Difficulty: Intermediate | Prerequisites: Understanding of overhead costs, product costing basics, cost behaviour (fixed vs variable).
Activity-based costing (ABC) is a more refined way to allocate overhead to products. Instead of spreading all overhead with a single rate (as traditional absorption costing does), ABC identifies the activities that cause costs and assigns costs to products based on how much of each activity a product consumes. This matters because products that look profitable under traditional costing sometimes turn out to be unprofitable once overhead is traced more carefully. Budgeting is the other major topic here: it is the process of translating a company's plans into a coordinated set of financial projections. The master budget starts with the sales forecast and cascades through production, materials, labour, overhead and cash budgets. Both topics are heavily tested with numbers.
ABC allocates overhead in two stages: first, assign resource costs to activity cost pools; second, assign each pool's costs to products using an activity rate based on the cost driver for that pool. Budgeting follows a set sequence starting with the sales budget, and exam questions focus on production budgets, cash collections schedules, cash disbursements, and merchandise purchases budgets.
Activity cost pool
A grouping of overhead costs associated with a particular activity (e.g. machining, setting up, order processing). Each pool collects the costs driven by one type of activity.
Think of it as a bucket that holds all the costs related to one kind of work.
Activity rate
The cost per unit of activity for a given cost pool. Calculated as total cost in the pool divided by total activity (the cost driver measure).
In simple terms, it is the price tag per unit of the thing that drives the cost (per machine-hour, per batch, per order).
First-stage allocation
The process of assigning resource costs (wages, depreciation, occupancy, etc.) to activity cost pools based on the proportion of each resource consumed by each activity.
Second-stage allocation
The process of assigning costs from each activity cost pool to products (or other cost objects) based on the activity each product consumes.
Cost driver
The measure of activity that causes costs in a particular cost pool. Examples: machine-hours for a machining pool, number of batches for a setup pool, number of orders for an order processing pool.
Product margin (ABC)
Sales minus direct materials minus direct labour minus overhead allocated via ABC. This is the profit attributable to a product after all costs traced to it through ABC.
Organisation-sustaining costs
Overhead costs that support the organisation as a whole and cannot meaningfully be assigned to individual products (e.g. the CEO's salary, general administration). In ABC, these costs are typically collected in an "Other" pool and not assigned to products.
Stage 1 (first-stage allocation): Assign each resource cost (wages, depreciation, rent, utilities) to activity cost pools based on the percentage of that resource consumed by each activity. This gives you the total cost in each pool.
Stage 2 (second-stage allocation): Divide each pool's total cost by its total activity to get the activity rate. Then multiply each product's activity consumption by the rate to assign overhead.
Costs in the "Other" pool (organisation-sustaining, idle capacity) are typically not assigned to products.
Activity rate = Total cost in the pool / Total activity measure.
Worked example (Q11, Paul Company): Activity 3 has total cost $14,600 and total activity 750. Activity rate = $14,600 / 750 = $19.47.
Worked example (Q20, Burlingame LLC): "Meeting with clients" pool has total cost $1,102,050 and total activity 6,975 meeting hours. Rate = $1,102,050 / 6,975 = $158 per meeting hour.
Resources: Wages $420,000, Depreciation $100,000, Occupancy $120,000.
Fabrication pool percentages: Wages 5%, Depreciation 15%, Occupancy 25%.
Wages allocated to Fabrication: 5% x $420,000 = $21,000
Depreciation allocated to Fabrication: 15% x $100,000 = $15,000
Occupancy allocated to Fabrication: 25% x $120,000 = $30,000
Total Fabrication pool = $66,000
Activity rate = $66,000 / 40,000 machine-hours = $1.65 per machine-hour.
Resources: Wages $260,000, Depreciation $220,000, Utilities $140,000.
Assembly pool percentages: Wages 50%, Depreciation 20%, Utilities 25%.
Wages: 50% x $260,000 = $130,000
Depreciation: 20% x $220,000 = $44,000
Utilities: 25% x $140,000 = $35,000
Total Assembly pool = $209,000.
Three pools: Machining ($28,000, driver: 20,000 MHs), Setting Up ($13,800, driver: 1,000 batches), Other ($27,200, not assigned).
Activity rates:
Machining: $28,000 / 20,000 = $1.40 per MH
Setting Up: $13,800 / 1,000 = $13.80 per batch
Overhead assigned to Product F8:
Machining: 5,200 MHs x $1.40 = $7,280
Setting Up: 500 batches x $13.80 = $6,900
Total: $14,180
Overhead assigned to Product J3:
Machining: 14,800 MHs x $1.40 = $20,720
Setting Up: 500 batches x $13.80 = $6,900
Total: $27,620
Product margins:
F8: Sales $124,300 - DM $53,100 - DL $54,000 - Overhead $14,180 = $3,020
J3: Sales $166,000 - DM $71,500 - DL $56,600 - Overhead $27,620 = $10,280
The allocation of overhead differs between the two methods for two reasons:
ABC allocates some costs as product costs that absorption costing treats as period costs (e.g. selling and distribution costs traced to specific activities).
