Activity-Based Costing

Study Objective 1

Recognize the difference between

traditional costing and activity-
based costing.
 Traditional Costing
Systems
 Often the most difficult part of computing
accurate unit costs is determining the proper
amount of overhead cost to assign to each
product, service, or job.
 Unlike direct materials and direct labor costs
which can usually be easily traced to the
product, overhead is an indirect or common
cost that generally cannot be traced to a
product.
 Traditional Costing
Systems
 In Chapters 2 and 3 a single predetermined
overhead rate was used throughout the year
to assign costs to products.
 We assumed that direct labor cost and
machine hours were the relevant activity
bases for the assignment of all overhead in
job order and process costing, respectively.
 Traditional Costing
Systems
When overhead cost allocation systems were first developed,
direct labor made up a large part of total manufacturing cost.
It was widely accepted that there was a high correlation
between direct labor and the incurrence of overhead cost. As
a result, direct labor became the most popular basis for
overhead allocation.
 A simplified (one-stage) traditional costing system relying on
direct labor to assign overhead is displayed below:

Direct
Overhead
Labor Products
Costs
Hours
Illustration 4-2
 Traditional Costing
Systems
 Even in today’s environment, direct labor is
often the appropriate basis for assigning
overhead cost to products.
 It is appropriate when
– direct labor constitutes a significant part of
total product cost, and
– a high correlation exists between direct
labor and changes in the amount of
overhead costs.
 The Need for a New Costing
System
 Advances in computerized systems, technological
innovation, international competition, and
automation have changed the manufacturing
environment drastically. The amount of direct labor
used in many industries is now greatly reduced, and
total overhead costs have significantly increased.
 Companies that continue to use plantwide
predetermined overhead rates based on direct labor,
where the correlation between direct labor and
overhead no longer exists, experience significant
product cost distortions.
 The Need for a New Costing
System
 Recognizing these distortions, many companies now
use machine hours as the overhead allocation base
in an automated manufacturing environment.
 But even machine hours may not suffice as the sole
plantwide basis for allocating all overhead.
 If the manufacturing process is complex, then only
multiple allocation bases can result in more accurate
computations.
 In such situations, managers need a new overhead
cost allocation method: activity-based costing.
 Activity-Based Costing
 Activity-based costing (ABC) allocates overhead to
multiple activity cost pools and assigns the activity
cost pools to production by means of cost drivers.
 In ABC, an activity is any event, action, transaction,
or work sequence that causes the incurrence of cost
in the production of a product or rendering of a
service.
 A cost driver is any factor or activity that has a
direct cause/effect relationship with the resources
consumed.
 Activity-Based Costing
 ABC first allocates costs to activities, and
then to the products based on each product’s
use of those activities.
 The reasoning behind ABC cost allocation is
simple: products consume activities;
activities consume resources.
 Activity-Based Costing
 ABC allocates overhead in a two-stage process:
– Overhead is allocated to activity cost
pools, each of which is a distinct type of
activity,
– Overhead in the cost pools is assigned to
products using cost drivers which represent
and measure the number of individual
activities undertaken or performed to
produce products or render services.
 Activity-Based Costing
 Not all products or services share equally in activities.
 The more complex a product’s manufacturing
operation, the more activities and cost drivers it is
likely to have.
 If there is little or no correlation between changes in
the cost driver and consumption of the overhead cost,
inaccurate product costs are inevitable.
 The next slide shows an illustration of an activity-
based costing system with seven activity cost pools
and correlated cost drivers.
 Activity-Based Costing
System
Overhead Costs

Ordering
Setting Inspecting
and Assem- Super-
Up Machining and Painting
Receiving bling vising
Machines Cost Pool Testing Cost Pool
Materials Cost Pool Cost Pool Cost Pool
Cost Pool
Cost Pool

