Chapter Three

Activity-Based Costing (ABC)

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After studying Chapter three, you should be able
to understand:

1. Traditional Cost Allocation

2. Refining a Costing System
3. Activity-Based Costing Systems
4. Traditional Cost Allocation vs ABC system
5. Considerations in Implementing Activity-Based-
Costing Systems
6. The Limitations of Activity-Based Costing
7. Activity-based Management (ABM)
8. Activity-Based Costing and Department Costing
Systems
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 1. Introduction

• This chapter introduces the concept of

activity-based costing which has been
embraced by a wide variety of
manufacturing, service, and non-profit
organizations.

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 …cont

• 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.

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 2. Traditional Cost Allocation

1. Broad Averaging

2. Simple costing system

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 …Cont

1. Broad Averaging and Its Results

Explain how broad averaging under-costs

and over-costs products or services?

Reported costs = actual costs.

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 …Cont
Product under-costing-a product consumes a
high level of resources but is reported to
have a low cost per unit.
Used resources > Reported cost

Product over-costing-a product consumes a

low level of resources but is reported to
have a high cost per unit.
Used resources < Reported cost
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 …cont
Recommended:
• Companies produced a limited variety of
products.

• Indirect (or overhead) costs were a

relatively small percentage of total costs.

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 …cont

For example: Consider the cost of a

restaurant bill for four colleagues who
meet monthly to discuss business
developments. Each diner orders separate
entrees, desserts, and drinks. The
restaurant bill for the most recent
meeting is as follows:

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 …Cont

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 …cont
What are the strategic consequences of
product under-costing and over-costing?

•Under-costed products = Underpriced

(losses—sales).

•Over-costed products= Overpricing (lose

market share).

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 …cont
2. Simple Costing System
• Allocating indirect costs using a single
indirect-cost rate (one cost-pool and one
Cost-allocation base).

• The seven steps to calculate budgeted

costs for each type of product are:

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 …cont

Step 1: Identify the Products (Cost Objects)

Step 2: Identify the Direct Costs of the

Products

Step 3: Select the Cost-Allocation Bases

Step 4: Identify the Indirect Costs

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 …cont
Step 5: Compute the Rate per Unit of
Each Cost-Allocation Base

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 …cont
Step 6: Compute the Indirect Costs
Allocated to the Products

Indirect cost = Budgeted indirect-cost

rate x total cost-allocation base

Step 7: Compute the Total Cost of the

Products

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 …cont
Example:
Assume that Max corporation produces two
types of lenses: Simple lens, S2, and
complex lens, CL4. The corporation uses
simple costing system to calculate
budgeted costs of 60,000 simple lenses
and 15,000 complex lenses that will
produce in 2021.

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 …cont
Total direct material costs are $1,800,000,
of which $1,125,000 is for simple lenses
and the remaining amount is for complex
lenses. Total direct manufacturing labor
costs are $795,000, out of which
$600,000 is for simple lenses and the
remaining is for complex lenses.

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 …cont
• Max uses direct manufacturing labor-
hours as the only allocation base to
allocate all manufacturing and
nonmanufacturing indirect costs to S2
and CL4. In 2021, Max plans to use
30,000 total direct manufacturing labor-
hours to make the 60,000 S2 lenses and
9,750 total direct manufacturing labor-
hours to make the 15,000 CL4 lenses.

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 …cont

Because Max uses only a single cost-

allocation base, Max groups all budgeted
indirect costs of $2,385,000 for 2021 into
a single overhead cost pool. How much
cost is required to produce one product
under each type of product?

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 3. Refining a Costing System

• A refined costing system reduces the use of broad

averages for assigning the cost of resources to
cost objects.

• Provides better measurement of the costs of

indirect resources used by different cost.

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 …cont
Reasons for refining a costing system:

1. Increase in product diversity

For example, Samsung Company produces many
different types of products like mobile, TV,
heating elements, etc.

2. Increase in indirect costs

3. Competition in product markets.

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 …cont
Guidelines for refining a costing System:

1. Direct-cost tracing (or classify more

costs as direct costs).

2. Indirect-cost pools (or expand the

number of indirect cost pools).

3. Cost-allocation bases (or identify cost

drivers).
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4.Activity-Based Costing Systems

• Activity-based costing (ABC) refines a

costing system by identifying individual
activities as the fundamental cost objects
or a technique that is designed to reflect
diverse factors more accurately when
costing products.

