AF3112

MANAGEMENT ACCOUNTING 2
Activity-Based Costing

1
 AGENDA

Difference between ABC and Traditional

Costing Approach
Design and Implementation of ABC Costing
System
Limitations of ABC

2
Activity Based Costing (ABC)

The objective of ABC is a

activity-based costing good supplement
is to understand to our traditional
cost system
overhead and the I agree!
profitability of
products and
customers.

3
Traditional Costing Systems
vs. ABC

Traditional cost systems were created

when manufacturing processes were
labor intensive.
A single company-wide overhead rate
based on, say direct labor hours may be
used to allocate overhead to products in
these labor intensive processes.

4
Traditional Costing Systems
vs. ABC (cont’d)
Job1 Job2
Labor Hours 2 6
OH allocation
Overhead will be allocated to jobs using direct labor
hours. If total overhead is $120, how much will be
allocated to each job?

Job1 Job2
Labor Hours 2 6
OH allocation $30 $90

Why?
5
 Traditional Costing Systems
vs. ABC (cont’d)
Now, the company introduces automated
machinery. Total overhead rises from $120 to
$420, while the labor time needed for Job2 falls
from 6 hours to 1 hour. Now allocate the $420
OH to the two jobs.
Job1 Job2
Labor Hours 2 1
OH allocation 280 140

Do you see the problem with traditional

costing system? 6
Traditional Costing Systems
vs. ABC (cont’d)
The automation process benefits only
Job2. But most of the additional
overhead cost resulted from automation
was allocated to Job1.
Clearly it is NOT a reasonable costing
method. We need look for another cost
driver.
ABC system makes it possible.

7
 How Costs are Treated Under
Activity–Based Costing
“Best
“Best practice”
practice”ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

Manufacturing Nonmanufacturing
costs costs

Some
Mo
st, b
All

not ut
all
Traditional ABC
product costing product costing

 ABC assigns both types of costs to products.

 ABC does not assign all manufacturing costs to products.
8
ABC differs from traditional cost accounting in five ways.
1. ABC assigns both manufacturing and nonmanufacturing
costs to products. Traditional cost systems assign only
manufacturing costs to products. However, ABC
systems can assign sales commissions, shipping costs,
and warranty repair costs to specific products.
2. ABC systems do not assign all manufacturing costs to
products, while traditional cost systems do assign all
manufacturing costs to products. ABC only assigns a
cost to a product if decisions concerning that product
will cause changes in the cost.

9
 How Costs are Treated Under
Activity–Based Costing
“Best
“Best practice”
practice”ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
Level of complexity

 ABC uses more cost

Activity–Based
Activity–Based
Costing
Costing pools.
ABC cost pools are created to
Departmental
Departmental correspond to the activities
Overhead
Overhead performed in an organization that
Rates
Rates cause the consumption of
overhead resources. The total
Plantwide
Plantwide number of ABC cost pools will
Overhead
Overhead definitely exceed one and it is
Rate
Rate likely to exceed the number of
departments within a company
Number of cost pools since more than one activity is
often performed within each
department.
10
 How Costs are Treated Under
Activity–Based Costing
“Best
“Best practice”
practice”ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

Volume
Allocation Bases

measures
Bases usually plus other
Number of

rely solely on bases.

volume
measures.

Traditional Costing ABC

 ABC uses more allocation bases.
11
The
The most
most commonly
commonly usedused allocation
allocation base
base
in
in traditional
traditional costing
costing is
is direct
direct labor
labor hours
hours (or
(or sometimes
sometimes
machine
machine hours).
hours). Direct
Direct labor
labor hours
hours work
work well
well when
when
overhead
overhead increases
increases asas direct
direct labor
labor hours
hours increase.
increase.
Problems:
1. In many processes, overhead is increasing while
direct labor is decreasing.
2. Variety and complexity of products is increasing.

Solutions:
ABC uses volume as well as other allocation bases
(such as customer relation activities, customer order,
lighting and heating etc.) not related to the volume of
production. 12
 How Costs are Treated Under
Activity–Based Costing
“Best
“Best practice”
practice”ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

Traditional Costing ABC

The predetermined Products are charged
overhead rate is based for the costs of
on budgeted activity. capacity they use – not
This results in applying for the costs of
all overhead costs capacity they don’t
including unused, or use. Unused capacity
idle capacity costs to costs are treated as
products. period expenses.

