Difficulty: Intermediate | Prerequisites: Cost Behaviour and Classifications (Ch. 1), CVP Analysis (Ch. 1)
Activity-based costing replaces a single overhead rate with multiple rates tied to the activities that actually drive costs, which can dramatically change which products or customers look profitable. Budgeting is a structured forecast that starts with expected sales and works through production, purchases, and cash needs. Variances tell you whether actual results beat or missed the plan, and the balanced scorecard measures performance from four perspectives, not just the financial one.
Activity-based costing (ABC)
A costing system that assigns overhead costs to products or customers based on the activities they consume, using multiple cost pools and activity rates rather than a single overhead rate. Think of it as matching costs to what actually causes them.
Activity rate
Estimated overhead cost for an activity divided by the estimated total activity units. This is the "price" per unit of activity.
Predetermined overhead rate
Estimated total overhead cost divided by estimated total direct labour cost (or hours). This is the traditional, single-rate alternative to ABC.
Customer margin
Sales from a customer minus all costs attributable to that customer. ABC often reveals that some customers who look profitable under traditional costing are actually unprofitable.
Flexible budget
A budget that adjusts for the actual level of activity by applying the planning budget's rates to the actual volume. It answers: "Given what we actually produced, what should we have spent?"
Favourable variance (F)
A variance where actual results are better than budget: revenue came in higher or costs came in lower than expected.
Unfavourable variance (U)
A variance where actual results are worse than budget: revenue was lower or costs were higher than expected.
Balanced scorecard (BSC)
A performance measurement framework that evaluates the organisation from four perspectives: financial (shareholder), customer, internal business processes, and innovation and learning.
Manufacturing cycle efficiency (MCE)
Process time divided by throughput time. It measures the fraction of total production time that actually adds value. An MCE of 1.0 (or 100%) would mean zero wasted time.
Throughput time
The total time a unit spends in production: process time + inspection time + move time + queue time.
Delivery cycle time
Wait time plus throughput time. This is the total elapsed time from when a customer places an order to when the product is delivered.
These chapters move from "how do we classify and predict costs" to "how do we plan, control, and evaluate performance." ABC (Ch. 7) refines how overhead is allocated so product and customer profitability numbers are more accurate. Budgeting (Ch. 8) turns predictions into a formal plan. Variances (Ch. 9) compare actual results against that plan. The balanced scorecard (Ch. 11) widens the lens beyond financials to measure whether the organisation is improving in the areas that drive long-term success. Together they form the control cycle: plan, execute, measure, improve.
The ABC process has four steps:
Step 0: Distribute overhead costs to activity cost pools using a percentage allocation table. Each cost item (wages, supplies, depreciation, vehicle expenses, etc.) is spread across pools such as "cleaning carpets," "travel to jobs," and "job support" based on how much each pool consumes.
Step 1: Calculate the activity rate for each pool. Activity rate = Total cost in the pool / Total activity measure for that pool.
Step 2: Apply the activity rate to each product or customer. Total activity cost = Activity rate x Quantity of activity consumed.
Step 3: Calculate customer (or product) margin = Sales minus Cost of goods sold minus Total activity costs.
Important: Overhead cost pools do not include direct materials or direct labour. Those are traced directly to products.
ABC vs. Traditional costing:
Traditional costing uses a single predetermined overhead rate (typically based on direct labour cost or hours) to allocate all overhead.
ABC uses multiple rates tied to the activities that actually drive costs.
ABC often reveals that high-volume, simple products are over-costed under the traditional system, while low-volume, complex products are under-costed.
In the course example, two customers with identical sales and COGS showed very different profitability under ABC ($140 margin vs. a $3,110 loss) because of different demands on delivery, order processing, and line-item picking.
Production budget mechanics:
Start with budgeted unit sales.
Add desired ending finished goods inventory.
Subtract beginning finished goods inventory.
The result is the number of units to produce.
Cash budget steps:
Step 1: Calculate cash collections for the month. Account for the timing of collections (some customers pay in the month of sale, others pay later).
Step 2: Calculate inventory purchases needed, then the cash disbursements for those purchases (some may not be paid in full in the same month).
Step 3: Combine collections and disbursements with other cash flows to determine the cash balance.
Depreciation is not a cash disbursement. It must be subtracted from selling and admin expenses when calculating cash outflows.
Flexible budgets:
A flexible budget applies the planning budget's per-unit rates to the actual level of activity.
It isolates the effect of volume changes from the effect of cost control.
Favourable (F): Revenue higher than budget, or costs lower than budget.
Unfavourable (U): Revenue lower than budget, or costs higher than budget.
The label tells you the direction of the effect on income, not whether the result is good or bad in context.
Balanced Scorecard (four perspectives):
Financial / Shareholder perspective: Traditional financial metrics (revenue growth, return on capital, profit margin).
Customer perspective: Customer satisfaction, retention, market share, on-time delivery.
Internal business process perspective: Process efficiency, quality, cycle times.
Innovation and learning perspective: Employee training, skill development, information system capabilities.
Manufacturing cycle efficiency (MCE):
MCE = Process time / Throughput time.
Throughput time = Process time + Inspection time + Move time + Queue time.
