Activity-Based Costing:

A Tool to Aid Decision Making

Chapter 7

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 7-2

Activity–Based Costing (ABC)

ABC is designed to
provide managers with ABC is a
cost information for good supplement
to our traditional
strategic and other cost system
decisions that I agree!
potentially affect
capacity, and therefore,
affect “fixed”
as well as variable
costs.
 7-3

Learning Objective 1

Understand activity-
based costing and how it
differs from a traditional
costing system.
 7-4

How Costs are Treated Under

Activity–Based Costing
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.

Manufacturing Nonmanufacturing
costs costs

Traditional ABC
product costing product costing

 ABC assigns both types of costs to products.

 7-5

How Costs are Treated Under

Activity–Based Costing
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.

Manufacturing Nonmanufacturing
costs costs
Mo

Some
st, b
All

not ut
all
Traditional ABC
product costing product costing

 ABC does not assign all manufacturing costs to products.

 7-6

How Costs are Treated Under

Activity–Based Costing
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.
Level of complexity

Activity–Based
Activity–Based
Costing
Costing

Departmental
Departmental
Overhead
Overhead
Rates
Rates
Plantwide
Plantwide
Overhead
Overhead
Rate
Rate

Number of cost pools

 ABC uses more cost pools.
 7-7

How Costs are Treated Under

Activity–Based Costing
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.

Each
Each ABC
ABC cost
cost pool
pool has
has its
its
own
own unique
unique measure
measure of
of activity.
activity.

Traditional
Traditional cost
cost systems
systems usually
usually rely
rely
on
on volume
volume measures
measures such
such as
as direct
direct labor
labor
hours
hours and/or
and/or machine
machine hours
hours to
to allocate
allocate
all
all overhead
overhead costs
costs to
to products.
products.

 ABC uses more cost pools.

 7-8

How Costs are Treated Under

Activity–Based Costing
An event that causes the
Activity consumption of overhead
resources.

A “cost bucket” in which

Activity costs related to a single
Cost Pool activity measure are
accumulated.
$$
$
$ $
$
 7-9

How Costs are Treated Under

Activity–Based Costing
The term cost driver is
Activity
also used to refer to
Measure
an activity measure.

An allocation base
in an activity-based
costing system.
 7-10

How Costs are Treated Under

Activity–Based Costing
Two common types of activity
measures:

Transaction Duration
driver driver

Simple count A measure

of the number of of the amount
times an activity of time needed
occurs. for an activity.
 7-11

How Costs are Treated Under

Activity–Based Costing

ABC defines
five levels of activity
that largely do not relate
to the volume of units
produced.

Traditional
Traditional cost
cost systems
systems usually
usually rely
rely on
on volume
volume
measures
measures such
such asas direct
direct labor
labor hours
hours and/or
and/or machine
machine
hours
hours to
to allocate
allocate all
all overhead
overhead costs
costs to
to products.
products.
 7-12

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 Customer-Level
Activity Organization- Activity
sustaining
Activity
 7-13

Characteristics of Successful ABC

Implementations

Strong top
management support Link to evaluations
and rewards

Cross-functional
involvement
 7-14

Baxter Battery – An ABC Example

Baxter Battery Company
Income Statement
Year Ended December 31, 2014

Sales $ 50,000,000
Cost of goods sold
Direct materials $ 15,000,000
Direct labor 12,000,000
Manufacturing overhead 14,000,000 41,000,000
Gross margin 9,000,000
Selling and administrative expenses
Shipping expenses 3,000,000
Marketing expenses 2,000,000
General administrative expenses 6,000,000 11,000,000
Net operating income
loss $ (2,000,000)

Manufacturing
Manufacturing overhead
overhead is
is allocated
allocated to
to products
products using
using
aa single
single plantwide
plantwide overhead
overhead rate
rate based
based on
on machine
machine hours.
hours.
 7-15

 Define Activities, Activity Cost

Pools, and Activity Measures
At Baxter Battery, the ABC team selected the following
activity cost pools and activity measures:
Activity Cost Pools at Baxter Battery
Activity Cost Pool Activity Measure
Customer orders Number of customer orders
Design changes Number of design changes
Order size Machine-hours
Customer relations Number of active customers
Other Not applicable
 7-16

