1. Activity-Based Costing: A Tool to Aid Decision Making
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Activity-Based Costing: A Tool to Aid Decision Making
Chapter Seven
This chapter introduces students to activity-based costing (ABC), which is a tool that has been embraced by a wide variety of service, manufacturing, and non-profit organizations.

2. Activity Based Costing (ABC)
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Activity Based Costing (ABC)
ABC is a
good supplement to our traditional cost system
ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore affect fixed as well as variable costs.
I agree!
ABC is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore “fixed” as well as variable costs. It is ordinarily used as a supplement to, rather than as a replacement for, the company’s usual costing system.

3. How Costs are Treated Under Activity–Based Costing
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How Costs are Treated Under Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Manufacturing costs
Nonmanufacturing costs
ABC differs from traditional cost accounting in three ways. The first is:
 Nonmanufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis. For example, ABC systems can assign sales commissions, shipping costs, and warranty repair costs to specific products.
Traditional product costing
ABC product costing
 ABC assigns both types of costs to products.

4. How Costs are Treated Under Activity–Based Costing
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How Costs are Treated Under Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Manufacturing costs
Non manufacturing costs
Most, but not all
Some
All
  Some manufacturing costs may be excluded from product costs. This is because ABC only assigns a cost to a product if decisions concerning that product will cause changes in the cost. ABC excludes two types of costs from product costs:
Organization-sustaining costs (which will be formally defined later); and
The costs of unused or idle capacity.
Traditional product costing
ABC product costing
ABC does not assign all manufacturing costs to products.

5. How Costs are Treated Under Activity–Based Costing
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How Costs are Treated Under Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Activity–Based
Costing
Level of complexity
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
 Numerous overhead cost pools are used, each of which is allocated to products and other cost objects using its own unique measure of activity. ABC cost pools are created to correspond to the activities performed in an organization that cause the consumption of overhead resources. Therefore, the total number of ABC cost pools will definitely exceed one (as in the plantwide approach) and it is likely to exceed the number of departments within a company (as in the departmental approach), since more than one activity is often performed within each department.
Number of cost pools
ABC uses more cost pools.

6. How Costs are Treated Under Activity–Based Costing
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How Costs are Treated Under Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Each ABC cost pool has its own unique measure of activity.
Traditional cost systems usually rely on volume measures such as direct labor hours and/or machine hours to allocate all overhead costs to products.
Each ABC cost pool has its own unique measure of activity. On the contrary, traditional cost systems usually rely on direct labor hours and/or machine hours to allocate all overhead costs to products.
Direct labor and machine hours work correctly when changes in the quantity of the base are correlated with changes in the overhead costs being assigned using the base.
Relying exclusively on these bases to assign overhead costs to products has come under increased scrutiny since, on an economy-wide basis, direct labor and overhead costs have been moving in opposite directions and the variety of products produced by companies has increased.
ABC uses more cost pools.

7. How Costs are Treated Under Activity–Based Costing
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How Costs are Treated Under Activity–Based Costing
Activity
An event that causes the consumption of overhead resources.
Activity Cost Pool
A “cost bucket” in which costs related to a particular activity measure are accumulated. $
Part I.
An activity is any event causes the consumption of overhead resources.
Part II.
An activity cost pool is a “bucket” in which costs are accumulated that relate to a single activity measure in an ABC system.

8. How Costs are Treated Under Activity–Based Costing
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How Costs are Treated Under Activity–Based Costing
The term cost driver is also used to refer to an activity measure.
Activity Measure
An allocation base in an activity-based costing system.
An activity measure is an allocation base in an activity-based costing system. The term cost driver is also used to refer to an activity measure. The two most common types of activity measures are shown on the next slide.

9. How Costs are Treated Under Activity–Based Costing
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How Costs are Treated Under Activity–Based Costing
Two common types of activity measures:
Simple count of the number of times an activity occurs.
Transaction driver
A measure of the amount of time needed for an activity.
Duration driver
Two types of activities measures include:
 Transaction drivers – simple counts of the number of times that an activity occurs such as the number of bills sent out to customers.
 Duration drivers — measures of the amount of time needed to perform an activity such as the time spent preparing individual bills for customers.

