5 Activity-Based Costing

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 ACTIVITY BASED COSTING
Traditional costing system
1. Direct and indirect costs
are allocated to process
centres or major departments
goods,
2. Cost driver as base for
allocation of overheads is not
based on cause and effect
relationship
3. There is only one cost
driver Or OH allocation
ABC System
1. The direct and indirect costs are
allocated to activities like
Purchases, Material handling,
Producing the goods, machine set
ups, Supervising production
workers, Inspecting finished
Dispatching good to customers
2.Cost driver as base for allocation
of overheads is based on cause
and effect relationship between
overheads and the overhead
allocation base (the cost driver)
Stores deptt – Labour hours or
machine hours or units produced
3. There are many allocation bases
as per activity chosen and cause
1-2
 Traditional, Volume-Based
Product-Costing System
• Aerotech produces three complex printed circuit
boards referred to as Mode I, Mode II, and Mode
III.
• The following information is obtained from
company records:

Mode I Mode II Mode III

Production:
Units 10,000 20,000 4,000
Runs 1 run of 10,000 4 runs of 10 runs of
units 5,000 units 400 units

1-3
Traditional, Volume-Based Product-Costing System

Additional information includes:

Mode I Mode II Mode III

Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor (hr/board) 3 4 2
Setup time (hr/run) 10 10 10
Machine time (hr/board) 1 1.25 2
Manufacturing overhead is determined as follows
1-4
 Traditional, Volume-Based
Product-Costing System

Budgeted manufacturing overhead $3,894,000

= $33 per hour
Budgeted direct-labor hours 118,000

1-5
 Traditional, Volume-Based
Product-Costing System
With these product costs, Aerotech established
target selling prices (Cost × 125%).

209.00 x 1.25
1-6
Activity Based Costing System
(ABC)

ABC systems Assigning

overhead to
follow a two- products is a
difficult process.
stage procedure I agree!
to assign
overhead costs to
products.

1-7
 Activity Based Costing System
(ABC)
ABC systems follow a
Let’s begin
two-stage procedure by identifying
to assign overhead our major
activities.
costs to products.

Stage One
Identify significant
activities and assign overhead
costs to each activity in
proportion to resources used.
1-8
 Activity Based Costing System
(ABC)
ABC systems follow a
two-stage procedure Overhead assigned to
to assign overhead activities are called
“activity cost pools.”
costs to products.

Stage Two
Identify cost drivers
appropriate to each activity
and allocate overhead to
the products.

1-9
ABC System

1. Identify major activities

activity consists of aggregation of tasks having common

characteristics)
e.g.
Activity: purchase of materials :

Tasks: receiving a purchase request, inviting quotations,

selecting supplier, placing orders, receiving material

1-10
2. Assigning costs to Activity Cost
Centers:
Cost incurred on these activities are
assigned to these Activity Cost Centers.

Direct costs are traced directly.

Indirect costs are assigned to activities on the

basis of cause and effect cost drivers.

1-11
There must be a cause - effect relationship
between the overheads to be allocated and the
allocation base otherwise inaccurate allocation
of overheads will occur.

For an example, it would be wrong to allocate

overheads of stores dept. on the basis of labor
hours.

It should be more appropriately based on

number of units handled or used in production
process.

1-12
3. Selecting cost drivers for allocating costs
to cost objects

The costs accumulated for an activity cost centre

are then allocated to different cost objects.

For this, a separate activity cost driver or

allocation rate is used.

In ABC analysis, the tracing of overheads to cost

objects requires that cost behavior must be
understood so that appropriate cost drivers are
identified.

