CHAPTER 2: JOB ORDER COSTING prices, and shipment date for the order, a

production order is issued.

Companies usually assign costs to their
products and services for two main Materials Requisition Form
reasons:
 The Production Department then prepares a
1. It helps them fulfill their planning, materials requisition form
controlling, and decision-making  document that specifies the type and
responsibilities. quantity of materials to be drawn from the
2. It helps them determine the value of ending storeroom and identifies the job that will be
inventories and cost of goods sold for charged for the cost of the materials.
external reporting purposes.  used to control the flow of materials into
production and also for making journal
Products unsold = recorded as ending entries in the accounting records
inventories (balance sheet)
Products sold = recorded as COGS (Income Job Cost Sheet
Statement)
 After a production order has been issued,
the Accounting Department’s job-order
 Most countries (including US) require some
costing software system automatically
form of absorption costing for external
generates a job cost sheet
financial reports, many companies use some
 records the materials, labor, and
form of absorption costing for product
manufacturing overhead costs charged to
costing purposes.
that job
 After direct materials are issued, the cost of
Absorption costing - all manufacturing costs,
both fixed and variable, are assigned to units of these materials are automatically recorded
product—units are said to fully absorb on the job cost sheet
manufacturing costs. Conversely, all
nonmanufacturing costs are treated as period Measuring Direct Labor Cost
costs and they are not assigned to units of
 Direct labor consists of labor charges that
product.
are easily traced to a particular job.
Job-order costing  Labor charges that cannot be easily traced
to specific jobs are treated as part of
 used in situations where many different manufacturing overhead.
products, each w/ individual and unique  labor cost is called indirect labor and
features, are produced each period. includes tasks such as maintenance,
 Costs are traced and allocated to jobs and
supervision, and cleanup.
then the cost of the jobs are divided by the
number of units in the job to arrive at an Time Tickets
average cost per unit.
 This average cost per unit also means  Most companies rely on computerized
unit product cost systems to maintain employee time tickets
 The example of a Levi Strauss clothing  an hour-by-hour summary of the employee’s
company, where each type of jeans is
activities throughout the day
considered a "job." The costs for a specific
order, like 1,000 pairs of jeans, are tracked  One computerized approach to creating time
and then divided by the number of units to tickets uses bar codes to capture data. Each
get the average cost per unit. employee and each job has a unique bar
 Also used extensively in service industries code.
(hospitals, law firms, movie studios,  When beginning work on a job, the
accounting firms, advertising agencies ,etc);
employee scans three bar codes using a
use variation of job order costing to
accumulate costs. handheld device much like the bar code
readers at grocery store checkout stands.
Measuring of Direct Material Cost  First bar code - indicates that a task is
being started
Bill of Materials
 Second bar code - unique bar code on
 document that lists the quantity of each
the employee’s identity badge
type of direct material needed to complete a
 Third bar code - unique bar code of the
unit of product.
job itself.
 When an agreement has been reached with
the customer concerning the quantities,
 This system automatically tracks labor costs  most widely used allocation bases in
by using an electronic network to record manufacturing are direct labor hours, direct
data and a computer to note the time a task labor cost, machine-hours, and (where a
starts. After an employee completes a job
company has only a single product) units of
and scans three barcodes, the system
automatically prepares a time ticket and product
posts the labor costs directly to the job cost NOTE: Manufacturing overhead is commonly
sheets.
assigned to products using a predetermined
Computing Predetermined Overhead Rates overhead rate.

