Activity-Based Costing

Chapter 03

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 1

Understand the basic

approach in activity-
based costing and how it
differs from
conventional costing.

3-2
Assigning Overhead Costs to Products

When
When cost
cost systems
systems were
were developed
developed in
in the
the 1800s,
1800s,
the
the emphasis
emphasis was
was on
on simplicity
simplicity because:
because:
1.
1. Cost
Cost and
and activity
activity data
data had
had to
to be
be collected
collected by
by
hand
hand and
and all
all calculations
calculations were
were done
done with
with paper
paper
and
and pencil.
pencil.
2.   Most
2.   Most companies
companies produced
produced aa limited
limited variety
variety of
of
similar
similar products,
products, so
so there
there was
was little
little difference
difference
in
in the
the overhead
overhead costs
costs consumed
consumed by by each
each
product.
product.

3-3
Plantwide Overhead Rate
Plantwide Overhead Rate
A single overhead rate used
throughout an entire factory.
Direct
Direct labor
labor has
has often
often been
been used
used asas the
the allocation
allocation
base
base for
for overhead
overhead because:
because:
1.   
1.    Direct
Direct labor
labor information
information was
was already
already being
being recorded.
recorded.
2.   
2.    Direct
Direct labor
labor was
was aa large
large component
component of of product
product costs.
costs.
3.
3. Managers
Managers believed
believed direct
direct labor
labor and
and overhead
overhead costs
costs
were
were highly
highly correlated.
correlated.

3-4
 Plantwide Overhead Rate
Today,
Today, direct
direct labor
labor may
may no no longer
longer be
be aa satisfactory
satisfactory base
base
for
for allocation
allocation of of overhead.
overhead.
1.
1. Most
Most companies
companies sellsell aa large
large variety
variety of
of products
products that
that
consume
consume differing
differing amounts
amounts of of overhead.
overhead.
2.
2. As
As aa percentage
percentage of of total
total costs,
costs, direct
direct labor
labor has
has been
been
shrinking
shrinking and
and overhead
overhead has has been
been increasing.
increasing. Many
Many of
of
these
these growing
growing overhead
overhead costscosts may
may not
not be
be correlated
correlated
with
with direct
direct labor.
labor.
3.
3. Technology
Technology advancements
advancements have
have reduced
reduced the
the cost
cost and
and
complexity
complexity of
of gathering
gathering diverse
diverse sources
sources of
of data.
data.

AAplantwide
plantwide overhead
overhead allocation
allocation system
system may
may not
not be
be optimal
optimal
for
for many
many companies
companies inin today’s
today’s business
business environment.
environment.
3-5
 Departmental Overhead Rates
Many
Many companies
companies have
have aa system
system in
in which
which each
each
department
department has
has its
its own
own overhead
overhead rate.
rate.
The
The allocation
allocation base
base depends
depends
on
on the
the nature
nature of
of the
the work
work
Machining Department performed
performed in in each
each department.
department.
In
In the
the machining
machining department,
department,
Assembly Department overhead
overhead may may be
be based
based on on
machine-hours,
machine-hours, but but in
in the
the
Shipping Department assembly
assembly department,
department,
overhead
overhead may may be
be based
based on on
labor-hours.
labor-hours. 3-6
 Departmental Overhead Rates
Departmental rates will not correctly assign overhead
in situations where a company has a range of
products and complex overhead costs.

The
The departmental
departmental approach
approach relies
relies
exclusively
exclusively on
on volume-related
volume-related allocation
allocation bases
bases while
while
some
some overhead
overhead costs
costs may
may be
be caused
caused byby factors
factors
that
that are
are not
not related
related to
to the
the volume
volume of
of production.
production.

Activity-based
Activity-based costing
costing is
is required
required to
to account
account for
for
these
these other
other factors.
factors.
3-7
Activity-Based Costing (ABC)

A number of allocation bases are used

for assigning costs to products.

3-8
Activity-Based Costing (ABC)
Cost
Cost Objects
Objects
(e.g.,
(e.g., products
products and
and customers)
customers)

Activities
Activities

Consumption
Consumption of
of Resources
Resources

Cost
Cost
3-9
Activity-Based Costing (ABC)
An event that causes
Activity the consumption of
overhead resources

Examples of Activities

Admitting
Setting up Billing Opening a
hospital
machines customers bank account
patients
3-10
Activity-Based Costing (ABC)
A “cost bucket” in which
Activity
costs related to a particular
Cost Pool activity are accumulated.

Expresses how much of the

Activity activity is carried out and is
Measure used as the allocation base
for applying overhead costs.

A predetermined overhead
Activity
rate for each activity
Rate cost pool.

