MONASH

BUSINESS
SCHOOL

Chapter 8 (including appendix)

Activity Based Costing

For this topic you should be able to:

1. Recognise problems with traditional product costing □

systems (for example, what we did last week)
2. Describe the key features of activity-based costing (ABC) □
3. Be able to use the ABC model to calculate product costs □
4. Explain differences between product costs prepared under
ABC and those under traditional costing □
5. Recognise what types of organisations benefit from ABC
and explain what these benefits are □
6. Outline the impediments to introducing ABC and its
limitations, and ways to overcome these. □
And always….

Understand why Activity-Based

Costing (ABC) represents a superior
method of costing
Explain specifically how and when
ABC can be useful to a variety of
managerial decision making contexts
Features of traditional product costing systems
• Direct material and direct labour costs are traced to products
• Overheads are aggregated into very large cost pools, sometimes for
individual departments but often for the whole organisation (plant)
• Manufacturing overhead costs are allocated to products using a
predetermined overhead rate, either plant wide or departmental
• Manufacturing overhead rate is calculated using some measures of
production volume (for example direct labour hours or machine hours)
• Non-manufacturing costs are not assigned to products

Slide 4
Traditional costing systems

Trace
Direct materials
Trace
Direct Labour
Individual
products or
Overhead costs services
Overhead Allocate
Indirect materials (cost objects)
Indirect labour cost pool
Production facility costs Plant-wide or (using
Etc. departmental volume
based cost
driver)

Last week’s lecture

Slide 5
Problems with traditional product costing systems
• Failure to adapt to the changing
business environment
– Increasing levels of non-volume-driven
manufacturing overhead costs
– Increasing proportions of non-
manufacturing costs
Steve Jobs hated this (
Click here)
• Causes of changes in cost structures include:
– Increased automation
– Increasing product diversity and complexity
– Increased emphasis on upstream and downstream areas of the value
chain, for example, customer demand for improved service, quality,
marketing and customer support
Indicators of problems with a product costing system
• Traditional product costing systems are likely to result
in inaccurate product costs when:
– product diversity increases
– the proportion of direct labour costs decreases and the
proportion of manufacturing overhead costs increases
– the proportion of manufacturing overhead costs, not
related directly to production volume, increases
– non-manufacturing costs that are product-related
become substantial

Slide 7
Has your costing system experienced any of the following symptoms?

Slide 8
 Activity-based costing
• A method that can be used to measure both the cost of
cost objects and the performance of activities

• Can help solve problems such as:

– Distorted product costs
– Poor cost control

• Activity:
– A unit of work performed within the organisation

Slide 9
Traditional approach (from week 5) …

Slide 10
ABC approach

Resource
Drivers

Activity
Drivers

Slide 11
Activity Based Costing (ABC)

Direct materials
Trace
Direct Labour
Trace or allocate Activity cost
Allocate using
using resource pools:
Overhead costs: Testing materials cost
activity cost
drivers pool drivers
Transport equipment Allocated using
costs number of materials Individual products
tested
or services or other
Supervisors’ salaries Inspection cost pool
cost objects
Allocated using
number of units
inspected
Inspectors’ salaries

Set-up machines cost

Other resource costs pools
Allocated using
number of set-ups

Slide 12
 Be careful…
• Do not confuse overhead costs with
activity cost pools (see previous slide)

• Overhead costs represent all the manufacturing

(and/or non-manufacturing) costs of the
organisation
• These are allocated to activity cost pools using
resource drivers
• Activity cost pools are an amalgamation of the
overhead costs that are used to carry out a
particular activity.
• These costs are then applied collectively to cost
objects (for example, products) using a common
activity cost driver

Slide 13
Activity-based vs. traditional product costs
• Traditional product costing is based on the use of
volume-based cost drivers
– Not all aspects of manufacturing overhead vary with
production volume, for example fixed costs
– Activity-based costing recognises both volume-based
and non-volume-based cost drivers
• In ABC, the quantity of activity drivers consumed by a
product often depends on whether the activity is
performed for each unit, batch or product line.

