Activity-Based Costing Example

Lisa Horton, Production Manager for Beautiful You skin care products, had just finished reading
several articles on product line simplification and was not pleased. The articles documented how
several major companies achieved cost savings by simplifying product lines or reducing the
number of unique inputs or parts from existing product lines. I wish our marketing department
had read these articles thought Lisa. In the past year, Beautiful You had introduced a Tiny bar
(1.5 oz.) of soap to complement the Little (3.0 oz.) and big (5.0 oz.) bars. Sales of the Tiny bar
had been disappointing.
At a soap team strategy meeting, Joe Johnson, the accountant assigned to the soap team,
recommended concentrating resources on the Tiny and Big bars and reducing or eliminating
production of the Little bars. Joe presented the information shown in Exhibits 1 and 2. As you
can see, our costs for the Tiny and Big bars are less than both the industry average and our major
competitor said Joe as he referred to Exhibit 2.
Lisa looked at the labor and overhead cost of the three bars of soap. Im certainly not an
accountant, she said, but it doesnt appear appropriate to allocate the total labor cost based on
direct labor hours. Thirty-five of our 125 employees are managers. Furthermore, Ive seen the
way the remaining employees categorize their time, and is pretty much a joke. The labor hours
certainly dont capture the set up costs. In addition, it appears arbitrary to allocate the remaining
$4,295,000 of cost based on the volume of bars produced.
Joe suggested performing an activity-based costing study to determine whether indirect costs
were appropriately allocated to the different products. Joe explained that under ABC, costs are
associated with activities required to produce the products instead of allocating the costs directly
to the products. Once the costs of the activities are determined, the activities required to produce
each product are used to allocate the costs to the individual products. The team members agreed
that Joe should conduct the ABC study.
Joe developed a questionnaire and administered it to the 125 employees. The results obtained
were frustrating. The employees indicated that they engaged in over forty different activities that
included over thirty different cost driver possibilities. Joe administered the questionnaire again
after reducing the number of potential activity categories to fifteen. He was elated when the
results indicated that the 125 employees spent 95 percent of their time on seven activities:
25%
20%
12%
12%
11%
11%
4%
5%

making soap
setting up or shutting down equipment due to product changeovers
reworking defective products
personal breaks
repairing equipment breakdowns
inventory movement
team-building meetings
miscellaneous other activities

Joe realized that driving the remaining overhead costs to the above activities was not a science
but called for judgment. Joe had lengthy discussions with the production people but realized that
choosing resource drivers and the costing of activities was inevitably hampered by the
constraints of data availability and collectibility. Joe and Lisa finally decided that the remaining
overhead costs should be driven to the activities in the manner shown in Exhibit 3.
After driving the general ledger labor and overhead costs to the activities, Joe analyzed the
activities and the potential activity drivers listed in Exhibit 3. The practical relevance of the
drivers was essential, and the necessary data had to be identified with the three different sized
bars of soap to permit the activity costs to be driven to the products. In some cases the necessary
data was not being collected, and the records had to be created, causing delays in the project. In
making the decision for the activity drivers, Joe and Lisa noted that the production process itself
was highly automated. While the dedicated employees were not truly unique to the products,
Lisa and Joe decided that the breaks and team building activity would probably have to depend
on this driver. Finally, Joe and Lisa decided to drive the miscellaneous other activities using
volume of soap produced.
EXHIBIT 1
Beautiful You Soap
Annual Budgeted Labor and Overhead Costs
Annual costs:
Labor (including benefits)
90 production employees
35 management employees
Total labor

$ 5,400,000
2,625,000
$ 8,025,000

Depreciation
Administrative overhead
Purchasing
Cost accounting
Buildings
Administration
Total administrative overhead
Taxes and insurance
Engineering and R&D
Utilities
Other
Total production costs excluding material

975,000

420,000
400,000
480,000
750,000
2,050,000
350,000
1,000,000
695,000
200,000
$ 13,295,000

EXHIBIT 2
Beautiful You Soap
Labor and Overhead Allocation - Traditional Costing
Tiny

Little

Big

Total

301,691

$ 5,752,256

$ 1,971,053

$ 8,025,000

24,158

676,412

274,430

975,000

2,947,549
$ 9,376,217

1,263,235
$ 3,508,718

4,295,000
$ 13,295,000

0.27

0.23

Labor and overhead costs:

Labor (allocated by labor hours)

Depreciation (allocated by machine hours)

All other costs (allocated by volume)
Total labor and overhead costs

84,216
410,065

Labor and overhead cost per bar

0.41

Comparative Cost Per Bar

Blue Company (chief competitor)

0.45

0.25

0.24

Industry average

0.50

0.20

0.30

EXHIBIT 3
Beautiful You Soap
Activity-Based Costing - First Stage Allocation Rates

Making

Downtime Changeover

Rework

Labor

25%

11%

20%

12%

Depreciation

32%

14%

25%

15%

Breaks
12%

Team

Material

Other

meetings

movement

activities

4%

11%

5%

14%
100%

25%

Engineering and R&D

50%

25%

32%

100%
14%

25%

15%

14%

100%

Other costs

100%

EXHIBIT 4
Beautiful You Soap
Second Stage Drivers
Times
Machine
hours

100%
100%

100%

Utilities

100%
100%

Administrative overhead
Taxes and insurance

Total

Efficiency rates
% uptime

% downtime

Changeover

Pounds

Dedicated

handled

Total bars

hours

recycled

employees

per bar

produced

Tiny

50,000

60%

40%

288

25,000

1,000,000

Little

1,400,000

64%

36%

192

60,000

70

35,000,000

Big

568,000
2,018,000

67%

33%

192
672

50,000
135,000

15
88

15,000,000
51,000,000

100%

EXHIBIT 5
Beautiful You Soap
First Stage Allocation - Costing Activities

Total labor
Percent
Depreciation
Percent
Administrative OH
Percent
Taxes and insurance
Percent
Engineering and R&D
Percent
Utilities
Percent
Other costs
Percent
Total labor and overhead
Percent

Team

Material

Other

Making

Downtime

Changeover

Rework

Breaks

meetings

movement

activities

Total

$ 2,006,250

$ 882,750

$ 1,605,000

$ 963,000

$ 963,000

$ 321,000

$ 882,750

$ 401,250

$ 8,025,000

25%

11%

20%

12%

12%

4%

11%

5%

100%

EXHIBIT 6
Beautiful You Soap
Second Stage Allocation - Costing Products

Making
Total labor and overhead costs

3,628,150

Cost drivers

Driver base

1,291,550

Changeover
2,110,000

Rework
1,213,500

Breaks
963,000

Material

Other

meetings

movement

activities

321,000

1,116,550

2,651,250

Uptime

Downtime

machine

machine

Changeover

Pounds

Dedicated

Dedicated

of times

Total bars

hours

hours

hours

recycled

employees

employees

handled

produced

1,306,560

Driver rate: (dollars per base unit) $

Downtime

Team

2.78

Tiny - total dollars

83,306

Tiny - dollars per bar

0.08

Little - total dollars

$ 2,488,077

Little - dollars per bar

Big - total dollars

$ 1,056,766

Big - dollars per bar

0.07

0.07

Number

Total
13,295,000