Managerial Accounting: Tools For Business Decision-Making

Managerial Accounting
Tools for Business Decision-Making

Sixth Canadian Edition
Weygandt Kimmel Aly
Chapter 5
Activity-Based Costing
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Copyright ©2021 John Wiley & Sons Canada, Ltd.

Learning Objectives
1. Recognize the difference between traditional costing
and activity-based costing (ABC) and understand the
nature of ABC.
2. Apply activity-based costing to a manufacturer.
3. Understand the benefits and limitations of activity-
based costing.
4. Apply activity-based costing to service industries.
Copyright ©2021 John Wiley & Sons Canada, Ltd. 2

ABC Versus Traditional Costing
• Traditional Costing Systems allocate overhead using a
single predetermined rate.
• Traditional costing assumes that all overhead costs
are caused or driven by a single activity or driver
o Job order costing: direct labour cost was assumed to
be the relevant activity base.
o Process costing: machine hours was assumed to be the
relevant activity base.

Traditional Costing Systems
• A traditional one-stage
costing system
• Direct labour hours or dollars
is often the appropriate basis
for assigning overhead costs
if direct labour is a significant
component of the end
product or service
Traditional one-stage
costing system

Traditional Costing System Example
(1 of 2)
• Atlas Company produces two fitness products—the Ab
Bench and the Ab Coaster.
• Each year 25,000 Ab Benches and 5,000 Ab Coasters
are produced and sold.
o Each unit requires one hour of direct labour, for a total
of 30,000 labour hours (25,000 + 5,000).
• Overhead is allocated with a single predetermined
overhead (POR) rate based on direct labour hours.
• The POR is $30 per direct labour hour ($900,000 ÷
30,000 direct labour hours).
Traditional Costing System Example
(2 of 2)
• The total manufacturing cost per unit for the Atlas
products, using traditional costing is:
• Each product has the same amount of overhead

allocated to it.
Need for a New Approach
• Increasing and continuous changes in manufacturing and
service industry technology and processes. Changes include:
o International competition
o Technological innovation
o Advances in computerization and automation.
• Use of a plant-wide pre-determined overhead rates based on
direct labour or machine hours may no longer be the best or
only cost driver
• Recognizing these changes, and managements need for better
quality cost information has led to Activity-Based Costing (ABC)
for overhead allocation.

The Reasoning Behind ABC
Traditional Costing AB C
• Volume-based; assumed • Activity-based; each unit
that overhead costs has different activities
driven solely by volume (or tasks) needed to
• Regardless of the complete them
activities or tasks needed • Each activity uses
to complete a unit, resources at different
overhead is allocated rates or quantities
with a single POR • Overhead is allocated at
a POR per activity
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Activity-Based Costing (ABC)
Activity-Based Costing (ABC) is:
• An overhead cost allocation system that allocates
overhead to multiple activity cost pools
and
• Assigns the activity cost pools to products or services
by means of cost drivers that represent the activities
used.

Terms
• Activity:
o Any event, action, transaction, or work sequence that
causes a cost to be incurred in producing a product or
providing a service.
• Activity Cost Pool:
o A distinct type of activity. For example, ordering
materials or setting up machines.
• Cost Drivers:
o Any factors or activities that have a direct cause-effect
relationship with the resources consumed.
Allocation of Overhead Costs
• ABC allocates overhead costs in four steps:
o Step 1: Identify and classify the major activities in the
manufacturing process and assign overhead to cost pools.
o Step 2: Identify the cost driver.
o Step 3: Calculate the activity-based overhead rate
o Step 4: Allocate overhead costs to products using the
activity-based overhead rate
• The more complex a product’s manufacturing operation,
the more activities and cost drivers likely to be present.

