Activity-Based Costing

(ABC)
and Cost Management
Systems

A revolutionized system for a

revolutionized Environment

Cost and Cost Terminology

Cost and Cost Terminology
Cost Object
Cost
Accumulation

Cost Object
Cost Object

Cost
Assignment

Tracing
Allocating

Traditional Costing Systems

Direct materials and direct
labor costs are easy to trace
Overhead cannot be traced easily
and must be assigned with estimates

A single or plantwide
rate called POHR used

Direct tracing
Driver tracing
Allocation

Spreads overhead cost

over entire product base
Products with high profit margins
subsidize orders with low profit margins

Indicators of Need for ABC

Direct
Direct labor
labor is
is aa
small
small percentage
percentage
of
of total
total costs
costs
Total
overhead
from
Total
overhead
from
depreciation
depreciation on
on equipment,
equipment,
utilities,
utilities, repairs,
repairs, maintenance
maintenance
has
has increased
increased

Product-line
Product-line profit
profit
margins
margins are
are hard
hard
to
to explain
explain
Each
Each product
product line
line can
can
consume
consume different
different ratios
ratios of
of
overhead
overhead costs
costs

Sales
Sales are
are increasing,
increasing,
but
but profits
profits are
are declining.
declining.

Line
Line managers
managers do
do not
not
believe
believe the
the product
product
costs
costs reports
reports

Marketing
Marketing does
does not
not
use
use costs
costs reports
reports for
for
pricing
pricing decisions
decisions

Some
Some products
products that
that
have
have reported
reported high
high
profit
profit margins
margins are
are not
not
sold
sold by
by competitors
competitors

Activity-Based Costing (ABC)

An

overhead cost allocation system that

allocates overhead to multiple activity cost
pools and assigns the activity cost pools to
products or services by means of cost drivers
that represent the activities used.

Activity
Activity based
based costing
costing allocates
allocates costs
costs based
based on
on the
the
discreet
discreet tasks
tasks (activities)
(activities) that
that drive
drive those
those costs.
costs.

Reasoning for ABC

ASSUMES

COSTS GENERATED BY ACTIVITES PERFORMED BY ORGANISATION

EACH ACTIVITY CARRIED OUT BY ORGANISATION IS THE PROCESS

Activity-Based Costing (ABC)

Calculate unit cost
Identify, define, classify activities
Identify cost driver
Compute cost of activities
Compute overhead rate
Assign overhead costs to products

Step 1: Identify Activity

Any event, action, transaction, or work sequence that causes a
cost to be incurred in producing a product or providing a
service.
TOP
TOPDOWN
DOWNAPPROACH
APPROACH
ABC
ABCteams
teamsof
ofmiddlemiddlemanagement
managementor
orabove
above
develop
developthe
theactivity
activity
dictionary.
dictionary.

RECYCLING
RECYCLING
APPROACH
APPROACH

Reuses
Reuses
documentation
documentationof
of
processes
processesused
usedfor
for
other
otherpurposes.
purposes.

INTERVIEW
INTERVIEWOR
OR
PARTICIPATIVE
PARTICIPATIVE
APPROACH
APPROACH

ABC
ABCteams
teamsinclude
include
or
orinterview
interview
operating
operating
employees.

Step 1- Classify Activities into Activity Cost Pool

The overhead cost allocated to a distinct type

of activity or related activities.
Unit
Level
Fabrication
cost
pool

Activity
must be
done on
each unit
produced.

Batch
Level
Assembly
Cost pool
Setup
cost pool
Activity
performed
on each
batch
produced.

ProductSustaining Level
Engineering
cost
pool

Activities
needed to
support
an entire
product
line

Facility Level
Quality
Control
cost pool

Activity
required in
order
for the
production
process
to occur.

Identification
Identification
of
of Activity
Activity
Cost
Cost Pools
Pools

Step 2 Identify Activity Cost Driver

Cost Drivers a characteristic of an activity or event that
results in the incurrence of costs.
In ABC cost drivers are used to assign activity cost pools to
products or services.
Have
Haveaacause-effect
cause-effect relationship
relationship with
with the
theactivity
activity
and
andthe
theuse
useof
ofresources
resources(costs).
(costs).
Be
Befeasible
feasibleto
to measure
measure
Predict
Predictor
orexplain
explain activities
activitiesuse
useof
ofresources
resources
(cost)
(cost)with
withreasonable
reasonableaccuracy
accuracy
Be
Bebased
basedon
on the
thepractical
practical capacity
capacityof
of the
the
resources
resourcesto
tosupport
supportactivities
activities

