Activity Based Costing

(ABC)
Activity-Based Costing: An Overview
• Traditional absorption costing is designed to provide data for external
financial reports.
• In contrast, activity-based costing is designed to be used for internal
decision making
• In activity-based costing:
1. Nonmanufacturing as well as manufacturing costs may be assigned to
products, but only on a cause-and-effect basis.
2. Some manufacturing costs may be excluded from product costs.
3. Numerous overhead cost pools are used, each of which is allocated to
products and other cost objects using its own unique measure of activity.
Manufacturing Costs and Activity-
Based Costing
• In traditional cost accounting systems, all manufacturing costs are assigned to
products— even manufacturing costs that are not caused by the product
• Manufacturing overhead includes costs such as the factory security guard’s
wages, the plant controller’s salary, and the cost of supplies used by the plant
manager’s secretary.
• These types of costs are assigned to products in a traditional absorption costing
system even though they are totally unaffected by which products are made
during a period.
• In contrast, activity-based costing systems do not arbitrarily assign these types
of costs, which are called organization-sustaining costs, to products. Activity-
based costing treats these types of costs as period expenses rather than product
costs
Manufacturing Costs and Activity-
Based Costing
• In a traditional absorption costing system, the costs of unused, or idle,
capacity are assigned to products.
• In contrast, in activity-based costing, products are only charged for
the costs of the capacity they use—not for the costs of capacity they
don’t use.
• The activity-based approach has appeal in today’s business
environment because it uses more cost pools and unique measures of
activity to better understand the costs of managing and sustaining
product diversity
Cost Pools, Allocation Bases, and
Activity-Based Costing
• An activity is any event that causes the consumption of overhead
resources
• An activity cost pool is a “bucket” in which costs are accumulated that
relate to a single activity measure in the ABC system
• An activity measure is an allocation base in an activity-based costing
system
• Transaction drivers are simple counts of the number of times an activity
occurs, such as the number of bills sent out to customers
• Duration drivers measure the amount of time required to perform an
activity, such as the time spent preparing individual bills for customers
Allocation Bases
1) Unit-level activities are performed each time a unit is produced.
• The costs of unit level activities should be proportional to the number
of units produced.
• For example, providing power to run processing equipment would be
a unit-level activity because power tends to be consumed in
proportion to the number of units produced.
Allocation Bases
• 2) Batch-level activities are performed each time a batch is handled
or processed, regardless of how many units are in the batch.
• For example, tasks such as placing purchase orders, setting up
equipment, and arranging for shipments to customers are batch-level
activities. They are incurred once for each batch (or customer order).
• Costs at the batch level depend on the number of batches processed
rather than on the number of units produced. For example, the cost
of setting up a machine for batch processing is the same regardless of
whether the batch contains one or thousands of item
Allocation Bases
3) Product-level activities 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.
• For example, activities such as designing a product, advertising a
product, and maintaining a product manager and staff are all product-
level activities.
Allocation Bases
4) Customer-level activities relate to specific customers and include
activities such as sales calls, catalog mailings, and general technical
support that are not tied to any specific product.
5) Organization-sustaining activities are carried out regardless of which
customers are served, which products are produced, how many
batches are run, or how many units are made.
This category includes activities such as heating the factory, cleaning
executive offices, providing a computer network, arranging for loans,
preparing annual reports to shareholders, and so on.
Designing an Activity-Based Costing
(ABC) System
Steps for Implementing Activity-
Based Costing:
1. Define activities, activity cost pools, and activity measures.
2. Assign overhead costs to activity cost pools.
3. Calculate activity rates.
4. Assign overhead costs to cost objects using the activity rates and
activity measures.
5. Prepare management reports.
Step 1: Define Activities, Activity
Cost Pools, and Activity Measures
Step 1: Define Activities, Activity
Cost Pools, and Activity Measures
• The Customer Orders cost pool will be assigned all costs of resources
that are consumed by taking and processing customer orders,
including costs of processing paperwork and any costs involved in
setting up machines for specific orders.
• The activity measure for this cost pool is the number of customer
orders received.
• This is a batch-level activity because each order generates work that
occurs regardless of whether the order is for one unit or 1,000 units
Step 1: Define Activities, Activity
Cost Pools, and Activity Measures
• The Product Design cost pool will be assigned all costs of resources
consumed by designing products.
• The activity measure for this cost pool is the number of products
designed.
• This is a product-level activity because the amount of design work on
a new product does not depend on the number of units ultimately
ordered or batches ultimately run.
Step 1: Define Activities, Activity
Cost Pools, and Activity Measures
• The Order Size cost pool will be assigned all costs of resources
consumed as a consequence of the number of units produced,
including the costs of miscellaneous factory supplies, power to run
machines, and some equipment depreciation.
• This is a unit-level activity because each unit requires some of these
resources. The activity measure for this cost pool is machine-hours.
Step 1: Define Activities, Activity
Cost Pools, and Activity Measures
• The Customer Relations cost pool will be assigned all costs associated
with maintaining relations with customers, including the costs of sales
calls and the costs of entertaining customers.
• The activity measure for this cost pool is the number of customers the
company has on its active customer list.
• The Customer Relations cost pool represents a customer-level
activity.
Step 1: Define Activities, Activity
Cost Pools, and Activity Measures
• The Other cost pool will be assigned all overhead costs that are not
associated with customer orders, product design, the size of the
orders, or customer relations.
• These costs mainly consist of organization-sustaining costs and the
costs of unused, idle capacity.
• These costs will not be assigned to products because they represent
resources that are not consumed by products.
Practice Question
Step 2: Assign Overhead Costs to
Activity Cost Pools
• The first-stage allocation in an ABC system is the process of assigning
functionally organized overhead costs derived from a company’s
general ledger to the activity cost pools.
• Refer to excel
Practice Question
Practice Question
Step 3: Calculate Activity Rates
• The ABC team determined the total activity for each cost pool that would be
required to produce the company’s present product mix and to serve its present
customers
• These numbers are listed in Exhibit 7–6 . For example, the ABC team found that 400
new product designs are required each year to serve the company’s present
customers. The activity rates are computed by dividing the total cost for each
activity by its total activity. For example, the $320,000 total annual cost for the
Customer Orders cost pool (which was computed in Exhibit 7–5 ) is divided by the
total of 1,000 customer orders per year to arrive at the activity rate of $320 per
customer order
• Note that an activity rate is not computed for the Other category of costs. This is
because the Other cost pool consists of organization-sustaining costs and costs of
idle capacity that are not allocated to products and customers
Practice Question
Step 4: Assign Overhead Costs to
Cost Objects
• In the second-stage allocation, activity rates are used to apply
overhead costs to products and customers
Step 4: Assign Overhead Costs to
Cost Objects
• we describe another example of second-stage allocation—assigning
activity costs to customers. The data needed by Classic Brass to assign
overhead costs to one of its customers—Windward Yachts—are as
follows:
Step 5: Prepare Management
Reports
• The most common management reports prepared with ABC data are
product and customer profitability reports.
• The Classic Brass ABC team realized that the profit from a product,
also called the product margin, is a function of the product’s sales and
the direct and indirect costs that the product causes