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Activity-Based CostingChapter 9Edited by Dr. Charles Bailey for ACCT3310

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPACopyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin9-#Chapter 9: Activity-Based Costing

Chapters 7 and 8 described product costing systems. In the last 15 years or so, many companies have experimented with and implemented costing systems based on production processes rather than accounting systems. One such system is activity-based costing, or ABC, which aids managers in the decision making process. Chapter 9 describes activity-based costing.

9-#Learning ObjectivesLO 9-1Understand the potential effects of using externally reportedproduct costs for decision making.LO 9-2Explain how a two-stage product costing system works.LO 9-3Compare and contrast plantwide and departmentallocation methods.LO 9-4Explain how activity-based costing and a two-stage productsystem are related.LO 9-5Compute product costs using activity-based costing.LO 9-6Compare activity-based product costing to traditionaldepartment product costing methods.LO 9-7Demonstrate the flow of costs through accounts usingactivity-based costing.LO 9-8Apply activity-based costing to marketing and administrativeservices.

9-#An understanding of Chapter 9 should enable you to: 1. Understand the potential effects of using externally reported product costs for decision making. 2. Explain how a two-stage product costing system works. 3. Compare and contrast plantwide and department allocation methods. 4. Explain how activity-based costing and a two-stage product system are related. 5. Compute product costs using activity-based costing. 6. Compare activity-based product costing to traditional department product costing methods. 7. Demonstrate the flow of costs through accounts using activity-based costing. 8. Apply activity-based costing to marketing and administrative services.9-#Product Costs and Decision MakingLO 9-1Understand the potential effects of using externallyreported product costs for decision making.Units producedDirect labor-hoursCosts:Direct materialsDirect laborManufacturing overhead(@ 120% of DL)TotalCost per unit 10 2,000

$ 40,000 72,000

86,400$198,400$ 19,840 30 3,000

$ 36,000 78,000

93,600$207,600$ 6,920 40 5,000

$ 76,000 150,000

180,000$406,000

C-27sC-20sTotalGrange is considering dropping C-27s.LO 9-1

9-#The cost per unit of C-27 is $19,840 and Grange is considering dropping it.9-#The accountant estimated that overheadwill be $163,800.Manufacturing overhead:UtilitiesSuppliesTrainingSupervisionMachine depreciationPlant depreciationMiscellaneousTotal overhead$ 2,400 2,500 30,000 54,900 29,550 40,050 20,600$180,000$ 1,800 1,300 15,600 54,900 29,550 40,050 20,600$163,800OriginalC-20s onlyLO 9-1Product Costs and Decision Making

9-#Remember, overhead is indirect and assigned to products based on a pre-determined overhead rate. In Granges case, overhead was allocated based on direct labor costs. Total overhead cost if both C-20s and C-27s are produced is $180,000. Total overhead if only C-20s is produced, is $163,800. Although Grange allocates $86,400 of overhead to the C-27s, only $16,200 of the overhead is avoided if C-27s is no longer produced. 9-#Direct materialsDirect laborManufacturing overheadTotal costs$ 76,000 150,000 180,000$406,000 $ 36,000 78,000 163,800$277,800OriginalC-20s onlyThe cost per unit for the C-20s willincrease from $6,920 to $9,260.LO 9-1Product Costs and Decision Making

9-#Granges total cost estimate when producing both C-20s and C-27s was $406,000, $198,400 for C-27s, and $207,600 for C-20s. However, if Grange produces only C-20s, total cost estimate is $277,800. If Grange continues the current production of 30 C-20s the per unit cost will go from $6,920 to $9,260 per unit. How can this be?9-#The Death SpiralThis is a process that begins byattempting to increase price tomeet reported product cost.This may result in demand foreven fewer units.LO 9-1

9-#Sometimes companies increase prices to meet reported product cost. This may result in a decrease in demand. 9-#Two-Stage Cost AllocationLO 9-2 Explain how a two-stage product costing system works.Allocate overhead costs to departments.First stage:Allocate department overhead coststo the products or services.Second stage:LO 9-2