Step 2 Identify Activity Cost Driver

Some Examples of Activity Cost Pools and Cost Drivers:

Activity Cost Pools

Cost Driver

Material purchasing

No. of purchase orders

Material handling

No. of parts

Production scheduling

No. of batches

Quality inspections

No. of inspections

Photocopying

No. of pages

Warranty service

No. of service calls

Activities and Related Cost Drivers

Illustration 4-3

Step 3 Compute Cost of Activities

When
Whenestimating
estimatingthe
thecost
cost
of
ofan
anactivity,
activity,only
onlythe
the
costs
costsassociated
associatedwith
withthe
the
product
productshould
shouldbe
beused
used
(practical
(practicalcapacity).
capacity). The
The
cost
costof
ofunused
unused
capacity
capacityshould
shouldnot
notbe
be
applied
appliedto
toproducts.
products.

EXAMPLE
EXAMPLE
Suppose
Supposewe
werent
rentaa1,000
1,000square
square
foot
footwarehouse
warehousefor
for$1,000
$1,000per
per
month.
month. Only
Only800
800sq.
sq.ft.
ft.are
areused
used
to
tostore
storeProduct
ProductA.
A. The
Therest
restof
of
the
thewarehouse
warehouseis
isunused.
unused.
How
Howmuch
muchrent
rentcost
costshould
shouldbe
be
allocated
allocatedto
toProduct
ProductA?
A?

80%, or $800
should be assigned
to Product A

20%, or $200 should

be assigned to
unused capacity

Step 4 Compute Overhead Rate

Two
Twopieces
piecesof
of
information
informationare
arerequired
required
to
tocompute
computethe
thecostcostdriver
driverrate:
rate:
Activity
ActivityCost
Cost
Activity
ActivityVolume
Volume

EXAMPLE
EXAMPLE#1
#1

XCo
The
employees
activity
in
its
Quality
case
Control
is
of
Salaries
produced.
and
XCohas
has
The4proper
4proper
employees
activity
inin
in
itsthis
this
Quality
case
Control
isthe
the##Dept.
Dept.
ofunits
units
Salaries
produced.
andcosts
costs
for
The
total
cost-driver
$360,000
rate
would
XCo
be:
forthe
thedepartment
department
The
total
cost-driver
$360,000per
per
rateyear.
year.
would
XCo
be:produces
produces500,000
500,000
units
$360,000
aayear.
500,000
What
is
$.72
activity,
unitsof
ofproduct
product
$360,000
year.
500,000
Whatunits
units
isthe
the==appropriate
appropriate
$.72per
perunit
unit
activity,##of
of
employees
employeesor
orunits
unitsof
ofproduct?
product?What
Whatis
isthe
thecost-driver
cost-driverrate?
rate?

Step 5 Assign Overhead Cost to Products

1.
1.Identify
Identifyall
all
the
theactivities
activities
related
relatedto
toaa
given
givenproduct
product
or
orservice.
service.

2.
2.Determine
Determine
how
how many
many
units
units of
of each
each
activity
activityare
are
used
used per
per unit
unit
of
of product.
product.

3.
3.Assign
Assigncosts
costs
to
to products
products
using
using the
thecostcostdriver
driver rates
ratesfor
for
each
eachactivity
activity

Traditional Costing vs ABC

Activity Cost Pools

Activity
Cost Drivers

When Should a Company Use ABC?

ABC is often considered as an option when one or more of
the following conditions exist:
Multiple products produced
Indirect costs are significant in proportion to direct costs and use only one or

two cost-drivers.

Goods are complex, requiring many inputs and processes.

Simple, high-volume products perform more poorly than complex, low-volume

products.

Different departments believe costs are assigned inaccurately.

The company loses bids it thought were low, and wins bids it thought were

high.

Operations have changed significantly, but the costing system has not changed.

Product Variety Creates Overhead Costs

What About Small Activities in ABC?

Approximately Relevant ABC Systems
Use only the most expensive activities for ABC
assignment. These costs are assigned using causeand-effect drivers.
All other activity costs are added to cost pools of
the expensive activities and assigned arbitrarily.

Why Companies Use ABC

Traditional Costing vs ABC

Chemtech produces hundreds of different chemicals.
AMONG ALL FOLLOWING CHEMICALS ARE MORE POPULAR

Aldehyde (a commodity chemical used by producing plastics) and

Phenylephrine Hydrochloride (PH), which is a specialty chemical for
manufacturing blood-pressure medications.
In the past, Chemtechs manufacturing department has used a single

indirect cost pool.

