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Activity Based Costing:
A Tool to Aid Decision Making
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Activity Based Costing (ABC)
ABC is designed to
provide managers
with cost
information for
strategic and other
decisions that
potentially affect
capacity and
therefore “fixed”
costs.
ABC is a
good supplement
to our traditional
cost system
I agree!
Activity Based Costing (ABC)
Both manufacturing
and nonmanufacturing
costs may be
assigned to
products.
A number
of cost pools each
allocated to a product
or cost object.
Some manufacturing
costs may be excluded
from product
costs.
Allocation bases often
differ from
traditional costing
systems.
Overhead rates may
be based on activity
at capacity.
How Costs are Treated Under
Activity-Based Costing
Activity Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
Overhead Allocation
Plantwide Overhead Rate
Companies tended to use direct labor as
the overhead allocation base. There was a
belief that direct labor and overhead
costs were highly correlated.
Departmental Overhead Rates
Finishing Department
Painting Department
Shipping Department
Many companies have a system
in which each department has
its own overhead rate.
Departmental Overhead Rates
Stage One:
Costs assigned
to pools
Cost pools
Indirect
Labor
Indirect
Materials
Other
Overhead
Department
1
Department
2
Department
3
Departmental Overhead Rates
Stage One:
Costs assigned
to pools
Cost pools
Stage Two:
Costs applied
to products
Indirect
Labor
Indirect
Materials
Other
Overhead
Department
1
Department
2
Department
3
Products
Departmental Overhead Rates
Stage One:
Costs assigned
to pools
Cost pools
Stage Two:
Costs applied
to products
Indirect
Labor
Indirect
Materials
Other
Overhead
Department
1
Department
2
Department
3
Direct
Labor
Hours
Machine
Hours
Raw
Materials
Cost
Products
Departmental Allocation Bases
Cost of Idle Capacity
Traditional Cost
Accounting
The predetermined
overhead rate is based
on budgeted activity.
This results in applying
overhead costs of
unused, or idle,
capacity.
Activity Based
Costing
Products are charged for
the costs of capacity
they use – not for the
costs of capacity they
don’t use.
Designing an ABC System
Cost Objects
(e.g., products
and customers)
Activities
Consumption
of Resources
Cost
Designing of 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.
Identify and Define Activities
and Activity Cost Pools
Unit-Level
Activity
Batch-Level
Activity
A part of the production
process for which management
wants a separate reporting of the
costs of the activity involved.
Product-Level
Activity
Organizationsustaining
Activity
Customer-Level
Activity
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
Customer orders
Product design
Order size
Customer relations
Other
Activity Measure
Number of customer orders
Number of product designs
Machine-hours
Number of active customers
Not applicable
Identify and Define Activities
and Activity Cost Pools
Activity Cost
Pool is a “bucket”
in which costs are
accumulated that
relate to a single
activity measure
in the ABC
system.
$$
$
$ $
$
Identify 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.
Whenever Possible, Directly Trace
Overhead Costs to Activities and Cost Objects
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)
Production Department
Indirect factory wages
$
Factory equipment depreciation
Factory utilities
Factory building lease
Shipping costs traced to customer orders
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total overhead costs
500,000
300,000
120,000
80,000
$
400,000
50,000
60,000
1,000,000
40,000
510,000
250,000
50,000
$
300,000
1,850,000
Assign Costs to Activity Cost Pools
At Classic Brass the following distribution of resource
consumption across activity cost pools is determined.
Activity Cost Pools
Customer Product
Order
Orders
Design
Size
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
Shipping costs **
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Customer
Relations
Other
Total
25%
20%
0%
0%
40%
0%
10%
0%
20%
60%
50%
0%
10%
0%
0%
0%
5%
20%
40%
100%
100%
100%
100%
100%
15%
30%
0%
5%
0%
0%
10%
0%
0%
30%
25%
0%
40%
45%
100%
100%
100%
100%
20%
10%
10%
0%
0%
0%
60%
70%
10%
20%
100%
100%
**Not included because they are directly traced to customer orders.
Assign Costs to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)
Activity
Customer
Orders
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
$ 125,000
Production Department
$
CostIndirect
Pools factory wages
Factory equipment depreciation
Product
Order
Customer
Factory utilities
Design
Sizelease Relations
Factory building
Shipping costs traced to customer orders
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total overhead costs
500,000
300,000
120,000
Other
80,000 $
400,000
50,000
60,000
Total
1,000,000
40,000
510,000
250,000
50,000
$
Indirect factory wages
$500,000
Percent consumed by customer orders
25%
$125,000
300,000
1,850,000
Assign Costs to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)
Activity
Customer
Orders
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
$ 125,000
60,000
Production Department
$
CostIndirect
Pools factory wages
Factory equipment depreciation
Product
Order
Customer
Factory utilities
Design
Sizelease Relations
Factory building
Shipping costs traced to customer orders
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total overhead costs
500,000
300,000
120,000
Other
80,000 $
400,000
50,000
60,000
Total
1,000,000
40,000
510,000
250,000
50,000
$
Factory equipment depreciation
$300,000
Percent consumed by customer orders
20%
$ 60,000
300,000
1,850,000
Assign Costs to Activity Cost Pools
Activity Cost Pools
Customer
Product
Orders
Design
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
Order
Size
Customer
Relations
Other
Total
$ 125,000
60,000
-
$ 200,000
12,000
-
$ 100,000
180,000
60,000
-
$ 50,000
-
$ 25,000
60,000
48,000
80,000
$
500,000
300,000
120,000
80,000
60,000
15,000
-
20,000
-
40,000
-
120,000
12,500
-
160,000
22,500
60,000
400,000
50,000
60,000
50,000
5,000
$ 315,000
25,000
$ 257,000
$ 380,000
150,000
35,000
$ 367,500
25,000
10,000
$ 490,500
250,000
50,000
$ 1,810,000
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 the team can compute the individual
activity rates by dividing the total cost for
each activity by the total activity levels.
Calculate Activity Rates
Computation of Activity Rates
Activity Cost Pools
Customer orders
Product design
Order size
Customer relations
Other
(a)
Total Cost
$ 315,000
257,000
380,000
367,500
490,500
(b)
Total Activity
1,000 orders
200 designs
20,000 MHs
100 customer
Not applicable
(a) ÷(b)
Activity Rate
$315 per order
$1,285 per design
$19 per MH
$3,675 per customer
Not applicable
Limitations of ABC
ABC systems are a
major project requiring
substantial resources.
The benefits of
increased accuracy
must outweigh these
additional costs.
ABC produces
numbers, like product
margins, that are at
odds with numbers
produced by traditional
costing system. Some
managers find it
difficult to adjust to this
change.
ABC data can be misinterpreted and must
be used with care when making decisions.