These lectures cover activity-based costing where manufacturing overhead is allocated using activities and cost pool rather than traditional cost accounting.

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Traditional cost accounting methods suffer from several limitations that can result in distorted costs for decision-making purposes. All manufacturing costs—even those that are not caused by any specific product—are allocated to products. Nonmanufacturing costs that are caused by products are not assigned to products. And finally, traditional methods tend to place too much reliance on unit-level allocation bases such as direct labor and machine-hours. This results in overcosting high-volume products and undercosting low-volume products and can lead to mistakes when making decisions. Activity-based costing estimates the costs of the resources consumed by cost objects such as products and customers. The activity-based costing approach assumes that cost objects generate activities that in turn consume costly resources. Activities form the link between costs and cost objects. Activity-based costing is concerned with overhead—both manufacturing overhead and selling and administrative overhead. The accounting for direct labor and direct materials is usually the same under traditional and ABC costing methods.

To build an ABC system, companies typically choose a small set of activities that summarize much of the work performed in overhead departments. Associated with each activity is an activity cost pool. To the extent possible, overhead costs are directly traced to these activity cost pools. The remaining overhead costs are allocated to the activity cost pools in the first-stage allocation. Interviews with managers often form the basis for these allocations. An activity rate is computed for each cost pool by dividing the costs assigned to the cost pool by the measure of activity for the cost pool. Activity rates provide useful information to managers concerning the costs of performing overhead activities. A particularly high cost for an activity may trigger efforts to improve the way the activity is carried out in the organization. In the second-stage allocation, activity rates are used to apply costs to cost objects such as products and customers. The costs computed under activity-based costing are often quite different from the costs generated by a company’s traditional cost accounting system. While the ABC system is almost certainly more accurate, managers should nevertheless exercise caution before making decisions based on the ABC data. Some of the costs may not be avoidable and hence would not be relevant.