It has used direct labor hours as its single allocation base at a 200%

rate.

Traditional Costing vs ABC

Chemtech Traditional Cost System
Aldehyde

PH

Sales price per pound

$10 $70 less
manufacturing cost per pound:
Direct materials
5 20
Direct labor
1 10 Manufacturing
overhead 2 20 Gross margin per pound
$ 2 $20
Under the traditional costing
approach gross margin for PH is
10 times as high as the gross
margin for the aldehyde.

Traditional Costing vs ABC

Assume that the company produced 7,000 pounds of

aldehyde and 5 pounds of PH.

What is the total labor cost What is total manufacturing

overhead allocated to each?
assigned to each product?
aldehyde --7,000 pounds x
Aldehyde--- $7,000 x 200% =
$1 = $7,000
$14,000
PH--- 5 pounds x $10 = $50
PH-- $50 x 200% = $100
Chemtech assigns to aldehyde
140 times as much direct labor Chemtech assigns 140 times
as
much
overhead
to
as it does to PH.
aldehyde as to PH.
$7,000/$50 = 140

Activity Based Costing

1 Identify the activities PERFORMED
Three specific activities were identified in the chemical

manufacturing department:
Mixing, Processing, Testing
2 Estimate the total indirect costs of performing each activity.

It was estimated that total mixing costs for all products

will be $600,000.
Labor
Depreciation
Other
Total

$150,000
200,000
250,000
$600,000

Depreciation
I
Ca

Activity Based Costing

3 Similarly, identify the primary cost driver for

each activitys indirect costs.

(1)

(2)

(3)
Activity Estimated Costs
Cost
Driver Mixing $600,000 # of batches
Processing
$300,000 # of machine
hours (MH) Testing
$600,000 # samples

Activity Based Costing

Workers mix ingredients separately

for each batch of chemicals, so the

number of batches drives mixing costs.

4 Estimate the total quantity of each

allocation base.

It was estimated that the mixing

department will produce 4,000 batches
of chemicals.

(1)
Activity

(4)
Estimated Quantity
of Cost Driver
Mixing
4,000 batches
Processing
5,000 machine
hours
Testing
3,000 samples

Activity Based Costing

5 Compute the allocation rate for each activity.
The estimated cost for each activity is divided by

the estimated quantity of the cost driver to obtain a

cost allocation rate.
5

Allocation rate = Estimated indirect costs of activity/Estimated

quantity of allocation base

(1)
Activity
Mixing

(5)
Cost Allocation Rate
$600,000/4,000 = $150/batch
Processing $300,000/5,000 = $60/MH
Testing
$600,000/3,000 = $200/sample

Activity Based Costing

6 Obtain the actual quantity of each allocation base

used by each product.

SUPPOSE, during the year, Chemtech produced 60

batches of aldehyde and 1 batch of PH.

The remaining batches consist of Chemtechs other

chemicals.

Activity Based Costing

7 Allocate the costs to each product.
Mixing costs are allocated as follows:
Aldehyde: 60 batches x $150 per batch = $9,000
PH: 1 batch x $150 per batch = $150

Activity

Cost Driver Units Cost Allocated to:

Used By:
Aldehyde PH
Aldehyde PH

Mixing

60 batches 1 batch $ 9,000 $150

Processing 301/2 MH
Testing

2 MH

1,830* 120

14 samples 1 sample

Total
*301/2 MH x $60 per MH = $1,830

2,800

$13,630

200
$470

Activity Based Costing

The ABC system allocates 29 times as much

overhead to aldehyde as to PH ($13,630/$470 = 29).

This is much less than the cost allocated to

aldehyde in the original direct-labor-based system,

which allocated 140 times as much overhead to
What is the total labor cost
aldehyde as to PH.
assigned to each product?
aldehyde --7,000 pounds x
$1 = $7,000
PH--- 5 pounds x $10 = $50
Chemtech assigns to aldehyde
140 times as much direct labor
as it does to PH.
$7,000/$50 = 140

Activity Based Costing

What is the overhead cost per pound?

