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Activity-Based Costing:

A Tool to Aid Decision Making

ActivityBased Costing (ABC)

ABC is designed to
provide managers with
cost information for
strategic and other
decisions that
potentially affect
capacity and therefore
affect fixed
as well as variable
costs.

ABC is a
good supplement
to our traditional
cost system

I agree!

Learning Objective 1

Understand activitybased costing and how


it differs from a
traditional costing
system.

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
costs

Nonmanufacturing
costs

Traditional
product costing

ABC
product costing

ABC assigns both types of costs to products.

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.

Traditional
product costing

Nonmanufacturing
costs
Mo
st,
not but
all

Some

All

Manufacturing
costs

ABC
product costing

ABC does not assign all manufacturing costs to products.

How Costs are Treated Under


ActivityBased Costing

Level of complexity

ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.
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.

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
systems usually
cost systems
usually rely
rely
on
on volume
volume measures
measures such
such as
as 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.
ABC uses more cost pools.

How Costs are Treated Under


ActivityBased Costing
Activity

An event that causes the


consumption of overhead
resources.

Activity
Cost Pool

A cost bucket in which


costs related to a single
activity measure are
accumulated.

$$
$
$ $
$

How Costs are Treated Under


ActivityBased Costing
Activity
Measure
An allocation base
in an activity-based
costing system.

The term cost driver is


also used to refer to
an activity measure.

How Costs are Treated Under


ActivityBased Costing
Two common types of activity measures:
Transaction
driver

Duration
driver

Simple count
of the number of
times an activity
occurs.

A measure
of the amount
of time needed
for an activity.

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 as
as 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.

How Costs are Treated Under


ActivityBased Costing
Unit-Level
Activity

Batch-Level
Activity

Manufacturing
companies typically combine
their activities into five
classifications.
Product-Level
Activity

Organizationsustaining
Activity

Customer-Level
Activity

Characteristics of Successful ABC


Implementations

Strong
Strong top
top
management support

Link
Link to
to evaluations
and rewards

Cross-functional
involvement

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.

Define Activities, Activity Cost Pools,


and Activity Measures
At Baxter Battery, the ABC team, selected the following
activity cost pools and activity measures:

Define Activities, Activity Cost Pools,


and Activity Measures
Customer
Customer Orders
Orders -- assigned
assigned all
all 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 all
all 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 of
of units
units
produced.
produced.
Customer
Customer Relations
Relations assigned
assigned all
all 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

Learning Objective 2

Assign costs to cost


pools using a firststage allocation.

Assign Overhead Costs to Activity Cost


Pools

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.

Assign Overhead Costs to Activity Cost


Pools
At Baxter Battery the following distribution of resource
consumption across activity cost pools is determined.

Assign Overhead Costs to Activity Cost


Pools

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

Assign Overhead Costs to Activity Cost


Pools

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

Assign Overhead Costs to Activity Cost


Pools

Learning Objective 3

Compute activity
rates for cost pools.

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.

Calculate Activity Rates

ActivityBased Costing at Baxter Battery


Direct
Materials

Direct
Labor

Shipping
Costs

Traced

Traced

Traced

Overhead Costs

Cost Objects:
Products, Customer Orders, Customers

ActivityBased Costing at Baxter Battery


Direct
Materials

Direct
Labor

Shipping
Costs

Overhead Costs

First-Stage Allocation

Customer
Orders

Design
Changes

Order
Size

Customer
Relations

Cost Objects:
Products, Customer Orders, Customers

Other

ActivityBased Costing at Baxter Battery


Direct
Materials

Direct
Labor

Shipping
Costs

Overhead Costs

First-Stage Allocation

Customer
Orders

Design
Changes

Order
Size

Customer
Relations

Other

Second-Stage Allocations
$/Order

$/Change

$/MH

$/Customer

Cost Objects:
Products, Customer Orders, Customers

Unallocated

Learning Objective 4

Assign costs to a cost


object using a secondstage allocation.

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 of
of 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.

Assigning Overhead to Products

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.

Assigning Overhead to Customers

Learning Objective 5

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

Prepare Management Reports


Product Margin Calculations
The first step in computing product margins is to
gather each products sales and direct cost data.

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.

Prepare Management Reports


Product Margin Calculations
The third step in computing product
margins is to deduct each products
direct and indirect costs from sales.

Prepare Management Reports


Product Margin Calculations
The product margins can be reconciled with
the companys net operating income as follows:

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.

Prepare Management Reports


Customer Margin Analysis
The second step is to incorporate Acme Auto Parts
previously computed activity-based cost assignments.

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.

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.

Product Margins Computed Using the


Traditional Cost System
The second step in computing product margins
is to compute the plantwide overhead rate.

Plantwide manufacturing
overhead rate

$14,000,000
800,000 MH

= $17.50 per machine-hour

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

Product Margins Computed Using the


Traditional Cost System
The fourth step is to actually
compute the product margins.

Differences Between ABC and Traditional


Product Costs

The traditional cost


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

The traditional cost


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

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.

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.

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.

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.

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 of
of the
the subjective
subjective allocation
allocation
process
process based
based on
on interviews
interviews with
with employees.
employees.

ABC Limitations
Substantial resources
required to implement
and maintain.

Resistance to
unfamiliar numbers
and reports.

Desire to fully
allocate all costs
to products.

Potential
misinterpretation of
unfamiliar numbers.

Does not conform to


GAAP. Two costing
systems may be needed.

ABC Action Analysis


Appendix 8A

Learning Objective 6

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

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.

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.

Appendix 8A: ABC Action Analysis

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


Other entries in the table are computed similarly.

$180 per order 4,000 orders = $720,000


Other entries in the table are computed similarly.

$180 per order 6,000 orders = $1,080,000


Other entries in the table are computed similarly.

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.

Appendix 8A: ABC Action Analysis

Using a Modified Form of Activity-Based


Costing to Determine Product Costs for
External Reports
Appendix 8B

Learning Objective 7

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

Appendix 8B
A modified
modified form
form of activity-based
costing
costing can
can be
be 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.

Appendix 8B
Simmons Industries provides the following information
for the company as a whole and for its only two
productsdeluxe and standard hedge trimmers.

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
=
overhead rate
400,000 DLHs

= $4.50 per DLH

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

Appendix 8B
The ABC project team at Simmons has
developed the following basic information.

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.

Appendix 8B
Deluxe Product

Standard Product

Appendix 8B
Activity-based
Activity-based unit
unit product
product costs
costs for
for both
both product
product lines
lines

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

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.

End of Chapter 8