 Define Activities, Activity Cost

Pools, and Activity Measures
•• Customer
Customer Orders
Orders -- assigned
assigned allall costs
costs of
of resources
resources
that
that are
are consumed
consumed by by taking
taking and
and processing
processing
customer
customer orders.
orders.
•• Design
Design Changes
Changes -- assigned
assigned allall costs
costs of
of resources
resources
consumed
consumed by by customer
customer requested
requested design
design changes.
changes.
•• Order
Order Size
Size -- assigned
assigned all
all costs
costs of
of resources
resources
consumed
consumed as as aa consequence
consequence of of the
the number
number ofof units
units
produced.
produced.
•• Customer
Customer Relations
Relations –– assigned
assigned allall costs
costs associated
associated
with
with maintaining
maintaining relations
relations with
with customers.
customers.
•• Other
Other –– assigned
assigned all
all organization-sustaining
organization-sustaining costs
costs
and
and unused
unused capacity
capacity costs
costs
 7-17

Learning Objective 2

Assign costs to cost

pools using a first-stage
allocation.
 7-18

 Assign Overhead Costs to

Activity Cost Pools
Overhead Costs at Baxter Battery
(Manufacturing and Nonmanufacturing)

Production Department
Indirect factory wages $ 6,000,000
Factory equipment depreciation 3,500,000
Factory utilities 2,500,000
Factory building lease 2,000,000 $ 14,000,000
General Administrative Department
Administrative wages and salaries 4,000,000
Office equipment depreciation 900,000
Administrative building lease 1,100,000 6,000,000
Marketing Department
Marketing wages and salaries 1,500,000
Selling expenses 500,000 2,000,000
Total overhead costs $ 22,000,000
 7-19

 Assign Overhead Costs to

Activity Cost Pools
Overhead Costs at Baxter Battery
(Manufacturing and Nonmanufacturing)

Production Department
Indirect factory wages $ 6,000,000
Factory equipment depreciation 3,500,000
Factory utilities 2,500,000
Factory building lease 2,000,000 $ 14,000,000
General Administrative Department
Administrative wages and salaries 4,000,000
Office equipment depreciation 900,000
Administrative building lease 1,100,000 6,000,000
Marketing Department
Direct materials,
Marketing wagesdirect labor, and shipping
and salaries 1,500,000 are excluded
because Baxter
Selling expensesBattery’s existing cost500,000
system can directly
2,000,000
Total overhead costs $ 22,000,000
trace these costs to products or customer orders.
 7-20

 Assign Overhead Costs to

Activity Cost Pools
At Baxter Battery the following distribution of resource
consumption across activity cost pools is determined.
Activity Cost Pools

Customer Design Order Customer

Orders Changes Size Relations Other Total
Production Department
Indirect factory wages 30% 30% 20% 10% 10% 100%
Factory equipment depreciation 20% 10% 60% 0% 10% 100%
Factory utilities 0% 10% 60% 0% 30% 100%
Factory building lease 0% 0% 0% 0% 100% 100%
General Administrative Department
Administrative wages and salaries 30% 10% 10% 30% 20% 100%
Office equipment depreciation 30% 10% 0% 20% 40% 100%
Administrative building lease 0% 0% 0% 0% 100% 100%
Marketing Department
Marketing wages and salaries 30% 10% 0% 50% 10% 100%
Selling expenses 20% 0% 0% 70% 10% 100%
 7-21

 Assign Overhead Costs to

Activity Cost Pools Overhead Costs at Baxter Battery
(Manufacturing and Nonmanufacturing)

Production Department
Indirect factory wages $ 6,000,000
Activity Factory equipment depreciation
Cost Pools 3,500,000
Customer Factory
Design utilities Customer 2,500,000
Orders Factory building
changes lease Relations
Order Size 2,000,000
Other $ 14,000,000
Total
Production Department General Administrative Department
Indirect factory wages $ 1,800,000 Administrative wages and salaries 4,000,000
Factory equipment depreciation Office equipment depreciation 900,000
Factory utilities Administrative building lease 1,100,000 6,000,000
Factory building lease Marketing Department
General Administrative Department Marketing wages and salaries 1,500,000
Administrative wages and salaries Selling expenses 500,000 2,000,000
Office equipment depreciation Total overhead costs $ 22,000,000
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

Indirect
Indirect factory
factory wages
wages $6,000,000
$6,000,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 30%
30%
$1,800,000
$1,800,000
 7-22

 Assign Overhead Costs to

Activity Cost Pools Overhead Costs at Baxter Battery
(Manufacturing and Nonmanufacturing)

