Activity Based Costing

Activity-Based Costing (ABC)


Activity-based costing (ABC), volume-based traditional costing; job costing, process costing; actual costing, normal costing, standard costing; steps of ABC; advantages and disadvantages of ABC

Cost accumulation methods represent methods used to accrue costs. There are two types: job costing and process costing. These methods depend on the type of production.

Job costing is a product costing system when costs are accumulated by specific job orders (e.g. Job Order XX2, Job Order 02357) and assigned to batches of products. In other words, manufacturing costs are assigned to specific jobs: specific customers, specific orders, specific projects, specific contracts, etc. Job costing is often used by small and medium-sized firms. Also, it is often used in the following industries: professional services (e.g. medical, legal), advertising agencies, construction, shipbuilding, custom equipment/furniture manufacturing, etc.

Process costing is a product costing system when costs are accumulated by departments or processes (e.g. Printing Department, Assembling Department) and assigned to a large number of homogenous, identical products. In other words, manufacturing costs are assigned to each process in each manufacturing department: assembling costs (including direct materials, direct labor, and factory overhead) in the assembling department; cost of printing (direct labor, direct materials, and factory overhead) in the printing department, etc. Process costing is usually used by companies characterized by continuous mass production (i.e. firms that produce one or a few homogenous products). Process costing is often used in the following industries: textiles, food processing, automobile manufacturing, electronics, drugs, paper, paint, oil refining, chemicals, service companies offering homogenous services, etc.

Cost measurement methods represent methods used to measure and record the cost of direct materials, direct labor, and factory overhead. There are three methods: actual costing, normal costing, and standard costing.

Actual costing is a product costing system when a company measures actual costs of direct materials, direct labor, and factory overhead. Actual costing system is rarely used because it does not provide accurate information on a timely basis: many costs can be measured only at the end of the production, and some actual costs fluctuate a lot leading to potential errors in price recording.

Normal costing is a product costing system when a company measures the actual costs of direct materials and direct labor, but uses predetermined factory overhead rates to measure the factory overhead cost for a period. In other words, throughout the production time, the company measures and records the actual costs of direct materials and direct labor used, but it estimates a portion of factory overhead to be assigned to the product(s) (i.e. factory overhead applied). Normal costing system provides a timely cost estimate of a product or batch of products.

Standard costing is a product costing system when a company measures all costs direct materials, direct labor, and factory overhead using standard quantities and costs. It is often used to measure performance, determine target costs, and improve production process.

Overhead assignment methods represent methods used to collect and allocate factory overhead costs. These methods depend on a type of cost drivers that a company uses to allocate factory overhead costs to products or batches of products.

Volume-based costing, also called traditional costing, is a product costing system when a company allocates factory overhead costs to a single cost pool (e.g. factory overhead) and then uses volume-based cost drivers to allocate factory overhead costs to individual products or services. The company uses volume-based cost drivers that depend on number of units manufactured. Cost bases (or drivers) often used are: labor hours, machine hours, labor costs, etc.

Activity-based costing (ABC) is a product costing system when a company allocates factory overhead costs to activity centers (e.g. machine set ups, running machines) and then uses activity cost drivers to allocate factory overhead costs to individual products or services.

An activity cost driver is a quantity of activities needed to produce a product (e.g. machine set ups activity center will have set-up hours as the activity cost driver).

The activity cost driver rate is calculated by dividing activity expenses by the total quantity of the activity cost driver (e.g. machine set up expenses divided by total number of machine set up hours).

An easy way to remember the relationship between products, activity cost drivers, and resources, is to recall that products consume activities and activities consume resources.

Now, when we have covered the various costing methods used to collect, measure, and allocate manufacturing costs, we can discuss in greater detail the costing methods used to allocate factory overhead costs.

2. Volume-based versus activity-based costing (ABC)

Many companies, especially small and medium-sized businesses, use the traditional volume-based costing system to allocate factory overhead costs to individual products or services. Volume-based costing system is simple and easy to use and understand, and it does not cause much product cost distortions if a company produces goods with very similar production volumes and batch sizes, or in other words, the company uses simple production. When using volume-based costing system, a company determines factory overhead rates for the entire production (i.e. plant-wide rate) or for each department separately (i.e. department-rate). Single plant-wide and multiple production department rate methods are shown in the illustration below.

