Activity-Based Costing:

A Tool to Aid Decision Making

Chapter 8

2010 The McGraw-Hill Companies, Inc.

 ActivityBased Costing (ABC)

ABC is a
ABC is designed to good supplement
provide managers with to our traditional
cost information for cost system
I agree!
strategic and other
decisions that
potentially affect
capacity and therefore
affect fixed
as well as variable
costs.

McGraw-Hill/Irwin Slide 2
 Learning Objective 1

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

McGraw-Hill/Irwin Slide 3
 How Costs are Treated Under
ActivityBased Costing
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.

Manufacturing Nonmanufacturing
costs costs

Traditional ABC
product costing product costing

ABC assigns both types of costs to products.

McGraw-Hill/Irwin Slide 4
 How Costs are Treated Under
ActivityBased Costing
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.

Manufacturing Nonmanufacturing
costs costs

Some
Mo
st,
All

not but
all
Traditional ABC
product costing product costing

ABC does not assign all manufacturing costs to products.

McGraw-Hill/Irwin Slide 5
 How Costs are Treated Under
ActivityBased Costing
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.
Level of complexity

ActivityBased
ActivityBased
Costing
Costing

Departmental
Departmental
Overhead
Overhead
Rates
Rates
Plantwide
Plantwide
Overhead
Overhead
Rate
Rate

Number of cost pools

ABC uses more cost pools.
McGraw-Hill/Irwin Slide 6
 How Costs are Treated Under
ActivityBased Costing
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.

Each
Each ABC
ABC cost
cost pool
pool has
has its
its
own
own unique
unique measure
measure of
of activity.
activity.

Traditional
Traditional cost
cost systems
systems usually
usually rely
rely
on
on volume
volume measures
measures such
such asas direct
direct labor
labor
hours
hours and/or
and/or machine
machine hours
hours toto allocate
allocate
all
all overhead
overhead costs
costs to
to products.
products.
ABC uses more cost pools.

McGraw-Hill/Irwin Slide 7
 How Costs are Treated Under
ActivityBased Costing
An event that causes the
Activity consumption of overhead
resources.

A cost bucket in which

Activity costs related to a single
Cost Pool activity measure are
accumulated.
$$
$
$ $
$

McGraw-Hill/Irwin Slide 8
 How Costs are Treated Under
ActivityBased Costing

The term cost driver is

Activity
also used to refer to
Measure
an activity measure.

An allocation base
in an activity-based
costing system.

McGraw-Hill/Irwin Slide 9
 How Costs are Treated Under
ActivityBased Costing

Two common types of activity measures:

Transaction Duration
driver driver

Simple count A measure

of the number of of the amount
times an activity of time needed
occurs. for an activity.

McGraw-Hill/Irwin Slide 10
 How Costs are Treated Under
ActivityBased Costing

ABC defines
five levels of activity
that largely do not relate
to the volume of units
produced.

Traditional
Traditional cost
cost systems
systems usually
usually rely
rely on
on volume
volume
measures
measures such
such asas direct
direct labor
labor hours
hours and/or
and/or machine
machine
hours
hours to
to allocate
allocate all
all overhead
overhead costs
costs to
to products.
products.
McGraw-Hill/Irwin Slide 11
 How Costs are Treated Under
ActivityBased Costing
Unit-Level Batch-Level
Activity Activity

Manufacturing
companies typically combine
their activities into five
classifications.

Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
McGraw-Hill/Irwin Slide 12
 Characteristics of Successful ABC
Implementations

Strong
Strong top
top
management support
Link
Link to
to evaluations
and rewards

Cross-functional
involvement

McGraw-Hill/Irwin Slide 13
 Baxter Battery An ABC Example

Manufacturing
Manufacturing overhead
overhead is
is allocated
allocated to
to products
products using
using
aa single
single plantwide
plantwide overhead
overhead rate
rate based
based on
on machine
machine hours.
hours.

