Activity-Based Costing (ABC)
Activity-based costing is a technique that uses an allocation base to assign
overhead costs more accurately to products than the plant-wide and
departmental approaches.
The basic idea of ABC is:
Here is a quick recap with respect to assigning overhead costs:
In ot...
Activity-based costing is a technique that uses an allocation base to assign
overhead costs more accurately to products than the plant-wide and
departmental approaches.
The basic idea of ABC is:
A customer order would trigger a number of activities;
The performance of these activities consumes resources;
The consumption of these resources incurs costs to the company.
Here is a quick recap with respect to assigning overhead costs:
In other courses you might have been introduced to the development of a single overhead rate for the entire plant and/or
speci c overhead rates that are applicable only to one department.
The plant-wide overhead rate is a simple method that uses the same overhead cost rate throughout the entire factory. In most
cases, direct labour is the allocation base for this rate. However, as manufacturing processes become more automated, requiring
less labour to complete the manufacturing process, this may not be an appropriate allocation base.
Departmental overhead rates are allocated on different bases depending on the nature of the work in the department. For
example, in the assembly area the basis for allocation may be the number of labour hours but in the fabricating department the
most logical basis might be machine-hours.
It is important that you recognize that the department rates may not correctly assign overhead costs when a company has a
range of products. The biggest risk that is encountered with traditional costing methods is that they tend to allocate indirect
costs without regard to the use of resources. In fact, cross-subsidization can arise when some products are allocated less than
their fair share of the total indirect costs. This occurs when costs are incorrectly allocated, forcing the sale price of some
products to cover more than the actual cost for that product due to the overhead costs assigned to this product being too high.
ABC helps to prevent this cross-subsidization.
Key Terminology
To help you going forward, here is some important terms and the de nitions that this course uses.
Activity
An activity, in activity-based costing, is an event that causes the consumption of overhead resources. Examples of
activities include: setting up machines; admitting patients to a hospital; billing customers; or opening an account at a bank.
Activity Cost Pool
, An activity cost pool is a “cost bucket” in which costs related to a speci c activity are captured. The result will be that each
activity will have its own rate to be used when allocating overhead costs.
Activity Measure
An activity measure expresses how much of an activity is carried out. It is this number that is used as the allocation base
for applying overhead to products and services. Activity measures can be related to volume or not related to volume.
Activity Rate
An activity rate is the predetermined overhead rate in an activity-based costing system.
Taking each activity in isolation, this system works exactly like the job-order costing system in that a predetermined overhead
rate is computed for each activity and then applied to jobs and products based on the amount of activity consumed by the job or
product.
Activity-based costing usually does not replace traditional costing methods like job costing or process costing. Instead, ABC
recognizes that the activities within a company vary and that each activity typically has a different driver that affects costs.
Example:
The following is an example where activity based costing could be used to provide insights into the indirect costs and the pro t
for each product line.
A company called Bathtubs Unlimited manufactures and sells bath tubs. In order to demonstrate ABC, the company
manufactures two types of bath tubs, either a standard bathtub or a custom bathtub. The income statement for the current year
is presented below and as you can see the company is losing money.
The senior of cials of the company are puzzled. Why are we losing money.
Income Statement Total Custom Standard
Sales $3,000,000 $450,000 2,550,000
Cost of Goods Sold
Direct Materials 566,000 90,000 476,000
Direct Labour 753,750 141,750 612,000
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