Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Chapter 3System Design: Activity Based Costing

PowerPoint Authors:Jon A. Booker, Ph.D., CPA, CIACharles W. Caldwell, D.B.A., CMASusan Coomer Galbreath, Ph.D., CPA

Learning Objective 1

Understand the basic approach in activity-based costing and how it differs

from conventional costing.

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When cost systems were developed in the 1800s, the emphasis was on simplicity because:

1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil.

2.   Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product.

Assigning Overhead Costs to Products

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Plantwide Overhead RatePlantwide Overhead RatePlantwide Overhead RateA single overhead rate usedA single overhead rate used

throughout an entire factory. throughout an entire factory.

Direct labor has often been used as the allocation base for overhead because:1.    Direct labor information was already being recorded.2.    Direct labor was a large component of product costs.3. Managers believed direct labor and overhead costs were highly correlated.

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Today, direct labor may no longer be a satisfactory base for allocation of overhead.

1. Most companies sell a large variety of products that consume differing amounts of overhead.

2. As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of the new overhead costs may not be correlated with direct labor.

3. Technology advancements have reduced the cost and complexity of gathering diverse sources of data.

Plantwide Overhead Rate

A plantwide overhead allocation system may not be optimalA plantwide overhead allocation system may not be optimalfor many companies in today’s business environment.for many companies in today’s business environment.

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Departmental Overhead Rates

Machining Department

Shipping Department

Assembly Department

Many companies have a system in which each department has its own overhead rate.

The allocation base depends on the nature of the work

performed in each department. In the machining department,overhead may be based on machine-hours, but in the

assembly department, overhead may be based on

labor-hours.

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Activity-base costing is required to account for these other factors.

The departmental approach reliesexclusively on volume-related allocation bases while

some overhead costs may be caused by factorsthat are not related to the volume of production.

Departmental rates will not correctly assign overhead in situations where a company has a range of

products and complex overhead costs.

Departmental Overhead Rates

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A number of allocation bases are used for assigning costs to products.

Activity-Based Costing (ABC)

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CostCost

Activity-Based Costing (ABC)

Consumption of ResourcesConsumption of Resources

ActivitiesActivities

Cost ObjectsCost Objects(e.g., products and customers)(e.g., products and customers)

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ActivityAn event that causes the consumption of overhead resources

Setting upmachines

Examples of Activities

Admitting hospitalpatients

Opening a bank account

Billingcustomers

Activity-Based Costing (ABC)

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Activity Cost Pool

A “cost bucket” in which costs related to a particular

activity are accumulated.

Activity Measure

Expresses how much of the activity is carried out and is used as the allocation base

for applying overhead costs.

Activity-Based Costing (ABC)

Activity Rate

A predetermined overhead rate for each activity

cost pool.

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Activity-Based Costing (ABC)For each activity in

isolation, this system works exactlylike the job-order costing system

described in Chapter 2.

A predetermined overhead rate is computed foreach activity and then applied to jobs andproducts based on the amount of activity

consumed by the job or product.

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Designing an Activity-BasedCosting System

The challenge is to select a reasonably small number of activities that explain the

bulk of the variation in overhead costs.

Activities are usually chosen by interviewing a Activities are usually chosen by interviewing a broad range of managers to find out what broad range of managers to find out what activities they think consume most of the activities they think consume most of the

organization’s resources.organization’s resources.

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Related activities arefrequently combined to reduce

the amount of detail andrecord-keeping costs.

An activity dictionary defines each of the activitiesthat will be included in the activity-based costingsystem and how the activities will be measured.

For example, several activities maybe involved in handling and moving

raw materials, but these may becombined into a single activity

entitled material handling.