Only process time adds value. The other three components are non-value-added.
Delivery cycle time = Wait time + Throughput time.
A higher MCE (closer to 1.0) means less wasted time in the production process.
\text{Activity Rate} = \frac{\text{Est. OH Cost for Pool}}{\text{Est. Activity Units}}\text{Predetermined OH Rate} = \frac{\text{Est. Total OH Cost}}{\text{Est. Direct Labour Cost}}\text{Customer Margin} = \text{Sales} - \text{COGS} - \text{Total Activity Costs}\text{Units to Produce} = \text{Budgeted Sales} + \text{Desired End FG} - \text{Beg FG}\text{MCE} = \frac{\text{Process Time}}{\text{Throughput Time}}\text{Throughput Time} = \text{Process} + \text{Inspection} + \text{Move} + \text{Queue}\text{Delivery Cycle Time} = \text{Wait Time} + \text{Throughput Time}ABC is widely used in industries with diverse product lines and significant overhead, such as banking (different transaction types consume very different resources) and healthcare (different procedures require different support activities). It often reveals that the 80/20 rule applies: a small number of high-maintenance customers or products drive a disproportionate share of overhead.
The balanced scorecard was developed by Kaplan and Norton and is used by organisations ranging from Apple to the US Army. The insight is that financial results are lagging indicators; leading indicators (customer satisfaction, process quality, employee capability) predict future financial performance.
Students include direct materials and direct labour in ABC activity cost pools. They do not belong there. Direct costs are traced to products; only overhead goes into activity pools.
Students assume "favourable" always means good. A favourable materials variance could mean the company bought cheaper, lower-quality inputs, which might cause quality problems later.
Students forget to remove depreciation from cash disbursements in the cash budget. Depreciation is a non-cash expense.
Students confuse throughput time with delivery cycle time. Throughput time starts when production begins; delivery cycle time includes the wait time before production starts.
⚠️ ABC problems typically walk you through the full four-step process. Practise the first-stage allocation table (percentage-based distribution) until it is automatic.
⚠️ Expect a question comparing traditional costing product margins with ABC product or customer margins for the same data. The point is to show how the traditional single rate can distort profitability.
⚠️ Cash budget questions are common and detail-heavy. Watch for timing of collections and payments across months, and remember to exclude depreciation from cash outflows.
⚠️ MCE and delivery cycle time are quick calculation questions. Know which time components are value-added (only process time) and which are not.
⚠️ Be able to name and briefly explain all four BSC perspectives.
True or False: Under ABC, direct materials are allocated to activity cost pools. (False: only overhead costs go into activity pools.)
Fill in the blank: Units to produce = Budgeted sales + Desired ending inventory minus ______. (Beginning inventory)
True or False: A favourable variance always means management did a good job. (False: it only means the result was better than budget on that line; the cause may be undesirable.)
Fill in the blank: MCE = Process time / ______. (Throughput time)
True or False: Delivery cycle time includes wait time before production begins. (True)
Q: A company has total overhead of $300,000 and total direct labour costs of $150,000. What is the predetermined overhead rate?
A: $300,000 / $150,000 = $2.00 per direct labour dollar.
Q: Under ABC, the "customer deliveries" activity pool has total costs of $50,000 and 500 expected deliveries. Customer A requires 20 deliveries. What is Customer A's delivery cost?
A: Activity rate = $50,000 / 500 = $100 per delivery. Customer A = 20 x $100 = $2,000.
Q: Budgeted sales are 10,000 units. Desired ending finished goods is 1,500 units. Beginning finished goods is 2,000 units. How many units must be produced?
A: 10,000 + 1,500 minus 2,000 = 9,500 units.
Q: A product has process time of 3 days, inspection time of 0.5 days, move time of 0.5 days, and queue time of 2 days. What is the MCE?
A: Throughput time = 3 + 0.5 + 0.5 + 2 = 6 days. MCE = 3 / 6 = 0.50 (50%).
Q: Name the four perspectives of the balanced scorecard.
A: Financial (shareholder), customer, internal business process, and innovation and learning.
ABC refines the overhead allocation that the traditional system (Ch. 1) handles with a single rate. The more diverse a company's products or customers, the more ABC changes the picture.
Budgeting applies the cost behaviour knowledge from Ch. 1 (fixed vs. variable) and the CVP framework to forward planning. The flexible budget is essentially a CVP model applied after the fact.
Variance analysis connects to budgeting (the budget is the benchmark) and to the costing methods (standard costs underpin the variance calculations). The balanced scorecard ties financial performance back to operational and strategic drivers.
Activity-based costing, ABC, activity rate, activity cost pool, first-stage allocation, second-stage allocation, predetermined overhead rate, customer margin, product margin, traditional costing, cost distortion, cross-subsidisation, budget, production budget, cash budget, cash collections, cash disbursements, flexible budget, planning budget, favourable variance, unfavourable variance, F variance, U variance, balanced scorecard, BSC, financial perspective, customer perspective, internal process perspective, innovation and learning, manufacturing cycle efficiency, MCE, throughput time, delivery cycle time, process time, queue time, inspection time, move time, wait time, value-added time, non-value-added time, ACCT 3001, management accounting