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Chapter 17
Activity-Based Costing and Analysis
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Conceptual Learning Objectives
C1: Distinguish between the plantwide overhead rate method, the departmental overhead rate method, and activity-based costing method.
C2: Explain cost flows for the plant wide overhead rate method.
C3: Explain cost flows for the departmental overhead rate method.
C4: Explain cost flows for activity-based costing.
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A1: Identify and assess advantages and disadvantages of the plantwide overhead rate method.
A2: Identify and assess advantages and disadvantages of the departmental overhead rate method.
A3: Identify and assess advantages and disadvantages of activity-based costing.
Analytical Learning Objectives
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P1: Allocate overhead costs to products using the plantwide overhead rate method.
P2: Allocate overhead costs to products using departmental overhead rate method.
P3: Allocate overhead costs to products using activity-based costing.
Procedural Learning Objectives
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Assigning Overhead CostsC1
Goods in Process
Cost of GoodsSold
Labor
Materials
Ind
irec
tIn
dir
ect
FinishedGoods
FactoryOverhead
Direct
Direct
Allocate
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Assigning Overhead Costs
Overhead costs are not directly related to production volume, and therefore cannot be traced to units of product in the same way as direct materials and direct labor. Consequently, we must assign overhead costs using an allocation system.
This chapter identifies three methods of overhead allocation.
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Assigning Overhead CostsC1
Overhead can be assigned to production in one of three ways:
Single plant-wide overhead
rate
Departmental overhead
rates
Activity-based costing
Plant Wide Overhead Rate MethodWhen overhead costs are closely related to volume-related measures this method is logical.
1. Total budgeted overhead costs are combined into one overhead cost pool.
2. Next, the cost pool is divided by the chosen allocation base, such as total direct labor hours, to arrive at a single plant wide allocation rate.
3. Finally, this rate is applied to assign costs to all products.
4. The target of the cost assignment or Cost Object is the unit of product.
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Plant Wide Overhead Rate Method
Overhead CostIndirect Costs
Cost Allocation
Base
Single Plant-Wide Overhead Rate
Cost Objects Product 1 Product 2 Product 3
C2
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Plant Wide Overhead Rate Method Illustration
Exhibit 17.2 KartCo's Budgeted Direct HoursDirect Total
Number Labor Direct Laborof units Hours Hours
Standard go-kart 5,000 X 15 =Custom go-kart 1,000 X 25 =Total
Kartco's Budgeted Overhead Costs
100,000
75,00025,000
$4,800,000
Indirect Labor costs………………………………………………………………………………………………………………………………..Factory Utilities………………………………………………………………………………………………………………………………………..Total Overhead Costs……………………………………………………………………………………………………………………………
$4,000,000800,000
P1
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Plant Wide Overhead Rate Method Illustration
P1
Plantwide overhead
rate=
Total budgeted overhead costs
Total budgeted DLH
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Plant Wide Overhead Rate Method Illustration
P1
Plantwide overhead
rate=
$4,800,000
100,000 DLH
= $48/DLH
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Plant Wide Overhead Rate Method Illustration
P1
Allocation of overhead cost to products
Overhead AllocatedRate Per Per
DLH DLH UnitStandard go-kart $48 X 15 = 720$ Custom go-kart $48 X 25 = 1,200$
Total product cost per unitTotal
Direct Direct Factory CostMaterials Labor Overhead Per Unit
Standard go-kart 400$ 350$ 720$ 1,470$ Custom go-kart 600 500 1,200 2,300
Plant Wide Overhead Rate Method -Advantages
Information is readily available Easy to implement Often sufficient to meet external
financial reporting needs
Plant Wide Overhead Rate Method -Disadvantages
Overhead costs may not bear any relationship with direct labor hours.
Example: Technology Intensive vs. Labor Intensive production stages.
Various types of products within the same company may not use overhead costs in the same proportion.