McGraw-Hill/Irwin Slide 14
 Define Activities, Activity Cost Pools,
and Activity Measures

At Baxter Battery, the ABC team, selected the following

activity cost pools and activity measures:

McGraw-Hill/Irwin Slide 15
 Define Activities, Activity Cost Pools,
and Activity Measures
Customer
Customer Orders
Orders -- assigned
assigned allall costs
costs of
of resources
resources
that
that are
are consumed
consumed by by taking
taking and
and processing
processing
customer
customer orders.
orders.
Design
Design Changes
Changes -- assigned
assigned allall costs
costs of
of resources
resources
consumed
consumed by by customer
customer requested
requested design
design changes.
changes.
Order
Order Size
Size -- assigned
assigned all
all costs
costs of
of resources
resources
consumed
consumed as as aa consequence
consequence of of the
the number
number ofof units
units
produced.
produced.
Customer
Customer Relations
Relations assigned
assigned allall costs
costs associated
associated
with
with maintaining
maintaining relations
relations with
with customers.
customers.
Other
Other assigned
assigned all
all organization-sustaining
organization-sustaining costs
costs and
and
unused
unused capacity
capacity costs
costs

McGraw-Hill/Irwin Slide 16
 Learning Objective 2

Assign costs to cost

pools using a first-
stage allocation.

McGraw-Hill/Irwin Slide 17
 Assign Overhead Costs to Activity Cost
Pools

McGraw-Hill/Irwin Slide 18
 Assign Overhead Costs to Activity Cost
Pools

Direct materials, direct labor, and shipping are excluded

because Baxter Batterys existing cost system can directly
trace these costs to products or customer orders.
McGraw-Hill/Irwin Slide 19
 Assign Overhead Costs to Activity Cost
Pools
At Baxter Battery the following distribution of resource
consumption across activity cost pools is determined.

McGraw-Hill/Irwin Slide 20
 Assign Overhead Costs to Activity Cost
Pools

Indirect
Indirect factory
factory wages
wages $6,000,000
$6,000,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 30%
30%
$1,800,000
$1,800,000

McGraw-Hill/Irwin Slide 21
 Assign Overhead Costs to Activity Cost
Pools

Factory
Factory equipment
equipment depreciation
depreciation $3,500,000
$3,500,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 20%
20%
$$ 700,000
700,000

McGraw-Hill/Irwin Slide 22
 Assign Overhead Costs to Activity Cost
Pools

McGraw-Hill/Irwin Slide 23
 Learning Objective 3

Compute activity
rates for cost pools.

McGraw-Hill/Irwin Slide 24
 Calculate Activity Rates

The ABC team determines that Baxter Battery will have

these total activities for each activity cost pool . . .
10,000 customer orders,
4,000 design changes,
800,000 machine-hours,
2,000 customers served.

Now
Now the
the team
team can
can compute
compute the the individual
individual
activity
activity rates
rates by
by dividing
dividing the
the total
total cost
cost for
for
each
each activity
activity by
by the
the total
total activity
activity levels.
levels.

McGraw-Hill/Irwin Slide 25
 Calculate Activity Rates

McGraw-Hill/Irwin Slide 26
 ActivityBased Costing at Baxter Battery
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

Traced Traced Traced

Cost Objects:
Products, Customer Orders, Customers

McGraw-Hill/Irwin Slide 27
 ActivityBased Costing at Baxter Battery
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Design Order Customer

Other
Orders Changes Size Relations

Cost Objects:
Products, Customer Orders, Customers

McGraw-Hill/Irwin Slide 28
 ActivityBased Costing at Baxter Battery
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Design Order Customer

Other
Orders Changes Size Relations

Second-Stage Allocations

$/Order $/Change $/MH $/Customer

Cost Objects:
Unallocated
Products, Customer Orders, Customers

McGraw-Hill/Irwin Slide 29
 Learning Objective 4

Assign costs to a cost

object using a second-
stage allocation.

