Activity-Based Costing: A Tool to
Aid Decision Making
Chapter Seven
8-2
Activity Based Costing (ABC)
ABC is designed to provide ABC is a
good supplement
managers with cost
to our traditional
information for strategic cost system
and other decisions that I agree!
potentially affect capacity
and therefore affect fixed
as well as variable costs.
8-3
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Manufacturing Nonmanufacturing
costs costs
Traditional ABC
product costing product costing
ABC assigns both types of costs to products.
8-4
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Manufacturing Non manufacturing
costs costs
Some
Mo
st,
not but
All
all
Traditional ABC
product costing product costing
ABC does not assign all manufacturing costs to products.
8-5
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Level of complexity
Activity–Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
Number of cost pools
ABC uses more cost pools.
8-6
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Each ABC cost pool has its
own unique measure of activity.
Traditional cost systems usually rely
on volume measures such as direct labor
hours and/or machine hours to allocate
all overhead costs to products.
ABC uses more cost pools.
8-7
How Costs are Treated Under
Activity–Based Costing
An event that causes the
Activity consumption of overhead
resources.
A “cost bucket” in which
Activity costs related to a particular
Cost Pool activity measure are
accumulated.
$$
$
$ $
$
8-8
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.
8-9
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.
8-10
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.
8-11
How Costs are Treated Under
Activity–Based Costing
Unit-Level Batch-Level
Activity Activity
Manufacturing
companies typically combine
their activities into five
classifications.
Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
8-12
Characteristics of Successful
ABC Implementations
Strong top
management support
Link to evaluations
and rewards
Cross-functional
involvement
8-13
Classic Brass – An ABC Example
Classic Brass
Income Statement
Year Ended December 31, 2005
Sales
Cost of goods sold $ 3,200,000
Direct materials $ 975,000
Direct labor 351,250
Manufacturing overhead 1,000,000 2,326,250
Gross margin 873,750
Selling and administrative expenses
Shipping expenses 65,000
Marketing expenses 300,000
General administrative expenses 510,000 875,000
Net operating income
loss $ (1,250)
Manufacturing overhead is allocated to products using
a single plantwide overhead rate based on machine hours.
8-14
Define Activities, Activity Cost Pools,
and Activity Measures
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
8-15
Define Activities, Activity Cost Pools,
and Activity Measures
• Customer Orders - assigned all costs of resources
that are consumed by taking and processing
customer orders.
• Product Designs - assigned all costs of resources
consumed by designing products.
• 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 overhead costs that are not
associated with the other cost pools.
8-16
Assign Overhead 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
Factory utilities 120,000
Factory building lease 80,000 $ 1,000,000
General Administrative Department
Administrative wages and salaries 400,000
Office equipment depreciation 50,000
Administrative building lease 60,000 510,000
Marketing Department
Marketing wages and salaries 250,000
Selling expenses 50,000 300,000
Total overhead costs $ 1,810,000
8-17
Assign Overhead 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
Factory utilities 120,000
Factory building lease 80,000 $ 1,000,000
General Administrative Department
Administrative wages and salaries 400,000
Office equipment depreciation 50,000
Administrative building lease 60,000 510,000
Marketing Department
Marketing
Direct wagesdirect
materials, and salaries 250,000 are excluded
labor, and shipping
SellingClassic
because expenses 50,000 can directly
Brass’ existing cost system 300,000
Total overhead costs $ 1,810,000
trace these costs to products or customer orders.
