Activity-Based Costing: A Tool to Aid Decision Making

Prepared by
Nour Abu Ridi & Abeer Yahya

Supervisor
Prof: Abd Alnasser Nour
Learning Objective 1
 Introduction

Assume that X ) Pen Manufacturing Company ( has an annual production capacity of

15,000 pens , The company received an order requiring the manufacture of 1,000
pens

Trace
Direct Material ab le cos
t – Di
rect a
l locate

D irect allocate
Traceable cost – 1000 (Pens order)
Direct Labor
n
u l atio
a cc um
t
Co s

Manufacturing
Overhead
 Introduction
Assume that X ) Pen Manufacturing Company ( has an annual production capacity of
15,000 pens , The company received an order requiring the manufacture of 1,000
pens

1000
Direct Material Pens
* 1 In k
* $2 =
$2000
DM

00
h ou r * $6 P/H = $30 1000 (Pens order)
1000 Pens * 0.5
Direct Labor

??
Cost pool

??
Insurance = $7,500

Manufacturing Cost accumulation Utilities = $2,500

Overhead Taxes = $7,500
Depreciation = $8,000
Total =$45,000 Rent = $20,000
 Traditional costing system
All costs are collected in one pool and these costs are distributed over the number of
units produced by using a single cost driver

DM= $2000
1000 (Pens order) DL = $ 3000
MOH=??

single cost driver (Product Volume) = $ 45,000* 1000 Pens/ 15000 Pens
=$3,000 (MOH)

Total cost = $2,000 + $3,000 + $3,000 =$8,000

Cost per pens= $8,000 / 1000 Pens = $8

 Traditional costing system
All costs are collected in one pool and these costs are distributed over the number of
units produced by using a single cost driver

DM= $2000
1000 (Pens order) DL = $ 3000
MOH=??

single cost driver (Direct labor hours …. 10000 hour ) = $ 45,000* 500 hour / 10000 hour
=$ 2,2250 (MOH)

Total cost = $2,000 + $3,000 + $2,250 =$7,250

Cost per pens= $7,250 / 1000 Pens = $7.25

 Traditional costing system
All costs are collected in one pool and these costs are distributed over the number of
units produced by using a single cost driver

DM= $2000
1000 (Pens order) DL = $ 3000
MOH=??

single cost driver ( Machine hours 30000 hour For the = $ 45,000* 3000 hour / 30000 hour
factory as a whole…3 hours for a pen) =$ 4,500 (MOH)

Total cost = $2,000 + $3,000 + $4,500 =$9,500

Cost per pens= $9,500 / 1000 Pens = $9.5

 Traditional costing system
Benefits - Easy implemented approach to
calculate the cost using a one cost
driver

- Compliance with generally accepted

accounting principles and tax reporting
regulation.

Limitation - Inaccurate product cost due to

significant portion of overhead in the
total cost.
- Lead to bad management decisions
because it excludes certain
nonmanufacturing costs.
- The inaccurate averaging or spreading
of indirect costs over products or
service units that use different
amounts of resources is called
peanut-butter costing.
 Activity–Based Costing (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

Activity-based costing is ordinarily used as a supplement to, rather than as a

replacement for, a company’s usual costing system

Most organizations that use activity

based costing have two costing systems
—the official costing system that is used
for preparing external financial reports
and the activity-based costing system
that is used for
internal decision making and for
managing activities.
 Activity-based costing and how it differs from a traditional
costing system.

Nonmanufacturing as well as manufacturing costs may be assigned to products,

but only on a cause-and-effect basis.

1. For example, ABC systems can assign sales

commissions, shipping costs, and warranty repair
costs to specific products.

Some manufacturing costs may be excluded from product costs.

1. This is because ABC only assigns a cost to a product if decisions concerning that
product will cause changes in the cost.
2. ABC excludes two types of costs from product costs:
a. Organization-sustaining costs (which will be formally defined later).
b.The costs of unused or idle capacity
 Activity-based costing and how it differs from a traditional
costing system.
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.
 Activity-based costing and how it differs from a traditional
costing system.
3. 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.

a. 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.

b. 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.
 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.
Activity–Based Costing (ABC)
 Activity–Based Costing (ABC)

Assume that X ) Pen Manufacturing Company ( has an annual production capacity of

15,000 pens , The company received an order requiring the manufacture of 1,000
pens

