Activity Based Costing:

A Tool to Aid Decision Making

 Activity Based Costing (ABC)

The objective of
ABC is a
activity-based good supplement
costing is to to our traditional
cost system
I agree!
understand
overhead and the
profitability of
products and
customers.

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 Activity Based Costing (ABC)
Activity-Based Costing

Both
Both manufacturing
manufacturing There
There are
are aa number
number
and
and nonmanufacturing
nonmanufacturing of
of cost
cost pools
pools each
each ofof
costs
costs may
may be
be which
which is
is allocated
allocated
assigned
assigned to
to using
using aa unique
unique
products.
products. measure
measure of of activity.
activity.
Some
Some manufacturing
manufacturing
costs
costs may
may be
be excluded
excluded
from
from product
product
costs.
costs.

Allocation
Allocation bases
bases often
often Overhead
Overhead rates
rates may
may
differ
differ from
from be
be based
based on
on activity
activity
traditional
traditional costing
costing at
at capacity.
capacity.
systems.
systems.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 How Costs are Treated Under
Activity-Based Costing
Activity
Activity Based
Based
Costing
Costing

Departmental
Departmental
Overhead
Overhead i ty
Rates
Rates ex
pl
o m
Plantwide f C
Plantwide o
Overhead
Overhead e l
v
Rate
Rate Le
Overhead Allocation
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 Plantwide Overhead Rate

Companies tend to use direct labor

as the overhead allocation base.

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 Departmental Overhead Rates

Finishing Department
AA two
two stage
stage process
process is
is
Painting Department necessary
necessary because
because costs
costs
are
are allocated
allocated to
to departments
departments
Shipping Department and
and then
then to
to products.
products.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Departmental Overhead Rates

Indirect Indirect Other

Labor Materials Overhead
Stage One:
Costs assigned
to pools
Department Department Department
Cost pools
1 2 3

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Departmental Overhead Rates

Indirect Indirect Other

Labor Materials Overhead
Stage One:
Costs assigned
to pools
Department Department Department
Cost pools
1 2 3

Stage Two:
Costs applied
to products
Products

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Departmental Overhead Rates

Indirect Indirect Other

Labor Materials Overhead
Stage One:
Costs assigned
to pools
Department Department Department
Cost pools
1 2 3
Direct Machine Raw
Stage Two: Labor Hours Materials
Costs applied Hours Cost
to products
Products

Departmental Allocation Bases

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Designing an ABC System
Cost
Cost Objects
Objects Consumption
Consumption
(e.g.,
(e.g.,products
products Activities
Activities of
of Resources
Resources
and
andcustomers)
customers)

Cost
Cost

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Designing an ABC System
Steps for Implementing ABC
 Identify and define activities and activity pools.
 Where possible, trace costs to activities and cost
objects.
 Assign costs to activity cost pools.
 Calculate activity rates.
 Assign costs to cost objects.
 Prepare management reports.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Identifying Activity to Include
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
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000
 Identifying Activity to Include

Activity Cost Pool $$

is a “bucket” in $
which costs are $ $
$
accumulated that
relate to a single
activity in the ABC
system.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 The Mechanics of ABC

At Classic Brass, the ultimate cost objects are:

 Products,
 Customer orders, and
 Customers.
One overhead cost - shipping - can be traced
directly to customer orders.
The company’s overhead costs are shown
on the next slide.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Production Department
Indirect factory wages $ 500,000
Factory equipment depreciation 300,000
Factory utilities 120,000
Factory building lease 80,000 $ 1,000,000
Shipping costs traced to customer orders 40,000
General Administrative Department
Administrative wages and salaries 400,000
Office equipment depreciation 50,000
Administrative building lease 60,000 510,000
Marketing Department
Marketing wages and salaries 250,000
Selling expenses 50,000 300,000
Total overhead costs $ 1,850,000

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Activity-Based Costing at Classic Brass
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

Traced $/DLH Traced

Cost Objects:
Products, Customer Orders, Customers

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 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

Cost Objects:
Products, Customer Orders, Customers

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Assigning Costs to Activity Cost
Pools
Management at Classic Brass believes overhead should be
distributed as follows:
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 traced to customer order N/A
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%

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Assigning Costs to Activity Cost
Pools
Using the total costs and percentage consumption of
overhead, costs are assigned to activity pools.
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000
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
Indirect
Indirect factory
factory wages
wages $500,000
$500,000
Percent
Percent consumed
consumed byby customer
customer orders
orders 25%
25%
$125,000
$125,000
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000
 Assigning Costs to Activity Cost
Pools
Using the total costs and percentage consumption of
overhead, costs are assigned to activity pools.
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000
Factory equipment depreciation 60,000
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
Factory
Factory equipment
equipment depreciation
depreciation $300,000
$300,000
Percent
Percent consumed
consumed byby customer
customer orders
orders 20%
20%
$$ 60,000
60,000
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000
 Assigning Costs to Activity Cost
Pools
Using the total costs and percentage consumption of
overhead, costs are assigned to activity 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Computation of Activity Rates

The ABC team has determined that Classic

Brass has the following total activities for each
activity cost pool . . .
 1,000 customer orders,
 200 new designs,
 20,000 machine-hours
 100 customers.
Now the team can compute the individual
activity rates.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Computation of Activity Rates
Activity Cost Pools
20,000
1,000 200 machine- 100
Orders Designs hours Customers Other
Production Department
Indirect factory wages $ 125
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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Computation of Activity Rates
Activity Cost Pools
20,000
1,000 200 machine- 100
Orders Designs hours Customers Other
Production Department
Indirect factory wages $ 125 $ 1,000 $ 5 $ 500 N/A
Factory equipment depreciation 60 - 9 -
Factory utilities - 60 3 -
Factory building lease - - - -
General Administrative Department
Administrative wages and salaries 60 100 2 1,200
Office equipment depreciation 15 - - 125
Administrative building lease - - - -
Marketing Department
Marketing wages and salaries 50 125 - 1,500
Selling expenses 5 - - 350
Total $ 315 $ 1,285 $ 19 $ 3,675

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Difference Between ABC and
Traditional Product Costs
ABC will ordinarily shift
batch-level and
product-level
overhead costs from
high-volume
products produced in
large batches to low-
volume products
produced in small
batches.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Difference Between ABC and
Traditional Product Costs
Under ABC both
manufacturing and
nonmanufacturing
costs may be
assigned to products.
Organization-
sustaining costs and
the costs of idle
capacity are not
assigned to products.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Ease of Adjustment
Costs that adjust automatically to changes in activity:
 Direct materials.
 Shipping.

Costs that could be adjusted to changes in activity:

 Direct labor.
 Factory utilities.
 Administrative wages and salaries.
 Office equipment depreciation.
 Marketing wages and salaries.
 Selling expenses.

Costs that are difficult to adjust to changes in activity:

 Factory equipment depreciation.
 Factory building lease.
 Administrative building lease.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000