Activity-Based Costing Systems

Learning Objective 3 Distinguish between simple and activity-based costing systems

• unlike simple systems, activity-based costing systems calculate costs of individual activities in order to cost products

One of the best tools for refining a costing system is activity-based costing. Activity-based costing (ABC) refines a costing system by identifying individual activities as the fundamental source of indirect costs. An activity is an event, task, or unit of work with a specified purpose—for example, designing products, setting up machines, operating machines, or distributing products. More informally, activities are verbs; they are things that a firm does. ABC systems identify activities in all functions of the value chain, calculate costs of individual activities, and assign costs to cost objects such as products and services on the basis of the mix of activities needed to produce each product or service.^*

Plastim’s ABC System

After reviewing its simple costing system and the potential miscosting of products inherent in it, Plastim’s managers decide to implement an ABC system. Direct material costs and direct manufacturing labor costs can be traced to products easily, so the ABC system focuses on refining the assignment of indirect costs to departments, processes, products, or other cost objects. To identify activities, Plastim organizes a team of managers from design, manufacturing, distribution, accounting, and administration. In the next step, Plastim’s ABC system breaks down its current single indirect-cost pool into finer pools of costs related to the different activities that have been identified.

Identifying activities is difficult. The team evaluates hundreds of tasks performed at Plastim. It must decide which tasks should be classified as separate activities and which should be combined. For example, should maintenance of molding machines, operations of molding machines, and process control be regarded as separate activities or combined into a single activity? An activity-based costing system with many activities may become overly detailed and unwieldy to operate. An activity-based costing system with too few activities may not be refined enough to accurately capture cause-and-effect relationships between cost drivers and various indirect costs. To achieve an effective balance, Plastim’s team focuses on activities that account for a sizable fraction of indirect costs and combines activities that have the same cost driver into a single activity. For example, the team decides to combine maintenance of molding machines, operations of molding machines, and process control into a single activity—molding machine operations—because all these activities have the same cost driver: molding machine-hours.

The team identifies the following seven activities based on the steps and processes needed to design, manufacture, and distribute S3 and C5 lenses.

1. Design products and processes
2. Set up molding machines to ensure that the molds are properly held in place and parts are properly aligned before manufacturing starts
3. Operate molding machines to manufacture lenses
4. Clean and maintain the molds after lenses are manufactured
5. Prepare batches of finished lenses for shipment
6. Distribute lenses to customers
7. Administer and manage all processes at Plastim

These activity descriptions (or activity list or activity dictionary) form the basis of the activity-based costing system. Compiling the list of activities, however, is only the first step in implementing activity-based costing systems. Plastim must also identify the cost of each activity and the related cost driver by using the three guidelines for refining a costing system described in Guidelines for Refining a Costing System.

1. TRACE MORE COSTS AS DIRECT COSTS. Plastim’s ABC system subdivides the single indirect-cost pool into seven smaller cost pools related to the different activities that have been identified. The costs in the cleaning and maintenance activity-cost pool (item d) consist of salaries and wages paid to workers who clean the mold. These costs are direct costs because they can be economically traced to a specific mold and lens.
2. INCREASE THE NUMBER OF INDIRECT-COST POOLS. The remaining six activity-cost pools are indirect-cost pools. Unlike the single indirect-cost pool of Plastim’s simple costing system, each of the activity-related cost pools is fairly homogeneous. That is, each activity-cost pool includes only those narrow and focused sets of costs that have the same cost driver. Consider, for example, distribution costs. Managers identify cubic feet of packages delivered as the only cost driver of distribution costs because all distribution costs (such as wages of truck drivers) vary with the cubic feet of packages delivered. In the simple costing system, Plastim pooled all indirect costs together and used a single cost-allocation base, direct manufacturing labor-hours, which was not a cost driver of all indirect costs such as distribution costs. Managers were therefore unable to accurately capture how different cost objects (the S3 and C5 lenses) used resources.

1. To determine the costs of activity pools, managers assign costs accumulated in various account classifications (such as salaries, wages, maintenance, and electricity) to each of the activity-cost pools. This process is commonly called first-stage allocation. For example, as we will see later in the chapter, of the $2,385,000 in the total indirect-cost pool, Plastim identifies setup costs of $300,000. Setup costs include depreciation and maintenance costs of setup equipment, wages of setup workers, and allocated salaries of design engineers, process engineers, and supervisors. We discuss first-stage allocation in more detail in Chapters 15 and 16. We focus here on the second-stage allocation, the allocation of costs of activity-cost pools to cost objects such as products or services.