Designing an Activity-BasedCosting System

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Hierarchy of ActivitiesLevel Activities Activity MeasureUnit-level Processing units on machines Machine-hours

Processing units by hand Direct labor-hoursConsuming factory supplies Units produced

Batch-level Processing purchase orders Purchase orders processedProcessing production orders Production orders processedSetting up equipment Number of setupsHandling materials Pounds of material handled

Product-level Testing new products Hours of testing timeAdministering parts inventories Number of part typesDesigning products Hours of design time

Facility-level General factory administration Direct labor-hoursPlant building and grounds Direct labor-hours

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Graphic Example of Activity-Based Costing

Various Manufacturing Overhead Costs

LaborLaborRelated PoolRelated Pool

MachineMachineRelated PoolRelated Pool

SetupSetupPoolPool

ProductionProductionOrder PoolOrder Pool

GeneralGeneralFactory PoolFactory Pool

PartsPartsAdmin. PoolAdmin. Pool

First-Stage Cost Assignment

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Unit-LevelActivity

Batch-LevelActivity

Facility-LevelActivity

Product-LevelActivity

Graphic Example ofActivity-Based Costing

Various Manufacturing Overhead Costs

Products

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

Second-Stage Allocations

LaborLaborRelated PoolRelated Pool

MachineMachineRelated PoolRelated Pool

SetupSetupPoolPool

ProductionProductionOrder PoolOrder Pool

GeneralGeneralFactory PoolFactory Pool

PartsPartsAdmin. PoolAdmin. Pool

First-Stage Cost Assignment

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Using Activity-Based CostingComtek Sound, Inc. Comtek Sound, Inc. makes two products: CD

players and DVD players.

The company has been losing bids to supply CD players, its main product, to lower priced competitors.

The company has been winning all bids to supply DVD players, its secondary product.

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Using Activity-Based CostingComtek 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.

HoursDVDs: 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

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Using Activity-Based CostingComtek Sound, Inc. Unit costs for materials and labor are:

DVD CDUnits Units

Direct materials 90$ 50$ Direct Labor 20$ 20$

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Total manufacturing overhead costs for the Total manufacturing overhead costs for the current year are estimated to be $10,000,000. current year are estimated to be $10,000,000. The company develops the following overhead The company develops the following overhead

rate based upon labor-hours:rate based upon labor-hours:

Predeterminedoverhead rate = $20 per DLH=

$10,000,000500,000 DLHs

Direct Labor-Hours as a Base

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DVD Unit CD UnitDirect materials 90$ 50$ Direct labor 20 20 Manufacturing overhead 40 40 (2 DLHs x $20 per DLH)

Unit product cost 150$ 110$

Direct Labor-Hours as a BaseSince each product requires two hours of

direct labor, $40 of overhead is assigned to each product.  

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Learning Objective 2

Compute activity rates for an activity-based costing

system.

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The ABC project team at Comtek hasdeveloped the following basic information.

Activity and Activity Measures

Estimated Overhead

Cost 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$

Expected Activity

Computing Activity Rates

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We can calculate the following activity rates:

Activity and Activity Measures

Estimated Overhead

Cost

Total Expected Activity

Labor related (DLHs) 800,000$ ÷ 500,000 = 1.60$ per DLHMachine related (MHs) 2,100,000 ÷ 1,000,000 = 2.10 per MHMachine setups (setups) 1,600,000 ÷ 4,000 = 400.00 per setupProduction orders (orders) 3,150,000 ÷ 1,200 = 2,625.00 per orderParts administration (part types) 350,000 ÷ 700 = 500.00 per part typeGeneral factory (MHs) 2,000,000 ÷ 1,000,000 = 2.00 per MH

10,000,000$

Activity Rate

Using the new activity rates, let’s assign overheadto the two products based upon expected activity.

Computing Activity Rates

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Learning Objective 3

Compute product costs using activity-based costing.

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Computing Overhead Cost per Unit

Activity and Activity MeasuresExpected Activity

Activity Rate

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$

Amount

DVD Units

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Computing Overhead Cost per Unit

Activity and Activity MeasuresExpected Activity

Activity Rate

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$

Amount

CD Units

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Note that the unit product cost of a CD Note that the unit product cost of a CD unit decreased from $110 to $95.55 . . . .unit decreased from $110 to $95.55 . . . .