1-13
Identifying activities and cost drivers
depends upon type of activity, Volume related or not volume related
Major activity Associated costs Cost drivers

1. Processing orders for 1. No. of purchase

Purchase of materials/ 1. Labor cost of orders processed
Stores employees
working in
2. Handling materials and purchase dept. 2. No. of materials and
Parts 2. Labor cost of
stores, depreciation parts requisitions
of machines used for
3. Inspection of material and moving materials
parts purchased 3. Labor cost of 3. No. of receipts of
inspection team, materials and parts
Depr. Of testing
4. Setting up production equipments
procedures 4. Labor cost of 4. No. of set ups
works involved in set-
ups and depr. of set
up equipments 1-14
Identifying activities and cost drivers
Depends upon type of activity, Volume related or not volume related
Major activity Associated costs Cost drivers

5. Producing the goods 5. No. of machine hours

5. Depreciation of
machines
6. Supervising production 6. No. of assembly
workers 6. Salary of assembly labor hours
supervisors
7. Inspecting finished goods 7. No. of inspections
7. Labor cost of
inspectors and
depreciation of test
equipments
8. Dispatching good to 8. No. of boxes packed
customers 8. Labor cost of
packing and cost of
Packing materials

1-15
 Two Key Points

A
A large
large proportion
proportion of of non-
non- Product
Product diversity
diversity
unit-level
unit-level activities
activities When
When the
the consumption
consumption
A
A unit-level
unit-level cost
cost driver,
driver, ratios
ratios differ
differ widely
widely
such
such asas direct
direct labor,
labor, between
between activities,
activities, no
no
machine
machine hours,
hours, or
or single
single cost
cost driver
driver will
will
throughput,
throughput, will
will not
not be
be accurately
accurately assign
assign the
the
able
able to
to assign
assign the
the costs
costs resulting
resulting overhead
overhead costs.
costs.
of
of non-unit-level
non-unit-level activities
activities
accurately.
accurately.

1-16
 Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .

Degree of Behavioral
Correlation Effects

Cost of
Measurement

1-17
 Direct versus Indirect Costs
Volume-Based
Volume-Based Costing
Costing Activity-Based
Activity-Based Costing
Costing
All
All production
production costs
costs An effort
effort is
is made
made to
to
except
except direct
direct account
account for
for as
as many
many
materials
materials and
and direct
direct costs
costs as
as possible
possible as
as
labor
labor are
are lumped
lumped direct costs of
together
together in
in one
one production.
production.
overhead
overhead cost
cost pool.
pool.

Indirect
Costs

1-18
Interviewing and Paper Trails
The information for ABC systems initially comes
from interviews with employees in the support
departments and a review of each department’s
records.

1-19
 Storyboarding
A procedure used to develop a detailed
process flow chart, which visually
represents activities and the relationships
among activities.
Step
Step These
These are
are the
the steps
steps wewe
11 follow
Step follow to
to build
build aa
Step memory
22 memory board.
board.
Step
Step
33
Step
Step
44

1-20
 Machinery
cost pool

Maintenance Lubrication

Depreciation Electricity

Computer Support Calibration

1-21
 Engineering
cost pool

Engineering salaries Engineering software

Engineering supplies Depreciation

1-22
 Facility
cost pool

Plant depr. Property taxes

Plant mgmt. Insurance

Plant maint. Security

1-23
 Overhead Costs
Total budgeted cost = $3,894,000 Identification
Identification
Activity
must be
of
of Activity
Activity
done on Cost
Cost Pools
Pools
each unit Activity
produced. Cost
Pools
Product-
Unit Batch Sustaining Facility
Level Level Level Level

Machinery Setup Engineering Facility

cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Activity Activities needed to support Activity required in order

performed an entire product line for the production
on each process to occur.
batch
produced.
1-24
 Product-
Unit Batch Sustaining Facility
Level Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Receiving/Inspection
cost pool $200,000

Material-Handling
cost pool $600,000

Quality-Assurance
cost pool $421,000

Packaging/Shipping
cost pool $250,000

1-25
 STAGE ONE

Various overhead
Maintenance Lubrication
costs related
to machinery Depreciation Electricity

Computer Support Calibration

Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1,212,600

1-26
 STAGE TWO
Calculate Budgeted Machinery Costs = $1,212,600
the pool Budgeted Machine Hours 43,000
rate = $28.20/hour

Cost
Assignment

1-27
 STAGE ONE

Calculation of
total setup cost

Activity
cost Setup Cost Pool
pool Total budgeted cost = $3,000

1-28
 STAGE TWO
Calculate Budgeted Setup Costs = $3,000
the pool Planned Production Runs 15 runs
rate = $200 per run

Cost
Assignment

1-29
 STAGE ONE
Various overhead Engineering salaries Engineering software
costs related
to engineering Engineering supplies Depreciation

Activity
cost Engineering Cost Pool
pool Total budgeted cost = $700,000

1-30
 STAGE TWO
Allocate based Engineering Cost Pool
on engineering Total budgeted cost = $700,000
transactions

Cost
Assignment

1-31
 Exh.

