ABC

Activity Based Costing:

A Tool to Aid Decision Making
Activity Based Costing (ABC)

ABC is designed to ABC is a

good supplement
provide managers to our traditional
with cost cost system
I agree!
information for
strategic and other
decisions that
potentially affect
capacity and
therefore “fixed”
costs.
Activity Based Costing (ABC)

Both
Both manufacturing
manufacturing AA number
number
and
and nonmanufacturing
nonmanufacturing of
of cost
cost pools
pools each
each
costs
costs may
may be
be allocated
allocated toto aa product
product
assigned
assigned to
to or
or cost
cost object.
object.
products.
products.
Some
Some manufacturing
manufacturing
costs
costs may
may be
be excluded
excluded
from
from product
product
costs.
costs.

Allocation
Allocation bases
bases often
often Overhead
Overhead rates
rates may
may
differ
differ from
from be
be based
based on
on activity
activity
traditional
traditional costing
costing at
at capacity.
capacity.
systems.
systems.
How Costs are Treated Under
Activity-Based Costing
Activity
Activity Based
Based
Costing
Costing

Departmental
Departmental
Overhead
Overhead
i ty
Rates
Rates ex
pl
o m
Plantwide
Plantwide f C
l o
Overhead
Overhead ve
Rate
Rate Le
Overhead Allocation
 Plantwide Overhead Rate

Companies tended to use direct labor as

the overhead allocation base. There was a
belief that direct labor and overhead
costs were highly correlated.
Departmental Overhead Rates

Finishing Department
Many
Many companies
companies have
have aa system
system
Painting Department in
in which
which each
each department
department has
has
its
its own
own overhead
overhead rate.
rate.
Shipping Department
 Departmental Overhead Rates
Indirect Indirect Other
Labor Materials Overhead
Stage One:
Costs assigned
to pools
Department Department Department
Cost pools
1 2 3
 Departmental Overhead Rates
Indirect Indirect Other
Labor Materials Overhead
Stage One:
Costs assigned
to pools
Department Department Department
Cost pools
1 2 3

Stage Two:
Costs applied
to products
Products
 Departmental Overhead Rates
Indirect Indirect Other
Labor Materials Overhead
Stage One:
Costs assigned
to pools
Department Department Department
Cost pools
1 2 3
Direct Machine Raw
Stage Two: Labor Hours Materials
Costs applied Hours Cost
to products
Products

Departmental Allocation Bases

 Cost of Idle Capacity

Traditional
Traditional Cost
Cost Activity
Activity Based
Based
Accounting
Accounting Costing
Costing
The
The predetermined
predetermined Products
Products are
are charged
charged forfor
overhead
overhead rate
rate is
is based
based the
the costs
costs of
of capacity
capacity
on
on budgeted
budgeted activity.
activity. they
they use
use –– not
not for
for the
the
This
This results
results in
in applying
applying costs
costs of
of capacity
capacity they
they
overhead
overhead costs
costs of
of don’t
don’t use.
use.
unused,
unused, oror idle,
idle,
capacity.
capacity.
Designing an ABC System

Cost Objects
(e.g., products Activities
and customers)

Consumption
of Resources

Cost
 Designing of 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.
 Identify and Define Activities
and Activity Cost Pools
Unit-Level Batch-Level
Activity Activity

A part of the production

process for which management
wants a separate reporting of the
costs of the activity involved.

Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
 Identify and Define Activities
and Activity Cost Pools
At Classic Brass, the ABC team, selected the following
activity cost pools and activity measures:
Activity Cost Pools at Classic Brass
Activity Cost Pool Activity Measure
Customer orders Number of customer orders
Product design Number of product designs
Order size Machine-hours
Customer relations Number of active customers
Other Not applicable
Identify and Define Activities
and Activity Cost Pools

Activity Cost $$
Pool is a “bucket” $
in which costs are $ $
$
accumulated that
relate to a single
activity measure
in the ABC
system.
Identify and Define Activities
and Activity Cost Pools
Customer
Customer Orders
Orders -- assigned
assigned allall costs
costs ofof resources
resources
that
that are
are consumed
consumed by by taking
taking and
and processing
processing
customer
customer orders.
orders.
Product
Product Designs
Designs -- assigned
assigned allall costs
costs ofof resources
resources
consumed
consumed by by designing
designing products.
products.
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 allall costs
costs associated
associated
with
with maintaining
maintaining relations
relations with
with customers.
customers.
Other
Other –– assigned
assigned all
all overhead
overhead costs
costs that
that are
are not
not
associated
associated with
with the
the other
other cost
cost pools.
pools.
 Whenever Possible, Directly Trace
Overhead Costs to Activities and Cost Objects
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Production Department
Indirect factory wages $ 500,000
Factory equipment depreciation 300,000
Factory utilities 120,000
Factory building lease 80,000 $
Shipping costs traced to customer orders
General Administrative Department
Administrative wages and salaries 400,000
Office equipment depreciation 50,000
Administrative building lease 60,000
Marketing Department
 Assign Costs to Activity Cost Pools
At Classic Brass the following distribution of resource
consumption across activity cost pools is determined.
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages 25% 40% 20% 10% 5% 100%
Factory equipment depreciation 20% 0% 60% 0% 20% 100%
Factory utilities 0% 10% 50% 0% 40% 100%
Factory building lease 0% 0% 0% 0% 100% 100%
Shipping costs **
General Administrative Department
Administrative w ages and salaries 15% 5% 10% 30% 40% 100%
Office equipment depreciation 30% 0% 0% 25% 45% 100%
Administrative building lease 0% 0% 0% 0% 100% 100%
Marketing Department
Marketing wages and salaries 20% 10% 0% 60% 10% 100%
Selling expenses 10% 0% 0% 70% 20% 100%

**Not included because they are directly traced to customer orders.

 Assign Costs to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Production Department
Indirect factory wages $ 500,000
Factory equipment depreciation 300,000
Activity Cost Pools
Factory utilities 120,000
Customer Product
Factory building lease
Shipping costs traced to customer orders
Order
80,000 $
Customer
1,000,000
40,000
Orders Design
General Administrative Department
Administrative wages and salaries
Size
400,000
Relations
Production Department Office equipment depreciation
50,000
Administrative building lease
60,000 510,000
Indirect factory wages $ 125,000
Marketing Department
Marketing wages and salaries
250,000
Factory equipment depreciation Selling expenses 50,000 300,000
Total overhead costs $ 1,850,000
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Indirect
Indirect factory
Marketing wages and salaries factory wages
wages $500,000
$500,000
Selling expenses Percent
Percent consumed
consumed by by customer
customer orders
orders 25%
25%
Total $125,000
$125,000 $125,000
 Assign Costs to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Production Department
Indirect factory wages $ 500,000
Factory equipment depreciation 300,000
Activity Cost Pools
Factory utilities 120,000
Customer Product
Factory building lease
Shipping costs traced to customer orders
Order
80,000 $
Customer
1,000,000
40,000
Orders Design
General Administrative Department
Administrative wages and salaries
Size
400,000
Relations
Production Department Office equipment depreciation
50,000
Administrative building lease
60,000 510,000
Indirect factory wages $ 125,000
Marketing Department
Marketing wages and salaries
250,000
Factory equipment depreciation 60,000
Selling expenses50,000 300,000
Total overhead costs $ 1,850,000
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Factory
Factory equipment
Marketing wages and salaries equipment depreciation
depreciation $300,000
$300,000
Selling expenses Percent
Percent consumed
consumed byby customer
customer orders
orders 20%
20%
Total $$ 60,000
60,000 $ 60,000
 Assign Costs to Activity Cost Pools

