5-1

Acitivity Based Costing – and Management

Chapter 7
 5-2

Activity–Based Costing (ABC)

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

LO 1
 5-3

How Costs are Treated Under

Activity–Based Costing

ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in four
four ways.
ways.

Manufacturing Non-manufacturing
costs costs

Traditional ABC
product costing product costing

 ABC assigns both types of costs to products.

LO 1
 5-4

How Costs are Treated Under

Activity–Based Costing

ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in four
four ways.
ways.

Manufacturing Non-manufacturing
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.

LO 1
 5-5

How Costs are Treated Under

Activity–Based Costing

ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in four
four 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. LO 1
 5-6

How Costs are Treated Under

Activity–Based Costing

ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in four
four 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 asas direct
direct labour
labour
hours
hours and/or
and/or machine
machine hours
hours toto allocate
allocate
all
all overhead
overhead costs
costs to
to products.
products.

 ABC uses more cost pools. LO 1

 5-7

How Costs are Treated Under

Activity–Based Costing

ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in four
four ways.
ways.

Traditional Costing ABC

The predetermined Products are charged
overhead rate is based for the costs of
on budgeted activity. capacity they use – not
This results in applying for the costs of
all overhead costs capacity they don’t
including unused, or use. Unused capacity
idle capacity costs to costs are treated as
products. period expenses.

 ABC bases level of activity on capacity.

LO 1
 5-8

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 particular
Cost Pool activity measure are
accumulated.

$$
$
$ $
$
 5-9

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.

LO 1
 5-10

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.
LO 1
 5-11

How Costs are Treated Under

Activity–Based Costing

ABC defines
four 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 as
as direct
direct labour
labour hours
hours and/or
and/or machine
machine
hours
hours to
to allocate
allocate all
all overhead
overhead costs
costs to
to products.
products.
LO 1
 5-12

How Costs are Treated Under

Activity–Based Costing

Unit-Level Batch-Level
Activity Activity

Manufacturing
companies typically combine
their activities into five
classifications.

Product Sustaining Facility Sustaining

Level Activity Level Activity
LO 1
 5-13

Characteristics of Successful ABC

Implementations

Strong top
management support
Link to evaluations
and rewards

Cross-functional
involvement
LO 1
 5-14

Designing an ABC System

Cost Objects
(e.g., products Activities
and customers)

Consumption
of Resources

Cost
LO 1
 5-15

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.

LO 1
 5-16

Classic Brass – An ABC Example

Classic Brass
Income Statement
Year Ended December 31, 2010

Sales
Cost of goods sold $ 3,200,000
Direct materials $ 975,000
Direct labor 351,250
Manufacturing overhead 1,000,000 2,326,250
Gross margin 873,750
Selling and administrative expenses
Shipping expenses 65,000
Marketing expenses 300,000
General administrative expenses 510,000 875,000
Net operating income
loss $ (1,250)

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.
LO 1
 5-17

 Define Activities, Activity Cost Pools, and

Activity Measures

At
At Classic
Classic Brass,
Brass, the
the ABC
ABC team,
team, selected
selected the
the following
following
activity
activity cost
cost pools
pools and
and activity
activity measures:
measures:

LO 1
 5-18

 Define Activities, Activity Cost Pools, and

Activity Measures
 Customer
Customer Orders
Orders -- assigned
assigned allall costs
costs ofof resources
resources
that
that are
are consumed
consumed by by taking
taking and
and processing
processing
customer
customer orders.
orders.
 Product
Product Designs
Designs -- assigned
assigned allall costs
costs ofof resources
resources
consumed
consumed by by designing
designing products.
products.
 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 of of
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 overhead
overhead costs
costs that
that are
are not
not
associated
associated with
with the
the other
other cost
cost pools.
pools.
LO 1
 5-19

 Assign Overhead Costs to Activity Cost Pools

LO 2
 5-20

 Assign Overhead Costs to Activity Cost Pools

Direct materials, direct labour, and shipping are excluded

because Classic Brass’ existing cost system can directly
trace these costs to products or customer orders.
LO 2
 5-21

 Assign Overhead Costs to Activity Cost Pools

At Classic Brass the following distribution matrix

across activity cost pools (based on resource drivers):

LO 2
 5-22

 Assign Overhead Costs to Activity Cost Pools

Activity Cost Pools

Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

Indirect
Indirect factory
factory wages
wages $500,000
$500,000
Percent
Percent consumed
consumed byby customer
customer orders
orders 25%
25%
$125,000
$125,000
LO 2
 5-23

 Assign Overhead Costs to Activity Cost Pools

Activity Cost Pools

Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000
Factory equipment depreciation 60,000
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

Factory
Factory equipment
equipment depreciation
depreciation $300,000
$300,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 20%
20%
$$ 60,000
60,000
LO 2
 5-24