Activities and Related Cost Drivers

Let’s Review 1
As the complexity of a product's manufacturing operation
increases, the number of activities and cost drivers used in an
activity-based cost system will likely:
a. Increase
b. Stay about the same
c. Decrease
d. Vary randomly

Let’s Review 1: Solution
As the complexity of a product's manufacturing operation
increases, the number of activities and cost drivers used in an
activity-based cost system will likely:
a. Increase (correct answer)
b. Stay about the same
c. Decrease
d. Vary randomly

Traditional Costing vs. ABC
• ABC does not replace an existing job order or process
costing system.
• ABC does segregate overhead into various cost pools to
provide more accurate cost information.
o Products that consume more resources (need more
activities) have more overhead allocated to them
• ABC supplements – it does not replace – the traditional
cost system.
• The only real difference between an A BC costing system
and traditional costing systems is how overhead costs are
allocated
An Example (1 of 3)
• Atlas Company produces two types of abdominal exercise
equipment:
o The Ab Bench: a high-volume item with sales totaling 25,000
units per year
o The Ab Coaster: a low-volume item with sales totaling 5,000 units
per year
• Each product requires 1 hour of direct labour
o Total annual direct labour hours (DLH) 30,000
• Estimated annual manufacturing overhead costs $900,000
• Traditional costing predetermined overhead rate: $900,000 ÷
30,000 DLH = $30 per DLH
An Example (2 of 3)
• Under Traditional Costing the respective product costs
and gross profit are as follows:
Ab Bench Ab Coaster
Selling price per unit $200 $170
Direct materials $40 $30
Direct labour 12 12
Manufacturing overhead - (1 hour x $30) 30 30
Total manufacturing cost per unit 82 72
Gross profit per unit $118 $ 98

An Example (3 of 3)
• Is there is a difference in the product costing if Atlas
Company used ABC?
o Traditional costing systems can lead to some products
being over or under costed
• Using the same information what are the respective
products costs under ABC
• Note 1: that there is no change to the direct materials
or direct labour cost for each product
• Note 2: total estimated overhead does not change
under ABC
Unit Costs under ABC
Step 1: Identify and Classify Activities and Allocate Overhead to Cost Pools
Activity cost pools and estimated overhead

Step 2: Identify Cost Drivers
Estimated Use of Cost

Activity Cost Pools Cost Drivers Drivers per Activity
Manufacturing Machine hours 50,000 machine hours
Machine set-ups Number of set-ups 2,000 set-ups
Purchase ordering Number of purchase orders 2,500 purchase orders
Factory maintenance Area (square metres) 25,000 square metres
Cost drivers and their estimated use

Step 3: Calculate Overhead Rates (ABOR)
Estimated Overhead Per Activity
Formula for Calculating ABOR :
Estimated Cost Driver Use Per Activity
Calculation of activity-based overhead rates

Step 4: Assign Overhead Costs to Products (1 of 2)
Part 1: Cost Driver Use Per Product
How many units of each cost driver does each product use or consume
during the production process?
Example: A total of 50,000 machine hours are used in the ‘Manufacturing’
activity. Ab Bench will use 30,000 machine hours; Ab Coaster will use
20,000 machine
Calculation of activity-based overhead rates

Step 4: Assign Overhead Costs to Products (2 of 3)
Part 2: Assign Cost Pools to Products
Assignment of activity cost pools to products

Comparison Of Unit Costs
Traditional vs. ABC
Comparison of unit product costs

Let’s Review 2
Which of the following is NOT one of the four steps involved in
calculating unit costs under activity-based costing?
a. Assign manufacturing overhead costs for each cost pool to
products, using the overhead rates
b. Identify the cost driver that has a minor correlation to the costs
accumulated in the activity cost pool
c. Identify and classify the major activities involved in the
manufacture of specific products, and allocate manufacturing
overhead costs to the appropriate cost pools
d. Calculate the overhead rate per cost driver

Which of the following is NOT one of the four steps involved in
calculating unit costs under activity-based costing?
a. Assign manufacturing overhead costs for each cost pool to
products, using the overhead rates
b. Identify the cost driver that has a minor correlation to the
costs accumulated in the activity cost pool (correct answer)
c. Identify and classify the major activities involved in the
manufacture of specific products, and allocate manufacturing
overhead costs to the appropriate cost pools
d. Calculate the overhead rate per cost driver