9-#Lets look at a two-stage cost allocation system. First, allocate overhead costs to departments and then allocate the department overhead costs to the products or services.9-#Two-Stage Cost AllocationOverheadDirect laborhoursMachinehoursCostpoolCostallocation ruleIntermediatecost poolsDepartment ADepartment BLO 9-2

9-#We discussed the two-stage approach to product costing in Chapter 6. Using the two-stage process first define the cost pool. The cost pool, overhead, is then separated into intermediate cost pools, departments (for example, Department A and Department B). Finally, allocate costs from the intermediate cost pools based on an appropriate allocation rule for each specific pool.9-#Two-Stage Cost AllocationNumber of unitsMachine hours Assembly

Direct materialsDirect labor AssemblyDirect labor PackagingTotal direct laborTotal direct costOverhead costs:AssemblyPackagingTotal overheadTotal costs 100,000 6,000

$1,500,000$ 750,000 990,000$1,740,000$3,240,000

40,000 30,000

$2,400,000$ 600,000 360,000$ 960,000$3,360,000

140,000 36,000

$3,900,000$1,350,000 1,350,000$2,700,000$6,600,000

$1,620,000 810,000$2,430,000$9,030,000J25PJ40XTotalThird Quarter Production and Cost DataThe cost system allocates manufacturing overheadto products based on direct labor costs.LO 9-2

9-#Here we have the data on the operations of the Port Arthur facility for the third quarter using a cost system that allocates manufacturing overhead to products based on direct labor costs.9-#Two-Stage Cost AllocationUnits produced

Direct materialDirect labor:AssemblyPackagingTotal direct laborDirect costApplied overhead(@ 90% of direct labor costs)

100,000

$ 15.00

$ 7.50 9.90$ 17.40$ 32.40

15.66$ 48.06 40,000

$ 60.00

$ 15.00 9.00$ 24.00$ 84.00

21.60$105.60J25PJ40XThird Quarter Unit Cost Report One allocation rateLO 9-2

9-#Allocating overhead based on direct labor costs, $15.66 of overhead costs are allocated to each unit of J25P resulting in a per-unit cost of $48.06. $21.60 of overhead costs are allocated to each unit of J40X resulting in a per-unit cost of $105.60. 9-#Two-Stage Cost AllocationUnits produced

Direct materialDirect labor:AssemblyPackagingTotal direct laborDirect costApplied overhead:Assembly @ $45/machine hourPackaging @ 60% of direct labor costTotal overheadUnit costs100,000

$ 15.00

$ 7.50 9.90$ 17.40$ 32.40

$ 2.70 5.94$ 8.64$ 41.04 40,000

$ 60.00

$ 15.00 9.00$ 24.00$ 84.00

$ 33.75 5.40$ 39.15$123.15J25PJ40XThird Quarter Unit Cost Report Two Stage AllocationLO 9-2Vs. $48.06 $105.60

9-#Allocating overhead using a two-stage allocation process, $8.64 of overhead costs are allocated to each unit of J25P resulting in a per-unit cost of $41.04. $39.15 of overhead costs are allocated to each unit of J40X resulting in a per-unit cost of $123.15.9-#Plantwide versusDepartment-Specific RatesLO 9-3Compare and contrast plantwide anddepartment allocation methods.Plantwide allocation methodAll overhead costs are recorded in onecost pool and applied to products usingone overhead allocation rate.LO 9-3One cost pool for each department

9-#Using a plantwide allocation method, all overhead costs are recorded in one cost pool and applied to products using one predetermined overhead rate. There is one cost pool for the factory.9-#Department allocation methodOverhead costs are traced to separatedepartments and applied to productsusing a department allocation rate.One cost pool for each departmentLO 9-3Plantwide versusDepartment-Specific Rates

9-#Using a department allocation method, overhead costs are traced to separate departments and then applied to products using a department allocation method. There is one cost pool for each department.9-#Choice of Allocation MethodsWhich cost application method is appropriate?Similar products usingsame resourcesPlantwideallocationMultiple products usingresources differentlyDepartmentallocationLO 9-3

9-#Different cost allocation methods result in different product costs. So which cost allocation method is appropriate? If the products are similar and use the same resources, a plantwide allocation method is appropriate. However, if multiple products use resources differently, a two-stage allocation method is appropriate.9-#Activity-Based Costing (ABC)LO 9-4Explain how activity-based costing anda two-stage product system are related.ABC is a costing method that first assigns coststo activities and then assigns them to productsbased on the products consumption of activities.Assign costs to activities.Stage 1:Assign costs to products basedon the use of each activityStage 2:LO 9-4

