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Variable Activity-Based Costing

and Decision Making Editorial Review

Matthew Geiszler, Kelsey Baker, and Jeffrey Lippitt

INTRODUCTION costs of an activity

Much of managerial decision making regarding are then allocated
This article only to those prod-
illustrates several product pricing and output depends on a careful
ucts that utilize
modifications to separation of the fixed and variable components of
that activity. Many
activity-based cost- costs. Without this separation, the decision maker would argue that the
ing (ABC) and shows will be unable to assess the impact of their deci- resulting product
how these approaches sions on profitability. This distinction is particularly costs are superior
will improve the rel- relevant in allocating overhead. Both traditional to traditional cost-
evance of the result- and activity-based costing (ABC) systems are full ing because the
ing product costs to absorption systems in the sense that they include resulting product
both long-term and both fixed and variable production costs in product costs do reflect the
short-term decision cost. This mixing of fixed and variable overhead resources that went
making. ABC was costs results in product costs that are difficult to into the production
developed to improve of the product more
use in decision making. This article uses a numeric
the allocation of accurately than tra-
example to compare several alternate approaches
indirect production ditional cost systems
costs to products and to overhead allocation. It highlights variable activ-
(Balakrishnan &
to aid in the manage- ity-based costing (VABC), which utilizes regression Sivaramakrishnan,
ment of these costs. analysis to estimate the fixed and variable portions 1996; Homburg, 2005;
Many managers felt of each cost pool. The results show that VABC can Schneeweiss, 1998).
that a single cost produce information that is more useful in deci- In some ways, the
pool allocation of sion making and that the resulting cost allocations ABC approach may
overhead resulted are superior to traditional costing approaches for present some dan-
in product costs decision-making purposes. © 2017 Wiley Periodicals, Inc. gers that were not as
that do not reflect pronounced under
the combination of traditional costing
resources that go into systems. Managers
the production of each prod- Datar, & Rajan, 2012). ABC are well aware that traditional
uct (Cardinaels, Roodhooft, refines the overhead allocation cost systems that mix together
& Warlop, 2004). The result- process by allocating overhead fixed and variable components
ing “peanut butter” costing costs to several cost pools, of overhead costs, are inappro-
overcosted some products and based on the activities involved priate for use in decision mak-
undercosted others (Horngren, in the production process. The ing. Because full absorption

