Chapter 7

Activity-Based
Costing

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Learning
Objective
1

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 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 tradeoffs between
simplicity and realism

Simple Methods Complex Methods

Unrealistic Realistic
 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 & undercosting
 Background
– The use of broad averages in allocating indirect costs
can have a number of adverse consequences.
– Traditional product-costing methods use a single
indirect cost rate to allocate costs to all products.
– When a company has a variety of products, this method
may not give the best results.
– Different products consume activities at different rates,
traditional costing does not recognize these differences.
– Peanut-butter costing uses broad averages to assign (or
spread) costs uniformly to cost objects.
 Over & Undercosting
• Overcosting – a product consumes a low
level of resources but is allocated high costs
per unit (Emma’s dinner)
• Undercosting – a product consumes a high
level of resources but is allocated low costs
per unit (James dinner)
 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
 Simple Costing System
• A simple costing system has few indirect
(often one) cost rates and allocates costs
broadly.
An Example:
Plastim
Plastim & Simple Costing
 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
 Rationale for selecting a more refined
costing system

• Increase in product diversity

• Increase in Indirect Costs
• Advances in information technology
• Competition in foreign markets
 Refining a Costing System
• A refined cost system reduces the use of
broad averages for assigning costs to
resources. There are three principal reasons
that have accelerated the demand for such
refinements.
– Increase in product diversity. The growing
demand for customized products has led to
product diversity with the result that products
demand differing levels of resources.
 Refining a Costing System
• Increase in indirect costs. With modern
technology, companies have experienced a
decrease in direct costs with a resulting
increase in indirect costs.
• Competition in product markets. Markets
have become more competitive, forcing
managers to obtain more accurate cost
information to help them make strategic
decisions.
 Guidelines
• Direct-cost tracing. Identify as many direct
costs as is economically feasible.
• Indirect-cost pools. Expand the number of
cost pools so that each pool is somewhat
homogeneous. Each cost in the pool has a
similar cause-and-effect relationship with a
single cost driver.
• Cost-allocation bases. The cost driver
serves as the cost allocation base for each
homogeneous indirect-cost pool.
 Activity-Based System
(ABC)
• An activity-based system (ABC) identifies
individual activities as fundamental cost
objects.
An activity is an event, task, or unit of
work with specific purpose—for example
designing product, setting up machines,
operating machines and distributing
products.
• Costs are then assigned to the activities and
allocated to the individual products.
 Cost Hierarchies
• ABC uses a four-level cost structure to
determine how far down the production
cycle costs should be pushed:
• A cost hierarchy categorizes various cost
pools on the basis of the different type of
cost drivers, cost-allocation bases, or
different degrees of difficulty in determining
cause-and-effect relationship.
 Cost Hierarchies
• Output unit-level costs are the costs of
activities performed on each individual unit
of a product or service. These costs
increase as the number of units produced
increases.
• Batch-level costs are the costs of activities
related to a group of units of products or
services rather than the individual unit. Set-
up costs are an example of batch level
costs, as this cost is incurred once for each
batch, regardless of the size of the batch.
 Cost Hierarchies
• Product-sustaining costs (service-
sustaining costs) are the costs of activities
undertaken to support individual products or
services regardless of the number of units or
batches produced. Design costs are an
example of this type of cost.
 Cost Hierarchies
• Facility-sustaining costs are the costs of
activities that cannot be traced to individual
products or services but support the
organization as a whole. Examples of this
type of cost include general administration,
rent, and building security. These costs
usually lack a cause-and-effect relationship
between the cost and the allocation base.
 Plastim’s ABC System
• To identify activities, Plastim organizes a team of
managers from design, manufacturing,
distribution, accounting and administration.
• The team identifies hundreds of task performed at
Plastim. The team then focuses on those activities
that account for a sizable fraction of indirect costs
and combines activities that have same cost driver
into single activity. For example the team decides
to combine maintenance of molding machine,
operation of molding machine, and process control
into single activity—molding machine operations.
 Plastim’s ABC System
• The team identifies the following seven
activities needed to design, manufacture,
and distribute S3 and C5 lenses:
• 1. Design products and processes
• 2. Set up molding machines to ensure that
the molds are properly held in place and
parts are properly aligned before
manufacturing starts.
• 3. Operate molding machines to
manufacture lenses
 Plastim’s ABC System
• 4. Clean and maintain the molds after
lenses are manufactured.
• 5. Prepare batches of finished lenses for
shipment
• 6. Distribute lenses to customers
• 7. Administer and manages all processes at
Plastim
• # 4 consists of salaries and wages paid to
workers who clean the mold (direct cost).
• All other costs are indirect cost pool.
 Plastim’s ABC System
• Design costs are product sustaining costs
and are function of complexity of mold,
measured by the number of parts in the
mold multiplied by the area (in square feet)
over which the molten plastic must flow (12
parts * 2.5 Sq Ft for the S3 lens and 14
parts and * 5 Sq Ft for the C5 lens.
• Molding machine set up costs are batch
level activity, S3 lens require, 60,000/240
lens per batch=250 batches.
 Plastim’s ABC System
• Each batch requires 2 hours Setup time.
Thus total setup hours required for S3 lens
are 500 hours.
• For C5 lens require, 15,000/50 lens per
batch=300 batches. Each batch requires 5
hours setup time. Thus total setup hours
required for C5 lens are 1,500 hours
 Plastim’s ABC System
• Machine operations costs are related to the
activity of running the automated molding
machines and are output unit level costs.
S3 requires 9,000 molding machine hours to
manufacture 60,000 lens and C5 require
3,750 molding machine hours to
manufacture 15,000 lens.
• Shipment Setup activity is a batch level
activity and each category of lenses require
100 shipments.
 Plastim’s ABC System
• Distribution is an output unit level activity.
S3 45,000 cubic feet delivered and C5
22,500 cubic feet delivered
• Administration is facility sustaining activity
and is measured in terms of direct
manufacturing labor required for both types
of lenses. S3 require 30,000 MLH and C5
require 9,750 MLH respectively.
Plastim and ABC Illustrated
Plastim and ABC Rate
Calculation
Plastim and ABC Product Costs
Plastim: Simple & ABC
Compared
 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
 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.
 Activity-Based Management
• A method of management that used ABC as
an integral part in critical decision-making
situations, including:
– Pricing & product-mix decisions
– Cost reduction & process improvement
decisions
– Design decisions
– Planning & managing activities
 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
 ABC and Service / Merchandising
Firms