 ABC bases level of activity on capacity.

13
Designing an ABC System

Cost Objects Activities

(e.g., products)

Consumption
of Resources

Cost
14
 Designing an ABC System

Steps for Implementing ABC

 Identify and define activities and
activity cost pools.
 Trace costs to activities and cost
objects.
 Assign costs to activity cost pools.
 Calculate activity rates.
 Assign costs to cost objects.
 Prepare management reports.

15
Identify and Define Activities
and Activity Cost Pools

An Activity Cost Pool $$

$
in the ABC system is a $ $
“bucket” in which costs $
associated with a single
activity measure are
accumulated.

16
 Identify and Define Activities
and Activity Cost Pools

Unit-Level Cost Batch-Level Cost

Cost Hierarchies
Categorize different cost pools based
on types of cost drivers.

Product-sustaining Facility-sustaining
Cost Cost

17
 Cost / Activities Hierarchies
Unit-level costs
 Cost of activities performed on each individual unit of
product/service
 E.g. machine operation costs (such as cost of energy consumed)
Batch-level costs
 Cost of activities related to a batch of units of a product/service
 E.g. machine setup costs ( such cost cannot be avoided by
producing one less unit)
Product-sustaining costs
 Cost of activities undertaken to support individual products/services
regardless of the number of units/batches produced
 E.g. product design costs, research and development expenses
Facility-sustaining costs
 Costs of activities that cannot be traced to individual
products/services but that support the organization as a whole
 Difficult to find good cause-and-effect relationship to output, so
some companies deduct the entire sum against operating income
 E.g. top management compensation, security and janitorial costs 18
 Identify and Define Activities
and Activity Cost Pools
Two 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.

19
Identify and Define Activities
and Activity Cost Pools
At Classic Brass, the ABC team, selected the
following activity cost pools and activity
measures:
Activity Cost Pools at Classic Brass
Activity Cost Pool Activity Measure
Customer orders Number of customer orders
Product design Number of product designs
Order size Machine-hours
Customer relations Number of active customers
Other Not applicable

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 Identify and Define Activities
and Activity Cost Pools
Customer
Customer Orders
Orders -- assigned
assigned allall costs
costs that
that are
are
consumed
consumed by by taking
taking and
and processing
processing customer
customer
orders.
orders.
Product
Product Designs
Designs -- assigned
assigned allall costs
costs consumed
consumed by by
designing
designing products.
products.
Order
Order Size
Size -- assigned
assigned allall costs
costs consumed
consumed as as aa
consequence
consequence of of the
the number
number of of units
units produced.
produced.
Customer
Customer Relations
Relations –– assigned
assigned allall costs
costs associated
associated
with
with maintaining
maintaining relations
relations with
with customers.
customers.
Other
Other –– assigned
assigned allall overhead
overhead costs
costs that
that are
are not
not
associated
associated with
with the
the other
other cost
cost pools.
pools.
21
When Possible, Directly Trace Overhead
Costs to Activities and Cost Objects
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Production Department
Indirect factory wages $ 500,000
Factory equipment depreciation 300,000
Factory utilities 120,000
Factory building lease 80,000 $ 1,000,000
Shipping costs traced to customer orders 40,000
General Administrative Department
Administrative wages and salaries 400,000
Office equipment depreciation 50,000
Administrative building lease 60,000 510,000
Marketing Department
Marketing wages and salaries 250,000
Selling expenses 50,000 300,000
Total overhead costs $ 1,850,000
22
 Assign Costs to Activity Cost Pools
At Classic Brass the following distribution of resource
consumption across activity cost pools is determined
(usually after interviewing the employees).
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages 25% 40% 20% 10% 5% 100%
Factory equipment depreciation 20% 0% 60% 0% 20% 100%
Factory utilities 0% 10% 50% 0% 40% 100%
Factory building lease 0% 0% 0% 0% 100% 100%
Shipping costs **
General Administrative Department
Administrative wages and salaries 15% 5% 10% 30% 40% 100%
Office equipment depreciation 30% 0% 0% 25% 45% 100%
Administrative building lease 0% 0% 0% 0% 100% 100%
Marketing Department
Marketing wages and salaries 20% 10% 0% 60% 10% 100%
Selling expenses 10% 0% 0% 70% 20% 100%
**Not included because they are directly traced to customer orders.
23
 Assign Costs to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Production Department
Activity CostIndirect
Pools factory wages $ 500,000
Customer Factory
Product equipment
Order depreciation
Customer 300,000
Factory utilities 120,000
Orders Design Size Relations Other Total
Factory building lease 80,000 $ 1,000,000
Production Department Shipping costs traced to customer orders 40,000
Indirect factory wages $ 125,000 General Administrative Department
Factory equipment depreciation Administrative wages and salaries 400,000
Factory utilities Office equipment depreciation 50,000
Administrative building lease 60,000 510,000
Factory building lease
Marketing Department
General Administrative Department Marketing wages and salaries 250,000
Administrative wages and salaries Selling expenses 50,000 300,000
Office equipment depreciation Total overhead costs $ 1,850,000
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