© 2017 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).
DOI 10.1002/jcaf.22277 45
46 The Journal of Corporate Accounting & Finance  /  July/August 2017
costing is required under gener-
ally accepted accounting prin-
ciples (GAAP), these product
costs are regularly produced
for financial reporting pur-
poses, but managers are aware
that these costs are not useful
in decision making (Datar &
Gupta, 1994). Decision making
depends on a careful separa-
tion of the fixed and variable
portions of product cost. ABC
costing is a significant refine-
ment of traditional cost sys-
tems because it does a better
job of having product costs
represent the resources that
went into the production of a
product; however, these costs
are still full absorption costs
and blend together fixed and
variable costs. An ABC costing
system produces cost informa-
tion that is also inappropriate
for decision making, but the
apparent refinement of cost
allocation in ABC may easily
mislead decision makers into
using these costs in pricing and
output decision making (Hom-
burg, 2005). In some situations,
ABC may avoid some of the
problems inherent in absorp-
tion costing. If an activity
supports a single product, the
fixed costs of that activity must
be included in some decisions
regarding the profitability of
that product, provided the fixed
costs associated with that activ-
ity are fully avoidable should
the product be discontinued.
This article uses a numeric
example to compare several
alternate approaches to over-
head allocation. It will high-
light variable activity-based
costing (VABC) and show how
these systems can produce
information that is useful in
decision making and show that
the resulting costs are superior
to traditional variable costing
for decision-making purposes.
DOI 10.1002/jcaf © 2017 Wiley Periodicals, Inc.
Both VABC models utilize
regression analysis to estimate
the fixed and variable portions
of each cost pool. Utilizing
the ABC approach, these
variable costs are allocated
only to those products that
utilize that activity.
When a job utilizes several
different types of materials,
the amount, cost, and cost per
unit of each input is separately
charged to the job. Under
VABC, there are several differ-
ent kinds of overhead involved
in production, and each of
these types has a different
cost that is individually charged
to the job.
The analysis presented is
based on a hypothetical job
shop setting that has three jobs.
The same data are used in each
model, allowing comparison of
allocated costs between each
model.
TRADITIONAL COSTING
Traditional analysis applies
total overhead costs ($157,835)
on the basis of direct labor
hours (DLH; 682 total hours),
resulting in an overhead appli-
cation rate of $231.43 per
direct labor hour. Exhibit 1,
Panel A demonstrates that
application of overhead to each
job, based on DLH.
ACTIVITY-BASED COSTING
For ABC, the total over-
head costs are separated into
three cost pools based on the
three activities involved in the
production process: machin-
ing, assembly, and inspection.
A cost driver is identified for
each cost pool: machine hours
(MH) for machining, labor
hours (DLH) for assembly,
and inspection hours (IH) for
inspection.
The assembly cost pool
consists of $62,345 of over-
head; the machining cost pool
is $24,294; and the inspection
cost pool is $71,196. Each cost
pool is divided by its respec-
tive cost driver (682 DLH, 244
MH, and 66 IH) to determine
the application rates: $91.41
per DLH used, $99.57 per
MH used, and $1,078.73 per
IH used. This process results
in allocating the average total
cost of each cost pool. Exhibit
1, Panel B illustrates the appli-
cation of these cost pools to
each of the three jobs. After
multiplying each rate by the
given driver for each job, new
overhead allocation totals
are calculated for each job.
Based on ABC, total overhead
allocated to each job is: Prod-
uct 1, $57,476.56; Product 2,
$27,366.75; and Product 3,
$72,991.69.
The total amount of over-
head allocated to the three
products is the same, but the
breakdown between products
varies greatly from that of tra-
ditional costing. The difference
is representative of the fact that
traditional costing, while a sim-
pler approach, takes less care to
be sure that the allocated cost
reflects the activities that went
into the production of each
product. ABC does a better job
of this; however, there is a com-
mon misconception that since
ABC provides a better alloca-
tion than traditional costing,
it is more useful for decision
making. This assumption is
wrong due to the fact that ABC
is still a full absorption cost-
ing approach to product cost-
ing. Both traditional costing
and ABC mix together fixed
and variable costs, rendering
the result of little or no value
in decision making. Decision
making requires the careful
The Journal of Corporate Accounting & Finance  /  July/August 2017 47

Exhibit 1

Traditional and Activity-Based Costing Manufacturing Overhead Allocations

Panel A: Traditional allocation based on direct labor hours (DLH)

Job DLH Rate per DLH Allocation
Product 1 400 × $231.43 = $92,572.00
Product 2 185 × $231.43 = $42,814.55
Product 3 97 × $231.43 = $22,448.71
Total: $157,835.26

Panel B: Activity-based costing using direct labor hours (DLH), machine hours (MH), and inspection hours (IH)

Product 1 (200 units) Product 3 (1,600 units)

Allocation Rate per unit of Allocation Rate per unit of
Driver base allocation base Allocation Driver base allocation base Allocation
DLH 400 × $91.41 = $36,564.00 DLH 97 × $91.41 = $8,866.77
MH 15 × $99.57 = $1,493.55 MH 189 × $99.57 = $18,818.73
IH 18 × $1,078.73 = $19,417.14 IH 42 × $1,078.73 = $45,306.66
Product 1 Total: $57,474.69 Product 3 Total: $72,992.16

Product 2 (320 units)

