Activity-Based

Costing
Learning Objectives
1) Understand activity-based costing and how it differs from
a traditional costing system.
2) Assign costs to cost pools using a first-stage allocation.
3) Compute activity rates for cost pools.
4) Assign costs to a cost object using a second-stage
allocation.
5) Use activity-based costing to compute product and
customer margins.
6) Know the benefits and limitations of activity-based
costing.
Activity–Based Costing (ABC)

ABC is designed to provide managers ABC is a

good
with cost information for strategic supplement to
our traditional I agree!
and other decisions that potentially cost system
affect capacity, and therefore, affect

“fixed”

as well as variable costs.

 How Costs are Treated Under
Activity–Based Costing
BC differs from traditional cost accounting in three ways.

Manufacturing Nonmanufacturing
costs costs

Traditional ABC
product costing product costing

 ABC assigns both types of costs to products.

 How Costs are Treated Under
Activity–Based Costing
BC differs from traditional cost accounting in three ways.

Manufacturing Nonmanufacturing
costs costs
Mo

Some
st ,
All not but
al l

Traditional ABC
product costing product costing

 ABC does not assign all manufacturing costs

to products.
 How Costs are Treated Under
Activity–Based Costing
BC differs from traditional cost accounting in three ways.

Level of complexity
Activity–Based
Activity–Based
Costing
Costing

Departmental
Departmental
Overhead
Overhead
Rates
Rates
Plantwide
Plantwide
Overhead
Overhead
Rate
Rate

Number of cost pools

 ABC uses more cost pools.

 How Costs are Treated Under
Activity–Based Costing
BC differs from traditional cost accounting in three ways.

Each ABC cost pool has its

own unique measure of activity.
Traditional cost systems usually rely
on volume measures such as direct labor
hours and/or machine hours to allocate
all overhead costs to products.

 ABC uses more cost pools.

How Costs are Treated Under
Activity–Based Costing
An event that causes the
Activity consumption of overhead
resources.
Activity A “cost bucket” in which
costs related to a single
Cost activity measure are
Pool $ $
$
accumulated.
$ $
$
How Costs are Treated Under
Activity–Based Costing
Activity The term cost driver is also used
Measure to refer to an activity measure.

An allocation base
in an activity-based
costing system.
 How Costs are Treated Under
Activity–Based Costing
o common types of activity measures:

Transaction Duration
driver driver
Simple count A measure
of the number of of the amount
times an activity of time needed
occurs. for an activity.
 How Costs are Treated Under
Activity–Based Costing

ABC defines five levels of activity

that largely do not relate to the
volume of units produced.

Traditional
Traditional cost
cost systems
systems usually
usually rely
rely on
on volume
volume
measures
measures such
such as
as direct
direct labor
labor hours
hours and/or
and/or machine
machine
hours
hours to
to allocate
allocate all
all overhead
overhead costs
costs to
to products.
products.
Characteristics of Successful ABC
Implementations
Unit-Level Batch-Level
Activity Activity

Manufacturing
companies typically
combine
their activities into five
classifications.
Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
Characteristics of Successful ABC
Implementations

Strong top
management support Link to evaluations
and rewards

Cross-functional
involvement
 Steps in Activity Based Costing
1) Define Activities, Activity Cost
Pools, and Activity Measures
2) Assign Overhead Costs to Activity
Cost Pools
3) Calculate Activity Rates
4) Assigning Overhead to Products
5) Prepare Management Reports
Baxter Battery – An ABC Example

Manufacturing overhead is allocated to products using

a single plantwide overhead rate based on machine hours.
 Define Activities, Activity Cost
Pools, and Activity Measures
At Baxter Battery, the ABC team selected the following
activity cost pools and activity measures:
  Define Activities, Activity Cost
Pools, and Activity Measures
• Customer Orders - assigned all costs of resources that are
consumed by taking and processing customer orders.
• Design Changes - assigned all costs of resources
consumed by customer requested design changes.
• Order Size - assigned all costs of resources consumed as a
consequence of the number of units produced.
• Customer Relations – assigned all costs associated with
maintaining relations with customers.
• Other – assigned all organization-sustaining costs and
unused capacity costs
 Assign Overhead Costs to
Activity Cost Pools
  Assign Overhead Costs to
Activity Cost Pools

Direct materials, direct labor, and shipping are excluded

because Baxter Battery’s existing cost system can directly
trace these costs to products or customer orders.
  Assign Overhead Costs to
Activity Cost Pools
At Baxter Battery the following distribution of
resource consumption across activity cost pools is
determined.
Indirect
Indirect factory
factory wages
wages $6,000,000
$6,000,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 30%
30%
$1,800,000
$1,800,000
Factory
Factory equipment
equipment depreciation
depreciation $3,500,000
$3,500,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 20%
20%
$$ 700,000
700,000
 Assign Overhead Costs to
Activity Cost Pools
 Calculate Activity Rates
The ABC team determines that Baxter Battery will
have these total activities for each activity cost
pool . . .
 10,000 customer orders
 4,000 design changes
 800,000 machine-hours
 2,000 customers served

Now
Now the
the team
team can
can compute
compute thethe individual
individual
activity
activity rates
rates by
by dividing
dividing the
the total
total cost
cost for
for each
each
activity
activity by
by the
the total
total activity
activity levels.
levels.
 Calculate Activity Rates
 Direct Direct Shipping
Overhead Costs
Materials Labor Costs

Traced Traced Traced

Cost Objects:
Products, Customer Orders, Customers
 Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Design Order Customer

