. 18,000 setups h.
 Inspections 1,000 inspections 1,600 inspections
Required:
1. IF a company uses Setups hours a only base to allocated O.H, How much of the cost to two
products?
2. By using ABC costing information, How much of the costs to two products?
3. Which product is overallocated?

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 The answer
Required: 1
 Allocated rate = 720000 /45000 = 16 per h
 O H Allocated TO Deluxe = 16 x 10000 = 160000 $
 O H Allocated TO Standard = 16x 18000 = 288000 $
 Deluxe Standard
 Direct Mat $ 40000 $ 70000
 Direct Labor $ 60000 $ 30000
 Manufacturing OH $ 160000 $ 288000
 Total Costs 260,000 388,000
Required: 2
 Activities allocated rates
 Total Costs / Activity-cost drivers
 Materials handling $ 45,000 / 90,000 orders = 0.5 orders
 Machine maintenance $300,000 / 15,000 = 20 hour
 Setups hours $270,000 / 45,000 = 6 hour
 Inspections $105,000/ 21,000 = 5 inspections

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O H allocated to by using ABC rate x actual activity:

Deluxe Standard

rate actual Cost rate actual cost

activity activity
0.5 20,000 10,000 0.5 40,000 20,000

20 5,000 100,000 20 6,000 120,000

6 10000 60,000 6 18,000 108,000

5 1000 5,000 5 1,600 8,000

Total O.H. 175,000 Total O.H. 256,000

 Deluxe Standard
Deluxe Standard
 Direct Mat $ 40,000 $ 70,000
 Direct Labor $ 60,000 $ 30,000
 Manufacturing OH $ 175,000 $ 256,000
 Total Costs 275,000 356,000
 Product Deluxe underAllocated but Standard are overAllocated O.H. cost,

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An Example: Plastim

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Plastim and Simple Costing

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Plastim and ABC Illustrated

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Plastim and ABC RateCalculation

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Plastim and ABC Product Costs

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Plastim: Simple and ABC Compared

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Conclusions
 Each method is mathematically correct.
 Each method is acceptable.
 Each method yields a different cost figure,
which will lead to different gross margin
calculations.
 Only overhead is involved. Total costs for the
entire firm remain the same—they are just
allocated to different cost objects within the
firm.
 Selection of the appropriate method and
drivers should be based on experience,
industry practices, as well as a cost-benefit
analysis of each option under consideration.

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A Cautionary Tale
 A number of critical decisions can be made using this
information:
 Should one product be “pushed” over another?
 Should one product be dropped?
 Accounting for overhead costs is an imprecise science.
Accordingly, best efforts should be put forward to arrive
at a cost that is fair and reasonable.

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Rationale for Selecting a
More Refined Costing System
 Increase in product diversity
 Increase in indirect costs
 Advances in information technology
 Competition in foreign markets

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Cost Hierarchies

 ABC uses a four-level cost structure to determine how

far down the production cycle costs should be pushed:
 Unit-level (output-level)
 Batch-level
 Product-sustaining-level
 Facility-sustaining-level

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ABC vs. Simple Costing
Schemes
 ABC is generally perceived to produce superior costing
figures due to the use of multiple drivers across
multiple levels.
 ABC is only as good as the drivers selected, and their
actual relationship to costs. Poorly chosen drivers will
produce inaccurate costs, even with ABC.

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Activity-Based Management

 A method of management that uses ABC as an integral

part in critical decision-making situations, including:
 Pricing and product-mix decisions
 Cost reduction and process improvement decisions
 Design decisions
 Planning and managing activities

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Signals that Suggest that ABC
Implementation Could Help a Firm:
 Significant overhead costs allocated using one or
two cost pools
 Most or all overhead is considered unit-level
 Products that consume different amounts of
resources
 Products that a firm should successfully make and
sell consistently show small profits
 Operations staff disagreeing with accounting over
manufacturing and marketing costs
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ABC and
Service/Merchandising Firms
 ABC implementation is widespread in a variety of applications outside
manufacturing, including:
 Health Care
 Banking
 Telecommunications
 Retailing
 Transportation

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