Activity Based Costing:
A Tool to Aid Decision Making
A B C
Activity Based Costing (ABC)
ABC is designed to ABC is designed to provide managers provide managers
with cost with cost
information for information for strategic and other strategic and other
decisions that decisions that potentially affect potentially affect
capacity and capacity and therefore “fixed”
therefore “fixed”
costs.
costs.
ABC is a
good supplement to our traditional
cost system
I agree!
Overhead rates may Overhead rates may be based on activity be based on activity
at capacity.
at capacity.
Overhead rates may Overhead rates may be based on activity be based on activity
at capacity.
at capacity.
Activity Based Costing (ABC)
Both manufacturing Both manufacturing and nonmanufacturing and nonmanufacturing
costs may be costs may be
assigned to assigned to
products.
products.
Both manufacturing Both manufacturing and nonmanufacturing and nonmanufacturing
costs may be costs may be
assigned to assigned to
products.
products.
Some manufacturing Some manufacturing costs may be excluded costs may be excluded
from product from product
costs.
costs.
Some manufacturing Some manufacturing costs may be excluded costs may be excluded
from product from product
costs.
costs.
A number A number
of cost pools each of cost pools each allocated to a product allocated to a product
or cost object.
or cost object.
A number A number
of cost pools each of cost pools each allocated to a product allocated to a product
or cost object.
or cost object.
Allocation bases often Allocation bases often
differ from differ from traditional costing traditional costing
systems.
systems.
Allocation bases often Allocation bases often
differ from differ from traditional costing traditional costing
systems.
systems.
How Costs are Treated Under Activity-Based Costing
Level of Complexity Level of Complexity Overhead Allocation
Plantwide Plantwide Overhead Overhead
RateRate
Plantwide Plantwide Overhead Overhead
RateRate
Departmental Departmental
Overhead Overhead
Rates Rates
Departmental Departmental
Overhead Overhead
Rates Rates
Activity Based Activity Based
Costing Costing Activity Based Activity Based
Costing Costing
Plantwide Overhead Rate
Companies tended to use direct labor direct labor as as the overhead allocation base. There was a
belief that direct labor and overhead
costs were highly correlated.
Departmental Overhead Rates
Finishing Department
Shipping Department Painting Department
Many companies have a system Many companies have a system
in which each department has in which each department has
its own overhead rate.
its own overhead rate.
Many companies have a system Many companies have a system
in which each department has in which each department has
its own overhead rate.
its own overhead rate.
Department Department
11
Department Department
11 DepartmentDepartment 22
Department Department
22 DepartmentDepartment 33
Department Department
33 Cost pools
Cost pools
Indirect Indirect
Labor Labor Indirect Indirect Labor
Labor IndirectIndirect Materials Materials
Indirect Indirect Materials
Materials OtherOther Overhead Overhead
Other Other Overhead Overhead Stage One:
Stage One:
Costs assigned Costs assigned
to pools to pools
Departmental Overhead Rates
Department Department
11
Department Department
11 DepartmentDepartment 22
Department Department
22 DepartmentDepartment 33
Department Department
33 Cost pools
Cost pools
Indirect Indirect
Labor Labor Indirect Indirect Labor
Labor IndirectIndirect Materials Materials
Indirect Indirect Materials
Materials OtherOther Overhead Overhead
Other Other Overhead Overhead Stage One:
Stage One:
Costs assigned Costs assigned
to pools to pools
Departmental Overhead Rates
Products Products
Products Products Stage Two:
Stage Two:
Costs applied Costs applied
to products to products
Department Department
11
Department Department
11 DepartmentDepartment 22
Department Department
22 DepartmentDepartment 33
Department Department
33 Cost pools
Cost pools
Indirect Indirect
Labor Labor Indirect Indirect Labor
Labor IndirectIndirect Materials Materials
Indirect Indirect Materials
Materials OtherOther Overhead Overhead
Other Other Overhead Overhead Stage One:
Stage One:
Costs assigned Costs assigned
to pools to pools
Departmental Overhead Rates
Products Products
Products Products Stage Two:
Stage Two:
Costs applied Costs applied
to products to products
Departmental Allocation Bases Departmental Allocation Bases Departmental Allocation Bases Departmental Allocation Bases Direct
Labor Hours
Machine Hours
Raw Materials
Cost
Cost of Idle Capacity
Traditional Cost Traditional Cost Accounting
Accounting
The predetermined The predetermined overhead rate is based overhead rate is based
on budgeted activity.
on budgeted activity.
