CHAPTER 3

Activity Based Costing (ABC)

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 Introduction
• Activity based costing ABC is a method for assigning costs to products,
services projects, tasks, or acquisitions, based on:
– Activities that go into them.

– Resources consumed by these activities.

• In ABC, the "indirect" or "overhead" cost contributors are viewed as

"activity pools."
• Under activity based costing, an activity pool is the set of all activities
required to complete a task, such as (a) process purchase orders, or (2)
perform machine set ups etc.

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 Introduction
• In order to "cost" activity pools, ABC identifies
activity units that are cost drivers for each pool. The
total costs for the activity pool "process purchase
orders," for instance, is driven by the number of
purchase orders processed, while the total cost for
activity pool "perform machine set ups" is driven by
the number of set ups.
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 Introduction
• Activity-based costing (ABC) refines a costing system by identifying
individual activities as the fundamental cost objects.
• An activity is an event, task, or unit of work with a specified purpose for
example, designing products, setting up machines, operating machines,
and distributing products.
• ABC systems identify activities in all functions of the value chain,
calculate costs of individual activities, and assign costs to cost objects
such as products and services on the basis of the mix of activities needed
to produce each product or service.

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 Cost Hierarchy
• A cost hierarchy categorizes various activity cost pools on the
basis of the different types of cost drivers, or cost-allocation
bases, or different degrees of difficulty in determining cause-
and-effect (or benefits-received) relationships.
• ABC systems commonly use a cost hierarchy with four levels—
– Output unit-level costs,
– Batch-level costs,
– Product-sustaining costs, and
– Facility-sustaining

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 1. Output Unit-level

• Output unit-level costs are the costs of activities

performed on each individual unit of a product or
service. Machine operations costs (such as the
cost of energy, machine depreciation, and repair)
related to the activity of running the automated
molding machines are output unit-level costs.
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 2. Batch – Level Costs
• Batch-level costs are the costs of activities related to a
group of units of a product or service rather than each
individual unit of product or service.
• Example, setup costs are batch-level costs because, over
time, the cost of this setup activity increases with setup-
hours needed to produce batches (groups) of lenses.

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 3. Product-sustaining costs

• Product-sustaining costs (service-sustaining costs)

are the costs of activities undertaken to support
individual products or services regardless of the
number of units or batches in which the units are
produced.

• Example, design costs are product-sustaining costs

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 4. Facility-sustaining costs
• Facility-sustaining costs are the costs of activities that
cannot be traced to individual products or services but
that support the organization as a whole.
• Example: the general administration costs (including
top management compensation, rent, and building
security) are facility-sustaining costs.

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Traditional Costing Accounting(TCA) Vs ABC

• ABC contrasts with traditional costing (cost accounting), which

sometimes assigns costs using somewhat arbitrary allocation
percentages for overhead or the so-called indirect costs.
• As a result, ABC and traditional cost accounting can estimate cost of
goods sold and gross margin very differently for individual products.
• Contradictory and uncertain cost estimates can be a problem when
management needs to know exactly which products are profitable and
which are selling at a loss.

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 TCA Vs ABC
• For example, consider a firm that manufactures automobile parts through a sequence
of machine operations on metal stock.
• In such settings, traditional accounting views product production costs as either
direct costs (Direct Material and Labor ) or indirect costs (or overhead) which might
include:
– Materials purchase order costs.
– Machine set up costs.
– Product packaging costs.
– Machine testing and calibration costs.
– Machine maintenance and cleaning costs
NB: Direct Costs Are the Same in traditional and Activity Based costing

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 Traditional Cost Systems

• Although it may be impossible to determine

the exact cost of a product or service, every
effort is made to provide the best possible
cost estimate
• 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

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Traditional Product Costing 1. Focus on the
product in the
Costs
costing process.
Allocatio 2. Costs are traced to
n: the product with
Costs are assumption to
Consumed by: allocated consuming of the
to resources in
products proportion to the
based on volume produced.
Products assumed 3. These volume
linkages drivers, fails to
or
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 Traditional Costing …..
• 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.

