4.
Chapter 4: Activity-Based Costing (ABC)
Lecture Notes
● Definition: A costing system that identifies various activities in a
company and allocates overhead costs to products and services based on
the consumption of those activities. ABC uses multiple cost drivers, unlike
traditional costing which often uses a single, volume-based driver (e.g.,
direct labor hours).
● Why ABC is Better than Traditional Costing:
○ Traditional costing, with its single plant-wide rate, can distort
product costs by overcosting high-volume products and
undercosting low-volume, specialized products.
○ ABC provides a more accurate cost of production, especially in
complex manufacturing environments with a variety of products
and non-volume-based overhead costs.
● The Two Stages of ABC:
○ Stage 1: Identify and Accumulate Costs by Activity Cost Pool.
■ An activity is any event that consumes resources.
■ An activity cost pool is a collection of costs related to a
single activity (e.g., "Setting up machines," "Inspecting
products").
○ Stage 2: Allocate Costs from Activity Pools to Products/Services.
■ A cost driver is a factor that causes or relates to the
incurrence of an activity cost (e.g., the number of setups for
the "Setting up machines" activity pool).
■ A cost driver rate is calculated for each activity cost pool:
■
■ The cost of each activity is then allocated to products based
on their actual usage of the activity.
● Hierarchy of Costs (Key to ABC):
○ Unit-Level Costs: Costs incurred for every single unit produced
(e.g., direct materials, direct labor).
○ Batch-Level Costs: Costs incurred for a group of units (a "batch")
but not for each individual unit (e.g., machine setup costs, material
handling).
○ Product-Sustaining Costs: Costs incurred to support a specific
product line, regardless of the number of units or batches (e.g.,
product design, product advertising).
○ Facility-Level Costs: Costs incurred to support overall company
operations and cannot be traced to specific products (e.g., factory
rent, CEO's salary). These are the most difficult to allocate
accurately in ABC.
● Benefits and Limitations of ABC:
○ Benefits:
■ More accurate product costing, leading to better pricing
decisions.
■ Highlights inefficient activities, promoting process
improvement.
■ Provides better information for cost control and performance
evaluation.
○ Limitations:
■ Can be expensive and time-consuming to implement.
■ Requires significant data collection and analysis.
■ Some overhead costs may still be difficult to trace to specific
activities.
Summary (Chapter 4)
Activity-Based Costing (ABC) is an advanced costing method that improves
the accuracy of overhead allocation compared to traditional costing. Instead of
using a single, volume-based cost driver, ABC identifies specific activities and
traces overhead to them (Stage 1). In Stage 2, costs from these activity pools
are then assigned to products based on their consumption of the activities. This
is driven by the use of multiple cost drivers, such as the number of setups or
the number of inspections. ABC's strength lies in its ability to handle different
levels of costs (unit, batch, product-sustaining, and facility-level) and
provides more accurate information for pricing and management decisions,
though it can be complex and costly to implement.