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Managerial Accounting Unit 6: Activity-Based Costing

Activity-based costing assigns overhead using the activities that cause it. It reveals which products and customers are truly profitable when products differ in complexity.

Covers: Limits of volume-based overhead rates, Activities, cost pools and drivers, Activity rates and assigning overhead, ABC cost hierarchy, Traditional vs. ABC product costs, Customer profitability, Activity-based management

Study guide

Traditional costing applies all overhead with one volume-based rate, such as direct labor-hours. That works when overhead is small or products are similar. But many overhead costs, like machine setups, inspections, purchasing and engineering, are driven by batches or product complexity, not by volume. A plantwide labor-hour rate spreads those costs by volume, so high-volume, simple products absorb costs that low-volume, complex products actually cause. The result is product cost distortion: high-volume products look more expensive than they are, specialty products look cheaper, and managers may price or promote the wrong items.

Activity-based costing fixes this by assigning overhead through activities. First, identify the major activities and create an activity cost pool for each. Second, assign overhead costs to the pools. Third, choose an activity driver for each pool, the measure that best causes its cost, such as number of setups, number of inspections or machine-hours. Fourth, compute an activity rate: estimated pool cost ÷ estimated total driver quantity. Finally, assign overhead to products by multiplying each rate by the product's driver usage and adding across pools. For example, with a $900 setup rate, a product using 160 setups receives $144,000 of setup cost.

ABC classifies activities in a cost hierarchy. Unit-level activities happen for every unit, such as machine processing. Batch-level activities happen once per batch regardless of batch size, such as setups and materials moves. Product-level activities support a specific product, such as design engineering or maintaining a parts list. Customer-level activities serve particular customers, such as sales calls or special handling. Facility-level, or organization-sustaining, activities keep the whole operation running, such as plant management and building security. Facility-level costs cannot be traced meaningfully to products, so many companies leave them unassigned for internal decisions.

ABC extends beyond products. Customer profitability analysis assigns order processing, shipping, returns and service costs to customers, often showing that a few demanding customers erase the profit earned on others. Activity-based management uses the cost of each activity to target improvement: cutting setups, reducing rework, or eliminating non-value-added moves. ABC costs more to build and maintain than traditional costing, so it is most valuable when overhead is large and products or customers differ a lot. Managers must also remember that an ABC cost is not automatically avoidable. Before dropping a product, check which costs would actually go away.

Key ideas

• Volume-based overhead rates distort product costs when products differ in batch size and complexity.
• ABC assigns overhead using several activity cost pools, each with its own driver and rate.
• Activity rate = estimated activity cost ÷ estimated activity driver quantity.
• The cost hierarchy is unit-level, batch-level, product-level, customer-level and facility-level.
• ABC usually shifts overhead from high-volume simple products to low-volume complex ones.
• Customer profitability analysis applies ABC to customers' use of service activities.
• ABC costs are not all avoidable; facility-level costs often remain if a product is dropped.

Formulas and rules

Common mistakes

• Using total overhead ÷ total driver for every pool instead of each pool's own cost and driver.
• Classifying setups as unit-level or design engineering as batch-level.
• Forgetting to divide total ABC overhead by units when asked for a per-unit cost.
• Assuming ABC always lowers product costs; it reallocates the same total overhead.
• Treating every ABC-assigned cost as avoidable when deciding to drop a product.

Before the test, make sure you can

• Explain why volume-based rates distort costs for diverse products.
• Calculate activity rates for several cost pools.
• Assign overhead to products using ABC and compute per-unit costs.
• Compare product costs and margins under traditional costing and ABC.
• Classify activities into the cost hierarchy.
• Perform a customer profitability analysis using activity rates.
• Explain when ABC is worth its cost and how activity-based management uses it.

Words to know

Activity-based costing (ABC)

A costing method that assigns overhead to products and customers based on the activities they use.

Activity

An event that causes overhead cost, such as a setup, inspection or purchase order.

Activity cost pool

A grouping of overhead costs caused by one activity.

Activity driver

A measure of how much of an activity a product or customer uses, such as number of setups.

Activity rate

Estimated activity cost divided by estimated driver quantity.

Unit-level activity

An activity performed for each unit produced, such as machine processing.

Batch-level activity

An activity performed for each batch regardless of its size, such as a setup.

Product-level activity

An activity that supports a specific product, such as design engineering.

Customer-level activity

An activity that serves a specific customer, such as sales calls or special handling.

Facility-level activity

An activity that sustains the whole organization, such as plant management.

Product cost distortion

Over- or undercosting of products caused by allocation bases that do not reflect cost drivers.

Customer profitability analysis

Measuring profit by customer after assigning the costs of activities each customer uses.

Activity-based management

Using ABC data to reduce or eliminate costly activities that add little value.

Non-value-added activity

An activity that consumes resources without adding value customers would pay for, such as moving materials.

Practical capacity

The activity level a resource can supply; using it as a rate base isolates unused capacity cost.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.