Activity-based costing (ABC)
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. Used for internal decision making
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 differs from traditional absorption costing in three ways
1. Nonmanufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis.
2. Some manufacturing costs may be excluded from product costs.
3. Numerous overhead cost pools are used, each of which is allocated to p
In traditional absorption costing, manufacturing costs are assigned to
Products. Non manufacturing costs are not assigned to products
In activity-based costing, we recognize that many nonmanufacturing costs relate to
Selling, distributing, and servicing specific products. ABC includes manufacturing and nonmanufacturing costs when calculating the entire cost of a product rather than just its manufacturing cost
There are two types of nonmanufacturing costs that ABC systems assign to products
1. ABC systems trace all direct nonmanufacturing costs to products. Commissions paid to salespersons, shipping costs, and warranty repair costs are examples of nonmanufacturing costs that can be directly traced to individual products
2. ABC systems alloca
Activity-based costing systems purposely do not assign two types of manufacturing overhead costs to products
Organization-sustaining costs and unused capacity costs
Organization-sustaining costs include costs such as
The factory security guard's wages, the plant controller's salary, and the cost of supplies used by the plant manager's secretary
Where are the factory security guard's wages, the plant controller's salary, and the cost of supplies used by the plant manager's secretary assigned in a TRADITIONAL ABSORPTION COSTING SYSTEM
Products even though they are totally unaffected by which products are made during a period
Where are the factory security guard's wages, the plant controller's salary, and the cost of supplies used by the plant manager's secretary assigned in an ACTIVITY-BASED COSTING SYSTEM
Expenses rather than arbitrarily assigning them to products
In a traditional absorption costing system, the cost of unused capacity is assigned to
Products. If the budgeted level of activity declines, the overhead rate and unit product costs rise thereby ensuring that the shrinking volume of output absorbs the increasing cost of idle capacity
In activity-based costing, products are only charged
For the cost of the capacity they use�not for the cost of the capacity they don't use. This provides more stable unit product costs and is consistent with the goal of assigning to products only the costs of the resources that they use
The activity-based approach has appeal in today's business environment because it
Uses more cost pools and unique measures of activity to better understand the costs of managing and sustaining product diversity
Activity Cost Pool
A "bucket" in which costs are accumulated that relate to a single activity measure in the ABC system
Activity Measure
An allocation base in an activity-based costing system
Cost driver
An activity measure because the activity measure should "drive" the cost being allocated
The two most common types of activity measures are
Transaction Drivers and Duration Drivers
Transaction drivers
Simple counts of the number of times an activity occurs, such as the number of bills sent out to customers
Duration drivers
Measure the amount of time required to perform an activity, such as the time spent preparing individual bills for customers. Duration drivers are more accurate measures of resource consumption than transaction drivers, but they take more effort to record.
Traditional cost systems rely exclusively on
Allocation bases that are driven by the volume of production
Activity-based costing defines five levels of activity
Unit-level
Batch-level
Product-level
Customer-level
Organization-sustaining
Unit-level activities
Performed each time a unit is produced. The costs of unit-level activities should be proportional to the number of units produced
(EX: Power for processing equipment since it is proportional to the number of units produced)
Batch-level activities
Performed each time a batch is handled or processed, regardless of how many units are in the batch.
(Ex: Purchase orders, setting up equipment, shipments to customers since they're incurred once for each batch)
Product-level activities
Specific products and typically must be carried out regardless of how many batches are run or units of product are produced or sold
(EX: designing a product, advertising a product, maintaining a product manager)
Customer-level activities
Relate to specific customers and include activities such as sales calls, catalog mailings, and general technical support that are not tied to any specific product
Organization-sustaining activities
Carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made
(EX: heating the factory, cleaning offices, WIFI, annual reports to shareholders)
There are three essential characteristics of a successful activity-based costing implementation
1. Top managers must strongly support the ABC implementation because their leadership is instrumental in properly motivating all employees to embrace the need to change.
2. Top managers should ensure that ABC data is linked to how people are evaluated and
Steps for Implementing Activity-Based Costing (5)
1. Define activities, activity cost pools, and activity measures.
2. Assign overhead costs to activity cost pools.
3. Calculate activity rates.
4. Assign overhead costs to cost objects.
5. Prepare management reports.
Define Activities, Activity Cost Pools, and Activity Measures
-Difficult and time consuming
-ABC implementation team will interview people who work in overhead departments and ask to describe major activities
-Results in long list of activities
-Long list= More accurate costs but costly to design, implement, maintai
When combining activities in an ABC system, activities should be grouped together at the
Appropriate level. Batch-level activities should not be combined with unit-level activities or product-level activities with batch-level activities and so on
Order Size cost pool
Assigned all costs of resources consumed as a consequence of the number of units produced, including the costs of miscellaneous factory supplies, power to run machines, and some equipment depreciation
-Unit-level, each unit requires some of these resource
Customer Relations cost pool
Assigned all costs associated with maintaining relations with customers, including the costs of sales calls and the costs of entertaining customers
Other" cost pool
Assigned all overhead costs that are not associated with customer orders, product design, the size of the orders, or customer relations.
