Welcome to another episode of managerial accounting. I'm Michael McLaughlin, PhD, CPA,
and professional wrestler. In today's episode we're going to discuss activity-based costing
or ABC for short. ABC is a cost system that can be used to measure the cost of providing a good
or a service, calculate the profitability of a company's product lines, and perform customer
profitability analysis. The possibilities are endless. Like when you let a dog loose in a
casino. Now there are many types of cost systems: job costing, operation costing, process costing.
But ABC stands apart from these traditional cost systems because it's more accurate. Traditional
cost systems rely on a single volume based cost driver (like machine hours or direct labor hours)
to allocate overhead to products. This can lead to distorted product costs when the cost driver
isn't correlated with overhead. If you allocate overhead based on direct labor hours for example
you're assuming that an increase in direct labor hours will create more overhead. But
what if direct labor hours aren't closely related to overhead? Your cost system will arbitrarily
allocate overhead costs and your cost figures will be meaningless. This can be a real problem
if you set prices based on costs. You might think it costs just one dollar to make this
ramen noodle hair protector, so you set the price at two dollars. But what if it really cost five
dollars to make the product? You'd be selling the product at a loss. Thus traditional cost systems
have largely become obsolete. You get bad cost information if you allocate the overhead using
a single volume-based cost driver, and the rise of automation has made this problem even worse.
Increased automation means that overhead accounts for a greater proportion of companies costs.
And the more overhead a company has, the more important it is to allocate that overhead in
a sensible way. That's a lot to take in so let's summarize what we've learned. If you're bald like
me, you don't need a product like this or even this. Instead you could buy something like this.
So what makes ABC better than traditional cost systems? With traditional cost systems you lump
all the overhead into a single bucket and then you spread the overhead to products using a single
cost driver, that may or may not even be related to overhead. But with ABC you logically identify
the activities that cause overhead to be incurred, then you group the overhead into cost pools based
on the activity type calculate activity rates for each of these cost pools, and then use the
activity rates to assign overhead costs to the cost object (which could be a product,
a customer, or a department). Thus, with ABC you're identifying all the different activities
that drive overhead costs, and then you're allocating overhead costs accordingly. With ABC,
costs are allocated based on cause and effect relationships (not using a single arbitrary cost
driver). For example, let's say that Santa's toy manufacturing makes two different toys, and has
10 million in overhead costs. For those of you who don't know, Santa Claus is a guy who sneaks into
people's homes at the end of each year to leave presents, eat cookies, and steal people's credit
cards. Santa wants to compare the profitability of his two products teddy bears and dolls. But
Santa didn't pay attention in accounting class, so he simply allocates overhead to products using
a single cost driver: machine hours. Multiplying the overhead rate of three dollars a machine hour
to the number of machine hours for each product results in $450,000 of overhead being allocated
to the teddy bear product line, and $300,000 of overhead being allocated to the dolls. We then
add the cost of direct materials used in the cost of direct labor, and divide by the total number of
units to find the cost per unit (Which is $6.00 a unit for the teddy bear product line, and $4.50 a
unit for the dolls). This is the result we get with traditional costing. Fortunately, Santa's
helper did pay attention in accounting class and she shows Santa how to use ABC. With ABC,
we first identify the various activities that cause overhead to be incurred. We do this by
interviewing Santa's workers, and we learned that 15% of the overhead is caused by machine time, 30%
of the overhead is caused by inspections, and 55% of the overhead is caused by setups for production
runs. We then assign overhead to each of these three cost pools based on these percentages.
Next, we calculate the activity rate for each of these cost pools. Note that instead of having a
single overhead rate we actually have three rates: $0.45 a machine hour, $22.50 per inspection, and
$825 per setup. We then multiply these activity rates by the corresponding activity level for
each product line. After adding the cost of direct materials used and direct labor to the overhead,
we divide by the total number of units to find the cost per unit for each product line.
And it turns out that the doll is actually more expensive to produce than the teddy bear.
This is the opposite of what the traditional cost system told us.
Santa had no idea the costs were so different. He also had no idea that identity theft is a crime,
and he's currently on the run from the police. So now you've seen how ABC first allocates the
cost to cost pools, and then allocates the cost of products using the activity rates. This is
sometimes called a two-stage allocation. But there's another difference between
ABC and traditional cost systems that pertains to manufacturers. Both U.S. GAAP and IFRS state that
inventoriable costs (aka product costs) include three things: the cost of direct materials,
the cost of direct labor, and manufacturing overhead. But because ABC is all about finding
the most accurate and relevant cost, this definition of what constitutes a product cost
is often ignored. When a company is calculating the cost per unit of a product with ABC,
the company might include some non-manufacturing costs and assign them to the cost of the product.
Or, it might exclude some manufacturing costs from the product. For example, the wages of a security
guard who watches the factory are technically a product cost. But, when choosing to calculate
the cost of a product using ABC, you might decide to exclude the cost of the security guard's wages
because it's really a cost of having a factory and not a cost of making any particular product.
In addition, you might choose to include some non-manufacturing costs in the cost per unit
(like warranty costs or sales commissions). For example. let's say that Santa's toy manufacturing
has had some problems with product quality. Thus, the company decides to include warranty
costs in its overhead when calculating the per unit cost of a product using ABC.
The total overhead of $900,000 is thus allocated among four cost pools. And, we then calculate
activity rates for each cost pool and allocate the overhead to the products, just like we did
before. The only difference is that we're now assigning a non-manufacturing cost to the product.
An adjustment like this would not be allowed when creating financial statements (according to U.S.
GAAP or IFRS) because warranty costs are not a product cost. Thus, a manufacturer that wants
to adopt activity-based costing would need to maintain two separate cost systems: one for
external reporting (the financial statements), and another for internal decision making (ABC). That
can be difficult. It's like having to manage not just one, but two Instagram accounts for your cat.
As you can see, there are a lot of differences between ABC and traditional cost systems,
but I've been holding out on some bad news. As great as ABC is, not all companies use it.
That's about as sad as an out of work wedding crasher. Now, there are many reasons a company
might choose not to use ABC: manufacturers find it costly to maintain two cost systems,
it's time consuming to interview employees to identify the various cost pools, employees
might overstate the amount of time they spend on various activities so they don't look lazy,
ABC results in a massive amount of data that takes time to analyze, and that's if you even manage to
implement ABC (which could be an arduous process that takes years, particularly if you have some
employees resisting the new system). Thus, even though ABC results in the most accurate
cost figures, some executives don't think it's worth a hassle. Now wasn't this lesson exciting!
Watching accounting videos online is way more exciting than watching Game of Thrones,
climbing a tower, or reading a newspaper that's on fire. So remember what you've learned today:
ABC is more accurate than traditional cost systems, ABC isn't easy to implement, and
never give your bank password to someone dressed as Santa. I hope you found this helpful. Bye bye.