McGraw-Hill/Irwin Slide 30
 Assigning Overhead to Products
Baxter Battery Information
SureStart
SureStart
1.
1. Requires
Requires no no new
new design
design resources.
resources.
2.
2. 800,000
800,000 batteries
batteries ordered
ordered with
with 4,000
4,000 separate
separate orders.
orders.
3.
3. Each
Each SureStart
SureStart requires
requires 36
36 minutes
minutes ofof machine
machine
time
time for
for aa total
total of
of 480,000
480,000 machine-hours.
machine-hours.

LongLife
LongLife
1.
1. Requires
Requires new new design
design resources.
resources.
2.
2. 400,000
400,000 batteries
batteries ordered
ordered with
with 6,000
6,000 separate
separate orders.
orders.
3.
3. 4,000
4,000 custom
custom designs
designs prepared.
prepared.
4.
4. Each
Each LongLife
LongLife requires
requires 48
48 minutes
minutes of
of machine
machine
time
time for
for aa total
total of
of 320,000
320,000 machine-hours.
machine-hours.

McGraw-Hill/Irwin Slide 31
 Assigning Overhead to Products

McGraw-Hill/Irwin Slide 32
 Assigning Overhead to Customers
Lets take a look at how Baxter Batterys system works for just
one of the 2,000 customers Acme Auto Parts who placed a
total of twelve orders. Note that the four orders for LongLifes
required a design change.

Orders
Orders
1.
1. Eight
Eight orders
orders for
for 60
60 SureStarts
SureStarts per
per order.
order.
2.
2. Four
Four orders
orders for
for 50
50 LongLifes
LongLifes per
per order.
order.

Machine-hours
Machine-hours
1.
1. The
The 480
480 SureStarts
SureStarts required
required 288
288 machine-hours.
machine-hours.
2.
2. The
The 200
200 LongLifes
LongLifes required
required 160
160 machine
machine hours.
hours.

McGraw-Hill/Irwin Slide 33
 Assigning Overhead to Customers

McGraw-Hill/Irwin Slide 34
 Learning Objective 5

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

McGraw-Hill/Irwin Slide 35
 Prepare Management Reports
Product Margin Calculations
The first step in computing product margins is to
gather each products sales and direct cost data.

McGraw-Hill/Irwin Slide 36
 Prepare Management Reports
Product Margin Calculations
The second step in computing product margins is to
incorporate the previously computed activity-based
cost assignments pertaining to each product.

McGraw-Hill/Irwin Slide 37
 Prepare Management Reports
Product Margin Calculations
The third step in computing product
margins is to deduct each products
direct and indirect costs from sales.

McGraw-Hill/Irwin Slide 38
 Prepare Management Reports
Product Margin Calculations
The product margins can be reconciled with
the companys net operating income as follows:

McGraw-Hill/Irwin Slide 39
 Prepare Management Reports
Customer Margin Analysis
The first step in computing Acme Auto Parts customer
margin is to gather its sales and direct cost data.

McGraw-Hill/Irwin Slide 40
 Prepare Management Reports
Customer Margin Analysis
The second step is to incorporate Acme Auto Parts
previously computed activity-based cost assignments.

McGraw-Hill/Irwin Slide 41
 Prepare Management Reports
Customer Margin Analysis
The third step is to compute Acme Auto Parts customer margin of
$384 by deducting all its direct and indirect costs from its sales.

McGraw-Hill/Irwin Slide 42
 Product Margins Computed Using the
Traditional Cost System
The first step in computing product margins is to
gather each products sales and direct cost data.

McGraw-Hill/Irwin Slide 43
 Product Margins Computed Using the
Traditional Cost System
The second step in computing product margins
is to compute the plantwide overhead rate.

Plantwide manufacturing $14,000,000

= = $17.50 per machine-hour
overhead rate 800,000 MH

McGraw-Hill/Irwin Slide 44
 Product Margins Computed Using the
Traditional Cost System
The third step in computing product margins is
allocate manufacturing overhead to each product.

