1. Activity Based Costing: A Tool to Aid Decision Making
Chapter8
Activity Based Costing: A Tool to Aid Decision Making

2. ABC Costing Used by management for internal decision making, such as…
Identify activities that would benefit from process improvement
Reduce fixed costs
Eliminate waste
Reduce processing time

3. Traditional Cost System
Direct labor and direct material are traced to products.
A single pool of overhead costs.
Overhead Allocation: actual usage of the cost driver (DLH or MH) times the predetermined rate.

4. Traditional Cost System
Inaccuracies arise when products do not use similar amounts of resources.
Solution: Activity based cost (ABC) systems.

5. Link ABC Cost System to Compensation
Requires people to change behavior.
Should be linked to evaluation and pay
Should be a cooperative venture

6. Designing an ABC System
Steps for Implementing ABC
Identify and define activities and activity pools.
Where possible, trace costs to activities and cost objects.
Assign costs to activity cost pools.
Calculate activity rates.
Assign costs to cost objects.
Prepare management reports.

7. ABC Terminology
Activity: Any event that causes overhead to be consumed.
Activity cost pool: Buckets (categories) in which costs of an activity are accumulated.
Activity measure: Allocation base (also referred to as cost driver.

8. Identifying Activity to Include
Unit-Level
Activity
Batch-Level
Activity
A part of the production
process for which management
wants a separate reporting of the
costs of the activity involved.
Product-Level
Activity
Customer-Level
Activity
Organization- sustaining
Activity

9. Types of Activities
Unit level: activity performed each time a unit is produced.
Batch level: cost incurred each time a batch is handled, regardless of the number of units in the batch.
Example: Cost of setting up machines to produce a particular product.

10. Types of Activities
Product level: costs related to a specific product that are unrelated to the number of batches or units produced.
Cost of designing the product
Cost of advertising a particular product.

11. Types of Activities
Customer level activities: costs that arise from interactions with specific customers.
Cost of sales calls
Cost of customer support that does not arise from specific products.

12. Types of Activities
Organization sustaining activities: cost incurred regardless of which customers are served.
Heating factory building
Chief executive office
Company wide services

13. At Classic Brass, the ultimate cost objects are:
The Mechanics of ABC
At Classic Brass, the ultimate cost objects are:
Products,
Customer orders, and
Customers.
One overhead cost - shipping - can be traced directly to customer orders.
The company’s overhead costs are shown on the next slide.

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

16. 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

17. 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

18. Assigning Costs to Activity Cost Pools
Management at Classic Brass believes overhead should be distributed as follows:

19. Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.
Indirect factory wages $500,000
Percent consumed by customer orders %
$125,000

20. Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.
Factory equipment depreciation $300,000
Percent consumed by customer orders %
$ 60,000

21. Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.

22. Exercise 1: Assigning Costs to Activity Pools
Use the Production Department costs on the next slide (23).
Assume the same percentage allocation of costs to the activity pools as shown in slide 18.
Calculate the Indirect Labor cost that will be assigned to the 5 activity cost pools.
Record your answer on slide 24.

24. Exercise 1 Assigning Costs to Activity Cost Pools
Indirect factory wages $400000
Percent consumed by customer orders 25%

25. Computation of Activity Rates
The ABC team has determined that Classic Brass has the following total activities for each activity cost pool . . .
1,000 customer orders,
200 new designs,
20,000 machine-hours
100 customers.
Now the team can compute the individual activity rates.

26. Computation of Activity Rates, Slide 21 data

27. Computation of Activity Rates

28. Assigning Costs to Cost Objects
Let’s take a look at how our system works for just one customer - Windward Yachts.
Windward ordered two products - Stanchions and Custom Compass housings. Here are the details:
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.

29. Assigning Costs to Cost Objects
Let’s take a look at how our system works for just one customer - Windward Yachts.
Windward ordered two products - Stanchions and Custom Compass housings. Here are the details:
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.

30. Assigning Costs to Cost Objects
Overhead cost of two orders for standard stanchions.
$125 per order × 2 orders = $250

31. Assigning Costs to Cost Objects
Overhead cost of two orders for standard stanchions.

32. Assigning Costs to Cost Objects
Overhead cost of one order for custom compass housing.
$125 per order × 1 order = $125

33. Assigning Costs to Cost Objects
Overhead cost of one order for custom compass housing.

34. Product Margins

35. Product Margins

36. Predetermined manufacturing
Product Margins
Traditional Cost Accounting System
Predetermined manufacturing
overhead rate
$1,000,000
20,000 MH
= $50/MH =

37. 400 units x 0.5 MH/unit x $50/MH = $10,000
Product Margins
Traditional Cost Accounting System
400 units x 0.5 MH/unit x $50/MH = $10,000