Activity Based Costing/Management

Vol.5

Mgr. Andrea Gažová, PhD.

 What is ABC?
- A costing method that identifies the activities
performed within the organization as it delivers
its goods and services.
- A costing method that assigns costs to
products, based on the number of activities the
organization used in producing them.

Direct Process
labor hours setups
Lot size

Design Machine Customer

time hours contact
 Both
Both manufacturing
manufacturing
and
and nonmanufacturing
nonmanufacturing ABC
ABC isis aa good
good
costs
costs may
may be
be supplement
supplement
assigned
assigned to
to to
to our
our traditional
traditional
products.
products. cost
cost system.
system.

Products Activities
Require Consume
Activities Resources Used
Used in
in internal
internal
decision
decision making
making as as well
well
as
as in
in inventory
inventory valuation
valuation
People for
for external
external reporting.
reporting.
Manage
Activities
Costing systems helps companies to determine the cost
of a product related to the revenue it generates.
Two common costing systems used in business are
traditional costing and activity-based costing.

Traditional costing assigns manufacturing overhead

based on the volume of a cost driver, such as the
amount of direct labor hours needed to produce an item.
A cost driver is a factor that causes cost to incur, such as
machine hours, direct labor hours and direct material
hours.

Activity-based costing allocates the costs of

manufacturing a product according to the activities
needed to produce the item. Managers should determine
which system they need to use to meet the needs of
their business.
 Major differences:
• The traditional costing method focuses on
structure rather than on processes while the
ABC is more on the activities than on structure.
• Traditional costing method is already obsolete
especially with the changing technology trends
such as the introduction of the business
accounting software.
• ABC provides accurate costs values whereas
TCA accumulates arbitrarily.
• Whereas the traditional costing method has
increasingly become obsolete, the ABC
became a rising method since 1981.
 Traditional Costing Activity-Based Costing
Resource Costs Resource Costs

Directly traced Directly traced

or allocated or allocated

Cost Pools: Cost Pools:

Plants or Activities or
Departments Activity Centers
Predetermined Cost driver
overhead rates for
rate* each activity
Cost Objects Cost Objects
* Overhead costs: The indirect costs or fixed expenses
of operating a business (that is, the costs not directly
related to the manufacture of a product or delivery of a
service) that range from rent to administrative costs to
marketing costs.

Overhead expenses can be fixed, meaning they are the

same from month to month, or variable, meaning they
increase or decrease depending on the business's
activity level. They can also be semi-variable, meaning
that some portion of the expense will be incurred no
matter what, and some portion depends on the level of
business activity. Overhead can also be general,
meaning that it applies to the company's operations as a
whole, or applied, meaning that it can be allocated to a
specific project or department. These expenses are
typically found on a company's income statement.
 Four steps in ABC process
1. Identify and classify the activities related
to the company’s products or services.
2. Estimate the cost of each activity
identified in 1.
3. Calculate a cost-driver rate for each
activity.
4. Assign activity costs to products using
the cost-driver rate.
1. Identify and classify the activities
• TOP DOWN APPROACH:
APPROACH ABC teams of people from top levels of
management generate the activity dictionary.
An investment approach that involves looking at the "big picture" in
the economy and financial world and then breaking those
components down into finer details. In this way the managers could
use their expertise in order to find about the activities performed for
making a product or service.

• RECYCLING APPROACH: Reuses documentation of processes

used for other purposes.

• INTERVIEW OR PARTICIPATIVE APPROACH: ABC teams include

or interview operating employees.
...where manager can interview their employees or set up a meeting
with the operational managers in order to get better understanding
of all activities in the process of creating their product or providing
their service.
2. Estimate the cost of activities
The ABC teams should gather data on the
costs of all the activities identified in Step 1.

- Examine accounting records for

recorded cost information.
- Ask employees to indicate how much
time they work on various activities.
 3. Calculate a cost-driver rate for activities

Two
Twopieces
piecesofof
information
informationare are
required
required toto compute
compute
the
thecost-driver
cost-driverrate:
rate:
••Activity
ActivityCost
Cost
••Activity
Activity Volume
Volume

