1. MSE608C – Engineering and Financial Cost Analysis
Activity Based Costing (ABC)

2. Activity Based Costing (ABC)
The purpose of ABC is to better associate Overhead costs with the product that incur them. It accomplishes this by:
defining a number of specific processes with a number of associated activities for each department;
measuring the indirect resource costs for each of these activities;
determining a cost driver, or output for each process;
allocating the costs based on the proportion used by each product.

3. ABC vs. Traditional Costing Methods
ABC allocates Overhead more closely aligned with each product’s consumption of resources.
Traditional Methods will tend to over-cost:
Products with fewer parts;
Larger products;
Products built in larger lots;
Products with less demanding performance specifications;
Standard products.
ABC, though, will require more effort and costs to administer and is unfamiliar to most businesses.
It can be used in specific Managerial accounting applications for analyzing product costs and improving marketing and sales strategies.

4. Implementing ABC (cont)
Step 1: Identify processes and activities
Perform an in-depth analysis of the conversion processes for each department and define activities for these processes.
These processes and activities must be clearly defined so raw cost data can be accurately measured.
Activity A
Process X
Activity B
Activity C

5. Implementing ABC (cont)
Step 2: Assign costs to activities
Indirect resource costs are assigned to the activities.
Costs will include:
Direct labor
Direct material
utilities
rent
depreciation
Resource Cost
Resource Cost
Activity A
Resource Cost
Process X
Activity B
Resource Cost
Activity C
Resource Cost
Resource Cost

6. Implementing ABC (cont)
Step 3. Define outputs (cost drivers)
Define what the output is for each process in each department. The output will depend on the process. Examples will include:
Number of machine setups
Machine or labor hours
Number of purchase orders placed
Number of parts (product complexity)
Number of Engineering Change Orders (ECO)
Resource Cost
Resource Cost
Activity A
Resource Cost
Output
Process X
Activity A
Resource Cost
Activity A
Resource Cost
Resource Cost

7. Implementing ABC (cont)
Step 4. Calculate Unit Cost
Unit Cost = Total (budgeted) Activity Costs/Total (budgeted) Cost Driver
Used to calculate budgeted Overhead costs;
Used to apply Overhead costs to process output.
Resource Cost
Resource Cost
Activity A
Resource Cost
Output
Process X
Activity A
Resource Cost
Activity A
Resource Cost
Resource Cost

8. Assessment What are the benefits of ABC?
Traditional methods of cost accounting tend to over-cost _______ ?
Is ABC allowed to be used for financial reports?