Chapter 7

Activity-Based
Costing

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All

Learning
Objective
1

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All

Background
Recall that Factory Overhead is applied to
production in a rational systematic manner, using
some type of averaging. There are a variety of
methods to accomplish this goal.
These methods often involve tradeoffs between
simplicity and realism
Simple Methods
Unrealistic

Complex Methods
Realistic

Broad Averaging
Historically, firms produced a limited variety
of goods while their indirect costs were
relatively small.
Allocating overhead costs was simple: use
broad averages to allocate costs uniformly
regardless of how they are actually incurred
Peanut-butter Costing

The end-result: overcosting & undercosting

Background
The use of broad averages in allocating indirect costs
can have a number of adverse consequences.
Traditional product-costing methods use a single
indirect cost rate to allocate costs to all products.
When a company has a variety of products, this method
may not give the best results.
Different products consume activities at different rates,
traditional costing does not recognize these differences.
Peanut-butter costing uses broad averages to assign (or
spread) costs uniformly to cost objects.

Over & Undercosting

Overcosting a product consumes a low
level of resources but is allocated high costs
per unit (Emmas dinner)
Undercosting a product consumes a high
level of resources but is allocated low costs
per unit (James dinner)

Cross-subsidization
The results of overcosting one product and
undercosting another.
The overcosted product absorbs too much
cost, making it seem less profitable than it
really is
The undercosted product is left with too little
cost, making it seem more profitable than it
really is

An Example:
Plastim

Rationale for selecting a more refined

costing system

Increase in product diversity

Increase in Indirect Costs
Advances in information technology
Competition in foreign markets

Refining a Costing System

A refined cost system reduces the use of
broad averages for assigning costs to
resources. There are three principal
reasons that have accelerated the demand
for such refinements.
Increase in product diversity. The growing
demand for customized products has led to
product diversity with the result that products
demand differing levels of resources.

Refining a Costing System

Increase in indirect costs. With modern
technology, companies have experienced a
decrease in direct costs with a resulting
increase in indirect costs.
Competition in product markets. Markets
have become more competitive, forcing
managers to obtain more accurate cost
information to help them make strategic
decisions.

Guidelines
Direct-cost tracing. Identify as many direct
costs as is economically feasible.
Indirect-cost pools. Expand the number of
cost pools so that each pool is somewhat
homogeneous. Each cost in the pool has a
similar cause-and-effect relationship with a
single cost driver.
Cost-allocation bases. The cost driver
serves as the cost allocation base for each
homogeneous indirect-cost pool.

Simple Costing System

A simple costing system has few indirect

(often one) cost rates and allocates costs
broadly.

Plastim & Simple Costing

Activity-Based System
(ABC)
An activity-based system (ABC) identifies
activities as fundamental cost objects.

Costs are then assigned to the activities and

allocated to the individual products.

ABC vs. Simple Costing Schemes

ABC is generally perceived to produce
superior costing figures due to the use of
multiple drivers across multiple levels
ABC is only as good as the drivers selected,
and their actual relationship to costs. Poorly
chosen drivers will produce inaccurate
costs, even with ABC

Plastim and ABC Illustrated

Cost Hierarchies
ABC uses a four-level cost structure to
determine how far down the production
cycle costs should be pushed:
Unit-level (output-level)
Batch-level
Product-sustaining-level
Facility-sustaining-level

Output unit-level costs are the costs of activities performed on each individual unit of a product or service. These costs increase as the number o
Batch-level costs are the costs of activities related to a group of units of products or services rather than the individual unit. Set-up costs are an e

Cost Hierarchies
Output unit-level costs are the costs of
activities performed on each individual unit of
a product or service. These costs increase
as the number of units produced increases.
Batch-level costs are the costs of activities
related to a group of units of products or
services rather than the individual unit. Setup costs are an example of batch level costs,
as this cost is incurred once for each batch,
regardless of the size of the batch.

Cost Hierarchies
Product-sustaining costs (service-sustaining
costs) are the costs of activities undertaken to
support individual products or services regardless
of the number of units or batches produced. Design
costs are an example of this type of cost.
Facility-sustaining costs are the costs of activities
that cannot be traced to individual products or
services but support the organization as a whole.
Examples of this type of cost include general
administration, rent, and building security. These
costs usually lack a cause-and-effect relationship
between the cost and the allocation base.

Cost Hierarchies
Facility-sustaining costs are the costs of
activities that cannot be traced to individual
products or services but support the
organization as a whole. Examples of this
type of cost include general administration,
rent, and building security. These costs
usually lack a cause-and-effect relationship
between the cost and the allocation base.

Plastim and ABC Rate

Calculation

Plastim and ABC Product Costs

Plastim: Simple & ABC

Compared

Conclusions
Each method is mathematically correct
Each method is acceptable
Each method yields a different cost figure, which will lead
to different Gross Margin calculations
Only Overhead is involved. Total Costs for the entire firm
remain the same they are just allocated to different cost
objects within the firm
Selection of the appropriate method and drivers should be
based on experience, industry practices, as well as a costbenefit analysis of each option under consideration

A Cautionary Tale
A number of critical decisions can be made
using this information;
Should one product be pushed over another?
Should one product be dropped?

