Activity–Based Costing (ABC)

 Activity-based costing (ABC) is a costing ABC is a

method that assigns overhead and indirect good supplement
costs to related products and services. to our traditional
 ABC is designed to provide managers with cost system
cost information for strategic and other
decisions that potentially affect capacity, and I agree!
therefore, affect “fixed” as well as variable
costs.
 This accounting method of costing recognizes
the relationship between costs, overhead
activities, and manufactured products.
Activity-Based Costing (ABC)

An event that causes the

Activity consumption of overhead
resources

A “cost bucket” in which

Activity costs related to a particular
Cost Pool activity are accumulated

Activity An allocation base in an

activity-based costing
measure system
Activity-Based Costing (ABC)
Model

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

Consumption
of Resources

Cost
Traditional Costing System
 Product Costs
 Direct labor Direct labor and direct materials
 Direct materials are easy to trace to products.
The problem comes with factory
 Factory Overhead overhead.
 Period Costs
 Administrative expense
 Sales expense

 Typically used one rate to allocate overhead to products.

 This rate was often based on direct labor dollars, direct
labor hours or machine hours used.
 This made sense, as direct labor was a major cost driver in
early manufacturing plants
Traditional Costing System

Advantages:
 All manufacturing costs are classified as material, labor, or
overhead and assigned to products regardless of whether they
drive or are driven by production.
 Offers accurate cost figures with large production volumes
 Cheap to implement
 Still able to tract all direct costs
 There is only one overhead cost pool and a single measure of
activity

Disadvantages:
 Weak in comparison to allocation through multiple cost drivers.
 Use of single cost driver may under-allocate or over-allocate.
 Does not account for non-manufacturing costs.
Differences Between ABC and
Traditional Product Costs :

Cost Pools

Applied
Focus
Rate

Differences

Cost
Suited for
Assignment

Benefits
Problems with Traditional
Costing Systems

 Manufacturing processes and the products they produce

are now more complex.
 This results in over-costing or under-costing.
 Complex products are not allocated an adequate amount
of overhead costs.
 Simple products get too much.
When do we use ABC costing?
 When one or more of the following
conditions are present:
 Product lines differ in volume and manufacturing
complexity. For e.g. The manufacturing process
has changed significantly from labor intensive to
capital intensive automation.
 Product lines are numerous and diverse, and they
require different degrees of support services.
 Overhead costs constitute a significant portion of
total costs.
When do we use ABC costing?

 The manufacturing process or number of products has

changed significantly—for example, from labor intensive
to capital intensive automation.
 Production or marketing managers are ignoring data
provided by the existing system and are instead using
“bootleg” costing data or other alternative data when
pricing or making other product decisions.
 Level of Activities in ABC

i. Unit-level activities: Activities performed for each unit of

production.
ii. Batch-level activities: Activities performed for each of batch of
products.
iii. Product-level activities: Activities performed in support of an entire
product line.
iv. Customer-level activities: Activities related to specific customer
v. Organization-sustaining activities: Activities carried out irrespective
of which products, which customers, etc.
Steps for implementing ABC

 Define activities, activity cost pools, and activity

measures: Identify the activities that will form the
foundation for the system.
 Assign overhead costs to activity cost pools.
 Calculate activity rates.
 Assign overhead costs to cost objects using the activity
rates and activity measures.
 Prepare management reports.
 ABC Limitations

Substantial resources Resistance to

required to implement unfamiliar numbers
and maintain. and reports.

Desire to fully Potential

allocate all costs misinterpretation of
to products. unfamiliar numbers.

Does not conform to

GAAP. Two costing
systems may be needed.
THANK YOU!