Activity Based Costing:

A Tool to Aid Decision Making

Activity Based Costing (ABC)
Both manufacturing
A number
and nonmanufacturing
of cost pools each
costs may be
allocated to a product
assigned to
or cost object.
products.

Some manufacturing
costs may be excluded
from product
costs.

Allocation bases often

Overhead rates may
differ from
be based on activity
traditional costing
at capacity.
systems.
How Costs are Treated Under
Activity-Based Costing
Activity Based
Costing

Departmental
Overhead
Rates

Plantwide
Overhead
Rate

Overhead Allocation
Cost of Idle Capacity
Traditional Cost Activity Based
Accounting Costing
The predetermined Products are charged for
overhead rate is based the costs of capacity
on budgeted activity. they use – not for the
This results in applying costs of capacity they
overhead costs of don’t use.
unused, or idle,
capacity.
Difference Between ABC and
Traditional Product Costs
Batch-level or product- Under ABC both
level costs will manufacturing and
ordinarily shift nonmanufacturing
overhead costs from costs may be
high-volume assigned to products.
products produced Organization-
in large batches to sustaining costs and
low-volume products the costs of idle
produced in small capacity are not
batches. assigned to products.
Designing an ABC System

Cost Objects
(e.g., products Activities
and customers)

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.
 Identify and Define Activities
and Activity Cost Pools
Unit-Level Batch-Level
Activity Activity

A part of the production

process for which management
wants a separate reporting of the
costs of the activity involved.

Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
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.
Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

First-Stage Allocation

Activity 1 Activity 2 Activity 3 Activity 4 Other

Cost Objects:
Products, Customer Orders, Customers
 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 Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages 25% 40% 20% 10% 5% 100%
Factory equipment depreciation 20% 0% 60% 0% 20% 100%
Factory utilities 0% 10% 50% 0% 40% 100%
Factory building lease 0% 0% 0% 0% 100% 100%
Shipping costs **
General Administrative Department
Administrative wages and salaries 15% 5% 10% 30% 40% 100%
Office equipment depreciation 30% 0% 0% 25% 45% 100%
Administrative building lease 0% 0% 0% 0% 100% 100%
Marketing Department
Marketing wages and salaries 20% 10% 0% 60% 10% 100%
Selling expenses 10% 0% 0% 70% 20% 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)

Production Department
Indirect factory wages $ 500,000
Activity CostFactory
Poolsequipment depreciation 300,000
Customer Product Order
Factory utilities Customer 120,000
Orders Design Sizelease Relations
Factory building Other
80,000 $ 1,000,000
Total
Shipping costs traced to customer orders 40,000
Production Department General Administrative Department
Indirect factory wages $ 125,000 Administrative wages and salaries 400,000
Factory equipment depreciation Office equipment depreciation 50,000
Administrative building lease 60,000 510,000
Factory utilities Marketing Department
Factory building lease Marketing wages and salaries 250,000
General Administrative Department Selling expenses 50,000 300,000
Total overhead costs $ 1,850,000
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total
Indirect factory wages $500,000
Percent consumed by customer orders 25%
$125,000
 Assign Costs to Activity Cost Pools

Activity Cost Pools

Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000 $ 200,000 $ 100,000 $ 50,000 $ 25,000 $ 500,000
Factory equipment depreciation 60,000 - 180,000 - 60,000 300,000
Factory utilities - 12,000 60,000 - 48,000 120,000
Factory building lease - - - - 80,000 80,000
General Administrative Department
Administrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000
Office equipment depreciation 15,000 - - 12,500 22,500 50,000
Administrative building lease - - - - 60,000 60,000
Marketing Department
Marketing wages and salaries 50,000 25,000 - 150,000 25,000 250,000
Selling expenses 5,000 - - 35,000 10,000 50,000
Total $ 315,000 $ 257,000 $ 380,000 $ 367,500 $ 490,500 $ 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
(a) (b) (a) ÷(b)
Activity Cost Pools Total Cost Total Activity Activity Rate
Customer orders $ 315,000 1,000 orders $315 per order
Product design 257,000 200 designs $1,285 per design
Order size 380,000 20,000 MHs $19 per MH
Customer relations 367,500 100 customer $3,675 per customer
Other 490,500 Not applicable Not applicable
Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

Traced Traced Traced

Cost Objects:
Products, Customer Orders, Customers
Activity-Based Costing at Classic Brass
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

Second-Stage Allocations

$/MH $/Order $/Design $/Customer

Cost Objects:
Unallocated
Products, Customer Orders, Customers
 Assigning Costs to Cost Objects
Let’s 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.
 Assigning Costs to Cost Objects
Overhead Cost for the Standard Stanchions
(a) (b) (a) (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 315 2 $ 630
Product design 1,285 0 -
Order size 19 200 3,800
Customer relations 3,675 N/A

Overhead Cost for the Custom Housing

The customer-level (a) (b) (a) (b)
Activity Cost Pools Activity Rate Activity ABC Cost
cost is assigned to Customer orders $ 315 1 $ 315
Product design 1,285 1 1,285
customers directly; Order size 19 4 76
it is not assigned to Customer relations 3,675 N/A

products.
 Limitations of ABC
ABC produces
numbers, like product
ABC systems are a
margins, that are at
major project requiring
odds with numbers
substantial resources.
produced by traditional
The benefits of
costing system. Some
increased accuracy
managers find it
must outweigh these
difficult to adjust to this
additional costs.
change.

ABC data can be misinterpreted and must

be used with care when making decisions.