Activity Based Costing

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Background
Recall that plant overhead is applied to production in a
rational systematic manner, using some type of
averaging. There are a variety of methods to
accomplish this goal.

These methods often involve trade-offs between

simplicity and realism.

Simple Methods ↔ Complex Methods

Can be Inaccurate Usually more accurate

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Plant-wide & Department Overhead
Calculations
Plantwide Overhead Rate:
Total Estimated Overhead ** / Total Estimated Base ***
** Obtain total of all overhead costs to be allocated.
*** Determine the best “base” – direct labor hours, machine hours, etc.

This rate is used to allocate overhead costs to all products

Department Overhead Rate:

Similar concept except overhead cost pools and selected base are obtained by
department rather than plantwide.
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Example Of Plant-wide & Department Overhead
Calculations
For our example, let’s say we have two departments, A and B with
overhead costs of $300,000 and $450,000, respectively.

The best base (the most likely cost driver) in Department A is

Direct Labor Hours and Machine Hours in Department B.

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Example of Plant-wide & Department
Overhead Calculations

- Dept A Dept B Plantwide

Overhead $300,000 $450,000 $750,000
Direct Labor Hrs 8,000 7,000 15,000
Machine Hours 750 1,200 1,950
Allocation Rate-DLH $37.50 n/a $50.00
Allocation Rate-MH n/a $375.00 $384.62

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 Broad Averaging
• Historically, firms produced a limited variety of goods and at the same time, their indirect
costs were relatively small.

• Allocating overhead costs was simple: use broad averages to allocate costs uniformly
regardless of how they are actually incurred.

• Generally known as “Peanut-butter costing” (perhaps because it is spread evenly??)

• The end-result:
• Products using fewer resources are overcosted and products using more resources are
undercosted.
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Over And Undercosting - Defined
• OVERCOSTING occurs when a product consumes a low level of
resources but is allocated high costs per unit.

• UNDERCOSTING occurs when a product consumes a high level of

resources but is allocated low costs per unit.

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Simple Example

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Product Cost
Cross-Subsidization
• If a company undercosts one of its products, it will overcost
at least one of its other products.

• The overcosted product absorbs too much cost, making it

seem less profitable than it really is.

• The undercosted product is left with too little cost, making it

seem more profitable than it really is.
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Product Cost
Cross-Subsidization
CONSIDER THIS:
• If you were using cost to determine price, what effect would
this have?

• If you were looking at product profitability to determine

marketing focus, what result?

• Managers use product costs everyday to make decisions. If

the cost is wrong, so will be the decision.
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Reasons For Refining A Costing System
Three principal reasons have accelerated the demand for refinements
to the costing system.

1. Increase in product diversity

2. Increase in indirect costs with different cost drivers

3. Competition in product markets

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 Changing Cost Environment

▪ Labor-intensive → Automated

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 Concepts Underlying ABC

▪ What is ABC?
▪ System of cost analysis
▪ Analyzes, identifies, and measures the cost of key activities
▪ Traces costs to cost objects

▪ When is ABC beneficial?

▪ Large amount of overhead costs
▪ Wide variety of products
▪ Intense competition

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 Activity-Based Costing (ABC)
▪ Involves determining the cost of activities and tracing their costs to cost
object on the basis of the cost objects’ utilization of units of activity

▪ Underlying premises

▪ Activities drive costs

▪ Costs should be assigned to products/services in proportion to the volume of

activities they consume

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 Cost Object
▪ A product or service provided to a customer

▪ Can be a customer

▪ A revenue-producing event for which management wants to know the cost

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Activity-Based Costing (ABC)
Activities performed to fill customer needs consume
resources that cost money.

Served
Customers Activities Consume Resources Have Costs
by

The cost of resources consumed by activities should be

assigned to cost objectives on the basis of the units of
activity consumed by the cost objective.