10. How Costs are Treated Under Activity–Based Costing
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How Costs are Treated Under Activity–Based Costing
ABC defines five levels of activity that largely do not relate to the volume of units produced.
Traditional cost systems rely exclusively on allocation bases that are driven by the volume of production. ABC defines five levels of activity that largely do not relate to the volume of units produced.
Traditional cost systems usually rely on volume measures such as direct labor hours and/or machine hours to allocate all overhead costs to products.

11. How Costs are Treated Under Activity–Based Costing
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How Costs are Treated Under Activity–Based Costing
Unit-Level
Activity
Batch-Level
Activity
Manufacturing companies typically combine their activities into five classifications.
 Unit-level activities are performed each time a unit is produced. For example, providing power to run processing equipment would be a unit-level activity.
 Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, setting up equipment and shipping customer orders are batch-level activities.
 Product-level activities relate to specific products and must be carried out regardless of how many batches are run or units produced and sold. For example, designing or advertising a product would be product-level activities.
 Customer-level activities relate to specific customers and are not tied to any specific product. For example, sales calls and catalog mailings would be customer-level activities.
 Organization-sustaining activities are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices are organization-sustaining activities.
Product-Level
Activity
Customer-Level
Activity
Organization- sustaining
Activity

12. Classic Brass – An ABC Example
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Classic Brass – An ABC Example
Classic Brass makes two product lines for luxury yachts—standard stanchions and custom compass housings. The company has reported its first loss ever of $1,250 as shown on the income statement.
Manufacturing overhead is allocated to products using a single plantwide overhead rate based on machine hours.

13. Define Activities, Activity Cost Pools, and Activity Measures
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Define Activities, Activity Cost Pools, and Activity Measures
At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:
The first step in implementing ABC is to define activities, activity cost pools, and activity measures. The activities are often identified and defined by interviewing the employees that work in the respective overhead departments. The lengthy list of activities that emerges from this process is usually reduced to a handful by combining similar activities.
Classic Brass selected the following five activity cost pools and corresponding activity measures:
Activity Cost Pool Activity Measure
Customer orders Number of customer orders
Product design Number of product designs
Order size Machine-hours
Customer relations Number of active customers
Other Not applicable

14. Define Activities, Activity Cost Pools, and Activity Measures
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Define Activities, Activity Cost Pools, and Activity Measures
Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders.
Product Designs - assigned all costs of resources consumed by designing products.
Order Size - assigned all costs of resources consumed as a consequence of the number of units produced.
Customer Relations – assigned all costs associated with maintaining relations with customers.
Other – assigned all overhead costs that are not associated with the other cost pools.
The definition for each of the activity cost pools is:
Customer Orders - assigned all costs of resources that are consumed by taking and processing customer orders.
Product Designs - assigned all costs of resources consumed by designing products.
Order Size - assigned all costs of resources consumed as a consequence of the number of units produced.
Customer Relations – assigned all costs associated with maintaining relations with customers.
Other – assigned all overhead costs that are not associated with the other cost pools.

15. Assign Overhead Costs to Activity Cost Pools
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Assign Overhead Costs to Activity Cost Pools
The second step in implementing ABC is to assign overhead costs to activity cost pools. This is also called first-stage allocation.
Classic Brass’ annual overhead costs (both manufacturing and nonmanufacturing) that it intends to assign to its activity cost pools are as shown. Notice:
The total costs for the Production Department ($1,000,000) equal the total manufacturing overhead costs shown in Classic Brass’ income statement.
The total costs for the General Administrative and Marketing Departments ($810,000) equal the marketing and general administrative expenses shown in Classic Brass’ income statement.

16. Assign Overhead Costs to Activity Cost Pools
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Assign Overhead Costs to Activity Cost Pools
Three costs included in Classic Brass’ income statement—direct materials, direct labor, and shipping—are excluded from this slide because Classic Brass’ existing cost system can directly trace these costs to products or customer orders.
Direct materials, direct labor, and shipping are excluded because Classic Brass’ existing cost system can directly trace these costs to products or customer orders.