Illustration 1: Overhead rates in volume-based costing

Volume-based costing system can be also used by companies that manufacture products or offer services that require a small amount of factory overhead costs or use the same amount of activity. However, such companies should also have stable technology and similar distribution systems for their products or services. Overall, when factory overhead costs have a high correlation with direct labor-costs, traditional costing system can be a relatively appropriate system to use.

Even though traditional costing system can be used relatively effectively in some cases, it has many limitations. Because volume-based costing uses an aggregate rate rather than a specific one, it loses a lot of information and control over product costs. A selected volume-based cost driver (e.g. direct labor-hours) might have little to do with how factory overhead costs accumulate. This can cause not only product price distortions, but it can also decrease the incentives for department managers to control product costs.

On the other hand, an activity-based costing (ABC) system is a complex cost system that provides detailed and accurate information about each products cost and thus each products profitability. The ABC system is very expensive and time-consuming system to implement due to the high cost of collecting, measuring, and recording production information, especially for companies that produce many different products that require hundreds of various activities. For a large company, it might take millions of dollars and many years to develop and implement an ABC system. Despite its high cost, ABC systems have many benefits to offer.


2.1. The advantages of an activity-based costing system

An activity-based costing system has the following advantages:

Accurate product cost and product and customer profitability measurement: An ABC system provides accurate and detailed product information that can be utilized by management in decision-making process. It can help to make better-informed management decisions concerning product pricing, product volumes, market segments, product lines, and target costing.

Better-informed strategic decisions: The information about cost drivers for each activity enables management to make better-informed decisions concerning product design, customer support, etc.

Production improvement: An ABC system provides information helpful in improving production processes.

Better product cost information: An ABC system provides a lot of information necessary for strategic budgeting, planning, and product pricing decisions. It also takes into consideration cost of unused capacity and measures it at all levels (i.e. product, batch, and facility-levels).

In activity-based costing: Both manufacturing and nonmanufacturing (period) costs could be allocated to products.

Some manufacturing costs that are not related to product costs can be excluded from product costs.

Activity cost drivers (or overhead rates) can be based on the level of activity at the factorys capacity rather than on the budgeted level of production. In other words, products are not assigned the cost of idle capacity, which results in a more stable unit cost. Idle capacity costs, in this case, are treated as period costs (i.e. an expense on income statement) and thus are not buried in inventory costs (i.e. cost of goods sold).

There are multiple specific cost drivers that are more accurate than a single plant-wide rate or multiple department overhead rates, which are used in volume-based costing (see illustration below).

Illustration 2: Overhead rates in activity-based costing

Though an ABC system has many benefits and advantages, it fails to properly include all product-related costs and fails to allocate the cost activities with ambiguous cost drivers. Many general costs, such as marketing, research and development, and engineering, are not included into an ABC system since they are classified as period costs (i.e. not product costs) according to GAAP (generally accepted accounting principles). For some activities, also, it is either impossible or unreasonable to try to identify a cost driver, and it is often better to use a volume-based cost system in that case. For example, it is better to allocate factory property taxes (i.e. factory overhead) using a volume-based cost driver (e.g. square-footage). The same will be true for a factorys manager salary, factory insurance, etc.

Now, when we have compared volume-based and activity-based costing and have determined the benefits of ABC, we can examine three steps in developing an ABC system.


3. Development of an activity-based system

There are three steps necessary to develop an ABC system. The steps are the following:

1. Identifying available resources and resource-consuming activities

2. Assigning costs of available resources to activities

3. Assigning costs of activities to cost objects (i.e. products, batches of products)

Let us review each of these steps in greater detail.

3.1. Identifying available resources and resource-consuming activities

At first, a company developing an ABC system has to identify the resources consumed by the company and their cost. Note that a resource is an economic good consumed in performing activities. For example, Friends Company, a manufacturer of valves, has the following resources: manufacturing equipment, supplies, utilities, wages, office expenses, furniture, etc.

In addition to identifying available resources, the company has to determine the activities that consume the companys resources, or in other words, resource-consumption cost drivers. Resource-consumption cost drivers can be divided into two categories: Transaction drivers and Duration drivers.

Transaction drivers count the number of times an activity occurs (e.g. number of orders processed, number of orders shipped, number of items inspected). Transaction drivers can accurately measure the activity rate when the activity requires the same amount of time. For example, the amount of bills processed would be an accurate activity measure when it takes the same amount of time to process each bill. However, a more accurate type of activity measure is a duration driver.

Duration drivers measure the time required to perform an activity. For example, duration drivers measure the amount of time required to inspect items, to process bills, to process orders, etc. Duration drivers are more accurate measurement of the consumption of resources.

