13 Activity-Based Costing

The Theory

Chapter 11, which covered job costing, mentioned activity-based costing (ABC) systems, stating that they involved pooling manufacturing overhead costs based on activities. That chapter also stated that the purpose of an activity-based costing system is to make the costs assigned to jobs more accurate by associating each pool of overhead with a cost allocation base that is highly related to it. In this chapter, we’ll build on those concepts by diving into activity-based costing a little deeper.

In traditional costing systems, the cost allocation base (or bases) a firm uses to allocate overhead is often based on volume—measures like direct labor hours, units, and direct materials cost are related to the number of units a firm manufactures, and they often do not vary much with the complexity of those units. So when a firm using volume-based cost allocation bases manufactures numerous products that differ in their level of complexity, the costs assigned to those products don’t capture the extra costs associated with higher complexity. As a result, more complex products, which are often lower volume than simpler products, are often undercosted in a traditional costing system—the costs assigned to them are too low to reflect the resources that actually go into manufacturing them. On the other hand, higher-volume, simpler products are often overcosted in a traditional costing system—the costs assigned to them are too high to reflect the resources that actually go into manufacturing them.

Both overcosting and undercosting can have serious consequences. If a product is overcosted, the company may set a higher price for it than is appropriate, as a product’s price is often based on or influenced by its cost. Basic economic principles imply that as price increases, demand decreases, and lower sales could lead to lower revenues despite the higher price. The reverse is also true—if a product is undercosted, the company may set a lower price than it should, which may result in higher demand for that product. This situation may also result in low margins or even losses, as the price may not be high enough to cover the product’s actual costs.

Activity-based costing offers an alternative to traditional costing that can account for the different levels of complexity across products when assigning costs. In an activity-based costing system, manufacturing overhead is grouped into cost pools, usually many cost pools, based on the activities they are associated with.^[1] Each of those pools can then be assigned a cost driver—a cost allocation base that has a causal relationship with the cost—that is related to the associated activity. For example, the costs of setting up production runs on a piece of machinery could be pooled together, and the number of setups could serve as the cost driver for that pool. Thus, products that require more setups would be assigned higher setup costs than simpler products that require fewer setups.

The strong connection between cost pools and their cost drivers in an activity-based costing system means that the costs assigned to products will more accurately represent the resources used to manufacture them. In contrast to traditional systems that rely heavily on volume-based drivers, ABC recognizes that not all overhead varies with production volume. Thus, the cost assigned to products using activity-based costing are closer to their true cost than a cost assigned using a traditional costing system.

However, activity-based costing systems are very expensive to implement because of the extra time required to track overhead costs and cost drivers separately for each pool of overhead. Firms considering adopting activity-based costing must weigh whether the benefits of more accurate costing would be greater than the costs of implementation.

The Method

We will focus on how activity-based costing (ABC) can improve managerial decision making by comparing the costs of products calculated using an activity-based system to their costs calculated using a traditional costing system, identifying which products are undercosted and overcosted, measuring the degree of cost distortion, and recommending changes to improve profitability. Because ABC is often used for planning and decision-making, these calculations typically rely on budgeted amounts rather than actuals.

The first step is to establish current financial perceptions by calculating each product’s total cost and profit under the traditional costing system.

Next, to build the ABC system, identify the activities involved in production, the manufacturing overhead costs associated with each activity, and the cost drivers that have a causal relationship with those costs.

Next, for each activity pool, divide the budgeted overhead costs by the budgeted amount of the cost driver to calculate a rate for each pool.

Next, assign overhead to each product line using the activity-based costing system by multiplying each activity rate by the amount of cost driver used by each product line. Add direct costs to calculate total product costs under ABC and subtract total product costs from revenue to calculate total profit under ABC.

Finally, compare costs and profits under the two systems, and use the insights from this analysis to recommend pricing, product mix, or operational changes to improve overall profitability.

Illustrative Example

Harveston Equipment, Inc. manufactures three customizable product lines: CropStar Sprayers, TerraTough Tractors, and FieldFlex Harvesters. Harveston, which pays direct labor $40.00 per hour, currently uses a traditional job costing system in which it applies all manufacturing overhead based on direct labor hours. Management suspects that this method distorts product costs and has commissioned a study to explore the use of activity-based costing (ABC) for better decision-making.

Manufacturing overhead is currently budgeted at $3,000,000 for the year. Harveston’s management has set a target profit margin of 20%. Products falling below this threshold may require further analysis or operational adjustments.

Harveston has identified four crucial activities involved in production, as well as the portion of manufacturing overhead costs associated with each activity: Machine Setup (20%), Machining (40%), Quality Control (30%), and Materials Handling (10%). Additional information about each product line is as follows:

Calculate total cost and profit for each product line using traditional costing and ABC costing and compare the results. What changes to pricing, product mix, or operations would you recommend based on your analysis?

First, calculate each product’s total cost and profit under the traditional costing system.

