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ACTIVITY-BASED COSTING
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KenGarrettdemystifiesActivitybasedcostingandprovidessometipsleadinguptotheall
importantexams
Conventionalcostingdistinguishesbetweenvariableandfixedcosts.Typically,itisassumedthatvariable
costsvarywiththenumberofunitsofoutput(andthatthesecostsareproportionaltotheoutputlevel)
whereasfixedcostsdonotvarywithoutput.Thisisoftenanoversimplificationofhowcostsactually
behave.Forexample,variablecostsperunitoftenincreaseathighlevelsofproductionwhereovertime
premiumsmighthavetobepaidorwhenmaterialbecomesscarce.Fixedcostsareusuallyfixedonly
overcertainrangesofactivity,oftensteppingupasadditionalmanufacturingresourcesareemployedto
allowhighvolumestobeproduced.
Variablecostsperunitcanatleastbemeasured,andthesumofthevariablecostsperunitisthe
marginalcostperunit.Thesearetheextracostscausedwhenonemoreunitisproduced.However,there
hasalwaysbeenaproblemdealingwithfixedproductioncostssuchasfactoryrent,heating,supervision
andsoon.Makingaunitdoesnotcausemorefixedcosts,yetproductioncannottakeplacewithoutthese
costsbeingincurred.Tosaythatthecostofproducingaunitconsistsofmarginalcostsonlywill
understatethetruecostofproductionandthiscanleadtoproblems.Forexample,ifthesellingpriceis
basedonamarkuponcost,thenthecompanyneedstomakesurethatallproductioncostsarecovered
bythesellingprice.Additionally,focusingexclusivelyonmarginalcostsmaycausecompaniestooverlook
importantsavingsthatmightresultfrombettercontrolledfixedcosts.
Theconventionalapproachtodealingwithfixedoverheadproductioncostsistoassumethatthevarious
costtypescanbelumpedtogetherandasingleoverheadabsorptionratederived.Theabsorptionrateis
usuallypresentedintermsofoverheadcostperlabourhour,orcostpermachinehour.Thisapproachis
likelytobeanoversimplification,butithasthemeritofbeingrelativelyquickandeasy.
EXAMPLE1
SeeTable1below.
Thebudgetedlabourhoursmustbe112,000hours.Thisisderivedfromthebudgetedoutputsof20,000
ordinaryunitswhicheachtakefivehours(100,000hours)toproduce,and2,000deluxeunitswhicheach
takesixhours(12,000hours).
Therefore,thefixedoverheadabsorptionrateperlabourhouris$224,000/112,000=$2/hour.
Thecostingofthetwoproductscanbecontinuedbyaddinginfixedoverheadcoststoobtainthetotal
absorptioncostforeachoftheproducts.
SeeTable2below.
Forfuturereference,notethatthetotalcostsaccountedfor(ifproductiongoesaccordingtoplan)willbe=
20,000x85+2,000x102=$1,904,000.
Theconventionalapproachoutlinedaboveissatisfactoryifthefollowingconditionsapply:
1. Fixedcostsarerelativelyimmaterialcomparedtomaterialandlabourcosts.Thisisthecaseinmanufacturing
environmentswhichdonotrelyonsophisticatedandexpensivefacilitiesandmachinery.
2. Mostfixedcostsaccruewithtime.
3. Therearelongproductionrunsofidenticalproductswithlittlecustomisation.