 In absorption costing, product costs POR= Estimated Total MOH Cost_______

include manufacturing overhead as well as Estimated Total Amount of the Allocation
Base
direct materials and direct labor.
 Manufacturing overhead also needs to be
The predetermined overhead rate is
recorded on the job cost sheet.
computed before the period begins using a
Assigning manufacturing overhead to a four-step process:
specific job is complicated by three  1st step - estimate the total amount of the
circumstances: allocation base (the denominator) that will
be required for next period’s estimated level
1. Manufacturing overhead is an indirect cost. of production
This means that it is either impossible or  2nd step - estimate the total fixed
difficult to trace these costs to a particular manufacturing overhead cost for the coming
product or job. period and the variable manufacturing
2. Manufacturing overhead consists of many overhead cost per unit of the allocation base
different types of costs ranging from the  3rd step - use the cost formula shown below
grease used in machines to the annual to estimate the total manufacturing
salary of the production manager. Some of overhead cost (the numerator) for the
these costs are: coming period:
 Variable Overhead Costs because they Y = a + bX
vary in direct proportion to changes in the Y = The estimated total manufacturing
level of production (e.g., indirect materials, overhead cost
supplies, and power) a = The estimated total fixed manufacturing
 Fixed Overhead Costs because they overhead cost
remain constant as the level of production b = The estimated variable manufacturing
fluctuates (e.g., heat and light, property overhead cost per unit of the
taxes, and insurance). allocation base
3. Many companies have a significant amount X = The estimated total amount of the
of fixed manufacturing overhead, which allocation base
causes their total overhead costs to be
relatively stable from period to period.  4th step - compute the predetermined
Because total costs don't change much but overhead rate.
the number of units produced can fluctuate,
the average overhead cost per unit will NOTE: The estimated amount of the allocation
vary inversely with production volume; as base is determined before estimating the total
production increases, the average cost per manufacturing overhead cost. This needs to be
unit decreases, and vice versa. done because total manufacturing overhead
cost includes variable overhead costs that
Allocation depend on the amount of the allocation base.
 used to assign overhead costs to products Applying Manufacturing Overhead
 accomplished by selecting an allocation
base that is common to all of the company’s  Predetermined overhead rate is computed
products and services. before the period begins.
 The POR is then used to apply overhead cost
Allocation Base to jobs throughout the period.
 Overhead Application - process of
 measure such as direct labor hours (DLH) or
assigning overhead cost to jobs
machine-hours (MH) that is used to assign
overhead costs to products and services.
The formula for determining the amount of  This approach smooths out seasonal cost
overhead cost to apply to a particular job is: variations, ensuring that all identical
products have the same overhead cost,
Overhead applied to allocation= making your costing system more
Predetermined Overhead x allocation base predictable and useful for management.
incurred by the job
Completing the Job Cost Sheet
When the allocation base is direct labor-hours,
the formula becomes: 1. Calculate Total Job Cost
Overhead applied to a particular = PRO x  The totals for DM, DL, MOH are moved to
Actual direct labor - hours worked on the job the Cost Summary section and added
together.
NOTE:
2. Calculate Unit Product Cost
 Amount of overhead applied to a particular
 This total cost is divided by the number of
job is not the actual amount of overhead units produced.
caused by the job
 Actual overhead costs are not assigned to  It's crucial to remember that the calculated
jobs—if that could be done, the costs would unit product cost of $1,195 (for example) is
be direct costs, not overhead. an average cost.
 The overhead assigned to the job is simply a  It should not be mistaken for the
incremental or marginal cost of producing
share of the total overhead that was
one more unit.
estimated at the beginning of the year Explanation:
 This approach to overhead application is
known as normal costing.  The incremental cost of an additional unit is
less than the average cost of $1,195
Normal Cost System because some overhead costs are fixed.
These fixed costs, like factory rent or a
 applies overhead costs to jobs by manager's salary, don't increase when you
multiplying a predetermined overhead rate make one more unit.
by the actual amount of the allocation base  Since the average cost of $1,195 includes
incurred by the jobs. these unchanging fixed costs, the actual
cost to produce just one more unit is lower
Issues with Using an Actual Overhead Rate because you're only adding the variable
costs, such as the direct materials and direct
1. Seasonal Fluctuations: Overhead costs labor needed for that single unit.
like heating and cooling a factory are not
consistent throughout the year. If you base Job-Order Costing—A Managerial
your rate on actual monthly costs, the rate Perspective
would be high in the winter and low in the
spring. 1. Managers use job cost information to
establish plans and make decisions
2. Inconsistent Product Costs: This
fluctuation means that two identical a) Developing Plans and Making Decisions
products, one made in January and one
 Managers use reports on a job's profitability
made in April, would be assigned different to create future sales and production plans.
overhead costs. This makes pricing and cost This data helps them decide which types of
control difficult for managers. jobs to pursue and which ones to avoid.

3. Lack of Timeliness: You can only calculate b) Targeting Profitable Jobs

an actual rate at the end of a period when
all costs are known. This delays getting the  If a specific kind of job, like a low-volume
final cost of a job, which is necessary for engineering project, is shown to be highly
timely decisions. profitable, managers may increase
advertising and sales efforts to attract more
of these jobs.

