Chapter 9

ACTIVITY-BASED COSTING

1 Understand activity-based costing and how it differs from a traditional

costing system.

2 Assign costs to cost pools using a first-stage allocation.

3 Compute activity rates for cost pools.

4 Assign costs to a cost object using a second-stage allocation.

5 Use activity-based costing to compute product and customer margins.

9.1 Activity-based costing (ABC)
This chapter introduces the concept of activity-based costing which has been

embraced by a wide variety of organizations. Activity-based costing

(ABC) is a costing method that is designed to provide managers with cost

information for strategic and other decisions that potentially affect capacity

and therefore “fixed” as well as variable costs. Activity-based costing is

ordinarily used as a supplement to, rather than as a replacement for, a

company’s usual costing system. Most organizations that use activity-based

costing have two costing systems—the official costing system that is used for

preparing external financial reports and the activity-based costing system

that is used for internal decision making and for managing activities. This

chapter focuses primarily on ABC applications in manufacturing to provide a

contrast with the material presented in earlier chapters.

9.11 Activity-Based Costing: An Overview

As stated above, traditional absorption costing is designed to provide data

for external financial reports. In contrast, activity-based costing is designed

to be used for internal decision making. As a consequence, activity-based

costing differs from traditional absorption costing in three ways. In activity-

based costing:

1. Nonmanufacturing as well as manufacturing costs may be assigned to

products, but only on a cause-and-effect basis.

2. Some manufacturing costs may be excluded from product costs.

3. Numerous overhead cost pools are used, each of which is allocated to

products another cost objects using its own unique measure of activity. Each

of these departures from traditional absorption costing will be discussed in

turn.

Nonmanufacturing Costs and Activity-Based Costing

In traditional absorption costing, manufacturing costs are assigned to

products and nonmanufacturing costs are not assigned to products.

Conversely, in activity-based costing, we recognize that many

nonmanufacturing costs relate to selling, distributing, and servicing specific

products. Thus, ABC includes manufacturing and nonmanufacturing costs

when calculating the entire cost of a product rather than just its

manufacturing cost. There are two types of nonmanufacturing costs that ABC

systems assign to products.

First, ABC systems trace all direct nonmanufacturing costs to products.

Commissions paid to salespersons, shipping costs, and warranty repair costs

are examples of nonmanufacturing costs that can be directly traced to

individual products.

Second, ABC systems allocate indirect nonmanufacturing costs to products

whenever the products have presumably caused the costs to be incurred. In

fact, in this chapter, we emphasize this point by expanding the definition of

overhead to include all indirect costs—manufacturing and nonmanufacturing.

In summary, ABC product cost calculations include all direct costs that can

be traced to products and all indirect costs that are caused by products. The

need to distinguish between manufacturing and nonmanufacturing costs

disappears—which is very different from earlier chapters that focused solely

on determining the manufacturing cost of a product.

Manufacturing Costs and Activity-Based Costing

In traditional absorption costing systems, all manufacturing costs are

assigned to products—even manufacturing costs that are not caused by the

products. For example, in the previous Chapters we learned that a

predetermined plant wide overhead rate is computed by dividing all

budgeted manufacturing overhead costs by the budgeted amount of the

allocation base. So, in the case of a company that uses budgeted direct

labor-hours as its allocation base, this approach will assign all of the

company’s manufacturing overhead costs to its products based on each

product’s direct labor-hour usage.

In contrast, activity-based costing systems purposely do not assign two types

of manufacturing overhead costs to products—organization-sustaining costs

and unused capacity costs (also called idle capacity costs).Organization-

sustaining costs include costs such as the factory security guard’s wages,

the plant controller’s salary, and the cost of supplies used by the plant

manager’s secretary. These types of manufacturing overhead costs are

assigned to products in a traditional absorption costing system even though

they are totally unaffected by which products are made during a period.
Whereas, activity-based costing systems treat these types of organization

sustaining costs as period expenses rather than arbitrarily assigning them to

products.

Additionally, in a traditional absorption costing system, the cost of unused

capacity is assigned to products. If the budgeted level of activity declines,

the overhead rate and unit product costs rise thereby ensuring that the

shrinking volume of output absorbs the increasing cost of idle capacity. In

contrast, in activity-based costing, products are charged only for the cost of

the capacity they use—not for the cost of the capacity they don’t use. This

provides more stable unit product costs and is consistent with the goal of

assigning to products only the costs of the resources that they use.

