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Activity-Based
Costing

A Tool to Aid Decision
Making
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
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.
It is ordinarily used as a
supplement to, rather
than as a replacement
for, the companys usual
costing system.

Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
How Costs are Treated Under
ActivityBased Costing
Best practice ABC differs from traditional costing in five ways.
Manufacturing
costs
Non-manufacturing
costs
ABC assigns both types of costs to products. For example,
ABC systems can assign sales commissions, shipping costs,
and warranty repair costs to specific products.
Traditional
product costing
ABC
product costing
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
How Costs are Treated Under
ActivityBased Costing
ABC does not assign all manufacturing costs to products. This
is because ABC only assigns a cost to a product if decisions
concerning that product will cause changes in the cost.
Manufacturing
costs
Non-manufacturing
costs
Best practice ABC differs from traditional costing in five ways.
Traditional
product costing
ABC
product costing
A
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l

S
o
m
e

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How Costs are Treated Under
ActivityBased Costing
Plantwide
Overhead
Rate
Departmental
Overhead
Rates
ActivityBased
Costing
Number of cost pools
L
e
v
e
l

o
f

c
o
m
p
l
e
x
i
t
y

ABC uses more cost pools.
ABC uses more cost pools than traditional cost systems that often
use a single plant wide overhead pool or just one overhead pool
per department.
Since more than one activity is often performed within each
department.

Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
How Costs are Treated Under
ActivityBased Costing
Best practice ABC differs from traditional costing in five ways.
ABC uses more allocation bases.
Traditional Costing
N
u
m
b
e
r

o
f

A
l
l
o
c
a
t
i
o
n

B
a
s
e
s

ABC
Bases usually
rely only on
volume
measures.
Volume
measures
plus other
bases.
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
How Costs are Treated Under
ActivityBased Costing
Best practice ABC differs from traditional costing in five ways.
ABC uses more allocation bases.
The most commonly used allocation base
in traditional costing is direct labor hours.
Direct labor hours work
well when overhead
increases as direct
labor hours increase.
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How Costs are Treated Under
ActivityBased Costing
Problems:
In many processes, overhead is increasing
while direct labor is decreasing.
Variety and complexity of products is increasing.
The most commonly used allocation base
in traditional costing is direct labor hours.
Best practice ABC differs from traditional costing in five ways.
ABC uses more allocation bases.
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
How Costs are Treated Under
ActivityBased Costing
Best practice ABC differs from traditional costing in five ways.
ABC uses more allocation bases.
All overhead
costs are not related
to volume measures like
direct labor
hours.
ABC uses
volume as well as
other allocation bases not
related to the volume
of production.
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
How Costs are Treated Under
ActivityBased Costing
Best practice ABC differs from traditional costing in five ways.
Traditional Costing
The predetermined
overhead rate is based
on budgeted activity.
This results in applying
all overhead costs
including unused, or
idle capacity costs to
products.
ABC
Products are charged
for the costs of
capacity they use not
for the costs of
capacity they dont
use. Unused capacity
costs are treated as
period expenses.
ABC bases level of activity on capacity.
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Characteristics of Successful
ABC Implementations
Strong top
management support
Cross-functional
involvement
Link to evaluations
and rewards
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Designing an ABC System
Cost Objects
(e.g., products
and customers)
Activities
Consumption
of Resources
Cost
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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.
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Identify and Define Activities
and Activity Cost Pools
Manufacturing
companies typically combine
their activities into five
classifications.
Unit-Level
Activity
Batch-Level
Activity
Product-Level
Activity
Customer-Level
Activity
Organization-
sustaining
Activity
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1. Unit-level activities are performed each time a unit is produced.
2. Batch-level activities are performed each time a batch is
handled or processed, regardless of how many units are in the
batch. e.g. inspection, setting up equipment and shipping
customer orders.
3. Product-level activities relate to specific products and must be
carried out regardless of how many batches are run or units
produced and sold. For example, designing or advertising a
product.
4. Customer-level activities relate to specific customers and are
not tied to any specific product. For example, sales calls and
catalog mailings.
5. Organization-sustaining activities are carried out regardless of
which customers are served, which products are produced, how
many batches are run, or how many units are made. For
example, heating a factory and cleaning executive offices.
Identify and Define Activities
and Activity Cost Pools--Explanation
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Identify and Define Activities
and Activity Cost Pools
Activities
should only be
combined within a level
if they are highly
correlated.
When combining
activities, they should be
grouped together only at
the appropriate
level.
Batch-level
Activities should not be
combined with unit-level
activities,
and so on
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Identify and Define Activities
and Activity Cost Pools
An Activity Cost
Pool is a bucket in
which costs are
accumulated that
relate to a single
activity measure in
the ABC system.
$
$
$
$
$
$
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Identify and Define Activities
and Activity Cost Pools
Simple count
of the number of
times an activity
occurs.
Transaction
driver
A measure
of the amount
of time needed
for an activity.
Duration
driver
Two types of activity measures:
When All Activity takes the
same time
Different amount of time
required to perform Activities
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Identify and Define Activities
and Activity Cost Pools
At Classic Brass, the ABC team, selected the following
activity cost pools and activity measures:
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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.
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When Possible, Directly Trace Overhead
Costs to Activities and Cost Objects
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Assign Costs to Activity Cost Pools
At Classic Brass the following distribution of resource
consumption across activity cost pools is determined.
**Not included because they are directly traced to customer orders.
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Assign Costs to Activity Cost Pools

