Activity Based Costing (ABC)

Chapter 7
Activity-Based Costing (ABC) System
• 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 typically used as a supplement to a
company’s usual costing system.
• ABC attempts to accurately trace indirect costs to
individual products, services, or customers.
• A two-stage approach that is similar to, but more
general than, traditional departmental costing
systems.
– Instead of departments, ABC uses activities.

2
How Costs are Treated Under Activity–Based
Costing
• Activity Measure
– An allocation base in an activity-based costing
system.
– The term cost driver is also used to refer to an
activity measure.
• ABC defines five levels of activity that largely do not
relate to the volume of units produced.
– Traditional cost systems usually rely on volume
measures such as direct labour hours and/or
machine hours to allocate all overhead costs to
products.

3
How Costs are Treated Under Activity–Based
Costing

Unit-Level Batch-Level
Activity Activity

Manufacturing
companies typically combine
their activities into five
classifications.

Product-Level Organization- Customer-Level

Activity sustaining Activity
Activity
4
Classes of costs
• Unit-level cost: costs that vary proportionally with
the number of units produced
– examples: direct material, direct labour,
machine hours
– these costs are proportional to short-run
production decisions
• Batch-level costs are incurred each time a batch
of goods is processed
– examples: setups, material movements,
purchase orders, inspection
– the demand for setup resources are
independent of the number of units produced
after completing the setup

5
Classes of costs
• Product –level costs: incurred to enable individual products to
be produced and sold
– the expenses of these activities can be traced to the
individual products, but the resources consumed by the
activities are independent of how many units or batches of
the products are produced
– examples: process engineering, product specifications,
product enhancements
• Customer-level costs: costs related to specific customers
– Examples: sales calls, catalogue mailings and general
support
• Organization-sustaining costs: costs incurred to create
productive capacity for all products
– examples: factory administration, maintenance, heating
and lighting

6
 Activity-Based Costing (ABC) System

Total Overhead
Activity
cost pools

Activity Cost Pool 1 Activity Cost Pool 2

cost-driver rate cost-driver rate

Job 1 Job 2

7
When to Implement ABC
• Activity Based Costing Systems are likely to
report significantly more accurate product costs
when
– the organization uses large amounts of
indirect resources in its production processes,
and/or
– the organization has significant diversity in
products, production processes, and
customers, and/or
– the company faces significant competition,
especially from more focused competitors.

8
Benefits of ABC
• Improved decisions: with respect to introduction,
pricing and discontinuance of products; Activity
Based Costing Systems eliminate cross-product
subsidies
• Continuous improvement activities to reduce
overhead costs: managers will now know what
activities cause which costs and can reduce or
eliminate those activities that add little or no value to
products or services
• Ease of determining relevant costs: product cost
data in traditional systems often needs to be
analyzed in order to obtain information relevant to a
special decision; under Activity Based Costing
Systems, the data is readily available.

9
Symptoms of a Dysfunctional
Functional-Based Costing System
Pricing related
• The outcome of bids is difficult to explain.
• Competitors’ prices appear unrealistically low.
• The company has a highly profitable niche all to
itself.
• Customers do not complain about price increases.
Production related
• Products that are difficult to produce show high
profits.
• Operational managers want to drop products that
appear profitable.
• Profit margins are difficult to explain.

10
Systems of a Dysfunctional
Functional-Based Costing System, continued
Accounting-system related
• The accounting department spends a lot of time
supplying cost data for special projects.
• Some departments are using their own
accounting system.
• Product costs change because of changes in
financial reporting regulations.

11
Differences Between
ABC and Traditional Product Costs
• There are three reasons why the reported product margins
for the two costing systems differ from one another
– Traditional costing allocates all manufacturing
overhead to products. ABC costing only assigns
manufacturing overhead costs consumed by products
to those products.
– Traditional costing allocates all manufacturing
overhead costs using a volume-related allocation base.
ABC costing also uses non-volume related allocation
bases.
– Traditional costing disregards selling and administrative
expenses because they are period expenses. ABC
costing will usually directly trace shipping costs to
products and could include non-manufacturing
overhead costs that may be caused by products in the
activity cost pools that are assigned to products.

12
Activity-Based Costing and External
Reporting
• Most companies do not use ABC for external
reporting because . . .
– External reports are less detailed than internal
reports.
– It may be difficult to make changes to the
company’s accounting system.
– ABC does not always conform to GAAP (i.e. if
you are allocating period costs to the costing of a
product)
– Auditors may be suspect of the subjective
allocation process based on interviews with
employees.

13
ABC Limitations
• Substantial resources required to implement
and maintain.
• Desire to fully allocate all costs to products.
• Resistance to unfamiliar numbers and reports.
• Potential misinterpretation of unfamiliar
numbers.
• Does not always conform to GAAP. Two costing
systems may be needed.

14
Designing an ABC System
• Steps for Implementing ABC
– Identify and define activities, activity cost
pools and activity measures.
– Assign overhead costs to activity cost pools.
– Calculate activity rates.
– Assign overhead costs to cost objects using
the activity rates and activity measures.
– Prepare management reports.

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The Traditional Costing Model at Hockeystick

Direct Direct Overhead costs

Materials Labour $336,000

Directly Traced Directly Traced $28 per DLH

Cost Objects: Nexus 8000 and Nexus 6000

The ABC Model at Hockeystick
Direct Direct Overhead costs
Materials Labour $336,000

Assign Overhead costs to activity cost pools

Directly Traced Directly Traced Direct Labour Engineering

Hours design hours
$168,000 $168,000

$14 per DLH $21 per EDH

Cost Objects: Nexus 8000 and Nexus 6000