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CMA1 - Supplementary Notes - Activity Base Costing
LO1 : Problems With Traditional Cost Systems
1. Manufacturing costs that do not actually arise because of a particular product are still assigned to that
product as part of the plant-wide overhead rate. Example, depreciation on equipment not used to make a
particular product
2. Non-mfg costs that are caused by a particular product are not assigned as a cost of that product.
Example, sales commissions on the sale of the product.
3. Since all manufacturing costs must be assigned to products via the overhead rate, the costs of idle
capacity must be assigned to all products. This is because the overhead rate will be higher if fewer
units than plant capacity are expected to be produced and this higher rate will therefore include a
component strictly due to idle capacity. Therefore, products will be charged for the costs of idle
resources (rather than only the costs of resources actually used in making the product).
4. Overhead costs are usually allocated to products using a single measure of activity such as direct labour
hours even though some manufacturing costs may not be affected by the number of DLH’s.
These problems may cause product costs to be distorted or to be incomplete under the traditional costing
approach.
LO2: Explain How ABC Overcomes the Limitation Described in LO1
1. A cost is assigned to a product only if that cost arose because of the use of that activity by the product.
Costs not caused by the product are not assigned to a product.
2. Non-mfg. costs that are involved in the design, development, selling, distributing, or servicing of a
product, are assigned as a cost of the product.
3. In traditional cost systems, the master budget volume is the most common denominator level used for
determining the overhead rate. This is usually less than plant capacity. Therefore, the mfg. overhead
rate is typically higher and includes a component for idle capacity. These idle capacity costs are
charged to the product even though they in no way enhance the value of the product. However, under
ABC, some measure of capacity is usually used as the denominator measure for calculating activity
rates. Therefore, the activity rates are lower and include no component for idle capacity. Any cost
for unused capacity will be written off as an adjustment to Cost of Goods Sold and will not be assigned
to the product itself.
4. By assigning cost to products on the basis of activities (using multiple activity cost pools with different
activity bases), there can be a more accurate assignment of costs to products that reflect cause and effect
rather than under the traditional system (where either a single plant-wide rate of multiple departmental
overhead rates are used). This is a particular problem for traditional cost systems when batch sizes
differ or the degree of complexity varies widely from one product to another.
LO3: Describe ABC and List 5 Ways It Differs from Traditional Costing
The key concept of ABC is that products or customers cause activities.
Activities are used by Products this leads to the Consumption of Resources to make the product which
gives rise to the assignment of costs to the Product or Customer.
Therefore, the key starting point for ABC is to identify all the activities used by a given product
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For a list of the 5 differences with Traditional Costing, see Item E on the Chapter Highlights from the Study
Guide for Chapter 8.
LO4: State How Companies Integrate ABC systems with their existing Accounting Systems.
Companies usually treat an ABC system as a supplement to the traditional accounting system in order to
generate more meaningful cost information for use in internal reports. Information is extracted from the GL
accounts of the existing accounting system and reconfigured in the ABC cost system. This may involve using
Excel spreadsheets or separate supplementary software. Typically, direct materials, direct labour and
shipping expenses do not need to be adjusted under an ABC system, but most manufacturing overhead items and
selling and administrative expenses do need to be re-configured.
LO5: List the Steps for Implementing an ABC System
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
order)
-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 5-5 )
-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 8-
5)
-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.
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-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 5-7) 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 5-16 on p. 199).
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 5-9 on p. 185),
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
product basis.
-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 5-11):
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 5-19 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 5-16), 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).
Interpreting the Action Analysis Report for Management Decisions
The Action Analysis Report is somewhat like a CM format income statement. Those costs
that can be eliminated fairly readily like the Green costs or the Yellow costs are similar to the
Variable costs in a CM format income statement. The Yellow Margin is analogous to the
Contribution Margin (i.e., the amount available to cover the fixed costs or those costs which
can only be eliminated with difficulty). Hence the Red Costs are analogous to the Fixed Costs
in the CM format income statement.
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If the Red Margin is negative, but the Yellow Margin is positive, then it is usually best to keep
the segment in production because the Yellow Margin is contributing to covering some of the
Red Costs which are going to be there regardless of whether you keep or drop the segment. It
is like a keep v. drop relevant cost question------you give up the Yellow Margin but you don’t
save the Red Costs.
L06: Define and Give Examples of the 5 Levels of Activities that make up the various activity cost pools, and
give and example of each.
1. Unit Level Activities: these are performed each time a unit is produced. Example: testing a
completed unit
2. Batch Level Activities: these are performed each time a batch is handled or processed. Example:
setting up equipment for a production run. These activities occur regardless of the number of units in
the batch.
3. Product Level Activities: these are required in order to have a product and must be performed
regardless of how many units or batches are produced. Example: the cost of maintaining an up to
date parts list for each product.
4. Customer Level Activities: these relate to specific customers and include activities such as sales calls
and catalogue mailings that are tied to a customer rather than to a specific product.
5. Organization Sustaining Activities: these activities are carried out regardless of which customers are
served, which products are involved, how many batches are run, or how many units are produced.
These costs should not be allocated to products or customers for purposes of making decisions.
Examples: cost of providing a computer network for the business; cost of preparing financial
statements.
LO10.
a) Understand the Difference in the Meaning of Product Cost under Traditional and ABC
systems.
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 MO).
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
businesses.
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.
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