• Manufacturing overhead of $3,000,000 is allocated based on direct labor hours
  • Total direct labor hours: (500 × 10) + (200 × 15) + (100 × 20) = 10,000
  • Manufacturing overhead rate: $3,000,000 ÷ 10,000 = $300 per direct labor hour
• CropStar Sprayers costs and profit:
  • Direct materials: 500 units × $12,000 per unit = $6,000,000
  • Direct labor: 500 units × 10 hours per unit × $40 per hour = $200,000
  • Overhead: 500 units × 10 hours per unit × $300 per hour = $1,500,000
  • Total cost: $6,000,000 + $200,000 + $1,500,000 = $7,700,000
  • Revenue: 500 units x $22,000 selling price per unit = $11,000,000
  • Profit = $11,000,000 = $7,700,000 = $3,300,000
  • Profit margin = $3,300,000 ÷ $11,000,000 = 30.00%
• TerraTough Tractors costs and profit:
  • Direct materials: 200 units × $25,000 per unit = $5,000,000
  • Direct labor: 200 units × 15 hours per unit × $40 per hour = $120,000
  • Overhead: 200 units × 15 hours per unit × $300 per hour = $900,000
  • Total cost: $5,000,000 + $120,000 + $900,000 = $6,020,000
  • Revenue: 200 units × $38,000 selling price per unit = $7,600,000
  • Profit = $7,600,000 = $6,020,000 = $1,580,000
  • Profit margin = $1,580,000 ÷ $7,600,000 = 20.79%
• FieldFlex Harvesters costs and profit:
  • Direct materials: 100 units × $40,000 per unit = $4,000,000
  • Direct labor: 100 units × 20 hours per unit × $40 per hour = $80,000
  • Overhead: 100 units × 20 hours per unit × $300 per hour = $600,000
  • Total cost: $4,000,000 + $80,000 + $600,000 = $4,680,000
  • Revenue: 100 units × $59,000 selling price per unit = $5,900,000
  • Profit = $5,900,000 = $4,680,000 = $1,220,000
  • Profit margin = $1,220,000 ÷ $5,900,000 = 20.68%

Next, set up the ABC system by identifying the activities involved in production and the manufacturing overhead costs associated with each activity. Then, determine the cost driver that has the best causal relationship with each activity.

• The activities involved in production are Machine Setup, Machining, Quality Control, and Materials Handling.
• Manufacturing overhead costs associated with each activity:
  • Machine Setup: $3,000,000 × 20% = $600,000
  • Machining: $3,000,000 × 40% = $1,200,000
  • Quality Control: $3,000,000 × 30% = $900,000
  • Materials Handling: $3,000,000 × 10% = $300,000
• The cost driver that has the best causal relationship with each activity:
  • Machine Setup: The number of setups would be most related to the cost of machine setups.
  • Machining: Total machine hours is likely the best driver of the cost of machining.
  • Quality Control: QC requires inspections, so inspection hours seems like the best driver.
  • Materials Handling: Materials are handled when moved, so material moves would be an appropriate driver.

Next, for each activity pool, divide the budgeted overhead costs by the budgeted amount of the cost driver to calculate a rate for each pool.

• Machine Setup: $600,000 ÷ (100 + 120 + 80) = $2,000 per setup
• Machining: $1,200,000 ÷ (8,000 + 10,000 + 6,000) = $50 per machine hour
• Quality Control: $900,000 ÷ (1,500 + 2,000 + 1,000) = $200 per inspection hour
• Materials Handling: $300,000 ÷ (200 + 400 + 400) = $300 per material move

Next, assign manufacturing overhead to each product line using the activity-based costing system by multiplying each activity rate by the amount of cost driver used by each product line. Add direct costs to calculate total product costs under ABC and subtract total product costs from revenue to calculate total profit under ABC.