Departmental Overhead Rate Method
Many companies have several departments that produce various products and consumes overhead resources in a substantially different way.
Example:Machining Dept => Machine HoursAssembly Dept => Labor Hours
Departmental OH Rate is a better method to allocate of costs to departments when overhead resources are consumed in substantially different ways.
Departmental Overhead Rate Method
Two stages of allocating overhead rates:
First stage: Overhead costs are determined separately for each production department.Cost Object is the ‘Department’.
Second stage:An overhead rate is computed for each production department to allocate the overhead costs to products passing through that department. Cost Object is the ‘Product’.
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Departmental Overhead Rate Method
Overhead Cost
First Stage
SecondStage
Department A
Indirect Costs
Cost Objects
Allocation Base
Cost Objects
Department A Overhead Rate
Department B
Department BOverhead Rate
Product 1 Product 2 Product 3
C3
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Departmental Overhead Rate Method: First Stage
Overhead Cost$4,800,000
First Stage
Machining Dept.$4,200,000
Assembly Dept.$600,000
P2
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Departmental Overhead Rate Method: Second Stage
SecondStage
Department A Overhead Rate
Department BOverhead Rate
Product 1 Product 2 Product 3
P2
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Departmental Overhead Rate Method: Second Stage
Number of
UnitsHours per
UnitTotal Hours
Hours per Unit Total Hours
Standard go-kart 5,000 10 MH 50,000 MH 5 DLH 25,000 DLHCustom go-kart 1,000 20 MH 20,000 MH 5 DLH 5,000 DLHTotals 70,000 MH 30,000 DLH
Exhibit 17.5 Allocation Information for Machinery and Assembly DepartmentsMachining Department Assembly Department
P2
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Departmental Overhead Rate Method: Second Stage
P2
Departmental Overhead
Rate=
Total departmental overhead costs
Total unit number in departmental allocation base
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Departmental Overhead Rate Method: Second Stage
P2
Machining Department Overhead
Rate
=$4,200,000
70,000 MH= $60/MH
Assembly Department Overhead
Rate
=$600,000
30,000 DLH= $20/DLH
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Departmental Overhead Rate Method: Second Stage
Departmental Overhead Rate
Hours per Unit
Overhead Allocated
Hours per Unit
Overhead Allocated
Machining Dept. $60 per MH 10 MH per unit $600 20 MH per Unit 1,200.00$ Assembly Dept. $20 per DLH 5 DLH per unit 100 5 DLH per unit 100.00$ Totals $700 1,300.00$
Total cost per unitDirect Direct Factory Total
Materials Labor Overhead CostStandard Go-Kart 400$ 350$ 700$ 1,450$ Custom Go-Kart 600 500 1,300 2,400
Exhibit 17.6 Overhead Allocation Using Departmental Overhead RatesStandard go-kart Custom go-kart
P2
Advantages of Departmental Overhead Rate Method
Advantages
•More accurate overhead allocations
•More refined than the plant-wide overhead rate method
Disadvantages of Departmental Overhead Rate Method
Since different products within the department may differ in batch size and complexity, Departmental Overhead Rate method:
•Can distort product costs
•Assumes that products are similar in volume, complexity, batch size
•Assumes that departmental overhead costs are proportional to the allocation base
Activity-Based Costing (ABC) MethodActivity-Based Costing (ABC) Rates and method attempts to more accurately assign overhead costs by focusing on activities.
The premise of ABC is that it takes activities to make products and provide services.
These activities drive cost. For example, costs are incurred and resources are used when we perform activities:
-Cutting Raw Materials;-Inspecting parts;-Processing Invoices
Activity-Based Costing (ABC) Method
Activity is the basic principle underlying ABC method.Activity is a TASK, OPERATION, or PROCEDURE which causes costs to be incurred => Cost Driver.
Example: Warehousing Products consumes resources (drives costs) such as:
-Employee time for driving forklift;-Electricity to power forklift;-Wear & tear (depreciation) on a forklift.