May
MayCompany
Companyhas has44employees
employeesininits
itsQuality
QualityControl
Control
Department.
Department.Salaries
Salariesand
andcosts
costsfor
forthe
thedepartment
departmenttotal
total
$360,000
$360,000per
peryear.
year.May
Mayproduces
produces500,000
500,000 units
units of
of product
product
aayear.
year.What
Whatisisthe
thecost-driver
cost-driverrate
rateper
perunit?
unit?
$360,000
$360,000÷÷500,000
500,000units
units==$.72
$.72per
perunit
unit
 Cost-driver base
Cause and effect
relationship between Measurable
activity and costs
Appropriate
cost-driver
base
Based on resource’s Predict or explain
practical capacity to an activity’s use
support activities of resources
 Task 1:
• Company XY has a customer service center
where customers can call to ask questions.
Customers pay a fixed fee for each call they
make to the service center. It costs company
XY $1,260,000 a year to operate the center.
The
Sincecenter receives 120,000 calls per year.
Since customers are charged “per call”, theproper
customers are charged “per call”, the proper
The center
activity
activityin
inthis
handles
thiscase
caseis
1,000,000
isthe
thenumber
numberof
minutes
ofcalls
of by
callshandled
handledby
calls. the
thecenter.
center.
The
Thecost-driver
cost-driverrate
ratewould
would be:
be:
• What is the appropriate cost driver: total
$1,260,000
$1,260,000
minutes ÷÷120,000
for all calls orunits
120,000 units ==$10.50
number $10.50 per
percall
call
of calls?
What is the cost-driver rate?
4. Assign activity costs to products
1. Identify all the activities related to a given
product or service.
2. Determine how many units of each activity
are used per unit of product.
3. Assign costs to products using the cost-
driver rates for each activity.

Activity cost / Activity Volume = Cost driver rate

 Example:
• Company Yeeks, Inc. produces 130,000 units of
Product A and 400,000 units for Product B.
• Using the following cost information, how much
overhead should be allocated to Product A?
 Pros and cons of ABC
+
More accurate and informative product costs lead to better
pricing decisions.
The activities driving costs are more accurately measured.
Managers gain easier access to the relevant costs.
Activity-based analysis can be used to track the costs of
serving customers and those customers’ contribution to
company profits.
–
An ABC system is very expensive to develop and
implement, and very time-consuming to maintain.
When should a company use ABC?
• Indirect costs are significant in proportion to direct costs.
• Goods are complex, requiring many inputs and
processes.
• Complex, low-volume products are profitable while
standard, high-volume products are not.
• Different departments believe costs are assigned
inaccurately.
• The company loses bids it thought were low, and wins
bids it thought were high.
• Operations have changed significantly, but the costing
system has not changed.
• Introduction of new models result in higher sales,
apparent profits per unit, but an overall income decline.
 HOMOGENEOUS POOLS OF ACTIVITIES
To reduce the number of predetermined overhead activity rates,
activities can be grouped into homogeneous pools.
• A homogeneous cost pool is a collection of overhead costs
associated with each set of activities. Only one activity driver need
to be used to assign the pool’s costs, thus the number of rates
required can be reduced.

To build homogeneous sets of related activities, activities are

classified into one of four general activity categories:
• Unit-level activities are activities performed each time a unit is
produced. For example, power is used each time a unit is produced.
• Batch-level activities are activities performed each time a batch of
products is produced. The costs of batch-level activities vary with
the number of batches but are fixed with respect to the number of
units in each batch. Examples include setups, inspections,
production scheduling, and materials handling.
• Product-level (sustaining) activities are activities performed as
needed to support the products. Examples include engineering
changes and equipment maintenance.
• Facility-level activities are activities that support a factory’s
general manufacturing process. Examples include plant
management and security.
 All unit-level activities that have the same
cost driver would be grouped into
homogeneous cost pools. For example,
the unit-level category might have the
following cost pools:
• labor-related overhead cost pool
• machine-related overhead cost pool
• material-related overhead cost pool
 Activity-Based Customer Costing
• Activity-based costing can be used to trace costs to
specific customers. The cost of serving different
customers can affect pricing decisions and profitability.
Customer Costing versus Product Costing
Customer costing involves three steps:
1. Activities, such as order entry, shipping, and sales
calls, are listed in an activity dictionary. Different levels
include order level, customer level, and channel level.
2. Cost of resources used are assigned to activities.
3. Cost of the activities are assigned to customers.

Activity-Based Supplier Costing

Activity-based supplier costing uses activity-based
costing to identify the true costs of suppliers. Activity-
based costing traces costs related to purchase, quality,
reliability, and delivery performance to specific suppliers.
 Cost Assignment

Customer Costing Product Costing

List customer activities List activities

Determine cost of activities Determine cost of activities

Group into homogeneous Group into homogeneous

customer-driven cost pools cost pools

Assign costs to customers Assign costs to products

 TASK: Relevant costing
Company A manufactures bicycles. It can
produce 1,000 units in a month for a fixed
cost of $300,000 and variable cost of $500
per unit.
Its current demand is 600 units which it
sells at $1,000 per unit. It is approached
by Company B for an order of 200 units at
$700 per unit.

Should the company accept the order?

 TASK: Solution
• A layman would reject the order because he would think
that the order is leading to loss of $100 per unit
assuming that the total cost per unit is $800...
= fixed cost of $300,000/1,000 and variable cost of $500
as compared to revenue of $700

• On the other hand, a management accountant will go

ahead with the order because in his opinion the special
order will yield $200 per unit.
– He knows that the fixed cost of $300,000 is irrelevant because it
is going to be incurred regardless of whether the order is
accepted or not. Effectively, the additional cost which Company
A would have to incur is the variable cost of $500 per unit.
= Hence, the order will yield $200 per unit ($700 minus $500 of
variable cost).