Trace
Direct Material ab le cos
t – Di
rect a
l locate

D irect allocate
Traceable cost – 1000 (Pens order)
Direct Labor
n
u l atio
a cc um
t
Co s

Manufacturing
Overhead
 Activity–Based Costing (ABC)

Assume that X ) Pen Manufacturing Company ( has an annual production capacity of

15,000 pens , The company received an order requiring the manufacture of 1,000
pens

1000
Direct Material Pens
* 1 In k
* $2 =
$2000
DM

00
h ou r * $6 P/H = $30 1000 (Pens order)
1000 Pens * 0.5
Direct Labor
Cost pool 1 Cost pool 2 Cost pool 3

Manufacturing Cost accumulation

Overhead

And so on ….
 Steps Activity–Based Costing (ABC)

1. Define activities
2. Resources activities
3. Resources cost pools.
4. Resources drivers .
5. Calculate activity rates ( cost per Resources drivers ) .
6. Assign overhead costs to cost objects using the activity rates and activity measures .
7. Prepare management reports.

1. Define activities, activity cost pools, and

activity measures.
2. Assign overhead costs to activity cost
pools.
3. Calculate activity rates. IN BOOK
4. Assign overhead costs to cost objects using
the activity rates and activity measures
5. Prepare management reports.
 Steps Activity–Based Costing (ABC)

Indirect Indirect Machine Batch

Inspection
material labor Setup Quality
$ 15,000
$ 50,000 $ 25,000 $ 30,000 $ 10,000

Product Product Depreciation Utilities Rent

design Testing $40,000 $25,000 $55,000
$ 15,000 $ 15,000

Insurance Safety Security Maintenance Total cost

$20,000 $25,000 $25,0000 $30,000 $380,000
Activity–Based Costing (ABC) : Steps 1 Define activities

Indirect Indirect
Inspection
material labor
$ 15,000
$ 50,000 $ 25,000

Machine Batch
Setup Quality
$ 30,000 $ 10,000

Product Product
design Testing
$ 15,000 $ 15,000
Activity–Based Costing (ABC) : Steps 1 Define activities

Depreciation Rent
$40,000 $55,000

Utilities Safety Security

$25,000 $25,000 $25,0000

Insurance Maintenance
$20,000 $30,000
Activity–Based Costing (ABC) : Steps 2 Resources activities

Indirect Indirect Materials

material labor Mandling
$ 50,000 $ 25,000

Batch
Inspection Quality &
Quality
$ 15,000 Inspection
$ 10,000

Product Product
design Testing Products
$ 15,000 $ 15,000
 Activity–Based Costing (ABC) : Steps 2 Resources activities

Depreciation Utilities Machine

Maintenance Machining
$40,000 $25,000 Setup
$30,000
$ 30,000

Insurance Safety
$20,000 $25,000
Facility Sustaining
Management

Rent Security
$55,000 $25,0000
Activity–Based Costing (ABC) Steps
3 Resources cost pools.

Materials Quality & Products Machining Facility

Mandling Inspection $30,000 $125,000 Sustaining
$75,000 $25,000 Management
4. $125,000
Resources
drivers

No. production Machine square

No. of
No. production unit footage
Inspections hours
unit 15,000 of factory
30,000 62,500 hours
15,000 10,000 sq

5.
C ost per
$3 $.84 $2 $2 $12.5
Resource
drivers
 production 1000
unit
unit 3 machine
6. No. production No. production
Inspected hours per unit
Activity unit unit
twice 3,000 -
cost 1,000 1,000
2,000
driver

7. Allocate resource costs to final cost object

$3*1000 units $.84*1000 units $2*1000 units $2*3000 units

=$3,000 + =$1,680 + +
=$2,000 =$6,000

= Total allocated costs= $12,680

 Activity–Based Costing (ABC)
Baxter Battery – An ABC Example
i.Baxter Battery—background information
1.The company makes two types of automobile batteries—SureStart (a standard
battery) and LongLife (a deluxe, higher quality battery).
2.The company has reported its first loss ever of $2,000,000 as shown on the
income statement.

Baxter Battery Company

Income Statement
Year Ended December 31, 2012

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 loss $ (2,000,000)
 Activity–Based Costing (ABC)
Step 1: 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.