Production Department
Indirect factory wages $ 6,000,000
Activity Factory equipment depreciation
Cost Pools 3,500,000
Customer Factory
Design utilities Customer 2,500,000
Orders Factory building
changes lease Relations
Order Size 2,000,000
Other $ 14,000,000
Total
Production Department General Administrative Department
Indirect factory wages $ 1,800,000 Administrative wages and salaries 4,000,000
Factory equipment depreciation 700,000 Office equipment depreciation 900,000
Factory utilities Administrative building lease 1,100,000 6,000,000
Factory building lease Marketing Department
General Administrative Department Marketing wages and salaries 1,500,000
Administrative wages and salaries Selling expenses 500,000 2,000,000
Office equipment depreciation Total overhead costs $ 22,000,000
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

Factory
Factory equipment
equipment depreciation
depreciation $3,500,000
$3,500,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 20%
20%
$$ 700,000
700,000
 7-23

 Assign Overhead Costs to

Activity Cost Pools
Activity Cost Pools
Customer Design Customer
Orders changes Order Size Relations Other Total
Production Department
Indirect factory wages $ 1,800,000 $ 1,800,000 $ 1,200,000 $ 600,000 $ 600,000 $ 6,000,000
Factory equipment depreciation 700,000 350,000 2,100,000 - 350,000 3,500,000
Factory utilities - 250,000 1,500,000 - 750,000 2,500,000
Factory building lease - - - - 2,000,000 2,000,000
General Administrative Department
Administrative wages and salaries 1,200,000 400,000 400,000 1,200,000 800,000 4,000,000
Office equipment depreciation 270,000 90,000 - 180,000 360,000 900,000
Administrative building lease - - - - 1,100,000 1,100,000
Marketing Department
Marketing wages and salaries 450,000 150,000 - 750,000 150,000 1,500,000
Selling expenses 100,000 - - 350,000 50,000 500,000
Total $ 4,520,000 $ 3,040,000 $ 5,200,000 $ 3,080,000 $ 6,160,000 $ 22,000,000
 7-24

Learning Objective 3

Compute activity
rates for cost pools.
 7-25

 Calculate Activity Rates

The ABC team determines that Baxter Battery will
have these total activities for each activity cost
pool:
▫ 10,000 customer orders,
▫ 4,000 design changes,
▫ 800,000 machine-hours,
▫ 2,000 customers served.

Now
Now the
the team
team can
can compute
compute the the individual
individual
activity
activity rates
rates by
by dividing
dividing the
the total
total cost
cost for
for
each
each activity
activity by
by the
the total
total activity
activity levels.
levels.
 7-26

 Calculate Activity Rates

Computation of Activity Rates
(a) (b) (a) ÷ (b)
Activity Cost Pools Total Cost Total Activity Activity Rate
Customer orders $ 4,520,000 10,000 orders $452 per order
Design changes 3,040,000 4,000 changes $760 per change
Order size 5,200,000 800,000 MHs $6.50 per MH
Customer relations 3,080,000 2,000 customers $1,540 per customer
Other 6,160,000 Not applicable Not applicable
Total $ 22,000,000
 7-27

Activity–Based Costing at Baxter Battery

Direct Direct Shipping
Overhead Costs
Materials Labor Costs

Traced Traced Traced

Cost Objects:
Products, Customer Orders, Customers
 7-28

Activity–Based Costing at Baxter Battery

Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Design Order Customer

Other
Orders Changes Size Relations

Cost Objects:
Products, Customer Orders, Customers
 7-29

Activity–Based Costing at Baxter Battery

Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Design Order Customer

Other
Orders Changes Size Relations

Second-Stage Allocations

$/Order $/Change $/MH $/Customer

Cost Objects:
Unallocated
Unallocated
Products, Customer Orders, Customers
 7-30

Learning Objective 4

Assign costs to a cost

object using a second-
stage allocation.
 7-31

 Assigning Overhead to Products

Baxter Battery Information
SureStart
SureStart
1.
1. Requires
Requires no no new
new design
design resources.
resources.
2.
2. 800,000
800,000 batteries
batteries ordered
ordered with
with 4,000
4,000 separate
separate orders.
orders.
3.
3. Each
Each SureStart
SureStart requires
requires 36
36 minutes
minutes ofof machine
machine
time
time for
for aa total
total of
of 480,000
480,000 machine-hours.
machine-hours.

