Activity Based Costing
ABC Approach
  1. identify the major activities that cause overhead costs to be incurred
    • some of these activities are related to production volume but others are not
  2. the cost of the resources consumed performing these activities are grouped into cost pools 
  3. identify measures of the activities -- the cost drivers 
  4. relate the costs to products using the cost drivers

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 indirect product costs, there is a danger that these costs may be incorrectly applied to products. 
  • Volume-based cost drivers vary in direct proportion to the units produced.  That is, for each unit of output 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 will be identical.
  • 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. 
Three Production Characteristics Justifying ABC
  • Production Characteristics Leading to Costing Errors
    1. Multiple product lines exist.  This assumes the more differentiated the products the more likely they will uniquely consume overhead resources.  If products do not consume overhead resource in the same ratio as the volume-based driver, costing errors will occur.
    2. Different products use different resources and activities.   This means different products actually use different overhead resources.  For example, one product may require special maintenance support because it is painted while another that isn’t painted does not. 
    3. Different products use different amounts of the same resources or activity.  This need not be a problem if the difference in consumption of overhead happens to be volume driven.  However, if the differences are due to nonvolume drivers costing errors may happen.
  • Products Consume Activities and Activities Consume Resources
    • Activity-based costing (ABC) requires computer technology.  Computers make ABC systems feasible.  Previously, unique product resource consumption patterns were only considered at the annual budgeting or on an “as needed” basis.  Often, the relationship between unique product needs and overhead consumption  were obscured by variations in day-to-day operations.  However, ABC measures direct relationships between individual products and overhead resource consumption.  The logic of ABC is that “products consume activities and activities consume resources.”  Where volume-based cost drivers focus on capacity, ABC measures activities to more accurately allocate overhead costs to products.  However, ABC is still relatively costly to install.  Thus, the decision to introduce ABC is a costly and important management decision
Describe how ABC uses resources and activities to calculate product costs.
  • Activity-based costing (ABC) improves costing accuracy by including nonvolume-based cost drivers as well as volume-based drivers to assign costs to products.  We achieve this by using a detailed analysis to determine which production activities consume overhead resources or indirect costs. 
  • The logic of ABC systems is “activities consume resources and products consume activities.”  ABC systems 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 product.
  • 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 activity.  For a cost pool of resources consumed by setup activities, this gives us a cost per setup.  Then, every time a product consumes a setup activity it is charged the setup cost.  The costs of using activities are assigned using the cost drivers associated with the activity.  For instance, we determine the overall cost of electricity, we calculate the number of kilowatt hours consumed, then determine the cost per kilowatt hour.  We allocate that cost per kilowatt-hour consumed to a specific product.
  • The number of cost pools can be extremely large.  A Northern Telecom plant boasted of having 40 cost drivers in its ABC system. 

The ABC Costing Hierarchy: Unit, Batch, Product, and Facilities

  • Despite improvements in technology ABC systems can be costly.   In practice, hierarchical cost systems were developed to reduce the costs of installing ABC systems.  All overhead resource costs are grouped into one of four categories; unit, batch, product or facilities.  The priority for assigning costs starts at the unit level.  All manufacturing 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 costs.  There is one setup for each batch.  Thus, setups are assigned to a batch-level cost pool.  Any remaining costs that do not meet batch-level cost criteria are moved to the remaining classes.  If they did not fit into product-level costs, they are classified as facilities costs.
ABC’s Hierarchy of Costs 
 Unit level               Costs directly related to each individual product
 Batch                    Costs directly related to each batch of products made
 Product                 Costs directly related to a particular product line
 Facilities                Manufacturing costs not directly related to a particular product line

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this page is maintained by Reed Fisher
last updated January 15, 2011