Slide 14
Activity-based vs. traditional product costs
• Traditional costing treats all costs as unit level
– Ignores product level and facility level costs
– Also ignores batch size
• Units produced in large batches consume a
relatively low cost per unit of batch costs
– For example, imagine the setup cost per batch of units
is $200 and in August 100 units were produced in
each batch ….. Therefore, the setup costs per unit is
$2
– Scenario 1: In September, the units produced per
batch increased to 300 due to higher consumer
demand. However, despite the increase in batch size,
it still costs $200 to setup the batch leading to a setup
cost of $0.67 per unit
– Scenario 2: In September, the setup cost per batch of
units increased to $250 due to the introduction of more
sophisticated machinery. However, despite the
increased cost, 100 units per batch are still made
leading to a setup cost of $2.50 per unit.
Slide 15
Activity-based vs. traditional product costs
• Traditional costing systems tend to overcost high-
volume, relatively simple products and undercost low-
volume, complex products
– High-volume, simple products may use less
activities
– Low-volume, complex products may use more
activities
– Traditional costing does not recognise these
differences

Slide 16
 Activity-based costing in
Cold Stone Creamery

 1,500 shops across the U.S offering the “ultimate ice cream
experience”
 Offers ice-cream with “mix-in” ingredients – 15 flavours, 30
ingredients and 3 sizes
 Different ice cream orders had large variations in cost in terms of
ingredients and time

(Mowen, Hanson & Heitger, 2014)

 Activity-based costing in
Cold Stone Creamery

 Overhead costs included training,

uniforms and employee benefits
 Introduced ABC to estimate the activity
drivers of each type of ice cream order
and to estimate the cost of these
activities
 2 important cost drivers – ingredients
and time
 Allowed an understanding of cost in
terms of preparation time and an
estimate of profit margin by product type
 For products not meeting desired profit
margins, their activities were fine-tuned.
(Mowen, Hanson & Heitger, 2014)
An activity-based costing model
• The costing view (ABC)
– Measures the cost of activities
– Assigns activity costs to cost objects (e.g. products)

• Activity-based management view (ABM)

– Provides information to manage activities, managing costs and
other sources of customer value

• Three types of cost drivers

– Resource drivers (ABC)
– Activity drivers (ABC)
– Root-cause cost drivers (ABM)

Slide 19
The ABC framework

Slide 20
Activity-based costing terminology
• Resource driver STEP ONE
– A cost driver used to estimate the cost of resources (i.e.
overhead costs) consumed by an activity
• Activity driver STEP TWO
– A cost driver used to estimate the cost of an activity
consumed by the cost object
• Bill of activities STEP THREE
– Identifies the activities, the activity cost per unit of activity
driver, the quantity of activity drivers consumed, and
therefore, the cost of the activities consumed by the product

Slide 21
The ABM framework

Slide 22
Activity-based management terminology
• Root-cause cost drivers
– The underlying factors that cause activities to
be performed and their costs to be incurred
– Used to monitor and control what is happening
in a business
– Provide information about root causes of
activities, their value to customers, and
appropriate performance measures to use.
– Can potentially be different to the activity
driver

Slide 23
 Research Cost - $1.5 million –
Remember Week Pharmaceutical Company
1??
The research department sends out
blood samples for examination to
an external pathology lab.
What is the cost driver of this
activity?

• For cost estimation purposes:

Number of blood samples sent
• For cost management purposes:
Skill level of staff
 The costing view

• Step one: Measuring the cost of activities

– Use resource drivers to assign overhead costs to separate
cost pools (for example, activity centres) for each activity
– Determine the total cost for each type of activity
• Step two: Assigning activity costs to products
– Choose an appropriate activity driver for each activity
– Calculate cost per unit of activity driver Total quantity
Total Cost of activity
of its activity driver
– Assign activity costs to cost objects using activity drivers
– Prepare a bill of activities for each major product
– Determine the total cost for each product (equals the cost of
activities used to produce each product)

Slide 25
Activity-based hierarchy of costs and activities
• Unit level activities
– Performed for each unit of product
Doesn’t matter if there
• Batch level activities are 100 or 150 units in
the batch – same cost!

– Performed for each batch of product

• Product level (or product-sustaining) activities
– Performed for specific products or product families
• Facility level (or facility-sustaining) activities
– Required to support the business as a whole, not
caused by any particular product (so arbitrary calculation
may still be inevitable unfortunately)

Slide 26
The costing view: Bill of activities

Product: Hensley Tooth

Slide 27
Lecture illustration

• Yummy's Bakery makes a number of different cakes and pastries. Two of its
best-selling products are the Lamington and the Vanilla Slice.
• It has a budgeted overhead amount of $425,000 for the coming year. It
anticipates 2,000 direct labour hours.
• 400 Lamingtons can be produced an hour. 500 Vanilla Slice can be produced an
hour.
• The prime cost for a Lamington is $0.30 and $0.50 for a Vanilla Slice.
• On the next slide is a list of the main activities performed at Yummy and their
annual costs. These costs represent an allocation of all the bakery’s overhead
costs. They were allocated to activities using resource drivers.
• Five potential activity cost drivers and the annual quantity of each activity driver
are also listed.

Slide 28
Lecture illustration contd….