c) Reducing Unprofitable Jobs

Why a Predetermined Rate is Better?  If a certain type of job, such as a high-

volume, labor-intensive one, is shown to be
 Calculated once at the beginning of the year unprofitable, managers might take steps to
using estimated annual data.
 reduce the number of these jobs they take 1. The Problem with Overhead Costs
on in the future.
 Unlike direct costs (like materials and labor)
2. Managers may also use job cost information which are easily traced to a specific job,
to make pricing decisions.
overhead costs cannot be directly tracked to
How Cost-Plus Pricing Works a job. This makes their assignment to jobs
less precise.
1. Calculate Total Manufacturing Cost:
First, managers determine the total cost to 2. The Root Cause of Inaccuracy
produce a job (e.g., $100 for Job A).
 The main reason for this inaccuracy is the
2. Apply Markup: They then add a incorrect choice of an allocation base—the
predetermined markup percentage to factor used to distribute the overhead costs
this cost. For example, a 50% markup on a
among different jobs. If the chosen base
$100 cost adds $50. This markup is
designed to cover non-manufacturing costs (e.g., direct labor-hours) doesn't accurately
and to generate profit. reflect how a job uses overhead resources,
the assigned costs will be wrong.
3. Determine Selling Price: The final selling
price is the total manufacturing cost plus the To improve job cost accuracy:
markup. In the example, the selling price for
Job A would be $150 ($100 + $50).  allocation base in the predetermined
NOTE: overhead rate should drive the overhead
cost
 This approach, known as cost-plus
pricing, the managers establish a markup Cost Driver
percentage that they believe will generate
enough revenue to cover all of a job’s  is a factor, such as machine-hours, beds
manufacturing costs and a portion of the occupied, computer time, or flight-hours,
company’s nonmanufacturing costs, while that causes overhead costs.
generating some residual profit.  If the base in the predetermined overhead
rate does not “drive” overhead costs, it will
Negative Consequences of Inaccurate not accurately measure the cost of overhead
Costing resources used by each job.
 Many companies use job order costing
Misguided Strategic Decisions:
systems that assume direct labor-hours (or
direct labor cost) is the only manufacturing
 Managers may mistakenly allocate more
overhead cost driver.
advertising to jobs they think are profitable,
 They use a single predetermined overhead
when they are actually losing money.
rate, or what is called a plantwide
 This misdirection of resources hurts the
overhead rate, to allocate all
company's overall financial health.
manufacturing overhead costs to jobs based
Poor Pricing: on their usage of direct-labor hours.
 When companies can identify more than one
 Distorted job cost data can cause managers overhead cost driver they can improve job
to set selling prices that are either too high, cost accuracy by using multiple
leading to a loss of customers to predetermined overhead rates
competitors with more accurate pricing, or Job-Order Costing Using Multiple
too low, resulting in financial losses on each Predetermined Overhead Rates
sale.
 A cost system with multiple
How can a job-order costing system predetermined overhead rates uses
inaccurately assign costs to jobs?? more than one overhead rate to apply
overhead costs to jobs, often one for each
 A job-order costing system can become department.
 This method, while more complex, is more
inaccurate when it fails to properly allocate
accurate because it accounts for how
indirect manufacturing costs, also known different departments use resources.
as manufacturing overhead.  For example, a department that relies
heavily on labor would use a rate based on
 direct labor-hours, while a department ledger. This means they provide the detailed
that is machine-intensive would use a rate breakdown of the total amounts listed on the
based on machine-hours. main financial statements.

Multiple POR – Activity Based Approach For example, they explain exactly which jobs
make up the total dollar amounts reported in:
 Activity-based costing is a method that
creates overhead rates based on the specific  Work-in-Process Inventory: The cost of
activities performed within departments, all jobs that are currently unfinished.
rather than just the departments
themselves.  Finished Goods Inventory: The cost of all
 This often results in more overhead rates jobs that have been completed but not yet
than a departmental approach because each sold.
department can have multiple activities.
 The main goal of ABC is to more accurately
measure how jobs, products, and customers  Cost of Goods Sold: The cost of all jobs
use a company's overhead resources. that have been sold to customers.

Overhead Application and the Income In short, while a company's balance sheet or
Statement income statement shows a single total for these
accounts, the job cost sheets provide the
detailed, underlying records for each and every
When a company uses predetermined overhead job.
rates, the amount of overhead applied to jobs
will almost always be different from the actual
amount spent. This difference is called either Job-Order Costing : Cost Flows and
underapplied or overapplied overhead, and External Reporting
it requires an adjustment to the company's
financial statements. Raw Materials

 RM purchases are recorded in the raw

 Underapplied Overhead - happens when
materials inventory account.
a company applies less overhead to its jobs
than it actually spent  Include any materials that go into the final
 Overapplied Overhead - occurs when a product
company applies more overhead to its jobs  When RM are used in production as direct
than was actually incurred. materials, their cost are transferred to
Work in Process inventory.
Financial Statement Implications  is an asset account; when RM are purchased
they are initially recorded as an asset – not
This difference must be adjusted on the income as an expense
statement.
Work in Process
 Underapplied overhead increases the  Units of product that are only partially
cost of goods sold, which in turn complete and will require further work
decreases the company's net operating before they are ready for sale to the
income. This makes sense, because the
customers
company under-estimated its costs, so the
final costs are actually higher.  To transform DM to completed jobs, direct
labor cost is added to WIP and
 Overapplied overhead decreases the cost manufacturing overhead cost is applied to
of goods sold, which increases the WIP by multiplying predetermined overhead
company's net operating income. This rate by the actual quantity of the allocation
reflects the fact that the company over- base consumer by each job.
estimated its costs.  Jobs completed, their cost are transferred
from WIP to finished goods inventory.
Job Cost Sheets: A Subsidiary Ledger
Finished Goods
 A job cost sheet is a document that keeps
 Completed units of product that have not
track of the total direct materials, direct
labor, and manufacturing overhead costs for yet been sold to customers
a specific job.  Amount transferred from WIP to Finished
Goods is referred to as the Cost of Goods
When you look at all of a company's job cost Manufactured.
sheets together, they act as a subsidiary
Cost of Goods Manufactured
 Includes any manufacturing cost associated The Concept of a Clearing Account
w/ units of product that were finished during  MOH account operates as a clearing account
the period.
Actual MOH Costs (Debits)
 Whenever actual overhead expenses
Cost of Goods Sold
happen (like electricity, factory supplies), we
 As jobs, are sold their cost are transferred
debit the Manufacturing Overhead account.
from Finished Goods to COGS.
 Example entry:
 Various costs attached to each job are
Dr. Manufacturing Overhead
recorded as an expense on the income Cr. Utilities Payable
statement; these costs are inventory Applied MOH Costs (Credits)
accounts on the balance sheet  When jobs are completed (or at the end of
an accounting period), overhead cost is
applied to the jobs using the predetermined
Period Cost (Selling and Administrative overhead rate—Work in Process is debited
Expenses) and Manufacturing Overhead is credited.
 Do not flow through inventories on the  Dr. Work in Process
balance sheet Cr. Manufacturing Overhead
 Recorded as expense on income  So during the year, actual costs pile up as
statement in the period incuured debits and applied costs are credited