To determine resource-consumption cost drivers, the company collects data concerning the activities performed in a manufacturing process. Such information can be gathered from the companys records and documents as well as from observations, interviews of personnel, and surveys. Some of the questions often asked are: What activities do you do? What resources are necessary to perform these activities? How much time do you spend performing these activities?

Besides collecting data regarding activities, the company ranks activities according to their level of resource consumption.

Activity levels of resource consumption:A unit-level activity is an activity performed on each individual product or service. At this level, the cost drivers will be volume-based since the amount of activity will proportionally depend on the number of units produced. For example, for Friends Company, a manufacturer of valves, the unit-level activities include inserting piston into piston valves, inspecting each unit, and providing power to run processing equipment.

A batch-level activity is an activity performed on each batch of products or services regardless of how many units are in the batch. For instance, the cost of setting up equipment is the same whether the batch has ten or thousand units. Examples of batch-level activities are: placing purchase orders, setting up machines (i.e. per batch and not per individual product), conducting inspections by batch, arranging for deliveries to customers, etc. At this level, examples of cost drivers are: orders processed, number (or duration) of set-ups, number of inspections, etc.

A product-level activity (also called, a product- or service-sustaining activity) is an activity performed to support production of a specific product or service regardless of how many batches are run or how many items are produced. Examples of product-level activities are: purchasing product parts, designing, modifying (re-engineering) and testing products, managing inventory, advertising a product, maintaining a product manager, etc. At the product-level, examples of cost drivers are: number of categories of product parts, design and testing time, number of engineering orders, number of inventory categories, etc.

A customer-level activity is an activity that relates to specific customers, not specific products. Examples of customer-level activities are: IT-support, sales calls, sales visits, catalog mailings, etc. We will talk in greater detail about customer-level costs when we will learn about customer cost and customer profitability analyses.

A facility-level activity (also called, a business/organization sustaining activity) is an activity that supports business operations in general and cannot be traced to individual units, batches, or products. Examples of facility-level activities are: managing factory, heating factory, providing factory safety and security, maintaining general-purpose equipment, cleaning executive offices, arranging for loans, closing books each month, preparing annual reports to shareholders, providing a computer network, etc.

Note, that the activities can be traced in the ascending order and not vice versa. For example, a unit-level activity can be traced to a batch-level activity, and a batch-level activity can be traced to a product level activity, but not vice versa. In addition, within each group of activities, the activity cost centers that use the same cost driver are combined into homogeneous cost pools (e.g. Customer Orders, Customer relations).


3.2. Assigning cost of resources to activities

Then, once the company has identified its available resources and resource-consuming activities, it will assign the cost of resources to the activities that consume those resources. To accomplish that, the company will choose resource consumption cost drivers. For example, for batch-level activities the resource consumption cost driver is the number of setups; for general maintenance activities the number of square feet; for machine maintenance or repair activities the number of machine hours; for labor-intensive activities (e.g. product testing, engineering) the number of labor hours, etc. For instance, if a machine set-ups activity requires 0.5 machine hours, and each machine hour costs $20, then, the machine set-ups activity costs $10 ($20 x 0.5).

The cost of resources consumed by an activity can be determined through direct tracing or estimation. For example, Friends Company, a manufacturer of valves, can directly trace the cost of electricity consumed by manufacturing machines by reading the power meter attached to the machines. When it is impossible to directly trace the cost of resources to activities, a factory supervisor and department managers will estimate the amount of effort (or time) spent by employees on performing such an activity.

By assigning cost of resources to the activities consuming those resources, a company can determine the cost of each activity. Using this information, the company can determine the cost of the factorys output.

3.3. Assigning cost of activities to cost objects

Finally, the company will assign cost of activities to cost objects based on activity consumption cost drivers. Examples of cost objects are: individual products or services, job orders, projects, customers, business units, etc. Activity-consumption drivers measure amount of activity consumed by a cost object.

For example, to assign a cost of inspection activities, a number of inspection hours (or reports) consumed by a cost object will be used as an activity-consumption driver. If an hour of inspection activities costs $15, and a cost object consumes two hours of inspection activities, then the cost object will be allocated $30 for inspection activities.

Using the example mentioned in an earlier section (i.e. if a machine set-ups activity requires 0.5 machine hours, and each machine hour costs $20, then the machine set-ups activity costs $10): if a cost object requires three machine set-ups, and the machine set-ups activity costs $10, then the cost object will be assigned $30.

