Activity Based Costing/Activity Based Management (ABC/ABM)

Activity Based Cost Management


  • ·        Traditional Volume-Based Cost Systems – The purpose for any cost system is to determine the cost of a company’s products, services, or customers.  Managers need cost information for a variety of reasons including pricing, resource allocation, and cost control.  Some costs, such as direct materials and direct labor, are directly traceable to specific units, products, or customers and are therefore relatively easy to account for.  The challenge comes in assigning indirect costs, or those not traceable to individual units, products or customers.  Indirect costs are also called overhead costs.  We will focus on applying indirect manufacturing costs, but the same principles apply to non-manufacturing costs such as corporate overhead or selling and administrative expenses.


Because indirect costs cannot be directly traced to specific products or services, they must be assigned or allocated based on some observable measure called an allocation base or cost driver.  As we cover in our cost behavior section, cost drivers or allocation bases can be as simple measures such as the number of units produced or direct labor hours, or can include multiple measures that capture the cause and effect relationship between activities and costs (which is known as activity based costing, which we will cover later).  We will start with the traditional systems in allocating overhead, but then we will cover activity based costing and activity based management, where we apply our costing knowledge in managing supply chain processes.


  • o       Volume Based Cost System – Here we use units produced or direct labor hour measures to allocate indirect manufacturing overhead.  Our first step is to calculate a predetermined overhead rate.  We do this by estimating the total manufacturing overhead cost and dividing this amount be the estimated units in the allocation base.  Examples of indirect manufacturing costs include depreciation, plant supervision, quality control, engineering, maintenance, insurance, janitorial staff and utilities.  These indirect manufacturing costs can be divided further into variable indirect manufacturing costs and fixed indirect manufacturing costs.


  • o       Assignment of Indirect Cost to Individual Products or Services – After calculating the overhead rate, we assign overhead based on the allocation base amount in each product.  For example, if our allocation base in direct labor hours and the overhead rate is $10 per direct labor hour, we multiply the number of direct labor hours in a product times the overhead rate to assign the proper amount of overhead to a product.


  • o       Calculation of Total Manufacturing Cost and Profitability – To compute the total manufacturing cost, we need to add the manufacturing overhead cost to the direct materials and direct labor costs.  We can also break down each cost on a per unit and total cost on a per unit basis.