Chapter 10

ACTIVITY-BASED COST SYSTEM FOR MANAGEMENT

Introduction
One of the most difficult tasks in product costing is the determination of the
proper amount of overhead cost to assign to each job, unit of product or service activity.

The traditional allocation of overhead is geared towards satisfying external

reporting but less often serves the needs of management and that it does not provide
realistic information for management function. Hence, activity-based costing (ABC) has
been developed in response to the manager’s need for more accurate product costs to
make the globally competitive. ABC helps managers to clearly identify the costs involved
in manufacturing a product of in providing a service and gives them a more accurate unit
cost information that is useful in pricing and other decisions.

Learning Objectives:

At the end of the chapter, the student should be able to:

 Define activity-based costing (ABC).

 Describe the steps in designing and activity-based costing system.
 Apply activity-based costing to a manufacturing company.

Activity-Based Costing

ABC is a costing method that is designed to provide managers with cost

information for strategic and other decisions that potentially affect capacity and therefore
“fixed” as well as variable costs. It is ordinarily used as a supplement to, rather than as
a replacement for, the company’s usual costing system.

How ABC differs from Traditional costing

ABC differs from traditional cost accounting in three ways.

 The first is that nonmanufacturing as well as manufacturing costs may be
assigned to products, but only on a cause-and-effect basis. For example, ABC
systems can assign sales commissions, shipping costs, and warranty repair
costs to specific products.

 The second major difference between ABC and traditional cost accounting is that
some manufacturing costs may be excluded from product costs. This is because
ABC only assigns a cost to a product if decisions concerning that product will
cause changes in the cost. ABC excludes two types of costs from product costs:
a. Organization-sustaining costs; and
b. The costs of unused or idle capacity.

 The third major difference between ABC and traditional cost accounting is that
numerous overhead cost pools are used, each of which is allocated to products
and other cost objects using its own unique measure of activity. ABC cost pools
are created to correspond to the activities performed in an organization that
cause the consumption of overhead resources. Therefore, the total number of
ABC cost pools will definitely exceed one (as in the plant-wide approach) and it is
likely to exceed the number of departments within a company (as in the
 departmental approach), since more than one activity is often performed within
each department.

The steps or activities required in designing an ABC system are

1. Process Value Analysis (PVA)
2. Identifying activity centers
3. Assigning costs to activity centers
4. Selecting cost drivers
Step 1. Process value analysis involves the following steps
a. Analyze activities required to make the product or perform the service. This can
be done through the preparation of a flow chart detailing each in the
manufacturing process from the receiving of materials to the final inspection of
the completed product.
b. Classify each activity as value-added or non-value-added.
c. Identify ways to either reduce or eliminate the non-value-added activities.
Step 2. Identifying Activity Centers
An activity center can be defined as a part of the production process for which
management wants a separate reporting of the cost of the activity involved. Generally,
the levels of activities can be classified into four as follows:
1. Unit-level activities, which are performed each time a unit is produced.
Example: machine-related activities, such as milling, cutting, and maintenance;
2. Batch-level activities, which are performed each time a batch of goods is
handled or processed. Example: purchase order processing, equipment setups,
material handling, and quality inspection;
 3. Product-level activities, which are performed as needed to support the
production of each different type of product. Example: product testing, product
inventory management, and product design; and
4. Facility-level activities which simply sustain a facility’s general manufacturing
process. Example: general factory, plant occupancy, and personnel
administration and training.
Step 3. Assign Cost to Activity Centers
Assign costs to the activity centers where they are accumulated while waiting to
be applied to products. Costs that are traceable to the activity center should be
assigned directly to activity centers. Other costs shared by two or more activity
centers should be assigned according to some cost driver that controls the
utilization of costs involved.
Step 4. Select Cost Drivers
This involves assigning costs from the activity center to the product using the
appropriate cost drivers. When selecting a cost driver, one must consider the
following factors
1. The ease of obtaining data relating to the cost driver.
2. The degree to which the cost driver measures actual consumption by
products of the activity involved.

