Activity Based Costing:

A Tool to Aid Decision Making

 LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Explain the major differences between activity-
based costing and a traditional costing system.
2. Distinguish between unit-level, product-level,
customer-level and organization-sustaining
activities.
3. Assign costs to cost pools using a first-stage
allocation.
4. Compute activity rates for cost pools and
explain how they can be used to target process
improvements.
 LEARNING OBJECTIVES
After studying this chapter, you should be able to:
5. Assign costs to a cost object using a second-
stage allocation.
6. Prepare a report showing activity-based
costing product margins from an activity view.
7. Prepare an action analysis report using
activity-based costing data and interpret the
report.
8. Use the simplified approach to compute
activity-based costs and margins.
9. (Appendix 8A) Record the flow of costs in an
activity-based costing system.
Activity Based Costing (ABC)

The objective of
ABC is a
activity-based good supplement
costing is to to our traditional
cost system
I agree!
understand
overhead and the
profitability of
products and
customers.
Activity Based Costing (ABC)

Activity-Based Costing

Both
Both manufacturing
manufacturing There
There are
are aa number
number
and
and nonmanufacturing
nonmanufacturing of
of cost
cost pools
pools each
each ofof
costs
costs may
may be
be which
which is
is allocated
allocated
assigned
assigned to
to using
using aa unique
unique
products.
products. measure
measure of of activity.
activity.
Some
Some manufacturing
manufacturing
costs
costs may
may be
be excluded
excluded
from
from product
product
costs.
costs.

Allocation
Allocation bases
bases often
often Overhead
Overhead rates
rates may
may
differ
differ from
from be
be based
based on
on activity
activity
traditional
traditional costing
costing at
at capacity.
capacity.
systems.
systems.
How Costs are Treated Under Activity-
Based Costing

Activity
Activity Based
Based
Costing
Costing

Departmental
Departmental
Overhead
Overhead i ty
Rates
Rates ex
pl
o m
Plantwide f C
Plantwide o
Overhead
Overhead e l
v
Rate
Rate Le
Overhead Allocation
Plantwide Overhead Rate

Companies tend to use direct labour

as the overhead allocation base.
Departmental Overhead Rates

Finishing Department
AA two
two stage
stage process
process is
is
Painting Department necessary
necessary because
because costs
costs
are
are allocated
allocated to
to departments
departments
Shipping Department and
and then
then to
to products.
products.
Departmental Overhead Rates

Indirect Indirect Other

Labour Materials Overhead
Stage One:
Costs assigned
to pools
Department Department Department
Cost pools
1 2 3
Departmental Overhead Rates

Indirect Indirect Other

Labour Materials Overhead
Stage One:
Costs assigned
to pools
Department Department Department
Cost pools
1 2 3

Stage Two:
Costs applied
to products
Products
Departmental Overhead Rates

Indirect Indirect Other

Labour Materials Overhead
Stage One:
Costs assigned
to pools
Department Department Department
Cost pools
1 2 3
Direct Machine Raw
Stage Two: Labour Hours Materials
Costs applied Hours Cost
to products
Products

Departmental Allocation Bases

Designing an ABC System

Cost
Cost Objects
Objects Consumption
Consumption
(e.g.,
(e.g.,products
products Activities
Activities of
of Resources
Resources
and
andcustomers)
customers)

Cost
Cost
Designing an ABC System

Steps for Implementing ABC

 Identify and define activities and activity pools.
 Where possible, trace costs to activities and cost
objects.
 Assign costs to activity cost pools.
 Calculate activity rates.
 Assign costs to cost objects.
 Prepare management reports.
Identifying Activity to Include

Unit-Level Batch-Level
Activity Activity

A part of the production

process for which management
wants a separate reporting of the
costs of the activity involved.

Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
Identifying Activity to Include

Activity Cost Pool $$

is a “bucket” in $
which costs are $ $
$
accumulated that
relate to a single
activity in the ABC
system.
The Mechanics of ABC

At Classic Brass, the ultimate cost objects are:

Products,
Customer orders, and
Customers.
One overhead cost - shipping - can be traced
directly to customer orders.
The company’s overhead costs are shown
on the next slide.
 Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Production Department
Indirect factory wages $ 500,000
Factory equipment amortization 300,000
Factory utilities 120,000
Factory building lease 80,000 $ 1,000,000
Shipping costs traced to customer orders 40,000
General Administrative Department
Administrative wages and salaries 400,000
Office equipment amortization 50,000
Administrative building lease 60,000 510,000
Marketing Department
Marketing wages and salaries 250,000
Selling expenses 50,000 300,000
Total overhead costs $ 1,850,000
Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labour Costs

Traced $/DLH Traced

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

Direct Direct Shipping

Overhead Costs
Materials Labour Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

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

Direct Direct Shipping

Overhead Costs
Materials Labour 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
 Assigning Costs to Activity Cost
Pools
Management at Classic Brass believes overhead should be
distributed as follows:
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages 25% 40% 20% 10% 5% 100%
Factory equipment amortization 20% 0% 60% 0% 20% 100%
Factory utilities 0% 10% 50% 0% 40% 100%
Factory building lease 0% 0% 0% 0% 100% 100%
Shipping costs traced to customer order N/A
General Administrative Department
Administrative wages and salaries 15% 5% 10% 30% 40% 100%
Office equipment amortization 30% 0% 0% 25% 45% 100%
Administrative building lease 0% 0% 0% 0% 100% 100%
Marketing Department
Marketing wages and salaries 20% 10% 0% 60% 10% 100%
Selling expenses 10% 0% 0% 70% 20% 100%
 Assigning Costs to Activity Cost
Pools
Using the total costs and percentage consumption of
overhead, costs are assigned to activity pools.
First-Stage Allocation to Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000
Factory equipment amortization
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment amortization
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

Indirect
Indirect factory
factory wages
wages $500,000
$500,000
Percent
Percent consumed
consumed byby customer
customer orders
orders 25%
25%
$125,000
$125,000
 Assigning Costs to Activity Cost
Pools
Using the total costs and percentage consumption of
overhead, costs are assigned to activity pools.
First-Stage Allocation to Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000
Factory equipment amortization 60,000
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment amortization
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

Factory
Factory equipment
equipment amortization
amortization $300,000
$300,000
Percent
Percent consumed
consumed byby customer
customer orders
orders 20%
20%
$$ 60,000
60,000
 Assigning Costs to Activity Cost
Pools
Using the total costs and percentage consumption of
overhead, costs are assigned to activity pools.
First-Stage Allocation to Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000 $ 200,000 $ 100,000 $ 50,000 $ 25,000 $ 500,000
Factory equipment amortization 60,000 - 180,000 - 60,000 300,000
Factory utilities - 12,000 60,000 - 48,000 120,000
Factory building lease - - - - 80,000 80,000
General Administrative Department
Administrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000
Office equipment amortization 15,000 - - 12,500 22,500 50,000
Administrative building lease - - - - 60,000 60,000
Marketing Department
Marketing wages and salaries 50,000 25,000 - 150,000 25,000 250,000
Selling expenses 5,000 - - 35,000 10,000 50,000
Total $ 315,000 $ 257,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000
 Assigning Costs to Activity Cost
Pools
Using the total costs and percentage consumption of
overhead, costs are assigned to activity pools.
First-Stage Allocation to Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000 $ 200,000 $ 100,000 $ 50,000 $ 25,000 $ 500,000
Factory equipment amortization 60,000 - 180,000 - 60,000 300,000
Factory utilities - 12,000 60,000 - 48,000 120,000
Factory building lease - - - - 80,000 80,000
General These costs
Administrative should
Department
Administrative wages and salaries
be cross-added to 60,000 This number
20,000 40,000 should
120,000 then
160,000 400,000
Office equipment amortization 15,000 - - 12,500 22,500 50,000
getbuilding
Administrative the total
lease - -
equal the
-
total of
-
the 60,000 60,000
Marketing Department individual overhead item
Marketing wages and salaries 50,000 25,000 to be- allocated
150,000 25,000 250,000
Selling expenses 5,000 - - 35,000 10,000 50,000
Total $ 315,000 $ 257,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000
Computation of Activity Rates