ABC does not allocate some costs that absorption costing treats as product costs (e.g. organisation-sustaining costs that ABC places in a non-assigned pool).
The correct answer to Q13 is C (Both A and B).
Sales budget
The starting point of the master budget. It forecasts the number of units to be sold and the revenue expected in each period.
Production budget
Determines how many units must be produced to meet sales demand and desired ending inventory levels. It follows the sales budget.
Formula: Required production = Budgeted sales + Desired ending inventory - Beginning inventory.
Cash budget
A schedule showing expected cash inflows, expected cash outflows, and the resulting cash balance for each period. It reveals whether the company needs to borrow or can invest surplus cash.
Schedule of expected cash collections
A breakdown of when cash from sales will be received, based on the company's collection pattern (e.g. 60% in the month of sale, 39% the following month, 1% uncollectible).
Cash disbursements schedule
A breakdown of when cash payments will be made for purchases, wages, selling and administrative expenses, interest, and other obligations.
Merchandise purchases budget
Used by merchandising (non-manufacturing) companies. It determines how much inventory to purchase based on budgeted cost of goods sold and desired ending inventory.
Formula: Required purchases = Budgeted COGS + Desired ending inventory - Beginning inventory.
The normal sequence for preparing budgets in a manufacturing company is:
Sales budget (always first)
Production budget
Direct materials budget
Direct labour budget
Manufacturing overhead budget
Selling and administrative expense budget
Cash budget
Budgeted income statement
Budgeted balance sheet
From the exam (Q17): the correct sequence among the given options is B: Production, Cash, Income Statement.
Budgeting formalises a manager's planning efforts, sets benchmarks for evaluating performance, and uncovers potential bottlenecks. It does not reduce the need for tracking actual cost activity (Q18, answer A).
Required production = Budgeted unit sales + Desired ending inventory - Beginning inventory.
Walsh Company, April:
April sales: 60,000 units
Desired ending inventory (40% of May sales): 40% x 75,000 = 30,000
Beginning inventory (March 31): 25,000
Required production = 60,000 + 30,000 - 25,000 = 65,000 units.
April purchases: $140,000. Payment pattern: 40% in month of purchase, 30% in next month, 30% in second month.
Purchases paid in April:
April purchases: 40% x $140,000 = $56,000
March purchases: 30% x $160,000 = $48,000
February purchases: 30% x $160,000 = $48,000
Total purchase payments: $152,000
Employee wages: 10% of April sales = 10% x $300,000 = $30,000
Selling and admin expenses: 20% of May sales = 20% x $260,000 = $52,000
Interest payment (quarterly, paid in April): $20,000
Total April cash disbursements = $152,000 + $30,000 + $52,000 + $20,000 = $254,000.
Beginning cash + Receipts - Disbursements = Ending cash before borrowing. $14,000 + $127,000 - $126,000 = $15,000.
Desired ending balance = $40,000. Shortfall = $40,000 - $15,000 = $25,000 to borrow.
Collection pattern: 60% in month of sale, 39% in the following month, 1% uncollectible.
November collections:
From November sales: 60% x $350,000 = $210,000
From October sales (accounts receivable): $70,000 (the entire beginning AR balance)
Total November collections: $280,000
December collections:
From December sales: 60% x $360,000 = $216,000
From November sales: 39% x $350,000 = $136,500
Total December collections: $352,500
COGS = 75% of sales. Desired ending inventory = 40% of next month's COGS.
November:
Budgeted COGS: 75% x $350,000 = $262,500
Desired ending inventory: 40% x (75% x $360,000) = 40% x $270,000 = $108,000
Beginning inventory: we need this figure. November beginning inventory = 40% x November COGS = 40% x $262,500 = $105,000 (this is what the October ending inventory should have been under the policy).
Required purchases = $262,500 + $108,000 - $105,000 = $265,500
December:
Budgeted COGS: 75% x $360,000 = $270,000
Desired ending inventory: 40% x (75% x $340,000) = 40% x $255,000 = $102,000
Beginning inventory: $108,000 (November's ending)
Required purchases = $270,000 + $102,000 - $108,000 = $264,000
Payment for merchandise is made in the month following the purchase. November beginning AP = $257,000 (October's purchases, paid in November). November purchases of $265,500 are paid in December.
\text{Activity rate} = \frac{\text{Total cost in the activity pool}}{\text{Total activity (cost driver)}}\text{First-stage allocation to a pool} = \sum (\text{Resource cost} \times \text{\% consumed by that pool})\text{Overhead assigned to product} = \sum (\text{Activity rate} \times \text{Product's activity consumption})\text{Product margin (ABC)} = \text{Sales} - \text{Direct materials} - \text{Direct labour} - \text{ABC overhead assigned}\text{Required production} = \text{Budgeted sales} + \text{Desired ending inventory} - \text{Beginning inventory}\text{Required purchases (merchandising)} = \text{Budgeted COGS} + \text{Desired ending inventory} - \text{Beginning inventory}\text{Cash needed to borrow} = \text{Desired ending cash balance} - (\text{Beginning cash} + \text{Receipts} - \text{Disbursements})ABC is widely used in manufacturing and service firms to understand which products or customers are profitable and which are not. A hospital, for example, might use ABC to understand the true cost of treating different types of patients. Budgeting is used by virtually every organisation: a cash budget is what tells a small business owner they need to arrange a line of credit before a lean month, and a production budget is what keeps a factory from running out of inventory or overproducing.
