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Activity-Based Costing: A Tool to
Aid Decision Making
Chapter Seven
8-2
Activity Based Costing (ABC)
ABC is designed to provide
managers with cost
information for strategic
and other decisions that
potentially affect capacity
and therefore affect fixed
as well as variable costs.
ABC is a
good supplement
to our traditional
cost system
I agree!
8-3
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Manufacturing
costs
Nonmanufacturing
costs
Traditional
product costing
ABC
product costing
 ABC assigns both types of costs to products.
8-4
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Traditional
product costing
Non manufacturing
costs
Some
All
Manufacturing
costs
ABC
product costing
 ABC does not assign all manufacturing costs to products.
How Costs are Treated Under
Activity–Based Costing
8-5
Level of complexity
ABC differs from traditional cost accounting in three ways.
Activity–Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
Number of cost pools
 ABC uses more cost pools.
8-6
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Each ABC cost pool has its
own unique measure of activity.
Traditional cost systems usually rely
on volume measures such as direct labor
hours and/or machine hours to allocate
all overhead costs to products.
 ABC uses more cost pools.
8-7
How Costs are Treated Under
Activity–Based Costing
Activity
An event that causes the
consumption of overhead
resources.
Activity
Cost Pool
A “cost bucket” in which
costs related to a particular
activity measure are
accumulated.
$$
$
$ $
$
8-8
How Costs are Treated Under
Activity–Based Costing
Activity
Measure
An allocation base
in an activity-based
costing system.
The term cost driver is
also used to refer to an
activity measure.
8-9
How Costs are Treated Under
Activity–Based Costing
Two common types of activity measures:
Transaction
driver
Duration
driver
Simple count
of the number of
times an activity
occurs.
A measure
of the amount
of time needed
for an activity.
8-10
How Costs are Treated Under
Activity–Based Costing
ABC defines
five levels of activity
that largely do not relate
to the volume of units
produced.
Traditional cost systems usually rely on volume
measures such as direct labor hours and/or machine
hours to allocate all overhead costs to products.
8-11
How Costs are Treated Under
Activity–Based Costing
Unit-Level
Activity
Batch-Level
Activity
Manufacturing
companies typically combine
their activities into five
classifications.
Product-Level
Activity
Organizationsustaining
Activity
Customer-Level
Activity
8-12
Classic Brass – An ABC Example
Classic Brass
Income Statement
Year Ended December 31, 2005
Sales
Cost of goods sold
Direct materials
Direct labor
Manufacturing overhead
Gross margin
Selling and administrative expenses
Shipping expenses
Marketing expenses
General administrative expenses
Net operating income
loss
$ 3,200,000
$
975,000
351,250
1,000,000
2,326,250
873,750
65,000
300,000
510,000
$
875,000
(1,250)
Manufacturing overhead is allocated to products using
a single plantwide overhead rate based on machine hours.
8-13
Define Activities, Activity Cost Pools,
and Activity Measures
At Classic Brass, the ABC team, selected the
following activity cost pools and activity measures:
8-14
Define Activities, Activity Cost Pools,
and Activity Measures
• 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.
8-15
Assign Overhead Costs
to Activity Cost Pools
8-16
Assign Overhead Costs
to Activity Cost Pools
Direct materials, direct labor, and shipping are excluded
because Classic Brass’ existing cost system can directly
trace these costs to products or customer orders.
8-17
Assign Overhead Costs
to Activity Cost Pools
At Classic Brass the following distribution of resource
consumption across activity cost pools is determined.
8-18
Assign Overhead Costs
to Activity Cost Pools
Indirect factory wages
$500,000
Percent consumed by customer orders
25%
$125,000
8-19
Assign Overhead Costs
to Activity Cost Pools
Factory equipment depreciation
$300,000
Percent consumed by customer orders
20%
$ 60,000
8-20
Assign Overhead Costs
to Activity Cost Pools
8-21
Calculate Activity Rates
The ABC team determines that Classic Brass will have these
total activities for each activity cost pool . . .
 1,000 customer orders,
 400 new designs,
 20,000 machine-hours,
 250 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.
8-22
Calculate Activity Rates
8-23
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Traced
Traced
Traced
Overhead Costs
Cost Objects:
Products, Customer Orders, Customers
8-24
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Cost Objects:
Products, Customer Orders, Customers
Other
8-25
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Customer
Orders
Product
Design
Order
Size
Customer
Relations
Other
Second-Stage Allocations
$/Order
$/Design
$/MH
$/Customer
Cost Objects:
Products, Customer Orders, Customers
Unallocated
8-26
Assigning Overhead to Products
Classic Brass Information
Standard Stanchions
1. Requires no new design resources.
2. 30,000 units ordered with 600 separate orders.