STAGE ONE 5-9

Various overhead Plant depr. Property taxes

costs related
Plant mgmt. Insurance
to general
operations Plant maint. Security

Activity
cost Facility Cost Pool
pool Total budgeted cost = $507,400

1-32
 Exh.

STAGE TWO 5-9

Calculate Budgeted Facilities Cost = $507,400

the pool Budgeted Direct-Labor Hours 118,000
rate = $4.30/hour

Cost
Assignment

1-33
 Other Overhead Costs
Re c e ivin g a n d In s pe c t ion Cos t P ool
Board Ove rh e ad × % ÷ U n its = Cos t/Un it
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00

Mat e ria l-Ha n dlin g Co s t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/U n it
Mode I $ 600,000 × 7% ÷ 10,000 = $ 4.20
Mode II 600,000 × 30% ÷ 20,000 = 9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50

Qu alit y-As s u ra n c e Co s t P ool

Board Ove rh e ad × % ÷ U n its = Cos t/U n it
Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10

P ac ka gin g a n d Sh ippin g Cos t P oo l

Board Ove rh e ad × % ÷ Un its = Cos t/U n it
Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
Mode III 250,000 × 66% ÷ 4,000 = 41.25

1-34
 Other Overhead Costs
Re c e ivin g a n d In s pe c t ion Cos t P ool
Board Ove rh e ad × % ÷ U n its = Cos t/Un it
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00

Mat e ria l-Ha n dlin g Co s t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/U n it
$14.82 Mode I
Mode II
$ 600,000
600,000
×
×
7%
30%
÷
÷
10,000
20,000
= $
=
4.20
9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50

Qu alit y-As s u ra n c e Co s t P ool

Board Ove rh e ad × % ÷ U n its = Cos t/U n it
Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10

P ac ka gin g a n d Sh ippin g Cos t P oo l

Board Ove rh e ad × % ÷ Un its = Cos t/U n it
Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
Mode III 250,000 × 66% ÷ 4,000 = 41.25

1-35
 Product Cost from ABC
These are the new product costs when Aerotech
uses ABC.

1-36
 Product Cost from ABC
These are the new product costs when Aerotech
uses ABC.

1-37
 Distorted Product Costs
Both original and ABC target selling prices are
based on (Cost × 125%).

1-38
 Distorted Product Costs
Both original and ABC target selling prices are
based on (Cost × 125%).

1-39
 Distorted Product Costs
Both original and ABC target selling prices are
based on (Cost × 125%).

1-40
 Distorted Product Costs
Both original and ABC target selling prices are
based on (Cost × 125%).

The selling price of Mode I and II are reduced

and the selling price for Mode III is increased.
[$209.00 × 1.25] [$183.44 × 1.25]

1-41
 Distorted Product Costs
Can you identify any problems Aerotech is likely
to face as a result of this distortion?

Traditional costing understates the cost

of complex, low volume products.

1-42
 Indicators of Need for ABC
Direct
Direct labor
labor is
is aa Product-line
Product-line profit
profit
small
small percentage
percentage margins
margins are
are hard
hard
of
of total
total costs
costs to
to explain
explain

Line
Line managers
managers do
do not
not
Sales
Sales are
are increasing,
increasing, believe
believe the
the product
product
but
but profits
profits are
are declining.
declining. costs
costs reports
reports

Some
Some products
products that
that
Marketing
Marketing does
does not
not have
have reported
reported high
high
use
use costs
costs reports
reports for
for profit
profit margins
margins are
are not
not
pricing
pricing decisions
decisions sold
sold by
by competitors
competitors
1-43
 The use of
ABC costing
information
to help
management
make decisions

1-44
Activity-based costing establishes relationships
between overhead costs and activities so that
we can better allocate overhead costs.
Activity-based management focuses
on managing activities to reduce costs.

