Traditional cost accounting methods suffer from several defects that can result in distorted costs for decision-making purposes. All manufacturing costs—even those that are not caused by any specific product—are allocated to products. And nonmanufacturing costs that are caused by products are not assigned to products. Traditional methods also allocate the costs of idle capacity to products. In effect, products are charged for resources that they don’t use. And finally, traditional methods tend to place too much reliance on unit-level allocation bases such as direct labor and machine-hours. This results in overcosting high-volume products and undercosting low-volume products and can lead to mistakes when making decisions.

Activity-based costing estimates the costs of the resources consumed by cost objects such as products and customers. The activity-based costing approach assumes that cost objects generate activities that in turn consume costly resources. Activities form the link between costs and cost objects. Activity-based costing is concerned with overhead—both manufacturing overhead and selling and administrative overhead. The accounting for direct labor and direct materials is usually the same under traditional and ABC costing methods.

To build an ABC system, companies typically choose a small set of activities that summarize much of the work performed in overhead departments. Associated with each activity is an activity cost pool. To the extent possible, overhead costs are directly traced to these activity cost pools. The remaining overhead costs are allocated to the activity cost pools in the first-stage allocation. Interviews with managers often form the basis for these allocations.

An activity rate is computed for each cost pool by dividing the costs assigned to the cost pool by the measure of activity for the cost pool. Activity rates provide useful information to managers concerning the costs of performing overhead activities. Aparticularly high cost for an activity may trigger efforts to improve the way the activity is carried out in the organization.

In the second-stage allocation, the activity rates are used to apply costs to cost objects such as products and customers. The costs computed under activity-based costing are often quite different from the costs generated by a company’s traditional cost accounting system. While the ABC system is almost certainly more accurate, managers should nevertheless exercise caution before making decisions based on the ABC data. Some of the costs may not be avoidable and hence would not be relevant.

Learning Objectives

Understand activity-based costing and how it differs from a traditional costing system.

Assign costs to cost pools using a first-stage allocation.

Compute activity rates for cost pools.

Assign costs to a cost object using a second-stage allocation.

Use activity-based costing to compute product and customer margins.

(Appendix 8A) Prepare an action analysis report using activity-based costing data and interpret the report.

(Appendix 8B) Use activity-based costing techniques to compute unit product costs for external reports.