Activity-Based Costing and

Activity-Based Management

Learning Objective 1
Explain undercosting
and overcosting of
products and services.

Undercosting and
Overcosting Example
Tariq, Nasir, and Hamid order
separate items for lunch.
Tariqs order amounts to
Rs 14
Nasir consumed
30
Hamids order is
16
Total
Rs 60
What is the average cost per lunch?

Undercosting and
Overcosting Example
Rs 60 3 = Rs 20

Tariq and Hamid

are overcosted.

Nasir is
undercosted.

Learning Objective 2
Present three guidelines for
refining a costing system.

Existing Single IndirectCost Pool System Example

Super Corporation manufactures a normal lens
(NL) and a complex lens (CL).
Super currently uses a single indirect-cost rate
job costing system.
Cost objects: 80,000 (NL) and 20,000 (CL).

Existing Single IndirectCost Pool System Example

Normal Lenses (NL)
Direct materials
Rs 1,520,000
Direct mfg. labor
800,000
Total direct costs
Rs 2,320,000
Direct cost per unit: Rs 2,320,000 80,000 = Rs29

Existing Single IndirectCost Pool System Example

Complex Lenses (CL)
Direct materials
Rs 920,000
Direct mfg. labor
260,000
Total direct costs
Rs1,180,000
Direct cost per unit: Rs 1,180,000 20,000 = Rs 59

Existing Single IndirectCost Pool System Example

INDIRECT-COST
POLL

INDIRECT
COST-ALLOCATION
BASE

All
AllIndirect
IndirectCosts
Costs
Rs
Rs2,900,000
2,900,000

50,000
50,000Direct
Direct
Manufacturing
Manufacturing
Labor-Hours
Labor-Hours
Rs 58 per Direct
Manufacturing
Labor-Hour

Existing Single IndirectCost Pool System Example

COST OBJECT:
NL AND CL
LENSES

Indirect
IndirectCosts
Costs
Direct
DirectCosts
Costs

DIRECT
COSTS
Direct
Direct
Materials
Materials

Direct
Direct
Manufacturing
Manufacturing
Labor
Labor

Existing Single IndirectCost Pool System Example

Super uses 36,000 direct manufacturing
labor-hours to make NL and 14,000 direct
manufacturing labor-hours to make CL.
How much indirect costs are allocated
to each product?

Existing Single IndirectCost Pool System Example

NL: 36,000 Rs 58 = Rs 2,088,000
CL: 14,000 Rs 58 = Rs 812,000
What is the total cost of normal lenses?
Direct costs Rs 2,320,000 +
Allocated costs Rs 2,088,000 = Rs 4,408,000
What is the cost per unit?
Rs 4,408,000 80,000 = Rs 55.10

Existing Single IndirectCost Pool System Example

What is the total cost of complex lenses?
Direct costs Rs 1,180,000 + Allocated costs
Rs 812,000 = Rs 1,992,000
What is the cost per unit?
Rs 1,992,000 20,000 = Rs 99.60

Existing Single IndirectCost Pool System Example

Normal lenses sell for Rs 60 each and
complex lenses for Rs 142 each.
Normal Complex
Revenue
Rs 60.00
Rs 142.00
Cost
55.10
99.60
Income
Rs 4.90 Rs
42.40
Margin
8.2%
29.9%

Refining a Costing System

Direct-cost tracing
Indirect-cost pools
Cost-allocation basis

Refining a Costing System

1. Design of Products and Process
The Design Department designs the molds
and defines processes needed (details of
the manufacturing operations).

Refining a Costing System

2. Manufacturing Operations
Lenses are molded, finished,
cleaned, and inspected.
3. Shipping and Distribution
Finished lenses are packed and
sent to the various customers.

Learning Objective 3
Distinguish between the
traditional and the
activity-based costing
approaches to designing
a costing system.

