Supplementary Notes - CMA1 - Activity-Based Costing - Chapter 8
Steps for Implementing an ABC System
1. Identify and Define Activities and Activity Cost Pools
-we must first identify the activities that form the foundation of the system.
-the ABC team interviews workers, supervisors, and managers in overhead, selling, and admin.
departments and asks them to describe the activities they perform. This typically results in a
very long list of activities.
-for practical purposes, these long lists of activities must be reduced to a handful. (5 or 6)
-this is done by combining similar activities e.g. all activities involving the receiving,
moving, and storing of materials might be grouped together as “material handling”.
-activities should also be grouped according to whether they are performed on each unit,
each batch , each product, each customer, or for the organization as a whole and these
activity types should not be mixed. (See Chapter Highlights, item G)
-activities are correlated with each other if they tend to move in tandem with one another
e.g. # of customers is likely correlated with # of completed orders shipped, so activities
using these two allocation bases could be grouped as a single activity.
2. Whenever Possible, Trace Costs Directly to the Cost Object (usually the product, job, or customer
-this can be done typically for DM, DL, and Shipping costs
-no activity pools are required for these costs
3. Assign Costs to Activity Cost Pools
-what is done in this stage is assigning mfg. overhead and selling and admin expenses based on
the amounts in GL accounts, to the various activities-----called “first stage allocations”
-in order to assign labour-type costs to activities, workers and supervisors are interviewed and
asked how much time and what % of their time is spent on each of the activities (if any)
-for other non-personal (non-labour-type) costs, the key question posed to supervisors or managers
is, “what % of the available resource is consumed by this activity?”
-these interviews lead to %’s being assigned for each GL cost account to the various activities.
The total %’s for a given GL cost account must add to 100% (see Exhibit 8-4 )
-a given GL cost account can then be assigned to each activity by multiplying the total cost in the
account by each of these %’s. This is repeated for each applicable GL cost account. (see exhibit
-a total cost can then be tabulated for each activity.
4. Calculate Activity Rates for Each Activity
-determine the activity measure (allocation base) for each activity and the number of units of the
activity base expected to be used for each activity for the period.
-to determine the activity rate for each activity, divide the total cost of each activity by the total
expected # of activity units (as in Exhibit 8-6) to get an overall rate for the activity, or the activity
rate can be broken down by individual cost account, line by line, (as in Exhibit 8-13 and 8-14, p.
5. Assign Costs to Cost Objects Using the Activity Rates and Actual Activity Units for a Given Cost
Object (usually a customer order----called Second Stage Allocations)
-can be done cost line by cost line, or based on the amount of the activity for a given job or
customer order (as in Exhibit 8-9 on p.326),
6. Prepare Management Reports
a. Product and Customer Margin Reports -these reports show the product margin (profitability)
for each product and then the customer margin.
-for the product margin, they include costs of activities that vary per unit, per batch and per
-the reports show product sales and deduct directly traceable costs like DM, DL, and Shipping,
and then the assigned activity costs as determined under part 5.
-costs of activities that vary by customer should be shown separately after all the product
margins as follows (see Exhibit 8-10):
Total of all Product Margins xxx
Less Activity costs that vary by customer xxx
Customer Margin xxx
b. Action Analysis Reports
-these reports are used by management to determine how easy it would be to adjust or
eliminate a given cost if a product or customer were dropped.
-costs are listed by GL account category for a given product, job or customer order.
-a simple colour code is used to group costs according to how easily that cost could be
adjusted or eliminated if the product or customer were dropped. (called “ease of adjustment
codes”); the colour codes are green, yellow and red (see Chapter Highlights item I, for a
description of each of these ease of adjustment colour codes)
-see Exhibit 8-16 and note that sales are shown for the product along with the cumulative
margin after the total costs grouped under each colour code are subtracted. The final
cumulative margin is the Red Margin.
-this report requires that the activity rate for a given activity be broken down by GL cost
account (as done in Exhibit 8-13 and 8-14), and can then be used by management to
determine what costs could be eliminated and/or how difficult it would be to cut each cost if
the product or customer were dropped. This could in turn affect the decision as to whether or
not to drop a product.
-this type of analysis can be done either for the product (which means customer amounts are
omitted), or for the customer (which means the unit, batch, or product costs are omitted), or
for the product and customer combined (in which all allocated costs are included). (Note:
DM, DL, and shipping expenses will normally show up in both the Margin report and the
Action Analysis report even though the first report type is grouped on the basis of activities
and the second report is grouped on the basis of GL accounts)
CMA1 - SUPPLEMENTARY NOTES FOR OBJECTIVES 9 AND 10 - ACTIVITY-
BASED COSTING (Chapter 8)
9. State Why Differences in Costing arise when an ABC system replaces a Traditional cost system
When an ABC system replaces a traditional cost system, high volume products generally end up
costing less and low volume products end up costing more than under the traditional system. The
reasons for this are as follows:
Under traditional costing, batch level costs like set-up costs are usually assigned to products
on a unit level basis as one component of the single plant-wide overhead rate (based on
estimates done at the beginning of the year). This has the effect of assigning set-up costs to
all products on a per unit basis regardless of the number of units in the batch that gave rise to
a particular setup cost. As a result, higher volume products (involving large batch sizes) end
up having higher assigned set up costs in total for set-up costs (or other similar batch-level or
product-level costs), than low volume products.
However, under an ABC system, batch level costs are first assigned to a batch-based activity--
---not on a per unit basis. Many of these costs are essentially fixed with respect to the size
of the batch. These costs may them be converted to a cost per unit based on the number of
units in the batch. This two-stage assignment of costs (first to the batch level activity, then to
the units of product) has the effect assigning a higher unit cost to low volume products with
small batch sizes and a lower unit cost to higher volume products with large batch sizes.
The same effect also applies to product level costs. This results in high-volume products
being cheaper and low volume products more expensive under ABC.
Also, under traditional costing, costs are assigned to products even though the product may not
have used any of the resources that gave rise to the cost. e.g. product design costs are
assigned to all products even though not all products used product design resources.
Under ABC, costs are assigned only if the cost object used the resource or activity that caused
10. a) Understand the Difference in the Meaning of Product Cost under Traditional and ABC
Under traditional costing, only mfg. costs are assigned to products including idle capacity
costs and organization sustaining costs that relate to the factory (included in DM, DL, and
Under ABC, both mfg. and non-mfg. costs are included but idle capacity costs and
organization-sustaining costs are excluded. Hence, product cost has a different meaning.
b) State the Problems that are often encountered when ABC concepts are used in service-type
While ABC systems are used in service businesses (eg., railroads, hospitals, banks, data
service companies, two problems often make implementation more of a challenge.
1) A larger proportion of costs tend to be organization-sustaining costs that cannot be
traced to any billable services provided by the firm
2) It is more difficult to capture activity data since many activities involve non-repetitive
human tasks that cannot be easily recorded.
c) Explain what is meant by Activity-Based Management (ABM)
An ABC system is often used to make improvements in a process.
When used in this way to manage activities in order to reduce waste, delays, or defects, it is
1) Assuming an ABC system is already in place, determine what processes or
activities have the greatest potential for improvement. This is done by using the
Theory of Constraints, and Benchmarking (compare the activity rate for the company
with an industry standard or a world class company)
2) Apply TQM or process re-engineering to improve the process and determine a
revised activity rate after implementing the changes.