Allocation Rate per unit of Total overhead allocated to
Driver base allocation base Allocation jobs Per Unit
DLH 185 × $91.41 = $16,910.85 Product 1 $57,474.69 $287.37
MH 40 × $99.57 = $3,982.80 Product 2 $27,366.03 $85.52
IH 6 × $1,078.73 = $6,472.38 Product 3 $72,992.16 $45.62
Product 2 Total: $27,366.03 Total: $157,832.88

separation of fixed and vari-
able components of production
costs for cost-benefit analysis.
This distinction is also neces-
sary for planning and control-
ling costs.
VARIABLE COSTING
Next, we consider a tradi-
tional variable costing approach
to the allocation of overhead.
As seen in Exhibit 2, Panel A,
a regression based on DLH is
run to determine fixed costs
(y-intercept), variable cost
(DLH coefficient), and residual
error. The coefficient of $41.48
per DLH is then used to apply
overhead to each job based on
the direct labor hours used for
that job. The allocations to each
job using variable costing are:
Product 1, $16,592.00; Prod-
uct 2, $7,673.8; and Product 3,
$4,023.56 (Exhibit 2, Panel B).
Under variable costing, a
total of $28,289.36 is allocated
to the three jobs, significantly
less than $157,832.88 under
absorption costing. This is
because $126,946.80 of fixed
overhead cost is not allocated
to the respective jobs.1
While this variable costing
approach does separate over-
head costs into fixed and vari-
able portions based on direct
labor hours, it may also pro-
duce results that are of limited
usefulness in decision making.
The use of a single cost driver
assumes that all overhead costs
either vary with direct labor
hours, or are fixed. One of the
main contributions of ABC is
that overhead costs vary based
upon the levels of several
different cost drivers. Many
short-term decisions could
potentially affect the levels of
each of these cost drivers. To
make sound decisions, manag-
ers must understand how their
decisions will affect each of
these cost drivers and how the
cost drivers will in turn affect
overhead costs. Each activity
within the manufacturing pro-
cess will have its own variable

© 2017 Wiley Periodicals, Inc. DOI 10.1002/jcaf

48 The Journal of Corporate Accounting & Finance  /  July/August 2017

Exhibit 2

Variable Traditional Manufacturing Overhead Allocation

Panel A: Regression analysis based on direct labor hours (DLH)

Total MOH = α + β 1 Direct Labor Hours + ε

Variable Coefficient
Intercept (α) 126,954.80 ***
DLH (β1 ) 41.48 ***
Adj. R2 0.4987
n 18

Panel B: Variable traditional allocation using direct labor hours (DLH)

Job DLH β1 Allocation
Product 1 400 × $41.48 = $16,592.00
Product 2 185 × $41.48 = $7,673.80
Product 3 97 × $41.48 = $4,023.56
Total: $28,289.36

*,**,*** indicate statistical significance at the 10%, 5%, and 1% levels, respectively. Total MOH = the total
manufacturing overhead (both fixed and variable), α = intercept (fixed portion of MOH), Direct Labor Hours = the
plant-wide overhead allocation base, ε = the residual (error) term.

cost. The total variable over-
head cost of a product will,
therefore, be determined by
multiplying the amount of
each activity used to manu-
facture that product, by the
variable cost of each activity
and summing these costs. The
resulting variable cost for that
product will reflect the likely
impact on total overhead of
changing the production level
of that product.
Our next analysis builds on
the ABC approach of separating
overhead costs into the cost pools
relevant to each activity. Then,
using the cost driver for each pool,
the cost pool is separated into
fixed and variable components.
VARIABLE ABC
In essence, variable cost-
ing and ABC are combined by
running a regression for each
of the cost drivers used in
ABC. Each regression calcu-
lates a fixed cost and a variable
cost, shown in Exhibit 3,
Panel A. The regression analy-
sis shows that DLH and MH
have a significant impact on
their respective cost pools.
Inspection hours, however, have
a variable cost that is not sta-
tistically significantly different
from zero at a 90% confidence
level.2 The lack of a relation-
ship between inspection hours
and the inspection cost pool
could indicate one of several
problems. First, it could mean
that we have chosen the wrong
cost driver. Second, it could
mean that the inspection costs
are not well controlled and the
variations in the inspection cost
due to other causes is mask-
ing the relationship between
inspection hours and inspection
costs. Third, it could indicate
that the inspection activity is
primarily a fixed cost. When
implementing this methodol-
ogy, it is important to consider
these issues before moving
forward with the overhead
allocations.
Overhead is applied to each
job by multiplying the level of
each of the cost drivers used in
that job by its respective vari-
able cost. DLH is applied at
$39.49 per direct labor hour,
MH at $60.23 per machine
hour, and inspection costs at
$10.34 per inspection hour.
The total costs of each of the
jobs are: Product 1, $16,885.57;
Product 2, $9,776.89; and Prod-
uct 3, $15,648.28 (Exhibit 3,
Panel B). Compared to the
variable costing total allocation
of $28,289 of variable overhead