This results in applying This results in applying
overhead costs of overhead costs of
unused, or idle, unused, or idle,
capacity.
capacity.
Traditional Cost Traditional Cost Accounting
Accounting
The predetermined The predetermined overhead rate is based overhead rate is based
on budgeted activity.
on budgeted activity.
This results in applying This results in applying
overhead costs of overhead costs of
unused, or idle, unused, or idle,
capacity.
capacity.
Activity BasedActivity Based Costing
Costing
Products are charged for Products are charged for
the costs of capacity the costs of capacity they use – not for the they use – not for the costs of capacity they costs of capacity they
don’t use.
don’t use.
Activity BasedActivity Based Costing
Costing
Products are charged for Products are charged for
the costs of capacity the costs of capacity they use – not for the they use – not for the costs of capacity they costs of capacity they
don’t use.
don’t use.
Designing an ABC System
Cost Objects Cost Objects (e.g., products (e.g., products and customers) and customers)
Cost Objects Cost Objects (e.g., products (e.g., products and customers)
and customers) ActivitiesActivitiesActivitiesActivities Consumption Consumption of Resources of Resources Consumption Consumption of Resources of Resources
CostCostCost Cost
Designing of an ABC System
Steps for Implementing ABC Steps for Implementing ABC
Identify and define activities and activity Identify and define activities and activity cost pools.
cost pools.
Trace costs to activities and cost objects.Trace costs to activities and cost objects.
Assign costs to activity cost pools.Assign costs to activity cost pools.
Calculate activity rates.Calculate activity rates.
Assign costs to cost objects.Assign costs to cost objects.
Prepare management reports.Prepare management reports.
Identify and Define Activities and Activity Cost Pools
A part of the production A part of the production
process for which management process for which management wants a separate reporting of the wants a separate reporting of the
costs of the activity involved.
costs of the activity involved.
Unit-Level Unit-Level
Activity Activity
Batch-Level Batch-Level
Activity Activity
Product-Level Product-Level
Activity Activity
Customer-Level Customer-Level
Activity Activity Organization-
Organization- sustaining sustaining
Activity Activity
Identify and Define Activities and Activity Cost Pools
At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:
At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:
Activity Cost Pool Activity Measure
Customer orders Number of customer orders Product design Number of product designs
Order size Machine-hours
Customer relations Number of active customers
Other Not applicable
Activity Cost Pools at Classic Brass
Identify and Define Activities and Activity Cost Pools
Activity Cost Activity Cost Pool is a “bucket” Pool in which costs are accumulated that
relate to a single activity measure
in the ABC system.
$
$
$ $
$
$
Identify and Define Activities and Activity Cost Pools
Customer Orders
Customer Orders - assigned all costs of resources - assigned all costs of resources that are consumed by taking and processing
that are consumed by taking and processing customer orders.
customer orders.
Product Designs
Product Designs - assigned all costs of resources - assigned all costs of resources consumed by designing products.
consumed by designing products.
Order Size
Order Size - assigned all costs of resources - assigned all costs of resources
consumed as a consequence of the number of units consumed as a consequence of the number of units produced.
produced.
Customer Relations
Customer Relations – assigned all costs associated – assigned all costs associated with maintaining relations with customers.
with maintaining relations with customers.
Other
Other – assigned all overhead costs that are not – assigned all overhead costs that are not associated with the other cost pools.
associated with the other cost pools.
Customer Orders
Customer Orders - assigned all costs of resources - assigned all costs of resources that are consumed by taking and processing
that are consumed by taking and processing customer orders.
customer orders.
Product Designs
Product Designs - assigned all costs of resources - assigned all costs of resources consumed by designing products.
consumed by designing products.
Order Size
Order Size - assigned all costs of resources - assigned all costs of resources
consumed as a consequence of the number of units consumed as a consequence of the number of units
produced.
produced.
Customer Relations
Customer Relations – assigned all costs associated – assigned all costs associated with maintaining relations with customers.
with maintaining relations with customers.
Other
Other – assigned all overhead costs that are not – assigned all overhead costs that are not associated with the other cost pools.
associated with the other cost pools.