 Assign Overhead Costs to Activity Cost Pools

Activity Cost Pools

Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000 $ 200,000 $ 100,000 $ 50,000 $ 25,000 $ 500,000
Factory equipment depreciation 60,000 - 180,000 - 60,000 300,000
Factory utilities - 12,000 60,000 - 48,000 120,000
Factory building lease - - - - 80,000 80,000
General Administrative Department
Administrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000
Office equipment depreciation 15,000 - - 12,500 22,500 50,000
Administrative building lease - - - - 60,000 60,000
Marketing Department
Marketing wages and salaries 55,000 20,000 - 150,000 25,000 250,000
Selling expenses 5,000 - - 35,000 10,000 50,000
Total $ 320,000 $ 252,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000

LO 2
 5-25

 Calculate Activity Rates

The ABC team determines that Classic Brass will

have these total activities for each activity cost
pool . . .
 1,000 customer orders,
 400 new designs,
 20,000 machine-hours,
 250 customer relations activities.

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.
LO 2
 5-26

 Calculate Activity Rates

Computation of Activity Rates

(a) (b) (a) ÷ (b)
Activity Cost Pools Total Cost Total Activity Activity Rate
Customer orders $ 320,000 1,000 orders $320 per order
Product design 252,000 400 designs $630 per design
Order size 380,000 20,000 MHs $19 per MH
Customer relations 367,500 250 customer $1,470 per customer
Other 490,500 Not applicable Not applicable

LO 2
 5-27

Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labour Costs

Traced
Traced Traced
Traced Traced
Traced

Cost Objects:
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
LO 2
 5-28

Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labour Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

Cost Objects:
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
LO 2
 5-29

Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labour Costs

First-Stage Allocation

Customer Product Order Customer

Other
Orders Design Size Relations

Second-Stage Allocations

$/Order
$/Order $/Design
$/Design $/MH
$/MH $/Customer
$/Customer

Cost Objects:
Unallocated
Unallocated
Products,
Products, Customer
Customer Orders,
Orders, Customers
Customers
LO 2
 5-30

 Assigning Overhead to Products

Classic Brass Information

Standard
Standard Stanchions
Stanchions
1.
1. Requires
Requires no no new
new design
design resources.
resources.
2.
2. 30,000
30,000 units
units ordered
ordered with
with 600
600 separate
separate orders.
orders.
3.
3. Each
Each stanchion
stanchion requires
requires 35
35 minutes
minutes of
of machine
machine
time
time for
for aa total
total of
of 17,500
17,500 machine-hours.
machine-hours.

Custom
Custom Compass
Compass Housing
Housing
1.
1. Requires
Requires new
new design
design resources.
resources.
2.
2. 400
400 separate
separate orders.
orders.
3.
3. 400
400 custom
custom designs
designs prepared.
prepared.
4.
4. 1,250
1,250 compass
compass housings
housings produced,
produced, requiring
requiring 22
machine-hours
machine-hours each
each for
for aa total
total of
of 2,500
2,500 machine-hours.
machine-hours.
LO 3
 5-31

 Assigning Overhead to Products

Overhead Cost for the Standard Stanchions

(a) (b) (a) × (b) The customer-level
Activity Cost Pools
Customer orders
Activity Rate
$ 320
Activity
600
ABC Cost
$ 192,000
cost is assigned to
Product design 630 0 - customers directly;
Order size 19 17500 332,500
Total $ 524,500 it is not assigned to
products.
Overhead Cost for the Custom Housing
(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 320 400 $ 128,000
Product design 630 400 252,000
Order size 19 2500 47,500
Total $ 427,500

LO 3
 5-32

 Prepare Management Reports

Product Margin Calculations

The first step in computing product margins is to
gather each product’s sales and direct cost data.

Custom
Standard Compass
Stanchions Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Direct costs
Direct material 905,500 69,500 975,000
Direct labour 263,750 87,500 351,250
Shipping 60,000 5,000 65,000

LO 4
 5-33

 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.
Custom
Standard Compass
Stanchions Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Direct costs
Direct material 905,500 69,500 975,000
Direct labour 263,750 87,500 351,250
Shipping 60,000 5,000 65,000
ABC cost assignments
Customer orders 192,000 128,000 320,000
Product design 252,000 252,000
Order size 332,500 47,500 380,000
LO 4
 5-34

 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.
Custom
Standard Stanchions Compass Housings
Sales $ 2,660,000 $ 540,000
Costs
Direct material $ 905,500 $ 69,500
Direct labour 263,750 87,500
Shipping 60,000 5,000
Customer orders 192,000 128,000
Product design 252,000
Order size 332,500 47,500
Total cost 1,753,750 589,500
Product margin $ 906,250 (49,500)
LO 4
 5-35

