Activity-Based Costing: A

Tool to Aid Decision Making

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 Activity Based Costing (ABC)

ABC is a
ABC is designed to good supplement
provide more accurate to our traditional
cost system
ways of assigning I agree!
indirect and support
service costs to
activities, processes,
products, customers

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 ABC differs from traditional costing

• Both manufacturing and non manufacturing

costs are allocated
• Use of several cost pools
• Different kinds of allocation base
• Allocation through capacity vs activity

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 Designing an ABC System

Cost Objects
(e.g., products Activities
and customers)

Consumption
of Resources

Cost

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 Designing an ABC System

Steps for Implementing ABC

Identify and define activities and activity cost
pools.
Trace costs to activities and cost objects.
Assign costs to activity cost pools.
Calculate activity rates.
Assign costs to cost objects.
Prepare management reports.

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 Identify and Define Activities
and Activity Cost Pools

Unit-Level Batch-Level
Activity Activity

Manufacturing
companies typically combine
their activities into five
classifications.

Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
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 Identify and Define Activities
and Activity Cost Pools

Activities
should only be
combined within a level
if they are highly
correlated.

When combining
activities, they should be
grouped together only at
the appropriate
level.

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 Identify and Define Activities
and Activity Cost Pools

An Activity Cost $$
Pool is a “bucket” in $
$ $
which costs are $
accumulated that
relate to a single
activity measure in
the ABC system.

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 Identify and Define Activities
and Activity Cost Pools

Two 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.

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 Identify and Define Activities
and Activity Cost Pools

At Classic Brass, the ABC team, selected the following

activity cost pools and activity measures:

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 Identify and Define Activities
and Activity Cost Pools

• Customer Orders - assigned all costs of resources

that are consumed by taking and processing
customer orders.
• Product Designs - assigned all costs of resources
consumed by designing products.
• 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 overhead costs that are not
associated with the other cost pools.
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 When Possible, Directly Trace Overhead
Costs to Activities and Cost Objects

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 Assign Costs to Activity Cost Pools

At Classic Brass the following distribution of resource

consumption across activity cost pools is determined.

**Not included because they are directly traced to customer orders.

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 Assign Costs to Activity Cost Pools

Indirect factory wages $500,000

Percent consumed by customer orders 25%
$125,000

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 Assign Costs to Activity Cost Pools

Factory equipment depreciation $300,000

Percent consumed by customer orders 20%
$ 60,000

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 Assign Costs to Activity Cost Pools

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 Calculate Activity Rates

The ABC team determines that Classic Brass will

have these total activities for each activity cost
pool . . .
 1,000 customer orders,
 200 new designs,
 20,000 machine-hours,
 100 customer relations activities.

Now the team can compute the individual

activity rates by dividing the total cost for
each activity by the total activity levels.
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 Calculate Activity Rates

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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

Traced Traced Traced

Cost Objects:
Products, Customer Orders, Customers
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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

Cost Objects:
Products, Customer Orders, Customers
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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

Second-Stage Allocations

$/MH $/Order $/Design $/Customer

Cost Objects:
Unallocated
Products, Customer Orders, Customers
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 Assigning Costs to Cost Objects

Let’s take a look at how our system works

for just one customer – Windward Yachts.
Standard Stanchions (no design required)
1. 400 units ordered with 2 separate orders.
2. Each stanchion required 0.5 machine-hours.
3. Selling price is $34 each.
4. Direct materials total $2,110.
5. Direct labor totals $1,850.
6. Shipping costs total $180.
Custom Compass Housing (requires new design)
1. One order during the year.
2. Each housing required 4 machine-hours.
3. Selling price is $650 each.
4. Direct materials total $13.
5. Direct labor totals $50.
6. Shipping costs total $25.
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 Assigning Costs to Cost Objects

The customer-level
cost is assigned to
customers directly;
it is not assigned to
products.

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 Prepare Management Reports

Standard Stanchions
Sales $ 13,600
Cost:
Direct materials $ 2,110
Direct labor 1,850
Shipping costs 180
Customer orders 630
Product design -
Order size 3,800 8,570
Product margin $ 5,030

Custom Compass Housing

Sales $ 650
Cost:
Direct materials $ 13
Direct labor 50
Shipping costs 25
Customer orders 315
Product design 1,285
Order size 76 1,764
Product margin $ (1,114)
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 Prepare Management Reports

Customer Profitability Analysis

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 Product Margins

Traditional Cost Accounting System

400 units x 0.5 MH/unit x $50/MH = $10,000

Predetermined manufacturing $1,000,000

= = $50/MH
overhead rate 20,000 MH
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 Differences Between ABC and
Traditional Product Costs
Product margins are different for four reasons:
 Traditional costing assigns design costs to both products
based on machine hours. ABC assigns product design
costs to a product only if product design work is required.
 Traditional costing assigns customer order costs, a batch-
level cost, using a unit-level allocation base, machine hours.
ABC assigns these batch-level costs using a batch-level
activity measure.
 Traditional costing assigns only manufacturing costs to
products. ABC also assigns nonmanufacturing costs to
products.
 Traditional costing assigns all manufacturing costs to
products. The ABC system does not assign organization-
sustaining manufacturing costs to the products.
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 Differences Between ABC and
Traditional Product Costs

When batch-level and

product-level costs are present,
ABC will usually shift costs from high
volume products, produced in large batches,
to low volume products produced in small batches.

This cost shifting will usually have its

greatest impact on the per
unit cost of the low
volume products.

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 So What????

• Diverse product line

 various models and variants
• The difference will be felt for specialty and
customized products
Cumulative products

WHALE CURVE-
After assigning service and
Support departments by ABC

+ profitability -

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 Activity Based Management

• Upon analysis of product costs thru ABC

 Re-price products
 Substitute products
 Redesign products
 Improve processes and operations strategy
 Technology investment
 Eliminate products

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 Customer Profitability Analysis
• High Cost to Serve
 Order custom products
 Small order quantity
 Unpredictable orders
 Customized delivery
 Large amount of pre-sales
efforts
 Large amount of post-
sales efforts
 Pay slow
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• High Cost to Serve
 Order std. products
 High order quantity
 Predictable orders
 Std. delivery
 No pre-sales efforts
 No post-sales efforts
 Pay on time
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 high
passive costly to serve but
product is crucial pay premium
good supplier match

price sensitive agrressive

few special demands low price
lots of customization
low
low cost to serve high

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 End of Discussion

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