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 Overhead Costs
• A single predetermined overhead rate is used
throughout the year for the entire factory
operation for the assignment of overhead costs
• In job order costing, direct labor hours or costs
are commonly used as the relevant activity base
• In process costing, machine hours are
commonly used as the relevant activity base

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 Activity-Based Costing
• Allocates overhead to multiple activity cost pools and assigns
the activity cost pools to products by means of cost drivers
• An activity is any event, action, transaction, or work sequence
that causes the incurrence of cost in producing a product or
providing a service
• A cost driver is any factor or activity that has a direct cause-
effect relationship with the resources consumed
• Allocates costs to activities first, and then to the products,
based on the product’s use of those activities
• Activities consume resources
• Products consume activities

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 Activity Based Costing 1. ABC focuses on
activities in the
Costs
costing process.
Resource Drivers:
Consumed by: Costs are assigned 2. Costs are traced
to activities based
on effort expended
from activities to
products, based on
Activities
Activity Drivers: the product’s
Activity costs are
assigned to demand for these
Consumed by: products on unique activities during the
consumption
patterns production
Products process.
3. ABC theory 17
 Activity-Based Costing
ABC is extremely valuable to an organization, because it provides
information on the range, cost and consumption of operating activities.
Specific benefits of and strategic use for this information are:
• More accurate product costs enable better strategic decisions regarding:
• Product pricing
• Product mix.
• Make vs. Buy
• Investments in R&D, Process automation, etc..

• Increased visibility of the activities performed enables a company to:

• Focus more on the management of activities, such as improving the
efficiency of high cost activities.
• Identify and reduce non-value added activities.
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 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.
• 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.

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 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).

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 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
asEstimated
shown below:Expected Use of Activity-based
Overhead per
Activity
 Cost Drivers
Activity
per = Overhead Rate

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 Setting OH Rates: Choices of Level of Aggregation

• Plant wide rate: simplest but most subject to

distortion when products vary in their use of
resources
• Departmental rates: more complex but subject
to distortion when costs that are not unit driven
are substantial and products use these costs
differently
• Activity Based Rates: more complex and
potentially more accurate
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 Who Uses ABC?

Industry

• Public Sector

40%
• Service

24%
• Manufacturing
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 Activity-Based Costing - Step 1:Identify the
major activities….
UNIT-LEVEL ACTIVITES
The work efforts that transform resources into individual products and resources

BATCH-LEVEL ACTIVITES
Manufacturing or service technology that affect multiple units of
activity equally and simultaneously
PRODUCT - LEVEL ACTIVITES
Support specific products or service lines

CUSTOMER- LEVEL ACTIVITES

Performed to meet the needs of specific customers

FACILITY-LEVEL ACTIVITIES
Support all of the organizations processes
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 Activity-Based Costing - Step 1
TOP DOWN APPROACH
ABC teams of middle-
management or above
develop the activity
dictionary. INTERVIEW OR
RECYCLING PARTICIPATIVE
APPROACH APPROACH
Reuses ABC teams include
documentation of or interview
processes used for operating
other purposes. employees. 25
 Activity-Based Costing – Step 2:
Identify the cost drivers….

The ABC teams should gather data on the

costs of all the activities identified in Step 1.

Examine Ask employees

accounting to provide
records for
recorded cost
information
information. on the time
they work on
various
activities. 26
 Activity-Based Costing – Step 2

When estimating the cost of EXAMPLE

an activity, only the costs
associated with the product Suppose we rent a 1,000
should be used (practical square foot warehouse for
capacity). The cost of
“unused capacity” should
$1,000 per month. Only 800
not be applied to products.
sq. ft. are used to store
Product A. The rest of the
warehouse is “unused”.
How much rent cost should be
allocated to Product A?
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Activity-Based Costing – Step 2

80%, or $800 20%, or $200 should

should be assigned be assigned to
to Product A “unused capacity”
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 Activity-Based Costing – Step 2

Two pieces of
information are
required to compute
the cost-driver rate:
•Activity Cost
•Activity Volume