-These costs will not be assigned to products because they represent resources that are not consumed by products
Customer Orders cost pool
Assigned all costs of resources that are consumed by taking and processing customer orders, including costs of processing paperwork and any costs involved in setting up machines for specific orders
-Number of customer orders received
-Batch level
Product Design cost pool
Assigned all costs of resources consumed by designing products
-Number of product designs
-Product level
General ledgers usually classify costs within
the departments where the costs are incurred.
(EX: salaries, supplies, rent, and so forth incurred in the marketing department are charged to that department)
First-stage allocation
The process of assigning functionally organized overhead costs derived from a company's general ledger to the activity cost pools
-First-stage allocations are usually based on the results of interviews with employees who have first-hand knowledge of the a
Departmental managers are typically interviewed to determine how
the nonpersonnel costs should be distributed across the activity cost pools
Calculate Activity Rates
The activity rates that will be used for assigning overhead costs to products and customers. The ABC team determined the total activity for each cost pool that would be required to produce the company's present product mix and to serve its present custome
Assign Overhead Costs to Cost Objects
Called second-stage allocation
Second-stage allocation
Activity rates are used to apply overhead costs to products and customers
Prepare Management Reports
The most common management reports prepared with ABC data are product and customer profitability reports. These reports help companies channel their resources to their most profitable growth opportunities while at the same time highlighting products and c
The ABC team uses a two-step process to compare its traditional and ABC product costs
1. Review the product margins reported by the traditional cost system
2. Contrast the differences between the traditional and ABC product margins
Three reasons why the traditional and activity-based costing systems report different product margins
1. Traditional cost systems allocates all manufacturing overhead costs to products
2. Traditional cost systems allocate all of the manufacturing overhead costs using a volume-related allocation base (machine hours) that may or may not reflect what actuall
Benchmarking
A systematic approach to identifying the activities with the greatest room for improvement. It is based on comparing the performance in an organization with the performance of other, similar organizations known for their outstanding performance. If a part
Activity-based costing (ABC)
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. Used for internal decision making
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 differs from traditional absorption costing in three ways
1. Nonmanufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis.
2. Some manufacturing costs may be excluded from product costs.
3. Numerous overhead cost pools are used, each of which is allocated to p
In traditional absorption costing, manufacturing costs are assigned to
Products. Non manufacturing costs are not assigned to products
In activity-based costing, we recognize that many nonmanufacturing costs relate to
Selling, distributing, and servicing specific products. ABC includes manufacturing and nonmanufacturing costs when calculating the entire cost of a product rather than just its manufacturing cost
There are two types of nonmanufacturing costs that ABC systems assign to products
1. ABC systems trace all direct nonmanufacturing costs to products. Commissions paid to salespersons, shipping costs, and warranty repair costs are examples of nonmanufacturing costs that can be directly traced to individual products
2. ABC systems alloca
Activity-based costing systems purposely do not assign two types of manufacturing overhead costs to products
Organization-sustaining costs and unused capacity costs
Organization-sustaining costs include costs such as
The factory security guard's wages, the plant controller's salary, and the cost of supplies used by the plant manager's secretary
Where are the factory security guard's wages, the plant controller's salary, and the cost of supplies used by the plant manager's secretary assigned in a TRADITIONAL ABSORPTION COSTING SYSTEM
Products even though they are totally unaffected by which products are made during a period
Where are the factory security guard's wages, the plant controller's salary, and the cost of supplies used by the plant manager's secretary assigned in an ACTIVITY-BASED COSTING SYSTEM
Expenses rather than arbitrarily assigning them to products
In a traditional absorption costing system, the cost of unused capacity is assigned to
Products. If the budgeted level of activity declines, the overhead rate and unit product costs rise thereby ensuring that the shrinking volume of output absorbs the increasing cost of idle capacity
In activity-based costing, products are only charged
For the cost of the capacity they use�not for the cost of the capacity they don't use. This provides more stable unit product costs and is consistent with the goal of assigning to products only the costs of the resources that they use
The activity-based approach has appeal in today's business environment because it
Uses more cost pools and unique measures of activity to better understand the costs of managing and sustaining product diversity
Activity Cost Pool
A "bucket" in which costs are accumulated that relate to a single activity measure in the ABC system
Activity Measure
An allocation base in an activity-based costing system
Cost driver
An activity measure because the activity measure should "drive" the cost being allocated
The two most common types of activity measures are
Transaction Drivers and Duration Drivers
Transaction drivers
Simple counts of the number of times an activity occurs, such as the number of bills sent out to customers
Duration drivers
Measure the amount of time required to perform an activity, such as the time spent preparing individual bills for customers. Duration drivers are more accurate measures of resource consumption than transaction drivers, but they take more effort to record.
