Chapter 07 – Lecture Notes
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Chapter 7
Lecture Notes
Chapter theme: This chapter introduces students to
activity-based costing (ABC) which is a tool that has
been embraced by a wide variety of service,
manufacturing, and non-profit organizations.
I. Activity-based costing: key definition
A. ABC is a costing method that is designed to provide
managers with cost information for strategic and other
decisions that potentially affect capacity, and therefore,
“fixed” as well as variable costs. It is ordinarily used as
a supplement to, rather than as a replacement for, the
company’s usual costing system.
II. How costs are treated under activity-based costing
A. ABC differs from traditional cost accounting in three
ways:
Learning Objective 1: Understand activity-based
costing and how it differs from a traditional costing
system.
i. Nonmanufacturing as well as manufacturing
costs may be assigned to products, but only on
a cause-and-effect basis.
1. For example, ABC systems can assign sales
commissions, shipping costs, and warranty
repair costs to specific products.
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ii. Some manufacturing costs may be excluded
from product costs.
1. This is because ABC only assigns a cost to a
product if decisions concerning that product
will cause changes in the cost.
2. ABC excludes two types of costs from
product costs:
a. Organization-sustaining costs (which
will be formally defined later).
b. The costs of unused or idle capacity.
Helpful Hint: Emphasize that ABC systems that are
used to support internal decision making do not need to
conform to GAAP. Therefore, while GAAP requires
treating selling and administrative expenses as period
expenses and it requires assigning all manufacturing
costs to products, ABC systems can assign selling and
administrative expenses to products and they can
exclude manufacturing costs from product costs where
appropriate.
iii. Numerous overhead cost pools are used, each
of which is allocated to products and other cost
objects using its own unique measure of
activity.
1. ABC cost pools are created to correspond to
the activities performed in an organization
that cause the consumption of overhead
resources. Therefore, the total number of
ABC cost pools will definitely exceed one
(as in the plantwide approach) and it is
likely to exceed the number of departments
within a company (as in the departmental
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approach) since more than one activity is
often performed within each department.
2. Each ABC cost pool has its own unique
measure of activity. On the contrary,
traditional cost systems usually rely on
direct labor hours and/or machine hours
to allocate all overhead costs to products.
a. Direct labor and machine hours work
correctly when changes in the quantity
of the base are correlated with changes
in the overhead costs being assigned
using the base.
b. Relying exclusively on these bases to
assign overhead costs to products has
come under increased scrutiny since,
on an economy-wide basis, direct labor
and overhead costs have been moving
in opposite directions and the variety
of products produced by companies
has increased.
B. Key definitions/concepts
i. An activity is any event that causes the
consumption of overhead resources.
ii. An activity cost pool is a “bucket” in which
costs are accumulated that relate to a single
activity measure in an ABC system.
iii. An activity measure is an allocation base in an
activity-based costing system. The term cost
driver is also used to refer to an activity
measure. The two most common types of
activity measures are:
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1. Transaction drivers are simple counts of
the number of times an activity occurs such
as the number of bills sent out to customers.
2. Duration drivers measure the amount of
time required to perform an activity such as
the time spent preparing individual bills for
customers.
Helpful Hint: Introduce the cost-benefit concept by
explaining that transaction drivers are more prevalent
in practice than duration drivers because the data is
much easier to obtain. The additional accuracy
provided by duration drivers often times does not pass
the cost-benefit test.
iv. Traditional cost systems rely exclusively on
allocation bases that are driven by the volume
of production. ABC defines five levels of
activity that largely do not relate to the
volume of units produced.
1. Unit-level activities are performed each
time a unit is produced.
a. For example, providing power to run
processing equipment would be a unit–
level activity.
2. Batch-level activities are performed each
time a batch is handled or processed,
regardless of how many units are in the
batch.
a. For example, setting up equipment and
shipping customer orders are batch–
level activities.
3. Product-level activities relate to specific
products and must be carried out regardless
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of how many batches are run or units are
produced or sold.
a. For example, designing or advertising
a product would be product-level
activities.
4. Customer-level activities relate to specific
customers and are not tied to any specific
product.
a. For example, sales calls and catalog
mailings would be customer-level
activities.
5. Organization-sustaining activities are
carried out regardless of which customers
are served, which products are produced,
how many batches are run, or how many
units are made.
a. For example, heating a factory and
cleaning executive offices are
organization-sustaining activities.
III. Designing an activity-based costing (ABC) system
A. Characteristics of a successful ABC
implementation:
i. There should be strong top management
support.
1. Without leadership from top management,
some managers may not be motivated to
embrace the need to change.