9.12 Cost Pools, Allocation Bases, and Activity-Based

Costing

In activity-based costing, an activity is any event that causes the

consumption of overhead resources. An activity cost pool is a “bucket” in

which costs are accumulated that relate to a single activity measure in the

ABC system. An activity measure is an allocation base in an activity-based

costing system. The term cost driver is also used to refer to an activity

measure because the activity measure should “drive” the cost being

allocated.

The two most common types of activity measures are transaction drivers and

duration drivers. Transaction drivers are simple counts of the number of

times an activity occurs, such as the number of bills sent out to customers.

Duration drivers measure the amount of time required to perform an

activity, such as the time spent preparing individual bills for customers. In

general, duration drivers are more accurate measures of resource

consumption than transaction drivers, but they take more effort to record.

For that reason, transaction drivers are often used in practice.

Traditional cost systems rely exclusively on allocation bases that are driven

by the volume of production. On the other hand, activity-based costing

defines five levels of activity—unit-level, batch-level, product-level,

customer-level, and organization sustaining—that largely do not relate to the

volume of units produced. The costs and corresponding activity measures for

unit-level activities do relate to the volume of units produced; however, the

remaining categories do not. These levels are described as follows:

1. Unit-level activities are performed each time a unit is produced. The

costs of unit level activities should be proportional to the number of units

produced. For example, providing power to run processing equipment would

be a unit-level activity because power tends to be consumed in proportion to

the number of units produced.

2. Batch-level activities are performed each time a batch is handled or

processed, regardless of how many units are in the batch. For example, tasks

such as placing purchase orders, setting up equipment, and arranging for

shipments to customers are batch-level activities. They are incurred once for

each batch (or customer order).Costs at the batch level depend on the
number of batches processed rather than on the number of units produced,

the number of units sold, or other measures of volume. For example, the cost

of setting up a machine for batch processing is the same regardless of

whether the batch contains one or thousands of items.

3. Product-level activities relate to specific products and typically must

be carried out regardless of how many batches are run or units of product

are produced or sold. For example, activities such as designing a product,

advertising a product, and maintaining product manager and staff are all

product-level activities.

4. Customer-level activities relate to specific customers and include

activities such as sales calls, catalog mailings, and general technical support

that are not tied to any specific product.

5. Organization-sustaining activities are carried out regardless of which

customers are served, which products are produced, how many batches are

run, or how many units are made. This category includes activities such as

heating the factory, cleaning executive offices, providing a computer

network, arranging for loans, preparing annual reports to shareholders, and

so on.

Many companies throughout the world continue to base overhead allocations

on direct labor-hours or machine-hours. In situations where overhead costs

and direct labor-hours are highly correlated or in situations where the goal of

the overhead allocation process is to prepare external financial reports, this

practice makes sense. However, if plant wide overhead costs do not move in
tandem with plant wide direct labor-hours or machine-hours, product costs

will be distorted—with the potential of distorting decisions made within the

company.

9.2 Designing an Activity-Based Costing (ABC)

System

There are three essential characteristics of a successful activity-based

costing implementation.

First, top managers must strongly support the ABC implementation because

their leadership is instrumental in properly motivating all employees to

embrace the need to change.

Second, top managers should ensure that ABC data is linked to how people

are evaluated and rewarded. If employees continue to be evaluated and

rewarded using traditional (non-ABC) cost data, they will quickly get the

message that ABC is not important and they will abandon it.

Third, a cross-functional team should be created to design and implement

the ABC system. The team should include representatives from each area

that will use ABC data, such as the marketing, production, engineering, and

accounting departments. These cross-functional employees possess intimate

knowledge of many parts of an organization’s operations that is necessary

for designing an effective ABC system.

Furthermore, tapping the knowledge of cross-functional managers lessens

their resistance to ABC because they feel included in the implementation

process. Time after time,

Steps for Implementing Activity-Based Costing:

1. Define activities, activity cost pools, and activity measures.

2. Assign overhead costs to activity cost pools.

3. Calculate activity rates.

4. Assign overhead costs to cost objects.

5. Prepare management reports.

Step 1: Define Activities, Activity Cost Pools, and Activity Measures

The first major step in implementing an ABC system is to identify the

activities that will form the foundation for the system. This can be difficult

and time-consuming and involves a great deal of judgment. A common

procedure is for the individuals on the ABC implementation team to interview

people who work in overhead departments and ask them to describe their

major activities. Ordinarily, this results in a very long list of activities.