LongLife
LongLife
1.
1. Requires
Requires new new design
design resources.
resources.
2.
2. 400,000
400,000 batteries
batteries ordered
ordered with
with 6,000
6,000 separate
separate orders.
orders.
3.
3. 4,000
4,000 custom
custom designs
designs prepared.
prepared.
4.
4. Each
Each LongLife
LongLife requires
requires 48
48 minutes
minutes of
of machine
machine
time
time for
for aa total
total of
of 320,000
320,000 machine-hours.
machine-hours.
 7-32

 Assigning Overhead to Products

Overhead Cost for the SureStart
(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 452.00 4,000 $ 1,808,000
Design changes 760.00 - -
Order size 6.50 480,000 3,120,000
Total $ 4,928,000

Overhead Cost for the LongLife

(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 452.00 6,000 $ 2,712,000
Design changes 760.00 4,000 3,040,000
Order size 6.50 320,000 2,080,000
Total $ 7,832,000
 7-33

Assigning Overhead to Customers

Let’s take a look at how Baxter Battery’s system works for
just one of the 2,000 customers – Acme Auto Parts who
placed a total of twelve orders. Note that the four orders
for LongLifes required a design change.

Orders
Orders
1.
1. Eight
Eight orders
orders for
for 60
60 SureStarts
SureStarts per
per order.
order.
2.
2. Four
Four orders
orders for
for 50
50 LongLifes
LongLifes per
per order.
order.

Machine-hours
Machine-hours
1.
1. The
The 480
480 SureStarts
SureStarts required
required 288
288 machine-hours.
machine-hours.
2.
2. The
The 200
200 LongLifes
LongLifes required
required 160
160 machine
machine hours.
hours.
 7-34

Assigning Overhead to Customers

Overhead Cost for Acme Auto Parts
(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 452.00 12 $ 5,424
Design changes 760.00 4 3,040
Order size 6.50 448 2,912
Customer relations 1,540.00 1 1,540
Total $ 12,916
 7-35

Learning Objective 5

Use activity-based
costing to compute
product and customer
margins.
 7-36

 Prepare Management Reports

Product Margin Calculations
The first step in computing product margins is to
gather each product’s sales and direct cost data.
SureStarts LongLifes Total
Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Direct costs
Direct material 9,000,000 6,000,000 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000
Shipping 2,000,000 1,000,000 3,000,000
 7-37

 Prepare Management Reports

Product Margin Calculations
The second step in computing product margins is to
incorporate the previously computed activity-based
cost assignments pertaining to each product.
SureStarts LongLifes Total
Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Direct costs
Direct material 9,000,000 6,000,000 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000
Shipping 2,000,000 1,000,000 3,000,000
ABC cost assignments
Customer orders 1,808,000 2,712,000 4,520,000
Design changes 3,040,000 3,040,000
Order size 3,120,000 2,080,000 5,200,000
 7-38

 Prepare Management Reports

Product Margin Calculations
The third step in computing product margins is to
deduct each product’s direct and indirect costs
from sales.
SureStarts LongLifes
Sales $ 31,300,000 $ 18,700,000
Costs
Direct material $ 9,000,000 $ 6,000,000
Direct labor 7,000,000 5,000,000
Shipping 2,000,000 1,000,000
Customer orders 1,808,000 2,712,000
Design changes 3,040,000
Order size 3,120,000 2,080,000
Total cost 22,928,000 19,832,000
Product margin $ 8,372,000 $ (1,132,000)
 7-39

 Prepare Management Reports

Product Margin Calculations
The product margins can be reconciled with the
company’s net operating income as follows:

SureStarts LongLifes Total

Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Total costs 22,928,000 19,832,000 42,760,000
Product margins $ 8,372,000 $ (1,132,000) $ 7,240,000

Less costs not assigned to products:

Customer relations 3,080,000
Other 6,160,000
Total 9,240,000
Nett operating income
loss $ (2,000,000)
 7-40

 Prepare Management Reports

Customer Margin Analysis
The first step in computing Acme Auto Parts’ customer
margin is to gather its sales and direct cost data.

Acme Auto
Parts
Sales $ 29,200
Direct costs
Direct material 7,500
Direct labor 6,700
Shipping 1,700
 7-41

 Prepare Management Reports

Customer Margin Analysis
The second step is to incorporate Acme Auto Parts’
previously computed activity-based cost assignments.
Acme Auto
Parts
Sales $ 29,200
Direct costs
Direct material 7,500
Direct labor 6,700
Shipping 1,700
ABC cost assignments
Customer orders 5,424
Product design 3,040
Order size 2,912
Customer relations 1,540
 7-42