. . . . while the unit cost of a DVD unit . . . . while the unit cost of a DVD unit increased from $150 to $207.80.increased from $150 to $207.80.

Comparing the Two Approaches

DVD Unit CD Unit DVD Unit CD UnitDirect 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$

Activity-Based Costing Direct-Labor Costing

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Learning Objective 4

Contrast the product costs computed under activity-

based costing and conventional costing

methods.

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DVD Unit CD Unit DVD Unit CD UnitDirect 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$

Activity-Based Costing Direct-Labor Costing

Comparing the Two Approaches

The ABC system assigns $14.45 The ABC system assigns $14.45 less overhead than the traditional less overhead than the traditional

system to each CD player.system to each CD player.

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DVD Unit CD Unit DVD Unit CD UnitDirect 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$

Activity-Based Costing Direct-Labor Costing

Comparing the Two Approaches

The ABC system assigns $57.80 The ABC system assigns $57.80 more overhead than the traditional more overhead than the traditional

system to each DVD player.system to each DVD player.

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DVD Unit CD Unit DVD Unit CD UnitDirect 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$

Activity-Based Costing Direct-Labor Costing

When a company implements activity-based costing, overhead cost often shifts from high-volume to low-

volume products with a higher unit product cost resulting for the low-volume products.

Low-volume productLow-volume product

Shifting of Overhead Cost

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DVD Unit CD Unit DVD Unit CD UnitDirect 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$

Activity-Based Costing Direct-Labor Costing

High-volume productHigh-volume product

Shifting of Overhead Cost

The traditional system assigns the same amount of all overhead costs to each CD or DVD player

($40 per unit).

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Shifting of Overhead Cost

DVD Units CD UnitsNumber 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

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

Production Orders Activity Cost Pool (a batch-level cost pool)

The ABC system assigns different amounts ofProduction Order-related overhead costs to each product.

This fact can be illustrated in a two-step process.

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Shifting of Overhead Cost2. Compute production order cost per unit for each product.

DVD Units CD UnitsCost 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, the costs are being shifted from the highvolume CD players to the low volume DVD players.

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Activity-Based ManagementActivity-Based ManagementFocuses on managing activities to eliminate Focuses on managing activities to eliminate

waste and reduce delays and defects.waste and reduce delays and defects.

Targeting Process Improvements

An ABC system can help identifyareas where the company can benefitfrom improving its current processes.

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The first step in any improvementThe first step in any improvementprogram is deciding what to improve.program is deciding what to improve.

Targeting Process Improvements

TheThe Theory of Constraints Theory of Constraintsapproach targets theapproach targets the

highest impacthighest impactimprovement opportunities.improvement opportunities.

Activity ratesActivity rates can be can beused to target areasused to target areaswhere costs seemwhere costs seemexcessively high.excessively high.

Benchmarking Benchmarking can be used to compare activity cost can be used to compare activity cost information with world-class standards of performance information with world-class standards of performance

achieved by other organizations.achieved by other organizations.

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Benefits of Activity-Based Costing

ABC improves the accuracy of product costing by:• Increasing the number of cost pools used to accumulate

overhead costs.• Using activity cost pools that are more homogeneous than

departmental cost pools.• Assigning overhead costs using activity measures that

cause those costs, rather than relying solely on direct labor hours.

Activity-based costing also highlights activities that could benefit most from process

improvement efforts, such as Six Sigma.

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Costs of implementing an ABC system may outweighthe 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.

Limitations of Activity-Based Costing

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The cost in each activity pool is The cost in each activity pool is strictly strictly proportional to its activity measureproportional to its activity measure. When this . When this assumption is violated, the accuracy of ABC assumption is violated, the accuracy of ABC

data can be called into question. data can be called into question.

Activity-Based CostingCritical Assumption

For example, managers should be particularly For example, managers should be particularly alert to product costs that contain alert to product costs that contain allocated allocated

facility-level costsfacility-level costs..