Issue of Direct and Indirect Materials Predetermined Overhead Rate (POHR)

 Materials charged to WIP represent Direct  Since companies can’t wait until the year
Materials for specific jobs; these costs are ends to know the exact overhead, they
also recorded on the appropriate job cost estimate it before the year begins.
sheet  Activity base = what drives overhead costs
 Manufacturing Overhead entry (machine hours, labor hours, etc.).
represents Indirect Materials
 Debit side of MOH account is always used to Why Actual ≠ Applied Overhead
record the actual MOH cost, such as indirect  Applied overhead is based on estimates
materials, that are incurred during the (POHR × actual activity).
period.  Actual overhead = real costs incurred.
 Credit side of MOH account is always used to  Since estimates are rarely perfect,
record MOH applied to WIP. differences arise:
 Overapplied Overhead → Applied >
Labor Cost Actual
 Only direct labor cost is added WIP account  Underapplied Overhead → Applied <
 At the same time, that DL costs are added to Actual
WIP, they are also added to the individual  At the end of the year, this difference must
job cost sheets. be adjusted (closed to Cost of Goods Sold
 MOH represents the indirect labor cost of or prorated).
the period, such as janitorial work,
supervision, and maintenance Where does Actual Overhead go?
 Actual overhead costs (factory rent,
Manufacturing Overhead Cost
utilities, depreciation, etc.)
 All manufacturing costs other than DM and
→ Debited to the Manufacturing
DL
Overhead account.
 Indirect Materials and indirect labor
 They never go directly to:
 These costs are entered directly into the
o Job Cost Sheets
MOH account as they are incurred
o Work in Process (WIP)
 All actual MOH costs are debited to the MOH
account as they are incurred
Why? Because you can’t trace actual
overhead to a specific job. You don’t know
Applying Manufacturing Overhead exactly how much electricity Job A or Job B
 actual manufacturing costs are charged to used.
the manufacturing overhead account rather
than WIP. Where does Applied Overhead go?
 Overhead is applied to jobs using the Formula for COGM
predetermined overhead rate (POHR).  Total Manufacturing Costs + Beginning WIP
 This applied amount is what: – Ending WIP = COGM
 Appears on the Job Cost Sheet (so  Direct Materials Used+Direct Labor+Applie
each job has a share of overhead). d MOH+Beginning WIP−Ending WIP=
 Goes into Work in Process (WIP) as COGM
part of the job’s total manufacturing
Cost of Goods Sold (COGS)
cost.
 As completed jobs are shipped to customers,
 Applied = WIP + Job Cost Sheets.
 Actual costs are the “real bills” from their accumulated costs are transferred
suppliers. Applied costs are the “estimated from Finished Goods to COGS
charges” you assign to each job.  If an entire job is shipped at one time, then
the entire cost appearing on the job cost
How are MOH costs assigned to WIP? sheet is transferred to COGS
 they are assigned by using the
predetermined overhead rate  COGS = the cost of goods that were
actually sold to customers during the
Nonmanufacturing Costs period.
 companies also incur selling and
administrative costs  It’s the final step in the product cost flow:
 These costs should be treated as period 👉 Raw Materials → WIP → Finished
Goods → COGS
expenses and charged directly to the
income statement
Flow of Costs
 should not go into the MOH account  When jobs are completed → costs move WIP
 Only manufacturing costs become → Finished Goods (COGM).
product costs(inventoried).  When jobs are sold → costs move Finished
 Nonmanufacturing = period expense → Goods → COGS.
Income Statement right away.
Journal Entry (when goods are sold):
Dr. Cost of Goods Sold
Cost of Good Manufactured Cr. Finished Goods
 COGM = Total cost of jobs completed during Two Cases
the period 1. Entire Job Sold at Once
 If the whole job is shipped, the entire
 When a job has been completed, the
cost on the Job Cost Sheet is transferred
finished output is transferred from the to COGS.
production departments to the finished 2. Only Part of Job Sold
goods warehouse.  Sometimes, not all units are sold right
 the accounting department will have away.
charged the job with direct materials and  In this case, we use the unit product
direct labor cost, and MOH will have been cost:
applied using the predetermined overhead
Unit Product Cost= Number of Units in Job
rate. Total Job Cost
 transfer of costs is made within the costing  Then, multiply by the number of units
system that parallels the physical transfer of sold to get the cost that moves to COGS.
goods to the finished goods warehouse
 costs of the completed job are Schedules of COGM
transferred out of the WIP account and into  contains three elements of product costs
the Finished Goods account —DM, DL, MOH
 sum of all amounts transferred between  Purpose: To show the total cost of
goods completed and transferred from
these two accounts represents the cost of
WIP → Finished Goods.
goods manufactured for the period.
FORMULAS:
 WIP → FG = COGM
 If it’s finished this period, it’s part of COGM. Raw Materials used in
= Beg RM Inventory + Purchases of RM –
Journal Entry (When Jobs Are Completed) Ending RM Inventory
Dr. Finished Goods
Cr. Work in Process Total Manufacturing Cost
= DM + DL + MOH applied to WIP
 o Credit balance = Overapplied
Overhead (Applied > Actual).
Cost of Goods Manufactured
= Total Manufacturing cost + Beg. WIP – End Activity–Based Costing: A Tool to Aid
WIP Decision Making
Unadjusted COGS Activity-Based Costing (ABC)
=Beg FG Inventory + COGM - End. FG
Inventory - costing method that is designed to provide
managers with cost information for strategic
Schedules of COGS and other decisions that potentially affect
 contains three elements of product costs—
capacity and therefore includes “fixed” as
DM, DL, MOH
well as variable costs.
 summarizes the portions of those costs that
- + used as a supplement rather than as a
remain in
replacement for a company’s usual costing
 Purpose: To show the cost of ending
system.
finished goods inventory that were actually
sold (FG → COGS).
2 activity costing systems are used
Underapplied vs. Overapplied Overhead a) The official costing system that is used for
 Overhead is applied to jobs using a preparing external financial reports
Predetermined Overhead Rate b) Internal decision-making and for managing
(POHR). activities.
 Since POHR is based on estimates,
Activity–Based Costing: An Overview
Applied Overhead ≠ Actual Overhead.
 The difference is called Underapplied or 1. Traditional Absorption Costing
Overapplied Overhead. - Designed to be used for external financial
 Underapplied Overhead → Applied < reports
Actual (we applied too little).
 Overapplied Overhead → Applied >
Actual (we applied too much) 2. Activity Based Costing
- Used for internal decision making
Formula
 Difference= Applied OH − Actual OH
End of Year Adjustment (Closing of COGS)  Negative = Underapplied
 Positive = Overapplied
 The balance in the Manufacturing
Overhead account must be cleared.
Consequences:
If Underapplied (Applied < Actual):
Dr. Cost of Goods Sold 1. Non-manufacturing as well as manufacturing
Cr. Manufacturing Overhead costs may be assigned to products, but only
(COGS increases → lower profit). on a cause-and-effect basis.

