Topic 6

Activity-Based Costing and Management,

Product and Customer Profitability

PwC Conversion Programme 2021

Instructor: Nadia Chou
 ACTIVITY–BASED COSTING (ABC)

ABC is a
good supplement to
ABC is designed to provide our traditional cost
managers with cost information system.
I agree!
for strategic and other decisions
that potentially affect capacity
and therefore affect “fixed”
as well as variable costs.
 OVERVIEW
NO direct costs in Activity based
costing
Traditional Costing ABC Costing

Manufacturing Costs = Product Costs

Photo credit: https://www.principlesofaccounting.com/chapter-20/activity-based-costing/

 HOW COSTS ARE TREATED UNDER
ACTIVITY–BASED COSTING
ABC differs from absorption (traditional) costing in three ways.

Manufacturing Nonmanufacturing
costs costs

Absorption ABC
product costing product costing

ΠABC assigns both types of costs to products.

 HOW COSTS ARE TREATED UNDER
ACTIVITY–BASED COSTING
ABC differs from absorption (traditional) costing in three ways.

Manufacturing Nonmanufacturing
costs costs
Mos

Some
All t, bu
not t
all

Absorption ABC
product costing product costing

 ABC does not assign all manufacturing costs to products.

 HOW COSTS ARE TREATED UNDER
ACTIVITY–BASED COSTING
ABC differs from absorption (traditional) costing in three ways.

Level of complexity
Activity–Based
Costing

Departmental
Overhead
Rates
Plantwide
Overhead
Rate

Number of cost pools

Ž ABC uses more cost pools.
 HOW COSTS ARE TREATED UNDER
ACTIVITY–BASED COSTING
ABC differs from absorption (traditional) costing in three ways.

Each ABC cost pool has its

own unique measure of activity.

Traditional absorption costing systems usually

rely on volume measures such as direct labor
hours and/or machine hours to allocate
all overhead costs to products.

Ž ABC uses more cost pools.

 HOW COSTS ARE TREATED UNDER
ACTIVITY–BASED COSTING
E.g. Product Design, Machine set up,
customer service are all in activity. An event that causes the
Activity consumption of overhead
resources.

A “cost bucket” in which costs

Activity Cost
related to a single activity
Pool measure are accumulated.
$$
$
$ $
$
 HOW COSTS ARE TREATED UNDER
ACTIVITY–BASED COSTING
The term cost driver is
Activity
also used to refer to an
Measure
activity measure.

An allocation base
in an activity-based
costing system.
If the activity is Machine Setup, then the COST
DRIVER would be : No. of Setups

Or if the activity is customer service, then the COST

DRIVER would be : No. of Customers
 HOW COSTS ARE TREATED UNDER
ACTIVITY–BASED COSTING
Two common types of activity measures:

Transaction Duration
driver driver

Simple count A measure

of the number of of the amount
times an activity of time needed
occurs. for an activity.
 HOW COSTS ARE TREATED UNDER
ACTIVITY–BASED COSTING

ABC defines
five levels of activity
that largely do not relate
to the volume of units
produced.

Traditional cost systems usually rely on volume

measures such as direct labor hours and/or machine
hours to allocate all overhead costs to products.
 Organisation sustain level of costs are ALWAYS
COMMON COSTS
HOW COSTS ARE TREATED UNDER
ACTIVITY–BASED COSTING Organization-
sustaining
E.g. building depreciation, property taxes, plant security, E.g. IT support, sales
insurance, accounting, outside landscape and maintenance calls, and catalogue
Customer-level emailing to customers
Manufacturing
E.g. product design
companies typically combine Product-level changes, advertising,
maintaining a product
their activities into five One type of product only
manager
classifications. Batch-level
As we go up the level, we No matter how many units, you only have to use setup ONCE
do it regardless of what the E.g. purchase orders, machine
lower level does. setup, and quality tests