Examples of activity consumption cost drivers are: direct labor hours, machine hours, number of set-ups, purchase orders, inspection and receiving reports, etc.

Overall, steps for implementing activity-based costing are summarized below:

Illustration 3: Steps in developing an activity-based costing (ABC) system


4. Comparison illustration of volume-based and activity-based costing

To better understand the differences between the traditional and activity-based costing and how those differences affect product profitability analysis as well as management decisions, we will look at the following example.

Friends Company, a manufacturer of valves, produces and sells two types of valves: Gas Safety Valves (GSV) and MSC Valves (MSC). Friends Company has the following data for the two products:

GSVMSC

Production Volume10,0005,000

Selling Price$78.00$130.00

Unit prime cost$21.00$35.00

Direct labor-hours30,00020,000

Direct labor-hours per unit34

Budgeted factory overhead$600,000

Budgeted direct labor-hours50,000

4.1. Using a volume-based costing system in an example

Lets calculate the unit product cost using volume-based costing. Under traditional costing, the factory overhead cost is assigned based on direct labor-hours (DLH). The factory overhead rate is determined as follows:

Factory Overhead Rate per DLH =Total Factory Overhead

Total DLH

In this case, the factory overhead rate per DLH = $600,000 / 50,000 = $12 per DLH (i.e. plant-wide rate). Using this information, we can determine the total amount of factory overhead assigned to each product and the factory overhead cost per unit for both products:

GSVMSC

Factory overhead cost per DLH$12.00 per DLH

Direct labor hours30,00020,000

Factory overhead assigned$360,000$240,000

Production volume (in units)10,0005,000

Factory overhead cost per unit$36.00$48.00

Note: $360,000 = $12.00 x 30,000 and $240,000 = $12.00 x 20,000.

Now we can calculate the unit margin profit for each product and determine how profitable the products are:

GSVMSC

Unit selling priceA$78.00$130.00

Less: Unit prime costB($21.00)($35.00)

Less: Unit overhead costC($36.00)($48.00)

Unit marginD=A-B-C$21.00$47.00

Unit margin percentageE=D/A x 100%26.92%36.15%

Note C: $36.00 = $12.00 x 3 hrs and $48.00 = $12.00 x 4 hrs.

Therefore, using the volume-based costing we can see that the product MSC is much more profitable than the product GSV. However, lets use the activity-based costing and see if we can get the same or similar results.


4.2. Using an activity-based costing (ABC) in an example

Friends Company, a manufacturer of valves, produces and sells two types of valves: Gas Safety Valves (GSV) and MSC Valves (MSC). Friends Company has the following data for the two products:

GSVMSC

Production Volume10,0005,000

Selling Price$78.00$130.00

Unit prime cost$21.00$35.00

In addition, Friends Company has identified the following activities, costs, and activity consumption cost drivers:

ActivityBudgeted CostCost Driver

Machine set-ups$100,000Number of set-ups

Machine running$400,000Machine-hours

Inspection$70,000Inspection-hours

Packing$30,000Number of packing-orders

Total$600,000

Friends Company also collected the activity data for each product:

Cost DriverGSVMSCTotal

Number of set-ups80260340

Machine-hours18,00036,00054,000

Inspection-hours3,0004,0007,000

Number of packing-orders2,1003,5005,600

Using the total cost for each activity and the total amount of activity cost driver we can determine the activity cost rate:

Cost Driver Cost ($)Activity AmountActivity Rate ($)

ABC=A/B

Number of set-ups100,000340294.12

Machine-hours400,00054,0007.41

Inspection-hours70,0007,00010.00

Number of packing-orders30,0005,6005.36

As we can see from the table above, one set-up costs $294.12, one machine-hour costs $7.41, one inspection-hour costs $10.00, and one packing order costs $5.36. Now, lets calculate the per-unit cost of each product manufactured by Friends Company:

GSV (10,000 units)

Activity Cost DriverActivity RateActivity AmountTotal OverheadOverhead per Unit

ABC=A x BD=C/10,000

Number of set-ups$ 294.1280$ 23,529.60 $ 2.35

Machine-hours7.4118,000133,380.00 13.34

Inspection-hours10.003,00030,000.00 3.00

Number of packing-orders5.362,10011,256.00 1.13

Total19.82

MSC (5,000 units)

Activity Cost DriverActivity RateActivity AmountTotal OverheadOverhead per Unit

ABC=A x BD=C/5,000

Number of set-ups$ 294.12260$ 76,471.20 $ 15.29

Machine-hours7.4136,000266,760.00 53.35

Inspection-hours10.004,00040,000.00 8.00

Number of packing-orders5.363,50018,760.00 3.75

Total80.39

The allocation of factory overhead using activity-based costing is summarized in the illustration below.