DOI 10.1002/jcaf © 2017 Wiley Periodicals, Inc.

The Journal of Corporate Accounting & Finance  /  July/August 2017 49

Exhibit 3

Variable Activity-Based Costing Manufacturing Overhead Allocations—Panel A

Panel A: Regression analysis based on direct labor hours (DLH), machine hours (MH), and inspection hours (IH)

(1) Total Direct Labor Cost Pool = α + β 1 Direct Labor Hours + ε

(2) Total Machine Hours Cost Pool = α + ű 1 Machine Hours + ε
(3) Total Inspection Hours Cost Pool = α + θ 1 Inspection Hours + ε

Coefficients
Variable DLH MH IH
Intercept (α) 33,761.00 *** 11,192.00 *** 70,234.00 ***
DLH (β1) 39.49 ***
MH (ű1) 60.23 ***
IH (θ1) 10.34
Adj. R 2 0.8609 0.5592 0.0709
n 18 18 18

*,**,*** indicate statistical significance at the 10%, 5%, and 1% levels, respectively. Total direct labor cost pool = the portion of the total
manufacturing overhead (both fixed and variable) attributable to direct labor hours, Total machine hours cost pool = the portion of the
total manufacturing overhead (both fixed and variable) attributable to machine hours, Total inspection hours cost pool = the portion of the
total manufacturing overhead (both fixed and variable) attributable to inspection hours, α = intercept (fixed portion of MOH for each
activity), Direct Labor Hours = the direct labor activity allocation base, Machine Hours = the machine hour activity allocation base,
Inspection Hours = the inspection hour activity allocation base, ε = the residual (error) term.

Variable Activity-Based Costing Manufacturing Overhead Allocations—Panel B

Panel B: Variable Activity-Based Costing using direct labor hours (DLH), machine hours (MH), and inspection hours (IH)
Product 1 (200 units) Product 3 (1,600 units)
Rate per unit Rate per unit
Allocation of allocation Allocation of allocation
Driver base base Allocation Driver base base Allocation
DLH (β1) 400 ˟ $39.49 = $15,796.00 DLH (β1) 97 ˟ $39.49 = $3,830.53
MH (ű1) 15 ˟ $60.23 = $903.45 MH (ű1) 189 ˟ $60.23 = $11,383.47
IH (θ1) 18 ˟ $10.34 = $186.12 IH (θ1) 42 ˟ $10.34 = $434.28
Product 1 Total: $16,885.57 Product 3 Total: $15,648.28

Product 2 (320 units)

Rate per unit
Allocation of allocation Total overhead allocated to
Driver base base Allocation jobs Per Unit
DLH (β1) 185 ˟ $39.49 = $7,305.65 Product 1 $16,885.57 $84.43
MH (ű1) 40 ˟ $60.23 = $2,409.20 Product 2 $9,776.89 $30.55
IH (θ1) 6 ˟ $10.34 = $62.04 Product 3 $15,648.28 $9.78
Product 2 Total: $9,776.89 Total: $42,310.74

cost, variable ABC allocates overhead cost that would result ABC is assigning the total
$42,311 of variable overhead from changing the amount of overhead cost to the vari-
cost. As a result, the total the product that is produced. ous cost pools. Errors in this
allocated cost to each product One of the more challeng- assignment will result in errors
reflects the likely change in ing aspects of implementing in the coefficients of the cost

