Activity Based Costing (ABC)

1. Activity Based Costing (ABC) The objective of ABC is to understand overhead and the profitability of products and customers.

2. Applying Overhead • Problem: Manufacturing overhead, by definition, cannot be traced directly to products or jobs • Solution: A predetermined overhead rate (POHR), based on estimated total overhead costs and the estimated denominator activity level, is used to apply manufacturing overhead

3. Plantwide Overhead Rate A single POHR is used to apply overhead to all jobs/production. The denominator activity is usually based on direct labor (e.g., direct labor hours)

4. Plantwide Overhead Rate • Problem: Manufacturing overhead is not a single cost but many; not all of these costs are closely tied to the incurrence of direct labor costs • Problem: When a company has different products with different direct labor requirements, some products may be over or under-charged with manufacturing overhead

5. Departmental Overhead Rates Each department estimates and accumulates its overhead costs separately and computes a separate POHR; each department may use a different activity base for overhead allocation

6. Departmental Overhead Rates • Problem: Same as for plantwide overhead rate, i.e., heterogeneous costs applied using a single POHR, although the problem is reduced since each department may use a different and more relevant activity base

7. Activity-Based Costing • Used primarily for internal decision-making, not for product costing for external reports • Objective is to identify activities within the business that drive the incurrence of overhead costs • Costs are allocated to products/jobs/ customers based on activities

8. Steps in Implementing ABC • Identify and define activities and cost pools • Where possible, trace and assign costs to activities and activity cost pools • Calculate activity rates • Assign costs to cost objects (jobs/products/ customers) • Prepare reports to management

9. Activities An activity (in an ABC system) is an event or process that causes the consumption of overhead resources in the business

10. Identifying Activities • Requires judgment and experience • Normally, ABC team interviews employees in overhead departments to determine major activities • Cost-benefit analysis is required. More activities results in better cost information but cost to implement the system increases as number of activities increases

11. Levels of Activities • Unit-level - the activity is performed for each unit produced • Batch-level - the activity is performed each time a batch is processed (regardless of number of units in the batch) • Product-level - the activity is related to a specific product, regardless of number of batches or units

12. Levels of Activities (2) • Customer-level - the activity is related to a specific customer or group of customers, but not tied to any specific product • Organization-sustaining - the activity is carried out regardless of customers served, products produced, number of batches or number of units

13. Activity Cost Pool An activity cost pool is a “bucket” in which costs that relate to a single activity in the ABC system are accumulated

14. Activity Measure An activity measure is the allocation base used for an individual activity cost pool within an ABC system

15. ABC Example (1) First stage allocation • Overhead costs are assigned to activity cost pools • Basis of allocation is interviews with employees involved with overhead cost being allocated

16. ABC Example (2) An activity rate is computed for each cost in the activity cost pool Cost in activity cost pool Activity measure

17. ABC Example (3) Overhead costs can be applied to products, jobs or customers using the activity rates computed

18. ABC Example (4) • The ABC system provides a different view of which customer is profitable to Custom Windows than did the traditional costing system • The ABC system could not be used as is for financial reporting because some period costs are assigned to products/customers

19. ABC vs. TraditionalProduct Costing • ABC will normally shift batch-level and product-level costs from high-volume products produced in large batches to low-volume products produced in small batches • ABC can assign both manufacturing and nonmanufacturing costs to products • ABC does not assign organization-sustaining costs to products

20. Simplified ABC • After first-stage allocation, compute a single (total) activity rate for each activity cost pool • Making windows: $4.14 / dlhours • Processing orders: $116 / order • Customer relations: $2,840 / customer • Apply OH costs using activity data for specific jobs/customers