If Overapplied (Applied > Actual): 2. Some manufacturing costs may be excluded

Dr. Manufacturing Overhead from product costs.
Cr. Cost of Goods Sold
(COGS decreases → higher profit)
3. Numerous overhead cost pools are used,
each of which is allocated to products and
Disposition of Underapplied or
Overapplied Overhead other cost objects using its own unique
measure of activity.
1. T-Account Method
Non-Manufacturing Cost and Activity-
Based Costing
 Manufacturing Overhead Account:
o Debits = Actual Overhead (costs Traditional Absorption Costing
incurred).
o Credits = Applied Overhead (costs  Manufacturing costs are assigned to
charged to jobs). products
 At the end of the period, the balance shows:  Non-manufacturing costs are not assigned
o Debit balance = Underapplied to products.
Overhead (Applied < Actual).
 - Purposely do not assign the two types of
manufacturing overhead costs to products
Activity-based costing
- Organization-sustaining cost: period
 recognize that many nonmanufacturing expense
costs relate to selling, distributing, and - Products are charged only to the cost of
servicing specific products. capacity they use
- Which pprovides more stable unit product
2 TYPES OF NON-MANUFACTURING COST costs and is consistent with the goal of
THAT ABC SYSTEM ASSIGNED TO - assigning to products only the costs of the
PRODUCTS resources that they use.
1. Direct Non- Manufacturing Cost traced to Cost Pools, Allocation Bases, and Activity-
product Based Costing
2. Indirect Manufacturing Cost that are caused
by the products Activity Based Costing