3. Each stanchion requires 35 minutes of machine
time for a total of 17,500 machine-hours.
Custom Compass Housing
1. Requires new design resources.
2. 400 separate orders.
3. 400 custom designs prepared.
4. 1,250 compass housings produced, requiring 2
machine-hours each for a total of 2,500 machine-hours.
8-27
Assigning Overhead to Products
8-28
Assigning Overhead to Customers
Let’s take a look at how Classic Brass system works for just
one of the 250 customers – Windward Yachts who placed
a total of three orders.
Orders
1. Two orders for 150 standard stanchions per order.
2. One order for a custom compass housing.
Machine-hours
1. The 300 standard stanchions required 175 machine-hours.
2. The custom compass housing required 2 machine hours.
8-29
Assigning Overhead to Customers
8-30
Prepare Management Reports
Product Margin Calculations
The first step in computing product margins is to
gather each product’s sales and direct cost data.
Sales
Direct costs
Direct material
Direct labor
Shipping
Standard
Stanchions
$ 2,660,000
Custom
Compass
Housings
$
540,000
Total
$ 3,200,000
905,500
263,750
60,000
69,500
87,500
5,000
975,000
351,250
65,000
8-31
Prepare Management Reports
Product Margin Calculations
The second step in computing product margins is to
incorporate the previously computed activity-based
cost assignments pertaining to each product.
Sales
Direct costs
Direct material
Direct labor
Shipping
ABC cost assignments
Customer orders
Product design
Order size
Standard
Stanchions
$ 2,660,000
Custom
Compass
Housings
$
540,000
Total
$ 3,200,000
905,500
263,750
60,000
69,500
87,500
5,000
975,000
351,250
65,000
192,000
128,000
252,000
47,500
320,000
252,000
380,000
332,500
8-32
Prepare Management Reports
Product Margin Calculations
The third step in computing product
margins is to deduct each product’s
direct and indirect costs from sales.
Sales
Costs
Direct material
Direct labor
Shipping
Customer orders
Product design
Order size
Total cost
Product margin
Custom
Compass Housings
$
540,000
Standard Stanchions
$ 2,660,000
$
905,500
263,750
60,000
192,000
$
332,500
1,753,750
$
906,250
69,500
87,500
5,000
128,000
252,000
47,500
589,500
(49,500)
8-33
Prepare Management Reports
Product Margin Calculations
The product margins can be reconciled with
the company’s net operating income as follows:
Sales
Total costs
Product margins
Less costs not assigned to products:
Customer relations
Other
Total
Nett operating income
loss
Standard
Stanchions
$ 2,660,000
1,753,750
$
906,250
Custom
Compass
Housings
$
540,000
589,500
$
(49,500)
Total
$ 3,200,000
2,343,250
$
856,750
$
367,500
490,500
858,000
(1,250)
8-34
Prepare Management Reports
Customer Profitability Analysis
The first step in computing Windward Yachts’ customer margin
is to gather its sales and direct cost data.
Sales
Direct costs
Direct material
Direct labor
Shipping
Windward
Yachts
$ 11,350
2,123
1,900
205
8-35
Prepare Management Reports
Customer Profitability Analysis
The second step is to incorporate Windward Yachts’ previously
computed activity-based cost assignments.
Sales
Direct costs
Direct material
Direct labor
Shipping
ABC cost assignments
Customer orders
Product design
Order size
Customer relations
Windward
Yachts
$ 11,350
2,123
1,900
205
960
630
3,363
1,470
8-36
Prepare Management Reports
Customer Profitability Analysis
The third step is to compute Windward Yachts’ customer
margin ($699) by deducting all its direct and indirect costs
from its sales.
Sales
Direct costs
Direct material
Direct labor
Shipping
Customer orders
Product design
Order size
Customer relations
Customer margin
Windward Yachts
$ 11,350
$
2,123
1,900
205
960
630
3,363
1,470
10,651
$
699
8-37
Activity-Based Costing and External Reporting
Most companies do not use ABC
for external reporting because . . .
1. External reports are less detailed than internal
reports.
2. It may be difficult to make changes to the
company’s accounting system.
3. ABC does not conform to GAAP.
4. Auditors may be suspect of the subjective
allocation process based on interviews with
employees.
8-38
End of Chapter 8