9-#Activity-based costing is a two-stage allocation method that first assigns overhead costs to activities rather than departments, and then allocates the cost of those activities to products based on the use of each activity.9-#Activity-Based Costing (ABC)Why ABC?ActivitiesconsumeresourcesProducts (or services)consumeactivities

LO 9-4

9-#Why are we doing this? Why would we allocate costs to activities? Because activities consume resources and products consume or use activities. 9-#Developing Activity-Based CostsStep 1:Identify the activities that consume resourcesand assign costs to them.Step 2:Identify the cost driver(s) associated witheach activity.Step 3:Compute a cost rate per cost driver unitor transaction. Step 4:Assign costs to products by multiplying thecost driver rate by the volume of cost driverunits consumed by the product.LO 9-4

9-#Developing an activity-based costing system consists of four steps. First, identify activities that consume resources and assign costs to them. Second, identify the cost drivers associated with each activity. Third, compute a cost rate per cost driver unit or transaction. And finally, fourth, allocate the cost of the activities to products by multiplying the cost driver rate by the volume of cost driver units consumed by the product.9-#Activity-Based Costing SystemCost of Activity AOther Indirect Costs of product/svc (including other non-ABC items)Cost of Product, Service, CustomerFundamental Cost Objects: Labor, materials, etc. (All indirect to the Product or Service)Cost driversActivity driversOtherCostdriversDirect CostsTracedCost of Activity B, etc.

5 - #9-#Cost DriversCost drivers are factors that cause or drivean activitys costs.Identified ActivitySetting up machinesHandling materialMachiningPackaging and shippingLO 9-4Identified Cost Driver ?

9-#A cost driver is a factor that causes or drives an activitys cost. For example, if setting up machines for production is the activity, what causes or drives the cost of setting up a machine? The number of labor hours need to prepare the equipment.9-#Cost HierarchiesThis is the classification of cost drivers into generallevels of activity; volume, batch, product, and so on.Cost ExampleHierarchy LevelCost Driver ExampleLO 9-4

9-#When we look at the cost flow diagram for the activity-based costing system and compare it to the two-stage cost flow diagram, a natural question is how do these two systems differ? The first difference, weve already identified. In the activity-based costing system, the first stage allocates cost to activities, not departments. This might seem like a small difference but we will see in Chapter 10 that it has important implications for cost management. Perhaps a more important difference is the nature of the cost drivers. Using the two-stage cost allocation system, costs were allocated based on machine hours and direct labor costs. These cost drivers are volume-related. Activity-based costing recognizes that overhead costs are caused by activities and that some activities are driven by something other than volume. Classifying costs in a cost hierarchy shows that some costs are driven by volume. Other costs may be batch related, product related, or facility related.9-#Cost HierarchiesCost ExampleSuppliesLubricating oilMachine repairHierarchy LevelVolume relatedCost Driver ExampleDirect labor costsMachine hoursNumber of unitsLO 9-4This is the classification of cost drivers into generallevels of activity; volume, batch, product, and so on.

9-#Look at some examples. Volume-related costs are costs like supplies, driven by direct labor costs, or the cost of lubricating oil driven by the number of machine hours.9-#Cost HierarchiesCost ExampleSuppliesLubricating oilMachine repairHierarchy LevelVolume relatedCost Driver ExampleDirect labor costMachine-hoursNumber of unitsSetup costsMaterial handlingShipping costsBatch relatedSetup hoursProduction runsNumber of shipmentsLO 9-4This is the classification of cost drivers into generallevels of activity; volume, batch, product, and so on.

9-#However, set-up costs are incurred for each batch and are driven by the number of set-up hours. Material handling costs for the batches of production is driven by the number of production runs. Shipping costs are driven by the number of shipments.9-#Cost HierarchiesCost ExampleSuppliesLubricating oilMachine repairHierarchy LevelVolume relatedCost Driver ExampleDirect labor costMachine-hoursNumber of unitsSetup costsMaterial handlingShipping costsBatch relatedSetup hoursProduction runsNumber of shipmentsCompliance costsDesign andspecification costsProduct relatedNumber of productsLO 9-4This is the classification of cost drivers into generallevels of activity; volume, batch, product, and so on.