Step 2: Assign Overhead Costs to Activity Cost Pools

General ledgers usually classify costs within the departments where the

costs are incurred. For example, salaries, supplies, rent, and so forth

incurred in the marketing department are charged to that department. The

functional orientation of the general ledger mirrors the presentation of costs

in the absorption income statement. Now that the first-stage allocations to

the activity cost pools have been completed, the next step is to compute the

activity rates.

Step 3: Calculate Activity Rates

Step 4: Assign Overhead Costs to Cost Objects

The fourth step in the implementation of activity-based costing is called

second-stage allocation. In the second-stage allocation, activity rates are

used to apply overhead costs to products and customers. First, we will

illustrate how to assign costs to products followed by an example of how to

assign costs to customers.

Step 5: Prepare Management Reports

The most common management reports prepared with ABC data are product

and customer profitability reports. These reports help companies channel

their resources to their most profitable growth opportunities while at the

same time highlighting products and customers that drain profits. We begin

by illustrating a product profitability report followed by a customer

profitability report.

Review Problem: Activity-Based Costing

Ferris Corporation makes a single product—a fire-resistant commercial filing

cabinet—that it sells to office furniture distributors. The company has a

simple ABC system that it uses for internal decision making. The company

has two overhead departments whose costs are as follows:

Manufacturing overhead….…………………………………………………..M 500,000

Selling and administrative overhead…..…………………………………….300, 000

Total overhead costs…….………………………………………………………M

800,000

The company’s ABC system has the following activity cost pools and activity

measures:

Activity Cost Pool ………………………………………………….Activity Measure

Assembling units…………..………………………………………Number of units

Processing orders………………………………………………….Number of orders

Supporting customers…………………………………………….Number of

customers

Other……………………………………………………………………Not applicable

Costs assigned to the “Other” activity cost pool have no activity measure;

they consist of organization-sustaining costs and unused capacity costs—

neither of which are assigned to orders, customers, or the product.

Ferris Corporation distributes the costs of manufacturing overhead and

selling and administrative overhead to the activity cost pools based on

employee interviews, the results of which are reported below:

Distribution of Resource Consumption across Activity Cost Pools

Assembling Processing Supporting
Units Orders Customers Other Total
Manufacturing overhead…………………..50% 35% 5% 10% 100%
Selling and administrative overhead…10% 45% 25% 20% 100%
Total activity………………………………….1, 000 250 100
Units orders Customers

Required:

1. Perform the first-stage allocation of overhead costs to the activity cost

pools as in.

2. Compute activity rates for the activity cost pools.

3. Office Mart is one of Ferris Corporation’s customers. Last year, Office Mart

ordered filing cabinets four different times. Office Mart ordered a total of 80

filing cabinets during the year. Construct a table as in Exhibit7–10 showing

the overhead costs attributable to Office Mart.

4. The selling price of a filing cabinet is M595. The cost of direct materials is

M180 per filing cabinet, and direct labor is M50 per filing cabinet. What is the

customer margin of Office Mart? See Exhibit 7–12 for an example of how to

complete this report.

Solution to Review Problem

1. The first-stage allocation of costs to the activity cost pools appears

below:

Activity Cost Pools

Assembling Processing Supporting

Units Orders Customers Other Total

Manufacturing overhead…………M 250,000 M175, 000 M 25,000 M 50,000 M

500,000
Selling and administrative OH…….30, 000 135,000 75,000 60,000 300,000

Total cost ……………………………. M 280,000 M 310,000 M 100,000 M 110,000 M

800,000

2. The activity rates for the activity cost pools are:

(a) (b) (a) ÷ (b)

Activity Cost Pools Total Cost Total Activity Activity Rate

Assembling units………………………..M280, 000 1,000 units M280 per unit

Processing orders………………………..M310, 000 250 orders M1, 240 per

order

Supporting customers M100, 000 100 customers M1, 000 per customer

3. The overhead cost attributable to Office Mart would be computed as

follows:

(a) (b) (a) × (b)

Activity Cost Pools Activity Rate Activity ABC Cost

Assembling units M280 per unit 80 units M22, 400

Processing orders M1, 240 per order 4 orders M4, 960

Supporting customers M1, 000 per customer 1 customer M1, 000

4. The customer margin can be computed as follows:

Sales (M595 per unit x 80 units) M 47,600

Costs:

Direct materials (M180 per unit x 80 units) M 14,400

Direct labor (M50 per unit x 80 units) 4,000

Assembling units (above) 22,400

Processing orders (above) 4,960

Supporting customers (above) 1,000

46,760

Customer margin M 840