EXAMPLE
EXAMPLE #1
#1
XCo has
The 4proper
employees
activity
in in
itsthis
Quality
caseControl
is the #Dept.
of units
Salaries
produced.
and costs
for the departmentThetotal
cost-driver
$360,000 per
rateyear.
wouldXCo
be: produces 500,000
units of product
$360,000
a year.
÷500,000
What units
is the=appropriate
$.72 per unitactivity, # of
employees or units of product? What is the cost-driver rate?
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Activity-Based Costing – Step 2
EXAMPLE #2
EXAMPLE #2
Since
XCocustomers are charged
has a customer “per call”,
service center wherethe
proper activity
customers can callin
tothis
ask case is the #Customers
questions. of calls
pay a fixedhandled by the
fee for each callcenter.
they make to the
service center. In addition, other XCo
The cost-driver
departments also use the rate would
service be: It costs
center.
XCo $1,260,000 a year to operate the center. The
$1,260,000
center ÷120,000
receives unitsper
120,000 calls = $10.50 per center
year. The call
handles 1,000,000 minutes of calls.

What is the appropriate cost driver; total

minutes per call or number of calls? What is
the cost-driver rate?
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 Activity-Based Costing – Step 3:
Assign overhead costs…
1. Identify all 2. Determine 3. Assign costs
the activities how many to products
related to a units of each using the cost-
given product activity are driver rates for
or service. used per unit each activity
of product.

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 Activity-Based Costing – Step 3
Example: Yazz, Inc. produces 130,000 units of Product A and
400,000 units for Product B. Using the following cost
information, how much overhead should be allocated to
Product A?

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Activity-Based Costing – Step 3

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 ABC’S 7 Steps
• Step 1: Identify the products that are the chosen cost objects.

• Step 2: Identify the direct costs of the products.

• Step 3: Select the activities and cost-allocation bases to use

• for allocating indirect costs to the products.

• Step 4: Identify the indirect costs associated with each cost allocation base
(activity).

• Step 5: Compute the rate per unit of each cost-allocation base (activity)
used to allocate indirect costs to the products.
• Step 6: Compute the indirect costs allocated to the products.

• Step 7: Compute the total costs of the products by adding all direct and
indirect costs assigned to the products.
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 Benefits of Activity-Based
Costing
• ABC leads to more activity cost pools with more relevant cost
drivers
• ABC leads to enhanced control of overhead costs since
overhead costs can be more often traced directly to activities
• ABC leads to better management decisions by providing more
accurate product costs, which contributes to setting selling
prices that will achieve desired product profitability levels.
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 off itself, change the
amount of overhead costs.

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 Limitations of ABC

• ABC can be expensive to use, as a result of

the higher cost of identifying multiple
activities and applying numerous cost
drivers
• Some arbitrary overhead costs will
continue, even though more overhead costs
can be assigned directly to products through
multiple activity cost pools.

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 When to Use ABC
• Product lines differ greatly in volume and manufacturing
complexity
• Product lines are numerous, diverse, and require differing
degrees of support services
• Overhead costs constitute a significant portion of total
costs
• The manufacturing process or the number of products has
changed significantly
• Production or marketing managers are ignoring data
provided by traditional cost systems and are using bootleg
cost information to make pricing decisions

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 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
• It is System wide, integrated approach that focuses
management’s attention on activities with the objectives of
improving customer value and the profit achieved by
providing this value
• It describes management decisions that use activity-based
costing information to satisfy customers and improve
profits.

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Functional-Based
Management Cost View
Model
Resources

Operational View

Efficiency Performance
Functions
Analysis Analysis

Products

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Activity-Based
Management Cost View
Model
Resources

Operational View

Driver Performance
Activities
Analysis Analysis

Products &
Customers
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 ABM: What and Why?
• Activity based management = using knowledge of costs gained by
ABC analysis to make pricing and product-mix decisions, to identify
and select cost reduction and process improvement projects,
including ones relating to product design

• Knowing what costs are related to which product allows better

analysis of:
– which markets to emphasize
– which products to consider for CIPs (cost improvement programs)
– which customers to target for changes in pricing or service
delivery

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 ABC in Service Industries
• Identifying activities, cost pools, and cost drivers are similar to
manufacturing industries
• A larger proportion of overhead costs are facility-level costs, that
cannot be directly traced to specific services rendered by the
company
• Although initially developed and implemented by manufacturing
companies that produce products, ABC has been widely adopted in
service industries.
• The general approach to identifying activities, activity cost pools,
and cost drivers is the same.
• Labeling activities as value-added and non value-added, and trying
to reduce or eliminate non value-added activities is just as valid.

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END of Chapter 3

Thank you !!!

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