Key Takeaways
- ABC assigns overhead to activities, then to products based on activity consumption.
- Cost pools group costs by activity; cost drivers measure activity consumption.
- ABC provides more accurate product costs for diverse product lines.
- Traditional costing uses volume-based drivers; ABC uses multiple activity drivers.
- Activity-based management (ABM) uses ABC data to improve operations and reduce costs.
Activity-Based Costing
Quick Answer: ABC assigns overhead costs to activities (cost pools) and then to products based on cost drivers. It provides more accurate product costs than traditional costing by using multiple drivers that reflect actual resource consumption. ABC is most valuable for companies with diverse products and significant overhead.
Activity-based costing (ABC) emerged to address limitations of traditional costing systems, particularly in companies with diverse products and high overhead costs.
Why Traditional Costing Falls Short
Traditional costing typically uses one volume-based driver (like direct labor hours) to allocate all overhead. This causes problems when:
| Problem | Impact |
|---|---|
| Product diversity | High-volume products subsidize low-volume products |
| High overhead | Volume measures don't reflect overhead drivers |
| Automation | Direct labor is no longer the main cost driver |
| Complex processes | Different products use resources differently |
Traditional Costing Example
| Product | Units | DL Hours | DL Hours % | Allocated OH |
|---|---|---|---|---|
| A (Simple) | 10,000 | 20,000 | 80% | $400,000 |
| B (Complex) | 1,000 | 5,000 | 20% | $100,000 |
| Total | 11,000 | 25,000 | 100% | $500,000 |
Per unit overhead:
- Product A: $400,000 ÷ 10,000 = $40
- Product B: $100,000 ÷ 1,000 = $100
But what if Product B requires more setups, inspections, and engineering support despite using fewer labor hours?
The ABC Approach
ABC uses a two-stage allocation process:
Stage 1: Assign Costs to Activity Cost Pools
Activity Cost Pool: A collection of costs associated with a specific activity.
| Activity | Cost Pool | Cost Driver |
|---|---|---|
| Machine Setups | $150,000 | Number of setups |
| Quality Inspection | $100,000 | Number of inspections |
| Engineering Support | $80,000 | Engineering hours |
| Material Handling | $120,000 | Number of moves |
| Machine Operations | $50,000 | Machine hours |
| Total Overhead | $500,000 |
Stage 2: Assign Activity Costs to Products
Calculate activity rates and apply to products based on their consumption.
Activity Rate Formula:
Activity Rate = Activity Cost Pool ÷ Total Activity Driver
ABC Calculation Example
Activity Cost Pool Data:
| Activity | Cost Pool | Driver | Total Activity |
|---|---|---|---|
| Setups | $150,000 | Setups | 500 setups |
| Inspections | $100,000 | Inspections | 2,000 inspections |
| Engineering | $80,000 | Eng. hours | 4,000 hours |
| Material handling | $120,000 | Moves | 6,000 moves |
| Machine ops | $50,000 | Machine hrs | 10,000 hours |
Activity Rates:
| Activity | Calculation | Rate |
|---|---|---|
| Setups | $150,000 ÷ 500 | $300/setup |
| Inspections | $100,000 ÷ 2,000 | $50/inspection |
| Engineering | $80,000 ÷ 4,000 | $20/eng. hour |
| Material handling | $120,000 ÷ 6,000 | $20/move |
| Machine ops | $50,000 ÷ 10,000 | $5/mach. hour |
Product Activity Consumption:
| Activity | Product A (10,000 units) | Product B (1,000 units) |
|---|---|---|
| Setups | 100 | 400 |
| Inspections | 500 | 1,500 |
| Engineering hours | 500 | 3,500 |
| Material moves | 2,000 | 4,000 |
| Machine hours | 8,000 | 2,000 |
ABC Overhead Assignment:
| Activity | Product A | Product B |
|---|---|---|
| Setups | 100 × $300 = $30,000 | 400 × $300 = $120,000 |
| Inspections | 500 × $50 = $25,000 | 1,500 × $50 = $75,000 |
| Engineering | 500 × $20 = $10,000 | 3,500 × $20 = $70,000 |
| Material handling | 2,000 × $20 = $40,000 | 4,000 × $20 = $80,000 |
| Machine ops | 8,000 × $5 = $40,000 | 2,000 × $5 = $10,000 |
| Total OH | $145,000 | $355,000 |
| Per Unit | $14.50 | $355.00 |
Comparison: Traditional vs. ABC
| Product | Traditional OH/Unit | ABC OH/Unit | Difference |
|---|---|---|---|
| A (Simple) | $40.00 | $14.50 | Overcosted by $25.50 |
| B (Complex) | $100.00 | $355.00 | Undercosted by $255.00 |
Key Insight: Traditional costing significantly understated the cost of the complex, low-volume product (B) and overstated the cost of the simple, high-volume product (A).