© 2017 Wiley Periodicals, Inc. DOI 10.1002/jcaf

50 The Journal of Corporate Accounting & Finance  /  July/August 2017

drivers for that cost pool and,
therefore, a misstatement of the
variable costs of the products.
Fortunately, the variable ABC
approach does not require this
assignment of total cost to
individual cost pools. In most
cases, the analysis can be com-
pleted by analysis of the total
overhead cost pool.
MULTIPLE REGRESSION
The variable ABC
approach can be implemented
by including all the cost driv-
ers in one multiple regression
analysis, eliminating the need
to separate cost pools. The mul-
tiple regression will still provide
a coefficient (variable cost) for
each driver, but one fixed cost.
Exhibit 4, Panel A shows this
calculation. In our example,
DLH and MH are significant
with coefficients of $37.78 and
$69.80, respectively. Inspection
hours, on the other hand, are
insignificant and negative. As
a negative coefficient, inspec-
tion hours appear to be a cost
absorber as opposed to a cost
driver.3 Combining both the
lack of statistical significance
and the counter factual sugges-
tion of a negative variable cost,
the inspection hour cost driver
is eliminated from the multiple
regression and recalculated as
shown in Exhibit 4, Panel B.
The reduced multiple
regression results in a coef-
ficient of $37.84 per DLH and
$69.41 per MH, respectively.
The allocation of overhead
to each job using reduced
multiple regression results in:
Product 1, $16,177.15; Product
2, $9,776.80; and Product 3,
$16,788.97. Altogether a total
of $42,742.92 is allocated using
multiple regression overhead
allocations (Exhibit 4, Panel C).
Once again, this amount is
more than variable costing.
Comparing these results to the
results of the traditional alloca-
tions in Exhibit 1, demonstrates
how absorption costing can
lead to overpricing of products
due to over costing. In addi-
tion, comparing Exhibit 2 to
Exhibit 3 and Exhibit 4 demon-
strates how traditional variable
costing, although it separates
costs into fixed and variable
components, is of only limited
usefulness in decision making.
CONCLUSION
As noted earlier, traditional
costing systems and ABC sys-
tems suffer from the problem
of being “full absorption” sys-
tems, limiting their usefulness
in decision making. Managers
and decision makers should be
acutely aware of this limita-
tion. This study highlights this
deficiency and demonstrates

Exhibit 4

Multiple Regression Overhead Allocation—Panel A

Panel A: Multiple regression analysis based on direct labor hours (DLH), machine hours (MH),
and inspection hours (IH)

Total MOH = + 1 Direct Labor Hours + 2 Machine Hours + 3 Inspection Hours +

Variable Coefficient
Intercept ( ) 115,086.88 ***
DLH ( 1) 37.78 ***
MH ( 2) 69.80 ***
IH ( 3) –5.38

Adj. R 2 0.7616
n 18

*,**,*** indicate statistical significance at the 10%, 5%, and 1% levels, respectively. Total MOH = the
total manufacturing overhead (both fixed and variable), = intercept (fixed portion of MOH), Direct
Labor Hours = the direct labor activity allocation base, Machine Hours = the machine hour activity
allocation base, Inspection Hours = the inspection hour activity allocation base, = the residual (error)
term.

DOI 10.1002/jcaf © 2017 Wiley Periodicals, Inc.

The Journal of Corporate Accounting & Finance  /  July/August 2017 51

Exhibit 4

Multiple Regression Overhead Allocation—Panel B

Panel B: Reduced multiple regression analysis based on direct labor hours (DLH) and machine
hours (MH)

Total MOH = + 1 Direct Labor Hours + 2 Machine Hours +

Variable Coefficient
Intercept ( ) 114,862.00 ***
DLH ( 1) 37.84 ***
MH ( 2) 69.41 ***

Adj. R 2 0.7763
n 18

*,**,*** indicate statistical significance at the 10%, 5%, and 1% levels, respectively. Total MOH = the
total manufacturing overhead (both fixed and variable), = intercept (fixed portion of MOH), Direct
Labor Hours = the direct labor activity allocation base, Machine Hours = the machine hour activity
allocation base, = the residual (error) term.