E.g. We have to design a

product regardless how Unit-level
many BATCHES or UNITS E.g. costs of direct materials,
we have to produce.
and direct labour
 QUICK CHECK
Classify each of the following activities occur at a company that manufacturers a variety of products:

1. Receive raw materials from suppliers. Batch Level

2. Do rough cutting work on each product. Unit Level

3. Interview and process new employees in the personnel department. Organisational-Sustaining

4. Design new products. Product Level

5. Perform periodic preventive maintenance on equipment. Organisational-Sustaining

6. Light and heat the company’s production facility. Organisational-Sustaining

7. Issue purchase orders for a job. Batch Level

8. Visit customers periodically to keep them informed about the

products by the sales representatives Customer Level
 CHARACTERISTICS OF SUCCESSFUL ABC
IMPLEMENTATIONS

Strong top
management support
Link to evaluations
and rewards

Cross-functional
involvement
 THE FIVE STEPS FOR IMPLEMENTING ABC
Baxter Battery Company
Income Statement
Year Ended December 31, 2013

Revenue $ 50,000,000
Cost of goods sold
Direct materials $ 15,000,000
Direct labor 12,000,000
Manufacturing overhead 14,000,000 41,000,000
Gross margin 9,000,000
Selling and administrative expenses
Shipping expenses 3,000,000
Marketing expenses 2,000,000
General administrative expenses 6,000,000 11,000,000
Net operating
operatingincome
loss $ (2,000,000)

The company makes two types of automobile batteries—SureStart (a standard

battery) and LongLife (a deluxe battery). Baxter reported its first loss ever.
ΠDEFINE ACTIVITIES, ACTIVITY COST POOLS,
AND ACTIVITY MEASURES
At Baxter Battery, the ABC team, selected the following
activity cost pools and activity measures:

Other: Organisational-sustaining costs

 ΠDEFINE ACTIVITIES, ACTIVITY COST POOLS,
AND ACTIVITY MEASURES
• Customer orders - assigned all costs of resources that are consumed by
taking and processing customer orders.
• Design changes - assigned all costs of resources consumed by customer
requested design changes.
• Order size - assigned all costs of resources consumed as a consequence
of the number of units produced.
• Customer relations – assigned all costs associated with maintaining
relations with customers.
• Other – assigned all organization-sustaining costs and unused capacity
costs
 ASSIGN OVERHEAD COSTS TO ACTIVITY COST
POOLS
 ASSIGN OVERHEAD COSTS TO ACTIVITY COST
POOLS
No need to allocate
Direct Costs, only
Indirect Costs

Direct materials,
direct labor, and
shipping are
excluded
because Baxter
Battery’s 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 factory wages $6,000,000

Percent consumed by customer orders 30%
$1,800,000
 ASSIGN OVERHEAD COSTS TO ACTIVITY COST
POOLS

Factory equipment depreciation $3,500,000

Percent consumed by customer orders 20%
$ 700,000
 ASSIGN OVERHEAD COSTS TO ACTIVITY COST
POOLS
 Ž 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 the team can compute the individual activity
rates by dividing the total cost for each activity by
the total activity levels.
 Ž CALCULATE ACTIVITY RATES

These are organization-sustaining costs and will

not be assigned to products or customers.
ACTIVITY–BASED COSTING AT BAXTER
BATTERY
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

Traced Traced Traced

Cost Objects:
Products, Customer Orders, Customers
ACTIVITY–BASED COSTING AT BAXTER
BATTERY
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Design Order Customer

Other
Orders Changes Size Relations

Cost Objects:
Products, Customer Orders, Customers
ACTIVITY–BASED COSTING AT BAXTER
BATTERY
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Design Order Customer

Other
Orders Changes Size Relations

Second-Stage Allocations

$/Order $/Change $/MH $/Customer

Cost Objects:
Unallocated
Products, Customer Orders, Customers
  ASSIGNING OVERHEAD TO PRODUCTS
Baxter Battery Information
SureStart
1. Requires no new design resources.
2. 800,000 batteries ordered with 4,000 separate orders.
3. Each SureStart requires 36 minutes of machine
time for a total of 480,000 machine-hours.

