ACTIVITY BASED COSTING

PRODUCT PROFITABILITY MODULE

(Mills)
Objective 1. Explain the role of activity-based systems
To create value and to satisfy customer needs for quality, reasonable price, and timely
delivery, managers must
work with suppliers and customers
view the organization as a collection of value-adding activities
use resources for value-adding activities
reduce or eliminate nonvalue-adding activities
know the total cost of creating value for a customer
The full product cost includes not only the costs of direct materials and direct labor, but
also the costs of all production and nonproduction activities required to satisfy the
customer.
Activity-based systems are information systems that provide quantitative information
about activities in an organization.
Objective 2. Define Activity-Based Management (ABM) and discuss its relationship
with the supply chain and value chain.
Activity-Based Management (ABM) is an approach to management that includes:
Identifying all major operating activities
Determining what resources are consumed by each activity
Categorizing the activities as either adding value to a product or service or not
adding value
ABM provides financial and operational performance information at the activity level
that:
Is helpful for making decisions about business segments
Helps managers eliminate waste and inefficiencies and redirect resources to
activities that add value to the product or service
Supply Chain is an interdependent collection or organizations that supplies materials,
products, or services to a customer. A supply chain includes suppliers and suppliers
suppliers as well as customers and customers customers.
A value chain is a related sequence of value-creating activities within an organization.
Helps managers better understand the interdependencies of those activities
A companys value chain is part of its supply chain
When organizations work cooperatively with others in their supply chain or larger
value chain, new processes can be introduced or existing processes redesigned to
reduce the total cost of products or services.

Objective 3. Distinguish between Value-Adding and Nonvalue-adding Activities

A value-adding activity is an activity that adds value to a product or service from the
customers perspective (e.g., assembling, painting or installing brakes on a car).
A nonvalue-adding activity is an activity that adds cost to a product or service but does
not increase its market value (e.g., moving or storing materials).
By identify nonvalue-adding activities, organizations can reduce costs and redirect
resources to value-adding activities.
ADDITIONAL NOTES
Cost systems estimate cost of objects, Why?
To determine profits
To price products/services
Direct cost assignment
Direct materials cost = materials cost X quantity of material consumed to make
one unit of product
Direct labor cost = labor cost per hour X quantity of hours consumed to make one
unit of product
Traditionally, direct materials and direct labor have been used to assign indirect
production costs (manufacturing overhead) to products cost. Why?
Represent the majority of product's cost
Usage and consumption must be controlled
Are fairly easy to measure
Traditional indirect cost assignment: Step 1. Calculate the rate
Identify indirect resource costs (ex: manufacturing overhead costs)
Identify cost driver (ex: direct labor hours, direct labor $, machine hours)
Calculate the cost driver rate (Resource costs divided by cost driver amount) (ex:
total manufacturing overhead costs / total direct labor hours = manufacturing
overhead rate per hour)
Traditional indirect cost assignment: Step 2. Assign cost to cost object
Multiply cost driver rate for each resource by the quantity consumed by product
or service
Traditional indirect cost assignment: Step 3. Calculate total cost

Sum indirect resource costs and add this to sum of direct costs. Divide by number
of units of cost object to obtain unit cost (Ex: Direct materials + Direct labor +
Manufacturing overhead = Total costs
Unit cost = total cost / total units

