Activity-Based Product Costing: Detailed Description

Activity-Based Costing (ABC) system first traces costs to activities and then to products.
The underlying assumption is that activities consume resources and that products, in turn,
consume activities. Thus, the basic activity based costing model is also a two-stage process. An
ABC costing system, however, emphasizes direct tracing and driver tracing (exploiting cause-
and-effect relationships), while a functional-based costing system tends to be allocation
intensive (largely ignoring cause-and-effect relationships). Identifying activities must be the first
step in designing an activity-based costing system.

 Identifying Activities and Their Attributes

Since an activity is action taken or work performed by equipment or people for

other people, identifying activities is usually accomplished by interviewing managers or
representatives of functional work areas (departments). A set of key questions is asked
whose answers provide much of the data needed for an activity-based costing system.
This interview-derived data is used to prepare an activity dictionary. An activity
dictionary lists the activities in an organization along with some critical activity
attributes. Activity attributes are financial and nonfinancial information items that
describe individual activities. What attributes are used depends on the purpose.
Examples of activity attributes associated with a costing objective include types of
resources consumed, amount (percentage) of time spent on an activity by workers, cost
objects that consume the activity output (reason for performing the activity), a measure
of the activity output (activity driver), and the activity name.

The activity dictionary names the activity (usually by using an action verb and an
object that receives the action), describes the tasks that make up the activity, classifies
 the activity as primary or secondary, lists the users (cost objects), and identifies a
measure of activity output (activity driver). A primary activity is an activity that is
consumed by a product or customer. A secondary activity is one that is consumed by
other primary and secondary activities. Ultimately, secondary activities are consumed by
primary activities. For example, the supervising activity is consumed by the following
primary activities: processing transactions, preparing statements, and answering
phones. The three products, classic, gold, and platinum credit cards, in turn, consume
the primary activities. It is not unusual for a typical organization to produce an activity
dictionary containing 200 to 300 activities.

 Assigning Costs to Activities

Once activities are identified and described, the next task is determining how
much it costs to perform each activity. This requires identification of the resources being
consumed by each activity. Activities consume resources such as labor, materials,
energy, and capital. The cost of these resources is found in the general ledger, but how
much is spent on each activity is not revealed. Thus, it becomes necessary to assign the
resource costs to activities using direct and driver tracing. For labor resources, a work
distribution matrix is often used. A work distribution matrix simply identifies the amount
of labor consumed by each activity and is derived from the interview process (or a
written survey).

 Assigning Activity Costs to Other Activities

Assigning costs to activities completes the first stage of activity-based costing. In

this first stage, activities are classified as primary or secondary. If there are secondary
activities, then intermediate stages exist. In an intermediate stage, the cost of secondary
activities is assigned to those activities that consume their output. For example,
supervising employees is a secondary activity. The output measure is the total employee
time used by each activity.

 Assigning Costs to Products

Once the costs of primary activities are determined, they can be assigned to
products in proportion to their usage of the activity, as measured by activity drivers.
This assignment is accomplished by calculating a predetermined activity rate and
multiplying this rate by the actual usage of the activity. To calculate an activity rate, the
practical capacity of each activity must be determined. To assign costs, we also need the
amount of each activity consumed by each product. For our purposes, we will assume
that the practical activity capacity is equal to the total activity usage by all products.
 Detailed Classification of Activities

For product-costing purposes, activities can be classified into one of the

following four general activity categories: (1) unit level, (2) batch level, (3) product level,
and (4) facility level. Classifying activities into these general categories facilitates
product costing because the costs of activities associated with the different levels
respond to different types of drivers (cost behavior differs by level). The definition of
the activities belonging to each general category clearly illustrates this feature.

1. Unit-level activities are those performed each time a unit is produced.

For example, machining and assembly are activities performed each time
a unit is produced. The costs of unitlevel activities vary with the number
of units produced.
2. Batch-level activities are those performed each time a batch of goods is
produced. The costs of batch-level activities vary with the number of
batches, but they are fixed with respect to the number of units in each
batch. Setups, inspections (unless each unit is inspected), production
scheduling, and material handling are examples of batch-level activities.
3. Product-level (sustaining) activities are those performed as needed to
support the various products produced by a company. These activities
consume inputs that develop products or allow products to be produced
and sold. These activities and their costs tend to increase as the number
of different products increases. Engineering changes, development of
product-testing procedures, marketing a product, process engineering,
and expediting are examples of product-level activities.
4. Facility level activities are those that sustain a factory’s general
manufacturing processes. These activities benefit the organization at
some level but do not provide a benefit for any specific product.
Examples include plant management, landscaping, support of community
programs, security, property taxes, and plant depreciation.