17. Assign Overhead Costs to Activity Cost Pools
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Assign Overhead Costs to Activity Cost Pools
At Classic Brass the following distribution of resource consumption across activity cost pools is determined.
Classic Brass’ cross-functional interviews resulted in resource allocations as shown. Notice for example:
The indirect factory workers allocated 25% of their time to the customer orders activity, 40% of their time to the product design activity, 20% of their time to the order size activity, 10% of their time to customer relations, and 5% of their time to the “other” activity.
100% of the factory building lease is allocated to the “other” activity. Since Classic Brass has a single production facility that it does not plan to contract or expand, the lease cost is an unavoidable organization-sustaining cost.

18. Assign Overhead Costs to Activity Cost Pools
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Assign Overhead Costs to Activity Cost Pools
Once the percentage allocations have been determined, it is a simple matter to assign costs to activity cost pools. For example, the indirect factory wages assigned to the customer orders activity ($125,000) was computed by multiplying the total amount of indirect factory wages ($500,000) by the percentage of time that indirect factory workers spent on this activity (25%).
Indirect factory wages $500,000
Percent consumed by customer orders %
$125,000

19. Assign Overhead Costs to Activity Cost Pools
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Assign Overhead Costs to Activity Cost Pools
As another example, the factory equipment depreciation assigned to the customer orders activity ($60,000) was computed by multiplying the total amount of factory equipment depreciation ($300,000) by the percentage of time that the factory equipment was used to support this activity (20%).
Factory equipment depreciation $300,000
Percent consumed by customer orders %
$ 60,000

20. Assign Overhead Costs to Activity Cost Pools
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Assign Overhead Costs to Activity Cost Pools
The completed grid of first-stage allocations is shown on your screen.

21. Calculate Activity Rates
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Calculate Activity Rates
The ABC team determines that Classic Brass will have these total activities for each activity cost pool . . .
1,000 customer orders,
400 new designs,
20,000 machine-hours,
250 customer relations activities.
The Classic Brass ABC team determined activity levels for each activity:
1,000 customer orders,
400 new designs,
20,000 machine-hours,
250 customer relations activities.
This information enabled the team to compute ABC rates for each activity by dividing the total cost in each activity cost pool by the respective quantity of the activity measure.
Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.

22. Calculate Activity Rates
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Calculate Activity Rates
The activity rate for each cost pool is computed by dividing the total cost for an activity cost pool by the total activity for that pool. For example, the customer orders activity rate is $320 per order. Importantly, this is an average figure.
Notice, the “other” cost pool does not have an activity rate. This is because these organization-sustaining costs will not be assigned to customer orders.

23. Activity-Based Costing at Classic Brass
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Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
Traced
Traced
Traced
Before proceeding, let’s get a visual perspective of the Classic Brass ABC system. The direct materials, direct labor and shipping costs were directly traced to customer orders.
Cost Objects:
Products, Customer Orders, Customers

24. Activity-Based Costing at Classic Brass
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Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Other
The first-stage allocation process assigned the remaining overhead costs to the five activity cost pools.
Cost Objects:
Products, Customer Orders, Customers

25. Activity-Based Costing at Classic Brass
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Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Customer Orders
Product
Design
Order Size
Customer
Relations
Other
Second-Stage Allocations
Then, activity measures were identified, activity levels were determined, and activity rates were computed for each activity as shown earlier. These rates will be used in the next step to assign overhead costs to customer orders.
$/Order
$/Design
$/MH
$/Customer
Cost Objects:
Products, Customer Orders, Customers
Unallocated

26. Assigning Overhead to Products
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Assigning Overhead to Products
Classic Brass Information
Standard Stanchions
Requires no new design resources.
30,000 units ordered with 600 separate orders.
Each stanchion requires 35 minutes of machine time for a total of 17,500 machine-hours.
Custom Compass Housing
Requires new design resources.
400 separate orders.
400 custom designs prepared.
1,250 compass housings produced, requiring 2 machine-hours each for a total of 2,500 machine-hours.
The data needed to assign overhead costs to Classic Brass’ two products—standard stanchions and custom compass housings—are as shown. Notice:
600 customer orders were placed for standard stanchions and 400 customer orders were placed for custom compass housings.
All 400 product designs related to custom compass housings.
Standard stanchions consumed 17,500 machine-hours and custom compass housings consumed 2,500 machine-hours.