Companies should use ABC when they have one or more of the following:
More than one product line
Different products use different resources or activities
Different products use different amounts of same resources or activities
Problems if marketing is unable to price the homes to be competitive
Standard products are overpriced so competition can sell for less than us. Thus,
the competition is stealing sales of standard products away from us.
Custom products are underpriced, so competition is unwilling to sell at our price.
The competition knows they would not be able to cover their costs with the lower
selling price and that would mean losses rather than profits.
Warning! Something is wrong with the accounting system!!!
Situations that create need for a new cost system:
Sales: Competition prices commodity products lower than us
Sales: Competition prices specialty products higher than us
Production: Wants to discontinue custom/specialty products
Accounting: Shows custom products to be more profitable than standard
Cause of problem is improperly assigning indirect costs to products
Solution? Activity Based Costing
A way to better assign costs to products, services or other cost objects leads to
better decisions.
Traditional costing systems -- products consume capacity and capacity consumes
resources. This justifies assigning overhead costs to products based on the capacity
required to manufacture them. Sales forecasts establish production schedules. Production
schedules determine the needed plant capacity (based on direct labor hours or machine
hours). The overhead budget is set to meet the plant's capacity needs.
Activity-Based Costing systems -- products consume activities and activities
consume resources. This explains the logic behind activity-based costing systems. With
the help of computer systems the activities necessary to provide goods and services can
be collected and recorded. Thus, unique product characteristics can be collected and
assigned resource costs based on the activities used by them. These activities are used to
budget overhead needs.
Cost Hierarchy
Unit Level -- performed each time a unit is produced. Direct variable costs (direct
materials, direct labor, sales commissions)
Batch Level -- performed each time a batch is produced. Step costs (setups,
materials handling, purchasing)
Product line Level -- direct fixed costs of a product line. Trace to product line and
then allocate (advertising, architectural costs, product line supervision)

Facilities Level -- Indirect fixed costs of having facilities available. Traditional

allocation (heating, building depreciation, insurance, property taxes)

ABC Income Statements show what activities really cost and which activities are
used in various products or services
Strategic Uses for ABC
Add/drop product line
Product pricing
Outsourcing
Product redesign
Process redesign
Customer profitability analysis
ABC System challenges
Costs may exceed benefits
Too many cost pools and drivers
Lack of top management support
Review Questions
1.
2.
3.
4.
5.
6.
7.

Define Activity- Based Management

How does ABM help managers?
Define the supply chain.
Define the value chain.
Explain the difference between a value-adding and a nonvalue-adding activity.
Explain the two steps of assigning indirect costs to a product or service.
What is the impact on net income if a product is overpriced? What is the impact
on net income if a product is underpriced?
8. What situations can happen in a company that might indicate the need to create a
new costing system?
9. Define Activity-Based Costing (ABC).
10. What are the three product or production related needs that make ABC a useful
costing system for a company?
11. What is the difference between traditional costing systems and ABC systems?
12. List the four levels of a cost hierarchy. Define and give an example of a cost in
each level.
13. List three strategic uses for ABC.
14. What are three challenges in implementing an ABC system?
Sample Multiple Choice Questions
1. Companies find it difficult to implement ABC when
a. Too many cost pools and drivers are chosen
b. Top management does not support the implementation
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c. Costs of implementing and maintaining the system exceed the benefits

d. All of the above are difficulties
e. None of the above are difficulties
2. ABC can be used for which of the following strategic decisions
a. Product pricing
b. Outsourcing
c. Product redesign
d. Customer profitability analysis
e. All of the above
3. An example of a batch level cost in ABC is
a. Direct labor
b. Setups
c. Advertising
d. Building depreciation
e. Answers b. and c. above
4. Activity-Based costing systems demonstrate that
a. Products consume activities and activities consume resources
b. Products consume capacity and capacity consumes resources
c. Resources consume products
d. Capacity consumes products
e. None of the above is correct

Additional Information: Questions/Answers

1. Explain briefly how a traditional accounting system allocates costs to
products.
Traditional accounting systems divides costs into two categories, direct and indirect costs,
by their relationship to the products. Costs easily traceable to products are called direct
costs. All other manufacturing costs are called indirect costs. Usually, only one or a few
volume-based drivers like labor hours or machine hours are used to assign (allocate) the
indirect costs to products. Using volume-based cost drivers, we calculate a Predetermined
overhead rate (POR) for each driver to assign the overhead costs to products.
2. What are some fundamental differences between traditional volume-based
systems and ABC systems?

Allocating overhead to product costs is much more detailed in ABC systems. The
allocations relate to the actual unique activities of each product.

Because of the ability to trace product-related characteristics, nonmanufacturing

costs are often included in the product cost for management purposes.

The cause/effect relationships are much clearer with ABC.

