Study Unit 2
ABC – Activity-Based Costing
LCC – Life-Cycle Costing
2.3 Activity-Based Costing
“Activity-based costing (ABC) is a response
to the significant increase in the incurrence
of indirect costs resulting from the rapid
advance of technology”
ABC may be used by manufacturing,
service, or retailing entities.
2.3 Activity-based costing
 Traditional
costing system: OH is simply
dumped into a single cost pool
 Under ABC, indirect costs are attached to
activities and then rationally allocated
 ABC may be used by manufacturing
service or retailing
Traditional Costing System
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
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Peanut-butter costing = product-cost crosssubsidization  inaccurate allocation of indirect
costs over products or service units
DL + DM are traced to products/services
A single pool of indirect costs is allocated based on a
single rate (overhead)
Indirect costs from the pool are assigned using an
allocative (rather than a tracing) procedure, such as
using a “single” overhead rate for an entire
department.
How much resources did I use on product X?
Example
 See
example - page 64
Volume-Based vs. Activity
Based Systems
 See
drawing on the bottom of page 64,
which shows OH Allocations of volumebased organizations.
 Appropriate when direct cost were the
bulk of manufacturing costs.
 Contemporary organization have a larger
percentage overhead due to
automation.
Steps in ABC process
1)
2)
3)
Activity Analysis: understand the different steps
and process from DM to Finished Goods
Assign Resource Costs to Activities: first-stage
allocation. Identify resource costs: a separate
Accounting System may be necessary to track
resource costs separately from the GL. Then we
need to define resource drivers to allocate it.
Allocate Activity Cost Pools to Cost Objects:
allocating the activity cost pools to final cost
objects = second-stage allocation
 What are my activity drivers?
Cost Drivers
 Cause-&-effect
relationship
 Cost object may be a job, product, process,
activity, service or anything else for which a
cost measure is desired
 Process value analysis: Organization flow


Value-adding Vs. Non Value-adding
Product costing / continuous improvement
ABC used to obtain full-absorption cost (US GAAP)
ABC
Advantages/Disadvantages








Product costing is improved, better decision making
Process value analysis (non-value adding activities can be
removed)
More cost assignment of OH
Better cost control and more efficient operations
Maintain a separate Accounting System to capture resource
costs
Design and implement drivers and cost pools
ABC-derived costs of products or services may not conform
with GAAP
Cost of implementing an ABC system
Organizational Benefits
 Significant
variance in volume, diversity of
activities, complexity of operations, relatively
high OH costs…
 ABC difficult for service organizations: high
facility-level costs hard to assign to service
 DL as a base for allocating OH
 No benefit for a single product and average
regular volume of activity
 Real benefits for high level of FC + wide
variety of products and level of production
ABC - Question 1
Question 1 - CMA1 Study Unit 2: Cost
Accumulation Systems
The use of activity-based costing (ABC)
normally results in
A. Substantially greater unit costs for lowvolume products than is reported by
traditional product costing.
B. Substantially lower unit costs for lowvolume products than is reported by
traditional product costing.
C. Decreased setup costs being charged to
low-volume products.
D. Equalizing setup costs for all product lines.
Question 1 - Answer
Correct Answer: A
ABC differs from traditional product costing because it uses
multiple allocation bases and therefore allocates overhead
more accurately. The result is that ABC often charges lowvolume products with more overhead than a traditional
system. For example, the cost of machine setup may be the
same for production runs of widely varying sizes. This
relationship is reflected in an ABC system that allocates setup
costs on the basis of the number of setups. However, a
traditional system using an allocation base such as machine
hours may underallocate setup costs to low-volume products.
Many companies adopting ABC have found that they have
been losing money on low-volume products because costs
were actually higher than originally thought.
ABC - Question 2
Question 2 - CMA1 Study Unit 2: Cost
Accumulation Systems
Multiple or departmental overhead rates
are considered preferable to a single or
plant-wide overhead rate when
A. Manufacturing is limited to a single product
flowing through identical departments in a
fixed sequence.
B. Various products are manufactured that do
not pass through the same departments or
use the same manufacturing techniques.
C. Cost drivers, such as direct labor, are the
same over all processes.
D. Individual cost drivers cannot accurately
be determined with respect to cause-andeffect relationships.
Question 2 - Answer
Correct Answer: B
Multiple rates are appropriate when a process
differs substantially among departments or
when products do not go through all
departments or all processes. The trend in cost
accounting is toward activity-based costing,
which divides production into numerous
activities and identifies the cost driver(s) most
relevant to each. The result is a more accurate
tracing of costs.
ABC - Question 3
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
Question 3 - CMA1 Study Unit 2: Cost
Accumulation Systems
New-Rage Cosmetics has used a traditional
cost accounting system to apply quality
control costs uniformly to all products at a
rate of 14.5% of direct labor cost. Monthly
direct labor cost for Satin Sheen makeup is
$27,500. In an attempt to distribute quality
control costs more equitably, New-Rage is
considering activity-based costing. The
monthly data shown in the chart below have
been gathered for Satin Sheen makeup.
ABC - Question 3 (CONTINUED)
Quantity for
Activity
Cost Driver
Cost Rates
Satin Sheen
Incoming material
inspection
Type of material
$11.50 per type
12 types
In-process inspection
Number of units
$0.14 per unit
17,500 units
Product certification
Per order
$77 per order
25 orders
The monthly quality control cost assigned to Satin Sheen makeup using activity-based costing (ABC) is
A.
$88.64 per order.
B.
$525.50 lower than the cost using the traditional system.
C.
$8,500.50
D.
$525.50 higher than the cost using the traditional system.
Question 3 - Answer
Correct Answer: D
ABC identifies the causal relationship between the incurrence
of cost and activities, determines the drivers of the activities,
establishes cost pools related to the drivers and activities, and
assigns costs to ultimate cost objects on the basis of the
demands (resources or drivers consumed) placed on the
activities by those cost objects. Hence, ABC assigns overhead
costs based on multiple allocation bases or cost drivers.
Under the traditional, single-base system, the amount
allocated is $3,987.50 ($27,500 × 14.5%). Under ABC, the
amount allocated is $4,513 [(12 × $11.50) + (17,500 × $.14) +
(25 × $77)], or $525.50 more than under the traditional system.
Life-cycle costing
 Estimate
revenues & expenses
 Over the entire sales life cycle
 Upstream costs (R&D, Design)
 Manufacturing
 Downstream costs (Mktg & Distribution,
Customer Service)
 Great value for Pricing Decision
Potential Benefits
 Relationships
among costs incurred at different
value-chain stages
 Incurring costs vs. locking in costs (SUNK)
 Focus on cost control Vs. cost reduction
 After-purchase costs (operating, support, repair,
disposal…)
 Life-cycle and whole-life cycle  target costing
 Value engineering: minimize cost without
reducing customer satisfaction
Life-Cycle vs. Other Costing
Methods
 Traditional



