11th Edition

Chapter 8

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 Activity-Based Costing: A
Tool to Aid Decision Making

Chapter Eight

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

Manufacturing Nonmanufacturing
costs costs

Some
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 practice” ABC differs from traditional costing in five ways.

Level of complexity

Activity–Based
Costing

Departmental
Overhead
Rates
Plantwide
Overhead
Rate

Number of cost pools

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

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

The most commonly used allocation base

in traditional costing is direct labor 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 practice” ABC differs from traditional costing in five ways.

The most commonly used allocation base

in traditional costing is direct labor 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 practice” ABC differs from traditional costing in five 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 practice” ABC differs from traditional costing in five ways.

Traditional Costing ABC

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

 ABC bases level of activity on capacity.

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 Characteristics of Successful
ABC Implementations

Strong top
management support
Link to evaluations
and rewards

Cross-functional
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 Orders - assigned all costs of resources

that are consumed by taking and processing
customer orders.
• Product Designs - assigned all costs of resources
consumed by designing products.
• Order Size - assigned all costs of resources
consumed as a consequence of the number of units
produced.
• Customer Relations – assigned all costs associated
with maintaining relations with customers.
• Other – assigned all overhead costs that are not
associated with the other cost 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

Indirect factory wages $500,000

Percent consumed by customer orders 25%
$125,000

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 Assign Costs to Activity Cost Pools

Factory equipment depreciation $300,000

Percent consumed by customer orders 20%
$ 60,000

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 Assign Costs to Activity Cost Pools

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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 the team can compute the individual

activity rates by dividing the total cost for
each activity by the total activity levels.
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 Calculate Activity Rates

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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

Traced Traced Traced

Cost Objects:
Products, Customer Orders, 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, Customer Orders, 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 $/Order $/Design $/Customer

Cost Objects:
Unallocated
Products, Customer Orders, 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

The customer-level
cost is assigned to
customers directly;
it is not assigned to
products.

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 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

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)
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 Prepare Management Reports

Customer Profitability Analysis

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 Product Margins

Traditional Cost Accounting System

400 units x 0.5 MH/unit x $50/MH = $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. External reports are less detailed than internal
reports.
2. It may be difficult to make changes to the company’s
accounting system.
3. ABC does not conform to GAAP.
4. Auditors may be suspect of the subjective allocation
process based on interviews with 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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 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.

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 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.
Let’s revisit the stage-one allocations
from the Classic Brass example that we
discussed earlier.
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 Appendix 8A: ABC Action Analysis

$125,000 ÷ 1,000 orders = $125 per order

Other entries in the table are computed similarly.
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 Appendix 8A: ABC Action Analysis

$125 per order × 2 orders = $250

Other entries in the table are computed similarly.
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 Appendix 8A: ABC Action Analysis

$125 per order × 1 orders = $125

Other entries in the table are computed similarly.
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 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 difficulty and with
management intervention.
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 Appendix 8A: ABC Action Analysis

Action Analysis of Custom Compass Housing

Sales $ 650
Green costs
Direct materials $ 13
Shipping costs 25 38
Green margin $ 612
Yellow costs
Direct labor 50
Indirect factory wages 1,145
Factory utilities 72
Administrative wages and salaries 168
Office equipment depreciation 15
Marketing wages and salaries 175
Selling expenses 5 1,630
Yellow margin $ (1,018)
Red costs
Factory equipment depreciation 96
Factory building lease -
Administrative building lease - 96
Red margin $ (1,114)

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 End of Chapter 8

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