8-1

Activity-Based
Costing:
A Tool to Aid
Decision Making
CHAPTER 8

Activity–Based Costing
(ABC)

ABC is designed to provide managers

with cost information for strategic and
other decisions that potentially affect
capacity and therefore affect “fixed”
as well as variable costs.

Slide 2
 8-2

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.

Slide 3

How Costs are Treated Under

Activity–Based Costing
ABC differs from traditional cost accounting in three ways.

Manufacturing Nonmanufacturing
costs costs
Some
All

Traditional ABC
product costing product costing

 ABC does not assign all manufacturing costs to products.

Slide 4
 8-3

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.
Slide 5

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.

Slide 6
 8-4

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 single
Cost Pool activity measure are
accumulated.

Slide 7

How Costs are Treated Under

Activity–Based Costing
The term cost driver is
Activity
also used to refer to
Measure
an activity measure.

An allocation base
in an activity-based
costing system.

Slide 8
 8-5

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.

Slide 9

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.
Slide 10
 8-6

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
Slide 11

Characteristics of
Successful ABC
Implementations

Strong top
management support
Link to evaluations
and rewards

Cross-functional
involvement

Slide 12
 8-7

Baxter Battery – An ABC

Example Baxter Battery Company
Income Statement
Year Ended December 31, 2009

Sales $ 50,000,000
Cost of goods sold
Direct materials $ 15,000,000
Direct labor 12,000,000
Manufacturing overhead 14,000,000 41,000,000
Gross margin 9,000,000
Selling and administrative expenses
Shipping expenses 3,000,000
Marketing expenses 2,000,000
General administrative expenses 6,000,000 11,000,000
Net operating income
loss $ (2,000,000)

Manufacturing overhead is allocated to products using

a single plantwide overhead rate based on machine hours.

Slide 13

 Define Activities, Activity

Cost Pools, and Activity
Measures
At Baxter Battery, the ABC team, selected the following
activity cost pools and activity measures:

Slide 14
 8-8

 Define Activities, Activity

Cost Pools, and Activity
Measures
 Customer Orders - assigned all costs of resources that
are consumed by taking and processing customer
orders.
 Design Changes - assigned all costs of resources
consumed by customer requested design changes.
 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 organization-sustaining costs and
unused capacity costs

Slide 15

 Assign Overhead Costs to

Activity Cost Pools

Slide 16
 8-9

 Assign Overhead Costs to

Activity Cost Pools

Direct materials, direct labor, and shipping are excluded

because Baxter Battery’s existing cost system can directly
trace these costs to products or customer orders.
Slide 17

 Assign Overhead Costs to

Activity Cost Pools
At Baxter Battery the following distribution of resource
consumption across activity cost pools is determined.

Slide 18
 8-10

 Assign Overhead Costs to

Activity Cost Pools

Indirect factory wages $6,000,000

Percent consumed by customer orders 30%
$1,800,000

Slide 19

 Assign Overhead Costs to

Activity Cost Pools

Factory equipment depreciation $3,500,000

Percent consumed by customer orders 20%
$ 700,000

Slide 20
 8-11

 Assign Overhead Costs

to Activity Cost Pools

Slide 21

 Calculate Activity Rates

The ABC team determines that Baxter Battery will have these total
activities for each activity cost pool . . .
 10,000 customer orders,
 4,000 design changes,
 800,000 machine-hours,
 2,000 customers served.

Now the team can compute the individual

activity rates by dividing the total cost for
each activity by the total activity levels.

Slide 22
 8-12

 Calculate Activity Rates

Slide 23

Activity–Based Costing at
Baxter Battery
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

Traced Traced Traced

Cost Objects:
Products, Customer Orders, Customers

Slide 24
 8-13

Activity–Based Costing at
Baxter Battery
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Design Order Customer

Other
Orders Changes Size Relations

Cost Objects:
Products, Customer Orders, Customers

Slide 25

Activity–Based Costing at
Baxter Battery
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Design Order Customer

Other
Orders Changes Size Relations

Second-Stage Allocations

$/Order $/Change $/MH $/Customer

Cost Objects:
Unallocated
Products, Customer Orders, Customers

Slide 26
 8-14

 Assigning Overhead to
Products
Baxter Battery Information
SureStart
1. Requires no new design resources.
2. 800,000 batteries ordered with 4,000 separate orders.
3. Each SureStart requires 36 minutes of machine
time for a total of 480,000 machine-hours.

LongLife
1. Requires new design resources.
2. 400,000 batteries ordered with 6,000 separate orders.
3. 4,000 custom designs prepared.
4. Each LongLife requires 48 minutes of machine
time for a total of 320,000 machine-hours.

Slide 27

 Assigning Overhead to
Products

Slide 28
 8-15

Assigning Overhead to
Customers
Let’s take a look at how Baxter Battery’s system works for just
one of the 2,000 customers – Acme Auto Parts who placed a
total of twelve orders. Note that the four orders for LongLifes
required a design change.

Orders
1. Eight orders for 60 SureStarts per order.
2. Four orders for 50 LongLifes per order.

Machine-hours
1. The 480 SureStarts required 288 machine-hours.
2. The 200 LongLifes required 160 machine hours.

