Activity Based Costing

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 Activity Based 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.

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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice”ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

Manufacturing Nonmanufacturing
costs costs

Traditional ABC
product costing product costing

 ABC assigns both types of costs to products.

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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice”ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

Manufacturing Nonmanufacturing
costs costs

Some
Mo
st, b
All

not ut
all

Traditional ABC
product costing product costing

 ABC does not assign all manufacturing costs to products.

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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice”ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
Level of complexity

Activity–Based
Activity–Based
Costing
Costing

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

Number of cost pools

 ABC uses more cost pools.
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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice”ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

Volume
Allocation Bases

measures
Bases usually plus other
Number of

rely solely on bases.

volume
measures.

Traditional Costing ABC

 ABC uses more allocation bases.
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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice”ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

The
The most
most commonly
commonly usedused allocation
allocation base
base
in
in traditional
traditional costing
costing is
is direct
direct labor
labor hours.
hours.

Direct labor hours

work
well when overhead
increases as direct
labor hours increase.

 ABC uses more allocation bases.

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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice”ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

The
The most
most commonly
commonly usedused allocation
allocation base
base
in
in traditional
traditional costing
costing is
is direct
direct labor
labor hours.
hours.

Problems:
 In many processes, overhead is increasing
while direct labor is decreasing.
 Variety and complexity of products is
increasing.

 ABC uses more allocation bases.

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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice”ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

ABC uses
volume as well as
other allocation bases not
All overhead related to the volume
costs are not related of production.
to volume measures like
direct labor
hours.

 ABC uses more allocation bases.

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 How Costs are Treated Under
Activity–Based Costing

“Best
“Best practice”
practice”ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

Traditional Costing ABC

The predetermined Products are charged
overhead rate is based for the costs of
on budgeted activity. capacity they use – not
This results in applying for the costs of
all overhead costs capacity they don’t
including unused, or use. Unused capacity
idle capacity costs to costs are treated as
products. period expenses.

 ABC bases level of activity on capacity.

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 Characteristics of Successful
ABC Implementations

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

Cross-functional
Cross-functional
involvement
involvement

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 Designing an ABC System

Cost Objects
(e.g., products Activities
and customers)

Consumption
of Resources

Cost

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 Designing an ABC System

Steps for Implementing ABC

 Identify and define activities and activity cost
pools.
 Trace costs to activities and cost objects.
 Assign costs to activity cost pools.
 Calculate activity rates.
 Assign costs to cost objects.
 Prepare management reports.

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 Identify and Define Activities
and Activity Cost Pools

Unit-Level Batch-Level
Activity Activity

Manufacturing
companies typically combine
their activities into five
classifications.

Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
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 Identify and Define Activities
and Activity Cost Pools

Activities
should only be
combined within a level
if they are highly
correlated.

When combining
activities, they should be
grouped together only at
the appropriate
level.

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 Identify and Define Activities
and Activity Cost Pools

An Activity Cost $$
Pool is a “bucket” in $
$ $
which costs are $
accumulated that
relate to a single
activity measure in
the ABC system.

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 Identify and Define Activities
and Activity Cost Pools

Two 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.

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 Identify and Define Activities
and Activity Cost Pools

At Classic Brass, the ABC team, selected the following

activity cost pools and activity measures:

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 Identify and Define Activities
and Activity Cost Pools

•• Customer
Customer Orders
Orders -- assigned
assigned allall costs
costs ofof resources
resources
that
that are
are consumed
consumed by by taking
taking and
and processing
processing
customer
customer orders.
orders.
•• Product
Product Designs
Designs -- assigned
assigned allall costs
costs ofof resources
resources
consumed
consumed by by designing
designing products.
products.
•• 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 of of 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 overhead
overhead costs
costs that
that are
are not
not
associated
associated with
with the
the other
other cost
cost pools.
pools.
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 When Possible, Directly Trace Overhead
Costs to Activities and Cost Objects

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 Assign Costs to Activity Cost Pools

At Classic Brass the following distribution of resource

consumption across activity cost pools is determined.

**Not included because they are directly traced to customer orders.

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 Assign Costs to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Production Department
Activity CostIndirect
Poolsfactory wages $ 500,000
Factory equipment depreciation 300,000
Customer Product Order Customer
Factory utilities 120,000
Orders Design Sizelease Relations
Factory building Other
80,000 $ Total
1,000,000
Production Department Shipping costs traced to customer orders 40,000
General Administrative Department
Indirect factory wages $ 125,000
Administrative wages and salaries 400,000
Factory equipment depreciation Office equipment depreciation 50,000
Factory utilities Administrative building lease 60,000 510,000
Factory building lease Marketing Department
Marketing wages and salaries 250,000
General Administrative Department
Selling expenses 50,000 300,000
Administrative wages and salaries Total overhead costs $ 1,850,000
Office equipment depreciation
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

