MANAGERIAL ACCOUNTING

COST BEHAVIORS, SYSTEMS, AND ANALYSIS

with Gary Hecht

Costing Systems II:

Activity-Based Costing

Fundamental Concepts and Implications

Lesson Objectives

LESSON 3-1 OBJECTIVES

You will understand:

The fundamental concepts of activitybased costing (ABC)
The advantages and disadvantages
of ABC

General Approach and Overview

GENERAL APPROACH
Costing method that focuses on two
key aspects
The activities that use resources
The causal relationship among
activities, resources, and cost objects

Intended to increase the accuracy of

cost information, relative to a more
traditional costing system

FUNDAMENTAL CONCEPTS
Activities
A description of work performed
Consume resources
Often grouped into pools

Drivers
Measure of activitys consumption of
resources

A more refined view of costs

Especially costs classified as overhead
in traditional costing systems

TRADITIONAL SYSTEM

Direct Materials

Direct Labor

OH Costs

Cost Pool 1

Cost Pool 2

Cost Object

ABC SYSTEM

Direct Materials

Direct Labor

Cost Object

ABC SYSTEM

Direct Materials

Direct Labor

OH Costs

Cost Pool 1

Cost Pool 2

Cost Object

Fundamental Components

ABC SYSTEM
Resources

Activity 1

Activity
Pool A

Activity 2

Activity 3

Activity Pool B

Cost Object

...

Activity n

...

Activity
Pool X

COMPONENTS
Resources

Activity 1

...

Activity n

Activity
Pool A

...

Activity
Pool X

Cost Object

Resources
Owned by firm and consumed
by activities
Examples include wages for
support staff and costs for
equipment maintenance,
supplies, utilities, etc.

COMPONENTS
Resources

Activity 1

...

Activity n

Activity
Pool A

...

Activity
Pool X

Cost Object

Activities
Processes engaged in by the firm,
managers, employees, etc.
Examples include logistics,
engaging with customers, setup,
production supporting processes,
maintenance, etc.

COMPONENTS
Resources

Activity 1

...

Activity n

Activity
Pool A

...

Activity
Pool X

Cost Object

Activity Pools
Groupings of activities according
to type
Helps to simplify the system so
that it is manageable
Examples include unit-level,
product-level, etc.

COMPONENTS
Resources

Cost Object
As defined earlier

Activity 1

...

Activity n

Activity
Pool A

...

Activity
Pool X

Cost Object

However, ABC systems afford a

great deal more flexibility in terms of
adopting different types of cost
objects to suit the setting or decision.
Examples include units of product,
product lines, departments,
customers, etc.

ABC Organization and Steps to Implementation

STEPS
Identify and estimate resources
Identify activities that consume
resources
Group activities into pools
Identify and compute appropriate
drivers
Assign costs to cost objects
according to associated activities
and drivers

GROUPING ACTIVITIES

Useful for simplifying a complex

system
Informed by two attributes
Activity type
Measure/driver type

ACTIVITY/COST
HIERARCHY
Unit activities/costs correspond to
production volume
Batch activities/costs correspond
to batches of production
Regardless of production volume

Product activities/costs correspond

to product lines
Facility/organization
Catch-all category

DRIVERS
Driver

Resources

Measure of activity that allows for

assignment of costs to cost
objects.

Activity 1

...

Activity n

Activity
Pool A

...

Activity
Pool X

Examples include # of units, # of

batches, inspections, orders, etc.

DRIVER
Cost Object

ADVANTAGES AND
DISADVANTAGES
More accurate cost information
Better decisions
Activity-based management

Flexibility
Choice in level of specification, cost
object, etc.

Development/implementation
Maintenance

What Weve Learned

WHAT WEVE LEARNED

IN LESSON 3-1
Basic framework of ABC systems
Very complex, relative to traditional
costing systems
A more realistic view of cost objects
usage of resources

Advantages and disadvantages

More accuracy, and therefore better
decisions
Flexibility
Costs are huge!

Applying Activity-Based Costing

Lesson Objectives

LESSON 3-2 OBJECTIVES

You will understand:

How to apply ABC to a product-costing
scenario
Other considerations related to ABC

Steps Through an Example

EXAMPLE
C-Brook Enterprises produces four
models of its flavored health drink.
Managers have used a simplified
cost system in the past, in which all
overhead was compiled in a single
cost pool.
Managers are now switching to an
ABC system.