Other
Orders Changes Size Relations

Cost Objects:
Products, Customer Orders, Customers
 Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Design Order Customer

Other
Orders Changes Size Relations

Second-Stage Allocations

$/Order $/Change $/MH $/Customer

Cost Objects:
Unallocated
Products, Customer Orders, Customers
  Assigning Overhead to Products
Baxter Battery Information
SureStart
SureStart
1.
1. Requires
Requires nono new
new design
design resources.
resources.
2.
2. 800,000
800,000 batteries
batteries ordered
ordered with
with 4,000
4,000 separate
separate orders.
orders.
3.
3. Each
Each SureStart
SureStart requires
requires 36
36 minutes
minutes of
of machine
machine
time
time for
for aa total
total of
of 480,000
480,000 machine-hours.
machine-hours.
LongLife
LongLife
1.
1. Requires
Requires new
new design
design resources.
resources.
2.
2. 400,000
400,000 batteries
batteries ordered
ordered with
with 6,000
6,000 separate
separate orders.
orders.
3.
3. 4,000
4,000 custom
custom designs
designs prepared.
prepared.
4.
4. Each
Each LongLife
LongLife requires
requires 48
48 minutes
minutes of
of machine
machine
time
time for
for aa total
total of
of 320,000
320,000 machine-hours.
machine-hours.
 Assigning Overhead to Products
  Assigning Overhead to Customers
Let’s take a look at how Baxter Battery’s system works for just one of the
2,000 customers – Acme Auto Parts who placed a total of twelve orders.
Note that the four orders for LongLifes required a design change.

Orders
Orders
1.
1. Eight
Eight orders
orders for
for 60
60 SureStarts
SureStarts per
per order.
order.
2.
2. Four
Four orders
orders for
for 50
50 LongLifes
LongLifes per
per order.
order.

Machine-hours
Machine-hours
1.
1. The
The 480
480 SureStarts
SureStarts required
required 288
288 machine-hours.
machine-hours.
2.
2. The
The 200
200 LongLifes
LongLifes required
required 160
160 machine-hours.
machine-hours.
 Assigning Overhead to Customers
 Prepare Management Reports

Product Margin Calculations

The first step in computing product margins is to
gather each product’s sales and direct cost data.
  Prepare Management Reports
Product Margin Calculations
The second step in computing product margins is to incorporate the
previously computed activity-based cost assignments pertaining to each
product.
 Prepare Management Reports
Product Margin Calculations
The third step in computing product margins is to deduct
each product’s direct and indirect costs from sales.
 Prepare Management Reports
Product Margin Calculations
The product margins can be reconciled with the
company’s net operating income as follows:
 Prepare Management Reports
Customer Margin Analysis
The first step in computing Acme Auto Parts’ customer
margin is to gather its sales and direct cost data.
 Prepare Management Reports
Customer Margin Analysis
The second step is to incorporate Acme Auto Parts’
previously computed activity-based cost assignments.
 Prepare Management Reports
Customer Margin Analysis
The third step is to compute Acme Auto Parts’ customer
margin of $384 by deducting all its direct and indirect costs
from its sales.
Product Margins Computed Using the
Traditional Cost System
The first step in computing product margins is to
gather each product’s sales and direct cost data.
Product Margins Computed Using the
Traditional Cost System
The second step in computing product margins is to
compute the plantwide overhead rate.

Plantwide manufacturing $14,000,000

= = $17.50 per machine-hour
overhead rate 800,000 MH
Product Margins Computed Using the
Traditional Cost System
The third step in computing product margins is
allocate manufacturing overhead to each product.

480,000 hours × $17.50 per hour = $8,400,000

Product Margins Computed Using the
Traditional Cost System
The fourth step is to actually compute the product margins.
 Differences Between ABC and
Traditional Product Costs

The traditional cost The traditional cost

system overcosts the system undercosts the
SureStarts and reports LongLifes and reports
a lower product a higher product
margin for this product. margin for this product.
 Differences Between ABC and
Traditional Product Costs
here are three reasons why the reported product margins for
wo costing systems differ from one another.

 Traditional costing allocates all manufacturing

overhead to products. ABC costing only assigns
manufacturing overhead costs consumed by
products to those products.
 Differences Between ABC and
Traditional Product Costs
here are three reasons why the reported product margins for
wo costing systems differ from one another.

 Traditional costing allocates all manufacturing

overhead costs using a volume-related allocation
base. ABC costing also uses non-volume related
allocation bases.
 Differences Between ABC and
Traditional Product Costs
here are three reasons why the reported product margins for
wo costing systems differ from one another.

 Traditional costing disregards selling and

administrative expenses because they are
assumed to be period expenses. ABC costing
directly traces shipping costs to products and
includes nonmanufacturing overhead costs
caused by products in the activity cost pools
that are assigned to products.
Targeting Process Improvement
Activity-based management is used in
conjunction with ABC to identify areas that
would benefit from process improvements.
While the theory of constraints
approach is a powerful tool for
targeting improvement efforts,
activity rates can also provide
valuable clues on where to focus
improvement efforts.

Benchmarking can be used to compare activity cost

information with world-class standards of
performance achieved by other organizations.
 ABC Limitations
Substantial resources required to implement and maintain.

Resistance to unfamiliar numbers and reports.

Desire to fully allocate all costs to products.

Potential misinterpretation of unfamiliar numbers.

Does not conform to GAAP. Two costing systems may be needed.