Activity-Based Costing (ABC) and
Activity-Based Management
Chapter 5
ABC – used to produce a refined costing
system where job costing is not appropriate
5-1
Learning Objective 1
Explain undercosting
and overcosting of
products and services.
5-2
Undercosting and
Overcosting Example
Jose, Roberta, and Nancy order
separate items for lunch.
Jose’s order amounts to $14
Roberta consumed 30
Nancy’s order is 16
Total $60
What is the average cost per lunch?
5-3
Undercosting and
Overcosting Example
$60 ÷ 3 = $20
Jose and Nancy Roberta is
are overcosted. undercosted.
5-4
Existing Single Indirect-
Cost Pool System Example
Kole Corporation manufactures a normal lens
(NL) and a complex lens (CL).
Kole currently uses a single indirect-cost rate
job costing system.
Cost objects: 80,000 (NL) and 20,000 (CL).
5-5
Existing Single Indirect-
Cost Pool System Example
Normal Lenses (NL)
Direct materials $1,520,000
Direct mfg. labor 800,000
Total direct costs $2,320,000
Direct cost per unit: $2,320,000 ÷ 80,000 = $29
5-6
Existing Single Indirect-
Cost Pool System Example
Complex Lenses (CL)
Direct materials $ 920,000
Direct mfg. labor 260,000
Total direct costs $1,180,000
Direct cost per unit: $1,180,000 ÷ 20,000 = $59
5-7
Existing Single Indirect-
Cost Pool System Example
INDIRECT-COST All Indirect Costs
POOL $2,900,000
INDIRECT 50,000 Direct
COST-ALLOCATION Manufacturing
BASE Labor-Hours
$58 per Direct
Manufacturing
Labor-Hour
5-8
Existing Single Indirect-
Cost Pool System Example
COST OBJECT: Indirect Costs
NL AND CL
LENSES Direct Costs
DIRECT
COSTS
Direct
Direct
Manufacturing
Materials Labor
5-9
Existing Single Indirect-
Cost Pool System Example
Kole uses 36,000 direct manufacturing
labor-hours to make NL and 14,000 direct
manufacturing labor-hours to make CL.
How much indirect costs are allocated
to each product?
5 - 10
Existing Single Indirect-
Cost Pool System Example
NL: 36,000 × $58 = $2,088,000
CL: 14,000 × $58 = $812,000
What is the total cost of normal lenses?
Direct costs $2,320,000 +
Allocated costs $2,088,000 = $4,408,000
What is the cost per unit?
$4,408,000 ÷ 80,000 = $55.10
5 - 11
Existing Single Indirect-
Cost Pool System Example
What is the total cost of complex lenses?
Direct costs $1,180,000 + Allocated costs
$812,000 = $1,992,000
What is the cost per unit?
$1,992,000 ÷ 20,000 = $99.60
5 - 12
Existing Single Indirect-
Cost Pool System Example
Normal lenses sell for $60 each and
complex lenses for $142 each.
Normal Complex
Revenue $60.00 $142.00
Cost 55.10 99.60
Income $ 4.90 $ 42.40
Margin 8.2% 29.9%
5 - 13
Learning Objective 2
Present three guidelines for
refining a costing system.
5 - 14
Refining a Costing System
More Direct-cost tracing
Smaller Indirect-cost pools
Better cause & effect
Cost-allocation basis
relationship
5 - 15
Learning Objective 3
Distinguish between the
traditional and the
activity-based costing
approaches to designing
a costing system.
5 - 16
Activity-Based Costing System
Fundamental Assignment to Other
Cost Objects Cost Objects
Activities Cost of:
• Product
• Service
Costs of Activities • Customer
5 - 17
Refining a Costing System
1. Design of Products and Process
The Design Department designs the molds
and defines processes needed (details of
the manufacturing operations).
5 - 18
Refining a Costing System
2. Manufacturing Operations
Lenses are molded, finished,
cleaned, and inspected.
3. Shipping and Distribution
Finished lenses are packed and
sent to the various customers.
