Activity-Based Costing:

A Tool to Aid Decision Making

Chapter 8

© 2010 The McGraw-Hill Companies, Inc.

 Activity–Based Costing (ABC)

ABC is designed to ABC is a

good supplement
provide managers with to our traditional
cost information for cost system
I agree!
strategic and other
decisions that potentially
affect capacity and
therefore affect “fixed”
as well as variable costs.

McGraw-Hill/Irwin Slide 2
 Learning Objective 1

Understand activity-based
costing and how it differs
from a traditional costing
system.

McGraw-Hill/Irwin Slide 3
 How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.

Manufacturing Nonmanufacturing
costs costs

Traditional ABC
product costing product costing

 ABC assigns both types of costs to products.

McGraw-Hill/Irwin Slide 4
 How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.

Manufacturing Nonmanufacturing
costs costs

Some
All

Traditional ABC
product costing product costing

 ABC does not assign all manufacturing costs to products.

McGraw-Hill/Irwin Slide 5
 How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Level of complexity

Activity–Based
Costing

Departmental
Overhead
Rates
Plantwide
Overhead
Rate

Number of cost pools

 ABC uses more cost pools.
McGraw-Hill/Irwin Slide 6
 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.

 ABC uses more cost pools.

McGraw-Hill/Irwin Slide 7
 How Costs are Treated Under
Activity–Based Costing
An event that causes the
Activity consumption of overhead
resources.

A “cost bucket” in which

Activity costs related to a single
Cost Pool activity measure are
accumulated.
$$
$
$ $
$

McGraw-Hill/Irwin Slide 8
 How Costs are Treated Under
Activity–Based Costing

The term cost driver is

Activity
also used to refer to
Measure
an activity measure.

An allocation base
in an activity-based
costing system.

McGraw-Hill/Irwin Slide 9
 How Costs are Treated Under
Activity–Based Costing

Two common types of activity measures:

Transaction Duration
driver driver

Simple count A measure

of the number of of the amount
times an activity of time needed
occurs. for an activity.

McGraw-Hill/Irwin Slide 10
 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 usually rely on volume

measures such as direct labor hours and/or machine
hours to allocate all overhead costs to products.
McGraw-Hill/Irwin Slide 11
 How Costs are Treated Under
Activity–Based Costing
Unit-Level Batch-Level
Activity Activity

Manufacturing
companies typically combine
their activities into five
classifications.

Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
McGraw-Hill/Irwin Slide 12
 Characteristics of Successful ABC
Implementations

Strong top
management support
Link to evaluations
and rewards

Cross-functional
involvement

McGraw-Hill/Irwin Slide 13
 Baxter Battery – An ABC Example
Baxter Battery Company
Income Statement
Year Ended December 31, 2009

Sales $ 50,000,000
Cost of goods sold
Direct materials $ 15,000,000
Direct labor 12,000,000
Manufacturing overhead 14,000,000 41,000,000
Gross margin 9,000,000
Selling and administrative expenses
Shipping expenses 3,000,000
Marketing expenses 2,000,000
General administrative expenses 6,000,000 11,000,000
Net operating income
loss $ (2,000,000)

Manufacturing overhead is allocated to products using

a single plantwide overhead rate based on machine hours.

McGraw-Hill/Irwin Slide 14
  Define Activities, Activity Cost Pools,
and Activity Measures

At Baxter Battery, the ABC team, selected the following

activity cost pools and activity measures:

McGraw-Hill/Irwin Slide 15
  Define Activities, Activity Cost Pools,
and Activity Measures
 Customer Orders - assigned all costs of resources
that are consumed by taking and processing
customer orders.
 Design Changes - assigned all costs of resources
consumed by customer requested design changes.
 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 organization-sustaining costs
and unused capacity costs

McGraw-Hill/Irwin Slide 16
 Learning Objective 2

Assign costs to cost pools

using a first-stage allocation.