*Expanded the definition of overhead to include - make more complex cost systems feasible,
all indirect cost- manufacturing and non- provides an alternative to the traditional
manufacturing plantwide and departmental approaches to
defining cost pools and selecting allocation
Manufacturing Cost and Activity Based bases
Costing - uses more cost pools and unique measures
of activity to better understand the costs of
Traditional Absorption Costing System
managing and sustaining product diversity
- All manufacturing costs are assigned to
Activity
products which includes:
- event that causes the consumption of
a. Organization-sustaining costs overhead resources
- include costs such as the factory security
guard’s wages, the plant controller’s salary, Activity Cost Pool
and the cost of supplies used by the plant
- a “bucket” in which costs are accumulated
manager’s secretary
that relate to a single activity measure in
- assigned even though they are totally
the ABC system
unaffected by which products are made
during a period. Activity Measure/ Cost Driver

- allocation base in an activity-based costing

b. Unused capacity
system
- is assigned to products
- two common types
- budgeted level of activity declines, the
a. Transaction Driver
overhead rate and unit product costs rise
o simple counts of the number of times an
thereby ensuring that the shrinking volume
of output absorbs the increasing cost of idle activity occurs, such as the number of
capacity. bills sent out to customers
b. Duration Drivers
Activity Based Costing System o measure the amount of time required to
perform an activity, such as the time
spent preparing individual bills for
customers.
o more accurate measures of resource
consumption than transaction drivers,
but they take more effort to record
o often used in practice

5 LEVELS OF ACTIVITY UNITS

- these do not relate to volumes of unit

produced

1. Unit-level activities
- are performed each time a unit is produced 1. Top managers must strongly support the
- costs of unit level activities should be ABC implementation because their
proportional to the number of units leadership is instrumental in properly
produced. motivating all employees to embrace the
- For example, providing power to run need to change.
processing equipment would be a unit-level 2. Top managers should ensure that ABC data
activity because power tends to be is linked to how people are evaluated and
consumed in proportion to the number of rewarded. If employees continue to be
units produced. evaluated and rewarded using traditional
(non-ABC) cost data, they will quickly get
the message that ABC is not important and
2. Batch-level activities
they will abandon it.
- are performed each time a batch is handled 3. A cross-functional team should be created to
or processed, regardless of how many units design and implement the ABC system.
are in the batch. - include representatives from each area that
- For example, tasks such as placing purchase will use ABC data, such as the marketing,
orders, setting up equipment, and arranging production, engineering, and accounting
for shipments to customers are batch-level departments.
activities. - possess intimate knowledge of many parts
- They are incurred once for each batch (or of an organization’s operations that is
customer order). necessary for designing an effective ABC
- Costs at the batch level depend on the system.
number of batches processed rather than on - Furthermore, tapping the knowledge of
the number of units produced, the number cross-functional managers lessens their
of units sold, or other measures of volume. resistance to ABC because they feel
- For example, the cost of setting up a included in the implementation process
machine for batch processing is the same
Steps for Implementing Activity-Based
regardless of whether the batch contains
Costing:
one or thousands of items.
3. Product-level activities 1. Define activities, activity cost pools,
- relate to specific products and typically must and activity measures.
be carried out regardless of how many - step can be difficult and time consuming
batches are run or units of product are
common procedure: interview people who
produced or sold.
work in overhead dept and ask them to describe
- For example, activities such as designing a
their major activities
product, advertising a product, and
maintaining a product manager and staff are - often result to a long list which possess a
all product-level activities. problem
4. Customer-level activities - but, the greater number of activities the
- relate to specific customers and include more accurate the costs are likely to be- also
activities such as sales calls, catalog it is costly to design, implement, maintain,
mailings, and general technical support that and use
are not tied to any specific product. - solution combine similar activities
5. Organization-sustaining activities
- are carried out regardless of which Customer Orders
customers are served, which products are
- cost pool will be assigned all costs of
produced, how many batches are run, or
resources that are consumed by taking and
how many units are made.
processing customer orders, including costs
- This category includes activities such as
of processing paperwork and any costs
heating the factory, cleaning executive
involved in setting up machines for specific
offices, providing a computer network,
orders
arranging for loans, preparing annual
- Activity measure - the number of
reports to shareholders, and so on.
customer orders received.
Designing an Activity Based Costing - Batch-level activity - each order
System generates work that occurs regardless of
whether the order is for one unit or 1,000
units
Product Design Activity Rate = Total Cost
Total Activity
- cost pool will be assigned all costs of
resources consumed by designing products.
- Activity measure - number of product 4. Assign overhead costs to cost objects.
designs.
Second-stage allocation, activity rates are
- Product-level activity because the
used to apply overhead costs to products and
amount of design work on a new product
customers.
does not depend on the number of units
ultimately ordered or batches ultimately run. ABC Cost = Total Activity x Activity
Rate
Order Size *Separate the Standard and customs
- cost pool will be assigned all costs of 5. Prepare management report
resources consumed as a consequence of
the number of units produced, including the - The most common management reports
costs of miscellaneous factory supplies, prepared with ABC data are product and
power to run machines, and some customer profitability reports.
equipment depreciation. - These reports help companies channel their
- Unit-level activity because each unit resources to their most profitable growth
requires some of these resources. opportunities while at the same time
- Activity measure for this cost pool is highlighting products and customers that
machine-hours. drain profits.