The ABC team has determined that Classic

Brass has the following total activities for each
activity cost pool . . .
– 1,000 customer orders,
– 200 new designs,
– 20,000 machine-hours
– 100 customers.
Now the team can compute the individual
activity rates.
 Computation of Activity Rates
Activity Rates for each Activity Cost Pools
20,000
1,000 200 machine- 100
Orders Designs hours Customers Other
Production Department
Indirect factory wages $ 125
Factory equipment amortization
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment amortization
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
 Computation of Activity Rates
Activity Rates for each Activity Cost Pools
20,000
1,000 200 machine- 100
Orders Designs hours Customers Other
Production Department
Indirect factory wages $ 125 $ 1,000 $ 5 $ 500 N/A
Factory equipment amortization 60 - 9 -
Factory utilities - 60 3 -
Factory building lease - - - -
General Administrative Department
Administrative wages and salaries 60 100 2 1,200
Office equipment amortization 15 - - 125
Administrative building lease - - - -
Marketing Department
Marketing wages and salaries 50 125 - 1,500
Selling expenses 5 - - 350
Total $ 315 $ 1,285 $ 19 $ 3,675
Assigning Costs to Cost Objects

Let’s take a look at how our system works for just one
customer - Windward Yachts.
– Windward ordered two products - Stanchions and
Customer Compass Housings.
– The details are outlined on the following slide.
Assigning Costs to Cost Objects
Standard
Standard Stanchions
Stanchions (no (no design
design required)
required)
1.
1. 400
400 units
units ordered
ordered withwith 22 separate
separate orders.
orders.
2.
2. Each
Each stanchion
stanchion required
required 0.5
0.5 machine-hours
machine-hours ..
3.
3. Selling
Selling price
price isis $34
$34 each.
each.
4.
4. Direct
Direct materials
materials total
total $2,110.
$2,110.
5.
5. Direct
Direct labour
labour totals
totals $1,850.
$1,850.
6.
6. Shipping
Shipping costs
costs total
total $180.
$180.

Custom
Custom Compass
Compass HousingHousing (requires
(requires new
new design)
design)
1.
1. One
One order
order during
during the the year.
year.
2.
2. Each
Each housing
housing required
required 44 machine-hours
machine-hours ..
3.
3. Selling
Selling price
price isis $650
$650 each.
each.
4.
4. Direct
Direct materials
materials total
total $13.
$13.
5.
5. Direct
Direct labour
labour totals
totals $50.
$50.
6.
6. Shipping
Shipping costs
costs total
total $25.
$25.
 Assigning Costs to Cost Objects

Overhead cost of two orders for standard stanchions.

Activity Cost Pools - Two Standard Stanchions
200
No new machine
2 Orders design hours N/A Total
Production Department
Indirect factory wages $ 250
Factory equipment amortization
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment amortization
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total $125 per order × 2 orders = $250
 Assigning Costs to Cost Objects

Overhead cost of two orders for standard stanchions.

Activity Cost Pools - Two Standard Stanchions
200
No new machine
2 Orders design hours N/A Total
Production Department
Indirect factory wages $ 250 $ - $ 1,000 $ - $ 1,250
Factory equipment amortization 120 - 1,800 - 1,920
Factory utilities - - 600 - 600
Factory building lease - - - -
General Administrative Department
Administrative wages and salaries 120 - 400 - 520
Office equipment amortization 30 - - - 30
Administrative building lease - - - -
Marketing Department
Marketing wages and salaries 100 - - - 100
Selling expenses 10 - - - 10
Total $ 630 $ - $ 3,800 $ - $ 4,430
 Assigning Costs to Cost Objects

Overhead cost of one order for custom compass housing.