Production Department
Indirect factory wages $ 500,000 Factory equipment depreciation 300,000 Factory utilities 120,000
Factory building lease 80,000 $ 1,000,000 Shipping costs traced to customer orders 40,000 General Administrative Department
Administrative wages and salaries 400,000 Office equipment depreciation 50,000
Administrative building lease 60,000 510,000 Marketing Department
Marketing wages and salaries 250,000
Selling expenses 50,000 300,000
Total overhead costs $ 1,850,000
Overhead Costs at Classic Brass (Manufacturing and NonManufacturing)
Whenever Possible, Directly Trace
Overhead Costs to Activities and Cost Objects
Assign Costs to Activity Cost Pools
Customer Orders
Product Design
Order Size
Customer
Relations Other Total Production Department
Indirect factory wages 25% 40% 20% 10% 5% 100%
Factory equipment depreciation 20% 0% 60% 0% 20% 100%
Factory utilities 0% 10% 50% 0% 40% 100%
Factory building lease 0% 0% 0% 0% 100% 100%
Shipping costs **
General Administrative Department
Administrative wages and salaries 15% 5% 10% 30% 40% 100%
Office equipment depreciation 30% 0% 0% 25% 45% 100%
Administrative building lease 0% 0% 0% 0% 100% 100%
Marketing Department
Marketing wages and salaries 20% 10% 0% 60% 10% 100%
Selling expenses 10% 0% 0% 70% 20% 100%
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.
Customer Orders
Product Design
Order Size
Customer
Relations Other Total Production Department
Indirect factory wages $ 125,000 Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department
Marketing wages and salaries Selling expenses
Total
Activity Cost Pools
Indirect factory wages $500,000 Indirect factory wages $500,000 Percent consumed by customer orders 25%
Percent consumed by customer orders 25%
$125,000
$125,000 Indirect factory wages $500,000 Indirect factory wages $500,000 Percent consumed by customer orders 25%
Percent consumed by customer orders 25%
$125,000
$125,000
Assign Costs to Activity Cost Pools
Production Department
Indirect factory wages $ 500,000 Factory equipment depreciation 300,000 Factory utilities 120,000
Factory building lease 80,000 $ 1,000,000 Shipping costs traced to customer orders 40,000 General Administrative Department
Administrative wages and salaries 400,000 Office equipment depreciation 50,000
Administrative building lease 60,000 510,000 Marketing Department
Marketing wages and salaries 250,000
Selling expenses 50,000 300,000
Total overhead costs $ 1,850,000
Overhead Costs at Classic Brass (Manufacturing and NonManufacturing)
Customer Orders
Product Design
Order Size
Customer
Relations Other Total Production Department
Indirect factory wages $ 125,000 Factory equipment depreciation 60,000 Factory utilities
Factory building lease
General Administrative Department Administrative wages and salaries Office equipment depreciation Administrative building lease Marketing Department
Marketing wages and salaries Selling expenses
Total
Activity Cost Pools
Production Department
Indirect factory wages $ 500,000 Factory equipment depreciation 300,000 Factory utilities 120,000
Factory building lease 80,000 $ 1,000,000 Shipping costs traced to customer orders 40,000 General Administrative Department
Administrative wages and salaries 400,000 Office equipment depreciation 50,000
Administrative building lease 60,000 510,000 Marketing Department
Marketing wages and salaries 250,000
Selling expenses 50,000 300,000
Total overhead costs $ 1,850,000
Overhead Costs at Classic Brass (Manufacturing and NonManufacturing)
Factory equipment depreciation $300,000 Factory equipment depreciation $300,000 Percent consumed by customer orders 20%
Percent consumed by customer orders 20%
$ 60,000
$ 60,000 Factory equipment depreciation $300,000 Factory equipment depreciation $300,000 Percent consumed by customer orders 20%
Percent consumed by customer orders 20%
$ 60,000
$ 60,000
Assign Costs to Activity Cost Pools
Customer Orders
Product Design
Order Size
Customer
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
Activity Cost Pools
Assign Costs to Activity Cost Pools
Calculate Activity Rates
The ABC team determines that Classic Brass will have these total activities for each activity
cost pool . . .
1,000 customer orders1,000 customer orders
200 new designs200 new designs
20,000 machine-hours20,000 machine-hours
100 customer relations activities100 customer relations activities
Now the team can compute the individual Now the team can compute the individual activity rates by dividing the total cost for activity rates by dividing the total cost for
each activity by the total activity levels.
each activity by the total activity levels.
