ACTIVITY-BASED COSTING

(ABC)

Problems 'With Traditional Costing Systems (TCS)

• The traditional costing system was developed in the early of 1900s. In those days most
manufacturing companies were labor intensive, the product variety was small, and the
overhead costs were generally very low compared to today.

• In the late 1970s and particulariy 1980s, FOH costs have increased significantly and the
direct costs of material and labor·have decreased due to the advances in technology and
productivity. For example, increased automation has reduced the use of worker (DL) and
increased depreciation. In addition, most companies started to produce more varieties of
their products to satisfy different needs fordifferent customers. Moreover, non-
manufacturing indirect costs such marketing . expenses became very important and
significant to achieve customer satisfaction.

-• The traditional approach to cost-allocation often allocate FOH to cost objects based on
single-volume measures as an overall cost driver such as direct-labor hours, direct-labor
costs, or machine hours.
• Traditional Costing considers only Indirect manufacturing costs as Product Cost.
Non-manufacturing costs such as selling and administrative costs are not assigned to
products or services. However, many of these non-manufacturing costs are significant
part of the costs of the products and can be identified with certain products. For example,
sales commission, shipping costs, and warranty repair costs can be easily traced to
individual products and services.

• Traditional Costing uses a single allocation base to allocate FOH costs to cost objects,
which may result in cost smoothing phenomeQ.on. Cost smoothing or peanut butter
costing describes a costing approach that uses broad averages to assign the indirect cost
of resources uniformly to cost objects when the individual products, services, or
customers in fact use those resources in a non-uniform way. This, in turn, may result
in over-costing some products and under-costing some others (a phenomenon called .
"product cost cross-subsidization".

• Product under-costine occurs when a product consumes a relatively high level of

resource but is reported (allocated) to have a relatively low total cost due to under
allocation of indirect costs. This may result in unrecognized losses on sales from
under pricing.

• Product oyer-costine occurs when a product consumes a relatively low level of

resources but is reported to have a relatively high total cost. This may result'in loss
of sales from overpricing. Consequently, the company might erroneously drop
certain successful products.

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 Activity-Based Costing (ABC)
ABC is a costing approach that assigns costs to products or services based on their
consumption of resources via activities required for the manufacturing of the products
. or providing services. It is based on the premise that a firm's products or services are
performed by activities and that the required activities incur costs. Cost of resources is
assigned to activities~ then activities are assigned to cost objects based on their use.
ABC recognizes the ~ausal relationships of cost drivers to activities. ABC's major
advantage is that it improves the traceability of overhead costs thus minimizes distortion
of product costs.

Figure 1
TRADITIONAL COSTING SYSTEM (TCS)

FOH are allocated Selling and Administrative

·oirect Direct
Mat. Labor based on one or two Expenses
allocation bases (Period Cost)

Ir l
Cost Objects
(e.g., Product, Service, Customer, etc.)

ACTMTY-BASED COSTING (ABC)

Non-Production &l.Other Indirect Costs

Costs that can be Manufacturing & Non-Manufacturing costs are
Direct Costs
traced to cost allocated to cost objects in two stages
DM+DL
objects
e.g., shipping ,
Sales Comm.,
I Stai!e I: Allocate Costs to Activity Cost Pools I
advettising etc.

Activity Cost-Pools
Sts. .... 11· Allor11t,. Cost Pool~ to Cod Ohi ects

Ir
•Ir Ir

Cost Objects
e.g., Products, Services, Customers, ... etc.

2
\
l

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Mechanics of Activity-Based Costing

In order to produce and sell a product or a service, a finn should carry out thousands of different
activities.

An activity is an event or a task or an action that should be taken to perfo~ a particulru: b~siness
operation. Examples include: designing/developing a product, purchasmg ~nd rece1v1~g raw
material or parts, setting up a machine to process a particular order~ operatm~ a ma~hine,
scheduling production to fulfill orders, inspecting products, correctmg defective umts,
packaging, shipping products, customer services, etc.