5 - 19
Activity-Based Costing System
A cross-functional team at Kole
Corporation identified key activities:
1. Design products and processes.
2. Set up molding machine.
3. Operate machines to manufacture lenses.
4. Maintain and clean the molds.
5 - 20
Activity-Based Costing System
5. Set up batches of finished lenses for shipment.
6. Distribute lenses to customers.
7. Administer and manage all processes.
5 - 21
Activity-Based Costing System
Activity
Indirect Cost Design Setup Shipping
Pool
Cost Parts- No. of
Square Setup No. of
Allocation Shipments
Base feet Hours
Product Lenses Lenses Lenses
Cost
Objects NL CL Other
5 - 22
Activity-Based Costing System
NL CL
Quantity produced 80,000 20,000
No. produced/batch 250 50
Number of batches 320 400
Setup time per batch 2 hours 5 hours
Total setup-hours 640 2,000
Total setup costs are $409,200.
5 - 23
Activity-Based Costing System
What is the setup cost per setup-hour?
$409,200 ÷ 2,640 hours = $155
What is the setup cost per
direct manufacturing labor-hour?
$409,200 ÷ 50,000 = $8.184
5 - 24
Activity-Based Costing System
Allocation using direct labor-hours:
NL: $8.184 × 36,000 = $294,624
CL: $8.184 × 14,000 = $114,576
Total $409,200
Allocation using setup-hours:
NL: $155 × 640 = $ 99,200
CL: $155 × 2,000 = $310,000
Total $409,200
5 - 25
Learning Objective 4
Describe a four-part
cost hierarchy.
5 - 26
Cost Hierarchies
A cost hierarchy is a categorization of costs
into different cost pools, based on……
•Cost drivers bases (cost-allocation bases)
•Degrees of difficulty in determining
cause-and-effect relationships
5 - 27
Cost Hierarchies
ABC systems commonly use a
four-part cost hierarchy to
identify cost-allocation bases:
1. Output unit-level costs
2. Batch-level costs
3. Product-sustaining costs
4. Facility-sustaining costs
5 - 28
1. Output Unit-Level Costs
These are resources sacrificed
on activities performed on each
individual unit of product or service.
Energy
Vary
Machine depreciation with
Output
Repairs
5 - 29
2. Batch-Level Costs
These are resources sacrificed on
activities that are related to a group
of units of product(s) or service(s)
rather than to each individual unit
of product or service.
Vary
Setup-hours with #
of
Procurement costs setups
etc
5 - 30
3. Product-Sustaining Costs
These are often called service-sustaining
costs and are resources sacrificed on
activities undertaken to support
individual products or services.
Design costs
Engineering costs
5 - 31
4. Facility-Sustaining Costs
These are resources sacrificed on
activities that cannot be traced to
individual products or services but
support the organization as a whole.
General administration “True”
indirect
– rent – building security costs
5 - 32
Learning Objective 5
Cost products or services using
activity-based costing.
5 - 33
Implementing
Activity-Based Costing
Step 1 Step 2
Identify cost objects. Identify the direct costs
of the products.
NL Direct material
CL Direct labor
Mold cleaning and
maintenance
5 - 34
Implementing
Activity-Based Costing
Cleaning and maintenance costs of
$360,000 are direct batch-level costs.
Why?
Because these costs consist of workers’
wages for cleaning molds after each
batch of lenses is run.
5 - 35
Implementing
Activity-Based Costing
Normal Lenses (NL)
Cost Hierarchy
Description Category
Direct materials Unit-level $1,520,000
Direct mfg. labor Unit-level 800,000
Cleaning and maint. Batch-level 160,000
Total direct costs $2,480,000
5 - 36
Implementing
Activity-Based Costing
Complex Lenses (CL)
Cost Hierarchy
Description Category
Direct materials Unit-level $ 920,000
Direct mfg. labor Unit-level 260,000
Cleaning and maint. Batch-level 200,000
Total direct costs $1,380,000
5 - 37
Implementing
Activity-Based Costing
Step 3
Select the cost-allocation bases to use for
allocating indirect costs to the products.
(1) (2) (3)
Activity Cost Hierarchy Total Costs
Design Product-sustaining $450,000
Setups Batch-level $409,200
Operations Unit-level $637,500
5 - 38
Implementing
Activity-Based Costing
Step 4
Identify the indirect costs associated
with each cost-allocation base.
Overhead costs incurred are assigned
to activities, to the extent possible, on
the basis of a cause-and-effect relationship.