Table1,Example1
Budget

Unitsproduced

Ordinaryunits

20,000

Deluxe
units

2,000

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Costsperunit:

Material

10

12

Labour

5hours
at
$12/hour

60

6hours
at
$12/hour

72

Variableoverhead

5hours
at
$1/hour

6hours
at
$1/hour

Marginalcosts

75

90

Budgetedfixedproductionoverheadsare$224,000
Table2,Example1
Budget

Ordinaryunits

Deluxe
units

Unitsproduced

20,000

2,000

Costsperunit:

Marginalcosts

75

90

Fixedoverheads

5hours
at
$2/hour

10

6hours
at
$2/hour

12

Totalabsorption

Cost/unit

85

102

However,muchmodernmanufacturingreliesonhighlyautomated,expensivemanufacturingplantsso
muchsothatsomecompaniesdonotseparatelyidentifythecostoflabourbecausethereissolittleused.
Instead,factorylabourissimplyregardedasafixedoverheadandaddedintothefixedcostsofrunning
thefactory,itsmachinery,andthesophisticatedinformationtechnologysystemwhichcoordinates
production.
Additionally,manycompaniesrelyoncustomisationofproductstodifferentiatethemselvesandtoenable
highermarginstobemade.Dell,forexample,aPCmanufacturer,hasawebsitewhichletscustomers
specifytheirownPCintermsofmemorysize,capacity,processorspeedetc.Thatinformationisthenfed
intotheirautomatedproductionsystemandthespecifiedcomputerisbuilt,moreorlessautomatically.
Insteadofofferingcustomerstheabilitytospecifyproducts,manycompaniesofferanextensiverangeof
products,hopingthatonememberoftherangewillmatchtherequirementsofaparticularmarket
segment.InExample1,thecompanyofferstwoproducts:ordinaryanddeluxe.Thecompanyknowsthat
demandforthedeluxerangewillbelow,buthopesthatthepricepremiumitcanchargewillstillallowitto
makeagoodprofit,evenonalowvolumeitem.However,thedeluxeproductcouldconsumeresources
whicharenotproperlyreflectedbythetimeittakestomakethoseunits.
Thesedevelopmentsinmanufacturingandmarketingmeanthattheconventionalwayoftreatingfixed
overheadsmightnotbegoodenough.Companiesneedtoknowthecausesofoverheads,andneedto
realisethatmanyoftheirfixedcostsmightnotbefixedatall.Theyneedtotrytoassigncoststoproducts
orservicesonthebasisoftheresourcestheyconsume.
EXAMPLE2
Ananalysisofthefixedoverheadsof$224,000showsthattheyconsistof:

Batchsetupcosts

90,000

Storesmaterialhandlingetc

92,000

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Other(rentetc)
Total

42,000
224,000

Ordinaryunitsareproducedinlongproductionruns,witheachbatchconsistingof2,000units.
Deluxeunitsareproducedinshortproductionruns,witheachbatchconsistingof100units.
Eachordinaryunitconsistsof20components,eachdeluxeunitof30components.
Whatwewanttodoistogetamoreaccurateestimateofwhateachunitcoststoproduce,andtodothis
wehavetoexaminewhatactivitiesarenecessarytoproduceeachunit,becauseactivitiesusuallyhavea
costattached.Thisisthebasisofactivitybasedcosting(ABC).Theoldapproachofsimplypretending
thatfixedcostsareincurredbecauseofthepassageoftime,andthattheycanthereforebeaccountedfor
onthebasisoflabour(ormachine)timespentoneachunit,isnolongergoodenough.Diverse,flexible
manufacturingdemandsamoreaccurateapproachtocosting.
TheABCprocessisasfollows:
1. Identifyadistinctfixedoverheadcost.
2. Identifytheactivitythatcausesthatcost.InABCterminology,thatactivityisthecostdriver,butitmightbebetterto
thinkofitasthecostcauser.
3. Workoutthecostincurredeachtimetheactivityoccurs.
4. Determinehowmanyunitsaremadeforeachincidenceofthecostcauser.Thisislikelytovaryforeachtypeofunit.
5. Workoutthecostthatcanbetracedintoeachunitproduced.

SeeFigure1below.