The indirect factory workers allocated twenty-
five percent of their time to the customer orders
activity, forty percent of their time to the product
design activity, twenty percent of their time to
the order size activity, ten percent of their time
to customer relations, and five percent of their
time to the other activity.
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Indirect factory wages $500,000
Percent consumed by customer orders 25%
$125,000
Assign Costs to Activity Cost Pools
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Factory equipment depreciation $300,000
Percent consumed by customer orders 20%
$ 60,000
Assign Costs to Activity Cost Pools
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Assign Costs to Activity Cost Pools
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
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.
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Calculate Activity Rates
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Traced Traced Traced
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
Cost Objects:
Products, Customer Orders, Customers
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Cost Objects:
Products, Customer Orders, Customers
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Other
Overhead Costs
First-Stage Allocation
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Cost Objects:
Products, Customer Orders, Customers
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Other
Overhead Costs
First-Stage Allocation
Second-Stage Allocations
$/MH $/Order $/Design $/Customer
Unallocated
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Cost Objects:
Products, Customer Orders, Customers
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Other
Overhead Costs
First-Stage Allocation
Second-Stage Allocations
$19/MH $315/Order $257/Design $3675/Customer
Unallocated
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Assigning Costs to Cost Objects
Lets 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.
For each activity
cost pool, the
amount of activity
consumed by the
product (or
customer) is
multiplied by the
activity rate to
arrive at the
amount of
overhead cost
applied to the
product (or
customer).
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Assigning Costs to Cost Objects
The customer-level
cost is assigned to
customers directly;
it is not assigned to
products.
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Prepare Management Reports
Standard Stanchions
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) $
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Prepare Management Reports
Customer Profitability Analysis
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Product Margins
Traditional Cost Accounting System
Predetermined manufacturing
overhead rate
$1,000,000
20,000 MH
= $50/MH =
400 units x 0.5 MH/unit x $50/MH = $10,000
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Differences Between ABC and
Traditional Product Costs
Product margins are different for four reasons:
Traditional costing assigns design costs to both products
based on machine hours. ABC assigns product design
costs to a product only if product design work is required.
Traditional costing assigns customer order costs, a batch-
level cost, using a unit-level allocation base, machine hours.
ABC assigns these batch-level costs using a batch-level
activity measure.
Traditional costing assigns only manufacturing costs to
products. ABC also assigns nonmanufacturing costs to
products.
Traditional costing assigns all manufacturing costs to
products. The ABC system does not assign organization-
sustaining manufacturing costs to the products.
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Differences Between ABC and
Traditional Product Costs
When batch-level and
product-level costs are present,
ABC will usually shift costs from high
volume products, produced in large batches,
to low volume products produced in small batches.

This cost shifting will usually have its
greatest impact on the per
unit cost of the low
volume products.
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Targeting Process Improvement
Activity-based management is
used in conjunction with ABC to
identify areas that would benefit
from process improvements.
While the theory of constraints
approach discussed in Chapter 1 is a
powerful tool for targeting
improvement efforts, activity rates
can also provide valuable clues on
where to focus improvement efforts.
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
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 companys
accounting system.
3. ABC does not conform to GAAP.
4. Auditors may be suspect of the subjective allocation
process based on interviews with employees.
Copyright 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
ABC Limitations
Substantial resources
required to implement
and maintain.
Resistance to
unfamiliar numbers
and reports.
Desire to fully
allocate all costs
to products.
Potential
misinterpretation of
unfamiliar numbers.
Does not conform to
GAAP. Two costing
systems may be needed.