AFM481 - Advanced Cost Accounting
Professor Grant Russell
Final Exam Material
Chapter 7: Activity-Based Costing and Management
Activity-based Costing (ABC) is a system that assigns overhead costs to the specific activities
performed in a manufacturing or service delivery process. It attempts to trace costs more accurately
to products or cost objects. It helps identify activities that contribute the most and least value to the
Under ABC, multiple cost pools are used to reflect the various activities performed in manufacturing
a good or providing a service. Costs of overhead resources are first assigned to activity cost pools,
then allocated to individual products or services, using cost drivers.
An activity is a type of task/function performed in an organization.
Organization-sustaining activities: related to the overall organization and unaffected by
number or types of facilities and customers or by volumes of products, batches or units.
o Administrative salaries, housekeeping, accountant salaries
Facility-sustaining activities: related to the overall operations of a facility and unaffected
o Facility janitorial service, building insurance and heating, plant manager’s salary,
o Customer sales rep salaries, technical support salaries, customer market research
o Cost Drivers: number of sales calls, hours of technical support, number of
Product-sustaining activities: production and distribution of a single product
o Product advertising, amortization of equipment, product engineer salaries
o Cost Drivers: # of orders, # of advertisements, machine hours
o Labour cost, utility costs, shipping costs for batches
o Cost Drivers: setup hours, # of batches, weight of orders shipped
o Material handling wages, production workers paid, supplies used
o Cost Drivers: Machine hours, units processed, materials quantity processed
ABC System: Overhead Costs -> Many Cost Pools -> Cost Objects (product line, batch, or units)
using Cost Drivers as allocation bases
1) Identify the relevant cost object.
2) Identify activities.
3) Assign costs to activity-based cost pools.
Indirect Material costs are traced directly to batch or unit cost pools.
Property taxes, insurance, and lease or amortization are directly traced to the facility. 4) For each ABC cost pool, choose a cost driver.
Cause-and-effect relationship must be evident.
Square footage as an allocation base for building-related costs, such as property taxes
5) For each ABC cost pool, calculate an allocation rate (activity costs / measure of volume)
Estimated Allocation Rate = Estimated Total Cost / Estimated # of Batches
6) For each ABC cost pool, allocate activity costs to the cost object.
Activity-based Management (ABM) is about using ABC information to evaluate the costs and
benefits of production and internal support activities, and identifying and implementing opportunities
for improvements in profitability, efficiency and quality.
Managing customer profitability: The most valuable customers are those who order high-margin
products which have low service requirements. Analyze customer ordering patterns and increase
Managing product and process design: Focus resources on value-added activities and
eliminate non-value-added activities
Managing environmental costs
Managing quality: prevention activities, appraisal activities, production activities and post-sales
Managing constrained resources: efficiency improvements; determine the contribution margin
per constrained resource
Target Costing: cost control method by which products and their manufacturing processes are
designed to meet specific target costs, based on expected product selling prices
Kaizen costing: cost reduction and quality improvement process
Benefits of an ABC System:
Focus on measurement at the activity level
Employees are more aware of cause-and-effect relationships of costs.
Motivation to reduce or eliminate non-value-added costs (e.g. holding excess levels of
inventories, waste in the setup process, and inspection inefficiencies)
Measure the flow of resources in an organization
Costs/Drawbacks of an ABC System:
System design costs, accounting and info system modifications and employee training
Mismeasurement of Costs Assigned to ABC Activities: errors in tracing or allocating individual
ABC activity pools often contain irrelevant costs that do not vary with activity levels, such as
o Flexible costs vary with activity levels, and committed costs remain fixed.
ABC costs are not typically separated into fixed and variable categories, so ABC is not very
useful for short-term decision making. Other Multi-Pool, Multi-Driver Cost Accounting Systems: GPK and RCA (Resource Consumption
Accounting) – measure costs and use resources more efficiently
GPK: Each cost is traced to a cost centre. Planned costs and volumes are used to develop a
standard cost function for each cost centre, using output measures as cost drivers. An output
measure tracks the volume of resource use, measured in time. (E.g. The output measure for a
machine would be the number of machine hours.) The cost function includes proportional costs,
which are attributable to changes in volume of resource use. The standard cost function is used to
develop budgets and to assign costs to units of product or other cost centres.
Practical Capacity is used for estimated denominator volume when assigning fixed costs,
allowing managers to track and analyze the cost of idle capacity.
Theoretical Capacity: Maximum capacity limit assuming continuous, uninterrupted operations 365
days per year
Practical Capacity: Maximum volume of a resource under typical operating conditions, assuming
that some downtime is unavoidable for maintenance, holidays, etc.
Budgeted Capacity: Expected volume for the upcoming time period
Idle/Excess Capacity: Difference between actual capacity used and theoretical, practical or
RCA (Resource Consumption Accounting): It attempts to accurately measure resource costs. Each
cost is initially assigned to a resource cost pool. Fixed and proportional cost rates for each resource
cost pool are developed using one output measure as the cost driver. Theoretical capacity rather
than practical capacity is used as estimated volume for fixed costs.
Primary Costs: traced directly to a cost pool (e,g, depreciation, supplies, electricity)
Secondary Costs: assigned based on resource use from separate cost pools (e.g. technician
labour, equipment maintenance, and facility maintenance)
Under both GPK and RCA, costs assigned from other cost pools are classified as fixed or
proportional, based on how the costs behave with respect to activity (e.g. hours of use)
RCA Fixed Cost Rate = Attributable Fixed Resource Costs / Theoretical Capacity
RCA Proportional Cost Rate = Attributable Proportional Resource Costs / Budgeted Capacity
GPK and RCA’s Benefits
Cost info is categorized and summarized according to its behaviour as fixed or proportional at
the resource level.
Relevant cost info is produced for many types of short-term decisions.
Budgeting, monitoring and control are enhanced through the development of appropriate cost
The use of cost functions allows budgets and cost rates to be updated easily.