Numbe Numbe Numbe Numbe Numbe Direct

Machin
r of r of r of r of r of Labor
e Hours
POs Setups Parts Tests Parts Hours

Products
Illustration 4-4
 Illustration of Traditional
Costing versus ABC
A simple case example will now be presented to compare
traditional costing and activity-based costing. It illustrates
the distortion that can occur in traditional overhead cost
allocation.
 Atlas Company products two automobile anti-theft devices,
The Boot and The Club. The Boot is a high-volume item,
totaling 25,000 units annually, while The Club is a low-
volume item totaling only 5,000 units a year. Both products
require one hour of direct labor. Therefore, annual direct labor
hours are 30,000. Expected annual manufacturing overhead
costs are $900,000. Thus, the predetermined overhead rate is
$30 ($900,000  30,000) per direct labor hour.
 Unit Costs Under
Traditional Costing
 The direct materials cost per unit is $40 for The
Boot and $30 for The Club. The direct labor cost is
$12 for each product.
 The computation of the unit cost for The Boot and
The Club under traditional costing is shown below:
Atlas Company
Products
Manufacturing Costs The Boot The Club
Direct material $40 $30
Direct labor 12 12
Overhead 30* 30*
Total unit cost $82 $72

*Predetermined overhead rate times direct labor hours ($30 x 1 hr. = $30)
Illustration 4-5
 Study Objective 2

Identify the steps in the development

of an activity-based costing system.
 Unit Costs under ABC
Activity-based costing involves the following steps:
1 Identify the major activities that pertain to the
manufacture of specific products and allocate
manufacturing overhead costs to activity cost pools.
2 Identify the cost drivers that accurately measure each
activity’s contributions to the finished product and
compute the activity-based overhead rate.
3 Assign manufacturing overhead costs for each activity
cost pool to products using the activity-based overhead
rates (cost per driver).
 Study Objective 3

Identify the activity cost pools used

in activity-based costing.
 Identifying Activities
A well designed activity-based costing system starts with
an analysis of the activities performed to manufacture a
product. This analysis should identify all resource-
consuming activities.
 Atlas Company identified three activity cost pools:
setting up machines, machining, and inspecting.
 Allocating Overhead to
Cost Pools
After the activity cost pools are identified, overhead
costs are assigned directly to activity cost pools.
 Atlas Company’s activity cost pools, along with with
estimated overhead allocated to each activity cost pool are
shown below:
Atlas Company

Estimated
Activity Cost Pools Overhead
Setting up machines $300,000
Machining 500,000
Inspecting 100,000
Total $900,000

Illustration 4-6
 Study Objective 4

Identify and use the activity cost

drivers in activity-based costing.
 Identifying Cost Drivers
After costs are allocated to the activity cost pools, the cost
drivers for each activity cost pool must be identified. To
achieve accurate costing, a high degree of correlation must
exist between the activity cost driver and the actual
consumption of the activity cost pool.
 The cost drivers identified by Atlas and their total expected use
per activity cost pool are shown below:
Atlas Company
Expected Use of
Cost Drivers
Activity Cost Pools Cost Drivers per Activity
Setting up machines Number of setups 1,500 setups
Machining Machine hours 50,000 machine hours
Inspecting Number of inspections 2,000 inspections
Illustration 4-7
 Computing Overhead Rates

 Availability and ease of obtaining data

relating to the activity cost driver is an
important factor that must be considered in its
selection.
 The activity-based overhead rate is computed
as shown below:

Estimated Expected Use of


Activity-based
Overhead per
Activity
Cost Drivers per
Activity
= Overhead Rate
 Computing Overhead Rates
 Atlas Company’s computations of its activity-
based overhead rates are below:
Atlas Company

Expected Use of


Estimated Cost Drivers Activity-Based
Activity Cost Pools
Setting up machines
Overhead
$300,000
per Activity = Overhead Rates
1,500 setups $200 per setup
Machining 500,000 50,000 machine hours $10 per machine hour
Inspecting 100,000 2,000 inspections $50 per inspection
Total $900,000

Illustration 4-9
 Assigning Overhead Costs
to Products under ABC
In assigning overhead costs, it is necessary to know the
expected use of cost drivers for each product.
 Because of its low volume, The Club requires more setups and
inspection than The Boot. The expected use of cost drivers per
product is shown below:
Atlas Company