3. How do ABC systems work? ABC systems directly trace resources to activities
and then activities to products and services. Resources are assets needed to
perform activities. Activities represent the work done in providing a service or
making a product.
4. What is a cost pool? Cost pools are groups of costs that have the same cost
drivers, like purchase orders, direct labor hours, etc. By grouping costs by the
drivers that cause them to change, we can assign all costs by their causes.
5. Define cost driver. What is its relationship to activity levels? The event, or
transaction, that causes the resources to be used is a cost driver. As activities
increase the cost drivers also increase. A machine setup is the activity using setup
resources, man-hours, etc. The number of setups is this activity's cost driver. A
cost driver is any factor that causes a change in the cost of an activity.

ILLUSTRATIONS OF ABC PROBLEMS WITH SOLUTIONS

Practice Problem 1. When is ABC useful? As a management accounting consultant,
four prospective clients (companies) have approached you. For each of the four following
situations, recommend for or against an activity-based costing system. Justify each
recommendation.
a. The first company mass produces a single product (chalk for schools and
artists). Each product is identical, so it should contain the same overhead
resources and include the same overhead cost. For product costing, ABC is not
needed. A simple allocation of overhead to each product, using product volume as
the cost driver should be sufficient. For management accounting (supporting
planning, operational monitoring, and performance evaluation), if different cost
pools exist, each with unique cost drivers, ABC can provide useful information.
But in this case, different cost pools will not exist.
b. The second company is a job shop (specialty printer of invitations, business
cards, etc.) Because each "product" (job) is unique, it probably uses different
resources than the next job. Many jobs will use the same resources, but in
different quantities. When multiple products are made using the same facilities,
and the products use different activities and resources, or the same resources but
in different amounts, ABC can provide more accurate product costs. ABC also
provides more relevant information for management accounting needs.
c. The third company makes many different variations of the same basic product (a
"product family" such as an automobile or telephone manufacturer). All products
within the product family use the same overhead resources in the same amount.
ABC may not improve product-costing accuracy when compared with a traditional cost
allocation system using a volume-based cost driver, such as direct labor or production

volume. If all products use the same overhead resources, they should contain the same
overhead cost.
ABC still can provide better management accounting information than a system using
one volume-based overhead cost driver when the company has multiple departments,
each responsible for its own budgeting and control and when each is separately evaluated.
ABC also provides information about nonmanufacturing costs, which can aid
management.
d. The fourth company (a milk producer) makes related products in large batch
runs, and each product goes through different departments. Each department has
unique overhead resources.
Because products are made indifferent departments, the resources they use probably are
unique to the specific departments involved. In these situations, ABC can identify which
resources and activities (and their costs) are traceable directly to individual product lines,
like milk, butter, and ice cream. Thus, ABC can provide better product costs and
management accounting information.
Practice Problem 2. Bozo, Roscoe, and Tina decided to spend a January weekend
together skiing at Angel Fire. Required (using the table of information below):

Food
Skiing
Lodging
Total

Estimated Costs
Cost Driver
$500 Lbs. Of food eaten
600 # of lift tickets
375 # of nights
$1,475

Activity Allocation
Bozo
Roscoe
Tina
20
30
50
3
2
0
2
2
2

A. Bozo suggests that the costs be shared equally based on number of people going on
trip. Calculate cost that each person would pay.
B. Tina doesn't like the idea because she plans to stay in the room rather than ski. She
suggests that each group of costs be allocated to each person based on the cost drivers
listed above. The information above lists his estimates of the cost driver allocations to
each person. Calculate the cost that each person would pay.
C. Calculate the total cost that was allocated in Part A and in Part B. Is there a difference?
Explain.

PracticeProblem 3. The following information is provided for the Astro Antennae Corp,
which manufactures two products, low-gain and high gain antennae.
Factory Overhead
Cost Pool 1 -- Setup Costs
Cost Pool 2 -- Inspection
CostsPool 3 -- Machine Costs
Cost
Total Factory Overhead Costs

Units produced
Prime Costs (Direct
Materials
+ Direct
Direct
labor
hours Labor)
Number of setups
Number of inspections
Number of machine hours

Costs
Cost driver
$50,000 # of setups
40,000 # of inspections
30,000 # of machine hours
$120,000