 Prepare Management Reports

Customer Margin Analysis
The third step is to compute Acme Auto Parts’ customer
margin of $384 by deducting all its direct and indirect
costs from its sales.
Acme Auto Parts
Sales $ 29,200
Direct costs
Direct material $ 7,500
Direct labor 6,700
Shipping 1,700
Customer orders 5,424
Product design 3,040
Order size 2,912
Customer relations 1,540 28,816
Customer margin $ 384
 7-43

Product Margins Computed Using the

Traditional Cost System
The first step in computing product margins is to
gather each product’s sales and direct cost data.
SureStarts LongLifes Total
Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Direct costs
Direct material 9,000,000 6,000,000 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000
 7-44

Product Margins Computed Using the

Traditional Cost System
The second step in computing product margins is
to compute the plantwide overhead rate.
Manufacturing Overhead Costs at Baxter Battery
Production Department
Indirect factory wages $ 6,000,000
Factory equipment depreciation 3,500,000
Factory utilities 2,500,000
Factory building lease 2,000,000
Total manufacturing overhead $ 14,000,000

Plantwide manufacturing $14,000,000

= = $17.50 per machine-hour
overhead rate 800,000 MH

Machine-hours
SureStarts (800,000 @ 0.60 hours) 480,000
LongLifes (400,000 @ 0.80 hours) 320,000
Total machine-hours 800,000
 7-45

Product Margins Computed Using the

Traditional Cost System
The third step in computing product margins is
allocate manufacturing overhead to each product.
Machine Overhead Overhead
Hours Rate Allocated
SureStarts 480,000 $ 17.50 $ 8,400,000
LongLifes 320,000 17.50 5,600,000
Total overhead allocated to products $ 14,000,000

480,000 hours × $17.50 per hour = $8,400,000

 7-46

Product Margins Computed Using the

Traditional Cost System
The fourth step is to actually compute the
product margins.

SureStarts LongLifes Total

Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Cost of goods sold
Direct materials $ 9,000,000 $ 6,000,000 $ 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000
Manufacturing overhead 8,400,000 24,400,000 5,600,000 16,600,000 14,000,000 41,000,000
Product margin $ 6,900,000 2,100,000 9,000,000
Selling and administrative 11,000,000
Nett operating
operating income
loss $ (2,000,000)

Shipping expenses $ 3,000,000

Marketing expenses 2,000,000
General administrative expenses 6,000,000
$ 11,000,000
 7-47

Differences Between ABC and

Traditional Product Costs
SureStarts LongLifes
Product margins – traditional $ 6,900,000 $ 2,100,000
Product margins – ABC 8,372,000 (1,132,000)
Change in reported margins $ 1,472,000 $ (3,232,000)

The traditional cost The traditional cost

system overcosts the system undercosts the
SureStarts and reports LongLifes and reports
a lower product a higher product
margin for this product. margin for this product.
 7-48

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.
 7-49

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 costs using a volume-related allocation
base. ABC costing also uses non-volume related
allocation bases.
 7-50

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 disregards selling and

administrative expenses because they are
assumed to be period expenses. ABC costing
directly traces shipping costs to products and
includes nonmanufacturing overhead costs caused
by products in the activity cost pools that are
assigned to products.
 7-51

Targeting Process Improvement

Activity-based management is used
in conjunction with ABC to identify
areas that would benefit from
process improvements by focusing
on activities to eliminate waste,
decrease processing time, and
reduce defects.

ABC activity rates can also provide valuable clues concerning

where there is waste and the opportunity for improvement.

Benchmarking
Benchmarking can
can be
be used
used to
to compare
compare activity
activity cost
cost
information
information with
with standards
standards of
of performance
performance achieved
achieved byby
other
other organizations.
organizations.
 7-52

Activity-Based Costing and External

Reporting

Most companies do not use ABC

for external reporting because . . .
1.
1. External
External reports
reports are
are less
less detailed
detailed than
than internal
internal
reports.
reports.
2.
2. ItIt may
may be
be difficult
difficult to
to make
make changes
changes to to the
the company’s
company’s
accounting
accounting system.
system.
3.
3. ABC
ABC does
does not
not conform
conform to to GAAP.
GAAP.
4.
4. Auditors
Auditors may
may be
be suspect
suspect ofof the
the subjective
subjective allocation
allocation
process
process based
based on
on interviews
interviews with
with employees.
employees.
 7-53

ABC Limitations
Substantial resources Resistance to
required to implement unfamiliar numbers
and maintain. and reports.

Desire to fully Potential

allocate all costs misinterpretation of
to products. unfamiliar numbers.

Does not conform to

GAAP. Two costing
systems may be needed.