This document discusses activity-based costing (ABC), which allocates overhead costs based on activities that drive costs rather than volume. It provides examples of unit, batch, product, and facility-level costs and cost drivers. The key advantage of ABC is that it eliminates cross-subsidies between high and low volume products seen in traditional volume-based costing. While initially developed for manufacturing, ABC has also been adopted by service industries.

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CHAPTER 6
Activity-Based
Costing
© 2009 Cengage Learning

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Introduction
Overhead costs have soared to 60
percent or more of total product
costs in heavily automated
manufacturing environments.
As overhead costs increase and
make up a larger portion of the total
costs of products, accuracy in
overhead application has become
much more important.

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Activity-Based Costing
In this chapter we introduce a
different approach to overhead
allocation using Activity-Based
Cost Drivers as opposed to
Volume-Based Cost Drivers

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Categories of Overhead
Costs
Unit-level costs are incurred each
time a unit is produced.
Examples:
Supplies for factory
Depreciation on factory machinery
Energy costs for factory machinery
Repairs and maintenance of factory
machinery

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Categories of Overhead
Costs
Batch-level costs are incurred
each time a batch of goods is
produced.
Examples:
Salaries related to purchasing and
receiving
Salaries related to moving material
Quality control costs
Depreciation of setup equipment

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Categories of Overhead
Costs
Product-level costs are incurred
as needed to support the
production of each different
type of product. Examples:
Salaries of engineers
Depreciation of engineering
equipment
Product development costs (testing)
Quality control costs

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Categories of Overhead
Costs
Facility-level costs simply sustain a
facility’s general manufacturing
process. Examples:
Depreciation or rent of a factory
building
Salary of a plant manager
Insurance, taxes, etc.
Training

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Activities and Cost Drivers:
Unit Level
Activity
•Machining
•Maintenance
of machines
Potential Cost Driver
•Machine hours,
labor hours or
number of units
produced
•Machine hours

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Activities and Cost Drivers:
Product Level
Activity
Product
Testing
Supervision
Potential Cost Driver
Number of change
orders, number of
tests, hours of testing
time
Number of supervision
hours

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Activities and Cost Drivers:
Batch Level
Activity
Purchasing
Receiving
Machine setups
Customer orders
Potential Cost Driver
Number of purchase
orders or number of
parts
Amount of material or
number of receipts
Number of setups
Number of orders,

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Activities and Cost Drivers:
Facility Level
Activity
Plant
Occupancy
Potential Cost Driver
Square footage,
number of employees,
labor hours, machine
hours

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Unit-level costs are incurred each time a
unit is produced. Batch-level costs are
incurred each time a batch of goods is
produced. Product-level costs are incurred
as needed to support the production of
each type of product. Facility-level costs
simply sustain a facility’s general
manufacturing process.
Unit-, Batch-, Product-, and
Facility-Level Costs
Key Concept

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The key feature of an Activity-Based
Costing system is allocating overhead costs
based on activities that drive costs rather
than on the volume or number of units
produced.
Activity-Based Costing
Key Concept

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Traditional Overhead Allocation
and ABC - An Example
Modular-Home Builder
Builds 2 basic models and
a fast-delivery Cottage
TopSail Construction

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Estimated Manufacturing
Overhead Costs for 2008

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Costs per Unit Using Volume-
Based OH Allocation

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Stage 1: Identification of
Activities

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Stage 2: Identification of
Cost Drivers & Allocation of
Costs
Activity
Inspections
Purchasing
Supervision
Delivery &
setup
Cost Driver
Number of
inspections
Number of purchase
orders
Hours of supervisor
time
Setup time (days)

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Estimated Cost Driver
Activity

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Calculation of
Predetermined Activity
Rates

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Cost of Units Based on
Activity-Based Costing

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Cost Comparisons between
Traditional and ABC Costing

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Price Comparison between
Traditional and ABC Costing

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Activity-Based
Costing
Volume-based costing systems
often result in over-costing high
volume products and under-
costing low-volume products.
This cross subsidy is eliminated
by the use of ABC.
Key Concept

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ABC Systems in Service
Industries
Although ABC was developed
for use primarily by
manufacturing companies, it
has gained widespread
acceptance in the service
sector.

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ABC Systems in Service
Industries
Problems
Type of work performed in service
industries tends to be non- repetitive
Activities differ for each customer
or service
Services have proportionately more
facility-level costs

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ABC Systems and
Nonmanufacturing Activities
ABC is used to determine the cost
of providing a selling or
administrative service.
Example: The U.S. Post Office used ABC to
help determine the costs and benefits of
allowing customers to pay using debit and
credit cards.

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Benefits of Activity-Based
Costing
Using ABC in the budgeting process
provides more accurate estimates
of resources
Provides more accurate cost
information for day-to-day decision
making
Costs that appeared to be indirect
using volume-based costing systems
are now traced to specific activities
using cost drivers

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Limitations of Activity-Based
Costing
High measurement costs
The higher the potential for cost
distortions, the more likely the
company will benefit from ABC
Distortions result from diverse
products
Diverse products: products that consume
resources in different proportions

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Backflush Costing
Companies using JIT generally have
little or no inventory or finished goods.
All manufacturing costs are flushed directly
into cost of goods sold
If the company has small amounts of
inventory on hand at the end of the period,
manufacturing costs are backflushed into
the appropriate materials inventory, WIP
inventory or finished goods inventory