Let’s Review 3
SG Ltd., uses ABC to allocate overhead. For the current year total manufacturing overhead
cost is estimated at $420,000 for an annual production capacity of 100,000 design
projects. SG has gathered the following information:
Cost pool Manufacturing overhead costs Estimated Activity level Actual Activity level
Design changes $60,000 300 design changes 250
Setups 320,000 5,000 setups 5,500
Inspections 40,000 8,000 inspections 6,667
Total $420,000
What are the activity-based overhead rates for the various cost pools? All amounts have
been rounded to the nearest whole dollar.
a. $200 per change, $64 per setup, $5 per inspection
b. $240 per change, $58 per setup, $6 per inspection
c. $240 per change, $30 per setup, $3 per inspection
d. $200 per change, $76 per setup, $5 per inspection
SG Ltd., uses ABC to allocate overhead. For the current year total manufacturing overhead
cost is estimated at $420,000 for an annual production capacity of 100,000 design
projects. SG has gathered the following information:
Cost pool Manufacturing overhead costs Estimated Activity level Actual Activity level
Design changes $60,000 300 design changes 250
Setups 320,000 5,000 setups 5,500
Inspections 40,000 8,000 inspections 6,667
Total $420,000
What are the activity-based overhead rates for the various cost pools? All amounts have
been rounded to the nearest whole dollar.
a. $200 per change, $64 per setup, $5 per inspection (correct answer)
b. $240 per change, $58 per setup, $6 per inspection
c. $240 per change, $30 per setup, $3 per inspection
d. $200 per change, $76 per setup, $5 per inspection
Benefits of ABC (1 of 5)
Three primary benefits to using ABC:
1. Uses more cost pools resulting in more accurate
product costing
2. Leads to improved overhead cost control
3. Supports better management decisions

product costing
• To gain full advantage of using multiple cost pools, the
costs within the pool must be correlated with the
driver.
• Achieved by classifying activities into four activity-level
groups
• Sometimes referred to as cost hierarchy

Classification of Activity Levels
1. Unit-level activities:
Performed for each unit of production
2. Batch-level activities:
Performed for each batch of product
3. Product-level activities:
Performed in support of an entire product line, but not
always performed every time a new unit or batch is
produced
4. Facility-level activities:
Required to support or sustain an entire production/process

Hierarchy of Activity Levels

1. Uses more cost pools resulting in more accurate product
costing
• Allows for recognizing value-added activities versus non-
value-added activities
o Value added activities: those that increase the perceived
value of a product or service; also referred to as essential
activities
o Non-value-added activities: those that, if eliminated would
not significantly change the perceived value of a product or
service ; also defined as non-essential activities
Value-Added vs. Non-Value-Added
Activities (1 of 2)
Value-Added Activity
An activity that increases the perceived value
of a product or service. Examples:
Manufacturing Company Service Company

Engineering design Performing surgery
Machining Legal research services
Assembly Delivering packages
Painting Packaging
Value-Added vs. Non-Value-Added
Activities (2 of 2)
Non-Value-Added Activities
An activity that adds cost to, or increases the time spent
on, a product/service without increasing its perceived
value such as:
Manufacturing Company Service Company
Repair of machines Taking appointments
Storage of inventory Reception
Moving of raw materials, assemblies, Bookkeeping/billing
and finished goods Travelling
Building maintenance Ordering supplies
Inspections Inventory Control
1. Uses more cost pools resulting in more accurate product
costing
• Allows for recognizing value-added activities versus non-value-
added activities
o Value added activities: those that increase the perceived value of a
product or service (example: assembly)
o Non-value-added activities: those that, if eliminated would not
significantly change the perceived value of a product or service
(example: inventory storage)
• Activity flowcharts used to identify value-added and non-value-
added activities
Activity Flowcharts
Flowchart showing value-added and non–value-added activities

product costing
• Strategic (adding or dropping product lines) and
operational decisions (revising or streamlining
processes)
• Helps to develop performance standards and to
benchmark performance against other companies in
the industry