Activity-Based Costing System

Fundamental
Cost Objects
Activities
Costs of Activities

Assignment to Other
Cost Objects
Cost of:
Product
Service
Customer

Activity-Based Costing System

A cross-functional team at Super
Corporation identified key activities:
Design products and processes.
Set up molding machine.
Operate machines to manufacture lenses.
Maintain and clean the molds.

Activity-Based Costing System

Set up batches of finished lenses for shipment.
Distribute lenses to customers.
Administer and manage all processes.

Activity-Based Costing System

Activity
Indirect Cost
Pool

Design

Setup

Shipping

Cost
Allocation
Base

PartsSquare
feet

No. of
Setup
Hours

No. of
Shipments

Product
Cost
Objects

Lenses
NL

Lenses
CL

Lenses
Other

Activity-Based Costing System

NL
CL
Quantity produced
80,000
20,000
No. produced/batch
250
50
Number of batches
320
400
Setup time per batch
2 hours
5 hours
Total setup-hours
640
2,000
Total setup costs are Rs 409,200.

Activity-Based Costing System

What is the setup cost per setup-hour?
Rs 409,200 2,640 hours = Rs 155
What is the setup cost per
direct manufacturing labor-hour?
Rs 409,200 50,000 = Rs 8.184

Activity-Based Costing System

Allocation using direct labor-hours:
NL: Rs 8.184 36,000 = Rs 294,624
CL: Rs8.184 14,000 = Rs114,576
Total
Rs409,200
Allocation using setup-hours:
NL: Rs155 640 = Rs 99,200
CL: Rs155 2,000 = Rs310,000
Total
Rs409,200

Learning Objective 4
Describe a four-part
cost hierarchy.

Cost Hierarchies
A cost hierarchy is a categorization
of costs into different cost pools.
Cost drivers bases (cost-allocation bases)
Degrees of difficulty in determining
cause-and-effect relationships

Cost Hierarchies
ABC systems commonly use a
four-part cost hierarchy to
identify cost-allocation bases:
1. Output unit-level costs
2.

Batch-level costs

3.

Product-sustaining costs

4.

Facility-sustaining costs

Output Unit-Level Costs

These are resources sacrificed
on activities performed on each
individual unit of product or service.
Energy
Machine depreciation
Repairs

Batch-Level Costs
These are resources sacrificed on
activities that are related to a group
of units of product(s) or service(s)
rather than to each individual unit
of product or service.
Setup-hours
Procurement costs

Product-Sustaining Costs
These are often called service-sustaining
costs and are resources sacrificed on
activities undertaken to support
individual products or services.
Design costs
Engineering costs

Facility-Sustaining Costs
These are resources sacrificed on
activities that cannot be traced to
individual products or services but
support the organization as a whole.
General administration
rent

building security

Learning Objective 5
Cost products or services using
activity-based costing.

Implementing
Activity-Based Costing
Step 1

Step 2

Identify cost objects.

Identify the direct costs

of the products.

NL
CL

Direct material
Direct labor
Mold cleaning and
maintenance

Implementing
Activity-Based Costing
Cleaning and maintenance costs of
Rs360,000 are direct batch-level costs.
Why?
Because these costs consist of workers
wages for cleaning molds after each
batch of lenses is run.

Implementing
Activity-Based Costing
Normal Lenses (NL)
Cost Hierarchy
Description Category
Direct materials Unit-level Rs1,520,000
Direct mfg. labor Unit-level
800,000
Cleaning and maint. Batch-level
160,000
Total direct costs Rs2,480,000

Implementing
Activity-Based Costing
Complex Lenses (CL)
Cost Hierarchy
Description Category
Direct materials Unit-level Rs 920,000
Direct mfg. labor Unit-level
260,000
Cleaning and maint. Batch-level
200,000
Total direct costs Rs1,380,000

Implementing
Activity-Based Costing
Step 3
Select the cost-allocation bases to use for
allocating indirect costs to the products.
(1)
(2)
(3)
Activity
Cost Hierarchy
Total Costs
Design
Product-sustaining
Rs450,000
Setups
Batch-level
Rs409,200
Operations Unit-level
Rs637,500

Implementing
Activity-Based Costing
Step 4
Identify the indirect costs associated
with each cost-allocation base.
Overhead costs incurred are assigned
to activities, to the extent possible, on
the basis of a cause-and-effect relationship.

