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 a
ABC is designed to good supplement
provide managers with to our traditional
cost information for cost system
I agree!
strategic and other
decisions that potentially
affect capacity, and
therefore, affect fixed
as well as variable costs.
 7-3

Learning Objective 1

Understand activity-
based 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 Nonmanufacturing
costs costs

Traditional ABC
product costing 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.

Manufacturing Nonmanufacturing
costs costs

Some
Mo
st,
All

not but
all
Traditional ABC
product costing product costing

ABC does not assign all manufacturing costs to products.

 7-6

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.
Level of complexity

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
cost systems
systems usually
usually rely
rely
on
on volume
volume measures
measures such
such asas direct
direct labor
labor
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.

 7-8

How Costs are Treated Under

ActivityBased Costing
An event that causes the
Activity consumption of overhead
resources.

A cost bucket in which

Activity costs related to a single
Cost Pool activity measure are
accumulated.
$$
$
$ $
$
 7-9

How Costs are Treated Under

ActivityBased 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.
 7-10

How Costs are Treated Under

ActivityBased 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.
 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 asas 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 Batch-Level
Activity Activity

Manufacturing
companies typically combine
their activities into five
classifications.

Product-Level Customer-Level
Activity Organization- Activity
sustaining
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 allall 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 allall 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 ofof 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 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
Indirect factory
factory wages
wages $6,000,000
$6,000,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 30%
30%
$1,800,000
$1,800,000
 7-22

Assign Overhead Costs to

Activity Cost Pools

Factory
Factory equipment
equipment depreciation
depreciation $3,500,000
$3,500,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 20%
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 Direct Shipping
Overhead Costs
Materials Labor Costs

Traced Traced Traced

Cost Objects:
Products, Customer Orders, Customers
 7-28

ActivityBased Costing at Baxter

Battery
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Design Order Customer

Other
Orders Changes Size Relations

Cost Objects:
Products, Customer Orders, Customers
 7-29

ActivityBased Costing at Baxter

Battery
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Design Order Customer

Other
Orders Changes Size Relations

Second-Stage Allocations

$/Order $/Change $/MH $/Customer

Cost Objects:
Unallocated
Products, Customer Orders, Customers
 7-30

Learning Objective 4

Assign costs to a cost

object using a second-
stage 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 ofof 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 $14,000,000

= = $17.50 per machine-hour
overhead rate 800,000 MH
 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 The traditional cost

system overcosts the system undercosts the
SureStarts and reports LongLifes and reports
a lower product a higher product
margin for this 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 ofof the
the subjective
subjective allocation
allocation
process
process based
based on
on interviews
interviews with
with employees.
employees.
 7-53

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.