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 …cont
For example, designing products, setting up
machines, operating machines, and
distributing products.
Example 1:
Recall, the Max Company, the team of ABC
systems identifies the following seven
activities by considering the appropriate
steps and processes needed to design,
manufacture, and distribute S2 and CL4
lenses.
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 …cont

Such activities are design products, set up

machines, operate molding machines to
manufacture lenses, clean and maintain the
molds after lenses are manufactured,
prepare batches of finished lenses for
shipment, distribute lenses to customers,
and administer and manage all processes.

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 …cont
Of the $2,385,000 in the total indirect-
cost pool, Max company identifies the
total costs of setups (consisting mainly of
depreciation on setup equipment and
allocated costs of process engineers,
quality engineers, and supervisors) to be
$300,000. The resources needed for each
setup depend on the complexity of the
manufacturing operation.

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 …cont

Complex lenses require more setup resources

(setup-hours) per setup than simple lenses.
Setup data for the simple S2 lens and the
complex CL4 lens are as follows:

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 …cont

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 …cont
How much will be the setup costs of each
product using direct manufacturing
labor-hours (DMLH) and setup-hours as
a cost driver?

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 …cont
Example 2:
Recall one more, the Max Company, the team
of ABC systems identifies the following
seven activities by considering the
appropriate steps and processes needed to
design manufacture, and distribute S2 and
CL4 lenses. Such activities are design
products (product-level activities), setup
machines (batch-level activities), machine
operations (unit-level activities), clean and
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 …cont
maintain, shipment setup (batch-level
activities), distribution (unit-level
activities), and administration
(organization-sustaining activities). Of the
$2,385,000 in the total indirect-cost pool,
$270,000 ($120,000 for S2 lense and
$150,000 for CL4 lens) cost is directly
traced to clean and maintain costs.

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 …cont
The company also found that of the
$2,385,000 indirect cost pool , $450,000,
$300,000, $637,500, $81,000, $391,500,
and $225,000 are design, setup machine,
machine operations, shipment setup,
distribution, and administration costs
respectively. Moreover, the company team
of ABC system identified 100 parts-square
feet for design activity (30 for S2 and 70
for CL4),
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 …cont
2,000 machine setup-hours for machine setup
activity (500 for S2 and 1,500 for CL4),
12,750 machine operation hours for machine
operations (9,000 for S2 and 3,750 for CL4),
200 shipments for shipment activity (100 for
each products), 67,500 cubic feet delivered
for distribution activity,( 45,000 for S2 and
22,500 for CL4), 39,750 direct
manufacturing labor hours for administration
activity (30,000 for S2 and 9,750 for Cl4).

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 …cont
Required:
1. What is the activity rate of each cost pool?

2. Allocate overhead costs to each product.

3. Compute cost per unit for each type of product?

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 4.1 Steps for Implementing Activity-Based Costing

The most common steps to allocate overhead

costs to cost objects:
1. Identify and define activities and
activity cost pools.

2. Wherever possible, directly trace costs

to activities and cost objects.

3. Assign costs to activity cost pools.

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 …cont
4. Calculate activity rates.

5. Assign costs to cost objects using the

activity rates and activity measures.

6. Prepare management reports.

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 …cont
1. Identify and define activities and activity
cost pools.
• Difficult

• Time-consuming

• Involves a great deal of judgment

• By interviewing people who work in overhead

departments and ask them to describe their
major activities.
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 …cont
Activities can be organized into four general
levels (Cost hierarchies):
1. Unit-level activities (output unit-level
costs)
2. Batch-level activities (batch-level costs)
3. Product-level activities (product-
sustaining costs or service-sustaining
costs), and
4. Organization-sustaining activities
(facility-sustaining costs).
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 …cont
1. Unit-level activities (Output unit-level
costs)
• Performed each time a unit is produced.

For example, tasks or costs such as

machine operations (machine operations
costs such as the cost of energy, machine
depreciation, and repair) related to the
activity of running the automated
machines are output unit-level costs.
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 …cont
2. Batch-level activities (Batch-level costs)

• Performed each time a batch is handled

or processed, regardless of how many units
are in the batch.

• They are incurred once for each batch

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 …cont

For example, tasks or costs such as placing

purchase orders (placing purchase orders
costs), setting up equipment (costs to
setting up equipment), and arranging for
shipments to customers (arranging costs
for shipments to customers) are batch-
level activities and costs.