Students assume ABC and absorption costing allocate exactly the same costs. They do not. ABC may allocate some period costs (like order processing or customer service) as product costs, and it typically does not allocate organisation-sustaining costs to products.
Students forget to include all payment sources in a cash disbursements calculation. In the Brandon Company problem, you must include purchase payments from three months (current and two prior), wages, selling and admin expenses, and quarterly interest.
Students mix up the production budget formula. Required production = Sales + Desired ending inventory - Beginning inventory. A common error is adding beginning inventory instead of subtracting it.
Students sometimes compute cash collections by using the sales figure for the wrong month. Map out which month's sales generate which month's cash carefully.
⚠️ Activity rate = Total pool cost / Total activity. Be careful to use the correct denominator (total activity across all products, not just one product).
⚠️ First-stage allocation: multiply each resource cost by its percentage for that pool, then sum across all resources.
⚠️ Production budget: Required production = Sales + Desired ending inventory - Beginning inventory. Ending inventory is based on next month's sales.
⚠️ Cash disbursements problems require tracking multiple payment streams across multiple months. Set up a grid.
⚠️ Cash budget borrowing: compute ending cash before borrowing, then compare to the desired minimum.
⚠️ The budget sequence question (Q17) tests whether you know the sales budget comes first and the balance sheet comes last.
True or False: The activity rate for a cost pool is computed by dividing the pool's total cost by the activity consumed by one product only. (False. Divide by total activity across all products.)
Fill in the blank: In ABC, organisation-sustaining costs are typically collected in an "Other" pool and ________ to products. (Not assigned/not allocated.)
True or False: The production budget comes before the sales budget in the normal budget sequence. (False. The sales budget comes first.)
Fill in the blank: Required production = Budgeted sales + Desired ending inventory - ________. (Beginning inventory.)
True or False: Budgeting reduces the need for tracking actual cost activity. (False. That is not a benefit of budgeting.)
Q: Paul Company's Activity 3 has total cost $14,600 and total activity of 750. What is the activity rate?
A: $19.47. Calculated as $14,600 / 750 = $19.47.
Q: McCaskey Corporation's Fabrication pool receives 5% of wages ($420,000), 15% of depreciation ($100,000), and 25% of occupancy ($120,000). There are 40,000 machine-hours. What is the activity rate?
A: $1.65 per machine-hour. Pool total = $21,000 + $15,000 + $30,000 = $66,000. Rate = $66,000 / 40,000 = $1.65.
Q: Walsh Company expects April sales of 60,000 units and May sales of 75,000 units. Desired ending inventory is 40% of next month's sales. Beginning inventory is 25,000 units. How many units should be produced in April?
A: 65,000 units. Production = 60,000 + (40% x 75,000) - 25,000 = 60,000 + 30,000 - 25,000 = 65,000.
Q: Brandon Company's April cash disbursements include purchase payments, wages, selling and admin expenses, and interest. Given purchases of $140,000 (April), $160,000 (March), $160,000 (February), April sales of $300,000, May sales of $260,000, and a $20,000 quarterly interest payment, what are total April disbursements?
A: $254,000. Purchase payments: (40% x $140,000) + (30% x $160,000) + (30% x $160,000) = $56,000 + $48,000 + $48,000 = $152,000. Wages: 10% x $300,000 = $30,000. S&A: 20% x $260,000 = $52,000. Interest: $20,000. Total = $254,000.
Q: Deschambault Inc. has beginning cash of $14,000, receipts of $127,000, disbursements of $126,000, and a desired ending balance of $40,000. How much must the company borrow?
A: $25,000. Ending cash before borrowing = $14,000 + $127,000 - $126,000 = $15,000. Shortfall = $40,000 - $15,000 = $25,000.
Q: Burlingame LLC's "meeting with clients" pool has total cost $1,102,050 and total activity of 6,975 meeting hours. What is the activity rate?
A: $158 per meeting hour. $1,102,050 / 6,975 = $158.
ABC connects to variable and absorption costing: understanding how overhead is allocated differently under each method is essential for interpreting product profitability. Budgeting connects to CVP analysis because the sales forecast that drives the budget is informed by break-even and target profit analysis. The cash budget ties into the balance sheet budget and provides the basis for financing decisions.
Activity-based costing, ABC, activity cost pool, activity rate, cost driver, first-stage allocation, second-stage allocation, product margin, organisation-sustaining costs, idle capacity, master budget, sales budget, production budget, cash budget, cash disbursements, cash collections, merchandise purchases budget, direct materials budget, ACCT 3001, management accounting, budgeting sequence