Activity Activity Cost Activity cost drivers Quantity

Process Receivables $15,000 Kg processed 200,000
Process Payables $25,000 No. batches
Program Production $28,000 1,000
Load mixer No. cakes produced 800,000
$14,050 No. invoices
Operate mixer $45,900 5,000
Clean mixer No. purchase orders 2,500
$6,900
Fill trays
$16,000
Set up ovens
$50,000
Bake cakes $130,000
Pack cakes
$80,000
Slide 29
Lecture illustration contd….

The data for the Lamington and the Vanilla Slice is as follows:

LAMINGTON VANILLA SLICE

Activity cost drivers Quantity used Activity cost drivers Quantity used
No. batches No. batches
100 200
No. purchase orders No. purchase orders
200 800
No. invoices No. invoices
500 1,000
Kg processed Kg processed 50,000
The bakery
30,000 also spent $2,150 in development and testing costs,
No. cakes produced
of which $860 was
spent on developing
No. cakes produced the Lamington and $1,290 spent on
100,000 developing the Vanilla
100,000
Slice. The rent of the facility that makes the Lamingtons and Vanilla Slices is
$12,000.

Slide 30
Lecture illustration contd…

Required:

1. Using traditional costing, with direct labour hours as a cost driver, calculate the
product cost for the Lamington and Vanilla Slice.

2. Select an appropriate driver for each of the activities identified.

3. Calculate cost per unit of activity driver for the activities listed.

4. Use the information in parts 2 and 3 to determine a cost per unit for the
Lamington and Vanilla Slice.

After all this: Reflect on the difference of calculating product costs using
this method and what we did last week!

Slide 31
Lecture illustration solution

Question One
Budgeted overhead $425,000

Budget volume of cost driver 2,000 DLHrs

Predetermined overhead rate $212.50 per DLH

Lamington Vanilla
Slice
400 produced/ hour = 0.0025 DLHrs 500 produced/ hour = 0.002 DLHrs
per unit
per unit
Applied overhead $0.53 Applied overhead $0.43

plus prime cost $0.30 plus prime cost $0.50

Slide 32
Lecture illustration solution

Question Two

Activity Activity Driver

Process Receivables
Process Payables
Program Production
Load Mixer
Operate Mixer
Clean Mixer
Fill Trays
Set up Ovens Cake Driver – get it?!
Bake Cakes
Pack Cakes

Slide 33
Lecture illustration solution

Question Three
Activity Activity Cost Activity Driver
Quantity Cost/unit of

activity driver
Receivables $15,000 No. invoices
5000 $
Payables $25,000 No. purchase orders 2500
$
Program Production $28,000 No. batches
1000 $
Load Mixer $14,050 No. batches
1000 $
Operate Mixer $45,900 Kg processed
200000 $
Clean Mixer $6,900 No. batches
1000 $
Fill Trays $16,000 No. cakes produced Slide 34
Question Four
Activity Activity Driver Cost/unit of Lamington
quantity Annual Cost
activity driver

Process Receivables No. invoices $3.00 500

$1,500
Process Payables No. purchase orders $10.00 200
$2,000
Program Production No. batches $28.00 100
$2,800
Load Mixer No. batches $14.05 100
$1,405
Operate Mixer Kg processed $0.23 30,000
$6,885
Clean Mixer No. batches $6.90 100
$690
Fill Trays No. cakes produced $0.02 100,000
$2,000
Set up Ovens No. batches $50.00 100
$5,000
Bake Cakes No. batches $130.00 100
$13,000
Pack Cakes No. cakes produced $0.10 100,000
$10,000 Slide 35
Question Four
Activity Activity Driver Cost/unit of Vanilla Slice
Annual Cost
activity driver
quantity
Process Receivables No. invoices $3.00 1,000 $
3,000
Process Payables No. purchase orders $10.00 800 $
8,000
Program Production No. batches $28.00 200
$ 5,600
Load Mixer No. batches $14.05 200
$ 2,810
Operate Mixer Kg processed $0.23 50,000
$11,475
Clean Mixer No. batches $6.90 200
$ 1,380
Fill Trays No. cakes produced $0.02 100,000 $
2,000
Set up Ovens No. batches $50.00 200
$10,000
Bake Cakes No. batches $130.00 200
$26,000
Pack Cakes No. cakes produced $0.10 100,000
Slide 36
Lecture illustration solution

Compare costs

Lamington
Vanilla Slice Traditional $0.83
$0.93
Activity Based $0.82 $1.38

Slide 37
When to use ABC?
• When overhead costs are a significant proportion of total
cost, and a large part of overhead is not directly related to
production volume

• When the business has a diverse product range, and an

individual product’s use of resources differs from its use of
volume-based cost drivers

• When production activity involves diverse batch sizes and

product complexity

Slide 38
When to use ABC?

