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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
II. How costs are treated under activity-based costing
A. ABC differs from traditional cost accounting in three
ways:
system.
i. Nonmanufacturing as well as manufacturing
costs may be assigned to products, but only on
a cause-and-effect basis.
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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
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
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.
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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.
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.
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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.
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.
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a. For example, designing or advertising
a product would be product-level
activities.
4. Customer-level activities relate to specific
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.
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ii. Top managers should ensure that ABC data are
linked to how people are evaluated and
rewarded.
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.
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).
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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.)
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:
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c. Three costs included in Baxter’s
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
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
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.
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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.
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
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b. The overhead cost assignments to
SureStart and LongLife are as shown.
Notice:
(1). The total overhead costs
assigned to SureStart and
LongLife are $4,928,000 and
$7,832,000, respectively.
2. Assigning overhead to customers
a. The data needed to assign overhead
costs to one of Baxter’s customers—
Acme Auto Parts is as shown.
b. The total overhead cost assigned to
Acme Auto Parts ($12,916) is
calculated as shown.
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vi. Step 5: prepare management reports
1. Product margin calculations
a. The first step in computing product
margins is to gather each product’s
sales and direct cost data which are
assumed to be as shown.
its sales.
d. The product margins can be
reconciled with the company’s net
operating income as shown.
2. Customer margin calculation
a. The first step in computing Acme Auto
Parts’ customer margin is to gather its
sales and direct cost data which are
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IV. Comparison of traditional and ABC product costs
A. Product margins computed using the traditional
cost system
ii. The second step is to compute the plantwide
overhead rate. Notice:
1. The numerator is the $14,000,000 of
manufacturing overhead shown earlier on
the company’s income statement.
iii. The third step is to allocate manufacturing
overhead to each product. Notice:
1. 480,000 machine-hours were worked on
SureStarts, so $8,400,000 (480,000 hours ×
$17.50) of manufacturing overhead is
assigned to this product. LongLifes are
assigning the remaining $5,600,000
(320,000 × $17.50) of manufacturing
overhead.
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