Customer Relations Comparison of Traditional and ABC Product

- cost pool will be assigned all costs Costs
associated with maintaining relations with
customers, including the costs of sales calls The ABC system provides a stark contrast to
and the costs of entertaining customers. margins calculated under the traditional costing
- Activity measure - number of customers system.
the company has on its active customer list.
- represents a customer-level activity.  Traditional Product Profitability: The
traditional costing method, which uses a
Other cost volume-based allocation base (like machine-
hours), typically shows high-volume
- pool will be assigned all overhead costs that
products as more profitable.
are not associated with customer orders,
product design, the size of the orders, or  For Classic Brass, the traditional system
customer relations yielded a product margin of $615,750 for
- costs mainly consist of organization- Standard Stanchions and $258,000 for
sustaining costs and the costs of unused, Custom Compass Housings.
idle capacity
- costs will not be assigned to products  ABC Product Profitability: In contrast, the
because they represent resources that are ABC system assigns costs more accurately,
not consumed by products. often revealing that low-volume, complex
products consume disproportionately more
The Mechanics of Activity-Based Costing resources (e.g., through more setups and
product design) and are thus less profitable
2. Assign overhead costs to activity cost
than traditionally reported.
pools.
 Total Reconciliation: Regardless of the
First-stage allocation
costing system used (traditional or ABC), the
- process of assigning functionally organized company's total sales, total costs, and
overhead costs derived from a company’s resulting Net Operating Loss ($1,250 in the
general ledger to the activity cost pools Classic Brass example) remain the same.
- based on the result of interviews
Why Product Margins Differ:
- just simply multiply the % to distribute the
cost into cost pools The differences between the two costing
systems arise for three main reasons:
3. Calculate activity rates.
1. Non-Volume-Related Overhead: The measures, such as direct labor-hours,
traditional system assigns batch-level and number of setups, and number of product
product-level costs using volume-related inspections.
allocation bases, causing it to overcost high-
ABC and External Reporting / Limitations
volume products (like Standard Stanchions)
and undercost low-volume products (like ABC systems are typically used only for internal
Custom Compass Housings). reports due to practical and regulatory issues.
2. Nonmanufacturing Costs: The ABC Reasons ABC is Infrequently Used for External
system assigns the nonmanufacturing Reports (Page 334)
overhead costs (like sales commissions or
shipping) that are caused by products 1. Lack of Detail: External reports are less
directly to those products on a cause-and- detailed, and errors from over- and
effect basis. The traditional system undercosting individual products often offset
disregards these costs because they are each other when costs are aggregated into
treated as period expenses. Cost of Goods Sold and Inventory18181818.

3. Organization-Sustaining Costs: The 2. System Difficulty: It is extremely difficult

traditional system includes all to modify the complex, in-house computer-
manufacturing overhead costs in product based accounting systems often used in
costs, even organization-sustaining costs8. large companies.
The ABC system excludes organization-
3. Non-Conformity to GAAP: The ABC
sustaining costs (and unused capacity costs)
system described does not conform to
from product costs because they are not
Generally Accepted Accounting Principles
caused by the products.
(GAAP). GAAP requires product costs to
Using ABC Data for Management Decisions include all manufacturing costs and only
(Management Focus) manufacturing costs, whereas ABC excludes
some manufacturing costs and includes
ABC data helps management make strategic some nonmanufacturing costs.
decisions, but caution is necessary:
4. Auditor Discomfort: Auditors are often
 Decision Caution: Managers should only uncomfortable with the subjective
consider costs that are truly affected by a allocations based on employee interviews,
decision (e.g., to drop a product or as the data could be easily manipulated by
customer). management.
If an ABC system assigns unavoidable fixed Limitations of Activity-Based
costs to a cost object, those costs should be Costing
ignored in the decision-making process.
Costly Maintenance: ABC is a major project that
 Benchmarking (Activity Management): requires substantial resources to implement.
Activity rates calculated in an ABC system Once implemented, it is more costly to maintain
can be used for benchmarking. than traditional systems because data for
numerous activity measures must be constantly
This involves comparing an organization’s
collected and checked.
performance with the "world-class standard"
of similar organizations to identify activities 1. Resistance to Change: ABC produces
with the greatest room for improvement. product margins that conflict with deeply
held beliefs, which leads to employee
Scenario: ABC Implementation in Thailand (APS
resistance to the new system.
Company)
2. Misinterpretation: Managers may insist on
 Company: APS, a parawood furniture factory
fully allocating all costs (including
in Southern Thailand.
organization-sustaining and unused capacity
 Traditional System: Assigned indirect costs) to products, leading to
manufacturing costs based on each misinterpretations that overstate costs and
product’s total sales. may result in incorrect pricing decisions.