• Proportion of product-related costs such as research and development,

customer support and so on are increasing relative to manufacturing
costs

• There are likely to be high costs associated with making inappropriate

decisions, based on inaccurate product costs

• The cost of designing, implementing and maintaining the ABC system

is relatively low due to sophisticated IT support

Slide 39
When to use ABC – four key questions

If an organisation makes one product,

1. Does the organisation make more No overhead cost per unit is simply total
than one product? overhead costs divided by units produced.

Yes

2. Does the organisation make multiple No

If different products are made using
similar processes, then the overhead costs
products using different processes? relating to those processes will be largely
identical, negating the need for ABC.
Yes

3. Does the organisation have a high If most overhead costs are unit based,
then overhead drivers will probably be
proportion of non-unit level costs? No volume-based drivers – traditional costing
systems are usually able to capture these
reasonably effectively
Yes

4. Are overheads a significant Though the organisation exhibits all the

proportion of total costs? No prior characteristics aligned with ABC use,
if overhead costs are not significant then
the implementation of ABC potentially
outweighs the benefits
Yes

The organisation should definitely use

ABC!

Slide 40
Different forms of ABC
• Simple approach: allocates manufacturing overhead costs
to products

• ABC system for indirect costs: allocates manufacturing

overhead costs and non-manufacturing costs to products

• Comprehensive system: allocates all product-related

costs, except direct materials, to products and is used for
activity management

Slide 41
Slide 42
Which costs should be included in an ABC system?
• Depends on the purpose of the system, which depends on
the needs of management and on the problems that need
to be addressed.

• A decision to include activity-based management (ABM) in

an ABC system will influence the range of costs included in
the system, as well as the type of cost drivers identified

Slide 43
Variations in forms of ABC
• Actual (past) or budgeted costs are analysed

• Cost objects, other than products, are included

– For example, the costs of using particular suppliers or the cost of
servicing particular customers

• Implementation of ABC is a one-off

project or an ongoing system
• ABC is used to cost just one part of a
business, with other parts relying on
more traditional methods

Slide 44
Impediments to introducing ABC
• The benefits of ABC can be significant
but the take-up rate has been relatively
slow. Why?
– Lack of awareness of ABC
– Uncertainty about the potential benefits
of ABC
– Concerns about the extensive resources
required to implement ABC
– Resistance to change from managers
and employees

Slide 45
Impediments to introducing ABC
• Behavioural issues in implementing activity-based
costing
– ABC may require substantial changes to:
o The way businesses are managed
o The type of data that is collected
o Collection and analysis procedures
– Implementation requires the time and effort of many
people across the organisation (not just accountants!)
– These changes can be perceived as threatening and
therefore may be resisted

Slide 46
Overcoming impediments of ABC
• ABC must be accompanied by a change management plan that takes into
account the extent of change needed and the personalities involved

• Bottom-up change management (as opposed to top-down) may give employees

some degree of ownership of any changes caused by ABC

• Management must be seen as

committed to the change
process, but also willing to let
their employees play a major role
in developing and implementing
ABC.

Slide 47
Limitations of activity-based costing
• Facility level costs
– When a high level of facility level costs is allocated to
products, an arbitrary element enters the product cost
• These costs bear no obvious relationship to products
• In lecture illustration: rent was split equally between products.
Could we do better? Allocate based on square footage used to
make products? Is that feasible/necessary?
• Use of average costs in decision making
– Batch, product level and facility level costs that have been
divided by the number of units produced (as in lecture
illustration) can lead to product costs that are of limited use for
decision making if there is any element of customisation

Slide 48
Limitations of activity-based costing
• Complexity
– The cost of updating an ABC system can be very high
although it may be needed to avoid producing outdated,
irrelevant information
– The level of complexity increases when the system is
used for both activity management and product costing
– Activity-based management requires extensive and
detailed analysis of costs and activities

Slide 49
Limitations of activity-based costing
• ABC can be difficult to implement in service firms
– High levels of facility costs, so potential for many
arbitrary allocations
– Individual activities are difficult to identify because they
are non-repetitive
– A non-repetitive production environment makes it difficult
to identify service outputs (so what is the cost object?)

• Despite these issues, ABC is used in many major Australian

service organisations

Slide 50
 Acknowledgement
Some of the slides contained in this presentation
were adapted from:

PowerPoint slides to accompany Management Accounting:

Information for managing and creating value 8e
Copyright © 2018 McGraw-Hill Australia Pty Ltd

Slide 51