Illustrative Problem: Manufacturing Applications of Activity-based Costing

Luzon Company manufactures 4,000 units of Product A and 20,000 units of Product B
each year. The company currently uses direct labor hours to assign overhead costs to
products. Product X requires 2.5 DLH and Product B requires 2.0 DLH to produce.
Presently, Luzon Company uses a plantwide overhead allocation rate. Using this
method, the unit product cost is:
Product A Product B
Direct material 36.00 30.00
Direct labor 17.50 14.00
Manufacturing overhead
2.5 DLH x P18/DLH 45.00
2.0 DLH x P18/DLH   36.00
Total unit product cost 98.50 80.00
Management at Luzon believes that overhead costs are actually caused by the following
five activities:
 Traceable
Activity Cost
Machine setups 255,000
Quality inspections 160,000
Production orders 81,000
Machine-hours worked 314,000
Material receipts 90,000
Total 900,000

The following transaction data have been compiled by the management of Luzon:
Activity Total Product A Product B
Machine setups 5,000 3,000 2,000
Quality inspections 8,000 5,000 3,000
Production orders 600 200 400
Machine-hours worked 40,000 12,000 28,000
Material receipts 750 150 600

These data can be used to develop overhead rates for each of the five activities:
Activity Costs Product A Product B
Machine setups P225,000 5,000 P 51.00 per setup
Quality inspections 160,000 8,000 20.00 per inspection
Production orders 81,000 600 135.00 per order
Machine-hours worked 314,000 40,000 7.85 per hour
Material receipts 90,000 750 120.00 per receipt

The activity based overhead rates that were just calculated can be used to assign
overhead costs to Luzon’s two products.

Product A
Activity ABC Rate Transactions Amount
Machine setups 50.00 3,000 153,000
Quality inspections 20.00 5,000 100,000
Production orders 135.00 200 27,000
Machine-hours worked 7.85 12,000 94,200
Material receipts 120.00 150 18,000
Total overhead assigned 392,200
Number of units produced ÷ 4,000
Overhead per unit 98.05

Product B
 Activity ABC Rate Transactions Amount
Machine setups 51.00 2,000 102,000
Quality inspections 20.00 3,000 60,000
Production orders 135.00 400 54,000
Machine-hours worked 7.85 28,000 219,800
Material receipts 120.00 600 72,000
Total overhead assigned 507,800
Number of units produced ÷ 20,000
Overhead per unit 25.39

Now compare the unit product costs using the old costing system and our ABC system.

Costing Method Product A Product B

Activity-based costing 151.55 69.39
Old costing system 98.50 80.00

Characteristics of Successful ABC Implementations

 There should be strong top management support. Without leadership from top
management, some managers may not be motivated to embrace the need to
change.
 Top managers should ensure that ABC data are linked to how people are
evaluated and rewarded. If employees continue to be evaluated and rewarded
using traditional (non-ABC) cost data, they will quickly get the message that ABC
is not important and they will abandon it.
 A cross-functional team should be created to design and implement the ABC
system. Cross-functional employees possess intimate knowledge of operations
that is necessary for designing an effective ABC system. Tapping the knowledge
of cross-functional managers lessens their resistance to ABC because they feel
included in the implementation process

Activity-based costing and External Reporting

There are four reasons why most companies do not use ABC for external reporting
purposes.
1. External reports are less detailed than internal reports in the sense that individual
product costs are not reported. External reports only disclose cost of goods sold
and ending inventory. Therefore, if some products are under-costed and others are
over-costed, the errors tend to cancel each other out when the product costs are
added together.
2. It is often very difficult to change a company’s accounting system because it is
deeply embedded within complex computer programs that have evolved over
many years.
3. An ABC system, such as the one described in the chapter, does not conform to
generally accepted accounting principles (GAAP). It excluded some organization-
sustaining manufacturing costs, some unused capacity costs, and it included some
nonmanufacturing costs in its product cost calculations. These cost system design
attributes do not comply with GAAP.
4. Auditors are likely to be uncomfortable with cost allocations that are based upon
interviews with the company’s personnel. This type of subjective data can be easily
manipulated by management.

Limitations of ABC

There are five limitations of activity-based costing.