Lo-Gain Hi-Gain
100
200
$100,000 $160,000
1,000
2,000
20
20
40
10
1,800
1,200

Required:
A. Use the Traditional cost allocation
1. Calculate the predetermined overhead rate based on direct labor hours.
2. Calculate the product cost per unit for each product line.
B. Activity-based cost allocation
1. Calculate the predetermined overhead rate for each cost pool.
2. Calculate the product cost per unit for each product line.
Practice Problem 4. Roscoe Corp is considering the use of Activity=Based Costing to
determine unit product cost. Overhead cost information follows:
Product A Product B
Total Direct Materials Cost
Total Direct Labor Cost
Units produced
Number of Direct labor
hours of setups
Number
Hours of maintenance

$140,000 $360,000
$60,000
200
6,000
30
1,250

$40,000
200
4,000
70
3,750

Factory Overhead
Cost Pool 1 -- Setup Costs
Cost Pool 2 -- Maintenance
Costs Factory Overhead Costs
Total

Costs
Cost driver
$100,000 # of setups
50,000 maintenance hours
$150,000

Required:
A. Traditional cost allocation Assuming that the company is currently applying overhead
based on direct labor hours
1. Calculate the predetermined overhead rate based on direct labor hours.
2. Calculate the product cost per unit for each product line.
B. Activity-based cost allocation
1. Calculate the predetermined overhead rate for each cost pool.
2. Calculate the product cost per unit for each product line.

Solutions
Solutions to Practice Problem 2
A. Total estimated costs divided by total number of people = $1,475 / 3 people = $491.67
per person
Note: This is an example of combining costs of three activities into one cost pool
($1,475) with one cost driver (or activity base; e.g. number of people). This illustrates the
traditional approach to applying overhead to manufactured products.
B. Calculate the cost that each person would pay.

Activities Step 1. Calculate rate.

Step 2
Eating
$500/100lb = $5 per lb.
X 20 lbs.
Skiing
$600/ 5 tickets = $120 per ticket
X 3 tkts
Lodging
Total

$375/6 nights = $62.50 per night

Step 3. Calculate unit cost.

X 2 nites

Bozo Step 2
Roscoe Step 2
$100 X 30 lbs
$150 X 50 lbs
360 X 2 tkts
240 X 0 tkts
125 X 2 nites
$585

125 X 2 nites
$515

Tina
$250
0
125
$375

Note: We are using Activity-based costing here. We realize that each individual is
consuming certain activities at different rates. It is not fair to charge Tina for skiing
if she chooses to stay in the cabin and eat half of the food. Likewise, the guys
shouldn't have to pay for food they didn't eat.
So step 1 is to calculate the rate for each cost pool. Three pools means three rates.
Step 2. Is to apply the rate to each person based on the amount of the activity
consumed.

Step 3. Is it add the costs together for each person to get the total cost assigned to
the person.
This problem illustrates the creation of three cost pools and three cost drivers,
which lead to more accurate cost assignment to individuals based on their level of
activity consumption.
C. Calculate the total cost that was allocated in Part A and in Part B. is there a difference?
Explain.
In either case, we are assigning a total cost of $1,475 to the three individuals. Using
activity-based costing means that you are simply slicing the pie differently, but the pie is
still the same size. When we look at this in a business context, you will see that ABC
does not immediately improve profits. The total overhead is still assigned to the products.
The difference is in the amount assigned to each product line. Over time, profits will
increase if we assume that you will make better pricing decisions using more accurate
cost information.
Questions and Solution to Problem 3
A. Use the Traditional cost allocation
1. Calculate the predetermined overhead rate based on direct labor hours.
Total Budgeted Factory Overhead Costs / total estimated direct labor hours = $120,000 /
(1,000 dlh for Lo-Gain + 2,000 dlh for Hi-Gain) = $40 per direct labor hour
Note: When you are getting the total direct labor hours, you have to combine the direct
labor hours related to all products for the year. Hence, we added 1,000 + 2,000 to get a
total of 3,000 direct labor hours worked for the year.
2. Calculate the product cost per unit for each product line.
Lo-Gain
Prime Costs (DM + DL)
$100,000
Factory overhead assigned
40,000
Total product cost for each product line $140,000
Divided by total units
100 units
Product cost per unit
$1,400

Hi-Gain
$160,000
80,000
$240,000
200 units
$1,200

Note: Overhead = $40 X 1,000 dlh;

$40 X 2,000 dlh
Note that we are using the traditional approach to assigning overhead. We have one cost
pool ($120,000) with one cost driver (3,000 direct labor hours).