1-45
Activities

1-46
Cost Assignment View

Resource
Resource costs
costs

Activities

Cost
Cost Objects
Objects
1-47
 Cost Assignment View

Resource
Resource costs
costs
Process View
Activity Analysis Activity Evaluation

Root
Root Activity
Activity Performance
Performance
Causes
Causes Triggers
Triggers Activities Measures
Measures

Cost
Cost Objects
Objects
1-48
 Activities

Nonvalue-
added
activities
Unnecessary Necessary

Reduce or Continually Evaluate

Eliminate
and Improve 1-49
 1. Identify Activities.
2. Identify Non-Value-Added Activities.
3. Understand Activity Linkages, Root Causes,
and Triggers.
Inspect
Inspect Rework
Rework
Specify
Specify Select
Select Receive
Receive Produce
Produce finished
finished defective
defective
parts
parts vendor
vendor parts
parts goods
goods goods
goods products
products

4. Establish Performance Measures.

5. Report Non-Value-Added Costs.

1-50
 Process time

Inspection time Storage time

Move time Waiting time

1-51
 Customer profitability analysis uses
activity-based costing to determine
the activities, costs, and profit associated
with serving particular customers.

1-52
 Required
special
packaging.
Orders Demand
small fast
quantities. service.

Often
Orders
changes
frequently.
orders.

A costly customer
1-53
 Cost
CostDrive
Drive
Customer-Related
Customer-Related Activities
Activities Cost
CostDriver
DriverBase
Base Rate
Rate
Order
Orderprocessing
processing Purchase
Purchaseorders
orders $$ 150
150
Sales
Salescontacts
contacts(phone
(phonecalls,
calls,faxes,
faxes,etc.)
etc.) Contacts
Contacts 100
100
Sales
Salesvisits
visits Visits
Visits 1,000
1,000
Shipment
Shipmentprocessing
processing Shipments
Shipments 200
200
Billing
Billing and
and collection
collection Invoices
Invoices 160
160
Design/engineering
Design/engineering change
changeorders
orders Design
Design changes
changes 4,000
4,000
Special
Specialpackaging
packaging Units
Unitspackaged
packaged 40
40
Special
Specialhandling
handling Units
Unitshandled
handled 60
60

A
A company
company maymay useuse these
these customer
customer
related
related costs
costs toto help
help determine
determine the
the
profitability
profitability of
of each
each customer.
customer.

1-54
No materials are purchased and no products
are manufactured until they are needed.

The
The primary
primary goal
goal of
of aa
JIT
JIT production
production system
system is is
to
to reduce
reduce oror eliminate
eliminate
inventories
inventories atat every
every
stage
stage of
of production.
production.

1-55
Smooth, uniform production rate
Pull method of production
Purchase is small lot sizes
Quick, inexpensive setups
High quality materials
Effective preventive maintenance
Teamwork
Multiskilled workers

1-56
 Long-term
Long-term
contracts
contracts with
with
suppliers.
suppliers.

Only
Only aa few
few Parts
Parts delivered
delivered
suppliers.
suppliers. in
in small
small lots.
lots.

Grouped
Grouped Minimal
Minimal
payments
payments to
to inspection
inspection of
of
vendor.
vendor. materials.
materials.

1-57
• Activity based costing in service industry
• As useful as in mfg. industry
• Mangers want more detailed and accurate
information about the cost of producing
products and services they are selling
• Airlines, ins co, banks, hospitals, fin service
firms, hotels railroads,
• Air France, American express, Bank of
America, DHL, Fed Ex, US postal service
1-58
ABC at service companies:
Identifying
Activities Activity cost pools Cost drivers
Classification of activities at
• Unit level :
• batch level,
• product sustaining level,
• facility (general operations) level

1-59
Bajaj Allianze General Insurance Co. Ltd
Claims Department
Classification of activities at
• Unit level : Entering initial claim into computer
• batch level: moving a batch of claims from one
processing step to the next
• product sustaining level: maintenance of the
medical service provider network ( physicians,
hospitals )
• facility (general operations) level: general
administration of claims business unit

