CHAPTER 5

ACTIVITY-BASED
COSTING
VNUK - IBM
 LEARNING OBJECTIVES

1. Understand the basic approach in activity-based costing

2. Compute the activity rate and the product cost in activity-based

costing

3. Record the flow of costs in an activity-based costing system.

Value-based system concepts

▪ Product costing system is facing problems in certain businesses

▪ Businesses influenced by customer demands prefer value-based systems because of more relevant
information

▪ Managers use value-based information reliably to compare the value created by products or
services with the full product cost (direct materials, direct labor, production and nonproduction
activities)
Product costing system issues
Product costing system issues
ACTIVITY-BASED MANAGEMENT
▪ Activity-based management (ABM) identifies all major operating
activities, determines the resources consumed by each activity, and
categorizes the activities as adding value to a product or service or not
adding value

▪ ABM focuses on reducing non-value-adding activities, it is useful both for

strategic planning and for making tactical and operational decisions about
business segments

▪ Activity-based costing (ABC) is the tool used in an ABM environment to

assign activity costs to cost objects
ACTIVITY-BASED MANAGEMENT
▪ Activity-based costing (ABC) calculates a more accurate product cost
than traditional methods

▪ ABC reflects the cause-and-effect relationships between costs and

individual processes, products, services, or customers.

▪ ABC improves the accuracy in allocating activity-driven costs to cost

objects
 Real life ABC Examples
Laporte Industries, Ltd. (UK)
- a British specialty chemicals and materials producer

- sales force tended to focus on big-name customers

- the prices charged to the larger customers were higher than the prices charged
to the smaller ones.
Real life ABC Examples
Laporte Industries, Ltd.
Smaller customers did not generate many overhead costs. These smaller customers placed
orders by telephone and required with little contact with the sales force. In contrast, big-
name customers required:
(i) constant contact with the sales force,
(ii) 24- hour technical support,
(iii) loans of equipment at no charge, and
(iv) other concessions.
=> When overhead was accurately allocated using ABC, it turned out that the Operating Profit
margins on the smaller customer sales were actually higher than those on sales to larger
customers.
Real life ABC Examples
The Boeing Company
In 2000, Boeing tested ABM in two operations at its Wichita plant.
One of the operations studied was Boeing's Phase I preassembly chemical
bath operation. It found that:
- Boeing incorrectly calculated the in-house cost of that operation at $7 per
part. As a result, Boeing outsourced that operation at a cost of $4 per part.
- Boeing found that it could actually conduct some of those outsourced
operations in house at a cost of $3.50 per part.
What if we use ABC system for this case???
Different product
costs 🡪
BENEFITS OF ABC SYSTEM
▪ Increases the number of cost pools used to accumulate overhead costs
▪ The activity cost pools are more homogeneous than departmental cost
pools
▪ Uses a variety of activity measures to assign overhead costs to
products (rather than relying solely on DLH)
LIMITATIONS OF ABC SYSTEM
EXERCISE 1
EXERCISE 2
REVIEW PROBLEM
Homework
▪ P2 (page 910)
▪ P7 (page 914 – 915)