STEP 1 IDENTIFY RESOURCES

Managers have estimated the following resources:
Support staff wages
Benefits and insurance

$30,000
12,000

Information systems

8,000

Equipment

7,000

Maintenance

3,000

Utilities

4,000

STEP 2
IDENTIFY ACTIVITIES
Managers have identified the
following activities:
Processing production orders
Scheduling production runs
Prepping line for new flavor
Purchasing
Preparing and releasing materials
Ensuring quality
Management and record-keeping

STEP 3
CREATE ACTIVITY POOLS
Management has decided to
group activities according to
activity/cost type.
They have identified four
different activity pools:
Run machines (unit)
Process production runs (batch)
Set up equipment (batch)
Manage products (product)

STEP 3 CREATE ACTIVITY POOLS (CONT.)

Ac#vity Pool
Total
Expense
Resource

Support sta wages

Benets and insurance

Informa#on systems

$30,000

Set Up
Equipment

Process
Produc#on Run

40%

40%

20%

8,000

30%

70%

Maintenance

3,000

50%

4,000

64,000

10%

10%

U#li#es

Total

20%

40%

7,000

40%

Equipment

12,000

Run
Machines

Manage
Products

10%

100%

50%

70%

STEP 3 CREATE ACTIVITY POOLS (CONT.)

Ac#vity Pool
Total
Expense
Resource

Set Up
Equipment

Process
Produc#on Run

4,800

2,400

2,400

5,600

7,000

7,000

3,000

1,500

1,500

4,000

64,000

400

21,100

400

17,200

400

14,400

2,800

11,300

12,000

4,800

Informa#on systems

8,000

Equipment
Maintenance

U#li#es

Total

12,000

Benets and insurance

6,000

12,000

$30,000

Support sta wages

Run
Machines

Manage
Products

STEP 4 COMPUTE DRIVERS

Once activity pools and drivers are
identified, managers calculate a rate
for each pool:
Rate = Activity Pool Amount
Total Volume of Driver

Use this rate to allocate costs

to cost objects.

STEP 4 COMPUTE DRIVERS (CONT.)

Ac#vity Pool
Total
Expense

Ac#vity Pool Amount

Driver

Driver Volume

Rate

$64,000

$21,100

Produc#on
Runs

105

$ 200.95

$17,200

Set Up
Hours

688

$ 25.00

Run
Machines

Manage
Products

Set Up
Equipment

Process
Produc#on Run

$14,400

Product
Lines

4

$ 3,600.00

$11,300

Machine
Hours

9,000

$ 1.26

HOW MUCH OF THE COST

OF PROCESSING
PRODUCTION RUNS IS
ABSORBED BY FLAVOR A?
$ 200.95
60
$12,057.00

per production run

production runs

STEP 5 ASSIGN COSTS

Sales

Expenses
Materials
Labor

Process Produc#on
Set Up Equipment
Manage Products
Run Machines

Total Expenses

Opera#ng Income

Flavor A

Flavor B

Flavor C

Flavor D

$85,000


29,000
11,000

12,057
5,250
3,600
6,930

67,837

$17,163

$50,000


18,000
6,500

11,052
1,125
3,600
4,725

45,002

$4,998

$16,500


5,250
2,150

8,440
5,800
3,600
1,260

26,500

-$10,000

$2,300


650
310

3,014
1,275
3,600
252

9,101

-$6,801

Total

$153,800


52,900
19,960

34,563
13,450
3,600
13,167

148,440

$5,360

Other Considerations

WHO NEEDS ABC?

Operational characteristics
Product lines are diverse.
Overhead is a substantial portion of cost structure.

Decision-making characteristics
Accounting department spends significant resources customizing
information.
Product line profitability information is difficult to rationalize.
Line managers do not believe product cost reports.
Competitors ignore higher profitability products and compete on lower
profitability products.

WHEN DO ABC SYSTEMS FAIL?

Garbage in, garbage out:

Cost estimates in activity pools are unreliable.
Difficult to identify and measure drivers.

When the system increases complexity, without the benefits:

Activity-cost rates need to be updated regularly can lead to confusion.
The system is costly to operate and difficult to understand because of the
high level of detail.

What Weve Learned

WHAT WEVE LEARNED

IN LESSON 3-2
Applying activity-based costing
Significant implementation
More accurate product costing
Takeaways

Other considerations
When do you need ABC?
Limitations

WHAT WEVE LEARNED IN MODULE 3

Fundamentals of activity-based costing

Advantages and disadvantages
Applying activity-based costing
and key takeaways
Other considerations