ABC Costing: A Five-Way Approach

Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
11th Edition
Chapter 8

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

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Activity Based Costing (ABC)
ABC is designed to
provide managers with
cost information for
strategic and other
decisions that
potentially affect
capacity and therefore
affect fixed as well as
variable costs.
ABC is a
good supplement
to our traditional
cost system
I agree!

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How Costs are Treated Under
Activity–Based Costing
“Best practice” ABC differs from traditional costing in five ways.
Manufacturing
costs
Nonmanufacturing
costs
 ABC assigns both types of costs to products.
Traditional
product costing
ABC
product costing

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 ABC does not assign all manufacturing costs to products.
Manufacturing
costs
Nonmanufacturing
costs
Traditional
product costing
ABC
product costing
All
Some

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Plantwide
Overhead
Rate
Departmental
Overhead
Rates
Activity–Based
Costing
Number of cost pools
Level
of
complexity
 ABC uses more cost pools.

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 ABC uses more allocation bases.
Traditional Costing
Number
of
Allocation
Bases
ABC
Bases usually
rely solely on
volume
measures.
Volume
measures
plus other
bases.

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The most commonly used allocation base
in traditional costing is direct labor hours.
Direct labor hours work
well when overhead
increases as direct
labor hours increase.

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Problems:
 In many processes, overhead is increasing
while direct labor is decreasing.
 Variety and complexity of products is increasing.
The most commonly used allocation base
in traditional costing is direct labor hours.

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All overhead
costs are not related
to volume measures like
direct labor
hours.
ABC uses
volume as well as
other allocation bases not
related to the volume
of production.

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Traditional Costing
The predetermined
overhead rate is based
on budgeted activity.
This results in applying
all overhead costs
including unused, or
idle capacity costs to
products.
ABC
Products are charged
for the costs of
capacity they use – not
for the costs of
capacity they don’t
use. Unused capacity
costs are treated as
period expenses.
 ABC bases level of activity on capacity.

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Characteristics of Successful
ABC Implementations
Strong top
management support
Cross-functional
involvement
Link to evaluations
and rewards

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

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Designing 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.
Prepare management reports.

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Identify and Define Activities
and Activity Cost Pools
Manufacturing
companies typically combine
their activities into five
classifications.
Unit-Level
Activity
Batch-Level
Activity
Product-Level
Activity
Customer-Level
Activity
Organization-
sustaining
Activity

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Activities
should only be
combined within a level
if they are highly
correlated.
When combining
activities, they should be
grouped together only at
the appropriate
level.

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

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Simple count
of the number of
times an activity
occurs.
Transaction
driver
A measure
of the amount
of time needed
for an activity.
Duration
driver
Two types of activity measures:

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At Classic Brass, the ABC team, selected the following
activity cost pools and activity measures:

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• Customer Orders - assigned all costs of resources
that are consumed by taking and processing
customer orders.
• Product Designs - assigned all costs of resources
consumed by designing products.
• Order Size - assigned all costs of resources
consumed as a consequence of the number of units
produced.
• Customer Relations – assigned all costs associated
with maintaining relations with customers.
• Other – assigned all overhead costs that are not
associated with the other cost pools.

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When Possible, Directly Trace Overhead
Costs to Activities and Cost Objects

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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.

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

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Factory equipment depreciation $300,000
Percent consumed by customer orders 20%
$ 60,000

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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.

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Calculate Activity Rates

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Traced Traced Traced
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
Cost Objects:
Products, Customer Orders, Customers

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Direct
Materials
Direct
Labor
Shipping
Costs
Cost Objects:
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Other
Overhead Costs
First-Stage Allocation

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Direct
Materials
Direct
Labor
Shipping
Costs
Cost Objects:
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Other
Overhead Costs
First-Stage Allocation
Second-Stage Allocations
$/MH $/Order $/Design $/Customer
Unallocated

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Assigning Costs to Cost Objects
Let’s 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.

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Assigning Costs to Cost Objects
The customer-level
cost is assigned to
customers directly;
it is not assigned to
products.