8-18
Assign Overhead 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%
General Administrative Department
Administrative wages 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 22% 8% 0% 60% 10% 100%
Selling expenses 10% 0% 0% 70% 20% 100%
8-19
Assign Overhead Costs
to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and Nonmanufacturing)
Production Department
Indirect
Activity Cost Pools factory wages $ 500,000
Customer Factory equipment
Product Order depreciation
Customer 300,000
Factory utilities 120,000
Orders Design Size
Factory building lease
Relations Other
80,000 $ Total
1,000,000
Production Department General Administrative Department
Indirect factory wages $ 125,000 Administrative wages and salaries 400,000
Factory equipment depreciation Office equipment depreciation 50,000
Administrative building lease 60,000 510,000
Factory utilities
Marketing Department
Factory building lease Marketing wages and salaries 250,000
General Administrative Department Selling expenses 50,000 300,000
Administrative wages and salaries Total overhead costs $ 1,810,000
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
Indirect factory wages $500,000
Percent consumed by customer orders 25%
$125,000
8-20
Assign Overhead Costs
to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and Nonmanufacturing)
Production Department
Activity Cost Pools
Indirect factory wages $ 500,000
Customer Factory equipment
Product Orderdepreciation
Customer 300,000
Factory utilities 120,000
Orders Design Size Relations Other Total
Factory building lease 80,000 $ 1,000,000
Production Department General Administrative Department
Indirect factory wages $ 125,000 Administrative wages and salaries 400,000
Factory equipment depreciation 60,000 Office equipment depreciation 50,000
Administrative building lease 60,000 510,000
Factory utilities
Marketing Department
Factory building lease Marketing wages and salaries 250,000
General Administrative Department Selling expenses 50,000 300,000
Administrative wages and salaries Total overhead costs $ 1,810,000
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
Factory
Factory equipment
equipment depreciation
depreciation $300,000
$300,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 20%
20%
$$ 60,000
60,000
8-21
Assign Overhead Costs
to Activity Cost Pools
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000 $ 200,000 $ 100,000 $ 50,000 $ 25,000 $ 500,000
Factory equipment depreciation 60,000 - 180,000 - 60,000 300,000
Factory utilities - 12,000 60,000 - 48,000 120,000
Factory building lease - - - - 80,000 80,000
General Administrative Department
Administrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000
Office equipment depreciation 15,000 - - 12,500 22,500 50,000
Administrative building lease - - - - 60,000 60,000
Marketing Department
Marketing wages and salaries 55,000 20,000 - 150,000 25,000 250,000
Selling expenses 5,000 - - 35,000 10,000 50,000
Total $ 320,000 $ 252,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000
8-22
Calculate Activity Rates
The ABC team determines that Classic Brass will have these
total activities for each activity cost pool . . .
1,000 customer orders,
400 new designs,
20,000 machine-hours,
250 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.
8-23
Calculate Activity Rates
Co m p u t a t io n o f Ac t iv it y Ra t e s
(a) (b) (a) ÷ (b)
Activity Cost Pools Total Cost Total Activity Activity Rate
Customer orders $ 320,000 1,000 orders $320 per order
Product design 252,000 400 designs $630 per design
Order size 380,000 20,000 MHs $19 per MH
Customer relations 367,500 250 customer $1,470 per customer
Other 490,500 Not applicable Not applicable
8-24
Activity-Based Costing at Classic Brass
Direct Direct Shipping
Overhead Costs
Materials Labor Costs
Traced Traced Traced
Cost Objects:
Products, Customer Orders, Customers
8-25
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, Customer Orders, Customers
8-26
Activity-Based Costing at Classic Brass
Direct Direct Shipping
Overhead Costs
Materials Labor Costs
First-Stage Allocation
Customer Product Order Customer
Other
Orders Design Size Relations
Second-Stage Allocations
$/Order $/Design $/MH $/Customer
Cost Objects:
Unallocated
Products, Customer Orders, Customers
8-27
Assigning Overhead to Products
Classic Brass Information
Standard Stanchions
1. Requires no new design resources.
2. 30,000 units ordered with 600 separate orders.
3. Each stanchion requires 35 minutes of machine
time for a total of 17,500 machine-hours.
Custom Compass Housing
1. Requires new design resources.
2. 400 separate orders.
3. 400 custom designs prepared.
4. 1,250 compass housings produced, requiring 2
machine-hours each for a total of 2,500 machine-hours.
8-28
Assigning Overhead to Products
Ov e rh e a d Co s t fo r th e S ta n d a rd S ta n c h io n s
(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 320 600 $ 192,000
Product design 630 0 -
Order size 19 17500 332,500
Total $ 524,500
Ov e rh e a d Co s t fo r th e Cu s to m Ho u s in g
(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 320 400 $ 128,000
Product design 630 400 252,000
Order size 19 2500 47,500
Total $ 427,500
8-29
Assigning Overhead to Customers
Let’s take a look at how Classic Brass system works for just
one of the 250 customers – Windward Yachts who placed
a total of three orders.
Orders
1. Two orders for 150 standard stanchions per order.
2. One order for a custom compass housing.
Machine-hours
1. The 300 standard stanchions required 175 machine-hours.
2. The custom compass housing required 2 machine hours.
8-30
Assigning Overhead to Customers
Ove rhe ad Co s t fo r Winward Yac hts
(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 320 3 $ 960
Product design 630 1 630
Order size 19 177 3,363
Customer relations 1,470 1 1,470
Total $ 6,423
8-31
Prepare Management Reports
Product Margin Calculations
The first step in computing product margins is to
gather each product’s sales and direct cost data.
Custom
Standard Compass
Stanchions Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Direct costs
Direct material 905,500 69,500 975,000
Direct labor 263,750 87,500 351,250
Shipping 60,000 5,000 65,000
8-32
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.