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B. Activity-based cost allocation

1. Calculate the predetermined overhead rate for each cost pool.
Factory Overhead
Cost Pools

Costs

Cost driver

Budgeted Level Overhead

of Cost Driver rate

Cost Pool 1 -- Setup $50,000

# of setups
40 setups
$1,250 per
Costs
setup
Cost Pool 2 -40,000 # of inspection
50 inspection
$800 per
Inspection Costs
inspection
Cost Pool 3 -30,000 # of machine 3,000 machine
$10 per
Machine Costs
hours
hours machine hour
2. Calculate the product cost per unit for each product line.

Prime Costs
Setup costs
Inspection costs
Machine costs

Application rate
from 1. above
DM + DL
$1,250 per setup
$800 per inspection
$10 / machine hour
Total product costs
Divide
Step 3. Unit cost.

St 2. Apply

Lo-Gain

St 2. Apply

Hi-Gain

$100,000
$160,000
X 20 setups $25,000 X 20 setups $25,000
x 40 insp
32,000 X 10 insp
8,000
X 1,800 mh
18,000 X 1,200 mh
12,000
$175,000
$205,000
100units
200 units
$1,750
$1,025

Note: The combined total product costs using the traditional approach ($140,000
for lo-gain + $240,000 for hi-gain) is the same as the combined total product costs
using ABC ($175,000 for lo-gain + $205,000 for hi-gain). So, net income or profit
will be the same for the company as a whole. The same cost of goods sold amount
will be subtracted from revenue, either way. However, the unit costs are different.
Since ABC is more accurate, it will provide better information for pricing and
bidding decisions.

Questions and Solutions to Practice Problem 4.

Assuming that the company is currently applying overhead based on direct labor hours,
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1. Calculate the predetermined overhead rate based on direct labor hours.

Total Budgeted Factory Overhead Costs / total estimated direct labor hours = $150,000 /
(6,000 dlh for Product A + 4,000 dlh for Product B) = $15 per direct labor hour
Note: When you are getting the total direct labor hours, you have to combine the direct
labor hours related to all products for the year. Hence, we added 6,000 + 4,000 to get a
total of 10,000 direct labor hours worked for the year.

Product A Product B
Direct Materials Cost
$140,000 $360,000
Direct Labor Cost
60,000
40,000
Factory overhead assigned (see note)
90,000
60,000
Total product cost for each product line $290,000 $460,000
Divide
200 units 200 units
Product cost per unit
$1,450
$2,300
Note: Overhead = $15 X 6,000 dlh;
$15 X 4,000 dlh

3. Calculate the product cost per unit for each product line.
Note that we are using the traditional approach to assigning overhead. We have one cost
pool ($150,000) with one cost driver (10,000 direct labor hours) representing all of the
budgeted costs and budgeted hours to be work for the year. The number of hours is
driven, in part, by capacity constraints. How many people can we really have working
and what is the maximum number of hours they can work? How is this to be scheduled
over production of several product lines?

B. Activity-based cost allocation

1. Calculate the predetermined overhead rate for each cost pool.

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Factory Overhead
Cost Pools
Cost Pool 1 -- Setup
Costs
Cost Pool 2 -Maintenance Costs