Costs of Assigned to Activity Reassigned to* Cost

Resources Pools Objectives

* Based on units of activity utilized by the cost objective

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 ABC Product Costing Model

Two–stage product cost model

1. Assign overhead resource costs to activity cost pools for key overhead activities

▪ Determine cost driver

▪ Calculate predetermined rate

▪ Predetermined rate = Cost pool / Cost driver activity level

2. Assign cost pools to cost objects

▪ Assigned cost = Predetermined rate x Quantity of cost driver used by the cost object

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ABC Product Costing Model
Operationalizing the two-stage model requires the
following:
Most CRITICAL
1. Identifying activities Step
2. Assigning cost to activities
3. Determining the basis (activity cost driver) for
assigning the cost of activities to cost objectives.
4. Determining the cost per unit of activity
5. Reassigning costs from the activity to the cost
objective on the basis of the cost objective’s volume of
consumption of activities

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Cost Hierarchies
A cost hierarchy categorizes various activity cost pools on the basis of
the different types of cost drivers, cost-allocation bases, or different
degrees of difficulty in determining cause-and-effect relationships.

ABC systems commonly use a cost hierarchy with four levels to identify
cost-allocation bases that are cost drivers of the activity cost pools.

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Cost Hierarchies
The four levels in the cost hierarchy are:
Output unit-level costs (related to the individual units
of a product or service)
Batch-level costs (related to a group of units)
Product (or service)-sustaining costs (related to support
a particular product or service without regard to the
number of units or batches)
Facility-sustaining costs (related to costs of activities
that cannot be traced to individual products or
services)

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ABC Vs. Simple Costing
• ABC is generally perceived to produce superior costing figures due to
the use of multiple drivers across multiple levels.

• ABC is only as good as the drivers selected, and their actual

relationship to costs. Poorly chosen drivers will produce inaccurate
costs, even with ABC.

• Using ABC does not guarantee more accurate costs!

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Signals that suggest that ABC Implementation
could help a Firm:
1. Significant amounts of indirect costs are allocated using only one or
two cost pools.
2. All or most indirect costs are identified as output unit-level costs.
3. Products make diverse demands on resources because of volume,
process steps, batch size or complexity.
4. Products that a company is well-suited to make show small profits
whereas products that a company is less suited to make show large
profits.
5. Operations staff has substantial disagreement with the reported
costs of manufacturing and marketing products or services

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 Traditional Product Costing
▪ Plant-wide overhead allocations are used often where production of only one
product occurs

▪ Departmental rates produce a more accurate allocation of overhead costs

than plant-wide rates

▪ Although product costs determined with department rates may not be as

precise as those determined with ABC, they are used because of relative
simplicity.

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Traditional Product Costing Example
Jump Start produces two energy drinks in 800 gallon
batches in two departments--mixing and bottling. A total
of 60 batches are estimated to be produced with 2,400
machine hours and estimated total manufacturing
overhead of $156,000. Data for the products follows:

Explosion Eruption
Machine hours required per batch 18 hours 22 hours
Total machine hours 1,080 hours 1,320 hours
Direct materials cost $260 per batch $380 per batch
Total direct labor cost per batch $80 $100
Total direct labor hours 240 hours 300 hours
Direct labor hours per batch 4 hours 5 hours

Continued
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Traditional Product Costing Example
Additional data: Machine Hours for 60 Batches
Departments Explosion Eruption Total
Mixing 400 600 1,000
Bottling 680 720 1,400
Totals 1,080 1,320 2,400

Overhead rate: $156,000 ÷ 2,400 = $65 per machine hour

Machine hours – Explosion: 1,080 ÷ 60 = 18 hours per batch
– Eruption: 1,320 ÷ 60 = 22 hours per batch
Unit Cost of Each Batch:
Explosion Eruption
Direct materials cost $ 260 $ 380
Direct labor cost 80 100
Overhead cost:
Explosion: 18 hours × $65 1,170
Eruption: 22 hours × $65 0 1,430
Unit cost per batch $ 1,510 $ 1,910
Continued
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Departmental Rates Costing Example
▪ Assign a portion of the total overhead
Two to the production departments
Steps ▪ Assign departmental costs to the
products
Additional data:
Direct Labor Hours for 60 Batches Overhead
Departments Explosion Eruption Total Department Application Base
Mixing 180 220 400 Mixing Direct labor hours
Bottling 60 80 140 in mixing
Bottling Machine hours in
Totals 240 300 540
bottling

Machine Hours for 60 Batches Overhead

Departments Explosion Eruption Total Per Department
Mixing 400 600 1,000 Mixing $40,000
Bottling 680 720 1,400 Bottling $116,000
Totals 1,080 1,320 2,400
Continued
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Departmental Rates Costing Example
Computation of departmental rates:

Overhead costs per activity Mixing Bottling

Department manufacturing overhead $40,000 $116,000
Quantity of overhead application base
Total direct labor hours in mixing ÷400
Total machine hours in bottling - ÷1,400
Overhead rates per department $ 100.00 $ 82.86
Per Per
direct machine
labor hour hour

Continued
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Departmental Rates Costing Example
Additional data:
Mixing direct labor hours per batch:
Explosion: 180 ÷ 60 = 3.00 direct labor hours
Eruption: 220 ÷ 60 = 3.67 direct labor hours
Bottling machine hours per batch:
Explosion: 680 ÷ 60 = 11.33 machine hours
Eruption: 720 ÷ 60 = 12.00 machine hours
Total Cost per Batch:
Explosion Eruption
Direct materials cost $260 $ 380
Direct labor cost 80 100
Manufacturing overhead
Mixing: $100 × 3 direct labor hours 300
Mixing: $100 × 3.67 direct labor hour 367
Bottling: $82.86 × 11.33 machine hours 939
Bottling: $82.86 × 12 machine hours - 994
Total costs per batch $1,579 $1,841
Continued
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Applying Overhead with ABC Example
Additional data:
Activity Cost Unit
Total Driver Activity Activity
Overhead Activity Activity Cost (Number of) Quantity Rates
Direct department costs -mixing $ 32,000 Labor hours 400 $80.00
Direct department costs -bottling 39,000 Machine hours 1,400 27.86
Common overhead costs
Support services
Receiving 17,000 Purchase orders 320 53.13
Inventory control 15,000 Batches produced 60 250.00
Engineering resources
Production setup 11,000 Production runs 18 611.11
Engineering and testing 16,000 Tests 400 40.00
Building and grounds
Maintenance, machines 12,000 Maintenance visits 150 80.00
Depreciation, machines 14,000 Machine hours 2,400 5.83
$156,000

Continued
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Applying Overhead with ABC Example
Explosion Eruption
Cost of Cost of
Overhead costs Rate Activity Activity Activity Activity
Mixing $ 80.00 220 $17,600 180 $14,400
Bottling 27.86 680 18,943 720 20,057
Receiving 53.13 240 12,750 80 4,250
Inventory control 250.00 30 7,500 30 7,500
Production setup 611.11 4 2,444 14 8,556
Engineering and testing 40.00 200 8,000 200 8,000
Maintenance, machines 80.00 70 5,600 80 6,400
Depreciation, machines 5.83 1,080 6,300 1,320 7,700
Total overhead product cost $79,137 $76,863

Each activity rate is multiplied by the actual activity

to determine the cost allocated to
each product batch.

Continued
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Cost per Unit ABC Example
Explosion Eruption
Total factory overhead product cost $79,137 $76,863
Batches produced ÷60 ÷60
Factory overhead cost per batch 1,319 1,281
Direct material cost per batch 260 380
Direct labor cost per batch 80 100
Total batch product cost using ABC $ 1,659 $ 1,761

There were 60 batches of product resulting in a cost

of $1,659 for Explosion and $1,761 for Eruption.

ABC provides more accurate cost

data for internal decision making.

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Comparing Overhead Cost
Allocation Methods
Explosion Eruption
Traditional plant-wide rate $1,510 $1,910
Traditional departmental rate 1,579 1,841
ABC 1,659 1,761

Traditional methods
undercost Explosion
Most accurate
Traditional methods costing method
overcost Eruption

ABC views operations of the company as activities.

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 ABC Implementation Issues
▪ After switching to ABC, companies may find that only 10 to 15% of their
products are profitable

▪ Causes management to alter the product mix by minimizing unprofitable products

which causes profits to increase

▪ Implementation mirrors the complexity of the organization

▪ Complete conversion to ABC requires auditors to accept the system when

used for financial reporting

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 Limitations of ABC
▪ Complete analysis requires consideration beyond manufacturing costs to
include nonmanufacturing

▪ How to measure quantity of activity

▪ Activity can be measured on practical capacity (i.e., maximum possible volume of
activity which allows for normal downtime for repairs/maintenance), actual capacity, or
other estimate

▪ Practical capacity preferred over actual capacity because

▪ Does not hide the cost of idle capacity within product costs

▪ Gives a truer cost of activities used to produce the product

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