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CHAPTER 6
Activity-Based
Costing

2009 Cengage Learning

Introduction
Overhead costs have soared
to 60 percent or more of total
product costs in heavily
automated manufacturing
environments.
As overhead costs increase
and make up a larger portion
of the total costs of products,
accuracy in overhead
application has become much

Activity-Based
Costing

In this chapter we
introduce a different
approach to overhead
allocation using ActivityBased Cost Drivers as
opposed to Volume-Based
Cost Drivers
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Categories of
Overhead Costs

Unit-level costs are incurred

each time a unit is produced.
Examples:
Supplies for factory
Depreciation on factory
machinery
Energy costs for factory
machinery
Repairs and maintenance of

Categories of
Overhead Costs

Batch-level costs are

incurred each time a batch
of goods is produced.
Examples:
Salaries related to purchasing
and
receiving
Salaries related to moving
material
Quality control costs

Categories of
Overhead Costs

Product-level costs are

incurred as needed to
support the production of
each different type of
product. Examples:
Salaries of engineers
Depreciation of engineering
equipment
Product development costs

Categories of
Overhead Costs

Facility-level costs simply

sustain a facilitys general
manufacturing process.
Examples:
Depreciation or rent of a factory
building
Salary of a plant manager
Insurance, taxes, etc.
Training

Activities and Cost

Drivers:
Unit Level
Activity
Machining

Potential Cost
Driver

Machine hours,
labor hours or
Maintenan
number of units
ce of
produced
machines
Machine hours
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Activities and Cost

Drivers:
Product Level
Activity
Product
Testing

Potential Cost
Driver
Number of change
orders, number of
tests, hours of
testing time

Supervisi
Number of
on
supervision hours

Activities and Cost

Drivers:
Batch Level

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Activity

Potential Cost Driver

Purchasing

Number of purchase
orders or number of
parts

Receiving
Machine
setups

Amount of material
or number of
receipts
Number of setups

Customer

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Activities and Cost

Drivers:
Facility Level
Activity
Plant
Occupanc
y

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Potential Cost
Driver
Square footage,
number of
employees, labor
hours, machine
hours
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Unit-, Batch-, Product-,

and Facility-Level Costs
Key Concept
Unit-level costs are incurred each
time a unit is produced. Batch-level
costs are incurred each time a
batch of goods is produced.
Product-level costs are incurred as
needed to support the production
of each type of product. Facilitylevel costs simply sustain a
facilitys general manufacturing

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Activity-Based
Costing
Key Concept
The key feature of an Activity-Based
Costing system is allocating
overhead costs based on activities
that drive costs rather than on the
volume or number of units
produced.
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Traditional Overhead
Allocation and ABC - An
Example

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TopSail Construction
Modular-Home Builder
Builds 2 basic models
and a fast-delivery
Cottage

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Manufacturing
Overhead Costs for
2008

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Costs per Unit Using

Volume-Based OH
Allocation

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Stage 1: Identification
of Activities

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Stage 2: Identification
of Cost Drivers &
Allocation of Costs
Activity

Cost Driver

Inspections

Number of
inspections

Purchasing
Supervision

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Number of
purchase orders
Hours of
supervisor time

Delivery &
setup

Setup time

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Estimated Cost
Driver Activity

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Calculation of
Predetermined Activity
Rates

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Cost of Units Based

on Activity-Based
Costing

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Cost Comparisons
between Traditional and
ABC Costing

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Price Comparison
between Traditional and
ABC Costing

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Activity-Based
Costing

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Key Concept

Volume-based costing
systems often result in
over-costing high volume
products and undercosting low-volume
products.
This cross subsidy is

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ABC Systems in
Service Industries

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Although ABC was

developed for use
primarily by
manufacturing
companies, it has gained
widespread acceptance in
the service sector.
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ABC Systems in
Service Industries

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Problems
Type of work performed in
service industries tends to be
nonrepetitive
Activities differ for each
customer or service
Services have proportionately
more
facility-level costs

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ABC Systems and

Nonmanufacturing
Activities

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ABC is used to determine the

cost of providing a selling or
administrative service.
Example: The U.S. Post Office used
ABC to help determine the costs and
benefits of allowing customers to pay
using debit and credit cards.
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Benefits of ActivityBased Costing

Using ABC in the budgeting
process
provides more
accurate estimates of resources
Provides more accurate cost
information for day-to-day
decision making
Costs that appeared to be
indirect
using volume-based
costing systems are now traced
to specific activities using cost

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Limitations of ActivityBased Costing

High measurement costs
The higher the potential for
cost
distortions, the more
likely the
company will
benefit from ABC
Distortions result from diverse
products
Diverse products: products that
consume resources in different

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Backflush
Costing

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Companies using JIT generally

have little or no inventory or
finished goods.
All manufacturing costs are flushed
directly into cost of goods sold
If the company has small amounts of
inventory on hand at the end of
the period, manufacturing costs are
backflushed into the appropriate
materials inventory, WIP

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