• ABC implementation is widespread in a

variety of applications outside
manufacturing, including:
– Health Care
– Banking
– Telecommunications
– Retailing
– Transportation
 Traditional, Volume-Based
Product-Costing System
• Aerotech produces three complex printed circuit
boards referred to as Mode I, Mode II, and Mode
III.
• The following information is obtained from
company records:

Mode I Mode II Mode III

Production:
Units 10,000 20,000 4,000
Runs 1 run of 10,000 4 runs of 10 runs of
units 5,000 units 400 units
 Traditional, Volume-Based
Product-Costing System
Mode I Mode II Mode III
Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor 60.00 80.00 40.00
Manufacturing overhead 99.00 132.00 66.00
Total $ 209.00 $ 302.00 $ 126.00

Additional information includes:

Mode I Mode II Mode III
Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor (hr/board) 3 4 2
Setup time (hr/run) 10 10 10
Machine time (hr/board) 1 1.25 2

Manufacturing overhead is determined as follows

 Traditional, Volume-Based
Product-Costing System
Mode I Mode II Mode III
Units produced 10,000 20,000 4,000
Direct labor (hr/unit) 3 4 2
Total hours 30,000 80,000 8,000

Total hours required 118,000

Budgeted manufacturing overhead $3,894,000

= $33 per hour
Budgeted direct-labor hours 118,000

Mode I Mode II Mode III

Direct labor (hr/unit) 3 4 2
Overhead rate per hour $ 33 $ 33 $ 33
Overhead per unit $ 99 $ 132 $ 66
 Traditional, Volume-Based
Product-Costing System
With these product costs, Aerotech established
target selling prices (Cost × 125%). Actual Selling
price is $261.25,$328,$250 for Mode I, Mode II
and Mode III respectively.
Mode I Mode II Mode III
Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor 60.00 80.00 40.00
Manufacturing overhead 99.00 132.00 66.00
Total $ 209.00 $ 302.00 $ 126.00
Mode I Mode II Mode III
Cost per unit $ 209.00 $ 302.00 $ 126.00
Target selling price 261.25 377.50 157.50