Activity Cost Pools - One Custom Compass Housing
4
1 new machine
1 Order design hours N/A Total
Production Department
Indirect factory wages $ 125
Factory equipment amortization
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment amortization
Administrative building lease
Marketing Department $125 per order × 1 order = $125
Marketing wages and salaries
Selling expenses
Total
 Assigning Costs to Cost Objects

Overhead cost of one order for custom compass housing.

Activity Cost Pools - One Custom Compass Housing
4
1 new machine
1 Order design hours N/A Total
Production Department
Indirect factory wages $ 125 $ 1,000 $ 20 $ - $ 1,145
Factory equipment amortization 60 - 36 - 96
Factory utilities - 60 12 - 72
Factory building lease - - - -
General Administrative Department
Administrative wages and salaries 60 100 8 - 168
Office equipment amortization 15 - - - 15
Administrative building lease - - - -
Marketing Department
Marketing wages and salaries 50 125 - - 175
Selling expenses 5 - - - 5
Total $ 315 $ 1,285 $ 76 $ - $ 1,676
Product Margins
Standard Stanchions
Sales $ 13,600
Cost:
Direct materials $ 2,110
Direct labour 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 labour 50
Shipping costs 25
Customer orders 315
Product design 1,285
Order size 76 1,764
Product margin $ (1,114)
Product Margins
Standard Stanchions
Sales $ 13,600
Cost:
Direct materials $ 2,110
Direct labour 1,850
Shipping costs 180
Customer orders 630
Product design -
Order size 3,800 8,570
Product margin $ 5,030

Custom Compass Housing

Windward Yachts Sales $ 650
Cost:
Product margins: Direct materials $ 13
Standard stanchion Direct$labour
5,030 50
Custom compass housing (1,114)
Shipping costs 25
Total product margin Customer orders
3,916 315
Product design 1,285
Less: Customer relationsOrder size
3,675 76 1,764
Customer margin $ 241
Product margin $ (1,114)
Product Margins

Traditional Cost Accounting System

Standard Compass
Stanchions Housing
Sales $ 13,600 $ 650
Costs
Direct materials (2,110) (13)
Direct labour (1,850) (50)
Manufacturing overhead (10,000) (200)
Product margin $ (360) $ 387

Predetermined manufacturing $1,000,000

= = $50/MH
overhead rate 20,000 MH
Product Margins

Traditional Cost Accounting System

Standard Compass
Stanchions Housing
Sales $ 13,600 $ 650
Costs
Direct materials (2,110) (13)
Direct labour (1,850) (50)
Manufacturing overhead (10,000) (200)
Product margin $ (360) $ 387

400
400 units
units xx 0.5
0.5 MH/unit
MH/unit xx $50/MH
$50/MH == $10,000
$10,000
Product Margins

Traditional Cost Accounting System

Standard Compass
Stanchions Housing
Sales $ 13,600 $ 650
Costs
Direct materials (2,110) (13)
Direct labour (1,850) (50)
Manufacturing overhead (10,000) (200)
Product margin $ (360) $ 387

11 units
units xx 4.0
4.0 MH/unit
MH/unit xx $50/MH
$50/MH == $200
$200
Difference Between ABC and
Traditional Product Costs

ABC will ordinarily shift

batch-level and
product-level
overhead costs from
high-volume
products produced in
large batches to low-
volume products
produced in small
batches.
Difference Between ABC and
Traditional Product Costs