Accounting for overhead costs is an

imprecise science. Accordingly, best efforts
should be put forward to arrive at a cost that
is fair and reasonable.

Activity-Based Management
A method of management that used ABC as
an integral part in critical decision-making
situations, including:
Pricing & product-mix decisions
Cost reduction & process improvement
decisions
Design decisions
Planning & managing activities

Signals that suggest that ABC

implementation could help a firm:
Significant overhead costs allocated using one or
two cost pools
Most or all overhead is considered unit-level
Products that consume different amounts of
resources
Products that a firm should successfully make and
sell consistently show small profits
Operations staff disagreeing with accounting over
manufacturing and marketing costs

ABC and Service / Merchandising

Firms
ABC implementation is widespread in a
variety of applications outside
manufacturing, including:
Health Care
Banking
Telecommunications
Retailing
Transportation

Traditional, Volume-Based
Product-Costing System
Aerotech produces three complex printed circuit
boards referred to as Mode I, Mode II, and Mode
III.
The following information is obtained from
company records:

Traditional, Volume-Based
Product-Costing System

Additional information includes:

Manufacturing overhead is determined as follows

Traditional, Volume-Based
Product-Costing System

Budgeted manufacturing overhead

Budgeted direct-labor hours

$3,894,000
118,000

= $33 per hour

Traditional, Volume-Based
Product-Costing System

With these product costs, Aerotech established

target selling prices (Cost 125%).

209.00 x 1.25

Learning
Objective
2

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All

Activity Based Costing System

(ABC)
ABC systems
follow a twostage procedure
to assign
overhead costs to
products.

Assigning
overhead to
products is a
difficult process.

I agree!

Activity Based Costing System

(ABC)
ABC systems follow a
two-stage procedure
to assign overhead
costs to products.

Stage One
Identify significant
activities and assign overhead
costs to each activity in
proportion to resources used.

Lets begin
by identifying
our major
activities.

Activity Based Costing System

(ABC)
ABC systems follow a
two-stage procedure
to assign overhead
costs to products.

Stage Two
Identify cost drivers
appropriate to each activity
and allocate overhead to
the products.

Overhead assigned to
activities are called
activity cost pools.

Learning
Objective
3

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All

Overhead Costs
Activity
must be
done on
each unit
produced.

Total budgeted cost = $3,894,000

Activity
Cost
Pools

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

Activity
performed
on each
batch
produced.

Activities needed to support

an entire product line

Identification
Identification
of
of Activity
Activity
Cost
Cost Pools
Pools

Facility
Level
Facility
cost pool
$507,400

Activity required in order

for the production
process to occur.

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

Receiving/Inspection
cost pool $200,000
Material-Handling
cost pool $600,000
Quality-Assurance
cost pool $421,000
Packaging/Shipping
cost pool $250,000

Facility
Level
Facility
cost pool
$507,400

Learning
Objective
4

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All

STAGE ONE
Various overhead
costs related
to machinery

Activity
cost
pool

Maintenance

Lubrication

Depreciation

Electricity

Computer Support

Calibration

Machinery Cost Pool

Total budgeted cost = $1,212,600

STAGE TWO
Calculate
the pool
rate

Cost
Assignment

Budgeted Machinery Costs = $1,212,600

Budgeted Machine Hours
43,000
= $28.20/hour

STAGE ONE
Calculation of
total setup cost

Activity
cost
pool

Setup Cost Pool

Total budgeted cost = $3,000

STAGE TWO
Calculate
the pool
rate

Cost
Assignment

Budgeted Setup Costs

Planned Production Runs

= $3,000
15 runs
= $200 per run

STAGE ONE
Various overhead
costs related
to engineering

Activity
cost
pool

Engineering salaries

Engineering software

Engineering supplies

Depreciation

Engineering Cost Pool

Total budgeted cost = $700,000

STAGE TWO
Allocate based
on engineering
transactions

Cost
Assignment

Engineering Cost Pool

Total budgeted cost = $700,000

Exh.
5-9

STAGE ONE
Various overhead
costs related
to general
operations

Activity
cost
pool

Plant depr.

Property taxes

Plant mgmt.

Insurance

Plant maint.