Calculate 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
Computation of Activity Rates
÷
Traced Traced Traced
Traced TracedTracedTracedTraced TracedTracedTracedTraced
Activity-Based Costing at Classic Brass
Direct Materials
Direct Materials
Direct Labor Direct Labor
Shipping Costs Shipping
Costs Overhead CostsOverhead Costs
Cost Objects:
Cost Objects:
Products, Customer Orders, Customers Products, Customer Orders, Customers
Cost Objects:
Cost Objects:
Products, Customer Orders, Customers Products, Customer Orders, Customers
Activity-Based Costing at Classic Brass
Direct Materials
Direct Materials
Direct Labor Direct Labor
Shipping Costs Shipping
Costs
Cost Objects:
Cost Objects:
Products, Customer Orders, Customers Products, Customer Orders, Customers
Cost Objects:
Cost Objects:
Products, Customer Orders, Customers Products, Customer Orders, Customers
Order Order SizeSize Order Order
SizeSize CustomerCustomer Orders Orders Customer Customer
Orders
Orders ProductProduct Design Design Product Product Design
Design CustomerCustomer Relations Relations Customer Customer Relations
Relations OtherOtherOtherOther Overhead Costs Overhead Costs
First-Stage Allocation First-Stage Allocation
Activity-Based Costing at Classic Brass
Direct Materials
Direct Materials
Direct Labor Direct Labor
Shipping Costs Shipping
Costs
Cost Objects:
Cost Objects:
Products, Customer Orders, Customers Products, Customer Orders, Customers
Cost Objects:
Cost Objects:
Products, Customer Orders, Customers Products, Customer Orders, Customers
Order Order SizeSize Order Order
SizeSize CustomerCustomer Orders Orders Customer Customer
Orders
Orders ProductProduct Design Design Product Product Design
Design CustomerCustomer Relations Relations Customer Customer Relations
Relations OtherOtherOtherOther Overhead Costs Overhead Costs
First-Stage Allocation First-Stage Allocation
Second-Stage Allocations Second-Stage Allocations Second-Stage Allocations Second-Stage Allocations
$/MH$/MH
$/MH$/MH $/Order$/Order$/Order$/Order $/Design$/Design$/Design$/Design $/Customer$/Customer$/Customer$/Customer
Unallocated Unallocated Unallocated Unallocated
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.
1. 400 units ordered with 2 separate orders.
2. Each stanchion required 0.5 machine-hours . 2. Each stanchion required 0.5 machine-hours . 3. Selling price is $34 each.
3. Selling price is $34 each.
4. Direct materials total $2,110.
4. Direct materials total $2,110.
5. Direct labor totals $1,850.
5. Direct labor totals $1,850.
6. Shipping costs total $180.
6. Shipping costs total $180.
Custom Compass Housing (requires new design) 1. One order during the year.
1. One order during the year.
2. Each housing required 4 machine-hours . 2. Each housing required 4 machine-hours . 3. Selling price is $650 each.
3. Selling price is $650 each.
4. Direct materials total $13.
4. Direct materials total $13.
5. Direct labor totals $50.
5. Direct labor totals $50.
6. Shipping costs total $25.
6. Shipping costs total $25.
Assigning Costs to Cost Objects
(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
Overhead Cost for the Standard Stanchions
(a) (b) (a) (b)
Activity Cost Pools Activity Rate Activity ABC Cost Customer orders $ 315 1 $ 315 Product design 1,285 1 1,285 Order size 19 4 76 Customer relations 3,675 N/A
Overhead Cost for the Custom Housing
The customer-level The customer-level cost is assigned to cost is assigned to customers directly;
customers directly;
it is not assigned to it is not assigned to
products.
products.