Costs
$100,000

Cost driver

Budgeted Level
of Cost Driver
# of setups 100 setups

Overhead rate
$1,000 per setup

50,000 Maintenance hrs 5,000 maintenance $10 per maintenance

hours
hour

2. Calculate the product cost per unit for each product line.
Activities
Application rate
Step 2
Product A Step 2
Product B
Direct Materials
$140,000
$360,000
Direct Labor
$60,000
$40,000
Setup
$1,000 per setup
x 30 setups
30,000 X 70 setups
70,000
Maintenance
$10 per maint hr
X 1,250 mh
12,500 X 3,750 mh
37,500
Total product costs
$242,500
$507,500
Divide
200units
200 units
Step 3. Unit cost.
$1,212.50
$2,537.50
Note: The combined total product costs using the traditional approach ($290,000 for
Product A + $460,000 for Product B) is the same as the combined total product costs
using ABC ($242,500 for Product A + $507,500 for Product B). So, net income or profit
will be the same for the company as a whole. The same cost of goods sold amount will be
subtracted from revenue, either way. However, the unit costs are different. Since ABC is
more accurate, it will provide better information for pricing and bidding decisions in the
long run. Thus, profits should improve in the future.

InClass Practice Problem #1. Turbo Champs Corp is considering the use of ActivityBased Costing to determine unit product cost. Overhead cost information follows:

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Factory Overhead

Costs

Cost Pool 1 -- Setup Costs

$60,000

# of setups

Cost Pool 2 -- Inspection

CostsPool 3 -- Maintenance
Cost
Costs Factory Overhead Costs
Total

15,000
7,500
$82,500

# of inspections
Maint hours

4-Wheeler
Total Direct Materials Cost

Cost driver

3-Wheeler

$141,500

$18,800

$7,500
10
500
20
30
100

$4,500
10
300
30
45
300

Total Direct Labor Cost

Number of units
Number of Direct labor
hours of setups
Number
Number of inspections
Hours of maintenance

Required:
A. Traditional cost allocation
1.Calculate the predetermined overhead rate based on direct labor hours.

2. Calculate the product cost per unit for each product line.

B. Activity-based cost allocation

1. Calculate the predetermined overhead rate for each cost pool.

2. Calculate the product cost per unit for each product line.

InClass Practice Problem #2. Textile Mills Corp is considering the use of ActivityBased Costing to determine unit product cost. Overhead cost information follows:
Setup
Maintenance

$125,000
75,000
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Total

$200,000

Other information:
Direct Materials
Direct Labor
Number of units
Number of direct labor hours
Number of setups
Hours of maintenance

Product A
$140,000
$60,000
200
6,000
30
1,250

Product B
$360,000
$40,000
200
4,000
70
3,750

1) Assume that the predetermined overhead rate is $10 per direct labor hour. The
product cost per unit for product A would be
a) $200
b) $300
c) $1,010
d) $1,300
e) $1,500
2) If the company uses ABC, the rate per setup would be
a) $12.50
b) $625
c) $1,250
d) $2,000

e) None of above

3) Assume ABC is used to assign overhead to the product lines and the rates are $500
per setup and $40 per maintenance hour. The product cost per unit for product B
would be
a) $3,250
b) $ 2,925
c) 1,325
d) $925
e) None of the above
4) Calculate the consumption ratios and place in the spaces provided:
Qty
Ratio
Qty
Number of direct labor hours
6,000
4,000
Number of setups
30
70
Hours of maintenance
1,250
3,750

Ratio

Assume we are currently using direct labor hours to assign overhead traditionally. If we
switch to ABC, will Product As product cost increase or decrease? Why?

5) Will net income change if we use ABC, assuming no inventories exist?

InClass Practice Problem #3. LMS Corp is considering the use of Activity-Based
Costing to determine unit product cost. Overhead cost information follows:
Setup

$30,000
15

Maintenance
Total

10,000
$40,000

Other information:
Direct Materials
Direct Labor
Number of units
Number of direct labor hours
Number of setups
Hours of maintenance

Product L
$50,000
$16,000
100
5,000
20
300

Product M
$24,000
$8,000
100
3,000
40
700

1.Assume

that the predetermined overhead rate is $6 per direct labor hour. The product
cost per unit for product L would be
a) $960
b) $660
c) $320
d) $300
e) $180
2.If the company uses ABC, the rate per setup would be
b) $3.75
b) $500
c) $750
d) $1,500

e) None of above

3.Assume ABC is used to assign overhead to the product lines and the rates are $400 per
setup and $20 per maintenance hour. The product cost per unit for product M would be
b) $320
b) $ 480
c) 620 d) $660
e) None of the above

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