Chapter 7: Activity-Based Costing - A Tool to Aid Decision Making

Objective 1 - Explain the activity-based costing model and how it differs from a traditional costing system.


Activity-Based Costing – A costing method based on activities designed to provide managers with cost info for strategic or other decisions that may affect capacity (fixed costs).

Most companies have 2 costing systems – The Official Costing System and the ABC system for internal decisions.


Treatment of Costs Under the Activity-Based Costing Model

  • Differences between traditional cost vs ABC costing.
  • Manufacturing and non-manufacturing costs may be assigned to products on a cause-and-effect basis.
  • Some manufacturing costs are excluded from product costs.
  • Numerous Overhead Costs Pools (groups of overhead cost elements) are used, allocated to products and other cost objects with a unique measurement.
  • Overhead rates may be based on level of activity rather than budgeted level.


Non-manufacturing Costs and Activity-Based Costing

Traditional - Only manufacturing costs are assigned to products.

ABC - Many non-manufacturing costs are lumped into overhead for reasonable estimation of cost.

  • The entire product cost is determined.


Manufacturing Costs and ABC Costing

  • Traditional - All manufacturing costs are assigned to products. (including costs not directly caused by products by spreading all MOH across products dependent on allocation base).
  • “Peanut butter-spreading” approach.
  • Costs of unused capacity are assigned to products, so lower level of activity causes higher MOH and higher unit product costs.
  • ABC - Some MOH costs that are unaffected by product-related decisions are treated as period expenses instead of period costs.
  • ABC products are only charged for costs of capacity used.
  • Highlights the cost of idle capacity rather than putting it into inventory and COGS.


Overhead Cost Pools, Allocation Bases, and Activity-Based Costing

  • ABC became more popular due to automated equipment allowing fast released products/services – limited overhead cost spools and traditional allocation bases distorted unit product costs.
  • Terms
  • Activity – Any event that causes consumption of overhead resources.
  • Activity Cost Pool – A “bucket” in which costs are accumulated that relate to a single activity measure in the activity-based costing system.
  • Activity Measure – An allocation base in an ABC system; a measure of amount of activity that drives the costs in an activity cost pool.
  • Transaction Driver – A simple count of the number of times an activity occurs.
  • Duration driver – A measure of the amount of time required to perform an activity.
  • More accurate but require more effort to record.


ABC defines five levels of activities to avoid distorting of product costs caused by overhead costs that do not move with allocation bases.

  • These do not relate to volume of units produced or services provided.


1) Unit Level Activities – Performed each time a unit is produced.

  • Costs are proportional to number of units produced.
  • i.e. providing power to processing equipment


2) Batch Level Activities – Performed each time a batch is handled/processed regardless of how many units are in the batch.

  • Costs at batch level depend on number of batches produced.
  • i.e. tasks such as placing purchase orders, setting up equipment, arranging shipments to customers.


3) Product-Level Activities – Relates to specific products and typically must be carried out regardless of batches or units.

  • i.e. Designing a product, advertising a product, and maintaining a product manager and staff.


4) Customer-Level Activities – Relate to specific customers but do not relate to a specific product.

  • i.e. sales calls, catalogue mailings, technical support.


5) Organization-Sustaining Activities – Carried out regardless of customers serviced, products produced, batches run, or units made.

  • i.e. heating the factory, cleaning executive offices, providing a computer network.


Activity Rates Based on Capacity, Not Budget

  • Products are charged for costs of capacity used rather than the costs of capacity they do not use.
  • Unit costs are more stable and consistent with objective of assigning appropriate costs.


Designing an Activity-Based Costing System

  • Three essential characteristics of successful ABC.
  • Top managers support the decision, top managers ensure a link between ABC data to evaluation and rewards of people, and a cross functional team is created to design/implement the ABC.
  • General Structure
  • Cost Objects → Activities → Consumption of Resources → Cost
  • ABC analyzes the relationships between the consumption of resources associated with certain activities to identify how products and customers affect costs.
  • Implementation of AB is broken down into 5 steps.


Step 1: Identify and Define Activities, Activity Cost Pools, and Activity Measures

  • Create a list of activities – The list may be long so often groups of activities are combined. (i.e. materials handling)
  • Combine activities that are at an appropriate activity level, such as batch-level or unit-level.
  • For the other category – Types of costs are not assigned to products because the resources are not consumed by products. It includes organization sustaining cost.


Objective 2 - Assign costs to cost pools using a first stage allocation, and compute activity rates.


Step 2 - Assign Overhead Costs to Activity Cost Pools

  • Assigning costs in ABC is a 2-stage process.
  1. Manufacturing and Non-manufacturing Overhead is allocated to the activity cost pools.
  2. Costs for activities are allocated to various cost objects.
  • General Ledgers classify costs by departments where they are incurred and mirrors that of an absorption income statement.
  • First-Stage Allocation – Process by which overhead costs are assigned to activity cost pools in an activity-based costing system.
  • Based on the results of employees with first-hand knowledge of activities.
  • Divide the cost by percentage, and then dollars based on how much they make up of each pool.

