Chapter Five

Activity-Based Costing (ABC)

Blocher, Stout, Juras, Cokins: Cost Management, 7e
Copyright © McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education
Learning Objectives
• Explain the strategic role of activity-based costing
(ABC)
• Describe ABC, the steps in developing an ABC
system, and the benefits of an ABC system
• Determine product costs under both the volume-
based method and the ABC method
• Explain activity-based management (ABM)
• Describe how ABC/M is used organizations
• Use an activity-based approach to analyze customer
profitability  Customer Profitability Analysis
Volume-based Costing (VBC)
Traditional cost systems (or volume-based costing) were
created when manufacturing processes were labor
intensive.
• A single company-wide overhead rate based on direct
labor (DL) hours is used to allocate overhead costs to
products.
Example: If total budgeted overhead cost is $350 and allocated to
jobs based on DL hours, how much will be allocated to each job?
Job 1 Job 2
Units produced 10 10
DL hour per unit 2.5 1
Labour hours 25 10
FOH = (350/35) x 25 = (350/35) x 10
= RM250 = RM100
Volume-based Costing

• Issue : What if Job 2 is machine-intensive? The

cost allocation will be distorted.

The use of volume-based costing also causes

cross-subsidization of outputs, that is, products
with higher outputs will be overcosted and
others with lower outputs will be undercosted.
Volume-based Costing

• However, VBC may be a good strategic choice

for some firms when:
o the costs to be allocated are relatively small
versus the directly traceable costs
o the activities supporting production are
relatively homogeneous across different
product/service lines
Activity-based Costing (ABC)
A
• ABC identifies the activities performed B C
within the organization as it delivers its
goods and services.
• ABC assigns costs (i.e. overhead) to
products, based on the number of
activities the organization used in
producing them.
• ABC is a good supplement to the
traditional costing system (or VBC).
Benefits of ABC Systems

1. Better profitability measures due to more

accurate costs.
2. Better decision making: identification of value-
added vs. non-value-added activities and
associated costs.
3. Information for process improvement.
4. Improved cost planning.
5. Helps identify and control the cost of unused
capacity.
ABC vs. VBC
1. ABC system defines cost pools as activities
rather than production plant or department cost
centers.
2. Cost drivers:
• ABC systems use drivers based on an activity
or activities performed for the cost object
• VBC uses a volume-based cost driver (or
single cost driver) that often bears little or no
relationship to the consumption of resources
by the cost objects
Developing an ABC System

Steps in the development of an ABC system:

 Identify resource costs and activities
 Assign resource costs to activities
 Assign activity costs to cost objects
VBC vs. ABC (Example)
Haymarket BioTech, Inc. (HBT) produces and sells two
secure communication systems, AW (Anywhere) and SZ
(SecureZone). HBT has the following operating data for the
two products:

AW SZ
Production volume (units) 5,000 20,000
Unit selling price $400 $200
Unit direct materials and labor $200 $80
Total direct labor-hours 25,000 75,000
Direct labor-hours per unit 5 3.75
Using Volume-based costing…
Suppose the traditional volume-based costing
system assigns factory overhead (FOH) based
on direct labor-hours (DLH), and the firm has a
total budgeted overhead of $2,000,000.
Since the firm budgeted 100,000 DLHs for the
year, the predetermined overhead rate (POHR)
per DLH is $20 ($2,000,000÷100,000 DLH).

Therefore...
 FOH assigned to AW is $500,000 (25,000 DLH ×
$20) in total and $100 ($500,000÷5,000 units) per
unit, since the firm used 25,000 direct labor hours to
manufacture 5,000 units of AW

and

FOH assigned to SZ is $1,500,000 (75,000 DLH ×

$20) in total and $75 ($1,500,000÷20,000 units)
per unit, since the firm used 75,000 direct labor
hours to manufacture 20,000 units of SZ
Product profitability analysis per unit using
volume-based costing:

AW SZ

Sales price $400 $200

Less:
DM & DL (200) (80)
FOH (100) (75)
Gross margin $100 $45
Using ABC…
In an attempt to use an ABC system, HBT has
identified the following activities, budgeted costs,
and activity consumption cost drivers:

Budgeted
Activity Cost Activity Cost Driver
Engineering $125,000 Engineering hours
Setups 300,000 Number of setups
Machine operations 1,500,000 Machine hours
Packing 75,000 Number of packing orders
Total FOH $2,000,000
 HBT also has gathered the following operating
data pertaining to each of its products:

Budgeted Consumption
Activity AW SZ Total
Engineering hours 5,000 7,500 12,500
Number of setups 200 100 300
Machine hours 50,000 100,000 150,000
Number of packing orders 5,000 10,000 15,000
 Using the operating data, the activity rate for each
activity consumption cost driver is calculated as
follows:
First step: (A) (B) (A) ÷ (B)
Budgeted
Budgeted Activity Cost Driver
Cost Driver Cost Consumption Rate

Engineering hours $125,000 12,500 $10 per hour

$1,000 per
Number of setups $300,000 300 setup

Machine hours $1,500,000 150,000 $10 per hour

Number of
packing orders $75,000 15,000 $5 per order
 FOH assigned to AW at 5,000 units of production is:
Second step:
Cost Driver Total
Cost Driver Rate Activity Overhead
Engineering hours $10 5,000 $50,000
Number of setups 1,000 200 200,000
Machine hours 10 50,000 500,000
Number of packing
orders 5 5,000 25,000
Total $775,000
FOH assigned to SZ at 20,000 units of production is:

Cost Driver Total

Cost Driver Rate Activity Overhead
Engineering hours $10 7,500 $75,000
Number of setups 1,000 100 100,000
Machine hours 10 100,000 1,000,000
Number of packing
orders 5 10,000 50,000
Total $1,225,000
 Product profitability analysis per unit using ABC:

AW SZ
Unit selling price $400 $200
Unit costs:
DM & DL (200) (80)
FOH:
Engineering (10) (3.75)
Setups (40) (5)
Machine running (100) (50)
Packing (5) (2.5)
Gross margin $45 $58.75
The following chart compares the results of the two
costing systems:
VBC ABC Can you see how
FOH cost per unit: different
AW $100  $155 allocation
methods might
SW $75  $61.25 lead to making
Gross margin: different
AW $100  $45.00 management
SW $45  $58.75 decisions?

Keep in mind that volume-based costing tends to undercost

low-volume products and overcost high-volume products, a
situation often referred to as product cost cross-subsidization
 Should HBT
increase the price
of AW? Should HBT
reduce the price
of SZ?

Now that we have

measured product Product
costs accurately, Profitability
we see how profitable
each product really is.
Activity-Based Management (ABM)

• ABM manages activities to improve the value of

products or services to customers and increase
the firm’s competitiveness and profitability:
o Focuses on the efficiency and effectiveness of
key business processes and activities
o Improves management’s focus on the firm’s
critical success factors thereby enhancing the
firm’s competitive advantage
o ABC is its major source of information
Activity-Based Management (ABM)
ABM applications can be classified into two
categories:
Operational ABM enhances operational
efficiency and asset utilization and lowers costs;
it focuses on doing things right and performing
activities more efficiently
Strategic ABM attempts to alter the demand for
activities and increases profitability through
improved activity efficiency
ABC/M Tools

Some key ABC/M tools:

• In activity analysis, an organization assesses
each of its activities based on its need by the
product or the customer, its efficiency, and its
value content.
• Value-added analyses are performed in an
effort to eliminate activities that add little or no
value to the customer; resource consumption
can be reduced and the firm can focus on
activities that increase customer satisfaction.
5-24
ABC/M Tools

High-value-added activities:
• Increase significantly the value of the product or
service
• Are necessary to meet customer requirements
• Enhance purchased materials or components
• Contribute to customer satisfaction
• Are critical steps in a business process
In short, removal would reduce the value of the
product or service
ABC/M Tools

Low-value-added activities:
• Consume time, resources, or space but add little
or nothing to satisfying customer needs
• Can be eliminated without affecting the
form/fit/function of the product or service
Customer Profitability Analysis
• ABC/M can be used to estimate customer-related costs
and in therefore in assessing the profitability of a specific
customer or group of customers.
• Customer profitability analysis identifies customer
service activities and cost drivers and determines
profitability for each customer or group:
– combines customer revenues and customer costs to
assess customer profitability and helps identify
actions to improve customer profitability
– this process allows the firm to chose its customer mix,
determine an appropriate offering of after-sale
services, decide what discounts to offer, etc.
Customer Profitability Analysis
Customer profitability analysis helps to assess a
customer’s value to the company:
– What is the growth potential of the customer
and the customer’s industry?
– What is its “cross-selling” potential?
– What are the possible reactions of the
customer to changes in sales terms or
services?
– How important is this customer as a future
sales reference?
5-28