 Prepare Management Reports

Product Margin Calculations

The product margins can be reconciled with
the company’s net operating income as follows:
Custom
Standard Compass
Stanchions Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Total costs 1,753,750 589,500 2,343,250
Product margins $ 906,250 $ (49,500) $ 856,750

Less costs not assigned to products:

Customer relations 367,500
Other 490,500
Total 858,000
Nett operating income
loss $ (1,250)

LO 4
 5-36

Practice

Step 2 – Assign Costs to Activity Cost Pools – Ex. 7-13

Step 3 – Calculate Activity Rates – Ex. 7-10
Step 4 – Assign Costs to Cost Objects – Ex. 7-11 (part 4 compares old way)
 5-37

Assigning Overhead to Customers

Let’s take a look at how Classic Brass system works for

just one of the 250 customers – Windward Yachts
who placed a total of three orders.

Orders
Orders
1.
1. Two
Two orders
orders for
for 150
150 standard
standard stanchions
stanchions per
per order.
order.
2.
2. One
One order
order for
for aa custom
custom compass
compass housing.
housing.

Machine-hours
Machine-hours
1.
1. The
The 300
300 standard
standard stanchions
stanchions required
required 175
175 machine-hours.
machine-hours.
2.
2. The
The custom
custom compass
compass housing
housing required
required 22 machine
machine hours.
hours.

LO 3
 5-38

Assigning Overhead to Customers

Overhead Cost for Winward Yachts

(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 320 3 $ 960
Product design 630 1 630
Order size 19 177 3,363
Customer relations 1,470 1 1,470
Total $ 6,423

LO 3
 5-39

 Prepare Management Reports

Customer Profitability Analysis

The first step in computing Windward Yachts’ customer
margin is to gather its sales and direct cost data.

Windward
Yachts
Sales $ 11,350
Direct costs
Direct material 2,123
Direct labour 1,900
Shipping 205

LO 4
 5-40

 Prepare Management Reports

Customer Profitability Analysis

The second step is to incorporate Windward Yachts’
previously computed activity-based cost assignments.
Windward
Yachts
Sales $ 11,350
Direct costs
Direct material 2,123
Direct labour 1,900
Shipping 205
ABC cost assignments
Customer orders 960
Product design 630
Order size 3,363
Customer relations 1,470
LO 4
 5-41

 Prepare Management Reports

Customer Profitability Analysis

The third step is to compute Windward Yachts’ customer margin
($699) by deducting all its direct and indirect costs from its sales.

Windward Yachts
Sales $ 11,350
Direct costs
Direct material $ 2,123
Direct labour 1,900
Shipping 205
Customer orders 960
Product design 630
Order size 3,363
Customer relations 1,470 10,651
Customer margin $ 699
LO 4
 5-42

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.

Custom
Standard Compass
Stanchions Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Direct costs
Direct material 905,500 69,500 975,000
Direct labour 263,750 87,500 351,250

LO 5
 5-43

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 Classic Brass
Production Department
Indirect factory wages $ 500,000
Factory equipment depreciation 300,000
Factory utilities 120,000
Factory building lease 80,000
Total manufacturing overhead $ 1,000,000

Plantwide manufacturing $1,000,000

= = $50 per machine-hour
overhead rate 20,000 MH

Machine-hours
Standard Stanchions 17,500
Custom compass Housings 2,500
Total machine-hours 20,000
LO 5
 5-44

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
Standard Stanchions 17,500 $ 50.00 $ 875,000
Custom Compass Housings 2,500 50.00 125,000
Total overhead allocated to products $ 1,000,000

17,500
17,500 hours
hours ×× $50
$50 per
per hour
hour == $875,000
$875,000

LO 5
 5-45

Product Margins Computed Using

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

Custom
Standard Stanchions Compass Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Cost of goods sold
Direct materials $ 905,500 $ 69,500 $ 975,000
Direct labor 263,750 87,500 351,250
Manufacturing overhead 875,000 2,044,250 125,000 282,000 1,000,000 2,326,250
Product margin $ 615,750 258,000 873,750
Selling and administrative 875,000
Nett operating
operating income
loss $ (1,250)

Shipping expenses $ 65,000

Marketing expenses 300,000
General administrative expenses 510,000
$ 875,000
LO 5
 5-46

The Differences Between ABC

and Traditional Product Costs

Standard Custom
Stanchions Compass Housings
Product margins – traditional $ 615,750 $ 258,000
Product margins – ABC 906,250 (49,500)
Change in reported margins $ 290,500 $ (307,500)

The traditional cost The traditional cost

system overcosts the system undercosts the
standard stanchions custom compass
and reports a lower housings and reports
product margin a higher product
for this product. margin for this product.
LO 5
 5-47

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.

LO 5
 5-48

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

LO 5
 5-49

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 disregards selling and

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

LO 5
 5-50

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.

LO 5
 5-51

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.
LO 5