Training employees consumes resources (drives costs) such as:
-Trainers’ salaries;-Training supplies
Activity-Based Costing (ABC) MethodThere are two basic stages to ABC:
The first stage of ABC cost assignment is to Identify the activities (cost objects) involved in manufacturing products and match those activities with the costs that they cause (cost driver).
To reduce the total number of activities that must be assigned costs, the homogeneous activities (those caused by the same factors such as cutting metal) are grouped into activity cost pool.
The second stage of ABC is to compute an activity rate for each cost pool and use this rate to allocate overhead costs to products (cost objects).
ActivityCost Driver
An event that causes the consumption of overhead
resources.
Activity Cost Pool
A “cost bucket” in which costs related to a particular
activity measure are accumulated.
$
$
$ $
$$
ABC: Activity (Cost Driver) and Activity Cost Pool
Cost Flows Under Activity-Based Costing Method
Overhead Cost
Activity Cost
Pool X
Activity Cost
Pool Y
Activity Cost
Pool Z
First Stage
Second Stage Activity Overhead
rateActivity Overhead
rateActivity Overhead
rate
Product 1 Product 2 Product 3
Indirect Costs
Cost Objects
Cost Objects
Cost Allocation Base
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Applying Activity-Based Costing
4 steps:
1. Identify activities and the costs they cause.
2. Group similar activities into activity pools.
3. Determine an activity rate for each activity cost pool.
4. Allocate overhead costs to products using those activity rates.
P3
Step one: Identify activities and cost pools.
Activities causing overhead cost are typically separated into four levels reflecting control:
(1) Unit level activities are performed on each product unit,
(2) Batch level activities are performed only on each batch or group of units,
(3) Product level activities are performed on each product line independent of the number of units or batches, and
(4) Facility level activities are performed to sustain facility capacity as a whole.
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Levels of types of activitiesP3
Unit level
Batch level
Product level
Facility level
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Levels of activities
Unit level activities are performed on
each product unit.
Example: Providing electricity to power
machinery in the machining department
is needed to produce each unit of product.
P3
Unit level
Levels of Activities
Batch level activities are performedonly on each batch or group of units.
Example: Machine setup is needed only for eachbatch regardless of the units in thatbatch.
Batch level
Levels of Activities
Product level activities are performed on each product line and are not affected by either numbers of units or batches.
Example: Product design is needed onlyfor each product line .
Product level costs do not vary with thenumber of units or batches produced.
Product level
Facility Level Activities
Facility level activities are performed to sustain facility capacity as a whole and are not caused by any specific product.
Example: Rent or factory maintenance costs are incurred no matter what is produced.
Factory level costs do not vary with what is manufactured, how many batches areproduced, or the output quality.
Facility level
Step Two: Trace Overhead Costs to Cost Pools
Overhead Cost
Activity Cost
Pool X
Activity Cost
Pool Y
Activity Cost
Pool Z
Four Cost Pools for KartCo:
-Craftsmanship -Setup
-Design Modification-Plant Services
Step Two: Trace Overhead Costs
to Cost Pools
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Step Two: Trace Overhead Costs to Cost Pools
ActivityIndirect
LaborFactory Utilities
Total Overhead
Replacing Tools $700,000 $700,000Machine Repair 1,300,000$ 1,300,000Factory Maintenance 800,000$ 800,000Engineer Salaries 1,200,000$ 1,200,000Assembly Line Power $600,000 600,000Heating and Lighting 200,000 200,000Totals $4,000,000 $800,000 $4,800,000
Exhibit 17.9 Kartco Overhead Cost Details
P3
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Step Two: Assigning Overhead to Activity Cost Pools
Activity Pools Activity Cost Pooled Cost Activity DriverCraftsmanship 30,000 direct labor hours Assembly line power $600,000 $600,000Set-up 200 batches Replacing tools 700,000 Machine repair 1,300,000 2,000,000Design modification 10 designs Engineer salaries 1,200,000 1,200,000Plant services Factory maintenance 800,000 20,000 square feet Heating and lighting 200,000 1,000,000Total overhead cost $4,800,000
Exhibit 17.10 Assigning Overhead Costs to Activity Pools
P3
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Step Three: Determine Activity Rate
Step 3 is to compute the activity rates used to assign overhead costs to final cost objects such as products.
