Activity-Based Costing: A

Tool to Aid Decision Making

Chapter Seven

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 Activity Based Costing (ABC)

ABC is a
ABC is designed to good supplement
provide more accurate to our traditional
cost system
ways of assigning I agree!
indirect and support
service costs to
activities, processes,
products, customers

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 ABC differs from traditional costing

• Both manufacturing and non manufacturing

costs are allocated
• Use of several cost pools
• Different kinds of allocation base
• Allocation through capacity vs activity

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 Designing an ABC System

Cost Objects
(e.g., products
Activities
and
customers)

Consumption
of Resources

Cost

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 Designing an ABC System

Steps for Implementing ABC

❶ Identify and define activities and activity cost
pools.
❷ Trace costs to activities and cost objects.
❸ Assign costs to activity cost pools.
❹ Calculate activity rates.
❺ Assign costs to cost objects.
❻ Prepare management reports.

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 ❶Identify and Define Activities
and Activity Cost Pools

Unit-Level Batch-Level
Activity Activity

Manufacturing
companies typically combine
their activities into five
classifications.

Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
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 ❶Identify and Define Activities
and Activity Cost Pools

Activities
should only be
combined within
a level
if they are highly
correlated.
When combining
activities, they
should be
grouped together
only at
the appropriate
level.
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 ❶Identify and Define Activities
and Activity Cost Pools

An Activity Cost $$
Pool is a “bucket” in $
$ $
which costs are $
accumulated that
relate to a single
activity measure in
the ABC system.

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 ❶Identify and Define Activities
and Activity Cost Pools

Two types of activity measures:

Transaction Duration
driver driver
Simple count
A measure
of the number
of the amount
of
of time
times an
needed
activity
for an activity.
occurs.
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 ❶Identify and Define Activities
and Activity Cost Pools

At Classic Brass, the ABC team, selected the following

activity cost pools and activity measures:

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 ❶Identify and Define Activities
and Activity Cost Pools

• Customer Orders - assigned all costs of resources

that are consumed by taking and processing
customer orders.
• Product Designs - assigned all costs of resources
consumed by designing products.
• 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 overhead costs that are not
associated with the other cost pools.
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 ❷When Possible, Directly Trace Overhead
Costs to Activities and Cost Objects

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 ❸Assign Costs to Activity Cost Pools

At Classic Brass the following distribution of resource

consumption across activity cost pools is determined.

**Not included because they are directly traced to customer orders.

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 ❸Assign Costs to Activity Cost Pools

Indirect factory wages $500,000

Percent consumed by customer orders 25%
$125,000

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 ❸Assign Costs to Activity Cost Pools

Factory equipment depreciation $300,000

Percent consumed by customer orders 20%
$ 60,000

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 ❸Assign Costs to Activity Cost Pools

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 ❹Calculate Activity Rates

The ABC team determines that Classic Brass will

have these total activities for each activity cost
pool . . .
⬥ 1,000 customer orders,
⬥ 200 new designs,
⬥ 20,000 machine-hours,
⬥ 100 customer relations activities.

Now the team can compute the individual

activity rates by dividing the total cost for
each activity by the total activity levels.
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 ❹Calculate Activity Rates

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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

Traced Traced Traced

Cost Objects:
Products, Customer Orders, Customers
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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

Cost Objects:
Products, Customer Orders, Customers
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 Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

Second-Stage Allocations

$/MH $/Order $/Design $/Customer

Cost Objects:
Unallocated
Products, Customer Orders, Customers
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 ❺Assigning Costs to Cost Objects

Let’s take a look at how our system works

for just one customer – Windward Yachts.
Standard Stanchions (no design required)
1. 400 units ordered with 2 separate orders.
2. Each stanchion required 0.5 machine-hours.
3. Selling price is $34 each.
4. Direct materials total $2,110.
5. Direct labor totals $1,850.
6. Shipping costs total $180.
Custom Compass Housing (requires new design)
1. One order during the year.
2. Each housing required 4 machine-hours.
3. Selling price is $650 each.
4. Direct materials total $13.
5. Direct labor totals $50.
6. Shipping costs total $25.
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 ❺Assigning Costs to Cost Objects

The customer-level
cost is assigned to
customers directly;
it is not assigned to
products.

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 ❻Prepare Management Reports

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 ❻Prepare Management Reports

Customer Profitability Analysis

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 Product Margins

Traditional Cost Accounting System

400 units x 0.5 MH/unit x $50/MH = $10,000

Predetermined manufacturing $1,000,000

= = $50/MH
overhead rate 20,000 MH
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 Differences Between ABC and
Traditional Product Costs
Product margins are different for four reasons:
❶ Traditional costing assigns design costs to both products
based on machine hours. ABC assigns product design
costs to a product only if product design work is required.
❷ Traditional costing assigns customer order costs, a batch-
level cost, using a unit-level allocation base, machine hours.
ABC assigns these batch-level costs using a batch-level
activity measure.
❸ Traditional costing assigns only manufacturing costs to
products. ABC also assigns nonmanufacturing costs to
products.
❹ Traditional costing assigns all manufacturing costs to
products. The ABC system does not assign organization-
sustaining manufacturing costs to the products.
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 Differences Between ABC and
Traditional Product Costs
When batch-level and
product-level costs are present,
ABC will usually shift costs from
high
volume products, produced in large
batches,
to low volume products produced in
small batches.

This cost shifting will usually have

its
greatest impact on the per
unit cost of the low
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 Activity Based Management

• Upon analysis of product costs thru ABC

⬥ Re-price products
⬥ Substitute products
⬥ Redesign products
⬥ Improve processes and operations strategy
⬥ Technology investment
⬥ Eliminate products

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 Solve the Problem

• Green Thumb Gardening is a small gardening service that

uses activity-based costing to estimate costs for pricing and
other purposes. The proprietor of the company believes that
costs are driven primarily by the size of customer lawns, the
size of customer garden beds, the distance to travel to
customers, and the number of customers. In addition, the
costs of maintaining garden beds depends on whether the
beds are low maintenance beds (mainly ordinary trees and
shrubs) or high maintenance beds (mainly flowers and
exotic plants). Accordingly, the company uses the five
activity cost pools listed below:

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 Solve the Problem

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 Solve the Problem

• Compute the activity rate for each of the activity

cost pools.
Solution:

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 End of Chapter 7

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