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Prepare Management Reports
Standard Stanchions
Sales 13,600
$
Cost:
Direct materials 2,110
$
Direct labor 1,850
Shipping costs 180
Customer orders 630
Product design -
Order size 3,800 8,570
Product margin 5,030
$
Custom Compass Housing
Sales 650
$
Cost:
Direct materials 13
$
Direct labor 50
Shipping costs 25
Customer orders 315
Product design 1,285
Order size 76 1,764
Product margin (1,114)
$

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Prepare Management Reports
Customer Profitability Analysis

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Product Margins
Traditional Cost Accounting System
Predetermined manufacturing
overhead rate
$1,000,000
20,000 MH
= $50/MH
=
400 units x 0.5 MH/unit x $50/MH = $10,000

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Differences Between ABC and
Traditional Product Costs
Product margins are different for four reasons:
 Traditional costing assigns design costs to both products
based on machine hours. ABC assigns product design
costs to a product only if product design work is required.
 Traditional costing assigns customer order costs, a batch-
level cost, using a unit-level allocation base, machine hours.
ABC assigns these batch-level costs using a batch-level
activity measure.
 Traditional costing assigns only manufacturing costs to
products. ABC also assigns nonmanufacturing costs to
products.
 Traditional costing assigns all manufacturing costs to
products. The ABC system does not assign organization-
sustaining manufacturing costs to the products.

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Differences Between ABC and
Traditional Product Costs
When batch-level and
product-level costs are present,
ABC will usually shift costs from high
volume products, produced in large batches,
to low volume products produced in small batches.
This cost shifting will usually have its
greatest impact on the per
unit cost of the low
volume products.

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Targeting Process Improvement
Activity-based management is
used in conjunction with ABC to
identify areas that would benefit
from process improvements.
While the theory of constraints
approach discussed in Chapter 1 is a
powerful tool for targeting
improvement efforts, activity rates
can also provide valuable clues on
where to focus improvement efforts.

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Activity-Based Costing and External Reporting
Most companies do not use ABC
for external reporting because . . .
1. External reports are less detailed than internal
reports.
2. It may be difficult to make changes to the company’s
accounting system.
3. ABC does not conform to GAAP.
4. Auditors may be suspect of the subjective allocation
process based on interviews with employees.

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ABC Limitations
Substantial resources
required to implement
and maintain.
Resistance to
unfamiliar numbers
and reports.
Desire to fully
allocate all costs
to products.
Potential
misinterpretation of
unfamiliar numbers.
Does not conform to
GAAP. Two costing
systems may be needed.

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Appendix 8A: ABC Action Analysis
Conventional ABC analysis does not
identify potentially relevant costs. An
action analysis report helps because it:
• Shows what costs have been
assigned to a cost object.
• Indicates how difficult it would be to
adjust those costs in response to
changes in the level of activity.

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Constructing an action analysis report
begins with the first-stage allocation
process. In addition to computing an
overall activity rate for each activity cost
pool, an activity rate is computed for each
type of overhead cost that is consumed
supporting a given activity.
Let’s revisit the stage-one allocations
from the Classic Brass example that we
discussed earlier.

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$125,000 ÷ 1,000 orders = $125 per order
Other entries in the table are computed similarly.

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$125 per order × 2 orders = $250

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$125 per order × 1 orders = $125

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Next, label each cost using an ease of adjustment
code:
• Green costs adjust more or less automatically to
changes in activity level without any action by
managers.
• Yellow costs can be adjusted to changes in activity
level, but it would require management action to
realize the change in cost.
• Red costs can be adjusted to changes in activity
level only with a great deal difficulty and with
management intervention.

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Sales 650
$
Green costs
Direct materials 13
$
Shipping costs 25 38
Green margin 612
$
Yellow costs
Direct labor 50
Indirect factory wages 1,145
Factory utilities 72
Administrative wages and salaries 168
Office equipment depreciation 15
Marketing wages and salaries 175
Selling expenses 5 1,630
Yellow margin (1,018)
$
Red costs
Factory equipment depreciation 96
Factory building lease -
Administrative building lease - 96
Red margin (1,114)
$
Action Analysis of Custom Compass Housing

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End of Chapter 8

ABC Costing: A Five-Way Approach

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