Indirect
Indirect factory
factory wages
wages $500,000
$500,000
Percent
Percent consumed
consumed by by customer
customer orders
orders X
X 25%
25%
$125,000
$125,000
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 Assign Costs to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Production Department
Activity CostIndirect
Poolsfactory wages $ 500,000
Factory equipment depreciation 300,000
Customer Product Order Customer
Factory utilities 120,000
Orders Design Sizelease Relations
Factory building Other
80,000 $ Total
1,000,000
Production Department Shipping costs traced to customer orders 40,000
General Administrative Department
Indirect factory wages $ 125,000
Administrative wages and salaries 400,000
Factory equipment depreciation 60,000 Office equipment depreciation 50,000
Factory utilities Administrative building lease 60,000 510,000
Factory building lease Marketing Department
Marketing wages and salaries 250,000
General Administrative Department
Selling expenses 50,000 300,000
Administrative wages and salaries Total overhead costs $ 1,850,000
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

Factory
Factory equipment
equipment depreciation
depreciation $300,000
$300,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders X X 20%
20%
$$ 60,000
60,000
25
 Assign Costs to Activity Cost Pools

Activity Cost Pools

Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000 $ 200,000 $ 100,000 $ 50,000 $ 25,000 $ 500,000
Factory equipment depreciation 60,000 - 180,000 - 60,000 300,000
Factory utilities - 12,000 60,000 - 48,000 120,000
Factory building lease - - - - 80,000 80,000
General Administrative Department
Administrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000
Office equipment depreciation 15,000 - - 12,500 22,500 50,000
Administrative building lease - - - - 60,000 60,000
Marketing Department
Marketing wages and salaries 50,000 25,000 - 150,000 25,000 250,000
Selling expenses 5,000 - - 35,000 10,000 50,000
Total $ 315,000 $ 257,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000

26
 Calculate 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
Now the
the team
team can
can compute
compute the the individual
individual
activity
activity rates
rates by
by dividing
dividing the
the total
total cost
cost for
for
each
each activity
activity by
by the
the total
total activity
activity levels.
levels. 27
 Calculate Activity Rates
Computation of Activity Rates
(a) (b) (a) ÷ (b)
Activity Cost Pools Total Cost Total Activity Activity Rate
Customer orders $ 315,000 1,000 orders $315 per order
Product design 257,000 200 designs $1,285 per design
Order size 380,000 20,000 MHs $19 per MH
Customer relations 367,500 100 customer $3,675 per customer
Other 490,500 Not applicable Not applicable

28
Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

Traced
Traced Traced
Traced Traced
Traced

Cost Objects:
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
29
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,
Products, Customer
Customer Orders,
Orders, Customers
Customers
30
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
$/MH $/Order
$/Order $/Design
$/Design $/Customer
$/Customer

Cost Objects:
Unallocated
Unallocated
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
31
 Assigning 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. 32
 Assigning Costs to Cost Objects
Overhead Cost for the Standard Stanchions
(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 315 2 $ 630
Product design 1,285 0 -
Order size 19 200 3,800
Customer relations 3,675 N/A