Implementing
Activity-Based Costing
Step 5
Compute the rate per unit.
(1)
(5)
NL
CL
Total
Setup-hours: 640
2,000
2,640
Rs409,200 2,640 = Rs155

Implementing
Activity-Based Costing
Step 6
Compute the indirect costs allocated
to the products.
NL: Rs155 640 =
Rs 99,200
CL: Rs155 2,000 =
310,000
Total
Rs409,200

Implementing
Activity-Based Costing
Step 7
Compute the costs of the products.
NL and CL would show three
direct cost categories.
1.
Direct materials
2.

Direct manufacturing labor

3.

Cleaning and maintenance

Implementing
Activity-Based Costing
NL and CL would show six indirect cost pools.
1.

Design

2.

Molding machine setups

3.

Manufacturing operations

4.

Shipment setup

5.

Distribution

6.

Administration

Learning Objective 6
Use activity-based
costing systems for
activity-based management.

Activity-Based Management
ABM describes management decisions that use
activity-based costing information to satisfy
customers and improve profits.
Product pricing and mix decisions
Cost reduction and process improvement decisions
Design decisions

Product Pricing and

Mix Decisions
ABC gives management insight into the cost
structures for making and selling diverse products.
It provides more accurate product cost
information and more detailed information
on costs of activities and the drivers of those costs.

Cost Reduction and Process

Improvement Decisions
Manufacturing and distribution personnel use
ABC systems to focus on cost-reduction efforts.
Managers set cost-reduction targets in terms of
reducing the cost per unit of the cost-allocation base.

Design Decisions
Management can identify and evaluate new designs
to improve performance by evaluating how product
and process designs affect activities and costs.
Companies can work with their customers to
evaluate the costs and prices of alternative designs.

Learning Objective 7
Compare activity-based costing
systems and departmentcosting systems.

ABC and Department

Indirect-Cost Rates
Many companies have evolved their
costing system from using a single
cost pool to using separate indirect-cost
rates for each department:
Design
Manufacturing
Distribution

ABC and Department

Indirect-Cost Rates
Why?
Because the cost drivers of resources in each
department or sub department differ from the
single, company-wide, cost-allocation base.
ABC systems are a further refinement of
department costing systems.

Learning Objective 8
Evaluate the costs and benefits
of implementing activity-based
costing systems.

Benefits of ABC Systems

Significant amounts of indirect costs are
allocated using only one or two cost pools.
All or most costs are identified
as output unit-level costs.
Products make diverse demands on
resources because of differences in
volume, process steps, batch size,
or complexity.

Benefits of ABC Systems

Products that a company is well-suited to
make and sell show small profits while
products for which a company is less
suited show large profits.
Complex products appear to be very
profitable and simple products
appear to be losing money.

Benefits of ABC Systems

Operations staff have significant
disagreements with the accounting
staff about the costs of manufacturing
and marketing products and services.

Limitations of ABC Systems

The main limitations of ABC are the
measurements necessary to
implement the system.
ABC systems require management
to estimate costs of activity pools
and to identify and measure cost
drivers for these pools.

Limitations of ABC Systems

Activity-cost rates also need to be
updated regularly.
Very detailed ABC systems are costly
to operate and difficult to understand.

ABC In Service and

Merchandising Companies
The general approach to ABC in the
service and merchandising areas is very
similar to the approach in manufacturing.
Costs are divided into homogeneous cost
pools and classified as output unit-level,
batch-level, product- or service-sustaining,
and facility-sustaining costs.

ABC In Service and

Merchandising Companies
The cost pools correspond to key activities.
Costs are allocated to products or customers
using activity drivers or cost-allocation
bases that have a cause-and-effect
relationship with the cost in the cost pool.

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