3-11
Activity-Based Costing (ABC)

For each activity in

isolation, this system works exactly
like the job-order costing system
described in Chapter 2.

AA predetermined
predetermined overhead
overhead rate
rate is
is computed
computed for for
each
each activity
activity and
and then
then applied
applied toto jobs
jobs and
and
products
products based
based onon the
the amount
amount of of activity
activity
consumed
consumed by by the
the job
job or
or product.
product.
3-12
Designing an Activity-Based
Costing System

The
The challenge
challenge isis to
to select
select aa reasonably
reasonably
small
small number
number of of activities
activities that
that explain
explain the
the
bulk
bulk of
of the
the variation
variation inin overhead
overhead costs.
costs.

Activities
Activities are
are usually
usually chosen
chosen by
by interviewing
interviewing aa
broad
broad range
range of
of managers
managers to
to find
find out
out what
what
activities
activities they
they think
think consume
consume most
most of
of the
the
organization’s
organization’s resources.
resources.
3-13
Designing an Activity-Based
Costing System
Related activities are
frequently combined to reduce
the amount of detail and
record-keeping costs.

For example, several actions may

be involved in handling and moving
raw materials, but these may be
combined into a single activity
titled material handling.

An
An activity
activity dictionary
dictionary defines
defines each
each of of the
the activities
activities
that
that will
will be
be included
included in
in the
the activity-based
activity-based costing
costing
system
system andand how
how the
the activities
activities will
will be
be measured.
measured. 3-14
 Hierarchy of Activities
Level Activities Activity Measure
Unit-level Processing units on machines Machine-hours
Processing units by hand Direct labor-hours
Consuming factory supplies Units produced
Batch-level Processing purchase orders Purchase orders processed
Processing production orders Production orders processed
Setting up equipment Number of setups
Handling materials Pounds of material handled
Product-level Testing new products Hours of testing time
Administering parts inventories Number of part types
Designing products Hours of design time
Facility-level General factory administration Direct labor-hours
Plant building and grounds Direct labor-hours

3-15
 Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs

First-Stage Cost Assignment

Labor
Labor Machine
Machine Setup
Setup Production
Production Parts
Parts General
General
Related
Related Pool
Pool Related
Related Pool
Pool Pool
Pool Order
Order Pool
Pool Admin.
Admin. Pool
Pool Factory
Factory Pool
Pool

3-16
 Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs

First-Stage Cost Assignment

Labor
Labor Machine
Machine Setup
Setup Production
Production Parts
Parts General
General
Related
Related Pool
Pool Related
Related Pool
Pool Pool
Pool Order
Order Pool
Pool Admin.
Admin. Pool
Pool Factory
Factory Pool
Pool

Second-Stage Allocations

$/DLH $/MH $/Setup $/Order $/Part Type $/MH

Products
Unit-Level Batch-Level Product-Level Facility-Level
Activity Activity Activity Activity 3-17
Using Activity-Based Costing
Comtek Sound, Inc.

 Comtek Sound, Inc., makes two products: CD players

and DVD players.
 The company has been losing bids to supply CD
players to lower-priced competitors.
 The company has been winning all bids to supply
DVD players.

3-18
Using Activity-Based Costing
Comtek Sound, Inc.
 For the current year, Comtek has budgeted sales
of 50,000 DVD units and 200,000 CD units.
 Comtek’s traditional cost system applies
manufacturing overhead to products based on direct-
labor hours.
 Both products require two direct labor-hours to
complete, for a total of 500,000 direct labor-hours.

Hours
DVDs: 50,000 units @ 2 hours per unit = 100,000
CDs: 200,00 units @ 2 hours per unit = 400,000
Total direct labor-hours 500,000
3-19
Using Activity-Based Costing
Comtek Sound, Inc.
 Unit costs for materials and labor are:

DVD CD
Units Units
Direct materials $ 90 $ 50
Direct labor $ 20 $ 20

3-20
 Direct Labor-Hours as a Base
Total manufacturing overhead costs for the
current year are estimated to be $10,000,000.
The company develops the following overhead
rate based upon labor-hours:

Predetermined $10,000,000
= = $20 per DLH
overhead rate 500,000 DLHs

3-21
Direct Labor-Hours as a Base
Since
Since each
each product
product requires
requires twotwo hours
hours of
of
direct
direct labor,
labor, $40
$40 of
of overhead
overhead is is assigned
assigned to
to
each
each product.
product.   
DVD Unit CD Unit
Direct materials $ 90 $ 50
Direct labor 20 20
Manufacturing overhead 40 40
(2 DLHs x $20 per DLH)
Unit product cost $ 150 $ 110

3-22
Learning Objective 2

Compute activity rates

for an activity-based
costing system.

