A Tool to Aid Decision Making
This chapter introduces students to activity-based costing (ABC) which is a tool that has been
embraced by a wide variety of service, manufacturing, and non-profit organizations.
ABC is a costing method that is designed to provide managers with cost information for strategic
and other decisions that potentially affect capacity and therefore “fixed” as well as variable
costs.It is ordinarily used as a supplement to, rather than as a replacement for, the company’s
usual costing system.
1.ABC and GAAP. Some ABC systems are used as replacements for a company’s regular
costing system and are used for external as well as for internal financial reports.
However, in most cases, a company’s ABC system is not integrated into the
company’s regular costing system. We tend to agree with experts who argue against
integrating the two systems because of their very different purposeshe text will
emphasize the use of activity-based costing as a decision-making tool.
2. The ABC approach taken in the chapter. In practice activity-based costing comes in
many variations. The text has consciously combined the best elements from practice and
have added some innovations of our own. As a consequence, the material in the chapter
should be regarded as ABC as it should be rather than a description of ABC as it is
commonly implemented in practice.
B. Differences Between ABC and Traditional Costing. The product costs computed in
Chapter 8 (ABC) differ in major aspects from the product costs in Chapters 2, 3, and 4 which
describe traditional costing systems.
1. Non-manufacturing costs in ABC. Strictly speaking, non-manufacturing costs are
excluded from product costs under GAAP. However, to the extent that these costs are
caused by specific products, excluding them may result in misleading information for
making decisions. It is true that these non-manufacturing costs can be deducted from
product revenues in addition to unit product costs when decisions are made, but this is not
always done. It is probably safer to build these costs right into product costs, which is the
approach taken in this chapter. (Remember, these costs are to be used for making decisions,
not valuing inventory and cost of goods sold.)
2. Multiple overhead cost pools in ABC. Traditional overhead costing systems are described
in Chapters 2, 3, and 4. In these traditional systems, an entire plant may have a single
overhead cost pool or each production department may have a separate overhead cost pool.
In nearly all cases, overhead costs are applied to products using either direct labour-hours,
www.notesolution.com direct labour cost, or machine-hours. In activity-based costing, each major activity has its
own separate overhead cost pool. An activity is any event that causes the consumption of
resources. The activities tracked in the ABC system may cut across many departments and
the measures of activity (i.e., allocation bases) may be quite different from the traditional
C. Cost Hierarchy in Activity-Based Costing. Thousands of activities are carried out in
most organizations. It would not be practical to track all of them in an activity-based costing
system. A great deal of simplification is necessary. Activities and their costs must be combined
to reduce the complexity and record-keeping requirements. One way to simplify is to group
activities into a hierarchy. Activities, and their costs, can be combined within each level of the
hierarchy into activity cost pools—hopefully with minimal loss in accuracy. The cost hierarchy
used in the text is not the only scheme that could be used, but it is reasonably comprehensive.
The levels in the hierarchy are as follows:
D. Mechanics of Activity-Based Costing. Several e xhibits in the text are useful for
summarizing the mechanics of activity-based costing. You may want to refer to them it
frequently as you walk through the steps of assigning costs using ABC.
1. Overview. Once the activity cost pools and their activity measures have been defined, costs
are allocated to the activity cost pools. The costs in the activity cost pools are then divided
by their activity measures to determine activity rates. (Activity rates are like the overhead
rates of Chapter 3.) The activity rates are then used to assign costs to cost objects such as
products and customers. For example, if a customer generates five orders and the activity
rate for orders is $15 per order, then the customer would be assigned $75 in order costs.
The mechanics are fundamentally no different from the mechanics covered in Chapter 3 for
applying overhead to products. The main difference is that instead of one predetermined
overhead rate, many activity rates are used.
2. First-stage allocations. The first stage in the allocation process is based on a table showing
the distribution of resource consumption across activities for each category of cost in the
company’s bookkeeping system. For example, if indirect factory wages is one of the
accounts in the company’s bookkeeping system, the table would show what percentage of
indirect wages is attributable to each of the activities in the company’s ABC system. The
text describes how interviews can be used to elicit these percentage distributions.
Nevertheless, these percentage distributions are always given in all examples and