9-#Moving up the cost hierarchy, compliance costs and design and specification costs are driven by the number of products.9-#Cost HierarchiesThe cost hierarchy in any ABC system depends onthe cost category and its cost driver. Cost ExampleSuppliesLubricating oilMachine repairHierarchy LevelVolume relatedCost Driver ExampleDirect labor costMachine-hoursNumber of unitsSetup costsMaterial handlingShipping costsBatch relatedSetup hoursProduction runsNumber of shipmentsCompliance costsDesign andspecification costsProduct relatedNumber of productsGeneral plant costsPlant admin. costsFacility relatedStaying in business!LO 9-4

9-#And finally, general plant costs are related to the facility. In fact, we have already seen this phenomenon. Some of Granges costs did not go away by decreasing the volume of production. These costs were necessary to run the facility regardless of the volume of production.9-#Activity-Based Costing IllustratedLO 9-5 Compute product costs using activity-based costing.Number of unitsMachine hours Assembly

Direct materialsDirect labor AssemblyDirect labor PackagingTotal direct laborTotal direct costOverhead costs:AssemblyPackagingTotal overheadTotal costs 100,000 6,000

$1,500,000$ 750,000 990,000$1,740,000$3,240,000

40,000 30,000

$2,400,000$ 600,000 360,000$ 960,000$3,360,000

140,000 36,000

$3,900,000$1,350,000 1,350,000$2,700,000$6,600,000

$1,620,000 810,000$2,430,000$9,030,000J25PJ40XTotalThird Quarter Production and Cost DataLO 9-5

9-#Lets go back to the Port Arthur Manufacturing Facility. Total direct costs, that is direct materials and direct labor, are $6,600,000. Total manufacturing overhead costs are $2,430,000. Lets cost the two products, the J25P and the J40X, using activity-based costing.9-#Activity-Based Costing IllustratedStep 1: Identify the ActivitiesPackaging DepartmentInspectionPackingShippingAssembly DepartmentSetting up machinesHandling materialProduct assemblyLO 9-5

9-#The first step in activity-based costing is to identify the activities. Activities in the Assembly Department include machine set up, material handling and product assembly. Activities in the Packaging Department include inspection and packing, and shipping.9-#Activity-Based Costing IllustratedStep 2: Identify the Cost DriversAssembly building:AssemblingSetting up machinesHandling materialPackaging building:Inspecting and packingShippingMachine-hoursSetup hoursProduction runs

Direct labor hoursNo. of shipments 6,000 40 8

60,000 10030,000 400 40

22,800 200J25PJ40XTotalCost Driver Volume36,000 440 48

82,800 300ActivityCost DriverLO 9-5

9-#After identifying the activities, the second step in activity-based costing is to identify the cost drivers and the expected volume of each cost driver. Product assembly costs are driven by machine hours and the expected volume of machine hours is 36,000. The cost driver for machine setup costs is setup hours. Port Arthur Manufacturing Facility expects 440 setup hours. The cost driver for material handling is production runs and Port Arthur Manufacturing Facility expects 48 production runs. In the Packaging Department, inspection and packing costs are driven by the number of direct labor hours. Total direct labor hours expected are 82,800. And finally, shipping costs are driven by the number of shipments: expected number of shipments, 300.9-#Activity-Based Costing IllustratedStep 3: Compute the Cost Driver RatesAssembly building:AssemblingSetting up machinesHandling materialTotal assembly overheadPackaging building:Inspecting and packingShippingTotal packaging overhead

