- Discuss activity-based costing and how it differs from a traditional costing system - Explain non-manufacturing costs and how they relate to an activity-based costing system - Explain manufacturing costs and how they relate to an activity-based costing system - Discuss how cost pools and allocation bases are used in an activity-based costing system [SLIDE 1] We have looked at several methods of costing in our previous lessons. In this lesson, we will introduce activity-based costing, also known as ABC costing. ABC costing is another tool that managers can use to aid in decision making. ABC is a costing method that is designed to provide managers with cost information to perform strategic and other decisions that may affect capacity and therefore fixed as well as variable costs. Companies use it as a supplement to the company's usual costing system rather than a replacement. Activity-based costing (ABC) systems are information systems that provide quantitative information about an organization's activities. They create opportunities to improve the cost information supplied to managers. They also help managers view their organization as a collection of activities. Activity-based cost information helps managers improve operating processes and make better pricing decisions. Activity-based systems developed because traditional accounting systems failed to produce the types of information that today's managers need for decision making. Traditional systems focused primarily on the measurements needed for financial reporting and auditing, such as the measurement of cost of goods sold and the valuation of inventory. Because they were not designed to capture data on activities or to trace the full cost of a product, these systems could not isolate the cost of unnecessary activities, penalize for overproduction, or quantify measures that improved quality or reduced throughput time. Let's review how the ABC method differs from the traditional costing method. [SLIDE 2] The traditional method allocates overhead based on production volume and the ABC method allocates overhead based on activities. The ABC costing method differs from traditional costing in three ways:
  1. ABC may assign nonmanufacturing and manufacturing costs to products but only on a cause-and-effect basis.
  2. ABC may exclude some manufacturing costs from product costs.
  3. ABC uses numerous overhead cost pools, each of which is allocated to products and other cost objects using its own unique measure of activity.
As we proceed with our discussion on the differences in ABC costing and traditional costing, we will look at each difference in more detail. [SLIDE 3] The traditional costing method assigns only manufacturing costs to products. It treats selling and administrative expenses as period expenses and does not assigns them to products. Yet, many of these nonmanufacturing costs, such as the costs of producing, selling, distributing, and servicing, are still a part of specific products. For example, commissions paid to salespersons, shipping costs, and warranty repair costs can be easily traced to individual products. These are all considered part of overhead for an organization. The activity-based costing method assigns all of the nonmanufacturing overhead costs to products where they can reasonably be assumed to have a cause-and-effect. Basically, we are determining the entire cost of a product rather than just its manufacturing cost. Cause-and-effect is the primary criterion used in ABC costing with regard to nonmanufacturing costs. [SLIDE 4] The traditional costing method assigns all manufacturing overhead costs to products even though they are not incurred by the products based on a predetermined plantwide overhead rate. Using this approach, we spread all manufacturing overhead costs across the products based on each product's direct labor-hour usage. These costs might include costs such as the property taxes, utilities, insurance, and the cost of supplies used by the plant manager's secretary. These types of costs are assigned to products in a traditional absorption costing system even though they are totally unaffected by which products are made during a period. These costs are considered organization-sustaining activities. In addition to these types of costs, the traditional costing method also assigns the costs of unused, or idle, capacity to products. If the budgeted level of activity declines, the overhead rate and unit product costs increase as the increasing costs of idle capacity are spread over a smaller base. Conversely, the activity-based costing system purposely does not arbitrarily assign manufacturing overhead costs that are organization-sustaining or related to unused capacity to products. Activity-based costing treats organization-sustaining costs as period expenses rather than product costs. In addition, activity-based costing does not consider idle or unused capacity cost as product costs and therefore, only charges for the costs of the capacity they use, not for the costs of capacity they don't use. This provides more stable unit product costs and is consistent with the goal of assigning to products only the costs of the resources that they use. [SLIDE 5] The traditional cost system usually relies on direct labor hours or machine hours to allocate all overhead costs to products. This type of allocation has come under scrutiny since direct labor and overhead have been moving in opposite directions and the variety of products produced by organizations has increased. Companies are moving to ABC costing to improve the accuracy of product or service cost estimates for organizations that sell many different types of products or services or that use varying, significant amounts of different production-related activities to complete the products or services. ABC costing is a more accurate method of assigning overhead costs to products or services than the traditional approach. It categorizes all indirect costs by activity, traces the indirect costs to those activities, and assigns activity costs to products or services using a cost driver related to the cause of the cost. This means that managers will calculate an overhead rate, or activity cost rate, for each activity cost pool and then use that rate and a cost driver amount to determine the portion of overhead costs to assign to a product or service produced. Cost pools are a collection of indirect costs assigned to a cost driver, which is a single unique activity measure. They are created to correspond to the activities performed in an organization that cause the consumption of overhead resources. The total number of cost pools in ABC will exceed one and will likely exceed the number of departments within an organization as more than one activity is often performed within each department. An activity measure, also known as a cost driver, is an allocation base in ABC costing. The two most common types of activity measure are: A traditional cost system relies on allocation bases that are driven by volume of production. ABC costing uses five levels of activity and they do not relate to the volume of units produced. Let's look in greater detail at the five levels of activity in ABC costing. [SLIDE 6] ABC systems classify costs in a cost hierarchy, distinguishing costs by whether the cost driver is: a unit of output (or variables such as machine-hours or direct manufacturing labor-hours that are related to units of output); or a group of units of a product, such as a batch in the case of set-up costs; or the complexity of the product itself, as in the case of design costs. A cost hierarchy categorizes various activity cost pools on the basis of the different types of cost drivers, or cost-allocation bases, or different degrees of difficulty in determining cause-and-effect relationships. In an ABC cost system, organizations combine activities into the five activity categories as follows:
  1. Unit-Level: The cost of activities performed on each individual unit of production. These costs over time increase with additional units of production. An example is power to run production equipment.
  2. Batch-Level: The cost of activities related to a group of units of production rather than to each individual unit of output. Examples would include equipment set up for a production run or shipping customer orders.
  3. Product-Level: The cost of activities undertaken to support individual production regardless of the number of units or batches in which the units are produced. An example is design cost.
  4. Customer-Level: The cost related to specific customers and not related to any specific product. Examples would include sales calls or catalog mailings.
  5. Organization-Sustaining: The cost of activities that cannot be traced to individual production but that support the organization as a whole. With these costs, it is hard to find a cause-and effect relationship between cost and the cost-allocation base. Examples are cleaning the executive offices and top management compensation. The absence of a cause-and-effect relationship provides a sound argument for not allocating these costs. Managers usually deduct them separately from operating profit and they will ensure that pricing policy covers these costs. However, some managers frequently want all costs allocated to the cost object. The only way to allocate organization-sustaining costs is to use an arbitrary cost-allocation base because, by definition, there is no cause–effect relationship between these costs and the cost object. While managers frequently do this, note that this practice contradicts the rationale of ABC and results in estimates of cost that are misleading.
As you can see, there is a difference in the traditional cost allocation and ABC cost allocation. ABC costing provides a more accurate allocation of indirect costs compared to the traditional method of cost allocation. This assists managers in being able to make decisions with more accurate information to improve the organization. In the next lesson, we will look at how to design an activity-based costing system for an organization.