Introduction to Managerial Accounting

(ACCT 2302)
Activity Based Costing

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 Assigning overhead costs to products
• In the early days, simplicity was the main objective behind cost allocations
since everything was manual.
• Plantwide Overhead Rate was popularly used because of its simplicity.
• Will plantwide overhead rate using Direct labor hours or Direct labor cost
be satisfactory today?
• Departmental Overhead Rates replaced Plantwide Overhead Rate for those
firms dissatisfied with Plantwide Overhead Rates.
• Worked better for some firms manufacturing a wide variety of products and
complex overhead costs
• There is no guarantee that the cost allocation basis selected for departmental
rates performed better. Challenges remained when overhead costs were not
directly proportional to the volume of production.
• Activity-based costing is helpful to increase the precision of the cost allocation
process.

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What is Activity-Based Costing (ABC)
• ABC uses multiple allocation bases for assigning costs to products based on allocation bases that
represent a major activity.
Cost Objects
(e.g., products and customers)

Activities

Activities Consume Resources

Consumption of Resources Incur Cost

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 Activity-Based Costing (ABC)
Examples of Activities
An event that causes the
Activity consumption of overhead
resources.

Examples of Activities

Admitting
Setting up Billing Purchasing
hospital
machines customers inventory
patients
 Activity-Based Costing (ABC)
Pools, Measures, Rates

A “cost bucket” in which costs

Activity Cost
related to a particular activity are
Pool accumulated.

Expresses how much of the

Activity activity is carried out and is used
Measure as the allocation base for
applying overhead costs.

A predetermined overhead rate

Activity Rate for each activity
cost pool.
 Designing an Activity-Based Costing System
• The challenge is to select a reasonably small number of activities that explain
the bulk of the variation in overhead costs.
• Activities are usually chosen by interviewing a broad range of managers to find
out what activities they think consume most of the organization’s resources.
• Related activities are frequently combined to reduce the amount of detail and
record-keeping costs.
• For example, several actions may be involved in handling and moving raw
materials, but these may be combined into a single activity titled material
handling.
• An activity dictionary defines each of the activities that will be included in the
activity-based costing system and how the activities will be measured.

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 Hierarchy of Activities
Level Activities Activity Measure
Unit-level Processing units on m achines Machine-hours
Processing units by hand Direct labor-hours
Consum ing factory supplies Units produced

Batch-level Processing purchase orders Purchase orders processed

Processing production orders Production orders processed
Setting up equipm ent Num ber of setups
Handling m aterials Pounds of m aterial handled

Product-level Testing new products Hours of testing tim e

Adm inistering parts inventories Num ber of part types
Maintaining inventories of parts Hours of design tim e

Facility-level General factory adm inistration Direct labor-hours

Plant building and grounds Direct labor-hours
 Graphic Example of
Activity-Based Costing – Stage 1

Various Manufacturing Overhead Costs

First-Stage Cost Assignment

Labor- Machine- Machine Production Parts General

Related Pool Related Pool Setup Pool Order Pool Admin. Pool Factory Pool
 Graphic Example of
Activity-Based Costing – Stage 2
Various Manufacturing Overhead Costs

Form activity cost pools

$450,000

Labor- Machine- Machine Production Parts General

Related Pool Related Pool Setup Pool Order Pool Admin. Pool Factory Pool
1,200 Orders

Compute activity cost rates

$375/Order
$/DLH $/MH $/Setup $/Order $/Part Type $/MH

Products
Unit-Level Batch-Level Product-Level Facility-Level
Activity Activity Activity Activity
 Comparing ABC approach to conventional approach

• Conventional costing approach assumes that overhead resources are consumed

strictly in proportion to a volume-based measure such as DL hours. This is not
true most of the time.
• In ABC approach, by making the activity that is responsible for the incurrence
of costs, we ensure that there is a causal relationship between cost allocation
basis and the costs incurred.
• In general, conventional costing system is likely to overcost high-volume
products and undercost low volume products with respect to the costs estimated
by the ABC system.

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Activity Based Management

• ABC system lends itself to greater understanding of costs and how they are incurred. This
knowledge can be used to manage activities to eliminate waste and reduce processing time and
defects.
The first step in any improvement
program is deciding what to improve.

Benchmarking can be
Activity rates can be used to compare activity
used to target areas cost information with
where costs seem world-class standards of
excessively high. performance achieved by
other organizations.

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Concluding remarks
• ABC system is expensive to implement. Benefits of ABC may outweigh
when
• Products variety is high.
• Conditions have changed substantially since the existing costs system
was established.
• Overhead costs are increasing, and no one knows why.
• Managers don’t use the cost numbers in their decision-making process.
• One can potentially produce two ABC cost numbers:
• One for external reporting purpose
• Needs to assign/allocate all manufacturing costs to products
• Another one for internal decision-making purpose
• May want to exclude facility-level costs from product costs
• May want to include SGA costs

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