McGraw-Hill/Irwin Slide 17
  Assign Overhead Costs to Activity Cost
Pools

McGraw-Hill/Irwin Slide 18
  Assign Overhead Costs to Activity Cost
Pools

Direct materials, direct labor, and shipping are excluded

because Baxter Battery’s existing cost system can directly
trace these costs to products or customer orders.
McGraw-Hill/Irwin Slide 19
  Assign Overhead Costs to Activity Cost
Pools
At Baxter Battery the following distribution of resource
consumption across activity cost pools is determined.

McGraw-Hill/Irwin Slide 20
  Assign Overhead Costs to Activity Cost
Pools

Indirect factory wages $6,000,000

Percent consumed by customer orders 30%
$1,800,000

McGraw-Hill/Irwin Slide 21
  Assign Overhead Costs to Activity Cost
Pools

Factory equipment depreciation $3,500,000

Percent consumed by customer orders 20%
$ 700,000

McGraw-Hill/Irwin Slide 22
  Assign Overhead Costs to Activity Cost
Pools

McGraw-Hill/Irwin Slide 23
 Learning Objective 3

Compute activity
rates for cost pools.

McGraw-Hill/Irwin Slide 24
  Calculate Activity Rates

The ABC team determines that Baxter Battery will have

these total activities for each activity cost pool . . .
 10,000 customer orders,
 4,000 design changes,
 800,000 machine-hours,
 2,000 customers served.

Now the team can compute the individual

activity rates by dividing the total cost for
each activity by the total activity levels.

McGraw-Hill/Irwin Slide 25
  Calculate Activity Rates

McGraw-Hill/Irwin Slide 26
 Activity–Based Costing at Baxter Battery
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

Traced Traced Traced

Cost Objects:
Products, Customer Orders, Customers

McGraw-Hill/Irwin Slide 27
 Activity–Based Costing at Baxter Battery
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Design Order Customer

Other
Orders Changes Size Relations

Cost Objects:
Products, Customer Orders, Customers

McGraw-Hill/Irwin Slide 28
 Activity–Based Costing at Baxter Battery
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Design Order Customer

Other
Orders Changes Size Relations

Second-Stage Allocations

$/Order $/Change $/MH $/Customer

Cost Objects:
Unallocated
Products, Customer Orders, Customers

McGraw-Hill/Irwin Slide 29
 Learning Objective 4

Assign costs to a cost object

using a second-stage
allocation.

McGraw-Hill/Irwin Slide 30
  Assigning Overhead to Products
Baxter Battery Information
SureStart
1. Requires no new design resources.
2. 800,000 batteries ordered with 4,000 separate orders.
3. Each SureStart requires 36 minutes of machine
time for a total of 480,000 machine-hours.

LongLife
1. Requires new design resources.
2. 400,000 batteries ordered with 6,000 separate orders.
3. 4,000 custom designs prepared.
4. Each LongLife requires 48 minutes of machine
time for a total of 320,000 machine-hours.

McGraw-Hill/Irwin Slide 31
  Assigning Overhead to Products

McGraw-Hill/Irwin Slide 32
 Assigning Overhead to Customers
Let’s take a look at how Baxter Battery’s system works for just
one of the 2,000 customers – Acme Auto Parts who placed a
total of twelve orders. Note that the four orders for LongLifes
required a design change.

Orders
1. Eight orders for 60 SureStarts per order.
2. Four orders for 50 LongLifes per order.

Machine-hours
1. The 480 SureStarts required 288 machine-hours.
2. The 200 LongLifes required 160 machine hours.

McGraw-Hill/Irwin Slide 33
 Assigning Overhead to Customers

McGraw-Hill/Irwin Slide 34
 Learning Objective 5

Use activity-based costing to

compute product and
customer margins.