Total overhead$1,080,000 396,000 144,000$1,620,000

$ 414,000 396,000$ 810,000

$2,430,000 36,000 machine hour = 440 hours = 48 runs =

82,800 direct labor hr = 300 shipments =

$ 30/machine hour$ 900/setup hour$ 3,000/run

$ 5/direct labor hour$ 1,320/shipment

Building and ActivityOverheadCostCost DriverVolumeCost DriverRateLO 9-5

9-#Third step: compute the cost driver rates. For product assembly we have $30 per machine hour. If costs assigned to machine setup equals $396,000 and the expected volume of setup hours is 440, the overhead rate is $900 per setup hour. Computing the cost driver rate for material handling gives us $3,000 per production run. In the Packaging Department, we have overhead rates of $5 per direct labor hour for inspection and packing and $1,320 per shipment for shipping.9-#Activity-Based Costing IllustratedStep 4: Assign Costs Using ABCAssembly building:Assembling @ $30/machine hourMachine setup @ $900/setup hourHandling material @ $3,000/run

Packaging building:Inspection and packaging @ $5/direct labor hourShipping @ $1,320/ shipmentTotal ABC overhead$180,000 36,000 24,000

300,000 132,000$672,000$ 900,000 360,000 120,000

114,000 264,000$1,758,000J25PJ40XOverheadLO 9-5

9-#Finally, allocate costs to the products using the predetermined overhead rate per activity. Product assembly at $30 per machine hour allocated $180,000 and $900,000 to J25P and J40X respectively. Machine setup at $900 per set-up hour allocates $36,000 and $360,000 to J25P and J40X respectively. Material handling at $3,000 per production run allocates $24,000 and $120,000 to J25P and J40X respectively and so on. Inspecting and packing at $5 per direct labor hour allocated $300,000 and $114,000 to J25P and J40X respectively. Finally, shipping is allocated at $1,320 per shipment which attributed $132,000 and $264,000 to J25P and J40X respectively. Allocating costs to the products using the predetermined overhead rate per activity results in total overhead costs allocated to J25P of $672,000 and to J40X of $1,758,000. 9-#Cost Flow Diagram ABC SystemManufacturingoverheadDirectcostsAssembly buildingPackaging buildingAssemblingSetupHandlingmaterialInspecting/packagingShippingJ25PJ40XDirectlyassignedMachinehoursSetuphoursRunsDirectLHShip-mentsLO 9-5

9-#Here is a quick review of the cost flow diagram for the Port Arthur Manufacturing Facility using activity-based costing. Overhead costs are assigned first to departments, either Assembly or Packaging. Then the department overhead costs are assigned to activities. Costs are allocated to the products based on an allocation rate per cost driver of each individual activity.9-#Activity Based Costing IllustratedDirect materialDirect labor:AssemblyPackagingTotal direct laborDirect costsOverhead:Assembly building:Assembling @ $30 per machine hourMachine setup @ $900 per setup hourHandling material @ $3,000 per runPackage building:Inspecting and packing @ $5 per direct labor hourShipping @ $1,320 per shipmentTotal ABC overheadTotal ABC costNumber of unitsUnit cost$1,500,000

$ 750,000 990,000$1,740,000$3,240,000

$ 180,000 36,000 24,000

300,000 132,000$ 672,000$3,912,000 100,000$ 39.12

$2,400,000

$ 600,000 360,000$ 960,000$3,360,000

$ 900,000 360,000 120,000

114,000 264,000$1,758,000$5,118,000 40,000$ 127.95J25PJ40XLO 9-5

9-#With overhead costs allocated using activity-based costing the per-unit cost for J25P and J40X are $39.12 and $127.95, respectively.

9-#Unit Costs ComparedLO 9-6Compare activity-based product costing totraditional department product costing methods.Plantwide rateDepartment (building) rateActivity-based costing$48.06$41.04$39.12$105.60$123.15$127.95J25PJ40XComparison of Reported Unit Product CostsLO 9-6

9-#Take a moment to compare the per-unit product cost using a plantwide rate, a department rate and activity-based costing for allocating overhead. The J25P has a per-unit product cost of $48.06 using a plantwide allocation rate for overhead costs, $41.04 using a department rate, and $39.12 using activity-based costing. The J40X has a per-unit product cost of $105.60 using a plantwide allocation rate for overhead costs, $123.15 using a department rate, and $127.95 using activity-based costing. Notice using volume to allocate overhead costs results in over costing high-volume products like the J25P and under costing low-volume products like the J40X.9-#Cost Flows through AccountsLO 9-7Demonstrate the flow of costs throughaccounts using activity-based costing.Lets see ABC cost flow for the Assembly Department.It's T-account time!LO 9-7