Under ABC both

manufacturing and
nonmanufacturing
costs may be
assigned to products.
Organization-
sustaining costs and
the costs of idle
capacity are not
assigned to products.
 Ease of Adjustment Codes
(Green, Yellow and Red Costs)
Costs that adjust automatically to changes in activity:
– Direct materials.
– Shipping.
Costs that could be adjusted to changes in activity:
– Direct labour.
– Factory utilities.
– Administrative wages and salaries.
– Office equipment amortization.
– Marketing wages and salaries.
– Selling expenses.
Costs that are difficult to adjust to changes in activity:
– Factory equipment amortization.
– Factory building lease.
– Administrative building lease.
Simplified Approach to ABC

After the first-stage allocation is complete, computation of

activity rates for each activity cost pool can be simplified
as follows:

Computation
Computationof ofthe
theActivity
ActivityRates
Rates
Customer
Customer Product
Product Customer
Customer
Orders
Orders Design
Design Order
OrderSize
Size Relations
Relations Other
Other
Costs
Costsfrom
fromfirst-
first-
stage
stageallocation
allocation $$ 315,000
315,000 $$ 257,000
257,000 $$ 380,000
380,000 $$ 367,500
367,500 $$ 490,500
490,500
Total
Totalactivity
activity ÷ 1,000
1,000 ÷ 200200 ÷ 20,000
20,000 ÷ 100100 N/A
N/A
Cost
Costper
perunit
unit
of
ofactivity
activity $$ 315
315 $$ 1,285
1,285 $$ 19
19 $$ 3,675
3,675
Simplified Approach to ABC

Standard Stanchions:
Sales $ 13,600
Costs:
Direct materials $ 2,110
Direct labour 1,850
Shipping costs 180
Customer orders (2) 630
Product design -
Order size (200) 3,800 8,570
Product margin $ 5,030

22 orders
orders @
@ $315
$315 per
per order
order
Simplified Approach to ABC

Custom Compass Housing

Sales $ 650
Costs:
Direct materials $ 13
Direct labour 50
Shipping costs 25
Customer orders (1) 315
Product design 1,285
Order size 76 1,764
Product margin $ (1,114)

11 design
design @
@ $1,285
$1,285 per
per design
design
Simplified Approach to ABC

Customer margin for Windward Yachts is shown below:

Customer Profitability Analysis
Product margins:
Standard stanchion $ 5,030
Custom compass housing (1,114)
Total product margins 3,916
Less: Customer relations (3,675)
Customer margin 241
Cost Flows in an Activity-
Based Costing System
Predetermined Overhead Rates

• Calculate the predetermined overhead

rate for each activity centre based on the
following formula:
Predetermined overhead rate =
Estimated overhead cost associated
with the activity centre
Expected activity level of the cost driver
JOURNAL ENTRIES

• Record purchase of raw materials

Dr Raw Materials
Cr Accounts Payable
• Record transfer of raw material to work in
process
Dr Work In Process (direct material)
Dr Manufacturing overhead (indirect material)
Cr Raw Materials
JOURNAL ENTRIES (con’t)

• Record labour costs

Dr Work In Process (direct labour)
Dr Manufacturing Overhead (indirect labour)
Cr Salaries and Wages Payable
• Record overhead costs
Dr Manufacturing Overhead
Cr Accumulated Amortization
Cr Property Taxes Payable
Cr Prepaid Insurance
Cr Accounts Payable
JOURNAL ENTRIES (con’t)

• Record applied overhead

Dr Work In Process
Cr Manufacturing Overhead

Applied overhead for each activity centre is

calculated by multiplying each of the individual
predetermined overhead rates by the actual
level of cost driver activity incurred. Then, sum
all these individual totals to determine the total
applied overhead for the company.
JOURNAL ENTRIES (con’t)

• Record transfer to finished goods

Dr Finished Goods
Cr Work In Process
• Record sale of goods
Dr Accounts Receivable
Cr Sales
and
Dr Cost of Goods Sold
Cr Finished Goods
End of Presentation
I call this
quality
time!