Security

Facility Cost Pool

Total budgeted cost = $507,400

STAGE TWO
Calculate
the pool
rate

Cost
Assignment

Budgeted Facilities Cost

= $507,400
Budgeted Direct-Labor Hours
118,000
= $4.30/hour

Exh.
5-9

Other Overhead Costs

Receiving and Inspection Cost Pool

Board
Overhead
Mode I
$ 200,000
Mode II
200,000
Mode III
200,000

%
6%
24%
70%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.20
=
2.40
=
35.00

Material-Handling Cost Pool

Board
Overhead
Mode I
$ 600,000
Mode II
600,000
Mode III
600,000

%
7%
30%
63%

Units
10,000
20,000
4,000

= Cost/Unit
= $
4.20
=
9.00
=
94.50

Quality-Assurance Cost Pool

Board
Overhead
Mode I
$ 421,000
Mode II
421,000
Mode III
421,000

%
20%
40%
40%

Units
10,000
20,000
4,000

= Cost/Unit
= $
8.42
=
8.42
=
42.10

Packaging and Shipping Cost Pool

Board
Overhead
Mode I
$ 250,000
Mode II
250,000
Mode III
250,000

%
4%
30%
66%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.00
=
3.75
=
41.25

Other Overhead Costs

Receiving and Inspection Cost Pool

Board
Overhead
Mode I
$ 200,000
Mode II
200,000
Mode III
200,000

%
6%
24%
70%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.20
=
2.40
=
35.00

Material-Handling Cost Pool

Board
Overhead
Mode I
$ 600,000
Mode II
600,000
Mode III
600,000

$14.82

%
7%
30%
63%

Units
10,000
20,000
4,000

= Cost/Unit
= $
4.20
=
9.00
=
94.50

Quality-Assurance Cost Pool

Board
Overhead
Mode I
$ 421,000
Mode II
421,000
Mode III
421,000

%
20%
40%
40%

Units
10,000
20,000
4,000

= Cost/Unit
= $
8.42
=
8.42
=
42.10

Packaging and Shipping Cost Pool

Board
Overhead
Mode I
$ 250,000
Mode II
250,000
Mode III
250,000

%
4%
30%
66%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.00
=
3.75
=
41.25

Product Cost from ABC

These are the new product costs when Aerotech
uses ABC.

Learning
Objective
5

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All

Distorted Product Costs

Both original and ABC target selling prices are
based on (Cost 125%).

The selling price of Mode I and II are reduced

and the selling price for Mode III is increased.
[$209.00 1.25]

[$183.44 1.25]

Distorted Product Costs

Can you identify any problems Aerotech is likely
to face as a result of this distortion?

Traditional costing understates the cost

of complex, low volume products.

Two Key Points

A
A large
large proportion
proportion of
of nonnonunit-level
unit-level activities
activities
A
A unit-level
unit-level cost
cost driver,
driver,
such
such as
as direct
direct labor,
labor,
machine
machine hours,
hours, or
or
throughput,
throughput, will
will not
not be
be
able
able to
to assign
assign the
the costs
costs
of
of non-unit-level
non-unit-level activities
activities
accurately.
accurately.

Product
Product diversity
diversity
When
When the
the consumption
consumption
ratios
ratios differ
differ widely
widely
between
between activities,
activities, no
no
single
single cost
cost driver
driver will
will
accurately
accurately assign
assign the
the
resulting
resulting overhead
overhead costs.
costs.

Learning
Objective
6

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All

Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs.

Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .
Degree of
Correlation

Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .
Degree of
Correlation
Cost of
Measurement

Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .
Degree of
Correlation

Behavioral
Effects
Cost of
Measurement

Learning
Objective
7

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All

Interviewing and Paper Trails

The information for ABC systems initially comes
from interviews with employees in the support
departments and a review of each departments
records.

Storyboarding
A procedure used to develop a detailed
process flow chart, which visually
represents activities and the relationships
among activities.
Step
Step
11
Step
Step
22
Step
Step
33
Step
Step
44

These
These are
are the
the steps
steps we
we
follow
follow to
to build
build aa
memory
memory board.
board.

Direct versus Indirect Costs

Volume-Based
Volume-Based Costing
Costing
All
All production
production costs
costs
except
except direct
direct
materials
materials and
and direct
direct
labor
labor are
are lumped
lumped
together
together in
in one
one
overhead
overhead cost
cost pool.
pool.

Activity-Based
Activity-Based Costing
Costing
An
An effort
effort is
is made
made to
to
account
account for
for as
as many
many
costs
costs as
as possible
possible as
as
direct
direct costs
costs of
of
production.
production.

Indirect
Costs

Indicators of Need for ABC

Direct
Direct labor
labor is
is aa
small
small percentage
percentage
of
of total
total costs
costs

Product-line
Product-line profit
profit
margins
margins are
are hard
hard
to
to explain
explain

Sales
Sales are
are increasing,
increasing,
but
but profits
profits are
are declining.
declining.

Line
Line managers
managers do
do not
not
believe
believe the
the product
product
costs
costs reports
reports

Marketing
Marketing does
does not
not
use
use costs
costs reports
reports for
for
pricing
pricing decisions
decisions

Some
Some products
products that
that
have
have reported
reported high
high
profit
profit margins
margins are
are not
not
sold
sold by
by competitors
competitors

Exh.
5-13

Optimal Product-Costing System

Cost
High

Total Cost

Cost of
inferior
decisions
resulting
from
inaccurate
information.

Design, implementation
and maintenance costs

Low
Low

Optimal
system

Information
System
High Accuracy

Learning
Objective
8

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All

ABC in the Service Industry

Objectives

End of Chapter 5
This is
my kind of cost
pool!