Activity Classification Hierarchy
ABC organizes activities into a cost hierarchy:
| Level | Description | Examples | Allocation Base |
|---|---|---|---|
| Unit-Level | Performed for each unit | Machining, inspection | Units produced |
| Batch-Level | Performed for each batch | Setups, material moves | Number of batches |
| Product-Level | Support specific products | Engineering, design | Product line |
| Facility-Level | Support the entire facility | Plant security, rent | Cannot trace—allocate |
Cost Drivers
Cost drivers are factors that cause costs to be incurred. Selecting appropriate drivers is critical for ABC accuracy.
Characteristics of Good Cost Drivers
| Characteristic | Explanation |
|---|---|
| Causal relationship | Driver should logically cause the cost |
| Measurable | Can be objectively quantified |
| Available data | Information can be collected cost-effectively |
| Understandable | Managers can relate driver to cost |
Common Cost Drivers by Activity
| Activity | Typical Cost Driver |
|---|---|
| Setups | Number of setups |
| Purchasing | Number of purchase orders |
| Material handling | Number of moves |
| Quality control | Number of inspections |
| Engineering | Engineering hours |
| Maintenance | Machine hours |
| Customer service | Number of customers |
Activity-Based Management (ABM)
ABM uses ABC information to improve operations and increase value:
Value-Added vs. Non-Value-Added Activities
| Category | Definition | Action |
|---|---|---|
| Value-Added | Activities customers would pay for | Optimize |
| Non-Value-Added | Activities that waste resources | Eliminate |
Examples of Non-Value-Added Activities:
- Moving inventory between departments
- Waiting time
- Rework and defect correction
- Storage of excess inventory
- Redundant inspections
ABM Applications
| Application | Description |
|---|---|
| Process improvement | Eliminate non-value-added activities |
| Product/customer profitability | Identify profitable segments |
| Pricing decisions | Set prices based on true costs |
| Make-or-buy decisions | Compare with accurate product costs |
| Capacity management | Identify unused capacity costs |
When to Use ABC
ABC provides the greatest benefit when:
| Condition | Reason |
|---|---|
| High overhead relative to direct costs | More costs to allocate accurately |
| Diverse product lines | Products consume resources differently |
| Complex manufacturing processes | Multiple activities involved |
| Significant batch/product-level costs | Volume-based allocation distorts costs |
| Competition requires accurate costs | Pricing/profitability decisions |
ABC Implementation Considerations
| Factor | Consideration |
|---|---|
| Cost | ABC is more expensive to implement and maintain |
| Complexity | Requires more data collection |
| Buy-in | Needs management support |
| Benefit | Greatest for diverse, complex operations |
The primary difference between activity-based costing and traditional costing is that ABC:
A company has a setup cost pool of $90,000 with 300 setups performed during the year. Product X required 50 setups. How much setup cost should be allocated to Product X?
Which activity would be classified as a batch-level activity in the activity cost hierarchy?
Which of the following is a characteristic of a company that would benefit most from implementing activity-based costing?