Step 3 - Calculate Activity Rates

  • Determine activity rates for assigning overhead costs to products and customers.
  • Calculation - Activity Rate = Total Cost / Total Activity
  • Figures are average.
  • Activity rate is not calculated for “Other.”
  • Upon calculation of the activity rates, the company may decide to defer some implementation of the ABC system if the cost of measuring data is too high.

Second Stage Allocation of Overhead Costs

  • The fourth step of ABC implementation is the second-stage allocation, the process where activity rates are used to apply costs to products and customers in ABC.


Objective 3 - Assign costs to a cost object using a second-stage allocation.


Step 4 - Assign Overhead Costs to Cost Objects

Using the Activity Rates and Activity Measures.

  • In the case of products, there may be “special” or alternative product orders, the activity cost pools and their activity rates are the same but the units may be different.
  • Calculation: ABC Cost = Activity Rate x Activity


Overhead Costs and Products

  • We do not include Customer-Level Activities nor Other Activities costs because they are not caused by products.
  • i.e. customer relations costs, and other costs.


Overhead Costs to Customers

  • Same calculation, but Customer-level Activities are included as part of the calculations.


Objective 4 - Use activity-based costing to compute product and customer margins.


Step 5: Prepare Management Reports


  • Profit Margin – Profit from a product, it is a function of the product’s sales and the direct and indirect costs.
  • Product Margin = Sales – Total Cost
  • As cost allocations summarize only each product’s overhead costs, sales and direct costs must be gathered and added.
  • Customer-level costs are caused by customers and are not included in product profitability report. Organization-sustaining costs are also excluded.
  • Sum up the product margins for both standard and special products, and reconcile with the company’s operating income by adding up sales, subtracting total costs to get Product Margins where applicable.
  • Add Overhead costs not assigned to get operating income.
  • Customer Profitability Report – gathers data concerning sales, and includes the sales minus direct costs (DL, DM, shipping), as well as other MOH from the pools that applied to the customer.
  • Results in the final “Customer Margin.”
  • Many firms use ABC to calculate supplier costs and margins as they may impact costs in the firm.
  • i.e. cost of purchased components includes price paid to supplier plus related costs.
  • They may be assigned to particular suppliers based on cost drivers, such as units of purchased or dollar value of products purchased.


Comparison of Traditional and Activity Based Costing Product Costs

Objective 5: Compare product costs computed using traditional and activity-based costing methods.


Traditional Product Margins

  • Only manufacturing costs are assigned to products (DL, DM, MOH) and selling/administrative costs are not included.
  • Steps
  1. Sales and direct materials and direct labour cost data are the same numbers as ABC.
  2. Traditional costing system uses a plantwide overhead rate to assign MOH costs.
  • Refer to previous chapters for the POHR steps.
  • Total sales, total costs, and resulting operating loss are the same regardless of whether you look at the absorption income statement or traditional product profitability analysis.
  • Might send misleading signals.


Differences Between Activity-Based Costs and Traditional Product Costs.

  • Under ABC, Not all MOH is assigned to products. Customer Relations and Other are not assigned to product cost.
  • Under ABC, multiple unique activity measures are used rather than the single allocation base used in traditional.
  • Under ABC, non-manufacturing overhead costs are assigned to products, while the traditional method assigns them to period costs.
  • Traditional cost overcosts the high-volume product and reports a lower product margin.
  • Traditional cost undercosts the low-volume product and reports a higher product margin.
  • Caution should be taken before acting based on ABC as costs must be analyzed concisely.


Targeting Process Improvements

  • Activity-Based Management (ABM) – Management approach that, in conjunction with activity-based costing, improves processes and reduces costs.
  • Activity Rates may provide clues on waste and scope for improvement.
  • Benchmarking – Systematic approach of comparing performance of some aspect of an organization’s operations to that of outstanding external companies or to other divisions in same organization.
  • For internal benchmarking, it compares performance within the company, or if it’s external benchmarking it compares it to outside organizations.


Activity-Based Costing and External Reports

  • ABC is infrequently used for external reports because external reports are less detailed and because individual product costs are not reported.
  • Errors tend to offset in terms of traditional costing.
  • A company’s costing system is difficult to change without bugs.
  • ABC systems do not conform to GAAP, it would have to be adjusted.
  • Auditors are likely to be uncomfortable with allocations based on interviews with personnel. (Data seems subjective)


Limitations of Activity-based Costing

  • Implementation requires substantial resources and is costly to maintain.
  • ABC numbers may be at odds with traditional produced numbers, so managers may not support it.
  • ABC data may be misinterpreted as costs assigned are only potentially relevant.
  • Reports generated do not conform to GAAP, so an organization must have two costing system – one for internal and one for external.


Objective 6 (Appendix) Use Activity-based costing techniques to compute unit product costs for external reports.


  • Modifying ABC allows it to be used to find product costs for external financial reports.
  • In this case, products costs include all manufacturing overhead costs, and excludes all non-manufacturing overhead costs.
  • A predetermined overhead rate is generated for each activity cost pool.
  • Calculation of ABC’s POHR: total cost of an activity pool / total activity associated.


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