5 - 39
Implementing
Activity-Based Costing
Step 5
Compute the rate per unit.
(1) (5)
NL CL Total
Setup-hours: 640 2,000 2,640
$409,200 ÷ 2,640 = $155
5 - 40
Implementing
Activity-Based Costing
Step 6
Compute the indirect costs allocated
to the products.
NL: $155 × 640 = $ 99,200
CL: $155 × 2,000 = 310,000
Total $409,200
5 - 41
Implementing
Activity-Based Costing
Step 7
Compute the costs of the products.
NL and CL would show three
direct cost categories.
1. Direct materials
2. Direct manufacturing labor
3. Cleaning and maintenance
5 - 42
Implementing
Activity-Based Costing
NL and CL would show six indirect cost pools.
1. Design
2. Molding machine setups
3. Manufacturing operations
4. Shipment setup
5. Distribution
6. Administration
5 - 43
Learning Objective 6
Use activity-based
costing systems for
activity-based management.
5 - 44
Activity-Based Management
ABM describes management decisions that use
activity-based costing information to satisfy
customers and improve profits.
1. Product pricing and mix decisions
2. Cost reduction and process improvement decisions
3. Design decisions
5 - 45
1.Product Pricing and
Mix Decisions
ABC gives management insight into the cost
structures for making and selling diverse products.
It provides more accurate product cost
information and more detailed information
on costs of activities and the drivers of those costs.
5 - 46
2. Cost Reduction and Process
Improvement Decisions
Manufacturing and distribution personnel use
ABC systems to focus on cost-reduction efforts.
Managers set cost-reduction targets in terms of
reducing the cost per unit of the cost-allocation base.
5 - 47
3. Design Decisions
Management can identify and evaluate new designs
to improve performance by evaluating how product
and process designs affect activities and costs.
Companies can work with their customers to
evaluate the costs and prices of alternative designs.
5 - 48
Learning Objective 7
Compare activity-based costing
systems and department-
costing systems.
5 - 49
ABC and Department
Indirect-Cost Rates
Many companies have evolved their
costing system from using a single
cost pool to using separate indirect-cost
rates for each department:
Design
Manufacturing
Distribution
5 - 50
ABC and Department
Indirect-Cost Rates
Why?
Because the cost drivers of resources in each
department or sub-department differ from the
single, company-wide, cost-allocation base.
ABC systems are a further refinement of
department costing systems.
5 - 51
Levels of refinement of Job Costing,
Department Costing and Activity-Based Costing
Job Costing is…….. good
Department Costing is ……..more refined
Activity-Based Costing is…… even more refined
5 - 52
Learning Objective 8
Evaluate the costs and benefits
of implementing activity-based
costing systems.
5 - 53
Benefits of ABC Systems are likely
to occur when…..
1. Significant amounts of indirect costs are
allocated using only one or two cost pools.
2. All or most costs are identified as output
unit-level costs.
3. Products make diverse demands on
resources because of differences in volume,
process steps, batch size, or complexity.
5 - 54
Benefits of ABC Systems are likely
to occur when…..(Cont’d)
4. Products that a company is well-suited to
make and sell show small profits while
products for which a company is less
suited show large profits.
5. Complex products appear to be very
profitable and simple products appear to
losing money.
5 - 55
Benefits of ABC Systems
Operations staff often have significant
disagreements with the accounting
staff about the costs of manufacturing
and marketing products and services.
5 - 56
Limitations of ABC Systems
The main limitations of ABC are the
measurements necessary to
implement the system.
ABC systems require management
to estimate costs of activity pools
and to identify and measure cost
drivers for these pools.
5 - 57
Limitations of ABC Systems
Activity-cost rates also need to be
updated regularly.
Very detailed ABC systems are costly
to operate and difficult to understand.
5 - 58
ABC In Service and
Merchandising Companies
The general approach to ABC in the
service and merchandising areas is very
similar to the approach in manufacturing.
Costs are divided into homogeneous cost
pools and classified as output unit-level,
batch-level, product- or service-sustaining,
and facility-sustaining costs.
5 - 59
ABC In Service and
Merchandising Companies
The cost pools correspond to key activities.
Costs are allocated to products or customers
using activity drivers or cost-allocation
bases that have a cause-and-effect
relationship with the cost in the cost pool.
5 - 60