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
Copyright2012byTheMcGrawHillCompanies,Inc.Allrightsreserved.

7-2

ActivityBased Costing (ABC)

ABC is designed to
provide managers with
cost information for
strategic and other
decisions that potentially
affect capacity, and
therefore, affect fixed
as well as variable costs.

ABC is a
good supplement
to our traditional
cost system

I agree!

7-3

Learning Objective 1
Understand activitybased costing and how it
differs from a traditional
costing system.

7-4

How Costs are Treated Under

ActivityBased Costing
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.
Manufacturing
costs

Nonmanufacturing
costs

Traditional
product costing

ABC
product costing

ABC assigns both types of costs to products.

7-5

How Costs are Treated Under

ActivityBased Costing
ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.

Traditional
product costing

Nonmanufacturing
costs
Mo
st,
not but
all

Some

All

Manufacturing
costs

ABC
product costing

ABC does not assign all manufacturing costs to products.

7-6

How Costs are Treated Under

ActivityBased Costing
Level of complexity

ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.
ActivityBased
ActivityBased
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

ActivityBased 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
systems usually
cost systems
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

ActivityBased Costing
Activity

An event that causes the

consumption of overhead
resources.

Activity
Cost Pool

A cost bucket in which

costs related to a single
activity measure are
accumulated.

$$
$
$ $
$

7-9

How Costs are Treated Under

ActivityBased Costing
Activity
Measure
An allocation base
in an activity-based
costing system.

The term cost driver is

also used to refer to
an activity measure.

7-10

How Costs are Treated Under

ActivityBased Costing
Two common types of activity measures:
Transaction
driver

Duration
driver

Simple count
of the number of
times an activity
occurs.

A measure
of the amount
of time needed
for an activity.

7-11

How Costs are Treated Under

ActivityBased 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 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.

7-12

How Costs are Treated Under

ActivityBased Costing
Unit-Level
Activity

Batch-Level
Activity

Manufacturing
companies typically combine
their activities into five
classifications.
Product-Level
Activity

Organizationsustaining
Activity

Customer-Level
Activity

7-13

Characteristics of Successful ABC

Implementations

Strong
Strong top
top
management support

Link
Link to
to evaluations
and rewards

Cross-functional
involvement

7-14

Baxter Battery An ABC Example

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:

7-16

Define Activities, Activity Cost

Pools, and Activity Measures
Customer
Customer Orders
Orders -- assigned
assigned all
all 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 all
all 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 of
of units
units
produced.
produced.
Customer
Customer Relations
Relations assigned
assigned all
all 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

7-19

Assign Overhead Costs to

Activity Cost Pools

Direct materials, direct labor, and shipping are excluded

because Baxter Batterys existing cost system can directly
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.

7-21

Assign Overhead Costs to

Activity Cost Pools

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

7-22

Assign Overhead Costs to

Activity Cost Pools

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

7-23

Assign Overhead Costs to

Activity Cost Pools

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

7-27

ActivityBased Costing at Baxter

Battery
Direct
Materials

Direct
Labor

Shipping
Costs

Traced

Traced

Traced

Overhead Costs

Cost Objects:
Products, Customer Orders, Customers

7-28

ActivityBased Costing at Baxter

Battery
Direct
Materials

Direct
Labor

Shipping
Costs

Overhead Costs

First-Stage Allocation

Customer
Orders

Design
Changes

Order
Size

Customer
Relations

Cost Objects:
Products, Customer Orders, Customers

Other

7-29

ActivityBased Costing at Baxter

Battery
Direct
Materials

Direct
Labor

Shipping
Costs

Overhead Costs

First-Stage Allocation

Customer
Orders

Design
Changes

Order
Size

Customer
Relations

Other

Second-Stage Allocations
$/Order

$/Change

$/MH

$/Customer

Cost Objects:
Products, Customer Orders, Customers

Unallocated

7-30

Learning Objective 4
Assign costs to a cost
object using a secondstage 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 of
of 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

7-33

Assigning Overhead to Customers

Lets take a look at how Baxter Batterys 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

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 products sales and direct cost data.

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.

7-38

Prepare Management Reports

Product Margin Calculations
The third step in computing product margins is to
deduct each products direct and indirect costs
from sales.

7-39

Prepare Management Reports

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

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.

7-41

Prepare Management Reports

Customer Margin Analysis
The second step is to incorporate Acme Auto Parts
previously computed activity-based cost assignments.

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.

7-43

Product Margins Computed Using the

Traditional Cost System
The first step in computing product margins is to
gather each products sales and direct cost data.

7-44

Product Margins Computed Using the

Traditional Cost System

The second step in computing product margins is

to compute the plantwide overhead rate.

Plantwide manufacturing
overhead rate

$14,000,000
800,000 MH

= $17.50 per machine-hour

7-45

Product Margins Computed Using the

Traditional Cost System
The third step in computing product margins is
allocate manufacturing overhead to each product.

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.

7-47

Differences Between ABC and

Traditional Product Costs

The traditional cost

system overcosts the
SureStarts and reports
a lower product
margin for this product.

The traditional cost

system undercosts the
LongLifes and reports
a higher 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.
While the theory of constraints
approach discussed in Chapter 1
is a powerful tool for targeting
improvement efforts, activity rates
can also provide valuable clues on
where to focus improvement efforts.
Benchmarking
Benchmarking can
can be
be used
used to
to compare
compare activity
activity cost
cost
information
information with
with world-class
world-class standards
standards of
of performance
performance
achieved
achieved by
by 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 companys
companys
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 of
of the
the subjective
subjective allocation
allocation
process
process based
based on
on interviews
interviews with
with employees.
employees.

7-53

ABC Limitations
Substantial resources
required to implement
and maintain.

Resistance to
unfamiliar numbers
and reports.

Desire to fully
allocate all costs
to products.

Potential
misinterpretation of
unfamiliar numbers.

Does not conform to

GAAP. Two costing
systems may be needed.