209.00 x 1.25
 Learning
Objective
2

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Activity Based Costing System
(ABC)

ABC systems Assigning

overhead to
follow a two- products is a
difficult process.
stage procedure I agree!
to assign
overhead costs to
products.
 Activity Based Costing System
(ABC)
ABC systems follow a
Let’s begin
two-stage procedure by identifying
to assign overhead our major
activities.
costs to products.

Stage One
Identify significant
activities and assign overhead
costs to each activity in
proportion to resources used.
 Activity Based Costing System
(ABC)
ABC systems follow a
two-stage procedure Overhead assigned to
to assign overhead activities are called
“activity cost pools.”
costs to products.

Stage Two
Identify cost drivers
appropriate to each activity
and allocate overhead to
the products.
 Learning
Objective
3

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Overhead Costs
Total budgeted cost = $3,894,000 Identification
Activity
of Activity
must be
done on Activity Cost Pools
each unit Cost
produced. Pools
Product-
Unit Batch Sustaining Facility
Level Level Level Level

Machinery Setup Engineering Facility

cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Activity Activities needed to support Activity required in order

performed an entire product line for the production
on each process to occur.
batch
produced.
 Product-
Unit Batch Sustaining Facility
Level Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Receiving/Inspection
cost pool $200,000

Material-Handling
cost pool $600,000

Quality-Assurance
cost pool $421,000

Packaging/Shipping
cost pool $250,000
 Learning
Objective
4

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 STAGE ONE

Various overhead
Maintenance Lubrication
costs related
to machinery Depreciation Electricity

Computer Support Calibration

Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1,212,600
 STAGE TWO
Calculate Budgeted Machinery Costs = $1,212,600
the pool Budgeted Machine Hours 43,000
rate = $28.20/hour

Mode I: Mode II:

$28.20 per hr. $28.20 per hr.
1 hr. per unit 1.25 hr. per unit
Cost $28.20 per unit $35.25 per unit

Assignment
Mode III:
$28.20 per hr.
2 hr. per unit
$56.40 per unit
 STAGE ONE
Total budgeted setup cost
Calculation of $20 per hour
total setup cost 10 hr. per setup
$200 cost per setup
15 production runs
$ 3,000 Total

Activity
cost Setup Cost Pool
pool Total budgeted cost = $3,000
 STAGE TWO
Calculate Budgeted Setup Costs = $3,000
the pool Planned Production Runs 15 runs
rate = $200 per run

Mode I: (1 Run) Mode II: (4 Runs)

$200 per run $200 per run
10,000 units per run 5,000 units per run
Cost = $.02 per unit = $.04 per unit
Assignment
Mode III: (10 Runs)
$200 per run
400 units per run
= $.50 per unit
 STAGE ONE
Various overhead Engineering salaries Engineering software
costs related
to engineering Engineering supplies Depreciation

Activity
cost Engineering Cost Pool
pool Total budgeted cost = $700,000
 STAGE TWO
Allocate based Engineering Cost Pool
on engineering Total budgeted cost = $700,000
transactions

Mode I: Mode II:

25% × $700,000 45% × $700,000
10,000 units 20,000 units
Cost = $17.50 per unit = $15.75 per unit
Assignment
Mode III:
30% × $700,000
4,000 units
= $52.50 per unit
 Exh.

STAGE ONE 5-9

Various overhead Plant depr. Property taxes

costs related
Plant mgmt. Insurance
to general
operations Plant maint. Security

Activity
cost Facility Cost Pool
pool Total budgeted cost = $507,400
 Exh.