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 …cont
3. Product-level activities (Product-
sustaining costs or service-sustaining
costs)

• Relate to specific products and typically

must be carried out regardless of how
many batches are run or units of product
are produced or sold.

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 …cont

For example, activities or costs such as

designing a product (design costs), product
research and development (research and
development costs), marketing to launch
new products (marketing costs to launch
new products), advertising a product
(advertising costs).

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 …cont
4. Organization-sustaining activities (Facility-
sustaining costs)

• Support the organization as a whole.

• It is usually difficult to find a good cause and

effect.
For example, the general administration (general
administration costs including top management
compensation, rent, building security, heating
the factory, and so on).
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 …cont
2. Whenever Possible, Directly Trace Overhead
Costs to Activities and Cost Objects (Identify
overhead costs)

Annual manufacturing overhead and selling

and administrative costs for Mall company,
example 3, are presented hereunder:

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 …cont

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 …cont

3. Assign Costs to Activity Cost Pools (first-stage

allocation)

• Costs should be traced directly to

activity cost pools.

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 …cont

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 …cont

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 …cont
4. Calculate Activity Rates

Activity rates = Total cost for each activity

Total activity (cost-driver)

Assume, for example, the ABC team of Mall company found

that 1,000 customer orders per year, 200 new product
designs, 20,000 machine hours with regard to order size,
100 customers, and 49,000 direct labour hours with regard
to other cost pool (such as organization-sustaining costs
and costs of idle capacity).What is the activity rate of
each cost pool?

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 …cont

5. Assign Costs to Cost Objects

• Called second-stage allocation

Example: let us consider one customer of

Mall company- Valley. This customer
ordered two different products—Valley
X and Valley Y. Data concerning these
two products appear as follows:
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 …cont
Valley X product:
1. Four hundred units were ordered during the
year, comprising two separate orders.
2. This is a standard design that does not
require any new design resources.
3. Each required 0.5 machine-hours.
4. Total required 500 direct labor hour
5. The selling price per unit was $34.
6. Direct materials for 400 units totaled $2,110.
7. Direct labor for 400 units totaled $1,850.

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 …cont

Valley Y product:
1. There was only one order for a single unit
during the year.
2. This is a custom product that requires new
design resources.
3. It required 4 machine-hours.
4. Total required 20 direct labor hour
5. The selling price was $650.
6. Direct materials were $13.
7. Direct labor was $50.
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 …cont

Required:
• Allocate overhead costs to each product.

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 …cont
6. Prepare Management Reports
Product margin or product profitability analysis for
the two products using ABC system:

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 …cont

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 5. Traditional Cost Allocation vs ABC system

In activity-based costing:

1. Nonmanufacturing as well as manufacturing

costs may be assigned to products.

2. A number of overhead cost pools are

used.

3. The allocation bases often varies.

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 6. The Limitations of Activity-Based Costing

1. Requires substantial resources (costly)

2. Overstated costs and understated margins

3. Activity-based costing data can easily be

misinterpreted.

4. Activity-based costing systems do not

conform to GAAP.
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 7. Considerations in Implementing
Activity-Based-Costing Systems
1. Significant amounts of indirect costs

2. All or most indirect costs are identified as

output unit-level costs

3. Products make diverse demands on resources

4. Operations staff has substantial

disagreement with the reported costs
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 8. Activity-based Management (ABM)

• Is a method of management decision

making that uses activity-based costing
information to improve customer
satisfaction and profitability.

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 …cont
We define ABM broadly to include:
1. Pricing and product mix decisions

2. Process improvement decisions and cost

reduction, and

3. Product and process designs.

4. Planning and Managing Activities

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9.Activity-Based Costing and Department Costing Systems

• ABC systems, with its focus on specific

activities, are a further refinement of
department costing systems into more
focused and homogenous cost pools.

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 …cont
Consider Max company as example, the
manufacturing department identifies two
activity cost pools—a setup cost pool and a
machine operations cost pool (ABC system)
—instead of a single manufacturing
department overhead cost pool
(department costing system).

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 …cont

When can department costing systems be

used instead of ABC systems? Or When
can department indirect cost rates to
allocate costs to products results in
similar information as activity cost
rates?

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 …cont

1. If each activity has the same cost driver

(cost-allocation base).

2. Different cost-allocation bases within a

department but different products use
resources from the different activity
areas in the same proportions.

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 End of chapter Three

Thank you too!!!

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