McGraw-Hill/Irwin Slide 35
  Prepare Management Reports
Product Margin Calculations
The first step in computing product margins is to
gather each product’s sales and direct cost data.
SureStarts LongLifes Total
Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Direct costs
Direct material 9,000,000 6,000,000 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000
Shipping 2,000,000 1,000,000 3,000,000

McGraw-Hill/Irwin Slide 36
  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.

SureStarts LongLifes Total

Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Direct costs
Direct material 9,000,000 6,000,000 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000
Shipping 2,000,000 1,000,000 3,000,000
ABC cost assignments
Customer orders 1,808,000 2,712,000 4,520,000
Design changes 3,040,000 3,040,000
Order size 3,120,000 2,080,000 5,200,000

McGraw-Hill/Irwin Slide 37
  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.
SureStarts LongLifes
Sales $ 31,300,000 $ 18,700,000
Costs
Direct material $ 9,000,000 $ 6,000,000
Direct labor 7,000,000 5,000,000
Shipping 2,000,000 1,000,000
Customer orders 1,808,000 2,712,000
Design changes 3,040,000
Order size 3,120,000 2,080,000
Total cost 22,928,000 19,832,000
Product margin $ 8,372,000 $ (1,132,000)

McGraw-Hill/Irwin Slide 38
  Prepare Management Reports
Product Margin Calculations
The product margins can be reconciled with
the company’s net operating income as follows:

SureStarts LongLifes Total

Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Total costs 22,928,000 19,832,000 42,760,000
Product margins $ 8,372,000 $ (1,132,000) $ 7,240,000

Less costs not assigned to products:

Customer relations 3,080,000
Other 6,160,000
Total 9,240,000
Nett operating income
loss $ (2,000,000)

McGraw-Hill/Irwin Slide 39
  Prepare Management Reports
Customer Margin Analysis
The first step in computing Acme Auto Parts’ customer
margin is to gather its sales and direct cost data.

Acme Auto
Parts
Sales $ 29,200
Direct costs
Direct material 7,500
Direct labor 6,700
Shipping 1,700

McGraw-Hill/Irwin Slide 40
  Prepare Management Reports
Customer Margin Analysis
The second step is to incorporate Acme Auto Parts’
previously computed activity-based cost assignments.
Acme Auto
Parts
Sales $ 29,200
Direct costs
Direct material 7,500
Direct labor 6,700
Shipping 1,700
ABC cost assignments
Customer orders 5,424
Product design 3,040
Order size 2,912
Customer relations 1,540

McGraw-Hill/Irwin Slide 41
  Prepare Management Reports
Customer Margin Analysis
The third step is to compute Acme Auto Parts’ customer margin of
$384 by deducting all its direct and indirect costs from its sales.
Acme Auto Parts
Sales $ 29,200
Direct costs
Direct material $ 7,500
Direct labor 6,700
Shipping 1,700
Customer orders 5,424
Product design 3,040
Order size 2,912
Customer relations 1,540 28,816
Customer margin $ 384

McGraw-Hill/Irwin Slide 42
 Product Margins Computed Using the
Traditional Cost System
The first step in computing product margins is to
gather each product’s sales and direct cost data.

SureStarts LongLifes Total

Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Direct costs
Direct material 9,000,000 6,000,000 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000

McGraw-Hill/Irwin Slide 43
 Product Margins Computed Using the
Traditional Cost System
The second step in computing product margins
is to compute the plantwide overhead rate.
Manufacturing Overhead Costs at Baxter Battery
Production Department
Indirect factory wages $ 6,000,000
Factory equipment depreciation 3,500,000
Factory utilities 2,500,000
Factory building lease 2,000,000
Total manufacturing overhead $ 14,000,000

Plantwide manufacturing $14,000,000

= = $17.50 per machine-hour
overhead rate 800,000 MH

Machine-hours
SureStarts (800,000 @ 0.60 hours) 480,000
LongLifes (400,000 @ 0.80 hours) 320,000
Total machine-hours 800,000

McGraw-Hill/Irwin Slide 44
 Product Margins Computed Using the
Traditional Cost System
The third step in computing product margins is
allocate manufacturing overhead to each product.