STAGE TWO 5-9

Calculate Budgeted Facilities Cost = $507,400

the pool Budgeted Direct-Labor Hours 118,000
rate = $4.30/hour

Mode I: Mode II:

$4.30 per hr. $4.30 per hr.
× 3 hr. per unit × 4 hr. per unit
Cost $12.90 per unit $17.20 per unit
Assignment
Mode III:
$4.30 per hr.
× 2 hr. per unit
$8.60 per unit
 Other Overhead Costs
Receiving and Inspection Cost Pool
Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00

Material-Handling Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 600,000 × 7% ÷ 10,000 = $ 4.20
Mode II 600,000 × 30% ÷ 20,000 = 9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50

Quality-Assurance Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10

Packaging and Shipping Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
Mode III 250,000 × 66% ÷ 4,000 = 41.25
 Other Overhead Costs
Receiving and Inspection Cost Pool
Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00

Material-Handling Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
$14.82 Mode I $ 600,000 × 7% ÷ 10,000 = $ 4.20
Mode II 600,000 × 30% ÷ 20,000 = 9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50

Quality-Assurance Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10

Packaging and Shipping Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
Mode III 250,000 × 66% ÷ 4,000 = 41.25
 Product Cost from ABC
These are the new product costs when
Aerotech uses ABC.
Mode I Mode II Mode III
Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor 60.00 80.00 40.00
Machinery 28.20 35.25 56.40
Setup 0.02 0.04 0.50
Engineering 17.50 15.75 52.50
Facilities 12.90 17.20 8.60
Other 14.82 23.57 212.85
Total $ 183.44 $ 261.81 $ 390.85
 Learning
Objective
5

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Distorted Product Costs
Both original and ABC target selling prices are
based on (Cost × 125%).

Mode I Mode II Mode III

Traditional costing $ 209.00 $ 302.00 $ 126.00
ABC costing 183.44 261.81 390.85

Original target selling price 261.25 377.50 157.50

ABC target selling price 229.30 327.26 488.56

The selling price of Mode I and II are reduced

and the selling price for Mode III is increased.
[$209.00 × 1.25] [$183.44 × 1.25]
 Distorted Product Costs
Can you identify any problems Aerotech is likely
to face as a result of this distortion?
Mode I Mode II Mode III
Traditional costing $ 209.00 $ 302.00 $ 126.00
ABC costing 183.44 261.81 390.85
Cost distortion per unit 25.56 40.19 (264.85)
Units produced 10,000 20,000 4,000
Total cost distortion 255,600 803,800 (1,059,400)

Traditional costing understates the cost

of complex, low volume products.
 Two Key Points
A large proportion of non-
unit-level activities
A unit-level cost driver,
such as direct labor,
machine hours, or
throughput, will not be
able to assign the costs
of non-unit-level activities
accurately.
Product diversity
When the consumption
ratios differ widely
between activities, no
single cost driver will
accurately assign the
resulting overhead costs.
 Learning
Objective
6

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs.
 Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .

Degree of
Correlation
 Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .

Degree of
Correlation

Cost of
Measurement
 Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .

Degree of Behavioral
Correlation Effects

Cost of
Measurement
 Learning
Objective
7

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Interviewing and Paper Trails
The information for ABC systems initially comes
from interviews with employees in the support
departments and a review of each department’s
records.
 Storyboarding
A procedure used to develop a detailed
process flow chart, which visually represents
activities and the relationships among
activities.
Step These are the steps we
1 follow to build a
Step
memory board.
2
Step
3
Step
4
 Direct versus Indirect Costs
Volume-Based Costing Activity-Based Costing
All production costs An effort is made to
except direct account for as many
materials and direct costs as possible as
labor are lumped direct costs of
together in one production.
overhead cost pool.

Indirect
Costs
 Indicators of Need for ABC
Direct labor is a Product-line profit
small percentage margins are hard
of total costs to explain

Line managers do not

Sales are increasing,
believe the product
but profits are declining.
costs reports

Some products that

Marketing does not
have reported high
use costs reports for
profit margins are not
pricing decisions
sold by competitors
 Exh.
5-13

Optimal Product-Costing System

Cost
Total Cost
High

Cost of
inferior
decisions
resulting Design, implementation
from and maintenance costs
inaccurate
information.

Information
Low
System
Low High Accuracy
Optimal
system
 Learning
Objective
8

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
ABC in the Service Industry

Objectives
End of Chapter 5
This is
my kind of cost
pool!