- identify the major activities that cause
overhead costs to be incurred
the cost of the resources consumed performing these
activities are grouped into cost pools
identify measures of the activities -- the cost
relate the costs to products using the cost drivers
- some of these activities are related to production volume
but others are not
Benefits of ABC systems...
- less likely to overcost simple high volume products
- less likely to undercost complex, low volume products
- may lead to improvements in cost control
Limitations of ABC systems...
- it is expensive
- it develops full costs of products, not the incremental
costs needed to make decisions
|Why do we need a new cost allocation system?
- Many overhead costs are NOT proportional to
volume thus high volume products are often over-costed while low-volume
products are under-costed.
- When companies have significant
costs, there is a danger that these costs may be
applied to products.
- Volume-based cost drivers
to the units produced. That is, for each unit of
a volume driver increases proportionately. It is just like a pure
variable cost - direct materials, direct labor, or machine hours.
For each identical unit made the change in the volume driver activity
- Volume-based drivers are
justified as causes
of overhead costs because they are associated with capacity.
To meet GAAP rules volume-based drivers are sufficient. However,
by assigning costs based on volume drivers, say direct labor hours, we
are saying all overhead resources are consumed in the same way products
consume direct labor hours.
Production Characteristics Justifying ABC
- Production Characteristics Leading to Costing Errors
Products Consume Activities and Activities Consume
- Multiple product lines exist.
This assumes the more differentiated the products the more likely they
will uniquely consume overhead resources. If products do not
overhead resource in the same ratio as the volume-based driver, costing
errors will occur.
- Different products use
and activities. This means different
actually use different overhead resources. For example, one
may require special maintenance support because it is painted while
that isn’t painted does not.
- Different products use
of the same resources or activity. This need not
a problem if the difference in consumption of overhead happens to be
driven. However, if the differences are due to nonvolume drivers
costing errors may happen.
- Activity-based costing (ABC) requires computer
make ABC systems feasible. Previously, unique product resource
patterns were only considered at the annual budgeting or on an “as
basis. Often, the relationship between unique product needs and
consumption were obscured by variations in day-to-day
However, ABC measures direct relationships between individual products
and overhead resource consumption. The logic of ABC is that
consume activities and activities consume resources.” Where
cost drivers focus on capacity, ABC measures activities to more
allocate overhead costs to products. However, ABC is still
costly to install. Thus, the decision to introduce ABC is a
and important management decision
ABC uses resources and activities to
calculate product costs.
- Activity-based costing (ABC) improves
accuracy by including nonvolume-based cost drivers as
as volume-based drivers to assign costs to products. We achieve
by using a detailed analysis to determine which production activities
overhead resources or indirect costs.
- The logic of ABC systems is “activities
resources and products consume activities.” ABC
directly trace resources to activities and then activities to products
and services. Resources are assets needed to perform activities.
Activities represent the work done in providing a service or making a
- Costs are assigned to products following this logic. Resource
costs are grouped into cost pools with identical cost drivers,
like machine setups. A cost per unit of cost driver is calculated
by dividing the budgeted cost pool by the budgeted cost driver
For a cost pool of resources consumed by setup activities, this gives
a cost per setup. Then, every time a product consumes a setup
it is charged the setup cost. The costs of using activities are
using the cost drivers associated with the activity. For
we determine the overall cost of electricity, we calculate the number
kilowatt hours consumed, then determine the cost per kilowatt
We allocate that cost per kilowatt-hour consumed to a specific product.
- The number of cost pools can be
A Northern Telecom plant boasted of having 40 cost drivers in its ABC
The ABC Costing Hierarchy: Unit, Batch, Product, and
ABC’s Hierarchy of Costs
- Despite improvements in technology ABC systems can be
In practice, hierarchical cost systems were developed to reduce the
of installing ABC systems. All overhead resource costs are
into one of four categories; unit, batch, product or facilities.
The priority for assigning costs starts at the unit level. All
costs that meet these criteria are assigned to unit cost pools. Direct
materials are unit costs. However, if setups are used for batches
of products, setups are not unit-level costs. They are batch
There is one setup for each batch. Thus, setups are assigned to a
batch-level cost pool. Any remaining costs that do not meet
cost criteria are moved to the remaining classes. If they did not
fit into product-level costs, they are classified as facilities costs.
Costs directly related to each individual product
Costs directly related to each batch of products made
Costs directly related to a particular product line
Manufacturing costs not directly related to a particular product line