Activity-Based Costing: A Tool to

Aid Decision Making

Chapter Seven
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Activity Based Costing (ABC)

ABC is designed to provide ABC is a

good supplement
managers with cost
to our traditional
information for strategic cost system
and other decisions that I agree!
potentially affect capacity
and therefore affect fixed
as well as variable costs.
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How Costs are Treated Under
Activity–Based Costing

ABC differs from traditional cost accounting in three ways.

Manufacturing Nonmanufacturing
costs costs

Traditional ABC
product costing product costing

 ABC assigns both types of costs to products.

 8-4
How Costs are Treated Under
Activity–Based Costing

ABC differs from traditional cost accounting in three ways.

Manufacturing Non manufacturing

costs costs

Some
Mo
st,
All

not but
all

Traditional ABC
product costing product costing

 ABC does not assign all manufacturing costs to products.

8-5
How Costs are Treated Under
Activity–Based Costing

ABC differs from traditional cost accounting in three ways.

Level of complexity

Activity–Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate

Number of cost pools

 ABC uses more cost pools.
8-6
How Costs are Treated Under
Activity–Based Costing

ABC differs from traditional cost accounting in three ways.

Each ABC cost pool has its

own unique measure of activity.

Traditional cost systems usually rely

on volume measures such as direct labor
hours and/or machine hours to allocate
all overhead costs to products.

 ABC uses more cost pools.

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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.

$$
$
$ $
$
8-8
How Costs are Treated Under
Activity–Based Costing

The term cost driver is

Activity
also used to refer to an
Measure
activity measure.

An allocation base
in an activity-based
costing system.
8-9
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.
8-10
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 cost systems usually rely on volume

measures such as direct labor hours and/or machine
hours to allocate all overhead costs to products.
8-11
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
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5 level of activities

• Unit-level activities: Performed each time a unit

is produced. The costs of unit level activities
should be proportional to the number of units
produced.
• Batch-level activities: Performed each time a
batch is handled or processed, regardless of how
many units are in the batch.
• Product-level activities: Relate to specific
products and typically must be carried out
regardless of how many batches are run or units of
product are produced or sold.
 8-13

5 level of activities

• Customer-level activities: Relate to specific

customers and include activities such as sales
calls, catalog mailings, and general technical
support that are not tied to any specific product.
• Organization-sustaining activities: This
category includes activities such as heating the
factory, cleaning executive offices, providing a
computer network, arranging for loans, preparing
annual reports to shareholders, and so on.
8-14

Classic Brass – An ABC Example

Classic Brass
Income Statement
Year Ended December 31, 2005

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 overhead is allocated to products using

a single plantwide overhead rate based on machine hours.
8-15
Define Activities, Activity Cost Pools,
and Activity Measures

At Classic Brass, the ABC team, selected the

following activity cost pools and activity
measures:
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Define Activities, Activity Cost Pools,
and Activity Measures

• Customer Orders - assigned all costs of resources

that are consumed by taking and processing
customer orders.
• Product Designs - assigned all costs of resources
consumed by designing products.
• Order Size - assigned all costs of resources
consumed as a consequence of the number of
units produced.
• Customer Relations – assigned all costs associated
with maintaining relations with customers.
• Other – assigned all overhead costs that are not
associated with the other cost pools.
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Assign Overhead Costs
to Activity Cost Pools
8-18
Assign Overhead Costs
to Activity Cost Pools

Direct materials, direct labor, and shipping are excluded

because Classic Brass’ existing cost system can directly
trace these costs to products or customer orders.
8-19
Assign Overhead Costs
to Activity Cost Pools

At Classic Brass the following distribution of resource

consumption across activity cost pools is determined.
8-20
Assign Overhead Costs
to Activity Cost Pools

Indirect factory wages $500,000

Percent consumed by customer orders 25%
$125,000
8-21
Assign Overhead Costs
to Activity Cost Pools

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
8-22
Assign Overhead Costs
to Activity Cost Pools
8-23

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 the team can compute the individual activity

rates by dividing the total cost for each activity by
the total activity levels.
8-24

Calculate Activity Rates

8-25

Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

Traced Traced Traced

Cost Objects:
Products, Customer Orders, Customers
8-26

Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

Cost Objects:
Products, Customer Orders, Customers
8-27

Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Product Order Customer

Other
Orders Design Size Relations

Second-Stage Allocations

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

Cost Objects:
Unallocated
Products, Customer Orders, Customers
8-28

Assigning Overhead to Products

Classic Brass Information

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

Custom Compass Housing

1. Requires new design resources.
2. 400 separate orders.
3. 400 custom designs prepared.
4. 1,250 compass housings produced, requiring 2
machine-hours each for a total of 2,500 machine-hours.
8-29

Assigning Overhead to Products

8-30

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

Machine-hours
1. The 300 standard stanchions required 175 machine-hours.
2. The custom compass housing required 2 machine hours.
8-31

Assigning Overhead to Customers

8-32

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 labor 263,750 87,500 351,250
Shipping 60,000 5,000 65,000
8-33

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 labor 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
8-34

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 labor 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)
 8-35

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)
 8-36

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 labor 1,900
Shipping 205
 8-37

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 labor 1,900
Shipping 205
ABC cost assignments
Customer orders 960
Product design 630
Order size 3,363
Customer relations 1,470
 8-38

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 labor 1,900
Shipping 205
Customer orders 960
Product design 630
Order size 3,363
Customer relations 1,470 10,651
Customer margin $ 699
8-39

Activity-Based Costing and External Reporting

Most companies do not use ABC

for external reporting because . . .

1. External reports are less detailed than internal

reports.
2. It may be difficult to make changes to the
company’s accounting system.
3. ABC does not conform to GAAP.
4. Auditors may be suspect of the subjective
allocation process based on interviews with
employees.
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End of Chapter 8