Custom
Standard Compass
Stanchions Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Direct costs
Direct material 905,500 69,500 975,000
Direct labor 263,750 87,500 351,250
Shipping 60,000 5,000 65,000
ABC cost assignments
Customer orders 192,000 128,000 320,000
Product design 252,000 252,000
Order size 332,500 47,500 380,000
8-33
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.
Custom
Standard Stanchions Compass Housings
Sales $ 2,660,000 $ 540,000
Costs
Direct material $ 905,500 $ 69,500
Direct labor 263,750 87,500
Shipping 60,000 5,000
Customer orders 192,000 128,000
Product design 252,000
Order size 332,500 47,500
Total cost 1,753,750 589,500
Product margin $ 906,250 (49,500)
8-34
Prepare Management Reports
Product Margin Calculations
The product margins can be reconciled with
the company’s net operating income as follows:
Custom
Standard Compass
Stanchions Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Total costs 1,753,750 589,500 2,343,250
Product margins $ 906,250 $ (49,500) $ 856,750
Less costs not assigned to products:
Customer relations 367,500
Other 490,500
Total 858,000
Nett operating income
loss $ (1,250)
8-35
Prepare Management Reports
Customer Profitability Analysis
The first step in computing Windward Yachts’ customer margin
is to gather its sales and direct cost data.
Windward
Yachts
Sales $ 11,350
Direct costs
Direct material 2,123
Direct labor 1,900
Shipping 205
8-36
Prepare Management Reports
Customer Profitability Analysis
The second step is to incorporate Windward Yachts’ previously
computed activity-based cost assignments.
Windward
Yachts
Sales $ 11,350
Direct costs
Direct material 2,123
Direct labor 1,900
Shipping 205
ABC cost assignments
Customer orders 960
Product design 630
Order size 3,363
Customer relations 1,470
8-37
Prepare Management Reports
Customer Profitability Analysis
The third step is to compute Windward Yachts’ customer
margin ($699) by deducting all its direct and indirect costs
from its sales.
Windward Yachts
Sales $ 11,350
Direct costs
Direct material $ 2,123
Direct labor 1,900
Shipping 205
Customer orders 960
Product design 630
Order size 3,363
Customer relations 1,470 10,651
Customer margin $ 699
8-38
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.
Custom
Standard Compass
Stanchions Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Direct costs
Direct material 905,500 69,500 975,000
Direct labor 263,750 87,500 351,250
8-39
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 Classic Brass
Production Department
Indirect factory wages $ 500,000
Factory equipment depreciation 300,000
Factory utilities 120,000
Factory building lease 80,000
Total manufacturing overhead $ 1,000,000
Plantwide manufacturing $1,000,000
= = $50 per machine-hour
overhead rate 20,000 MH
Machine-hours
Standard Stanchions 17,500
Custom compass Housings 2,500
Total machine-hours 20,000
8-40
Product Margins Computed Using
the Traditional Cost System
The third step in computing product margins is
allocate manufacturing overhead to each product.
Machine Overhead Overhead
Hours Rate Allocated
Standard Stanchions 17,500 $ 50.00 $ 875,000
Custom Compass Housings 2,500 50.00 125,000
Total overhead allocated to products $ 1,000,000
17,500 hours × $50 per hour = $875,000
8-41
Product Margins Computed Using
the Traditional Cost System
The fourth step is to actually
compute the product margins.
Custom
Standard Stanchions Compass Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Cost of goods sold
Direct materials $ 905,500 $ 69,500 $ 975,000
Direct labor 263,750 87,500 351,250
Manufacturing overhead 875,000 2,044,250 125,000 282,000 1,000,000 2,326,250
Product margin $ 615,750 258,000 873,750
Selling and administrative 875,000
Nett operating
operating income
loss $ (1,250)
Shipping expenses $ 65,000
Marketing expenses 300,000
General administrative expenses 510,000
$ 875,000
8-42
The Differences Between ABC
and Traditional Product Costs
Standard Custom
Stanchions Compass Housings
Product margins – traditional $ 615,750 $ 258,000
Product margins – ABC 906,250 (49,500)
Change in reported margins $ 290,500 $ (307,500)
The traditional cost The traditional cost
system overcosts the system undercosts the
standard stanchions custom compass
and reports a lower housings and reports
product margin a higher product
for this product. margin for this product.
8-43
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.
8-44
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.
8-45
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.
8-46
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 can be used to compare activity cost
information with world-class standards of
performance achieved by other organizations.
8-47
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.
8-48
ABC Limitations
Substantial resources Resistance to
required to implement unfamiliar numbers
and maintain. and reports.
Desire to fully Potential
allocate all costs misinterpretation of
to products. unfamiliar numbers.
Does not conform to
GAAP. Two costing
systems may be needed.
8-49
End of Chapter 8