Chemtech Traditional Cost

Remember that 7,000 pounds of

System

aldehyde were produced and 5

pounds of PH.
Aldehyde $13,630/7,000 = $1.95
PH $470/5 = $94

Aldehyde

PH

Sales price per pound

less manufacturing
per pound:
Direct materials
Direct labor
Manufacturing overhead
Gross margin per pound

$10

$70
cost

5
1
2
$2

20
10
20
$20

Comparison of overhead cost per pound under the

traditional system with the ABC costs:

Overhead

Traditional direct

ABC

Aldehyde

labor system
$ 2.00

system
$ 1.95

PH

$20.00

$94.00

Activity Based Costing

Chemtech Gross Margin per Pound

Aldehyde
PH
Sales price per pound
$10.00
$70.00 less manufacturing
cost per pound:
Direct materials
5.00
20.00
Direct labor
1.00
10.00
Manufacturing overhead 1.95
94.00
Gross margin per pound $2.05
$(54.00)

124

Activity Based Costing

USING ABC COSTS TO MAKE BUSINESS DECISIONS.

Two main benefits of ABC are...

1 more accurate product cost information.
2 more detailed information on costs of activities and

the drivers of those costs.

These benefits help managers make better

decisions about cost control and the sales prices to

charge for their products.

Activity Based Costing

ABC system shows that Chemtechs manufacturing cost for PH is $124,

rather than the $50 reported by the traditional system.

Chemtech was losing $54 on every pound of PH - and this is before

considering non-manufacturing costs such as R&D, marketing and

distribution.

Chemtechs PH Cost Comparision

PH (ABC)
PH (Traditional)
Sales price per pound
$70
$70
less manufacturing
cost
per pound:
Direct
materials
20
20
Direct labor
10
10 Manufacturing overhead
94
20
Gross margin per pound
$ (54)

Activity Based Costing

Chemtech has three alternatives:
1 Cut the cost of PH.
2 Increase the sale price of PH.
3 Drop the PH product.

Benefits of Activity-Based Costing

More accurate product costing which
necessitates:
More cost pools used to assign
overhead
Enhanced control over overhead
Better management decisions

Limitations of Activity-Based Costing

Can be expensive to use.
Some arbitrary allocations
continue.

Switch to ABC when...

Products differ greatly in volume and

manufacturing complexity

Products lines are

numerous
diverse
require differing degrees of support services
Overhead costs constitute a significant portion

of total costs

The manufacturing process or number of

products has changed significantly

Production or marketing managers are

ignoring data provided existing system

Activity Based Costing

DECIDE WHEN ABC IS MOST LIKELY TO PASS
THE COST-BENEFIT TEST.
ABCs benefits are higher when...
the company produces many different products

that use different amounts of resources.

the company has high overhead costs.
the company produces high volumes of some

products, and low volume of other products.

Activity Based Costing

DECIDE WHEN ABC IS MOST LIKELY TO PASS
THE COST-BENEFIT TEST.
The costs of adopting ABC are lower when the

company has...
accounting and information system expertise to

develop the system.

information technology (bar coding, optical

scanning) to record cost driver data.

Activity Based Management

Activity Based Management (ABM) uses an

activity based costing system to improve the

operations of an organization.
Keep in mind !
ABC and ABM are being applied in both
Manufacturing and Service Industries!!!

ACTIVITY BASED COSTING

Two Stage Assignment Process: Activity Based Costing
Stage 1
Determine
what activities
are performed
by company
resources
Stage 2
Attribute
costs to
products
based on
their use of
resources

SETUP
DEPTT

RAW
MFCTG
MATERIAL
ENGINRG
INVENTORY DEPTT
DEPTT

SETUP
MACHINES

PRODUCT 1

SUPPORT
DIRECT
LABOUR

PRODUCT 2

Other
***indirect
resources

Other
ADMINISTER
***activities
PARTS

PRODUCT 3

Other
***products

ACTIVITY BASED COSTING

GAINING COMPETITIVE ADVANTAGE THROUGH ABC
WHICH PRODUCTS
SHOULD WE PROMOTE?
ANALYSE PROFIT CONTRIBUTION &
IMPACT OF INTER-RELATIONSHIPS OF
PRODUCT/SERVICES
WHICH PRICES SHOULD
WHICH CUSTOMERS
WE SET?
ARE PROFITABLE & WHY?
IDENTIFY THE TRUE COST/
IDENTIFY THE TRUE COST
PROFITABLY OF
OF CUSTOMERS OR TYPES
GAINING
PRODUCTS/SERVICES
OF CUSTOMERS
COMPETITIVE
ADVANTAGE
WHICH DISTRIBUTION
HOW SHOULD WE
CHANNEL SHOULD WE USE?
MEASURE PERFORMANCE?
ANALYSE THE COST &
IDENTIFY ACCOUNTABILITY
PERFORMANCE OF
RESPONSIBILITY FOR
ALTERNATIVE DISTRIBUTION
COST BEHAVIOUR
CHANNELS