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CHAPTER FOUR
Activity-Based Costing
This chapter examines how overhead costs are applied using activity-
based costing. It also examines how overhead allocation based on activity
Key Concepts
• Activity-based costing allocates costs based on activities that drive
overhead rather than simple volume or unit-based measures.
• Although there are common activities that drive overhead cost, every
Learning Objectives
LO1— Classify overhead costs as unit-, batch-, product-, or facility level.
LO2— Describe ABC and recognize typical activities and cost drivers in an ABC
system.
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Lecture Outline
A. Introduction
1. In a “labor intensive” environment overhead typically made up a
2. In heavily automated manufacturing environments, direct labor
costs have shrunk whereas overhead costs have soared. As
3. Allocating overheads based on activity-based costing is an effective
B. Unit-, Batch-, Product-, and Facility Level Costs (LO1)
1. Unit-level costs are incurred each time a unit is produced.
2. Batch-level costs are incurred each time a batch of goods is
produced.
C. Activity Based Costing (LO2)
Activity-based costing (ABC) allocates overhead costs assuming that
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1. Stage 1—Identification of Activities: In Stage 1, activities are
2. Stage 2—Identification of Cost Drivers: In Stage 2, cost drivers for
activities are chosen. Cost drivers should cause or drive the
incurrence of costs. Unit-, batch-, and product level activities are
assigned to products by using cost drivers. Facility-level costs are
usually not allocated or are allocated in some arbitrary manner.
The following table provides some examples of activities and cost
drivers:
Activity
Level
Typical Cost Drivers
Repair and maintenance of
factory equipment
Unit
Machine hours, labor hours,
or number of units
Machining of products
Unit
Machine hours
Receiving
Batch
Amount of material or
number of receipts
Setting up equipment
Batch
Number of setups
Product testing
Product
Number of change orders,
number of tests, or hours of
testing time
Product design
Product
Number of new or revised
products
Although there are common activities that drive overhead cost, every
company should evaluate its activities carefully.
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3. ABC Systems in Nonmanufacturing Environments
ABC can be implemented in the service sector as well. Like
manufacturing companies, service companies also identify different
activities and cost drivers. However, implementing ABC in service
companies has its own problems.
a. Analyzing the activities of a service provider can be
D. Traditional Overhead Allocation and ABC – An Example (LO3)
TopSail Construction, a modular home builder, presently builds two basic
Key Concept
Activity-based costing allocates costs based on activities that drive
overhead rather than simple volume- or unit-based measures.
MAKING IT REAL
ABC in Service Companies
Key Concept
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allocating overhead based on square footage. The company’s chief financial
officer (CFO) has some reservations about costing the new cottage by the
traditional method. She has recommended investigating the use of activity-
based costing (ABC).
1. Stage 1: Identification of Activities: The company has identified the
following four primary activities:
2. Stage 2: Identification of Cost Drivers and Allocation of Costs: The
cost drivers identified are as follows:
Cost Driver
Number of inspections
Number of purchase orders
Setup time (days)
o The estimated cost of cottage computed based on ABC
works out to be the less than the targeted cost. This
happens because traditional costing methods resulted in
o In general, when there are batch- and product-level costs,
ABC will typically shift costs from high-volume products
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usually results in a greater impact on the low-volume
products than on the high-volume products.
o One important aspect of ABC systems is the elimination of
cross subsidies between products. Cross subsidies occur
o The cross subsidy may make high-volume products appear
unprofitable when they may not be, or it may make them
.
E. Benefits and Limitations of ABC (LO4)
1. Benefits
o ABC systems provide more accurate cost information.
o ABC systems enhance day-to-day decision-making ability.
2. Limitations
Key Concept
Volume-based costing systems often result in overcosting high-volume
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o ABC systems are often time consuming.
End-of-Chapter Material
Brief exercises, exercises, problems, and cases based on different learning
Key Concept
ABC systems generally improve the accuracy of cost data, but are often
time consuming and expensive to develop.