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ii. Top managers should ensure that ABC data are
linked to how people are evaluated and
rewarded.
1. If employees continue to be evaluated and
rewarded using traditional (non-ABC) cost
data, they will quickly get the message that
ABC is not important and they will abandon
it.
iii. A cross-functional team should be created to
design and implement the ABC system.
1. Cross-functional employees possess intimate
knowledge of operations that is necessary
for designing an effective ABC system.
2. Tapping the knowledge of cross-functional
managers lessens their resistance to ABC
because they feel included in the
implementation process.
B. The five steps for implementing ABC
i. Baxter Battery—background information
1. The company makes two types of
automobile batteries—SureStart (a
standard battery) and LongLife (a deluxe,
higher quality battery).
2. The company has reported its first loss ever
of $2,000,000 as shown on the income
statement.
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ii. Step 1: define activities, activity cost pools,
and activity measures (The activities are often
identified and defined by interviewing the
employees that work in the respective overhead
departments. The lengthy list of activities that
emerges from this process is usually reduced to
a handful by combining similar activities.)
1. Baxter Battery selected the five activity cost
pools and corresponding activity measures
as shown.
a. The definition for each of the activity
cost pools is as shown.
Learning Objective 2: Assign costs to cost pools using a
first-stage allocation.
iii. Step 2: assign overhead costs to activity cost
pools (this is also called first-stage
allocation)
1. Baxter’s annual overhead costs (both
manufacturing and nonmanufacturing) that it
intends to assign to its activity cost pools are
as shown. Notice:
a. The total costs for the Production
Department ($14,000,000) equal the
total manufacturing overhead costs
shown in the income statement.
b. The total costs for the General
Administrative and Marketing
Departments ($8,000,000) equal the
marketing and general administrative
expenses shown in Baxter’s income
statement.
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c. Three costs included in Baxter’s
income statement—direct materials,
direct labor, and shipping—are
excluded from this slide because
Baxter’s existing cost system can
directly trace these costs to products or
customer orders.
2. Baxter’s cross-functional interviews resulted
in resource allocations as shown. Notice for
example:
a. The indirect factory workers allocated
30% of their time to the customer
orders activity, 30% of their time to
the design changes activity, 20% of
their time to the order size activity,
10% of their time to customer
relations, and 10% of their time to the
“other” activity.
b. The lease costs are allocated entirely to
the “other” activity. Since Baxter has a
single facility that it does not plan to
contract or expand, the lease costs are
treated as organization-sustaining
costs.
3. Once the percentage allocations have been
determined, it is a simple matter to assign
costs to activity cost pools.
a. For example, the indirect factory
wages assigned to the customer orders
activity ($1,800,000) was computed by
multiplying the total amount of
indirect factory wages ($6,000,000) by
the percentage of time that indirect
factory workers spent on this activity
(30%).
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b. As another example, the factory
equipment depreciation assigned to the
customer orders activity ($700,000)
was computed by multiplying the total
amount of factory equipment
depreciation ($3,500,000) by the
percentage of time that the factory
equipment was used to support this
activity (20%).
c. The complete grid of first-stage
allocations would be as shown.
Learning Objective 3: Compute activity rates for cost
pools.
iv. Step 3: calculate activity rates
1. The Baxter Battery ABC team determined
activity levels for each activity as shown.
This information enabled the team to
compute ABC rates for each activity by
dividing the total cost in each activity cost
pool by the respective quantity of the
activity measure.
a. The activity rate for each cost pool is
as shown. For example, the customer
orders activity cost pool has an activity
rate of $452 per order. Importantly,
this is an average figure.
b. Notice, the “other” cost pool does not
have an activity rate. This is because
these organization-sustaining costs
will not be assigned to products or
customers.
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2. Before proceeding, let us get a visual
perspective of the Baxter Battery ABC
system.
a. The direct materials, direct labor, and
shipping costs are directly traceable
to products or customer orders.
b. The first-stage allocation process
assigned the remaining overhead costs
to five activity cost pools.
c. Then, activity measures were
identified, activity levels were
determined, and activity rates were
computed for each activity. These rates
will be used in the next step to assign
overhead costs to cost objects.
v. Step 4: assign overhead costs to cost objects
(this is also called second stage allocation)
Learning Objective 4: Assign costs to a cost object
using a second-stage allocation.
1. Assigning overhead to products
a. The data needed to assign overhead
costs to Baxter Battery’s two
products—SureStart and LongLife—
are as shown. Notice:
(1). 4,000 customer orders were
placed for SureStart and 6,000
customer orders were placed for
LongLife.
(2). All 4,000 product designs
related to LongLife
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