Chapter 7

Activity-Based
Costing

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All

 Learning
Objective
1

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All

 Background
Recall that Factory Overhead is applied to
production in a rational systematic manner, using
some type of averaging. There are a variety of
methods to accomplish this goal.
These methods often involve tradeoffs between
simplicity and realism

Simple Methods Complex Methods

Unrealistic Realistic
 Broad Averaging
Historically, firms produced a limited variety
of goods while their indirect costs were
relatively small.
Allocating overhead costs was simple: use
broad averages to allocate costs uniformly
regardless of how they are actually incurred
Peanut-butter Costing
The end-result: overcosting & undercosting
 Background
The use of broad averages in allocating indirect costs
can have a number of adverse consequences.
Traditional product-costing methods use a single
indirect cost rate to allocate costs to all products.
When a company has a variety of products, this method
may not give the best results.
Different products consume activities at different rates,
traditional costing does not recognize these differences.
Peanut-butter costing uses broad averages to assign (or
spread) costs uniformly to cost objects.
 Over & Undercosting
Overcosting a product consumes a low
level of resources but is allocated high costs
per unit (Emmas dinner)
Undercosting a product consumes a high
level of resources but is allocated low costs
per unit (James dinner)
 Cross-subsidization
The results of overcosting one product and
undercosting another.
The overcosted product absorbs too much
cost, making it seem less profitable than it
really is
The undercosted product is left with too little
cost, making it seem more profitable than it
really is
 Simple Costing System
A simple costing system has few indirect
(often one) cost rates and allocates costs
broadly.
An Example:
Plastim
Plastim & Simple Costing
 ABC vs. Simple Costing Schemes
ABC is generally perceived to produce
superior costing figures due to the use of
multiple drivers across multiple levels
ABC is only as good as the drivers selected,
and their actual relationship to costs. Poorly
chosen drivers will produce inaccurate
costs, even with ABC
 Rationale for selecting a more refined
costing system

Increase in product diversity

Increase in Indirect Costs
Advances in information technology
Competition in foreign markets
 Refining a Costing System
A refined cost system reduces the use of
broad averages for assigning costs to
resources. There are three principal
reasons that have accelerated the demand
for such refinements.
Increase in product diversity. The growing
demand for customized products has led to
product diversity with the result that products
demand differing levels of resources.
 Refining a Costing System
Increase in indirect costs. With modern
technology, companies have experienced a
decrease in direct costs with a resulting
increase in indirect costs.
Competition in product markets. Markets
have become more competitive, forcing
managers to obtain more accurate cost
information to help them make strategic
decisions.
 Guidelines
Direct-cost tracing. Identify as many direct
costs as is economically feasible.
Indirect-cost pools. Expand the number of
cost pools so that each pool is somewhat
homogeneous. Each cost in the pool has a
similar cause-and-effect relationship with a
single cost driver.
Cost-allocation bases. The cost driver
serves as the cost allocation base for each
homogeneous indirect-cost pool.
 Activity-Based System
(ABC)
An activity-based system (ABC) identifies
individual activities as fundamental cost
objects.
An activity is an event, task, or unit of
work with specific purposefor example
designing product, setting up machines,
operating machines and distributing
products.
Costs are then assigned to the activities
and allocated to the individual products.
 Cost Hierarchies
ABC uses a four-level cost structure to
determine how far down the production
cycle costs should be pushed:
A cost hierarchy categorizes various cost
pools on the basis of the different type of
cost drivers, cost-allocation bases, or
different degrees of difficulty in determining
cause-and-effect relationship.
 Cost Hierarchies
Output unit-level costs are the costs of
activities performed on each individual unit of
a product or service. These costs increase
as the number of units produced increases.
Batch-level costs are the costs of activities
related to a group of units of products or
services rather than the individual unit. Set-
up costs are an example of batch level costs,
as this cost is incurred once for each batch,
regardless of the size of the batch.