Traditional cost systems rely exclusively on
Allocation bases that are driven by the volume of production
Activity-based costing defines five levels of activity
Unit-level
Batch-level
Product-level
Customer-level
Organization-sustaining
Unit-level activities
Performed each time a unit is produced. The costs of unit-level activities should be proportional to the number of units produced
(EX: Power for processing equipment since it is proportional to the number of units produced)
Batch-level activities
Performed each time a batch is handled or processed, regardless of how many units are in the batch.
(Ex: Purchase orders, setting up equipment, shipments to customers since they're incurred once for each batch)
Product-level activities
Specific products and typically must be carried out regardless of how many batches are run or units of product are produced or sold
(EX: designing a product, advertising a product, maintaining a product manager)
Customer-level activities
Relate to specific customers and include activities such as sales calls, catalog mailings, and general technical support that are not tied to any specific product
Organization-sustaining activities
Carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made
(EX: heating the factory, cleaning offices, WIFI, annual reports to shareholders)
There are three essential characteristics of a successful activity-based costing implementation
1. Top managers must strongly support the ABC implementation because their leadership is instrumental in properly motivating all employees to embrace the need to change.
2. Top managers should ensure that ABC data is linked to how people are evaluated and
Steps for Implementing Activity-Based Costing (5)
1. Define activities, activity cost pools, and activity measures.
2. Assign overhead costs to activity cost pools.
3. Calculate activity rates.
4. Assign overhead costs to cost objects.
5. Prepare management reports.
Define Activities, Activity Cost Pools, and Activity Measures
-Difficult and time consuming
-ABC implementation team will interview people who work in overhead departments and ask to describe major activities
-Results in long list of activities
-Long list= More accurate costs but costly to design, implement, maintai
When combining activities in an ABC system, activities should be grouped together at the
Appropriate level. Batch-level activities should not be combined with unit-level activities or product-level activities with batch-level activities and so on
Order Size cost pool
Assigned all costs of resources consumed as a consequence of the number of units produced, including the costs of miscellaneous factory supplies, power to run machines, and some equipment depreciation
-Unit-level, each unit requires some of these resource
Customer Relations cost pool
Assigned all costs associated with maintaining relations with customers, including the costs of sales calls and the costs of entertaining customers
Other" cost pool
Assigned all overhead costs that are not associated with customer orders, product design, the size of the orders, or customer relations.
-These costs will not be assigned to products because they represent resources that are not consumed by products
Customer Orders cost pool
Assigned all costs of resources that are consumed by taking and processing customer orders, including costs of processing paperwork and any costs involved in setting up machines for specific orders
-Number of customer orders received
-Batch level
Product Design cost pool
Assigned all costs of resources consumed by designing products
-Number of product designs
-Product level
General ledgers usually classify costs within
the departments where the costs are incurred.
(EX: salaries, supplies, rent, and so forth incurred in the marketing department are charged to that department)
First-stage allocation
The process of assigning functionally organized overhead costs derived from a company's general ledger to the activity cost pools
-First-stage allocations are usually based on the results of interviews with employees who have first-hand knowledge of the a
Departmental managers are typically interviewed to determine how
the nonpersonnel costs should be distributed across the activity cost pools
Calculate Activity Rates
The activity rates that will be used for assigning overhead costs to products and customers. The ABC team determined the total activity for each cost pool that would be required to produce the company's present product mix and to serve its present custome
Assign Overhead Costs to Cost Objects
Called second-stage allocation
Second-stage allocation
Activity rates are used to apply overhead costs to products and customers
Prepare Management Reports
The most common management reports prepared with ABC data are product and customer profitability reports. These reports help companies channel their resources to their most profitable growth opportunities while at the same time highlighting products and c
The ABC team uses a two-step process to compare its traditional and ABC product costs
1. Review the product margins reported by the traditional cost system
2. Contrast the differences between the traditional and ABC product margins
Three reasons why the traditional and activity-based costing systems report different product margins
1. Traditional cost systems allocates all manufacturing overhead costs to products
2. Traditional cost systems allocate all of the manufacturing overhead costs using a volume-related allocation base (machine hours) that may or may not reflect what actuall
Benchmarking
A systematic approach to identifying the activities with the greatest room for improvement. It is based on comparing the performance in an organization with the performance of other, similar organizations known for their outstanding performance. If a part