Expected Use
of Cost Drivers
Expected Use of
per Product
Cost Drivers
Activity Cost Pools Cost Drivers per Activity The Boot The Club
Setting up machines Number of setups 1,500 setups 500 1,00
Machining Machine hours 50,000 machine hours 30,000 20,000
Inspecting Number of inspections 2,000 inspections 500 1,500

Illustration 4-10
 Assigning Overhead Costs
to Products under ABC
To assign overhead costs to each product, the activity-based
overhead rates are multiplied by the number of cost drivers
expected to be used per product.
 The assignment of Atlas Company’s estimated annual
overhead cost to The Boot is shown below. Estimated
overhead assigned to The Club is shown on the next slide.
Atlas Company: The Boot
Expected Use Activity-Based
of Cost Drivers Overhead Cost
Activity Cost Pools per Product x Rates = Assigned
Setting up machines 500 $200 $100,000
Machining 30,000 $ 10 300,000
Inspecting 500 $ 50 25,000
Total assigned costs (a) $425,000
Units produced (b) 25,000
Overhead cost per unit (a)  (b) $17 Illustration 4-11a
 Assigning Overhead Costs
to Products under ABC
Atlas Company: The Club
Expected Use Activity-Based
of Cost Drivers Overhead Cost
Activity Cost Pools per Product x Rates = Assigned
Setting up machines 1,000 $200 $200,000
Machining 20,000 $ 10 200,000
Inspecting 1,500 $ 50 75,000
Total assigned costs (a) $475,000
Units produced (b) 5,000
Overhead cost per unit (a)  (b) $95
Illustration 4-11b

 These data show that under ABC, overhead

costs are shifted from the high volume product
(The Boot) to the low-volume product (The
Club).
 Assigning Overhead Costs
to Products under ABC
This shift of overhead from high to low volume
products results in more accurate costing for two
reasons:
– Low-volume products often require more special
handling, such as setups. Thus, the low-volume
product is responsible for more overhead costs per
unit than a high-volume product.
– The overhead costs incurred by the low-volume
product often are disproportionate to a traditional
allocation base such as direct labor hours.
 Comparing Unit Costs
Atlas Company

The Boot The Club

Traditional Traditional
Manufacturing Costs Costing ABC Costing ABC
Direct materials $40 $40 $30 $ 30
Direct labor 12 12 12 12
Overhead 30 17 30 95
Total cost per unit $82 $69 $72 $137

The comparison shows that unit costs under traditional

costing are significantly distorted. The cost of
producing The Boot is overstated $13 per unit and the
cost of producing The Club is understated $65 per unit.
 Comparing Unit Costs
 The differences in cost per unit are
attributable entirely to how manufacturing
overhead is assigned.
 A likely consequence of the differences is that
Atlas Company has been overpricing The
Boot and possibly losing market share to
competitors. In addition, it has been
sacrificing profitability by underpricing The
Club.
 Study Objective 5

Understand the benefits and

limitations of activity-based costing.
 Benefits of ABC
The primary benefit of ABC is more accurate
product costing because:
 ABC leads to more cost pools used to assign
overhead costs to products. Instead of one pool and
one driver, numerous activity cost pools with more
relevant cost drivers are utilized.
 ABC leads to enhanced control over overhead
costs. Many overhead costs can be traced directly to
activities. Thus, managers become more aware of
their responsibility to control the activities that
generate costs.
 Benefits of ABC
 ABC leads to better management decisions. More
accurate product costing helps in setting selling
prices and in deciding to whether make or buy
components.
Activity-based costing does not, in and of itself,
change the amount of overhead costs, but it does in
certain circumstances allocate those costs in a more
accurate manner. And, if the score-keeping is more
realistic, more accurate, and better understood,
managers should be able to better understand cost
behavior and overall profitability.
 Limitations of ABC
Although ABC systems often provide better product cost
data than traditional volume-based systems, there are
limitations.
 ABC can be expensive to use. ABC systems are more
complex than traditional costing systems. There is a
cost to identifying multiple activities and applying
numerous cost drivers.
 Some arbitrary allocations continue. Even though
more overhead costs can be assigned directly to
products, certain overhead costs remain to be allocated
by means of some arbitrary volume-based cost driver.
 When to Switch to ABC
The presence of one or more of the following factors
indicates ABC as the superior costing system:
 Product lines differ greatly in volume and
manufacturing complexity.
 Product lines are numerous, diverse, and require
differing degrees of support services.
 The manufacturing process or the number of products
has changed significantly.
 Production or marketing managers are ignoring data
provided by the existing system, and are instead using
alternative data in making decisions.
 When to Switch to ABC
The redesign and installation of a new product-
costing system is a significant decision that
requires considerable cost and a major effort to
accomplish. Therefore, financial managers need
to be very cautious and deliberative when
initiating changes in costing systems.
 Study Objective 6

