Ch.

7 – Activity Based Costing

Product Costing Systems
Goal: Track product costs and trace to
specific products
2 Systems “Normal (Absorption/Traditional)
1. Job-Order Costing Costing”
2. Process Costing

• Why do companies need a new approach?

 Tremendous change in manufacturing and service
industries Decrease in amount of direct labor usage &
significant increase in total overhead costs.
 May be inappropriate to use plant-wide predetermined
overhead rates based on direct labor or machine hours
when a lack of correlation exists.
 Complex manufacturing processes may require multiple
allocation bases (cost drivers); this approach is called
Activity-Based Costing (ABC).
Traditional (Absorption) Costing
Cost
Manufactur Objects
ing (products,
Overhead jobs,
Costs customers,
etc.)

 To assign/allocate product costs (DM+DL+MOH) to cost

objects (jobs, customers, products, etc.)
 To determine the amount of MOH to assign to each product,
service or job  Use single, volume based cost driver (DLHs,
MHs, DLC, etc.) to allocate MOH costs
 What’s the issue?
 When production uses a large amount of non-volume
based activities (activities other than DL or machine hrs),
using one cost driver will not assign MOH correctly
 Result: distorted product costs
 So why use it? It’s cheap and convenient
Activity Based Costing: Some Definitions
Cost
Objects
Overhe Activities
(products,
adCost (“Cost
jobs,
s Pools”)
customers,
First- Second-
etc.)
stage stage
allocatio allocation
n

Activity-based costing is an alternative

product-costing system which follows a two-
stage procedure to assign overhead costs to
products.
How Costs are Treated Under Activity–Based Costing

ABC Costing differs from traditional costing in four

ways:

1. In ABC, nonmanufacturing as well as manufacturing

costs may be assigned to products, but only on a
cause-and-effectcosts
Manufacturing basis. Nonmanufacturing costs

Traditional
ABC product costing
product costing
* All direct manufacturing and nonmanufacturing costs are
traced to products. For example, ABC systems can assign
sales commissions and shipping costs to specific products.
* Overhead costs include all indirect costs (manufacturing
and nonmanufacturing) that are presumably caused by
products
How Costs are Treated Under Activity–Based Costing

ABC Costing differs from traditional costing in four

ways:

2. In ABC, some manufacturing costs may be excluded

from product costs.
Manufacturing costs Nonmanufacturing costs
All Most, but Some
not all
Traditional
ABC product costing
product costing

ABC excludes organization-sustaining (facility-level)

costs (e.g., factory security guard’s wages, plant
controller’s salary, etc.) and idle capacity costs from
product cost. ABC treats organization-sustaining costs as
period expenses.
How Costs are Treated Under Activity–Based Costing

ABC Costing differs from traditional costing in four

ways:

3. ABC differs from traditional cost accounting because

numerous overhead cost pools are used.

4. Each ABC cost pool has its own unique measure of

activity, while traditional cost systems usually rely
on direct labor hours and/or machine hours to
allocate all overhead costs to products.
Activity Based Costing: Some Definitions
Cost
Objects
Overhe Activities
(products,
adCost (“Cost
jobs,
s Pools”)
customers,
First- Second-
etc.)
stage stage
allocatio allocation
n
Activity: any event that causes the consumption of overhead

Activity cost pool: “Buckets” of costs related to a single

activity

Activity measure: allocation base; also called a “cost driver”

Transaction drivers: # of times an activity occurs (most
common)
Duration drivers: amount of time spent on the activity (more
accurate)
What are types of activities?
Traditional cost systems rely exclusively on allocation bases that
are driven by the volume of production. ABC defines five levels
of activity that largely do not relate to the volume of units
produced.

1. Unit-level activities - Performed each time a unit is produced.

 Example: Machine electricity
 Possible cost driver: machine hours

2. Batch-level activities - Performed each time a batch (group of

units) is handled or processed. A truckload – set cost incurred
no matter # of units in load.
 Example: Machine setups
 Possible cost driver: # of setups

3. Product-level activities - Costs to keep type (or brand) of

product, regardless of # of units or batches.
 Product design costs
 Possible cost driver: # of products designed
What are types of activities?

