6.8 Variations of Activity-Based Costing (ABC)

Bill Bonner

46 6.8 Variations of Activity-Based Costing (ABC)

Last updated

Dec 28, 2020

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Learning Objectives

Expand the use of activity-based costing.

Question: The primary focus of activity-based costing thus far has been on allocating manufacturing overhead costs to products. Although this is important for external reporting purposes, we can expand ABC to include costs beyond manufacturing overhead. Also, we can organize costs in different ways to help managers evaluate performance. What different approaches can be used to organize cost data in a way that helps managers make better decisions?

External Reporting and Internal Decision Making

Question: U.S. Generally Accepted Accounting Principles require the allocation of all manufacturing costs to products for inventory costing purposes. The choice of an allocation method is not critical to this process. Companies that use direct labor hours, machine hours, activity-based costing, or some other method to allocate overhead costs to products are likely to be in compliance with U.S. GAAP. Throughout this chapter, we have illustrated how ABC is used to allocate manufacturing overhead costs. However, organizations often use ABC for purposes that go beyond allocating costs solely for external reporting. How might ABC be used to help companies in areas other than external reporting?

Table 6.1 provides examples of costs that could be allocated to products. It also includes cost categories—product, selling, and general and administrative (G&A)—and indicates whether the cost allocation complies with U.S. GAAP for external reporting. As you can see in the far right column, all costs can be allocated to products for internal reporting purposes.

Table 6.1 – Examples of Costs Allocated to Products
Cost	Cost Category*	OK to Allocate to Products for External Reporting (U.S. GAAP)?	OK to Allocate to Products for Internal Reporting?
Direct materials	Product	Yes	Yes
Direct labor	Product	Yes	Yes
Manufacturing overhead**	Product	Yes	Yes
Sales commissions	Selling	No	Yes
Shipping products to customers	Selling	No	Yes
Product advertising	Selling	No	Yes
Legal costs for product lawsuit	G&A	No	Yes
Processing payroll for production personnel	G&A	No	Yes
Company president’s salary	G&A	No	Yes
Costs of implementing ABC	G&A	No	Yes

*See Chapter 5 for information about category definitions.

**Includes all manufacturing costs other than direct labor and direct materials, such as factory-related costs for supervisors, building rent, machine maintenance, utilities, and indirect materials. See Chapter 5 for more detail.

Allocating Service Department Costs Using the Direct Method

Question: Most companies have departments that are classified as either service departments or production departments. Service departments¹⁰ provide services to other departments within the company and include such functions as accounting, human resources, legal, maintenance, and computer support. Production departments¹¹ are directly involved with producing goods or providing services for customers and include such functions as ordering materials, assembling products, and performing quality inspections. Why do companies often allocate a share of service department costs to

production departments for internal reporting purposes even though U.S. GAAP generally does not allow it for external reporting?

Question: How do companies allocate service department costs to production departments and how might this be done at SailRite?

The Hierarchy of Costs

Question: Some organizations group activities into four cost categories, called the hierarchy of costs, to help managers form cost pools for activity-based costing purposes. The cost hierarchy¹³ Credit for developing the cost hierarchy is generally given to R. Cooper and R. S. Kaplan, “Profit Priorities from Activity-Based Costing,” Harvard Business Review, May 1991, 130–35.groups costs based on whether the activity is at the facility level, product or customer level, batch level, or unit level. What is the difference between each of these categories, and how does this information help managers?

The cost hierarchy serves as a framework for managers to establish cost pools and determine what drives the change in costs for each cost pool. It also provides a sense of how quickly (or slowly) costs change based on decisions made by management. Examples of activities often identified by companies using activity-based costing, and how these activities fit in the cost hierarchy, appear in Table 6.2.

Cost Hierarchy Category	Activity/Cost
Facility-level	Plant depreciation
	Building rent
	Management of facility
Product/customer-level	New product development
	Product engineering
	Product marketing and advertising
	Maintaining customer records
Batch-level	Machine setups
	Processing purchase orders
	Batch quality inspections
Unit-level	Energy to run production machines
	Direct labor
	Direct materials

Measuring the Costs of Controlling and Improving Quality

Question: The hierarchy of costs is not the only approach organizations use to group costs. Managers are also concerned about measuring the costs associated with quality. Quality-related costs can be organized into four categories. The first two categories—prevention and appraisal—are costs incurred to control and improve quality. The final two categories—internal failure and external failure—are costs incurred as a result of failing to control and improve quality. What is the difference between these cost categories, and how does this information help managers improve quality?

Key Takeaway

Activity-based costing is not simply used to allocate manufacturing overhead costs to products for external reporting purposes; it is also often used to allocate selling, general, and administrative costs to products for internal decision-making purposes. A number of methods can be used to assist in the cost allocation process. For example, the cost of service departments can be allocated to production departments using the direct method. Also the cost hierarchy can be used to help establish cost pools and identify cost drivers used to allocate costs. Organizations are also concerned with measuring and reducing the cost of quality by categorizing quality costs into four categories—prevention, appraisal, internal failure, and external failure.

Review problem 6.6

Fill in the following table to identify if the cost item can be included in the cost of products for external reporting purposes and/or internal reporting purposes. The first item is completed for you.

Cost	OK to Allocate to Products for External Reporting (U.S. GAAP)?	OK to Allocate to Products for Internal Reporting?
Direct materials	Yes	Yes
Salaries of sales people
Indirect materials used in production
Rent for headquarters building
Product promotions
Direct labor
Legal costs for patent applications
Processing payroll for human resource personnel
Depreciation of factory equipment
Marketing vice president’s salary
Depreciation of administrative department equipment

: Definitions

Departments that provide services to other departments within a company.
Departments directly involved with producing goods or providing services for customers.
A method of allocating costs that allocates service department costs directly to production departments but not to other service departments.
A method of costing that groups costs based on whether the activity is at the facility level, product or customer level, batch level, or unit level.
Activities required to sustain facility operations and include items such as building rent and management of the factory.
Activities required to develop, produce, and sell specific types of products.
Activities required to produce batches (or groups) of products.
Activities required to produce individual units of product, such as direct materials and direct labor.
Costs for activities that prevent defects in products and services.
Costs for activities that detect defective products before they are delivered to customers.
Costs incurred as a result of detecting defective products before they are delivered to customers.
Costs for activities that result from delivering defective products to customers.

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