9-#Lets see how costs flow through the accounts in the Assembly Department using activity-based costing.9-#Direct Materials CostsMaterials Inventory1,500,0002,400,000Assembly WIP J25PDM 1,500,000Assembly WIP J40XDM 2,400,000LO 9-7

9-#Direct costs flow the same way as they do in any other cost system. The material inventory account is credited for the direct materials that go into the assembly work-in-process account for the J25P product and for the direct materials that go into the assembly work-in-process account for the J40X product.9-#Direct Labor CostsWages Payable750,000600,000Assembly WIP J25PDM 1,500,000DL 750,000Assembly WIP J40XDM 2,400,000DL 600,000LO 9-7

9-#Wages payable is credited for the direct labor that goes into the assembly work-in-process account for the J25P product and for the direct labor that goes into the assembly work-in-process account for the J40X product.9-#Overhead CostsAssembly WIP J25PDM 1,500,000DL 750,000OH 240,000Assembly WIP J40XDM 2,400,000DL 600,000OH1,380,000Assembling180,000900,0001,080,000Setting Up 36,000360,000396,000Handling Material 24,000120,000144,000LO 9-7

9-#The overhead control account for each activity is credited for the cost allocated to the individual products. The assembling control account is credited and the assembly work-in-process account for the J25P is debited for $180,000. The assembling control account is credited and the assembly work-in-process account for the J40X is debited for $900,000. The machine setup control account is credited and the assembly work-in-process account for the J25P is debited for $36,000. The assembling control account is credited and the assembly work-in-process account for the J40X is debited for $360,000. The material handling control account is credited and the assembly work-in-process account for the J25P is debited for $24,000. The assembling control account is credited and the assembly work-in-process account for the J40X is debited for $120,000. Total overhead allocated to the J25P product is $240,000 ($180,000 assembling costs plus $36,000 set-up costs plus $24,000 material handling costs). Total overhead allocated to the J40X product is $1,380,000 ($900,000 assembling, $360,000 set-up and $120,000 material handling). Remember, the overhead control accounts were originally debited for the cost assigned to that activity.9-#Transfer from Assembly to PackagingPackaging WIP J25P2,490,000Packaging WIP J40X4,380,000Assembly WIP J25P2,490,000DM 1,500,000DL 750,000OH 240,000Assembly WIP J40X4,380,000DM 2,400,000DL 600,000OH1,380,000LO 9-7

9-#Just like you did in previous chapters, the assembly work-in-process account is credited and the packaging work-in-process account is debited when the product, the J25P or the J40X is transferred from assembly to packaging.9-#ABC Costing in AdministrationLO 9-8Apply activity-based costing to marketingand administrative services.Step 1:Identify the activities that consume resources.Step 2:Identify the cost driver associated with each activity.Step 3:Compute a cost rate per cost driver for each unitor transaction. Step 4:Assign costs to the marketing or administrationactivity by multiplying the cost driver rate by thevolume of cost driver units consumed for that activity.The same four-step process:LO 9-8

9-#Applying activity-based costing to marketing and administrative services involves the same four-step process. First, identify the activities that consume resources and assign costs to them. Second, identify the cost drivers associated with each activity. Third, compute a cost rate per cost driver unit or transaction. And finally, fourth, assign the cost of the activities to marketing or administration by multiplying the cost driver rate by the volume of cost driver units consumed by the activity.9-#Major Differences,Traditional Costing vs. ABCTypical System ABCOne or a few indirect Many poolscost pools Application base may Base more likely a be a true cost driver true cost driver Application base often Bases likely to befinancial (direct labor cost, non-financial (# of parts, direct material cost, etc) number of operations, hours of testing, etc.)

5 - #9-#Decision Usefulness of Cost HierarchiesDifferent levels of cost drivers:Level_______ Useful for Decisions Such AsOutput-unitShall we increase production, and at what price?BatchHow often should we produce batches?What base amount must we charge to set up a run, regardless of the number of units made?Product/Service-RelatedShould we continue to offer this service/product?Facility-RelatedShall we continue in business or dissolve it?

5 - #9-#End of Chapter 9

9-#End of Chapter 9.9-#