480,000 hours $17.50 per hour = $8,400,000

McGraw-Hill/Irwin Slide 45
 Product Margins Computed Using the
Traditional Cost System
The fourth step is to actually
compute the product margins.

McGraw-Hill/Irwin Slide 46
 Differences Between ABC and Traditional
Product Costs

The traditional cost The traditional cost

system overcosts the system undercosts the
SureStarts and reports LongLifes and reports
a lower product a higher product
margin for this product. margin for this product.

McGraw-Hill/Irwin Slide 47
 Differences Between ABC and Traditional
Product Costs
There are three reasons why the
reported product margins for the two
costing systems differ from one another.

Traditional costing allocates all manufacturing

overhead to products. ABC costing only assigns
manufacturing overhead costs consumed by
products to those products.

McGraw-Hill/Irwin Slide 48
 Differences Between ABC and Traditional
Product Costs
There are three reasons why the
reported product margins for the two
costing systems differ from one another.

Traditional costing allocates all manufacturing

overhead costs using a volume-related allocation
base. ABC costing also uses non-volume related
allocation bases.

McGraw-Hill/Irwin Slide 49
 Differences Between ABC and Traditional
Product Costs
There are three reasons why the
reported product margins for the two
costing systems differ from one another.

Traditional costing disregards selling and

administrative expenses because they are
assumed to be period expenses. ABC costing
directly traces shipping costs to products and
includes nonmanufacturing overhead costs caused
by products in the activity cost pools that are
assigned to products.

McGraw-Hill/Irwin Slide 50
 Targeting Process Improvement
Activity-based management is
used in conjunction with ABC to
identify areas that would benefit
from process improvements.

While the theory of constraints

approach discussed in Chapter 1
is a powerful tool for targeting
improvement efforts, activity rates
can also provide valuable clues on
where to focus improvement efforts.

Benchmarking
Benchmarking can
can be
be used
used to
to compare
compare activity
activity cost
cost
information
information with
with world-class
world-class standards
standards of
of performance
performance
achieved
achieved by
by other
other organizations.
organizations.
McGraw-Hill/Irwin Slide 51
 Activity-Based Costing and External Reporting

Most companies do not use ABC

for external reporting because . . .
1.
1. External
External reports
reports are
are less
less detailed
detailed than
than internal
internal
reports.
reports.
2.
2. ItIt may
may be
be difficult
difficult to
to make
make changes
changes to
to the
the companys
companys
accounting
accounting system.
system.
3.
3. ABC
ABC does
does not
not conform
conform to
to GAAP.
GAAP.
4.
4. Auditors
Auditors may
may be
be suspect
suspect ofof the
the subjective
subjective allocation
allocation
process
process based
based on
on interviews
interviews with
with employees.
employees.

McGraw-Hill/Irwin Slide 52
 ABC Limitations

Substantial resources Resistance to

required to implement unfamiliar numbers
and maintain. and reports.

Desire to fully Potential

allocate all costs misinterpretation of
to products. unfamiliar numbers.

Does not conform to

GAAP. Two costing
systems may be needed.

McGraw-Hill/Irwin Slide 53
ABC Action Analysis

Appendix 8A

2010 The McGraw-Hill Companies, Inc.

 Learning Objective 6

(Appendix 8A)
Prepare an action
analysis report using
activity-based costing
data and interpret the
report.

McGraw-Hill/Irwin Slide 55
 Appendix 8A: ABC Action Analysis

Conventional ABC analysis does not

identify potentially relevant costs. An
action analysis report helps because it:
Shows what costs have been
assigned to a cost object.
Indicates how difficult it would be to
adjust those costs in response to
changes in the level of activity.

McGraw-Hill/Irwin Slide 56
 Appendix 8A: ABC Action Analysis

Constructing an action analysis report

begins with the first-stage allocation process.
In addition to computing an overall activity
rate for each activity cost pool, an activity
rate is computed for each type of overhead
cost that is consumed supporting a given
activity.
Lets revisit the stage-one allocations
from the Baxter Battery Company example
that we discussed earlier.