 Cost Hierarchies
Product-sustaining costs (service-
sustaining costs) are the costs of activities
undertaken to support individual products or
services regardless of the number of units
or batches produced. Design costs are an
example of this type of cost.
 Cost Hierarchies
Facility-sustaining costs are the costs of
activities that cannot be traced to individual
products or services but support the
organization as a whole. Examples of this
type of cost include general administration,
rent, and building security. These costs
usually lack a cause-and-effect relationship
between the cost and the allocation base.
 Plastims ABC System
To identify activities, Plastim organizes a team of
managers from design, manufacturing,
distribution, accounting and administration.
The team identifies hundreds of task performed at
Plastim. The team then focuses on those activities
that account for a sizable fraction of indirect costs
and combines activities that have same cost driver
into single activity. For example the team decides
to combine maintenance of molding machine,
operation of molding machine, and process control
into single activitymolding machine operations.
 Plastims ABC System
The team identifies the following seven
activities needed to design, manufacture,
and distribute S3 and C5 lenses:
1. Design products and processes
2. Set up molding machines to ensure that
the molds are properly held in place and
parts are properly aligned before
manufacturing starts.
3. Operate molding machines to
manufacture lenses
 Plastims ABC System
4. Clean and maintain the molds after
lenses are manufactured.
5. Prepare batches of finished lenses for
shipment
6. Distribute lenses to customers
7. Administer and manages all processes at
Plastim
# 4 consists of salaries and wages paid to
workers who clean the mold (direct cost).
All other costs are indirect cost pool.
 Plastims ABC System
Design costs are product sustaining costs
and are function of complexity of mold,
measured by the number of parts in the
mold multiplied by the area (in square feet)
over which the molten plastic must flow (12
parts * 2.5 Sq Ft for the S3 lens and 14
parts and * 5 Sq Ft for the C5 lens.
Molding machine set up costs are batch
level activity, S3 lens require, 60,000/240
lens per batch=250 batches.
 Plastims ABC System
Each batch requires 2 hours Setup time.
Thus total setup hours required for S3 lens
are 500 hours.
For 15,000 C5 lenses require 50 lens per
batch=300 batches. Each batch requires 5
hours setup time. Thus total setup hours
required for C5 lens are 1,500 hours
 Plastims ABC System
Machine operations costs are related to the
activity of running the automated molding
machines and are output unit level costs.
S3 requires 9,000 molding machine hours to
manufacture 60,000 lens and C5 require
3,750 molding machine hours to
manufacture 15,000 lens.
Shipment Setup activity is a batch level
activity and each category of lenses require
100 shipments.
 Plastims ABC System
Distribution is an output unit level activity.
S3 45,000 cubic feet delivered and C5
22,500 cubic feet delivered
Administration is facility sustaining activity
and is measured in terms of direct
manufacturing labor required for both types
of lenses. S3 require 30,000 MLH and C5
require 9,750 MLH respectively.
Plastim and ABC Illustrated
Plastim and ABC Rate
Calculation
Plastim and ABC Product Costs
Plastim: Simple & ABC
Compared
 Conclusions
Each method is mathematically correct
Each method is acceptable
Each method yields a different cost figure, which will lead
to different Gross Margin calculations
Only Overhead is involved. Total Costs for the entire firm
remain the same they are just allocated to different cost
objects within the firm
Selection of the appropriate method and drivers should be
based on experience, industry practices, as well as a cost-
benefit analysis of each option under consideration
 A Cautionary Tale
A number of critical decisions can be made
using this information;
Should one product be pushed over another?
Should one product be dropped?
Accounting for overhead costs is an
imprecise science. Accordingly, best efforts
should be put forward to arrive at a cost that
is fair and reasonable.
 Activity-Based Management
A method of management that used ABC as
an integral part in critical decision-making
situations, including:
Pricing & product-mix decisions
Cost reduction & process improvement
decisions
Design decisions
Planning & managing activities
 Signals that suggest that ABC
implementation could help a firm:
Significant overhead costs allocated using one or
two cost pools
Most or all overhead is considered unit-level
Products that consume different amounts of
resources
Products that a firm should successfully make and
sell consistently show small profits
Operations staff disagreeing with accounting over
manufacturing and marketing costs
 ABC and Service / Merchandising
Firms

ABC implementation is widespread in a

variety of applications outside
manufacturing, including:
Health Care
Banking
Telecommunications
Retailing
Transportation
 Traditional, Volume-Based
Product-Costing System
Aerotech produces three complex printed circuit
boards referred to as Mode I, Mode II, and Mode
III.
The following information is obtained from
company records:
 Traditional, Volume-Based
Product-Costing System

Additional information includes:

Manufacturing overhead is determined as follows

 Traditional, Volume-Based
Product-Costing System

Budgeted manufacturing overhead $3,894,000

= $33 per hour
Budgeted direct-labor hours 118,000
 Traditional, Volume-Based
Product-Costing System
With these product costs, Aerotech established
target selling prices (Cost 125%).