Overhead Cost for the Custom Housing

(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 315 1 $ 315
Product design 1,285 1 1,285
Order size 19 4 76
Customer relations 3,675 N/A

In this example, the customer-level cost is assigned

to customers directly; it is not assigned to products.
33
 Prepare
Standard Stanchions
Management Reports
Sales $ 13,600
Cost:
Direct materials $ 2,110
Direct labor 1,850
Shipping costs 180
Customer orders 630
Product design -
Order size 3,800 8,570
Product margin $ 5,030
Custom Compass Housing
Sales $ 650
Cost:
Direct materials $ 13
Direct labor 50
Shipping costs 25
Customer orders 315
Product design 1,285
Order size 76 1,764
Product margin $ (1,114)
34
Prepare Management Reports

Customer Profitability Analysis

Windward Yachts
Product margins:
Standard stanchion $ 5,030
Custom compass housing (1,114)
Total product margin 3,916
Less: Customer relations 3,675
Customer margin $ 241

35
 Product Margins
Traditional Cost Accounting System
Standard Compass
Stanchions Housing
Sales $ 13,600 $ 650
Costs
Direct materials (2,110) (13)
Direct labor (1,850) (50)
Manufacturing overhead (10,000) (200)
Product margin $ (360) $ 387

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

Predetermined manufacturing $1,000,000

= = $50/MH
overhead rate 20,000 MH
36
 Differences Between ABC and
Traditional Product Costs
Reason 1
 Traditional:
 Assigns only manufacturing costs to products.
 ABC
 Assigns BOTH manufacturing and non-manufacturing
costs to products.
Reason 2
 Traditional
 Assigns all manufacturing costs to products.
 ABC
 Not to assign all manufacturing costs to products,
such as facility-sustaining manufacturing costs (i.e.
factory building leasing) 37
Differences Between ABC and Traditional
Product Costs at Classic Brass
Reason 3
 Traditional:
 Assignsdesign costs to both products based on
machine hours.
 ABC
 Assigns design costs to a product only if product
design work is required.
Reason 4
 Traditional
 Assigns customer order costs (a batch-level cost),
using a unit-level allocation base, i.e. machine hours.
 ABC
 Assigns batch-level costs using a batch-level driver38
 Characteristics of Successful
ABC Implementations

Strong
Strong top
top
management
management support
support Link
Link to
to evaluations
evaluations
and
and rewards
rewards

Cross-functional
Cross-functional
involvement
involvement
39
 Activity-Based Costing and
External Reporting
Most companies do not use ABC for external reporting
because . . .
1.
1. External
Externalreports
reportsareareless
less detailed
detailedthan
thaninternal
internalreports
reportsin in
the
thesense
sensethat
thatindividual
individualproduct
productcosts
costs are
arenot
notreported.
reported.
External
Externalreports
reportsonly
onlydisclose
disclosecost
costofofgoods
goodssoldsoldand
and
ending
endinginventory.
inventory.
2.
2. ItItmay
may be
bedifficult
difficultto
tomake
makechanges
changes to tothe
thecompany’s
company’s
accounting
accountingsystem.
system.
3.
3. ABC
ABCdoes
doesnotnotconform
conformto toGAAP.
GAAP.ItItexcludes
excludes some
some
organization-sustaining
organization-sustainingmanufacturing
manufacturingcosts
costsandandincludes
includes
some
somenon-manufacturing
non-manufacturingcosts costsin
inits
itsproduct
productcostcost
calculations.
calculations.These
Thesecostcostsystem
systemdesign
designattributes
attributes don’t
don’t
comply
complywith
withGAAP.
GAAP.
4.
4. Auditors
Auditorsmay
may be besuspect
suspectofofthe
thesubjective
subjectiveallocation
allocation
process
process based
basedon oninterviews
interviewswith
withemployees.
employees. 40
 The Non-GAAP Issue

Product and Company

For each Profitability
product line
Total product revenue
<Total product cost>
Net product margin
<Organizational/facility-level costs>
Company profit or loss
This is Not
GAAP
41
 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.
42
End of Topic

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