Chapter theme: This chapter introduces students to
activity-based costing (ABC) which is a tool that has 1 been embraced by a wide variety of service,
manufacturing, and non-profit organizations.
I. Activity-based costing: key definition
A. 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
2 ―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.
II. How costs are treated under activity-based costing
A. ABC differs from traditional cost accounting in three
Learning Objective 1: Understand activity-based
costing and how it differs from a traditional costing 3
i. Nonmanufacturing as well as manufacturing
costs may be assigned to products, but only on
a cause-and-effect basis.
4 1. For example, ABC systems can assign sales
commissions, shipping costs, and warranty
repair costs to specific products.
ii. Some manufacturing costs may be excluded
from product costs.
1. This is because ABC only assigns a cost to a
product if decisions concerning that product
will cause changes in the cost. 5 2. ABC excludes two types of costs from
a. Organization-sustaining costs (which
will be formally defined later)
b. The costs of unused or idle capacity.
Helpful Hint: Emphasize that ABC systems that are
used to support internal decision making do not need to
conform to GAAP. Therefore, while GAAP requires
treating selling and administrative expenses as period
expenses and it requires assigning all manufacturing
costs to products, ABC systems can assign selling and
administrative expenses to products and they can
exclude manufacturing costs from product costs where
iii. Numerous overhead cost pools are used, each
of which is allocated to products and other cost
objects using its own unique measure of
1. ABC cost pools are created to correspond to
the activities performed in an organization 6
that cause the consumption of overhead
resources. Therefore, the total number of
ABC cost pools will definitely exceed one
(as in the plantwide approach) and it is
likely to exceed the number of departments
within a company (as in the departmental
approach) since more than one activity is
6 often performed within each department.
2. Each ABC cost pool has its own unique
measure of activity. On the contrary,
traditional cost systems usually rely on
direct labor hours and/or machine hours
to allocate all overhead costs to products.
a. Direct labor and machine hours work
correctly when changes in the quantity
of the base are correlated with changes
in the overhead costs being assigned
7 using the base.
b. Relying exclusively on these bases to
assign overhead costs to products has
come under increased scrutiny since,
on an economy-wide basis, direct labor
and overhead costs have been moving
in opposite directions and the variety
of products produced by companies
B. Key definitions/concepts
i. An activity is any event that causes the
consumption of overhead resources.
ii. An activity cost pool is a ―bucket‖ in which 8
costs are accumulated that relate to a single
activity measure in an ABC system.
iii. An activity measure is an allocation base in an
activity-based costing system. The term cost
driver is also used to refer to an activity 9
measure. The two most common types of
activity measures are:
1. Transaction drivers are simple counts of
the number of times an activity occurs such
as the number of bills sent out to customers.
2. Duration drivers measure the amount of 10
time required to perform an activity such as
the time spent preparing individual bills for
Helpful Hint: Introduce the cost-benefit concept by
explaining that transaction drivers are more prevalent
in practice than duration drivers because the data is
much easier to obtain. The additional accuracy
provided by duration drivers often times does not pass
the cost-benefit test.
iv. Traditional cost systems rely exclusively on
allocation bases that are driven by the volume
of production. ABC defines five levels of 11
activity that largely do not relate to the
volume of units produced.
1. Unit-level activities are performed each
time a unit is produced.
a. For example, providing power to run
processing equipment would be a unit-
2. Batch-level activities are performed each
time a batch is handled or processed, 12
regardless of how many units are in the
a. For example, setting up equipment and
shipping customer orders are batch-
3. Product-level activities relate to specific
products and must be carried out regardless
of how many batches are run or units are
produced or sold.
a. For example, designing or advertising
a product would be product-level
4. Customer-level activities relate to specific
customers and are not tied to any specific
a. For example, sales calls and catalog
12 mailings would be customer-level
5. Organization-sustaining activities are
carried out regardless of which customers
are served, which products are produced,
how many batches are run, or how many
units are made.
a. For example, heating a factory and
cleaning executive offices are
III. Designing an activity-based costing (ABC) system
A. Characteristics of a successful ABC implementation:
i. There should be strong top management
1. Without leadership from top management,
some managers may not be motivated to
embrace the need to change.
ii. Top managers should ensure that ABC data are
linked to how people are evaluated and