• Manufacturing overhead assigned to CropStar Sprayers:
  • Machine Setup: $2,000 per setup × 100 setups = $200,000
  • Machining: $50 per machine hour × 8,000 machine hours = $400,000
  • Quality Control: $200 per inspection hour × 1,500 inspection hours = $300,000
  • Materials Handling: $300 per material move × 200 material moves = $60,000
  • Total overhead: $200,000 + $400,000 + $300,000 + $60,000 = $960,000
• Manufacturing overhead assigned to TerraTough Tractors:
  • Machine Setup: $2,000 per setup × 120 setups = $240,000
  • Machining: $50 per machine hour × 10,000 machine hours = $500,000
  • Quality Control: $200 per inspection hour × 2,000 inspection hours = $400,000
  • Materials Handling: $300 per material move × 400 material moves = $120,000
  • Total overhead: $240,000 + $500,000 + $400,000 + $120,000 = $1,260,000
• Manufacturing overhead assigned to FieldFlex Harvesters:
  • Machine Setup: $2,000 per setup × 80 setups = $160,000
  • Machining: $50 per machine hour × 6,000 machine hours = $300,000
  • Quality Control: $200 per inspection hour × 1,000 inspection hours = $200,000
  • Materials Handling: $300 per material move × 400 material moves = $120,000
  • Total overhead: $160,000 + $300,000 + $200,000 + $120,000 = $780,000
• Total product costs and profit of CropStar Sprayers:
  • Direct materials: $6,000,000 (same as traditional)
  • Direct labor: $200,000 (same as traditional)
  • Manufacturing overhead: $960,000
  • Total cost: $6,000,000 + $200,000 + $960,000 = $7,160,000
  • Revenue: $11,000,000 (same as traditional)
  • Profit = $11,000,000 − $7,160,000 = $3,840,000
  • Profit margin = $3,840,000 / $11,000,000 = $34.91%
• Total product costs and profit of TerraTough Tractors:
  • Direct materials: $5,000,000 (same as traditional)
  • Direct labor: $120,000 (same as traditional)
  • Manufacturing overhead: $1,260,000
  • Total cost: $5,000,000 + $120,000 + $1,260,000 = $6,380,000
  • Revenue: $7,600,000 (same as traditional)
  • Profit = $7,600,000 − $6,380,000 = $1,220,000
  • Profit margin = $1,220,000 / $7,600,000 = $16.05%
• Total product costs and profit of FieldFlex Harvesters:
  • Direct materials: $4,000,000 (same as traditional)
  • Direct labor: $80,000 (same as traditional)
  • Manufacturing overhead: $780,000
  • Total cost: $4,000,000 + $80,000 + $780,000 = $4,860,000
  • Revenue: $5,900,000 (same as traditional)
  • Profit = $5,900,000 − $4,860,000 = $1,040,000
  • Profit margin = $1,040,000 / $5,900,000 = $17.63%

Finally, compare costs and profits under the two systems. Which product(s) are overcosted and which are undercosted under traditional costing? Use the insights from this analysis to recommend pricing, product mix, or operational changes to improve overall profitability.

The costs under each of the two systems are reported below:

	CropStar Sprayers	TerraTough Tractors	FieldFlex Harvesters
Cost – Traditional	7,700,000	6,020,000	4,680,000
Cost – ABC	7,160,000	6,380,000	4,860,000
Difference	540,000	360,000	180,000

CropStar Sprayers are overcosted by $540,000 under the traditional costing system (and profits understated by the same amount), while TerraTough Tractors are undercosted by $360,000 and FieldFlex Harvesters are undercosted by $180,000 (with profits overstated by the same amounts) under the traditional costing system. If prices are set based on costs, CropStarSprayers could be overpriced as well, which could reduce demand for the product. Likewise, TerraTough Tractors and FieldFlex Harvesters could be underpriced, increasing demand for products whose margins may be overstated.

The profit margins under each of the two systems are reported below:

	CropStar Sprayers	TerraTough Tractors	FieldFlex Harvesters
Profit margin – Trad.	30.00%	20.79%	20.68%
Profit margin – ABC	34.91%	16.05%	17.63%

CropStar Sprayers are more profitable than Harveston believed they were, while TerraTough Tractors and FieldFlex Harvesters are less profitable. Harveston’s profit margin goal is 20%, and under the traditional system, they believed all three divisions were meeting the goal. However, only CropStar Sprayers are actually meeting the goal.

These insights could lead Harveston to make decisions such as the following:

• Raise the price of TerraTough Tractors and FieldFlex Harvesters if they believe the market will support the change
• Lower the price of CropStar Sprayers to increase demand for a profitable product
• Engage in value engineering to lower the costs of TerraTough Tractors and FieldFlex Harvesters, if the costs can be reduced without sacrificing value

Lecture Example

CoreWave Devices assembles wearable technology for the global market. It currently uses direct labor hours to allocate manufacturing overhead, but management has grown concerned that this system underestimates the true cost of their customized products.

In response, the company has started evaluating activity-based costing (ABC). CoreWave’s production staff earn $22 per hour, and the company’s target profit margin is 45%.

Production data is as follows:

Product	Units	DLH/Unit	DM/Unit	Selling Price
Standard Smartwatch	80,000	0.15	28	85
Fitness Tracker	60,000	0.10	22	60
Hybrid Smartwatch	40,000	0.25	38	120
Custom Edition	5,000	0.80	50	250

The company’s total manufacturing overhead for the quarter is $1,500,000, broken down as follows:

Activity	Overhead	Brief Description
PCB Soldering	420,000	Attaching internal circuit boards
Assembly & Calibration	540,000	Component integration & sensor tuning
Packaging & Accessories	300,000	Boxing, inserts, cables, and manuals
Custom Coordination	240,000	Unique design and packaging for custom models

Potential cost drivers include the following:

Calculate the total product cost and profit for each product line using both the traditional costing system and the activity-based costing system. Then, compare the results. Which product(s) are overcosted and which are undercosted under traditional costing? What changes to pricing, product mix, or operations would you recommend based on your analysis?