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ACTIVITY BASED COSTING:

A TOOL TO AID DECISION


MAKING

Activity Based Costing


(ABC)
Both
Both manufacturing
manufacturing
and
and nonmanufacturing
nonmanufacturing
costs
costs may
may be
be
assigned
assigned to
to
products.
products.

AAnumber
number
of
of cost
cost pools
pools each
each
allocated
allocated to
to aa product
product
or
or cost
cost object.
object.
Some
Some manufacturing
manufacturing
costs
costs may
may be
be excluded
excluded
from
from product
product
costs.
costs.

Allocation
Allocation bases
bases often
often
differ
differ from
from
traditional
traditional costing
costing
systems.
systems.

Overhead
Overhead rates
rates may
may
be
be based
based on
on activity
activity
at
at capacity.
capacity.

How Costs are Treated Under ActivityBased Costing


Activity
Activity Based
Based
Costing
Costing
Departmental
Departmental
Overhead
Overhead
Rates
Rates
Plantwide
Plantwide
Overhead
Overhead
Rate
Rate

f
o
l
e
v
e
L

ty
i
x
e
pl
m
o
C

Overhead Allocation

Cost of Idle Capacity


Traditional Cost
Accounting
The predetermined
overhead rate is
based on budgeted
activity. This results
in applying overhead
costs of unused, or
idle, capacity.

Activity
Activity Based
Based
Costing
Costing

Products are charged


for the costs of
capacity they use
not for the costs of
capacity they dont
use.

Difference Between ABC and Traditional


Product Costs
Batch-level or
product-level
costs will
ordinarily shift
overhead costs
from high-volume
products
produced in large
batches to lowvolume products
produced in small
batches.

Under ABC both


manufacturing and
nonmanufacturing
costs may be
assigned to
products.
Organizationsustaining costs
and the costs of idle
capacity are not
assigned to
products.

Designing an ABC System


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

Activities

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
Activity

Batch-Level
Activity

A part of the production


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

Product-Level
Activity

Organizationsustaining
Activity

Customer-Level
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
Materials
Materials

Direct
Direct
Labor
Labor

Shipping
Shipping
Costs
Costs

Overhead
Overhead Costs
Costs

First-Stage Allocation

Activity
Activity 11

Activity 2 Activity 3 Activity 4

Cost
Cost Objects:
Objects:
Products,
Products, Customer Orders,
Orders, Customers

Other
Other

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.

Assign Costs to Activity Cost


Pools
Activity Cost Pools
Customer
Product
Orders
Design
Production Department
Indirect factory wages
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

Order
Size

Customer
Relations

Other

$ 125,000

Indirect
$500,000
Indirect factory
factory wages
wages
$500,000
Percent
25%
Percent consumed
consumed by
by customer
customer orders
orders
25%
$125,000
$125,000

Total

Assign Costs to Activity Cost


Pools
Activity Cost Pools
Customer
Product
Orders
Design
Production Department
Indirect factory wages
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

Order
Size

Customer
Relations

Other

Total

$ 125,000
60,000
-

$ 200,000
12,000
-

$ 100,000
180,000
60,000
-

$ 50,000
-

$ 25,000
60,000
48,000
80,000

500,000
300,000
120,000
80,000

60,000
15,000
-

20,000
-

40,000
-

120,000
12,500
-

160,000
22,500
60,000

400,000
50,000
60,000

50,000
5,000
$ 315,000

25,000
$ 257,000

$ 380,000

150,000
35,000
$ 367,500

25,000
10,000
$ 490,500

250,000
50,000
$ 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
Activity Cost Pools
Customer orders
Product design
Order size
Customer relations
Other

(a)
Total Cost
$ 315,000
257,000
380,000
367,500
490,500

(b)
Total Activity
1,000 orders
200 designs
20,000 MHs
100 customer
Not applicable

(a) (b)
Activity Rate
$315 per order
$1,285 per design
$19 per MH
$3,675 per customer
Not applicable

Activity-Based Costing at Classic


Brass
Direct
Direct
Materials
Materials

Direct
Direct
Labor
Labor

Shipping
Shipping
Costs
Costs

Traced
Traced

Traced
Traced

Traced
Traced

Overhead
Overhead Costs
Costs

Cost
Cost Objects:
Objects:
Products,
Products, Customer Orders,
Orders, Customers

Activity-Based Costing at Classic


Brass
Direct
Direct
Materials
Materials

Direct
Direct
Labor
Labor

Shipping
Shipping
Costs
Costs

Overhead
Overhead Costs
Costs

First-Stage Allocation

Order
Order
Size

Customer
Customer
Orders
Orders

Product
Product
Design
Design

Customer
Customer
Relations
Relations

Other
Other

Second-Stage Allocations
$/MH
$/MH

$/Order
$/Order

$/Design
$/Design

$/Customer
$/Customer

Cost
Cost Objects:
Objects:
Products,
Products, Customer Orders,
Orders, Customers

Unallocated
Unallocated

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.

Assigning Costs to Cost


Objects
Overhead Cost for the Standard Stanchions
Activity Cost Pools
Customer orders
Product design
Order size
Customer relations

(a)
Activity Rate
$
315
1,285
19
3,675

The customer-level
cost is assigned to
customers directly;
it is not assigned to
products.

(b)
Activity
2
0
200
N/A

(a) (b)
ABC Cost
$
630
3,800

Overhead Cost for the Custom Housing


Activity Cost Pools
Customer orders
Product design
Order size
Customer relations

(a)
Activity Rate
$
315
1,285
19
3,675

(b)
Activity
1
1
4
N/A

(a) (b)
ABC Cost
$
315
1,285
76

Limitations of ABC
ABC systems are a
major project requiring
substantial resources.
The benefits of
increased accuracy
must outweigh these
additional costs.

ABC produces
numbers, like product
margins, that are at
odds with numbers
produced by traditional
costing system. Some
managers find it
difficult to adjust to this
change.

ABC data can be misinterpreted and must


be used with care when making decisions.