Multiple Regression Overhead Allocation—Panel C

Panel C: Reduced multiple regression allocations

Product 1 (200 units) Product 3 (1,600 units)
Rate per unit Rate per unit
Allocation of allocation Allocation of allocation
Driver base base Allocation Driver base base Allocation
DLH ( 1) 400 × $37.84 = $15,136.00 DLH ( 1) 97 × $37.84 = $3,670.48
MH ( 2) 15 × $69.41 = $1,041.15 MH ( 2) 189 × $69.41 = $13,118.49
Product 1 Total: $16,177.15 Product 3 Total: $16,788.97

Product 2 (320 units)

Rate per unit
Allocation of allocation Total overhead allocated to
Driver base base Allocation jobs Per Unit
DLH ( 1) 185 × $37.84 = $7,000.40 Product 1 $16,177.15 $80.89
MH ( 2) 40 × $69.41 = $2,776.40 Product 2 $9,776.80 $30.55
Product 2 Total: $9,776.80 Product 3 $16,788.97 $10.49
Total: $42,742.92

that VABC can produce LIMITATIONS limitations. Cost drivers must

information that is useful in
decision making and that the
resulting cost allocations are
superior to traditional variable
costing for decision-making
purposes.
Although multiple regres-
sion provides a better way to
allocate overhead costs per
activity driver to each job,
there remain fundamental
be accurately selected by
management and costs must
be controlled. While multiple
regression does not require the
separation of total overhead
cost into cost pools, this is

© 2017 Wiley Periodicals, Inc. DOI 10.1002/jcaf

52 The Journal of Corporate Accounting & Finance  /  July/August 2017

often an essential step in the
control of these costs. The rec-
ognition of the variable nature
of the cost pools may also help
in planning and controlling
these costs.
Regression analysis is a
mathematical tool that lacks
any respect for economic real-
ity. Management must carefully
assess the results of this analy-
sis to be certain that the results
are not driven by anomalies
that do not reflect the true
underlying relationships.
NOTES
1. Together, only $155,263.16 of the total
overhead ($157,835) was allocated
during the year. The difference is a
result of the residual error calculated
in the regression. Similar to absorp-
tion costing, variable costing can lead
to misvalued, specifically undervalued,
unit cost pricing.
2. The coefficient is significant at the 85%
confidence level. This highlights an
important judgment call that must be
made with respect to what is an accept-
able cutoff threshold for use in the
overhead allocations.
3. It is important to note that due to
the lack of statistical significance of
the coefficient, interpretation of the
direction of the sign on the coefficient
becomes inconclusive.
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(1996). Is assigning capacity costs
to individual products necessary for
capacity planning? Accounting Horizons,
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Cardinaels, E., Roodhooft, F., & Warlop,
L. (2004). The value of activity-based
costing in competitive pricing decisions.
Journal of Management Accounting
Research, 16(1), 133–148.
Datar, S., & Gupta, M. (1994). Aggrega-
tion, specification and measurement
errors in product costing. Accounting
Review, 69(4), 567–591.
Homburg, C. (2005). Using relative profits
as an alternative to activity-based cost-
ing. International Journal of Production
Economics, 95(3), 387–397.
Horngren, C. T., Datar, S. M., &
Rajan, M. V. (2012). Cost accounting:
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Upper Saddle River, NJ: Pearson/
Prentice Hall.
Schneeweiss, C. (1998). On the applica-
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Matthew Geiszler, PhD, is an Assistant Professor of Accounting at Ithaca College. Kelsey Baker is an
Assurance Associate with PricewaterhouseCoopers. She received both her BS in accounting and MBA in
professional accountancy from Ithaca College. Jeffrey Lippitt, PhD, is an Associate Professor of Account-
ing at Ithaca College.

DOI 10.1002/jcaf © 2017 Wiley Periodicals, Inc.