Illustration 4: Friends Companys allocation of factory overhead costs using ABC

Using the obtained data we can perform the product profitability analysis; that is, we will determine the unit margin profit of each product:

GSVMSC

Unit selling priceA$78.00$130.00

Less: Unit prime costB($21.00)($35.00)

Less: Unit overhead costC($19.82)($80.39)

Unit marginD=A-B-C$37.18$14.61

Unit margin percentageE=D/A x 100%47.67%11.24%

According to the data presented in the table above, the MSC product is actually $22.57 ($37.18 $14.61) less profitable than the GSV product. The unit margin percentage for the MSC product is lower than the one for the GSV product when using the activity-based costing. Therefore, the management of Friends Company might consider changing the production process of the MSC product (e.g. increase batch-size to decrease the cost of machine set-ups per item produced) and increasing the selling price (i.e. as long as the increase in selling price would not substantially decrease product sales).

Using this example we can see that activity-based costing provides a lot of information about production activities and how they affect the cost of products, which the volume-based costing system does not explain.

Lets compare the product profitability analyses under volume-based and activity-based costing:

Volume-based CostingActivity-based Costing

GSVMSCGSVMSC

Unit selling price$78.00$130.00$78.00$130.00

Less: Unit prime cost($21.00)($35.00)($21.00)($35.00)

Less: Unit overhead cost($36.00)($48.00)($19.82)($80.39)

Unit margin$21.00$47.00$37.18$14.61

Unit margin percentage26.92% 36.15%47.67%11.24%

As we can see from the table above, the product per-unit cost and per-unit margin profit differ under the volume-based and activity-based costing. The reason is that activity-based costing traces overhead consumption by each product and thus provides a more accurate per-unit overhead cost.

On the other hand, volume-based costing assigns factory overhead costs using direct labor-hours or machine-hours as a cost driver. As the result, volume-based costing undercosts low-volume product (i.e. products requiring fewer direct labor hours in total) and overcosts high-volume products (i.e. products requiring more direct labor-hours in total). In our example, the production of GSV product and MSC product required 30,000 and 20,000 direct labor-hours, respectively. Therefore, the overhead per unit cost for products GSV and MSC were overstated and understated, accordingly.

Using the data obtained under the activity-based costing, for example, we can see that the overhead per-unit cost of product GSV is overstated by $16.18 (i.e. $16.18 = $36.00 $19.82) under the volume-based costing because the production of GSV requires more direct labor-hours (in total). Thus, a product MSC in this case is subsidized at the expense of others. In cost accounting this is called cross-subsidization.Activity-Based Costing (ABC)

5. Dangers of product price distortion

Inaccurate product costing can lead to unrealistic strategic focus and pricing, ineffective management decisions and resource allocation, inaccurate inventory valuation, and lost competitive position and advantage.

For example, Friends Corporation may change its marketing and production priorities to sell more units of product GSV because this product provides a better return on sales.

6. Benefits of activity-based costing

Companies likely to benefit from ABC are those with:

1. Relatively high factory overhead costs

2. Complex operations (i.e. products or services with various production volumes and requiring many diverse activities)

3. Operations that undergone significant technological changes

Even though both manufacturing and service companies can benefit from an ABC system, service businesses might have more difficulties implementing an ABC system. First of all, service companies tend to have a lot of facility-level activities and costs that are difficult to allocate to specific service units. In addition, service companies employees often engage in many non-uniformal activities for which it might be challenging to collect cost data. Nonetheless, activity-based costing has been implemented by various banks, health care providers, and insurance companies. Examples of companies using ABC are: American Express, Cambridge Hospital Community Health Network, the City of Indianapolis, Dana Corporation, GE Medical Systems, Hallmark, ITT Automotive North America, Pillsbury, the U.S. Immigration and Naturalization Service (INS) and the U.S. Postal Service.

ABC can be used not only to improve product pricing, but also to improve the value of products or services to customers, which could help to increase the firms profitability. After developing an ABC system, a firms management can utilize such tools as activity-based management (ABM) and customer profitability analysis discussed in other accounting tutorials.

Activity Based Costing

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