Machine Overhead Overhead

Hours Rate Allocated
SureStarts 480,000 $ 17.50 $ 8,400,000
LongLifes 320,000 17.50 5,600,000
Total overhead allocated to products $ 14,000,000

480,000 hours × $17.50 per hour = $8,400,000

McGraw-Hill/Irwin Slide 45
 Product Margins Computed Using the
Traditional Cost System
The fourth step is to actually
compute the product margins.

SureStarts LongLifes Total

Sales $ 31,300,000 $ 18,700,000 $ 50,000,000
Cost of goods sold
Direct materials $ 9,000,000 $ 6,000,000 $ 15,000,000
Direct labor 7,000,000 5,000,000 12,000,000
Manufacturing overhead 8,400,000 24,400,000 5,600,000 16,600,000 14,000,000 41,000,000
Product margin $ 6,900,000 2,100,000 9,000,000
Selling and administrative 11,000,000
Nett operating
operating income
loss $ (2,000,000)

Shipping expenses $ 3,000,000

Marketing expenses 2,000,000
General administrative expenses 6,000,000
$ 11,000,000

McGraw-Hill/Irwin Slide 46
 Differences Between ABC and Traditional
Product Costs

SureStarts LongLifes
Product margins – traditional $ 6,900,000 $ 2,100,000
Product margins – ABC 8,372,000 (1,132,000)
Change in reported margins $ 1,472,000 $ (3,232,000)

The traditional cost The traditional cost

system overcosts the system undercosts the
SureStarts and reports LongLifes and reports
a lower product a higher product
margin for this product. margin for this product.

McGraw-Hill/Irwin Slide 47
 Differences Between ABC and Traditional
Product Costs
There are three reasons why the
reported product margins for the two
costing systems differ from one another.

Traditional costing allocates all manufacturing

overhead to products. ABC costing only assigns
manufacturing overhead costs consumed by
products to those products.

McGraw-Hill/Irwin Slide 48
 Differences Between ABC and Traditional
Product Costs
There are three reasons why the
reported product margins for the two
costing systems differ from one another.

 Traditional costing allocates all manufacturing

overhead costs using a volume-related allocation
base. ABC costing also uses non-volume related
allocation bases.

McGraw-Hill/Irwin Slide 49
 Differences Between ABC and Traditional
Product Costs
There are three reasons why the
reported product margins for the two
costing systems differ from one another.

 Traditional costing disregards selling and

administrative expenses because they are
assumed to be period expenses. ABC costing
directly traces shipping costs to products and
includes nonmanufacturing overhead costs caused
by products in the activity cost pools that are
assigned to products.

McGraw-Hill/Irwin Slide 50
 Targeting Process Improvement
Activity-based management is
used in conjunction with ABC to
identify areas that would benefit
from process improvements.

While the theory of constraints

approach discussed in Chapter 1
is a powerful tool for targeting
improvement efforts, activity rates
can also provide valuable clues on
where to focus improvement efforts.

Benchmarking can be used to compare activity cost

information with world-class standards of performance
achieved by other organizations.
McGraw-Hill/Irwin Slide 51
 Activity-Based Costing and External Reporting

Most companies do not use ABC

for external reporting because . . .
1. External reports are less detailed than internal
reports.
2. It may be difficult to make changes to the company’s
accounting system.
3. ABC does not conform to GAAP.
4. Auditors may be suspect of the subjective allocation
process based on interviews with employees.

McGraw-Hill/Irwin Slide 52
 ABC Limitations

Substantial resources Resistance to

required to implement unfamiliar numbers
and maintain. and reports.

Desire to fully Potential

allocate all costs misinterpretation of
to products. unfamiliar numbers.

Does not conform to

GAAP. Two costing
systems may be needed.

McGraw-Hill/Irwin Slide 53
ABC Action Analysis

Appendix 8A

© 2010 The McGraw-Hill Companies, Inc.