Performing each of these activities consume resources (i.e., incwTing costs). Following are the
steps of designing and implementing an ABC system:

1. Identify all the activitie.ythat the firm has to perfonn in order to produce a product or to
perform a service.

2. Estimate the resources (i.e., costs) required to fulfill .each activity.

3. Identify activih•cost pools. Since it is impractical to track thousands of activities, it is
important to simplify the process by grouping each set of similar activities into one activity
cost pool. For example, activities that could be associated with running a machine may
include the costs of labor, maintenance and power. These costs usually incurred when the
machine is running.

A useful way to think about forming activitv cost pools is to organize them into four
general categories/levels (cost hierarchy): (a) unit-level, (b) batch-level, (c) product-
, level, and (d) organization-level activities.

(a). Unit-Jevel activities: Activities that are performed each time a unit is produced.
The costs incurred to perform activities at the unit level are assigned to each unit
produced.

·,
Examples unit-level include direct materials, direct labor, indirect materials, and
certain types of indirect costs that are highly correlated with the units produced such as
electricity to run machine, depreciation of machines, maintenance of machines, etc.
Each unit produ~ed consumes ~e same amount of these resources. The activity
measure (allocation base) for this cost pool could be units produced or machine-
hours.

(b). Batch-level activities: Activities that are performed each time a batch of goods is
proc~ssed, regardless of how m_any units are in the batch. For examples, tasks such as
placmg purchase orders, se~h_n~ up machines, and arranging for shipments to
customers are batch-level activities. Costs incurred at the batch-level depend on the
number 1 batches processed regardless of the number of units produced in each
0

b~tch. The hatch-level costs are indirect to each individual units produced but al"e
dtrectlyrelated to the batch.

3
 (c). Product-level activities: Activities that are related to a specific product regardless
of how many units produced or batches run. Examples of this type of activities
include, designing & developing a product, and advertising for a product.

(d). Facility-level activities: Activities that are carried out regardless of which
products are produced, how many batches are run, or how many units are produced.

4. Develop Activity Measures for each Activity Cost Pool:

An activity measure is a cost driver that causes the amount of costs incurred in
an activity cost pool to change. The
activity measures are used as an allocation
.ll!s,_to assign the costs accumulated in a cost pool to the users of the cost pool.
There are two types of drivers (indicators) for the amount of resources consumed
each time a user (i.e., a cost object) uses an activity:

• Transaction Driver: A siµiple count of the number of times an activity occurs

(e.g., # of bills sent out to customers, assuming that all bills consume the same
amount of time to prepare).

• Duration Driver: A measure of the amount of time required to perform an

activity.

5. Co~~ute activity rates (i.e., the cost per unit of activity)

Activity rate for each cost pool is calculated as fo1lows:

The activity rate= the total cost assigned to an activity cost pool
the total amount of activity for the cost pool ·

6. Assign costs to cost objects.

The activity rates can then be used to assign costs t 11 .
cost pool. Following is the allocation equation: o a cost obJects that consume or use the

Assigned costs= the activity rate x the amount of activity used up by the cost object.

ABCandGAAP
Accordi~g to GAAP' firms are required to use th .. .
(absorption_ Costing) for external reportin e actual tradition~} costing system
system for mtemal reporting system as dg P1:11Yose. Most companies, however adopt ABC
t • . a ec1s1on maki t I Th • '
sys em is not mtegrated with the com , n~ oo . us, m most firms the ABC
pany s regular costmg system.

4
 ~_pc:11L U11 \,.,av1• -p1- V UU\.I _
L

model I, 24o/o model Il, and70% model III)

spent on eac·h product
tnodel I, 30% model II, and 63% 1nodel III)

: spent on each product

1 model I, 40% model II, and 40% model Ill)
: spe11t on each product
model I, 30¾ model II, and _66% model III)

for each product under:

1 allocation base.

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