209.00 x 1.25
 Learning
Objective
2

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All

Activity Based Costing System
(ABC)

ABC systems Assigning

overhead to
follow a two- products is a
difficult process.
stage procedure I agree!
to assign
overhead costs to
products.
 Activity Based Costing System
(ABC)
ABC systems follow a
Lets begin
two-stage procedure by identifying
to assign overhead our major
activities.
costs to products.

Stage One
Identify significant
activities and assign overhead
costs to each activity in
proportion to resources used.
 Activity Based Costing System
(ABC)
ABC systems follow a
two-stage procedure Overhead assigned to
to assign overhead activities are called
activity cost pools.
costs to products.

Stage Two
Identify cost drivers
appropriate to each activity
and allocate overhead to
the products.
 Learning
Objective
3

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All

 Overhead Costs
Total budgeted cost = $3,894,000 Identification
Identification
Activity
of
of Activity
Activity
must be
done on Cost
Cost Pools
Pools
each unit Activity
produced. Cost
Pools
Product-
Unit Batch Sustaining Facility
Level Level Level Level

Machinery Setup Engineering Facility

cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Activity Activities needed to support Activity required in order

performed an entire product line for the production
on each process to occur.
batch
produced.
 Product-
Unit Batch Sustaining Facility
Level Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Receiving/Inspection
cost pool $200,000

Material-Handling
cost pool $600,000

Quality-Assurance
cost pool $421,000

Packaging/Shipping
cost pool $250,000
 Learning
Objective
4

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All

 STAGE ONE

Various overhead
Maintenance Lubrication
costs related
to machinery Depreciation Electricity

Computer Support Calibration

Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1,212,600
 STAGE TWO
Calculate Budgeted Machinery Costs = $1,212,600
the pool Budgeted Machine Hours 43,000
rate = $28.20/hour

Cost
Assignment
 STAGE ONE

Calculation of
total setup cost

Activity
cost Setup Cost Pool
pool Total budgeted cost = $3,000
 STAGE TWO
Calculate Budgeted Setup Costs = $3,000
the pool Planned Production Runs 15 runs
rate = $200 per run

Cost
Assignment
 STAGE ONE
Various overhead Engineering salaries Engineering software
costs related
to engineering Engineering supplies Depreciation

Activity
cost Engineering Cost Pool
pool Total budgeted cost = $700,000
 STAGE TWO
Allocate based Engineering Cost Pool
on engineering Total budgeted cost = $700,000
transactions

Cost
Assignment
 Exh.

STAGE ONE 5-9

Various overhead Plant depr. Property taxes

costs related
Plant mgmt. Insurance
to general
operations Plant maint. Security

Activity
cost Facility Cost Pool
pool Total budgeted cost = $507,400
 Exh.

STAGE TWO 5-9

Calculate Budgeted Facilities Cost = $507,400

the pool Budgeted Direct-Labor Hours 118,000
rate = $4.30/hour

Cost
Assignment
 Other Overhead Costs
Receiving and Inspection Cost Pool
Board Overhead % Units = Cost/Unit
Mode I $ 200,000 6% 10,000 = $ 1.20
Mode II 200,000 24% 20,000 = 2.40
Mode III 200,000 70% 4,000 = 35.00

Material-Handling Cost Pool

Board Overhead % Units = Cost/Unit
Mode I $ 600,000 7% 10,000 = $ 4.20
Mode II 600,000 30% 20,000 = 9.00
Mode III 600,000 63% 4,000 = 94.50

Quality-Assurance Cost Pool

Board Overhead % Units = Cost/Unit
Mode I $ 421,000 20% 10,000 = $ 8.42
Mode II 421,000 40% 20,000 = 8.42
Mode III 421,000 40% 4,000 = 42.10

Packaging and Shipping Cost Pool

Board Overhead % Units = Cost/Unit
Mode I $ 250,000 4% 10,000 = $ 1.00
Mode II 250,000 30% 20,000 = 3.75
Mode III 250,000 66% 4,000 = 41.25
 Other Overhead Costs
Receiving and Inspection Cost Pool
Board Overhead % Units = Cost/Unit
Mode I $ 200,000 6% 10,000 = $ 1.20
Mode II 200,000 24% 20,000 = 2.40
Mode III 200,000 70% 4,000 = 35.00