Differentiate between value-added

and nonvalue-added activities.
Activity-Based Management
 Activity-based management (ABM) is an
extension of ABC from a product costing
system to a management function that focuses
on reducing costs and improving processes
and decision making.
 A refinement of activity-based costing used in
ABM is the classification of activities as
either value-added or nonvalue-added.
 Value-Added versus
Nonvalue-Added Activities
 Value-added activities increase the worth of a
product or service to customers.
 They involve resource usage and related costs
that customers are willing to pay for.
 Value-added activities are the functions of
actually manufacturing a product or service.
 Examples include engineering design,
machining, assembly, painting, and packaging.
 Value-Added versus
Nonvalue-Added Activities
 Nonvalue-added activities are production- or
service-related activities that simply add cost to,
or increase the time spent on, a product or
service without increasing its market value.
 Examples include the repair of machines,
storage of inventory, moving of materials,
maintenance, and inspections.
Identifying and labeling activities as value-added
or nonvalue-added is part of the analysis of
operations, the first step, in an ABC system.
 Value-Added versus
Nonvalue-Added Activities
 Not all activities labeled nonvalue-added are
totally wasteful, nor can they be totally
eliminated.
 For example, although inspection is a nonvalue-
added activity from a customer’s perspective,
few companies would eliminate their quality
control functions. Similarly, moving and
waiting time is nonvalue-added, but it would be
impossible to completely eliminate.
 Value-Added versus
Nonvalue-Added Activities
 Nevertheless, because managers recognize the
nonvalue-added characteristic of these
activities, they are motivated to minimize
them as much as possible.
 Attention to such matters is part of the
growing practice of activity-based
management which helps managers
concentrate on continuous improvement of
operations and activities.
 Study Objective 7

Understand the value of a hierarchy

of activity levels to activity-based
costing.
 Hierarchy of Activity Levels
The recognition that not all activity costs are driven by
output units has led to the development of a hierarchy of
ABC activities:
– Unit-level activities are performed for each unit of
production. (Ex.: materials)
– Batch-level activities are performed for each batch of
products. (Ex.: setups)
– Product-level activities are performed in support of an
entire product line. (Ex.: design)
– Facility-level activities are required to support or
sustain an entire production facility. (Ex.: security)
 Study Objective 8

Apply activity-based costing to

service industries.
 Activity-Based Costing in Service
Industries
 Although initially developed and implemented
by manufacturing companies that produce
products, ABC has been widely adopted in
service industries.
 The overall objective of ABC in service firms
is no different than it is in manufacturing
company: to identify the activities that
generate costs and to keep track of how many
of those activities are performed for each
service that is rendered.
 Activity-Based Costing in Service
Industries
 The general approach to identifying activities,
activity cost pools, and cost drivers is the
same for service and manufacturing
companies.
 Labeling activities as value-added and
nonvalue-added, and trying to reduce or
eliminate nonvalue-added activities is just as
valid in service industries.
 Activity-Based Costing in Service
Industries
 Classifying activities as unit-level, batch-
level, product-level, and facility-level also
applies to service industries.
 What sometimes makes implementation of
ABC difficult in service industries is that a
larger proportion of overhead costs are
facility-level costs that cannot be directly
traced to specific services rendered by the
company.