1-60
• ABC at Delaware medical centre (Primary Care
Unit- OPD)
• Patient Appointment
• New routine extended complex
• Continuing routine extended complex
• Every appointment needs
• Regd. nurse 1 : vital signs/preparing patient for
Primary health care professional
• PHCP 1: physician / intern / resident doctor or
nurse practitioner
1-61
• ABC team identified :
• Activities
Physician time
Practitioner nurse time
Intern or resident time
Regd. Nurse time
Clerical time: new patients
Clerical time : continuing
Billing
Facility
cost drivers
Physician minutes with patient
P-Nurse minutes with patient
Intern minutes with patient
Regd. Nurse minutes with patient
New patient visits
Continuiing patient visits
Billing lines (items on a bill)
Patient visits (both new and continuing)
1-62
• Activity : physician time
• Cost driver : physician minutes with patient
• Cost cost driver rate PV driver activity no. of activity
• pool qty Type qty cost visits cost /p
• 960000 240000 4 R 80000 320000 8000 $40
• E 100000 400000 5000 $80
• C 60000 240000 2000 $120

• Activity Nurse Practitioner time

• Cost driver : NP minutes with patient
• Cost cost driver rate PV driver activity no. of activity
• pool qty Type qty cost visits cost /p
• 90000 30000 3 R 12000 36000 1200 $30
• E 10000 30000 500 $60
• C 8000 24000 320 $75

1-63
• Activity : intern or resident time
• Cost driver : intern or resident minutes with patient
• Cost cost driver rate PV driver activity no. of activity
• pool qty Type qty cost visits cost /p
• 412500 125000 3.30 R 40000 132000 4000 $33
• E 50000 165000 2500 $66
• C 35000 115500 1000 $115

• Activity : Rgd. nurse time

• Cost driver : RN minutes with patient
• Cost cost driver rate PV driver activity no. of activity
• pool qty Type qty cost visits cost /p
• 281980 245200 1.15 R 132000 151800 13200 $11.50
• E 80000 92000 8000 $11.50
• C 33200 38180 3320 $11.50

1-64
• Activity : Clerical time –new patients
• Cost driver : New patients number
• Cost cost driver rate PV driver activity no. of activity
• pool qty Type qty cost visits cost /p
• 135300 12300 11.00 R 7200 79200 7200 $11
• E 3000 33000 3000 $11
• C 2100 23100 2100 $11

• Activity : Cleical time – continuing patients

• Cost driver : cont. patients number
• Cost cost driver rate PV driver activity no. of activity
• pool qty Type qty cost visits cost /p
• 61100 12220 5.00 R 6000 30000 6000 $5
• E 5000 25000 5000 $5
• C 1220 6100 1220 $5

1-65
• Activity : Billing
• Cost driver : Billing lines on a bill
• Cost cost driver rate PV driver activity no. of activity
• pool qty Type qty cost visits cost /p
• 38480 76960 0.50 R 26400 13200 13200 $1.00
• E 24000 12000 8000 $1.50
• C 26560 13280 3320 $4.00

• Activity : Facility
• Cost driver : number of new plus cont. patients visits
• Cost cost driver rate PV driver activity no. of activity
• pool qty Type qty cost visits cost /p
• 245200 24520 10.00 R 13200 132000 13200 $10
• E 8000 80000 8000 $10
• C 3320 33200 3320 $10

1-66
• Costing of service
• 1. Each patient sees either a physician or PN or
intern or resident – not all four
• 2. each patient is either a new patient or a
continuing patient and not both.
• 3. to compute cost of particular appointment, we
should select only one of primary health care
professionals, and select one of the two clerical
time categories –new or continuing.
• 3.4. finally since every appointment involves RN ,
billing, and use of primary care unit facility, all of
these activities must be included in the cost
calculation.
1-67
• Cost of extended appointment for a new patient
seeing a nurse practitioner
• Activity Cost
• Nurse practitioner time
• RN time
• Clerical time –new patients
• Billing
• Facility
• Total 94.00

1-68
• Cost of extended appointment for a new patient
seeing a nurse practitioner
• Activity cost
• Nurse practitioner time 60.00
• RN time 11.50
• Clerical time –new patients 11.00
• Billing 1.50
• Facility 10.00

• Total 94.00
1-69
End of Chapter 5
This is
my kind of cost
pool!

1-70