EXAMPLE3
Applyingthesestepstothe
fixedcostbreakdownshown
inExample2resultsinthefollowinganalysis:
Batchsetupcosts
1. Costofsetups=$90,000
2. Costdriver(orcostcauser)=eachbatchsetup(presumably)
3. Thenumberofsetupsare:
Forordinaryunits20,000/2,000=10
Fordeluxeunits2,000/100=20
Totalsetupoccasions30
Costpersetup90,000/30=$3,000
4. Eachsetupproduces2,000ordinaryunits
Eachsetupproduces100deluxeunits
5. Ordinaryunits:$3,000/2,000=$1.50/unit
Deluxeunits:$3,000/100=$30/unit

Materialhandlingcosts
1. Costofmaterialhandling
2. Costdriverwillbenumberofcomponentshandled(presumably)
3. Thenumberofmaterialhandlingeventsfortheyear=20x20,000+30x2,000=460,000(fromtheinformationgiven
above)
Costpermaterialhandlingevent=$92,000/460,000=$0.20
4. Eachordinaryunittakes20itemsofmaterialEachdeluxeunittakes30itemsofmaterial
5. Eachordinaryunitwillcost$0.2x20=$4/unitEachdeluxeunitwillcost$0.2x30=$6/unit

Otherfixedoverheadswillhavetobeabsorbedonalabourhourratebecausethereisnoinformation
providedthatwouldallowabetterapproach:
$42,000/112,000=$0.375/labourhour
TheABCapproachtocostingthereforeresultsinthefiguresshowninTable3below.Check:totalcosts
accountedforifallgoesaccordingtobudget=20,000x82.375+128.25x2,000=$1,904,000,as
before.
Table3,Example3
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Budget

Ordinaryunits

Deluxe
units

Unitsproduced

20,000

2,000

Marginalcosts
(asbefore)

75.00

90.00

Fixedoverheads:

Setup

1.50

30.00

Materialhandling

4.00

6.00

Other

5hours
at
0.375

6hours
at
0.375

2.25

Totalabsorptioncost/unit

1.875

82.375

128.25

COMPARINGTHEAPPROACHES

Totalabsorptioncost/unit
conventionalapproach

Ordinary
units

Deluxe
units

85.000

102.000

Totalabsorptioncost/unitABC
approach

82.375

128.25

YouwillseethattheABCapproachsubstantiallyincreasesthecostofmakingadeluxeunit.Thisis
primarilybecausethedeluxeunitsaremadeinsmallbatches.Eachbatchcausesanexpensivesetup,
butthatcostisthenspreadoveralltheunitsproducedinthatbatchwhetherfew(deluxe)ormany
(ordinary).Itcanonlyberightthattheeffortandcostincurredinproducingsmallbatchesisreflectedin
thecostperunitproduced.Therewould,forexample,belittlepointinproducingdeluxeunitsatalliftheir
highersellingpricedidnotjustifythehighercostsincurred.
Inadditiontoestimatingmoreaccuratelythetruecostofproduction,ABCwillalsogiveabetterindication
ofwherecostsavingscanbemade.Remember,thetitleofPaperF5isPerformanceManagement,
implyingthataccountantsshouldbeproactiveinimprovingperformanceratherthanpassivelymeasuring
costs.Forexample,itsclearthatasubstantialpartofthecostofproducingdeluxeunitsissetupcosts
(almost25%ofthedeluxeunitstotalcosts).
Workingontheprinciplethatlargecostsavingsarelikelytobefoundinlargecostelements,
managementsattentionwillstarttofocusonhowthiscostcouldbereduced.
Forexample,isthereanyreasonwhydeluxeunitshavetobeproducedinbatchesofonly100?Abatch
sizeof200unitswoulddramaticallyreducethosesetupcosts.
Thetraditionalapproachtofixedoverheadabsorptionhasthemeritofbeingsimpletocalculateand
apply.However,simplicitydoesnotjustifytheproductionanduseofinformationthatmightbewrongor
misleading.
ABCundoubtedlyrequiresanorganisationtospendtimeandeffortinvestigatingmorefullywhatcausesit
toincurcosts,andthentousethatdetailedinformationforcostingpurposes.Butunderstandingthe
driversofcostsmustbeanessentialpartofgoodperformancemanagement.
KenGarrettisafreelancewriterandlecturer

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