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Activity-Based Costing

Managerial Accounting

Prepared by Diane TannerUniversity of North Florida

Chapter 36

Activity-Based Costing

• What is activity-based costing?– A system of allocating indirect costs to cost objects– Utilizes multiple cost pools– Is used with normal costing– Based on activities that drive costs rather than on volume-

based denominators

• Primarily used to allocated manufacturing overhead– Sometimes used to allocate support department costs to

divisions

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Underlying PremisesActivities underlie costs.

3

Comparing ABC and Traditional Costing

Advantages of ABC over traditional costing ABC results in more accurate costing. ABC helps managers control costs better. ABC considers the fact that only products that use

particular resources are assigned costs. ABC mitigates overcosting and undercosting of cost

objects.  Disadvantages of ABC

Very expensive to implement No separation of fixed and variable costs which makes

incremental analysis difficult

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Setting Up an ABC System

Step 1: Determine the cost object. Step 2: Form cost pools.

The costs of performing a particular activity are grouped into a cost pool.

All costs in a pool should have the same cause. Step 3: Select a cost driver that has a cause-

and-effect relationship with the costs to be allocated.

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How to Perform ABC

Step 1: Calculate the rate for each cost pool. Estimated Cost / Estimated Activity = RateStep 2: Multiply each cost pool rate times the

respective actual activity to determine allocated costs.

Step 3: Total up the allocated costs from step 2. This results in the applied overhead cost.

Step 4: Add the allocated costs to the direct costs of each cost object to obtain the total cost of each cost object.

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Considerations of ABC

Complete analysis requires allocation beyond manufacturing costs to include nonmanufacturing

Activity can be measured on practical capacity, actual capacity, or other estimate Practical capacity preferred over actual capacity

because Does not hide the cost of idle capacity within product

costs Gives a truer cost of activities used to produce the

product

ABC Implementation Issues

After switching to ABC, companies may find that only 10 to 15% of their products are profitable Causes management to alter the product mix by

minimizing unprofitable products which causes profits to increase

Implementation mirrors the complexity of the organization

Complete conversion to ABC requires auditors to accept the system when used for financial reporting

Activity-Based Management A tool in which managers analyze activities that cause

indirect costs of products or services Goal is to improve efficiency and effectiveness of the

activities in order to reduce costs Serves as the basis for numerous process

improvement programs of companies Helps focus managerial attention on what is most

important among the activities performed to create value for customers

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Overcosting and Undercosting Occurs due to broad, equal costs allocated to all

products

Undercosting

Overhead allocated under ABC is greater than if traditional is

used

A product consumes a relatively high level of resources but is reported to have a relatively

low total cost

Overcosting

Overhead allocated under ABC is less than if traditional is used

A product consumes a relatively low level of resources but is reported to have a relatively

high total cost

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ABC Vs. Traditional Costing Example

A complete walk through problem using Excel is presented in a separate video.

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The End