 Learning Objective 6

(Appendix 8A)
Prepare an action analysis
report using activity-based
costing data and interpret
the report.

McGraw-Hill/Irwin Slide 55
 Appendix 8A: ABC Action Analysis

Conventional ABC analysis does not

identify potentially relevant costs. An
action analysis report helps because it:
• Shows what costs have been
assigned to a cost object.
• Indicates how difficult it would be to
adjust those costs in response to
changes in the level of activity.

McGraw-Hill/Irwin Slide 56
 Appendix 8A: ABC Action Analysis

Constructing an action analysis report

begins with the first-stage allocation process.
In addition to computing an overall activity
rate for each activity cost pool, an activity
rate is computed for each type of overhead
cost that is consumed supporting a given
activity.
Let’s revisit the stage-one allocations
from the Baxter Battery Company example
that we discussed earlier.

McGraw-Hill/Irwin Slide 57
 Appendix 8A: ABC Action Analysis

$1,800,000 ÷ 10,000 orders = $180 per order

Other entries in the table are computed similarly.
McGraw-Hill/Irwin Slide 58
 $180 per order × 4,000 orders = $720,000
Other entries in the table are computed similarly.
McGraw-Hill/Irwin Slide 59
 $180 per order × 6,000 orders = $1,080,000
Other entries in the table are computed similarly.
McGraw-Hill/Irwin Slide 60
 Appendix 8A: ABC Action Analysis
Next, label each cost using an ease of adjustment
code:
• Green costs adjust more or less automatically to
changes in activity level without any action by
managers.
• Yellow costs can be adjusted to changes in activity
level, but it would require management action to
realize the change in cost.
• Red costs can be adjusted to changes in activity
level only with a great deal of difficulty and with
management intervention.

McGraw-Hill/Irwin Slide 61
 Appendix 8A: ABC Action Analysis
Action Analysis of LongLife Batteries
Sales $ 18,700,000
Green costs
Direct materials $ 6,000,000
Shipping costs 1,000,000 7,000,000
Green margin $ 11,700,000
Yellow costs
Direct labor 5,000,000
Indirect factory wages 3,360,000
Factory utilities 850,000
Administrative wages and salaries 1,280,000
Office equipment depreciation 252,000
Marketing wages and salaries 420,000
Selling expenses 60,000 11,222,000
Yellow margin $ 478,000
Red costs
Factory equipment depreciation 1,610,000
Factory building lease -
Administrative building lease - 1,610,000
Red margin $ (1,132,000)

McGraw-Hill/Irwin Slide 62
Using a Modified Form of Activity-Based
Costing to Determine Product Costs for
External Reports
Appendix 8B

© 2010 The McGraw-Hill Companies, Inc.

 Learning Objective 7

(Appendix 8B)
Use activity-based costing
techniques to compute unit
product costs for external
reports.

McGraw-Hill/Irwin Slide 64
 Appendix 8B
A modified form of activity-based
costing can be used to develop product
costs for external financial reports.

ABC product costs:

• Include organization-sustaining costs
and unused capacity costs.
• Exclude nonmanufacturing costs even
if they are caused by the products.

McGraw-Hill/Irwin Slide 65
 Appendix 8B

Simmons’ Industries provides the following information

for the company as a whole and for its only two
products—deluxe and standard hedge trimmers.