1. Implementing an ABC system requires substantial resources. The benefits of

increased cost accuracy may not outweigh the implementation costs. 
2. ABC systems produce numbers, such as product margins, that are at odds
with the numbers produced by traditional cost systems. Managers are not
accustomed to managing their operations using these numbers; hence, ABC
inevitably faces resistance.
3. In practice, most managers insist on fully allocating all costs to products. The
ABC system described does not conform to this preference. 
4. ABC systems do not automatically identify the relevant costs for particular
decisions; therefore, ABC data can be easily misinterpreted and must be
used with care when making decisions.
5. Finally, most organizations use ABC as a supplement to rather a replacement
for their existing cost system. Maintaining two cost systems is costlier than
 maintaining just one system and it may cause confusion about which set of
numbers is to be relied on.

CHAPTER EXERCISES

I – Review Questions

1. Why are new approaches to overhead cost application, such as activity-based

costing, needed in many companies today?
2. When designing an ABC system, why should process value analysis always be the
starting point?
3. What are the levels of activity that can be identified in a company?
4. Why is direct labor a poor base for allocating overhead in many companies?
5. What are the limitations of ABC?

II – Fill in the missing item. Listed below are several terms relating to activity-based
costing:

Process value analysis Plant-wide overhead rate

Facility level Low volume
High volume Batch level
Activity centers Two stage
Product level Unit Level
Volume Stage

Choose the term or terms above that most appropriately complete the following
statements. The terms can be used more than once. (Note that a blank can hold out
more than one word).

1. A single overhead rate used throughout an entire plant operation is known as a

_______________.
2. The major problem with direct labor-hours or machine-hours as the basis for
assigning overhead cost to products is that these bases rely on ___________
as the sole factor in overhead cost assignment.
3. Activity-based costing involves a ____________ allocation process, in which the
first ___________ assigns overhead costs to activity centers and the second
 ____________ assigns overhead costs from activity centers to products and
services.
4. ____________, which involves a systematic analysis of the activities required to
make a product or perform a service, is the beginning point in activity-based
costing.
5. ____________ activities, such as the consumption of power, are performed each
time a unit is produced and arise as a result of the total volume of production
going through a facility.
6. ____________ activities, which are performed each time a batch of goods is
handled or processed, include tasks such as placement of a purchase order.
7. ____________ activities which are performed as needed to support the
production of a particular product, include tasks such as maintaining parts
inventories.
8. ____________ activities just sustain a facility’s general manufacturing process
and include items such as insurance or general factory management.
9. The use of activity-based costing often causes a shift in overhead costs from
____________ products to ____________ products, thereby causing the unit
cost of the ___________ products to sharply increase.
10. One of the benefits of activity-based costing is that it increases the number of
cost pools, or ____________, used to accumulate and assign overhead costs to
products and services.

III – Identification: The following activities occur at Luca Corporation, a company that
manufactures a variety of products.
a. Various individuals manage the parts inventories.
b. A clerk in the factory issues purchase order for a job.
c. The personnel department trains new production workers.
d. The factory’s general manager meets with other department heads such as
marketing to coordinate plans.
e. Direct labor workers assemble products.
f. Engineers design new products.
g. The materials storekeeper issues raw materials to be used in jobs.
h. The maintenance department performs periodic preventive maintenance on
general-use equipment.
Required:
Classify each of the activities above as either a unit-level, batch-level, product-level, or
organization-sustaining activity.

IV – Problem
BB systems, Inc. makes paragliders for sale through specialty sporting goods stores.
The company has a standard paraglider model, but also makes custom-designed
paragliders. Management has designed an activity-based costing system with the
following activity cost pools and activity rates:
Activity Cost Pool Activity Rate
Supporting manufacturing 18 per direct labor-hour
Order processing 192 per order
Custom designing 261 per custom design
Custom service 426 per customer
Management would like an analysis of the profitability of a particular customer, Fly High,
which has ordered the following products over the last 12 months:
Standard Model Custom Design
Number of gliders 10 2
Number of orders 1 2
Number of custom designs 0 2
Direct labor-hours per glider 28.5 32.0
Selling price per glider 1,650 2,300
Direct materials cost per glider 462 576
The company’s direct labor rate is P19 per hour.
Required: Using the company’s activity-based costing system, compute the customers
margin of Fly High.