1. Activity Based Costing: A Tool to Aid Decision Making
Chapter 8
Activity Based Costing: A Tool to Aid Decision Making

2. Activity Based Costing (ABC)
ABC is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore “fixed” costs.
ABC is a
good supplement to our traditional cost system
I agree!

3. Activity Based Costing (ABC)
Both manufacturing
and nonmanufacturing
costs may be
assigned to
products.
A number
of cost pools each allocated to a product
or cost object.
Some manufacturing
costs may be excluded
from product
costs.
Allocation bases often
differ from
traditional costing
systems.
Overhead rates may
be based on activity
at capacity.

4. How Costs are Treated Under Activity-Based Costing
Departmental
Overhead
Rates
Level of Complexity
Plantwide
Overhead
Rate
Overhead Allocation

5. Plantwide Overhead Rate
Companies tended to use direct labor as
the overhead allocation base. There was a belief that direct labor and overhead costs were highly correlated.

6. Departmental Overhead Rates
Finishing Department
Many companies have a system in which each department has its own overhead rate.
Painting Department
Shipping Department

7. Departmental Overhead Rates
Indirect
Labor
Indirect
Materials
Other
Overhead
Stage One:
Costs assigned
to pools
Department 1
Department 2
Department 3
Cost pools

8. Departmental Overhead Rates
Indirect
Labor
Indirect
Materials
Other
Overhead
Stage One:
Costs assigned
to pools
Department 1
Department 2
Department 3
Cost pools
Stage Two:
Costs applied
to products
Products

9. Departmental Overhead Rates
Indirect
Labor
Indirect
Materials
Other
Overhead
Stage One:
Costs assigned
to pools
Department 1
Department 2
Department 3
Cost pools
Direct
Labor
Hours
Machine
Hours
Raw
Materials
Cost
Stage Two:
Costs applied
to products
Products
Departmental Allocation Bases

10. Cost of Idle Capacity Activity Based Costing
Traditional Cost Accounting
The predetermined overhead rate is based on budgeted activity. This results in applying overhead costs of unused, or idle, capacity.
Activity Based Costing
Products are charged for the costs of capacity they use – not for the costs of capacity they don’t use.

11. Designing an ABC System
Cost Objects
(e.g., products
and customers)
Activities
Consumption
of Resources
Cost

12. Designing of an ABC System
Steps for Implementing ABC
Identify and define activities and activity cost pools.
Trace costs to activities and cost objects.
Assign costs to activity cost pools.
Calculate activity rates.
Assign costs to cost objects.
Prepare management reports.

13. Identify and Define Activities and Activity Cost Pools
A part of the production
process for which management
wants a separate reporting of the
costs of the activity involved.
Unit-Level
Activity
Batch-Level
Product-Level
Customer-Level
Organization- sustaining

14. Identify and Define Activities and Activity Cost Pools
At Classic Brass, the ABC team, selected the following activity cost pools and activity measures:

15. Identify and Define Activities and Activity Cost Pools$
Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity measure in the ABC system.

16. Identify and Define Activities and Activity Cost Pools
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.

17. Whenever Possible, Directly Trace Overhead Costs to Activities and Cost Objects

18. Assign Costs to Activity Cost Pools
At Classic Brass the following distribution of resource consumption across activity cost pools is determined.
**Not included because they are directly traced to customer orders.

19. Assign Costs to Activity Cost Pools
Indirect factory wages $500,000
Percent consumed by customer orders %
$125,000

20. Assign Costs to Activity Cost Pools
Factory equipment depreciation $300,000
Percent consumed by customer orders %
$ 60,000

21. Assign Costs to Activity Cost Pools

22. Calculate Activity Rates
The ABC team determines that Classic Brass will have these total activities for each activity cost pool . . .
1,000 customer orders
200 new designs
20,000 machine-hours
100 customer relations activities
Now the team can compute the individual activity rates by dividing the total cost for each activity by the total activity levels.

23. Calculate Activity Rates÷

24. Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
Traced
Cost Objects:
Products, Customer Orders, Customers

25. 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
Cost Objects:
Products, Customer Orders, Customers

26. 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
Second-Stage Allocations
$/MH
$/Order
$/Design
$/Customer
Cost Objects:
Products, Customer Orders, Customers
Unallocated

27. Assigning Costs to Cost Objects
Let’s take a look at how our system works for just one customer – Windward Yachts.
Standard Stanchions (no design required)
units ordered with 2 separate orders.
2. Each stanchion required 0.5 machine-hours .
3. Selling price is $34 each.
4. Direct materials total $2,110.
5. Direct labor totals $1,850.
6. Shipping costs total $180.
Custom Compass Housing (requires new design)
1. One order during the year.
2. Each housing required 4 machine-hours .
3. Selling price is $650 each.
4. Direct materials total $13.
5. Direct labor totals $50.
6. Shipping costs total $25.

28. Assigning Costs to Cost Objects
The customer-level cost is assigned to customers directly; it is not assigned to products.

29. Prepare Management Reports

30. Prepare Management Reports
Customer Profitability Analysis

31. Predetermined manufacturing
Product Margins
Traditional Cost Accounting System
400 units x 0.5 MH/unit x $50/MH = $10,000
Predetermined manufacturing
overhead rate
$1,000,000
20,000 MH
= $50/MH =

32. Difference Between ABC and Traditional Product Costs
Batch-level or product-level costs will ordinarily shift overhead costs from high-volume products produced in large batches to low-volume products produced in small batches.
Under ABC both manufacturing and nonmanufacturing costs may be assigned to products. Organization-sustaining costs and the costs of idle capacity are not assigned to products.

33. Targeting Process Improvement
Activity-based costing can be used to identify areas that would benefit from process improvements.
The theory of constraints approach is a powerful tool for targeting the area in an organization whose improvement will yield the greatest benefits.

34. 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.

35. Limitations of ABC
ABC produces numbers, like product margins, that are at odds with numbers produced by traditional costing system. Some managers find it difficult to adjust to this change.
ABC systems are a major project requiring substantial resources. The benefits of increased accuracy must outweigh these additional costs.
ABC data can be misinterpreted and must be used with care when making decisions.

36. End of Chapter 8