McGraw-Hill/Irwin Slide 57
 Appendix 8A: ABC Action Analysis

$1,800,000 10,000 orders = $180 per order

Other entries in the table are computed similarly.
McGraw-Hill/Irwin Slide 58
 $180 per order 4,000 orders = $720,000
Other entries in the table are computed similarly.
McGraw-Hill/Irwin Slide 59
 $180 per order 6,000 orders = $1,080,000
Other entries in the table are computed similarly.
McGraw-Hill/Irwin Slide 60
 Appendix 8A: ABC Action Analysis
Next, label each cost using an ease of adjustment
code:
Green costs adjust more or less automatically to
changes in activity level without any action by
managers.
Yellow costs can be adjusted to changes in activity
level, but it would require management action to
realize the change in cost.
Red costs can be adjusted to changes in activity
level only with a great deal of difficulty and with
management intervention.

McGraw-Hill/Irwin Slide 61
 Appendix 8A: ABC Action Analysis

McGraw-Hill/Irwin Slide 62
Using a Modified Form of Activity-Based
Costing to Determine Product Costs for
External Reports
Appendix 8B

2010 The McGraw-Hill Companies, Inc.

 Learning Objective 7

(Appendix 8B)
Use activity-based
costing techniques to
compute unit product
costs for external
reports.

McGraw-Hill/Irwin Slide 64
 Appendix 8B
A modified
modified form
form of activity-based
costing
costing can
can bebe used
used to develop product
product
costs for
for external financial reports.
reports.

ABC
ABC product
product costs:
costs:
Include
Include organization-sustaining
organization-sustaining costs
costs
and
and unused
unused capacity
capacity costs.
costs.
Exclude
Exclude nonmanufacturing
nonmanufacturing costs
costs even
even
ifif they
they are
are caused
caused by
by the
the products.
products.

McGraw-Hill/Irwin Slide 65
 Appendix 8B

Simmons Industries provides the following information

for the company as a whole and for its only two
productsdeluxe and standard hedge trimmers.

McGraw-Hill/Irwin Slide 66
 Appendix 8B

Assuming that Simmons traditional cost system relies

on one predetermined plantwide overhead rate with
direct labor-hours (DLHs) as the allocation base, then
its plantwide overhead rate is computed as follows:

Predetermined $1,800,000
= = $4.50 per DLH
overhead rate 400,000 DLHs

McGraw-Hill/Irwin Slide 67
 Appendix 8B

Simmons traditional cost system would

report unit product costs as follows:

2.0 DLH $4.50 per DLH

1.0 DLH $4.50 per DLH

McGraw-Hill/Irwin Slide 68
 Appendix 8B

The ABC project team at Simmons has

developed the following basic information.

McGraw-Hill/Irwin Slide 69
 Appendix 8B

We can calculate the following activity rates:

Using the new activity rates, lets assign overhead

to the two products based upon expected activity.

McGraw-Hill/Irwin Slide 70
 Appendix 8B
Deluxe Product

Standard Product

McGraw-Hill/Irwin Slide 71
 Appendix 8B

Activity-based
Activity-based unit
unit product
product costs
costs for
for both
both product
product lines
lines

McGraw-Hill/Irwin Slide 72
 Appendix 8B

Activity-based
Activity-based unit
unit product
product costs
costs for
for both
both product
product lines
lines

$1,130,000 100,000 units

$670,000 200,000 units

McGraw-Hill/Irwin Slide 73
 Appendix 8B
Comparing the two approaches

Note that the unit product cost of a Standard unit

decreased from $44.50 to $43.35 . . . . .

. . . . . while the unit cost of a Deluxe unit increased from

$71.00 to $73.30.

McGraw-Hill/Irwin Slide 74
 End of Chapter 8

McGraw-Hill/Irwin Slide 75