Activity-Based Costing (ABC)

• Activity-based costing (ABC) calculates unit product costs for internal decision-making, impacting strategic choices and capacity.
• Traditional absorption costing has limits for internal use by focusing solely on financial reporting.

Limitations of Traditional Absorption Costing

• Manufacturing costs are exclusively assigned to products, overlooking non-manufacturing costs.
• All manufacturing costs are assigned, regardless of actual consumption by products.
• Limited overhead cost pools rely on volume-related allocation bases, ignoring non-volume drivers that exist.

Activity-Based Costing Advantages

• ABC is designed for internal management, effectively overcoming traditional cost system limitations.
• Non-manufacturing costs can be assigned on a cause-and-effect basis, alongside manufacturing costs.
• Manufacturing costs can be excluded from product costs if not directly caused by the product.
• Multiple overhead cost pools are used, each with unique activity measures for allocation.
• ABC treats organization-sustaining costs as period expenses, different from absorption costing.
• Costs of unused capacity are not charged to products, focusing on used capacity.
• ABC expands overhead to include both manufacturing and non-manufacturing indirect costs.
• Direct non-manufacturing costs are recognized as product costs.

Cost Pools and Allocation

• Traditional systems use few overhead cost pools and volume-related allocation bases.
• ABC uses numerous non-volume-related cost drivers to improve cost accuracy.
• An activity in ABC is an event that consumes overhead resources.
• An activity cost pool accumulates costs related to a specific activity measure.
• Activity measures act as allocation bases or cost drivers, influencing cost allocation.
• Transaction drivers count activity occurrences, while duration drivers measure time required.
• Five activity levels are defined in ABC as unit, batch, product, customer and organization-sustaining

Activity Levels Explained

• Unit-level activities occur per unit produced, proportional to production volume.
• Batch-level activities are performed per batch handled, regardless of batch size.
• Product-level activities support specific products.
• Customer-level activities are tailored to specific customers.
• Organization-sustaining activities support the entire organization, like factory upkeep and admin.

ABC Implementation Steps

• Define activities, cost pools, and measures.
• Assign overhead costs to activity cost pools.
• Calculate activity rates for each cost pool.
• Assign overhead costs to cost objects using activity rates.
• Prepare management reports based on ABC data.
• Customer Orders involve resources used to take and process orders.
• Product Design activity includes resources for designing new products.
• Order Size includes costs consumed making individual units of product.
• Customer Relations manages customer relationships through sales calls and more.

Overhead Cost Assignment

• A general ledger classifies costs by department where they are incurred.
• Annual overhead costs are assigned to activity cost pools based on employee estimates of activity drivers.
• The ABC implementation relies on employees for first-stage allocation of overhead costs.
• Exhibit 7-4 provides percentages for allocating departmental overhead costs to activities.
• Indirect factory wages are allocated to customer orders, product design, order size, customer relations, and other activities.
• Overhead costs not associated with specific activities comprise organization-sustaining costs.
• Activity rates are computed to assign overhead costs to products, representing the average cost per activity unit.
• The other category of costs includes organization-sustaining and unused capacity costs not allocated.
• Exhibits 7-7 provides a visual for the ABM cost model, using overhead, direct materials, direct labor and shipping

Allocating Costs to Products

• Second-stage allocation applies activity rates to cost objects using activity resources.
• ABC assigns overhead costs to products like standard stanchions and custom compass housings, and can be used to assign activity costs to customers too.
• The Customer Relations activity pertains to customer management and relationships.
• Organization-sustaining activities are not caused by any particular product.

Management Reports

• ABC data produce product and customer profitability to channel company resources.
• Profit from a product, also the product margin, depend product direct and indirect costs
• Activity-based costing helps categorize revenues and expenses
• Costs in the Customer Relations and Other activity cost pools are excluded because they are not caused by products.

Further Considerations for Activity-Based Costing

• ABC rates help identify process improvement
• ABC can be called activity-based management
• An ABC does not replace a company's systems in order to give them external reporting
• ABC systems can measure cost that are consumed by products and customer
• ABC systems can be often not be embraced reasons for the accounting in the operational side of the business