LongLife
1. Requires new design resources.
2. 400,000 batteries ordered with 6,000 separate orders.
3. 4,000 custom designs prepared.
4. Each LongLife requires 48 minutes of machine
time for a total of 320,000 machine-hours.
 ASSIGNING OVERHEAD TO PRODUCTS
These are only the
overhead (OH) costs
assigned to each type of
product.

Remember! Product cost

should include not only
the OH but also all the
direct costs such as direct
material and direct
labour.
 ASSIGNING OVERHEAD TO CUSTOMERS
Let’s take a look at how Baxter Battery’s system works for just one
of the 2,000 customers – Shaw Auto Parts who placed a total of
twelve orders. Note that the four orders for LongLifes required a
design change.

Orders
1. Eight orders for 60 SureStarts per order. Total = 8 x 60 = 480
2. Four orders for 50 LongLifes per order. Total = 4 x 50 = 200

Machine-hours
1. The 480 SureStarts required 288 machine-hours.
2. The 200 LongLifes required 160 machine-hours.
ASSIGNING OVERHEAD TO CUSTOMERS
  PREPARE MANAGEMENT REPORTS
Product Margin Calculations
The first step in computing product margins is to
gather each product’s sales and direct cost data.

SureStarts LongLifes Total

Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Direct costs
Direct material 9,000,000 6,000,000 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000
Shipping 2,000,000 1,000,000 3,000,000

Sales (31.3M) - All Product Costs (Direct

Material + Direct Labour + Shipping)
  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.

SureStarts LongLifes Total

Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Direct costs
Direct material 9,000,000 6,000,000 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000
Shipping 2,000,000 1,000,000 3,000,000
ABC cost assignments
Customer orders 1,808,000 2,712,000 4,520,000
Design changes 3,040,000 3,040,000
Order size 3,120,000 2,080,000 5,200,000
  PREPARE MANAGEMENT REPORTS
Product Margin Calculations
The third step in computing product
margins is to deduct each product’s
direct and indirect costs from sales.
SureStarts LongLifes
Sales $ 31,300,000 $ 18,700,000
Costs
Direct material $ 9,000,000 $ 6,000,000
Direct labor 7,000,000 5,000,000
Shipping 2,000,000 1,000,000
Customer orders 1,808,000 2,712,000
Design changes 3,040,000
Order size 3,120,000 2,080,000
Total cost 22,928,000 19,832,000
Product margin $ 8,372,000 $ (1,132,000)
  PREPARE MANAGEMENT REPORTS
Product Margin Calculations
The product margins can be reconciled with
the company’s net operating loss as follows:

SureStarts LongLifes Total

Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Total costs 22,928,000 19,832,000 42,760,000
Product margins $ 8,372,000 $ (1,132,000) $ 7,240,000

Less costs not assigned to products:

Customer relations 3,080,000
Other 6,160,000
Total 9,240,000
Nett operating income
loss $ (2,000,000)
  PREPARE MANAGEMENT REPORTS
Customer Margin (Profitability) Analysis
The first step in computing Shaw Auto Parts’ customer margin is
to gather its sales and direct cost data.

Shaw Auto
Parts
Sales $ 29,200
Direct costs
Direct material 7,500
Direct labor 6,700
Shipping 1,700
  PREPARE MANAGEMENT REPORTS
Customer Margin (Profitability) Analysis
The second step is to incorporate Shaw Auto Parts’ previously
computed activity-based cost assignments.
Shaw Auto
Parts
Sales $ 29,200
Direct costs
Direct material 7,500
Direct labor 6,700
Shipping 1,700
ABC cost assignments
Customer orders 5,424
Product design 3,040
Order size 2,912
Customer relations 1,540
  PREPARE MANAGEMENT REPORTS
Customer Margin (Profitability) Analysis
The third step is to compute Shaw Auto Parts’ customer margin of $384
by deducting all its direct and indirect costs from its sales.
Shaw Auto Parts
Sales $ 29,200
Direct costs
Direct material $ 7,500
Direct labor 6,700
Shipping 1,700
Customer orders 5,424
Product design 3,040
Order size 2,912
Customer relations 1,540 28,816
Customer margin $ 384
PRODUCT MARGINS COMPUTED USING THE
TRADITIONAL COST SYSTEM
The first step in computing product margins is to
gather each product’s sales and direct cost data.