3. IDENTIFY COST DRIVERS. ABC systems are developed by identifying the activities that are the source of indirect costs. In many instances, the volume or number of units of an activity performed can be measured in different ways, and managers must decide which metric best captures the cause-and-effect relationship between the activity and the costs in the activity pool. Plastim’s managers consider various alternatives and use their knowledge of operations to choose among them. For example, Plastim’s managers choose setup-hours rather than the number of setups as the cost driver of setup costs because Plastim’s managers believe that the more complex setups of C5 lenses take more time and are more costly than the simpler setups of S3 lenses. Over time, Plastim’s managers can use data to test their choices of cost drivers. (Chapter 10 discusses several methods to estimate the relationship between a cost driver and the associated costs.)

The logic of ABC systems is twofold. First, when managers structure activity-cost pools more finely, it leads to more precise costing of the individual activities. Second, allocating the costs in the activity pools to products by measuring the units of the cost-allocation bases of the various activities used by different products leads to more accurate product costs. We illustrate this logic by focusing on the setup activity at Plastim.

Setting up molding machines frequently entails trial runs, fine-tuning, and adjustments. Improper setups cause quality problems such as scratches on the surface of the lens. The resources needed for each setup depend on the complexity of the manufacturing operation. Complex lenses require more setup resources (setup-hours) per setup than simple lenses. Furthermore, complex lenses can be produced only in small batches because the molds for complex lenses need to be cleaned more often than molds for simple lenses. Relative to simple lenses, complex lenses therefore not only use more setup-hours per setup, but also require more frequent setups.

Setup data for the simple S3 lens and the complex C5 lens are as follows.

Recall that in its simple costing system, Plastim uses direct manufacturing labor-hours to allocate all $2,385,000 of indirect costs (which includes $300,000 of indirect setup costs) to products. The following table compares how setup costs allocated to simple and complex lenses will be different if Plastim allocates setup costs to lenses based on setup-hours rather than direct manufacturing labor-hours. Of the $60 total rate per direct manufacturing labor-hour (see Applying the Five-Step Decision-Making Process as Plastim), the setup cost per direct manufacturing labor-hour amounts to $\mathrm{\$}7.54717$ ($\$\text{300,000}÷\text{39,750}$ total direct manufacturing labor-hours). The setup cost per setup-hour equals .

ABC systems that use available time (setup-hours in our example) to allocate activity costs to cost objects are sometimes called time-driven activity-based costing (TDABC) systems. Following guidelines 2 and 3, Plastim should use setup-hours, the cost driver of setup costs, and not direct manufacturing labor-hours, to allocate setup costs to products. The C5 lens uses substantially more setup-hours than the S3 lens ($\text{1,500}\hspace{0.17em}\text{hours}÷\text{2,000}\hspace{0.17em}\text{hours\hspace{0.17em}}=75\%$ of the total setup-hours) because the C5 requires a greater number of setups (batches) and each setup is more challenging and requires more setup-hours.

The ABC system therefore allocates significantly more setup costs to C5 than to S3. When direct manufacturing labor-hours rather than setup-hours are used to allocate setup costs in the simple costing system, the S3 lens is allocated a very large share of the setup costs because the S3 lens uses a larger proportion of direct manufacturing labor-hours $(\text{30,000}÷\text{39,750}=75.47\%)$. As a result, the simple costing system overcosts the S3 lens with regard to setup costs.

As we will see later in the chapter, ABC systems provide valuable information to managers beyond more accurate product costs. For example, identifying setup-hours as the cost driver correctly orients managers’ cost-reduction efforts on reducing setup-hours and cost per setup-hour. Note that setup-hours are related to batches (or groups) of lenses made, not the number of individual lenses. Activity-based costing attempts to identify the most relevant cause-and-effect relationship for each activity-cost pool without restricting the cost driver to be units of the cost objects or metrics related to units of the cost objects (such as direct manufacturing labor-hours). As our discussion of setups illustrates, limiting cost-allocation bases to only units of cost objects may weaken the cause-and-effect relationship between the cost-allocation base and the costs in a cost pool. Broadening cost drivers to batches (or groups) of lenses, not just individual lenses, leads us to cost hierarchies.