approaches:
Focus on cost control not cost reduction.
Treat pre- and postproduction costs as
period costs largely ignored in determining
profitability.
After purchase costs are ignored.
Life-Cycle vs. Other Costing
Methods (continued)

Whole-life is closely associated with life-cycle
costing.

Life-cycle cost + after purchase costs

Life-cycle and whole-life are associated with
target costing and pricing.

Value engineering is not lessening the quality,
it focuses on value-added and non-value
added.
Internal & External Reporting
 For
external financial statement purposes,
costs during the upstream phase must be
expensed in the period incurred
 IFRS
 For
allows development costs to be capitalized
internal purposes, the costs (R&D) must be
capitalized in a life-cycle costing
 Organizations must develop an accounting
system consistent with GAAP
Advantage
 Better
measure for evaluating the
performance of Product Managers
 Life-cycle
costing combines all costs and
revenues for all periods to provide a
better view of a product’s overall
performance
Life-cycle Costing - Question 1
Question 1 - CMA1 Study Unit 2: Cost
Accumulation Systems
Life-cycle costing
A. Is sometimes used as a basis for cost
planning and product pricing.
B. Includes only manufacturing costs incurred
over the life of the product.
C. Includes only manufacturing cost, selling
expense, and distribution expense.
D. Emphasizes cost savings opportunities
during the manufacturing cycle.
Question 1 - Answer
Correct Answer: A
Life-cycle costing estimates a product’s revenues and
expenses over its expected life cycle. This approach is
especially useful when revenues and related costs do
not occur in the same periods. It emphasizes the need to
price products to cover all costs, not just those for
production. Hence, costs are determined for all valuechain categories: upstream (R&D, design),
manufacturing, and downstream (marketing, distribution,
and customer service). The result is to highlight upstream
and downstream costs in the cost planning process that
often receive insufficient attention.
Life-cycle Costing - Question 2
Question 2 - CMA1 Study Unit 2: Cost
Accumulation Systems
Target pricing
A. Is more effective when applied to mature,
long-established products.
B. Considers short-term variable costs and
excludes fixed costs.
C. Is often used when costs are difficult to
control.
D. Is a pricing strategy used to create
competitive advantage.
Question 2 - Answer
Correct Answer: D
Target pricing and costing may result in a competitive
advantage because it is a customer-oriented approach that
focuses on what products can be sold at what prices. It is also
advantageous because it emphasizes control of costs prior to
their being locked in during the early links in the value chain.
The company sets a target price for a potential product
reflecting what it believes consumers will pay and competitors
will do. After subtracting the desired profit margin, the longrun target cost is known. If current costs are too high to allow
an acceptable profit, cost-cutting measures are implemented
or the product is abandoned. The assumption is that the target
price is a constraint.
Life-cycle Costing - Question 3
Question 3 - CMA1 Study Unit 2: Cost Accumulation Systems
Claremont Company has been asked to evaluate the profitability of a
product that it manufactured and sold from Year 7 through Year 10. The
product had a one-year warranty from date of sale. The following
information appears in the financial records.
Research,
Manufacturing
development, and distribution Warranty costs Warranty cost
and design cost
costs
Yr 5 & Yr 6
Yr 7 - Yr 10
Yr 7 - Yr 10
Yr 11
$5,000,000
$7,000,000
$200,000
$100,000
Life-cycle Costing - Question 3
(continued)
The life-cycle cost for this product is
A. $10,000,000
B. $12,000,000
C. $12,200,000
D. $12,300,000
Question 1 - Answer
Correct Answer: D
Life-cycle costing takes into account costs
incurred at all stages of the value-chain, not
just manufacturing. The life-cycle cost for
this product is thus $12,300,000 ($5,000,000 +
$7,000,000 + $200,000 + $100,000).