SureStarts LongLifes Total

Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Direct costs
Direct material 9,000,000 6,000,000 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000
 PRODUCT MARGINS COMPUTED USING THE
TRADITIONAL COST SYSTEM
The second step in computing product margins is to compute
the plantwide overhead rate.
Manufacturing Overhead Costs at Baxter Battery
Production Department
Indirect factory wages $ 6,000,000
Factory equipment depreciation 3,500,000
Factory utilities 2,500,000
Factory building lease 2,000,000
Total manufacturing overhead $ 14,000,000
Predetermined Overhead Rate
Plantwide manufacturing $14,000,000 (POHR)
= = $17.50 per machine-hour
overhead rate 800,000 MH

Machine-hours
SureStarts (800,000 @ 0.60 hours) 480,000
LongLifes (400,000 @ 0.80 hours) 320,000
Total machine-hours 800,000
PRODUCT MARGINS COMPUTED USING THE
TRADITIONAL COST SYSTEM
The third step in computing product margins is to
allocate manufacturing overhead to each product.

Machine Overhead Overhead

Hours Rate Allocated
SureStarts 480,000 $ 17.50 $ 8,400,000
LongLifes 320,000 17.50 5,600,000
Total overhead allocated to products $ 14,000,000

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.

SureStarts LongLifes Total

Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Cost of goods sold
Direct materials $ 9,000,000 $ 6,000,000 $ 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000
Manufacturing overhead 8,400,000 24,400,000 5,600,000 16,600,000 14,000,000 41,000,000
Product margin $ 6,900,000 2,100,000 9,000,000
Selling and administrative 11,000,000
Nett operating
operating income
loss $ (2,000,000)

Shipping expenses $ 3,000,000

Marketing expenses 2,000,000
General administrative expenses 6,000,000
$ 11,000,000
DIFFERENCES BETWEEN ABC AND TRADITIONAL
PRODUCT COSTS

SureStarts LongLifes
Product margins – traditional $ 6,900,000 $ 2,100,000
Product margins – ABC 8,372,000 (1,132,000)
Change in reported margins $ 1,472,000 $ (3,232,000)

The traditional cost The traditional cost

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

ŒTraditional 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
uses both volume-related and 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.

Ž 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.
 ACTIVITY-BASED MANAGEMENT
• Activity-based management (ABM) is to use activity-based costing to identify
activities that would benefit from process improvements.
• ABC activity rates can also provide valuable clues concerning where there is
waste and the opportunity for improvement.
• ABM involves focusing on activities to eliminate waste, decrease processing time,
and reduce defects.
• ABM seeks to eliminate or reduce nonvalue-added activities and to create new
value added activities.
• ABM is used in organizations as diverse as manufacturing companies, hospitals,
banks, government departments, etc.
 ACTIVITY-BASED MANAGEMENT:
PROCESS MANAGEMENT

A business process is a series of steps that are followed in

order to carry out some task in a business.

R&D Product Manufactur Marketing Distribution Customer

Design -ing Service

Business functions making up the

value chain
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.
 Substantial resources required to implement and maintain.

Resistance to unfamiliar numbers and reports.

Potential misinterpretation of unfamiliar numbers.

Limitations Desire to fully allocate all costs to products.

Does not conform to GAAP. Two costing systems may be

needed.
Exercise 7-13 on Page 338

Exercise 7-18 on Page 341, 342

Additional Exercises

Ex.7-5
Ex.7-15
Prob.7-16