3-23
 Computing Activity Rates
The ABC project team at Comtek has
developed the following basic information.
Estimated
Overhead
Activity and Activity Measures Cost Expected Activity
Total DVD CD
Labor-related (DLH) $ 800,000 500,000 100,000 400,000
Machine-related (MH) 2,100,000 1,000,000 300,000 700,000
Machine setups (setups) 1,600,000 4,000 3,000 1,000
Production orders (orders) 3,150,000 1,200 800 400
Parts administration (part types) 350,000 700 400 300
General factory (MH) 2,000,000 1,000,000 300,000 700,000
$ 10,000,000

3-24
 Computing Activity Rates

Estimated Total
Overhead Expected
Activity and Activity Measures Cost Activity Activity Rate
Labor-related (DLHs) $ 800,000 ÷ 500,000 = $ 1.60 per DLH
Machine-related (MHs) 2,100,000 ÷ 1,000,000 = 2.10 per MH
Machine setups (setups) 1,600,000 ÷ 4,000 = 400.00 per setup
Production orders (orders) 3,150,000 ÷ 1,200 = 2,625.00 per order
Parts administration (part types) 350,000 ÷ 700 = 500.00 per part type
General factory (MHs) 2,000,000 ÷ 1,000,000 = 2.00 per MH
$ 10,000,000

We can calculate an activity rate for each of the six activities

by dividing the estimated overheard for an activity by the
total expected activity.
3-25
Learning Objective 3

Compute product costs

using activity-based
costing.

3-26
Computing Overhead Cost per Unit
DVD Units
Expected Activity
Activity and Activity Measures Activity Rate Amount
Labor-related (DLHs) 100,000 × $ 1.60 = $ 160,000
Machine-related (MHs) 300,000 × 2.10 = 630,000
Machine setups (setups) 3,000 × 400.00 = 1,200,000
Production orders (orders) 800 × 2,625.00 = 2,100,000
Parts administration (part types) 400 × 500.00 = 200,000
General factory (MHs) 300,000 × 2.00 = 600,000
Total overhead cost assigned $ 4,890,000
Number of units produced 50,000
Overhead cost per unit $ 97.80

3-27
Computing Overhead Cost per Unit
CD Units
Expected Activity
Activity and Activity Measures Activity Rate Amount
Labor-related (DLHs) 400,000 × $ 1.60 = $ 640,000
Machine-related (MHs) 700,000 × 2.10 = 1,470,000
Machine setups (setups) 1,000 × 400.00 = 400,000
Production orders (orders) 400 × 2,625.00 = 1,050,000
Parts administration (part types) 300 × 500.00 = 150,000
General factory (MHs) 700,000 × 2.00 = 1,400,000
Total overhead cost assigned $ 5,110,000
Number of units produced 200,000
Overhead cost per unit $ 25.55

3-28
Comparing the Two Approaches
Activity-Based Costing Direct Labor Costing
DVD Unit CD Unit DVD Unit CD Unit
Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

Note that the unit product cost of a CD

unit decreased from $110 to $95.55 . . . .
. . . . while the unit cost of a DVD unit
increased from $150 to $207.80.
3-29
Learning Objective 4

Contrast the product

costs computed under
activity-based costing
and conventional
costing methods.

3-30
Comparing the Two Approaches
Activity-Based Costing Direct Labor Costing
DVD Unit CD Unit DVD Unit CD Unit
Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

The
The ABC
ABC system
system assigns
assigns $14.45
$14.45
less
less overhead
overhead than
than the
the traditional
traditional
system
system to
to each
each CD
CD player.
player.
3-31
Comparing the Two Approaches
Activity-Based Costing Direct Labor Costing
DVD Unit CD Unit DVD Unit CD Unit
Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

The
The ABC
ABC system
system assigns
assigns $57.80
$57.80
more
more overhead
overhead than
than the
the traditional
traditional
system
system to
to each
each DVD
DVD player.
player.
3-32
 Shifting of Overhead Cost
Activity-Based Costing Direct Labor Costing
DVD Unit CD Unit DVD Unit CD Unit
Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

Low-volume product
When
When aa company
company implements
implements activity-based
activity-based
costing,
costing, overhead
overhead cost
cost often
often shifts
shifts from
from high-
high-
volume
volume to
to low-volume
low-volume products
products with a higher unit
product
product cost
cost resulting
resulting for
for the
the low-volume
low-volume products.
products.
3-33
 Shifting of Overhead Cost
Activity-Based Costing Direct Labor Costing
DVD Unit CD Unit DVD Unit CD Unit
Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

High-volume product

The
The traditional
traditional system
system assigns
assigns the
the same
same amount
amount of
of
all
all overhead
overhead costs
costs to
to each
each CD
CD oror DVD
DVD player
player
($40
($40 per
per unit).
unit).
3-34
Shifting of Overhead Cost
Production
Production Orders
OrdersActivity
Activity Cost
Cost Pool
Pool
(a
(a batch-level
batch-level cost
cost pool)
pool)
The
TheABC
ABC system
system assigns
assigns different
different amounts
amounts of of
Production
Production Order-related
Order-related overhead
overhead costscosts to
to each
each product.
product.
This
This fact
fact can
can be
be illustrated
illustrated in
in aa two-step
two-step process.
process.