4. Customer-level activities - Costs to keep a customer

happy; activities may include sales calls, promotional
mailings and general technical support not tied to one
specific product.
 Technical support
 Possible cost driver: # of customers

5. Organization-sustaining (facility-level) activities -

Costs to keep company or factories operating,
regardless of # of units, batches, # of products, or # of
customers.
 Costs tracked by factory = rents on factories, plant maintenance
 These types of activities are grouped as “OTHER” and not
assigned to products because they are not consumed by
products (i.e., lack cause and effect relationship). Therefore, a
“cost driver” is typically not identified.
E7-1 Cost Hierarchy
Identify the following as either unit-level, batch-level,
product-level, or organization-sustaining:

Receive raw-materials from suppliers: batch-level

Do rough milling work on product: unit-level

Design new product: product-level

Perform periodic preventative maintenance on

general-use equipment: org-sustaining
Plant-Wide MOH Pre-determined
Overhead Rate

Estimated
Manufacturing Plant-Wide
Overhead Cost MOH Rate

Estimated Cost (Single

Driver Rate)
Departmental MOH Predetermined
Overhead Rates

Budgeted
Estimated MOH Estimated MOH Departmen
Cost Cost
Manufacturing tal MOH
Overhead Cost
Department A Department B Rates

Estimated Cost Estimated Cost (1 Rate per

Driver
Department A
Driver
Department B
Departmen
t)
Activity Rates for ABC

Department Department
EstimatedAOverhead Cost – Activity
B Cost
Est. C.D. Pool A
Budgeted Manufacturing
Pool A
Estimated Overhead Cost – Activity Cost
Overhead
Pool B Cost
Est. C.D. Pool B
Estimated Overhead Cost – Activity Cost
Est. C.D. Pool C
BudgetedPool CPeriod
Estimated Overhead Cost – Activity Cost
Overhead
Pool D
Cost Est. C.D. Pool D

ABC Activity Rates

(1 Rate per Activity Cost Pool)

When to Use ABC?
When the benefits outweigh the costs!
Costs of ABC
More complex calculation
More complex data collection
Change of culture
Benefits
More accurate costing (we hope!)
 Especially important if our costs are big!
Better ability to properly set prices
Steps for Implementing Activity-Based
Costing

1. Define activities and identify an activity-based

activity measure (=cost driver) for each activity
2. Assign overhead costs to activity cost pools
(First-stage Allocation)
3. Calculate an activity rate for each activity (Total
estimated overhead cost for activity cost
pool/total estimated cost driver quantity)
4. Assign overhead costs (Activity Rate * Actual Cost
Driver Quantity) to cost objects (product, service,
customer, etc.) (Second-stage Allocation)
5. Prepare management reports (e.g., product or
customer profitability reports)
E7-15 Shenzhen Order
Overhead Units
Costs ordered 10 units
Wages and DLHs 2 DLHs per unit
salaries $300,000 Selling price $300 per unit
Other OH DM $180 per unit
Costs $100,000 DL $50 per unit
Total OH costs $400,000 Step 1: Define
activities and identify
Activity cost an activity-based
Activity Measure Total Activity activity measure
pool
Supporting DL # of DLH 20,000 DLHs (=cost driver) for each
Order # of Customer activity
400 orders
processing orders
Customer 200
# of Customer
support customers
Org. sustaining
NA
Other activity
1. First-stage allocations? (Step 2: Assign overhead costs to
activityofcost
Distribution pools)
Resource
2. Activity rates? (Step 3: Calculate a activity rate for each
Consumption
activity) Order Customer
Supporting DL Other Total
3. OH for Shenzhen Enterprises order? (Step 4:support
Processing Assign overhead)
Traditional and ABC Costing Product Margins (Sales – Costs of
Products) Can Differ. Why?
Traditional Costing ABC Costing

Differenc Assign all manufacturing costs. Only assigns costs that are
es This forces the product to absorbcaused by the product,
MOH, even if it didn’t consume therefore: some
the cost manufacturing costs may
not be assigned to
products (i.e., facility level
Uses a single volume-based costs: factory security
overhead rate to apply MOH guard’s wages, plant
[using single volume –based cost controller’s salary
driver, e.g., DLHs, MHs, DLC]. unaffected by which products
This may not reflect what are made)
actually caused the cost.
 Result: high-volume (low- Uses different activity
volume) products are over- rates for each activity pool
costed (under-costed) (using cost drivers unique to
the pool
Does not assign non-