Prepare Management Reports
Standard Stanchions
Sales $ 13,600
Cost:
Direct materials $ 2,110 Direct labor 1,850 Shipping costs 180 Customer orders 630 Product design -
Order size 3,800 8,570
Product margin $ 5,030
Standard Stanchions
Sales $ 13,600
Cost:
Direct materials $ 2,110 Direct labor 1,850 Shipping costs 180 Customer orders 630 Product design -
Order size 3,800 8,570
Product margin $ 5,030
Custom Compass Housing
Sales $ 650
Cost:
Direct materials $ 13 Direct labor 50 Shipping costs 25 Customer orders 315 Product design 1,285
Order size 76 1,764
Product margin $ (1,114)
Custom Compass Housing
Sales $ 650
Cost:
Direct materials $ 13 Direct labor 50 Shipping costs 25 Customer orders 315 Product design 1,285
Order size 76 1,764
Product margin $ (1,114)
Windward Yachts
Product margins:
Standard stanchion $ 5,030 Custom compass housing (1,114) Total product margin 3,916 Less: Customer relations 3,675 Customer margin $ 241
Prepare Management Reports
Customer Profitability Analysis Customer Profitability Analysis
Product Margins
Standard Stanchions
Compass 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
Traditional
Traditional Cost Accounting SystemCost Accounting System
Predetermined manufacturing overhead rate
$1,000,000
20,000 MH = $50/MH
=
400 units x 0.5 MH/unit x $50/MH = $10,000 400 units x 0.5 MH/unit x $50/MH = $10,000 400 units x 0.5 MH/unit x $50/MH = $10,000 400 units x 0.5 MH/unit x $50/MH = $10,000
Difference Between ABC and Traditional Product Costs
Batch-level or product- Batch-level or product-
level costs will level costs will ordinarily shift ordinarily shift
overhead costs from overhead costs from
high-volume high-volume
products produced products produced in large batches to in large batches to low-volume products low-volume products
produced in small produced in small
batches.
batches.
Batch-level or product- Batch-level or product-
level costs will level costs will ordinarily shift ordinarily shift
overhead costs from overhead costs from
high-volume high-volume
products produced products produced in large batches to in large batches to low-volume products low-volume products
produced in small produced in small
batches.
batches.
Under ABC both Under ABC both
manufacturing and manufacturing and nonmanufacturing nonmanufacturing
costs may be costs may be
assigned to products.
assigned to products.
Organization- Organization-
sustaining costs and sustaining costs and
the costs of idle the costs of idle capacity are not capacity are not assigned to products.
assigned to products.
Under ABC both Under ABC both
manufacturing and manufacturing and nonmanufacturing nonmanufacturing
costs may be costs may be
assigned to products.
assigned to products.
Organization- Organization-
sustaining costs and sustaining costs and
the costs of idle the costs of idle capacity are not capacity are not assigned to products.
assigned to products.
Targeting Process Improvement
Activity-based costing can be used to identify areas that would
benefit from process improvements.
Activity-based costing can be used to identify areas that would
benefit from process improvements.
The theory of constraints approach is a powerful tool for
targeting the area in an
organization whose improvement will yield the greatest benefits.
The theory of constraints approach is a powerful tool for
targeting the area in an
organization whose improvement will yield the greatest benefits.
Activity-Based Costing and External Reporting
Most companies do not use ABC for external reporting because . . . Most companies do not use ABC for external reporting because . . .
1.1. External reports are less detailed than internal External reports are less detailed than internal reports.
reports.
2.2. It may be difficult to make changes to the company’s It may be difficult to make changes to the company’s accounting system.
accounting system.
3.3. ABC does not conform to GAAP.ABC does not conform to GAAP.
4.4. Auditors may be suspect of the subjective allocation Auditors may be suspect of the subjective allocation process based on interviews with employees.
process based on interviews with employees.
Limitations of ABC
ABC systems are a ABC systems are a major project requiring major project requiring substantial resources.
substantial resources.
The benefits of The benefits of increased accuracy increased accuracy must outweigh these must outweigh these
additional costs.
additional costs.
ABC systems are a ABC systems are a major project requiring major project requiring substantial resources.
substantial resources.
The benefits of The benefits of increased accuracy increased accuracy must outweigh these must outweigh these
additional costs.
additional costs.
ABC produces ABC produces
numbers, like product numbers, like product
margins, that are at margins, that are at odds with numbers odds with numbers produced by traditional produced by traditional costing system. Some costing system. Some
managers find it managers find it
difficult to adjust to this difficult to adjust to this
change.
change.
ABC produces ABC produces
numbers, like product numbers, like product
margins, that are at margins, that are at odds with numbers odds with numbers produced by traditional produced by traditional costing system. Some costing system. Some
managers find it managers find it
difficult to adjust to this difficult to adjust to this
change.
change.
ABC data can be misinterpreted and must ABC data can be misinterpreted and must be used with care when making decisions.
be used with care when making decisions.
ABC data can be misinterpreted and must ABC data can be misinterpreted and must be used with care when making decisions.
be used with care when making decisions.