Chapter 7: Activity-Based Costing (ABC) - A Tool to Aid Decision-Making

Introduction to Activity-Based Costing (ABC)

• ABC is a method for assigning costs to products/services based on activities and resources.
• Differs from traditional costing by assigning overhead costs based on specific activities (e.g., machine setups, quality inspections).
• Focuses heavily on overhead cost allocation.

Learning Objectives

1. Explain the ABC model and its differences from traditional costing.
2. Assign costs using first and second-stage allocations.
3. Use ABC to compute product and customer margins.
4. Compare traditional costing with ABC.

What is Activity-Based Costing?

• Provides cost information for decisions affecting capacity, impacting both fixed and variable overheads.
• Typically used for internal decisions and not available to external stakeholders.
• Includes costs not typically included in product costs and excludes some normally included.

Differences from Traditional Costing

• ABC includes non-manufacturing costs if there's a cause-and-effect basis.
• Excludes some manufacturing costs without a cause-and-effect relationship.
• Uses multiple overhead cost pools and unique measures of activity.
• Traditional methods use a single cost driver, potentially leading to inaccurate cost allocations.

Non-Manufacturing Costs in ABC

• Determines entire cost of a product, not just manufacturing.
• Allocates selling and admin costs if directly related to the product.
• Includes costs like design, marketing, distribution, and some customer service.

Overhead Costs and Cost Pools in ABC

• Multiple cost pools with unique measures for better cost management.
• Activities are events causing consumption of resources.
• Cost pools group costs for specific activities (e.g., machine setups, quality inspections).
• Activity measures (transaction and duration drivers) allocate costs.

Levels of Activities in ABC

1. Unit-Level Activities: Direct materials/labor; increases with more units.
2. Batch-Level Activities: Costs incurred per batch, independent of batch size.
3. Product-Level Activities: Support entire product lines; design, testing.
4. Customer-Level Activities: Support specific customer needs; sales, support.
5. Organizational Sustaining Activities: Support the organization as a whole.

Case Study: Classic Brass

• Example of ABC applied in a company making stanions and Compass Holdings.
• Initial income statement showed a loss.
• ABC used to assess product cost accuracy.

Implementing ABC

1. Identify and define activities, cost pools, and measures.
2. Assign costs to activity pools (first stage allocation).
3. Calculate activity rates.
4. Assign overhead costs to cost objects (second stage allocation).
5. Produce management reports and analyze results.

Assigning Overhead Costs in ABC

• Overhead costs assigned to cost pools using knowledge-based estimates.
• Different activity pools include customer orders, product designs, etc.
• Activity rates calculated by dividing total costs by total driver units.
• Costs assigned to products based on their consumption of activities.

Comparing ABC and Traditional Costing

• Traditional costing overstates costs for high-volume products and understates for low-volume.
• ABC provides more accurate cost assignments based on cause and effect.
• Traditional uses a single cost driver; ABC uses multiple, more specific drivers.

Benefits and Limitations of ABC

• Benefits: Improved cost control, better pricing decisions, enhanced cost behavior understanding.
• Limitations: High resource use, potential internal resistance, not conforming to GAAP.

Conclusion

• ABC offers detailed, accurate internal cost data.
• Requires careful implementation and maintenance.
• Generally used alongside traditional methods for external reporting due to GAAP requirements.