TOPIC 2

ACTIVITY-BASED COSTING (ABC)

PREVIEW OF PREVIOUS TOPIC
 Traditional Costing and Activity-Based Costing
Traditional costing systems
The need for a new approach
Activity-based costing

 Illustration of Traditional Costing

versus ABC
Unit costs under traditional costing
Unit costs under ABC
Comparing unit costs
ACTIVITY-BASED COSTING VERSUS
TRADITIONAL COSTING

Traditional Costing Systems

 Allocates overhead using a single predetermined
rate.
Job order costing: direct labor cost is assumed
to be the relevant activity base.
Process costing: machine hours is the relevant
activity base.

 Assumption was satisfactory when direct labor was

a major portion of total manufacturing costs.
Wide acceptance of a high correlation between
direct labor and overhead costs.
 Traditional Costing Systems:
Continued

 Direct labor is still often the appropriate basis

for assigning overhead costs when:
Direct labor constitutes a significant part of
total product cost
and
High correlation exists between direct labor and
changes in overhead costs.

Overhead Direct Labor Products

Costs Hours/Dollars
 Need for a New Approach
 Tremendous change in manufacturing and service
industries.

 Decrease in amount of direct labor usage.

 Significant increase in total overhead costs.

 May be inappropriate to use plant-wide

predetermined overhead rates based on direct labor
or machine hours when a lack of correlation exists.

 Complex manufacturing processes may require

multiple allocation bases; this approach is called
Activity-Based Costing (ABC).
 Activity-Based Costing (ABC)

 An overhead cost allocation system that allocates

overhead to multiple activity cost pools
and
 Assigns the activity cost pools to products or services
by means of cost drivers that represent the activities
used.
 Activity-Based Costing (ABC)
Terms
 Activity: any event, action, transaction, or work
sequence that causes a cost to be incurred in producing a
product or providing a service.

 Activity Cost Pool: a distinct type of activity.

For example: ordering materials or setting up machines.

 Cost Drivers: any factors or activities that have a direct

cause-effect relationship with the resources consumed.
The Logic Behind ABC

Products consume activities,

and
activities consume resources.
 Activity-Based Costing (ABC) – Continued

 ABC allocates overhead costs in two stages:

Stage 1: Overhead costs are allocated to activity

cost pools.

Stage 2: The overhead costs allocated to the cost

pools is assigned to products using cost
drivers.

 The more complex a product’s manufacturing

operation, the more activities and cost drivers likely
to be present.
Activities and Related Cost Drivers
ABC System Design – Lift Jack Company
 Traditional Costing vs ABC

 ABC does not replace an existing job

order/process cost system.

 ABC does segregate overhead into various

cost pools to provide more accurate cost
information.

 ABC, thus, supplements – it does not replace

– the traditional cost system.
 Traditional Costing vs ABC
An Illustration

 Atlas Company produces two automotive antitheft devices:

 The Boot: a high volume item with sales totaling 25,000 per year
 The Club: a low volume item with sales totaling 5,000 per year

 Each product requires 1 hour of direct labor

 Total annual direct labor hours (DLH) 30,000 (25,000 + 5000)
 Direct labor cost $12 per unit for each product

 Expected annual manufacturing overhead costs $900,000

 Direct materials cost:

 The Boot - $40 per unit
 The Club - $30 per unit
 Activity-Based Costing:
A Closer Look

More accurate product costing through:

 Use of more cost pools to assign overhead costs
 Enhanced control over overhead costs
 Better management decisions
Activity-Based Costing: A Closer Look
Limitations of ABC

 Can be expensive to use

 Some arbitrary allocations continue
 Activity-Based Costing:
A Closer Look
Use ABC When One or More of the Following Exist:
 Products differ greatly in volume/manufacturing complexity
 Products lines are
 Numerous
 Diverse
 Require different degrees of support services
 Overhead costs are a significant portion of total costs
 Significant change in manufacturing process or number of
products
 Managers ignore data from existing system and instead use
“bootleg” costing data
 Value-Added vs.
Non-Value-Added Activities
Study Objective 6

Activity Based Management (ABM):

 An extension of ABC from a product costing system to a

management function
that focuses on reducing costs and improving processes and
decision making
 A refinement of ABC used in ABM classifies activities as
either value-added or non-value-added.
 Value-Added vs.
Non-Value-Added Activities
Value-Added Activity
An activity that increases the worth
of a product or service such as:

Manufacturing Company Service Company

engineering design performing surgery
machining legal research services
assembly delivering packages
painting
packaging
 Value-Added vs.
Non-Value-Added Activities
Non-Value-Added Activities
An activity that adds cost to, or increases the time
spent on, a product/service without increasing its
market value such as:
Manufacturing Company Service Company
Repair of machines Taking appointments
Storage of inventory Reception
Moving of raw materials, Bookkeeping/billing
assemblies, and finished goods Traveling
Building maintenance Ordering supplies
Inspections
Inventory Control
 CLASSIFICATION OF
ACTIVITY LEVELS

 Unit-level activities:
Performed for each unit of production
 Batch-level activities:
Performed for each batch of product
 Product-level activities:
Performed in support of an entire product line, but
not always performed every time a new unit or
batch is produced
 Facility-level activities:
Required to support or sustain an entire production
process
 Hierarchy of Activity Levels
Four Levels Types of Activities Cost Drivers
Unit-Level Activities Machine-related: Machine Hours
Drilling, cutting, milling
Labor-related Direct labor hours/cost
Assembling, painting
Batch-Level Activities Equipment setups Number of setups/setup time
Purchase ordering Number of purchase orders
Inspection Number of inspections or
inspection time
Material handling Number of material moves
Product-Level Activities Product design Number of product designs
Engineering changes Number of changes
Facility-Level Activities Plant management Number of employees
salaries managed
Plant depreciation Square footage
Property taxes Square footage
Utilities Square footage
 Activity-Based Costing
in Service Industries

Similarities with Manufacturing Firms

 Overall objective:
Identify key cost-generation activities and keep track of quantity
of activities performed for each service provided

 General approach is to identify activities, cost pools, and

cost drivers

 Labeling of activities as value-added or non-value-added

 Reduction of non-value-added activities

 Activity-Based Costing
in Service Industries

Major difficulty to implementing

ABC:

A larger proportion of overhead

costs are company-wide costs
that cannot be directly traced to
specific services.
 Summary of Study Objectives
 Recognize the difference between traditional and activity-based
costing.
Traditional system allocates overhead to products using
predetermined unit-based output rate.
ABC allocates overhead to activity cost pools and assigns cost
to products using cost drivers.

 Identify the steps in the development of an activity-based

costing system.
Step 1: Identify the major activities and allocate the overhead costs
to cost pools.
Step 2: Identify the cost driver highly correlated to the cost pool.
Step 3: Compute the overhead rate per cost driver.
Step 4: Assign cost pools to products or services using the overhead
rates.
 Summary of Study Objectives
 Know how companies identify cost pools used in ABC.
Analyze each operation or process, document and time every task, action, or
transaction.

 Know how companies identify and use cost drivers in ABC.

Cost drivers identified for assigning activity cost pools must:
 Accurately measure the consumption of the activity
 Have related data easily available.

 Understand the benefits and limitations of ABC

Benefits:
 Enhanced control over overhead costs
 Better management decisions
Limitations:
 Higher costs accompany multiple activity centers and cost
drivers
 Some costs must still be allocated arbitrarily
 Summary of Study Objectives
 Differentiate between value-added and non-value-added activities.
Value-added activities increase the worth of a product or service.
Non-value-added activities add cost to, or increase the time spent on, a
product or service without increasing its market value.

 Understand the value of using activity levels in ABC

Activities may be classified as:
 Unit-level
 Batch-level
 Product-level
 Facility-level

Failure to recognize this classification can result

in distorted product costing.
 Summary of Study Objectives

 Apply ABC to service industries.

Same objective – improved costing of services
provided.
The general approach to costing is also the
same:
 analyze operations
 identify activities
 accumulate overhead costs by activity
cost pools
 identify and use cost drivers to assign
cost to services
 Appendix
Just-In-Time Processing (JIT)
A processing system dedicated to having the
right amount of materials, products, or parts
arrive as they are needed, thereby reducing
the amount of inventory.
Just-In-Time Processing

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sneakers... shoe laces directly
got it! to the factory.

Sales Order
Received
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Cu st o mer
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 JIT Processing
Objective of JIT:
Eliminate all manufacturing inventories

Elements of JIT:
 Dependable suppliers
 Multi-skilled work force
 Total quality control system

Benefits of JIT:
 Reduced inventory
 Enhanced product quality
 Reduced rework and storage costs
 Savings from improved flow of goods