Activity-Based Costing

Better Costing for Better Decisions

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Indirect Costs

 Not easily and conveniently traceable to cost

objects
 Cost element is shared among cost objects
 Physically impossible to trace
 Not cost effective to trace

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Indirect Costs

 Need for allocation

 Estimate product or activity cost
 What does it really cost?

 Increase awareness of indirect costs

 Activities are not free

 Plan more cost efficient operations

 Now that we know what it costs, what should we do?

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Allocation of Indirect Costs

 Typical allocation methods

 Ability to bear
 Fairness or equity
 Benefits received
 Cause and effect

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Traditional Allocation Method

 Indirect costs allocated to cost object based

on the cost object’s consumption of some
measure of activity, usually labor hours

$10,000,000 total indirect cost

= $25 per hour rate
400,000 total labor hours

A product consuming 6 labor hours would be charged

$150 of indirect costs

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Criticisms of Traditional Overhead
Allocation
 Assumes all overhead is volume-related
 Factory-wide or departmental rates
 All related to single activity measure

 Departmental focus, not process focus

 Focus on costs incurred, not cause of costs

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Activity-Based Costing

 Purpose
 Allocation of indirect costs based on causal
activities
 Attempts to identify “direct” link between cost and cost
object

 Results in better allocation

 Does not provide “true” cost

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Activity-Based Costing

 Traditional allocation method

Costs Products

 Activity-based allocation method

Costs Activities Products

First stage Second stage

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Overview of ABC

 Identifies activities required to produce the

product or service
 Determines the cost of the activities
 Allocates costs to the cost object based on
the object’s consumption of activities

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Levels of Cost Incurrence

 Not all costs are volume-related

 Unit level
 Batch level
 Product level
 Facility level

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Operation of an ABC System
 Assign costs to activity pools
 First stage allocation
 Identify the costs incurred to perform
various activities

 Determine the measure of activity

best related to each cost pool
 Cost drivers

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Operation of an ABC System

 Determine rate per unit of activity

 Assign costs to products/services based on
consumption of activities
 Second stage allocation

 Indirect costs are converted to direct costs

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Implementing ABC

 Step 1 – Plan the system

 What are the goals?
 Inventory valuation
 Process improvement

 Foster active involvement

 Assemble cross-functional team
 Functional specialists

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Implementing ABC

 Step 2 – Define, analyze activities and

resources
 Decompose organization into elemental activities
 Who does what, and why?
 Interview employees
 Determine resources
 Determine inputs and outputs

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Implementing ABC

 Gather statistics on activities

 Inputs and outputs
 Transaction, duration, intensity
 For possible use as second-stage cost drivers

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Implementing ABC
 Step 3 – Establish activity cost pools
and determine first stage allocation
 First stage allocations assign costs to cost
pools
 Requires costs to be re-categorized according
to why they are incurred, not by type
 Drivers may be employee time, square footage,
etc.

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Implementing ABC

 Step 4 – Determine second stage drivers and

assign costs to cost objects
 Outputs of activity analysis may be second stage
drivers
 Distance moved, times handled, machine hours, units,
etc.

 Amount assigned to the cost object is the amount

of activity consumed times the rate per unit of the
activity

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When is ABC Most Useful?

 High amounts of overhead cost

 Multiple products
 Complex products
 Complex production system
 Significant variation in volume between high
and low volume products

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When is ABC Most Useful?

 Different products place different demands on

resources
 Problems with current cost allocations due to
changes in products or processes
 Better cost information is needed

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Activity-Based Management

 Natural extension of ABC

 Why are activities performed?
 Are they necessary?
 Are they consistent with organizational goals?

 How are they performed?

 Are they performed efficiently?
 Can they be redesigned or eliminated?

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ABM for Process Improvement

 Focus on problems, opportunities

 Prioritize opportunities for improvement
 Most critical
 Greatest potential for cost savings

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ABM for Process Improvement

 Determine and explain causes for problems

and opportunities
 Cannot improve the system without first
understanding it

 Select specific improvement projects

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ABM for Process Improvement

 Use ABC/ABM data to test potential impact of

changes
 Make changes
 Iterate
 Process of continual improvement

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Implications of ABC/ABM

 Shifts focus from managing costs to

managing activities
 Aids in recognizing, measuring and
controlling complexity
 Promotes understanding of why costs
are incurred
 Provides better cost allocation
information

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Implications of ABC/ABM

 Useful for planning future operations

 Fosters continuous improvement
 Likely to meet with substantial
resistance
 Analysis of why and how activities are
performed

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