At Baxter Battery, the ABC team selected the following

activity cost pools and activity measures:
Activity Cost Pools at Baxter Battery
Activity Cost Pool Activity Measure
Customer orders Number of customer orders
Design changes Number of design changes
Order size Machine-hours
Customer relations Number of active customers
Other Not applicable
 Activity–Based Costing (ABC)

Step 2: assign overhead costs to activity cost pools (this is also called first-stage
allocation)

Overhead Costs at Baxter Battery

(Manufacturing and Nonmanufacturing)

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 $ 14,000,000
General Administrative Department
Administrative wages and salaries 4,000,000
Office equipment depreciation 900,000
Administrative building lease 1,100,000 6,000,000
Marketing Department
Direct materials,
Marketing direct
wages and labor, and shipping
salaries 1,500,000are excluded
Selling expenses
because Baxter Battery’s existing cost500,000
system can2,000,000
directly
Total overhead costs $ 22,000,000
trace these costs to products or customer orders.
 Activity–Based Costing (ABC)
 Assign Overhead Costs to
Activity Cost Pools
At Baxter Battery the following distribution of resource consumption across
activity cost pools is determined.

Activity Cost Pools

Customer Design Order Customer

Orders Changes Size Relations Other Total
Production Department
Indirect factory wages 30% 30% 20% 10% 10% 100%
Factory equipment depreciation 20% 10% 60% 0% 10% 100%
Factory utilities 0% 10% 60% 0% 30% 100%
Factory building lease 0% 0% 0% 0% 100% 100%
General Administrative Department
Administrative wages and salaries 30% 10% 10% 30% 20% 100%
Office equipment depreciation 30% 10% 0% 20% 40% 100%
Administrative building lease 0% 0% 0% 0% 100% 100%
Marketing Department
Marketing wages and salaries 30% 10% 0% 50% 10% 100%
Selling expenses 20% 0% 0% 70% 10% 100%
 Activity–Based Costing (ABC)
Overhead Costs at Baxter Battery
(Manufacturing and Nonmanufacturing)
Activity Cost Pools
Customer DesignProduction Department
Customer
Orders changes Indirect
Orderfactory
Size wages
Relations Other
$ 6,000,000 Total
Production Department Factory equipment depreciation 3,500,000
Indirect factory wages $ 1,800,000 Factory utilities 2,500,000
Factory equipment depreciation Factory building lease 2,000,000 $ 14,000,000
Factory utilities General Administrative Department
Factory building lease Administrative wages and salaries 4,000,000
General Administrative Department Office equipment depreciation 900,000
Administrative wages and salaries Administrative building lease 1,100,000 6,000,000
Office equipment depreciation Marketing Department
Administrative building lease Marketing wages and salaries 1,500,000
Marketing Department Selling expenses 500,000 2,000,000
Marketing wages and salaries Total overhead costs $ 22,000,000
Selling expenses
Total

Indirect
Indirect factory
factory wages
wages $6,000,000
$6,000,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 30%
30%
$1,800,000
$1,800,000
 Activity–Based Costing (ABC)
 Assign Overhead Costs to
Activity Cost Pools Overhead Costs at Baxter Battery
(Manufacturing and Nonmanufacturing)
Activity Cost Pools
Customer Design
Production Department Customer
Orders changes Orderwages
Indirect factory Size Relations $ 6,000,000
Other Total
Production Department Factory equipment depreciation 3,500,000
Indirect factory wages $ 1,800,000 Factory utilities 2,500,000
Factory equipment depreciation 700,000 Factory building lease 2,000,000 $ 14,000,000
Factory utilities General Administrative Department
Factory building lease Administrative wages and salaries 4,000,000
General Administrative Department Office equipment depreciation 900,000
Administrative wages and salaries Administrative building lease 1,100,000 6,000,000
Office equipment depreciation Marketing Department
Administrative building lease Marketing wages and salaries 1,500,000
Marketing Department Selling expenses 500,000 2,000,000
Marketing wages and salaries Total overhead costs $ 22,000,000
Selling expenses
Total