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 Assign Costs to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Production Department
Activity CostIndirect
Poolsfactory wages $ 500,000
Factory equipment depreciation 300,000
Customer Product Order Customer
Factory utilities 120,000
Orders Design Sizelease Relations
Factory building Other
80,000 $ Total
1,000,000
Production Department Shipping costs traced to customer orders 40,000
General Administrative Department
Indirect factory wages $ 125,000
Administrative wages and salaries 400,000
Factory equipment depreciation 60,000 Office equipment depreciation 50,000
Factory utilities Administrative building lease 60,000 510,000
Factory building lease Marketing Department
Marketing wages and salaries 250,000
General Administrative Department
Selling expenses 50,000 300,000
Administrative wages and salaries Total overhead costs $ 1,850,000
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

Factory
Factory equipment
equipment depreciation
depreciation $300,000
$300,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 20%
20%
$$ 60,000
60,000

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 Assign Costs to Activity Cost Pools

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 depreciation 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 depreciation 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

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 Calculate Activity Rates

The ABC team determines that Classic Brass will

have these total activities for each activity cost
pool . . .
 1,000 customer orders,
 200 new designs,
 20,000 machine-hours,
 100 customer relations activities.

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.
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 Calculate Activity Rates

Computation of Activity Rates

(a) (b) (a) ÷ (b)
Activity Cost Pools Total Cost Total Activity Activity Rate
Customer orders $ 315,000 1,000 orders $315 per order
Product design 257,000 200 designs $1,285 per design
Order size 380,000 20,000 MHs $19 per MH
Customer relations 367,500 100 customer $3,675 per customer
Other 490,500 Not applicable Not applicable

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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

Traced
Traced Traced
Traced Traced
Traced

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

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

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

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

Second-Stage Allocations

$/MH
$/MH $/Order
$/Order $/Design
$/Design $/Customer
$/Customer

Cost Objects:
Unallocated
Unallocated
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
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 Assigning Costs to Cost Objects

Let’s take a look at how our system works

for just one customer – Windward Yachts.
Standard Stanchions (no design required)
1. 400 units ordered with 2 separate orders.
2. Each stanchion required 0.5 machine-hours.
3. Selling price is $34 each.
4. Direct materials total $2,110.
5. Direct labor totals $1,850.
6. Shipping costs total $180.
Custom Compass Housing (requires new design)
1. One order during the year.
2. Each housing required 4 machine-hours.
3. Selling price is $650 each.
4. Direct materials total $13.
5. Direct labor totals $50.
6. Shipping costs total $25.
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 Assigning Costs to Cost Objects

Overhead Cost for the Standard Stanchions

(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 315 2 $ 630
Product design 1,285 0 -
Order size 19 200 3,800
Customer relations 3,675 N/A

The customer-level Overhead Cost for the Custom Housing

(a) (b) (a) × (b)
cost is assigned to Activity Cost Pools Activity Rate Activity ABC Cost

customers directly; Customer orders

Product design
$ 315
1,285
1
1
$ 315
1,285
it is not assigned to Order size 19 4 76
Customer relations 3,675 N/A
products.

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 Prepare Management Reports

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

Custom
Custom Compass
Compass Housing
Housing
Sales
Sales $$ 650
650
Cost:
Cost:
Direct
Direct materials
materials $$ 13
13
Direct
Direct labor
labor 50
50
Shipping
Shipping costs
costs 25
25
Customer
Customer orders
orders 315
315
Product
Product design
design 1,285
1,285
Order
Order size
size 76
76 1,764
1,764
Product
Product margin
margin $$ (1,114)
(1,114)
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 Prepare Management Reports

Customer Profitability Analysis

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 Product Margins

Traditional Cost Accounting System

Standard Compass
Stanchions Housing
Sales $ 13,600 $ 650
Costs
Direct materials (2,110) (13)
Direct labor (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

Predetermined manufacturing $1,000,000

= = $50/MH
overhead rate 20,000 MH
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 Differences Between ABC and
Traditional Product Costs
Product margins are different for four reasons:
 Traditional costing assigns design costs to both products
based on machine hours. ABC assigns product design
costs to a product only if product design work is required.
 Traditional costing assigns customer order costs, a batch-
level cost, using a unit-level allocation base, machine
hours.
ABC assigns these batch-level costs using a batch-level
activity measure.
 Traditional costing assigns only manufacturing costs to
products. ABC also assigns nonmanufacturing costs to
products.
 Traditional costing assigns all manufacturing costs to
products. The ABC system does not assign organization-
sustaining manufacturing costs to the products.
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 Differences Between ABC and
Traditional Product Costs

When batch-level and

product-level costs are present,
ABC will usually shift costs from high
volume products, produced in large batches,
to low volume products produced in small batches.

This cost shifting will usually have its

greatest impact on the per
unit cost of the low
volume products.

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 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.
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 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 company’s
company’s
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.

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 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.
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 Questions?

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