P3
Activity Cost
Pool X
Activity Cost
Pool Y
Activity Cost
Pool Z
Activity Overhead rate
Activity Overhead
rateActivity Overhead
rate
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Step Three: Determine Activity Rate
P3
Proper identification of the factor that drives
the cost
Proper measures of
activities
Proper determination of activity rates depends on:
and
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Step Three: Determine Activity Rate
For example:
Set-up cost pool activity rate = $2,000,000 / 200 batches
= $10,000 per batch
Craftsmanship cost pool activity rate = $600,000/30,000 DLH
= $20 per DLH
P3
Activity rate =
Total cost in activity pool
Measure of the activity
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Step Three: Determine Activity Rate
Activity CostPools
Overhead CostsAssigned to
Pool
Activity MeasureChosen
Number of Activities
Activity Rate
Craftsmanship $600,000 DLH 30,000 DLH $20 per DLHSet-up 2,000,000 Batches 200 batches $10,000 per batch
Designmodification
1,200,000
Number of design
modifications10 designs $120,000 per design
Plant services 1,000,000 Square feet 20,000 sq. ft. $50 per sq. ft.
Exhibit 17.11 Activity Rates for KartCo.
P3
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Step Four: Assign Overhead Costs to Cost Objects
Step 4 is to assign overhead costs in each activity cost pool to final cost objects using activity rates.
P3
Activity Overhead rate
Activity Overhead
rateActivity Overhead
rate
Product 1 Product 2 Product 3
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Step Four: Assign Overhead Costs to Cost Objects
To illustrate, the overhead costs in the craftsmanship pool are allocated to standard go-karts as follows:
Overhead allocated to standard go-kart = Activities consumed X Activity rate =
25,000 DLH x $20 / DLH = $500,000
P3
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Step Four: Assign Overhead Costs to Cost Objects
Standard go-karts Custom go-kartsActivities
ConsumedActivity
RateActivity Cost
AllocatedActivities
ConsumedActivity
RateActivity Cost
AllocatedCraftsmanship 25,000 DLH $20 per DLH $500,000 5,000 DLH $20 per DLH $100,000
Set-up 40 batches$10,000 per
batch 400,000 160 batches $10,000 per batch 1,600,000Design
modification 0 designs$120,000 per
design 0 10 designs $120,000 per design 1,200,000Plant services 12,000 sq. ft. $50 per sq. ft. 600,000 8,000 sq. ft. $50 per sq. ft 400,000
Total cost $1,500,000 $3,300,000
Exhibit 17.12 Overhead Allocated to Go-Karts for KartCo.
P3
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Step Four: Assign Overhead Costs to Cost Objects
(A)Total Overheadcost allocated
(B) Budgeted units of
production
(A/B)Overhead cost
per UnitStandard go-kart $1,500,000 5,000 units $300 per unitCustom go-kart 3,300,000 1,000 units $3,300 per unit
Exhibit 17.13 Overhead Cost per Unit for go-karts Using ABC
P3
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Comparison of Overhead Allocations by Method
C1
Comparison of Overhead Allocation by Method
Allocation method Standard CustomPlantwide overhead rate 720$ 1,200 Departmental overhead rate 700 1,300 ABC overhead rate 300 3,300
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Advantages and Disadvantages of Activity-Based Costing
A3
Advantages:
•More accurate overhead cost allocation
•More effective overhead cost control
•Focus on relevant factors
•Better management of activities
Disadvantages:
•Costs to implement and maintain
•Uncertainty with decisions still remains
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End of Chapter 17