Factory
Factory equipment
equipment depreciation
depreciation $3,500,000
$3,500,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 20%
20%
$$ 700,000
700,000
 Activity–Based Costing (ABC)
 Assign Overhead Costs to
Activity Cost Pools
Activity Cost Pools
Customer Design Customer
Orders changes Order Size Relations Other Total
Production Department
Indirect factory wages $ 1,800,000 $ 1,800,000 $ 1,200,000 $ 600,000 $ 600,000 $ 6,000,000
Factory equipment depreciation 700,000 350,000 2,100,000 - 350,000 3,500,000
Factory utilities - 250,000 1,500,000 - 750,000 2,500,000
Factory building lease - - - - 2,000,000 2,000,000
General Administrative Department
Administrative wages and salaries 1,200,000 400,000 400,000 1,200,000 800,000 4,000,000
Office equipment depreciation 270,000 90,000 - 180,000 360,000 900,000
Administrative building lease - - - - 1,100,000 1,100,000
Marketing Department
Marketing wages and salaries 450,000 150,000 - 750,000 150,000 1,500,000
Selling expenses 100,000 - - 350,000 50,000 500,000
Total $ 4,520,000 $ 3,040,000 $ 5,200,000 $ 3,080,000 $ 6,160,000 $ 22,000,000
 Activity–Based Costing (ABC)

 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
Nowthetheteam
teamcan
cancompute
computethetheindividual
individualactivity
activityrates
ratesby
by
dividing
dividingthe
thetotal
totalcost
costfor
foreach
eachactivity
activityby
bythe
thetotal
totalactivity
activity
levels.
levels.
 Activity–Based Costing (ABC)
 Calculate Activity Rates
Computation of Activity Rates
(a) (b) (a) ÷ (b)
Activity Cost Pools Total Cost Total Activity Activity Rate
Customer orders $ 4,520,000 10,000 orders $452 per order
Design changes 3,040,000 4,000 changes $760 per change
Order size 5,200,000 800,000 MHs $6.50 per MH
Customer relations 3,080,000 2,000 customers $1,540 per customer
Other 6,160,000 Not applicable Not applicable
Total $ 22,000,000
 Activity–Based Costing (ABC)
Activity–Based Costing at Baxter Battery

Direct Direct Shipping

Overhead Costs
Materials Labor Costs

Traced Traced Traced

Cost Objects:
Products, Customer Orders, Customers
 Activity–Based Costing (ABC)
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 Unallocated

Unallocated
 Activity–Based Costing (ABC)
Assign costs to a cost object using a second-stage allocation.
SureStart
SureStart
1.
1. Requires
Requires no no new
new design
design resources.
resources.
2.
2. 800,000
800,000 batteries
batteries ordered
ordered with
with 4,000
4,000 separate
separate orders.
orders.
3.
3. Each
Each SureStart
SureStart requires
requires 36
36 minutes
minutes ofof machine
machine
time
time for
for aa total
total of
of 480,000
480,000 machine-hours.
machine-hours.

LongLife
LongLife
1.
1. Requires
Requires new new design
design resources.
resources.
2.
2. 400,000
400,000 batteries
batteries ordered
ordered with
with 6,000
6,000 separate
separate orders.
orders.
3.
3. 4,000
4,000 custom
custom designs
designs prepared.
prepared.
4.
4. Each
Each LongLife
LongLife requires
requires 48
48 minutes
minutes of
of machine
machine
time
time for
for aa total
total of
of 320,000
320,000 machine-hours.
machine-hours.
 Activity–Based Costing (ABC)
 Assigning Overhead to Products

Ov e rh e a d Co s t fo r t h e S u re S t a rt
(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 452.00 4,000 $ 1,808,000
Design changes 760.00 - -
Order size 6.50 480,000 3,120,000
Total $ 4,928,000

Ov e rh e a d Co s t fo r th e Lo n g Life
(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 452.00 6,000 $ 2,712,000
Design changes 760.00 4,000 3,040,000
Order size 6.50 320,000 2,080,000
Total $ 7,832,000
 Activity–Based Costing (ABC)
 Assigning Overhead to Products
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
Orders
1.
1. Eight
Eight orders
orders for
for 60
60 SureStarts
SureStarts per
per order.
order.
2.
2. Four
Four orders
orders for
for 50
50 LongLifes
LongLifes per
per order.
order.