1.
1. Compute
Compute the
the number
number of of units
units processed
processed
per
per production
production order
order for
for each
each product.
product.

DVD Units CD Units

Number of units produced per year 50,000 200,000
Number of production orders issued per year 800 400
Number of units processed per production order 62.5 500
3-35
 Shifting of Overhead Cost
2.
2. Compute
Compute production
production order
order cost
cost per
per unit
unit for
for each
each product.
product.

DVD Units CD Units

Cost to issue a production order $ 2,625 $ 2,625
Average number of units processed per
production order 62.5 500
Production order cost per unit $ 42.00 $ 5.25

Notice,
Notice, the
the costs
costs are
are being
being shifted
shifted from
from the
the high-
high-
volume
volume CDCD players
players to
to the
the low-volume
low-volume DVD
DVD players.
players.
3-36
Targeting Process Improvements

An ABC system can help identify

areas where the company can benefit
from improving its current processes.

Activity-Based Management
Focuses on managing activities to eliminate
waste and reduce delays and defects.

3-37
 Targeting Process Improvements
The
The first
first step
step in
in any
any improvement
improvement
program
program isis deciding
deciding what
what to
to improve.
improve.

The
The Theory
Theory of
of Constraints
Constraints Activity
Activity rates
rates can
can be
be
approach
approach targets
targets the
the used
used toto target
target areas
areas
highest
highest impact
impact where
where costs
costs seem
seem
improvement
improvement opportunities.
opportunities. excessively
excessively high.
high.

Benchmarking
Benchmarking can
can be
be used
used to
to compare
compare activity
activity cost
cost
information
information with
with world-class
world-class standards
standards of
of performance
performance
achieved
achieved by
by other
other organizations.
organizations.
3-38
Benefits of Activity-Based Costing
ABC improves the accuracy of product costing by:
1. Increasing the number of cost pools used to accumulate
overhead costs.
2. Using activity cost pools that are more homogeneous
than departmental cost pools.
3. Assigning overhead costs using activity measures that
cause those costs, rather than relying solely on direct
labor hours.

Activity-based
Activity-based costing
costing also
also highlights
highlights activities
activities
that
that could
could benefit
benefit most
most from
from process
process
improvement
improvement efforts,
efforts, such
such asas Six
Six Sigma.
Sigma.
3-39
Limitations of Activity-Based Costing

Costs of implementing an ABC system may outweigh

the benefits. However, the benefits are more likely to be
worth the costs when:
1. Products differ substantially in volume, batch size, and in
activities required.
2. Conditions have changed substantially since the existing
cost system was established.
3. Overhead costs are high and increasing and no one seems
to understand why.
4. Management does not trust the existing cost system and it
ignores data from it when making decisions.

3-40
 Activity-Based Costing
Critical Assumption

The
The cost
cost in
in each
each activity
activity pool is strictly
strictly
proportional
proportional to
to its
its activity
activity measure.
measure. When
When this
this
assumption
assumption is is violated,
violated, the
the accuracy
accuracy of
of ABC
ABC
data
data can
can be be called
called into
into question.
question.

For
For example,
example, managers
managers should be be particularly
alert
alert to
to product
product costs
costs that
that contain
contain allocated
allocated
facility-level
facility-level costs.
costs.
3-41
Modifying the ABC Model
The
The illustrations
illustrations inin the
the chapter
chapter assume
assume
that
that ABC
ABC is is being
being used
used for
for external
external reporting
reporting
purposes.
purposes. IfIf the
the system
system is is used
used for
for internal
internal
decision-making
decision-making purposes,
purposes, two two important
important
modifications
modifications should
should bebe made:
made:
1.
1. Selling
Selling and
and administrative
administrative costs
costs should
should be
be
assigned
assigned to to products,
products, where
where appropriate.
appropriate.
2.
2. Facility-level
Facility-level costs
costs should
should bebe removed
removed
from
from product
product costs.
costs.

3-42
End of Chapter 03

3-43