Slide 29

Assigning Overhead to
Customers

Slide 30
 8-16

 Prepare Management
Reports
Product Margin Calculations
The first step in computing product margins is to
gather each product’s sales and direct cost data.

SureStarts LongLifes Total

Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Direct costs
Direct material 9,000,000 6,000,000 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000
Shipping 2,000,000 1,000,000 3,000,000

Slide 31

 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.

SureStarts LongLifes Total

Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Direct costs
Direct material 9,000,000 6,000,000 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000
Shipping 2,000,000 1,000,000 3,000,000
ABC cost assignments
Customer orders 1,808,000 2,712,000 4,520,000
Design changes 3,040,000 3,040,000
Order size 3,120,000 2,080,000 5,200,000

Slide 32
 8-17

 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.
SureStarts LongLifes
Sales $ 31,300,000 $ 18,700,000
Costs
Direct material $ 9,000,000 $ 6,000,000
Direct labor 7,000,000 5,000,000
Shipping 2,000,000 1,000,000
Customer orders 1,808,000 2,712,000
Design changes 3,040,000
Order size 3,120,000 2,080,000
Total cost 22,928,000 19,832,000
Product margin $ 8,372,000 $ (1,132,000)
Slide 33

 Prepare Management
Reports
Product Margin Calculations
The product margins can be reconciled with
the company’s net operating income as follows:
SureStarts LongLifes Total
Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Total costs 22,928,000 19,832,000 42,760,000
Product margins $ 8,372,000 $ (1,132,000) $ 7,240,000

Less costs not assigned to products:

Customer relations 3,080,000
Other 6,160,000
Total 9,240,000
Nett operating income
loss $ (2,000,000)

Slide 34
 8-18

 Prepare Management
Reports
Customer Margin Analysis
The first step in computing Acme Auto Parts’ customer
margin is to gather its sales and direct cost data.

Acme Auto
Parts
Sales $ 29,200
Direct costs
Direct material 7,500
Direct labor 6,700
Shipping 1,700
Slide 35

 Prepare Management
Reports
Customer Margin Analysis
The second step is to incorporate Acme Auto Parts’
previously computed activity-based cost assignments.
Acme Auto
Parts
Sales $ 29,200
Direct costs
Direct material 7,500
Direct labor 6,700
Shipping 1,700
ABC cost assignments
Customer orders 5,424
Product design 3,040
Order size 2,912
Customer relations 1,540
Slide 36
 8-19

 Prepare Management
Reports
Customer Margin Analysis
The third step is to compute Acme Auto Parts’ customer margin of
$384 by deducting all its direct and indirect costs from its sales.

Acme Auto Parts

Sales $ 29,200
Direct costs
Direct material $ 7,500
Direct labor 6,700
Shipping 1,700
Customer orders 5,424
Product design 3,040
Order size 2,912
Customer relations 1,540 28,816
Customer margin $ 384
Slide 37

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.
SureStarts LongLifes Total
Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Direct costs
Direct material 9,000,000 6,000,000 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000

Slide 38
 8-20

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 Baxter Battery
Production Department
Indirect factory wages $ 6,000,000
Factory equipment depreciation 3,500,000
Factory utilities 2,500,000
Factory building lease 2,000,000
Total manufacturing overhead $ 14,000,000

Plantwide manufacturing $14,000,000

= = $17.50 per machine-hour
overhead rate 800,000 MH

Machine-hours
SureStarts (800,000 @ 0.60 hours) 480,000
LongLifes (400,000 @ 0.80 hours) 320,000
Total machine-hours 800,000

Slide 39

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
SureStarts 480,000 $ 17.50 $ 8,400,000
LongLifes 320,000 17.50 5,600,000
Total overhead allocated to products $ 14,000,000

480,000 hours × $17.50 per hour = $8,400,000

Slide 40
 8-21

Product Margins Computed

Using the Traditional Cost System

The fourth step is to actually

compute the product margins.

SureStarts LongLifes Total

Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Cost of goods sold
Direct materials $ 9,000,000 $ 6,000,000 $ 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000
Manufacturing overhead 8,400,000 24,400,000 5,600,000 16,600,000 14,000,000 41,000,000
Product margin $ 6,900,000 2,100,000 9,000,000
Selling and administrative 11,000,000
Nett operating
operating income
loss $ (2,000,000)

Shipping expenses $ 3,000,000

Marketing expenses 2,000,000
General administrative expenses 6,000,000
$ 11,000,000
Slide 41

Differences Between ABC

and Traditional Product
Costs
SureStarts LongLifes
Product margins – traditional $ 6,900,000 $ 2,100,000
Product margins – ABC 8,372,000 (1,132,000)
Change in reported margins $ 1,472,000 $ (3,232,000)

The traditional cost The traditional cost

system overcosts the system undercosts the
SureStarts and reports LongLifes and reports
a lower product a higher product
margin for this product. margin for this product.
Slide 42
 8-22

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.

Slide 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 costs using a volume-related allocation
base. ABC costing also uses non-volume related
allocation bases.

Slide 44
 8-23

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.
Slide 45

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.
Slide 46
 8-24

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.

Slide 47

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.

Slide 48