Machine-hours
Machine-hours
1.
1. The
The 480
480 SureStarts
SureStarts required
required 288
288 machine-hours.
machine-hours.
2.
2. The
The 200
200 LongLifes
LongLifes required
required 160
160 machine
machine hours.
hours.
 Activity–Based Costing (ABC)
 Assigning Overhead to Products

Ov e rh e a d Co s t fo r Ac m e Au t o P a rt s
(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 452.00 12 $ 5,424
Design changes 760.00 4 3,040
Order size 6.50 448 2,912
Customer relations 1,540.00 1 1,540
Total $ 12,916
 Activity–Based Costing (ABC)
5. 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
 Activity–Based Costing (ABC)

 5. 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
 Activity–Based Costing (ABC)
 5. 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)
 Activity–Based Costing (ABC)
 5. 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)
 Activity–Based Costing (ABC)
 5. 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
 Activity–Based Costing (ABC)
 5. 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
 Activity–Based Costing (ABC)
 5. 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
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
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
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

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
Differences Between ABC and Traditional Product
Costs
1.The changes in product margins caused by switching from the traditional
cost system to the activity-based costing system are as shown. Notice:

1.The traditional cost system overcosts the SureStarts and consequently

reports an artificially low product margin for this product.
2.Conversely, the traditional cost system undercosts the LongLifes and
consequently reports an artificially high product margin for this product.

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)
 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.

1.The traditional cost system allocates all manufacturing overhead to products.

The ABC system only assigns manufacturing overhead costs consumed by
products to those products. More specifically:
a.The ABC system does not assign the manufacturing overhead costs consumed by
the customer relations
b.activity to products because these costs are caused by customers, not specific
products.
c.The ABC system does not assign the manufacturing overhead costs included in
the “other” activity to products because these organization-sustaining and unused
capacity costs are not caused by products.
 Differences Between ABC and Traditional Product Costs
2.The traditional cost system allocates all manufacturing overhead costs
using a volume-related allocation base (machine-hours). The ABC system
uses volume-related and non-volume related allocation bases to assign
manufacturing overhead to products. More specifically:

a.The traditional cost system allocates 60% of all manufacturing overhead to

SureStarts and 40% to LongLifes.

b.The ABC system assigns 40% and 60% of customer orders activity cost batch-
level cost) to SureStarts and LongLifes, respectively.

c.The ABC system assigns 0% and 100% of product design activity cost
product-level cost) to SureStarts and LongLifes, respectively.
Differences Between ABC and Traditional Product Costs

3.The traditional cost system disregards selling and administrative expenses

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

A.Key definitions/concepts

i.Activity-based management is used in conjunction with ABC to identify areas

that would benefit from process improvement. It involves focusing on activities
to eliminate waste, decrease processing time, and reduce defects.

ii.While the theory of constraints approach discussed in Chapter 1 is a powerful

tool for targeting process improvement efforts, the activity rates computed in
ABC can also provide valuable clues concerning where there is waste and the
opportunity for improvement.

1.Benchmarking can be used to compare an organization’s activity rates with

standards of performance that are external to the organization.
 Activity-based costing and external reports
There are four reasons why most companies do not use ABC for external
reporting purposes.

1. 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

2. errors tend to cancel each other out when the product costs are added
together.

3.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.
 Activity-based costing and external reports
4. An ABC system, such as the one described in the chapter, does not conform
to generally accepted accounting principles (GAAP).

1.It excluded some organization-sustaining manufacturing costs, some unused

capacity costs, and it included some nonmanufacturing costs in its product cost
calculations. These cost system design attributes do not comply with GAAP.

5. Auditors are likely to be uncomfortable with cost allocations that are based
on interviews with the company’s personnel. This type of subjective data can
be easily manipulated by management.
 The limitations of activity-based costing
There are five limitations of ABC

1. Implementing an ABC system requires substantial resources. The benefits of

increased cost accuracy may not outweigh the implementation costs.

2.ABC systems produce numbers, such as product margins, that are at odds with
the numbers produced by traditional cost systems. Managers are not accustomed
to managing their operations using these numbers; hence, ABC inevitably faces
resistance. This underscores the importance of having top management support
for and cross-functional involvement with the ABC implementation.

3.In practice, most managers insist on fully allocating all costs to products. The
ABC system described in the main portion of this chapter does not conform to
this preference.
 The limitations of activity-based costing
4. ABC systems do not automatically identify the relevant costs for particular
decisions; therefore, ABC data can be easily misinterpreted and must be used with
care when making decisions. Costs assigned to products, customers, and other
cost objects are only potentially relevant.

5. Most organizations use ABC as a supplement to rather than a replacement for

their existing cost system. Maintaining two cost systems is costlier than
maintaining just one system and it may cause confusion about which set of
numbers is to be relied on.
 THANK YOU FOR LISTING
NOUR & ABEER

SUPERVISOR
PROF . ABD ALNASSER NOUR