Activity Cost Pools

Customer Product Order Customer
Orders Design Size Relations
Production Department
Indirect factory wages $ 125,000 $ 200,000 $ 100,000 $ 50,000 $
Factory equipment depreciation 60,000 - 180,000 -
Factory utilities - 12,000 60,000 -
Factory building lease - - - -
General Administrative Department
Administrative wages and salaries 60,000 20,000 40,000 120,000
Office equipment depreciation 15,000 - - 12,500
Administrative building lease - - - -
Marketing Department
Marketing wages and salaries 50,000 25,000 - 150,000
Selling expenses 5,000 - - 35,000
Total $ 315,000 $ 257,000 $ 380,000 $ 367,500 $
 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.
 Calculate Activity Rates

Computation of Activity Rates

(a) (b) (a)÷ (b)
Activity Cost Pools Total Cost Total Activity Activity Rate
Customer orders $ 315,000 1,000 orders $315 per order
Product design 257,000 200 designs $1,285 per design
Order size 380,000 20,000 MHs $19 per MH
Customer relations 367,500 100 customer $3,675 per customer
Other 490,500 Not applicable Not applicable
Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

Traced
Traced Traced
Traced Traced

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

Cost Objects:
Unallocated
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
 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.
 Assigning Costs to Cost Objects
Overhead Cost for the Standard Stanchions
(a) (b) (a) (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 315 2 $ 630
Product design 1,285 0 -
Order size 19 200 3,800
Customer relations 3,675 N/A

Overhead Cost for the Custom Housing

The customer-level (a) (b) (a) (b)
Activity Cost Pools Activity Rate Activity ABC Cost
cost is assigned to Customer orders $ 315 1 $ 315
Product design 1,285 1 1,285
customers directly; Order size 19 4 76

it is not assigned to Customer relations 3,675 N/A

products.
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 $
Cost:
Direct materials $ 13
Direct labor 50
Shipping costs 25
Customer orders 315
Product design 1,285
Order size 76
Prepare Management Reports

Customer Profitability Analysis

Windward Yachts
Product margins:
Standard stanchion $ 5,030
Custom compass housing (1,114
Total product margin 3,916
Less: Customer relations 3,675
Customer margin $ 241
 Product Margins
Traditional Cost Accounting System
Standard Compass
Stanchions Housing
Sales $ 13,600 $ 650
Costs
Direct materials (2,110) (13)
Direct labor (1,850) (50)
Manufacturing overhead (10,000) (200)
Product margin $ (360) $ 387

400
400 units
units xx 0.5
0.5 MH/unit
MH/unit xx $50/MH
$50/MH == $10,000
$10,000

Predetermined manufacturing $1,000,000

= = $50/MH
overhead rate 20,000 MH
 Difference Between ABC and
Traditional Product Costs

Batch-level
Batch-level or or product-
product- Under
Under ABC
ABC both
both
level
level costs
costs will
will manufacturing
manufacturing and and
ordinarily
ordinarily shift
shift nonmanufacturing
nonmanufacturing
overhead
overhead costscosts from
from costs
costs may
may be be
high-volume
high-volume assigned
assigned toto products.
products.
products
products produced
produced Organization-
Organization-
in
in large
large batches
batches to to sustaining
sustaining costs
costs andand
low-volume
low-volume products
products the
the costs
costs ofof idle
idle
produced
produced in in small
small capacity
capacity are
are notnot
batches.
batches. assigned
assigned toto products.
products.
 Targeting Process Improvement

Activity-based costing can be

used to identify areas that would
benefit from process
improvements.

The theory of constraints

approach is a powerful tool for
targeting the area in an
organization whose improvement
will yield the greatest benefits.
 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.
 Limitations of ABC

ABC produces
numbers, like product
ABC systems are a
margins, that are at
major project requiring
odds with numbers
substantial resources.
produced by traditional
The benefits of
costing system. Some
increased accuracy
managers find it
must outweigh these
difficult to adjust to this
additional costs.
change.

ABC data can be misinterpreted and must

be used with care when making decisions.
The End