Material-Handling Cost Pool

Board Overhead % Units = Cost/Unit
$14.82 Mode I $ 600,000 7% 10,000 = $ 4.20
Mode II 600,000 30% 20,000 = 9.00
Mode III 600,000 63% 4,000 = 94.50

Quality-Assurance Cost Pool

Board Overhead % Units = Cost/Unit
Mode I $ 421,000 20% 10,000 = $ 8.42
Mode II 421,000 40% 20,000 = 8.42
Mode III 421,000 40% 4,000 = 42.10

Packaging and Shipping Cost Pool

Board Overhead % Units = Cost/Unit
Mode I $ 250,000 4% 10,000 = $ 1.00
Mode II 250,000 30% 20,000 = 3.75
Mode III 250,000 66% 4,000 = 41.25
 Product Cost from ABC
These are the new product costs when Aerotech
uses ABC.
 Learning
Objective
5

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All

 Distorted Product Costs
Both original and ABC target selling prices are
based on (Cost 125%).

The selling price of Mode I and II are reduced

and the selling price for Mode III is increased.
[$209.00 1.25] [$183.44 1.25]
 Distorted Product Costs
Can you identify any problems Aerotech is likely
to face as a result of this distortion?

Traditional costing understates the cost

of complex, low volume products.
 Two Key Points

A
A large
large proportion
proportion of of non-
non- Product
Product diversity
diversity
unit-level
unit-level activities
activities When
When the
the consumption
consumption
A
A unit-level
unit-level cost
cost driver,
driver, ratios
ratios differ
differ widely
widely
such
such asas direct
direct labor,
labor, between
between activities,
activities, no
no
machine
machine hours,
hours, oror single
single cost
cost driver
driver will
will
throughput,
throughput, will
will not
not be
be accurately
accurately assign
assign the
the
able
able to
to assign
assign the
the costs
costs resulting
resulting overhead
overhead costs.
costs.
of
of non-unit-level
non-unit-level activities
activities
accurately.
accurately.
 Learning
Objective
6

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All

 Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs.
 Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .

Degree of
Correlation
 Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .

Degree of
Correlation

Cost of
Measurement
 Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .

Degree of Behavioral
Correlation Effects

Cost of
Measurement
 Learning
Objective
7

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All

Interviewing and Paper Trails
The information for ABC systems initially comes
from interviews with employees in the support
departments and a review of each departments
records.
 Storyboarding
A procedure used to develop a detailed
process flow chart, which visually
represents activities and the relationships
among activities.
Step
Step These
These are
are the
the steps
steps wewe
11 follow
Step follow to
to build
build aa
Step memory
22 memory board.
board.
Step
Step
33
Step
Step
44
 Direct versus Indirect Costs
Volume-Based
Volume-Based Costing
Costing Activity-Based
Activity-Based Costing
Costing
All
All production
production costs
costs An
An effort
effort is
is made
made toto
except
except direct
direct account
account for for as
as many
many
materials
materials and
and direct
direct costs
costs asas possible
possible as
as
labor
labor are
are lumped
lumped direct
direct costs
costs of
of
together
together in
in one
one production.
production.
overhead
overhead cost
cost pool.
pool.

Indirect
Costs
 Indicators of Need for ABC
Direct
Direct labor
labor is
is aa Product-line
Product-line profit
profit
small
small percentage
percentage margins
margins are
are hard
hard
of
of total
total costs
costs to
to explain
explain

Line
Line managers
managers dodo not
not
Sales
Sales are
are increasing,
increasing, believe
believe the
the product
product
but
but profits
profits are
are declining.
declining. costs
costs reports
reports

Some
Some products
products that
that
Marketing
Marketing does
does not
not have
have reported
reported high
high
use
use costs
costs reports
reports for
for profit
profit margins
margins are
are not
not
pricing
pricing decisions
decisions sold
sold by
by competitors
competitors
 Exh.
5-13

Optimal Product-Costing System

Cost
Total Cost
High

Cost of
inferior
decisions
resulting Design, implementation
from and maintenance costs
inaccurate
information.

Information
Low
System
Low High Accuracy
Optimal
system
 Learning
Objective
8

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ABC in the Service Industry

Objectives
End of Chapter 5
This is
my kind of cost
pool!