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Modifying the ABC Model The illustrations in the chapter assume that ABC is being used for external reporting purposes. If the system is used for internal decision-making purposes, two important modifications should be made: 1. Selling and administrative costs should be assigned to products, where appropriate. 2. Facility-level costs should be removed from product costs.

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Learning Objective 5

Record the flow of costs in an activity-based costing

system.

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Sarvik Company uses activity-based costing. Sarvik Company uses activity-based costing. The company has five cost pools shown below.The company has five cost pools shown below.

Activity Cost Pool Activity Measure

Estimated Overhead

CostMachine related Machine hours 175,000$ 5,000 MHsPurchase orders Number of orders 63,000 700 ordersMachine setups Number of setups 92,000 460 setupsProduct testing Number of tests 160,000 200 testsGeneral factory Direct labor hours 300,000 25,000 DLHs

790,000$

Expected Activity

Cost Flows in an ABC System

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Activity rates are determined as follows:

Activity Cost Pool

Estimated Overhead

Cost

Total Expected Activity

Machine related 175,000$ ÷ 5,000 MHs = 35$ per MHPurchase orders 63,000 ÷ 700 orders = 90$ per orderMachine setups 92,000 ÷ 460 setups = 200$ per setupProduct testing 160,000 ÷ 200 tests = 800$ per testGeneral factory 300,000 ÷ 25,000 DLH = 12$ per DLH

790,000$

Activity Rate

Cost Flows in an ABC System

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Overhead is applied on the basis of actual activities during the year.

Activity Cost PoolActivity

RateActual Activity

Applied Overhead

CostMachine related $35/MH × 4,600 MHs = 161,000$ Purchase orders $90/order × 800 orders = 72,000 Machine setups $200/setup × 500 setups = 100,000 Product testing $800/test × 190 tests = 152,000 General factory $12/DLH × 23,000 DLHs = 276,000 Total Overhead Applied 761,000$

Cost Flows in an ABC System

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Selected transactions recorded by the company:a. Raw materials purchased on account, $915,000.b. Raw materials used in production, $900,000 ($810,000

direct and $90,000 indirect).c. Factory labor costs, $370,000 ($95,000 direct and

$275,000 indirect).d. Depreciation of factory assets, $180,000.e. Miscellaneous manufacturing overhead costs

incurred on account, $230,000.f. Manufacturing overhead applied, $761,000.g. Goods costing $1,650,000 were manufactured.

Cost Flows in an ABC System

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The following journal entries would be usedto record transactions (a) and (b).

Cost Flows in an ABC System

Description Debit Credita. Raw Materials 915,000

Accounts Payable 915,000 b. Work in Process 810,000

Manufacturing Overhead 90,000 Raw Materials 900,000

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The following journal entries would be usedto record transactions (c) and (d).

Cost Flows in an ABC System

Description Debit Creditc. Work in Process 95,000

Manufacturing Overhead 275,000 Salaries and Wages Payable 370,000

d. Manufacturing Overhead 180,000 Accumulated Depreciation 180,000

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Description Debit Credite. Manufacturing Overhead 230,000

Cash/Accounts Payable 230,000

The following journal entry would be used to record transaction (e).

Cost Flows in an ABC System

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Description Debit Creditf. Work in Process 761,000

Manufacturing Overhead 761,000

The following journal entry would be used to record transaction (f).

Cost Flows in an ABC System

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Description Debit Creditg. Finished Goods 1,650,000

Work in Process 1,650,000

The following journal entry would be used to record transaction (g).

Cost Flows in an ABC System

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Bal. 14,000

Manufacturing Overhead(b) 90,000(c) 275,000(d) 180,000(e) 230,000

(g) 761,000

Underapplied Underapplied Overhead CostsOverhead Costs

Cost Flows in an ABC System

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Cost Flows in an ABC SystemThe flow of costs

through Raw Materials, Work in Process, and other accounts is the same under activity

based costing.The only difference in

activity based costing is that more than one

predetermined overhead rate is used to apply costs to products.

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End of Chapter 3

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