Let’s Review 4
An appropriate facility-level cost driver for heating costs
is:
a. Machine hours
b. Direct material
c. Floor space
d. Direct labour cost

An appropriate facility-level cost driver for heating costs
is:
a. Machine hours
b. Direct material
c. Floor space (correct answer)
d. Direct labour cost

Let’s Review 5
Which of the following activities is value added?
a. Storage of raw materials
b. Moving parts from machine to machine
c. Shaping a piece of metal on a lathe
d. All of the above

Which of the following activities is value added?
a. Storage of raw materials
b. Moving parts from machine to machine
c. Shaping a piece of metal on a lathe (correct answer)
d. All of the above

Activity-Based Costing
Limitations of ABC
• Can be expensive to use
o Costs in identifying value-added activities, the cost
drivers and the various cost pools
• Some arbitrary allocations continue

When to Use Activity-Based Costing
Use ABC When One or More of the Following Exist:
• Product lines differ greatly in volume and
manufacturing complexity
• Products lines are numerous, diverse and require
different degrees of support services
• Overhead costs are a significant portion of total costs
• Significant change in manufacturing process or
number of products
• Managers ignore data from existing system and
instead use “bootleg” costing data
Let’s Review 6
The presence of any of the following factors would
suggest a switch to ABC except
a. when product lines differ greatly in volume.
b. when overhead costs constitute a minor portion of
total costs.
c. when the manufacturing process has changed
significantly.
d. when production managers are ignoring data
provided by the existing system.

The presence of any of the following factors would
suggest a switch to ABC except
a. when product lines differ greatly in volume.
b. when overhead costs constitute a minor portion of
total costs. (correct answer)
c. when the manufacturing process has changed
significantly.
d. when production managers are ignoring data
provided by the existing system.

Activity-Based Costing in Service
Industries (1 of 2)
Similarities with Manufacturing Firms
• Overall objective:
o Identify key cost-generation activities and keep track of
quantity of activities performed for each service provided
• General approach is to identify activities, cost pools, and
cost drivers
• Labelling of activities as value-added or non-value-added
• Reduction or elimination of non-value-added activities

Industries (2 of 2)
Major difficulty in implementing ABC:
A larger proportion of overhead costs are company-wide

costs that cannot be directly traced to specific services.

Activity-Based Costing in Service Industries:
Traditional Costing Example (1 of 2)
Annual Budget
Condensed annual budget of a service firm under traditional

costing
Activity-Based Costing in Service Industries:
Traditional Costing Example (2 of 2)
Cost driver is direct labour cost; the pre-determined
overhead rate is 50.0% of direct labour cost. Or $0.50 per
direct labour dollar spent
Overhead applied under traditional costing system

Industries: ABC Costing Example (1 of 3)
Condensed annual budget of a service firm under activity-based costing

Assigning overhead in a service company

Comparison of traditional costing with ABC in a service company

Let’s Review 7
Activity-based costing has been found to be useful in
each of the following service industries except
a. hotels
b. hospitals
c. telephone companies
d. ABC has been useful in any of these industries

Activity-based costing has been found to be useful in
each of the following service industries except
a. hotels
b. hospitals
c. telephone companies
d. ABC has been useful in any of these industries
(correct answer)

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Tools for Business Decision-Making

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• Each product has the same amount of overhead

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Activity cost pools and estimated overhead

Estimated Use of Cost

Cost drivers and their estimated use

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Calculation of activity-based overhead rates

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Calculation of activity-based overhead rates

Assignment of activity cost pools to products

Comparison of unit product costs

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Manufacturing Company Service Company

Flowchart showing value-added and non–value-added activities

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A larger proportion of overhead costs are company-wide

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Condensed annual budget of a service firm under traditional

Overhead applied under traditional costing system

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Condensed annual budget of a service firm under activity-based costing

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Assigning overhead in a service company

Comparison of traditional costing with ABC in a service company

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