Total estimated manufacturing overhead $ 1,800,000

Total estimated direct labor hours 400,000

Deluxe Standard
Direct materials cost per unit $ 38.00 $ 28.00
Direct labor cost per unit $ 24.00 $ 12.00
Direct labor hours per unit 2.0 1.0
Units produced 100,000 200,000

McGraw-Hill/Irwin Slide 66
 Appendix 8B

Assuming that Simmons’ traditional cost system relies

on one predetermined plantwide overhead rate with
direct labor-hours (DLHs) as the allocation base, then
its plantwide overhead rate is computed as follows:

Predetermined $1,800,000
= = $4.50 per DLH
overhead rate 400,000 DLHs

McGraw-Hill/Irwin Slide 67
 Appendix 8B

Simmons’ traditional cost system would

report unit product costs as follows:

Deluxe Standard
Direct materials cost per unit $ 38.00 $ 28.00
Direct labor cost per unit 24.00 12.00
Manufacturing overhead per unit 9.00 4.50
Unit product cost $ 71.00 $ 44.50

2.0 DLH × $4.50 per DLH

1.0 DLH × $4.50 per DLH

McGraw-Hill/Irwin Slide 68
 Appendix 8B

The ABC project team at Simmons has

developed the following basic information.

Estimated
Overhead
Activity and Activity Measures Cost Expected Activity
Deluxe Standard Total
Direct labor support (DLHs) $ 900,000 200,000 200,000 400,000
Machine setups (setups) 600,000 400 100 500
Parts administration (part types) 300,000 200 100 300
Total manufacturing overhead $ 1,800,000

McGraw-Hill/Irwin Slide 69
 Appendix 8B

We can calculate the following activity rates:

Estimated Total
Overhead Expected
Activity and Activity Measures Cost Activity Activity Rate
Direct labor support (DLHs) $ 900,000 ÷ 400,000 = $ 2.25 per DLH
Machine setups (setups) 600,000 ÷ 500 = $ 1,200 per setup
Parts administration (part types) 300,000 ÷ 300 = $ 1,000 per part type
Total manufacturing overhead $ 1,800,000

Using the new activity rates, let’s assign overhead

to the two products based upon expected activity.

McGraw-Hill/Irwin Slide 70
 Appendix 8B
Deluxe Product
Expected Activity
Activity and Activity Measures Activity Rate Amount
Direct labor support (DLHs) 200,000 × $ 2.25 = $ 450,000
Machine setups (setups) 400 × $ 1,200 = 480,000
Parts administration (part types) 200 × $ 1,000 = 200,000
Total overhead cost assigned $ 1,130,000

Standard Product
Expected Activity
Activity and Activity Measures Activity Rate Amount
Direct labor support (DLHs) 200,000 × $ 2.25 = $ 450,000
Machine setups (setups) 100 × $ 1,200 = 120,000
Parts administration (part types) 100 × $ 1,000 = 100,000
Total overhead cost assigned $ 670,000
McGraw-Hill/Irwin Slide 71
 Appendix 8B

Activity-based unit product costs for both product lines

Premium Standard
Direct materials cost per unit $ 38.00 $ 28.00
Direct labor cost per unit 24.00 12.00
Manufacturing overhead per unit 11.30 3.35
Unit product cost $ 73.30 $ 43.35

McGraw-Hill/Irwin Slide 72
 Appendix 8B

Activity-based unit product costs for both product lines

Premium Standard
Direct materials cost per unit $ 38.00 $ 28.00
Direct labor cost per unit 24.00 12.00
Manufacturing overhead per unit 11.30 3.35
Unit product cost $ 73.30 $ 43.35

$1,130,000 ÷ 100,000 units

$670,000 ÷ 200,000 units

McGraw-Hill/Irwin Slide 73
 Appendix 8B
Comparing the two approaches
Activity-Based Costing Traditional Costing
Deluxe Standard Deluxe Standard
Direct material $ 38.00 $ 28.00 $ 38.00 $ 28.00
Direct labor 24.00 12.00 24.00 12.00
Manufacturing overhead 11.30 3.35 9.00 4.50
Unit product cost $ 73.30 $ 43.35 $ 71.00 $ 44.50

Note that the unit product cost of a Standard unit

decreased from $44.50 to $43.35 . . . . .

. . . . . while the unit cost of a Deluxe unit increased from

$71.00 to $73.30.

McGraw-Hill/Irwin Slide 74
 End of Chapter 8

McGraw-Hill/Irwin Slide 75