27. Assigning Overhead to Products
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Assigning Overhead to Products
The overhead cost assignments to standard stanchions and custom compass housings are as shown. Notice:
The total overhead costs assigned to standard stanchions and custom compass housings are $524,500 and $427,500, respectively, for a total of $952,000 assigned to the two products..
The total overhead costs assigned to products ($952,000) plus the total overhead costs not assigned to products ($858,000) equal the total overhead cost of $1,810,000 from slides 18 and 23. The overhead not assigned to products consists of customer relations ($367,500) and other ($490,500).

28. Assigning Overhead to Customers
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Assigning Overhead to Customers
Let’s take a look at how Classic Brass system works for just one of the 250 customers – Windward Yachts who placed a total of three orders.
Orders
Two orders for 150 standard stanchions per order.
One order for a custom compass housing.
Windward Yachts placed three orders. Two orders were for 150 standard stanchions each, and one order was for one custom compass housing. The 300 standard stanchions required 175 machine-hours, and the custom compass housing required 2 machine-hours.
Machine-hours
The 300 standard stanchions required 175 machine-hours.
The custom compass housing required 2 machine hours.

29. Assigning Overhead to Customers
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Assigning Overhead to Customers
The total overhead cost assigned to Windward Yachts ($6,423) is calculated as shown.

30. Prepare Management Reports
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Prepare Management Reports
Product Margin Calculations
The first step in computing product margins is to gather each product’s sales and direct cost data.
One of the most common management reports prepared with ABC data is product profitability (product margin) reports.
The first step in computing product margins is to gather each product’s sales and direct cost data which are assumed to be as shown.

31. Prepare Management Reports
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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.
The second step is to incorporate the previously computed activity-based cost assignments pertaining to each product.

32. Prepare Management Reports
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Prepare Management Reports
Product Margin Calculations
The third step in computing product margins is to deduct each product’s direct and indirect costs from sales.
The third step is to compute product margins ($906,250 for standard stanchions and a loss of $49,500 for custom compass housings) by deducting each product’s direct and indirect costs from its sales.

33. Prepare Management Reports
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Prepare Management Reports
Product Margin Calculations
The product margins can be reconciled with the company’s net operating income as follows:
The product margins can be reconciled with the company’s net operating loss as shown.

34. Prepare Management Reports
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Prepare Management Reports
Customer Profitability Analysis The first step in computing Windward Yachts’ customer margin is to gather its sales and direct cost data.
The first step in computing Windward Yachts’ customer margin is to gather its sales and direct cost data which are assumed to be as shown.

35. Prepare Management Reports
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Prepare Management Reports
Customer Profitability Analysis The second step is to incorporate Windward Yachts’ previously computed activity-based cost assignments.
The second step is to incorporate Windward Yachts’ previously computed activity-based cost assignments.

36. Prepare Management Reports
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Prepare Management Reports
Customer Profitability Analysis The third step is to compute Windward Yachts’ customer margin ($699) by deducting all its direct and indirect costs from its sales.
The third step is to compute Windward Yachts’ customer margin ($699) by deducting all its direct and indirect costs from its sales.

37. Activity-Based Costing and External Reporting
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Activity-Based Costing and External Reporting
Most companies do not use ABC for external reporting because . . .
External reports are less detailed than internal reports.
It may be difficult to make changes to the company’s accounting system.
ABC does not conform to GAAP.
Auditors may be suspect of the subjective allocation process based on interviews with employees.
There are four reasons why most companies do not use ABC for external reporting purposes:
 External reports are less detailed than internal reports in the sense that individual product costs are not reported. External reports only disclose cost of goods sold and ending inventory. Therefore, if some products are undercosted and others are overcosted, the errors tend to cancel each other out when the product costs are added together.
 It is often very difficult to change a company’s accounting system because it is deeply embedded within complex computer programs that have evolved over many years.
 An ABC system, such as the one described in the chapter, does not conform to generally accepted accounting principles (GAAP). It excluded some organization-sustaining manufacturing costs and it included some nonmanufacturing costs in its product cost calculations. These cost system design attributes do not comply with GAAP.
 Auditors are likely to be uncomfortable with cost allocations that are based upon interviews with the company’s personnel. This type of subjective data can be easily manipulated by management.

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End of Chapter 8
End of Chapter 8.