 ABC System: Relies on various volume-

related and non-volume-related activity
3. Dual Cost Systems: Maintaining separate activity measures—such as number of orders
ABC (internal) and traditional (external) cost and number of inspections—which
systems is costly and can cause confusion. demonstrated that the complexity of processing
and managing the job was a much better cost
REAL-LIFE SCENARIOS
predictor than simply the material's volume.
1. BUSINESS FOCUS: Airline Fuel Cost
Explanation The company moved from a
Drivers
simple volume-based driver (tons) to
Summary of Scenario Airlines recognized that transaction-based drivers (number of orders,
airplane weight is a key fuel cost driver. They inspections). This showed that a small, complex
used this insight to initiate a cost-reduction order requiring multiple checks and separate
strategy, replacing heavy paper navigation shipments could be far more costly to fulfill than
charts and manuals carried by pilots with iPads. one massive, simple order. ABC forces the
American Airlines estimated this action would company to price based on the logistical
yield annual savings of $1.2 million and 400,000 overhead consumed, not just the raw material
gallons of fuel. cost.

Explanation This illustrates how Activity-Based 4. IN BUSINESS: CARE FOR A TWINKIE?

Costing (ABC) principles help identify non- (Hostess Brands)
obvious cost drivers. While miles flown is an
Summary of Scenario Hostess Brands was
obvious driver, weight is a hidden driver of
operating 11 factories at 50% capacity before
consumption (overhead). By isolating weight as
financial distress. The subsequent restructuring
a driver, the airline made a strategic, high-ROI
plan involved operating only four factories at a
decision (digital manuals) that drastically
much higher utilization (85%–90%). ABC is
reduced an ongoing variable cost (fuel). This is
noted as the tool that helps companies quantify
a classic ABC win: small changes to activity
and manage the cost of unused capacity.
drivers yield massive operational savings.
Explanation This demonstrates the ABC focus
2. IN BUSINESS: DINING IN THE CANYON
on capacity management. The cost of keeping
Summary of Scenario A river rafting company half-empty factories running (utilities,
analyzed costs using the activity hierarchy. They maintenance, depreciation) is a massive drain
determined that wages for two guides per raft that ABC calls "unused capacity cost." By
are a batch-level cost (fixed per raft consolidating operations and increasing
regardless of guest count). Souvenir mugs are a utilization, the company is isolating and
unit-level cost (proportional to guests). Food eliminating those avoidable, non-value-added
costs were also classified as a batch-level cost costs, leading to a leaner, more profitable
because food is prepackaged in large lots per structure.
raft, making it impractical to adjust precisely for
5. MANAGERIAL ACCOUNTING IN ACTION:
minor changes in the guest count.
THE ISSUE (Classic Brass)
Explanation This example highlights the
Summary of Scenario Classic Brass, which
difference between volume-based and non-
manufactures high-volume standard products
volume-based costs in a service environment.
and low-volume custom products, was
To cost the trip accurately, the company must
experiencing a net operating loss. Management
realize that adding one guest adds the cost of
suspected its traditional cost system was
one mug (unit cost), but it does not increase the
distorting profitability: over-costing the simple,
cost of the guides or the food (batch costs).
high-volume product and making the complex,
Traditional costing might spread guide/food
low-volume product appear falsely profitable by
wages evenly per guest, inaccurately inflating
understating its required overhead
the perceived marginal cost of each guest.
consumption. The company decided to
3. IN BUSINESS: AN ABC APPLICATION IN implement an ABC system to correctly trace
THE CONSTRUCTION INDUSTRY resource consumption.

Summary of Scenario A Korean manufacturer Explanation This is the foundational problem

of reinforced steel bars (rebar) switched from a ABC solves: Product Cost Distortion.
traditional cost system that assigned indirect Complex, low-volume products consume
costs based solely on the rebar's tonnage disproportionate amounts of support resources
(weight). Their new ABC system used multiple (e.g., engineering time, setups). When overhead
is allocated based on volume (like machine Example: If the Customer Orders Pool has a
hours), the simple product subsidizes the total cost of $120,000 and the company expects
complex one. ABC is the diagnostic tool used to to process 500 customer orders (the activity
re-allocate these batch- and product-level costs level), the Activity Rate is: 500 orders$120,000
accurately, revealing the true profitability of =$240 per order
each product line.
Step 4: Second-Stage Allocation
6. Appendix 7A: Ridley Company (Time- (Assigning Costs to Cost Objects)
Driven ABC)
This formula assigns the overhead cost from the
Summary of Scenario Ridley Company activity pools to a specific cost object (e.g., a
utilized Time-Driven Activity-Based Costing product or a customer) based on its
(TDABC) to analyze labor costs and capacity in consumption of the activity.
its Customer Service Department. TDABC uses
Overhead Cost Assigned to Cost Object =
time equations (e.g., minutes per call) rather
Activity Rate ×
than interviews for allocation, providing an
Activity Consumed by Cost Object
objective way to quantify both used and
unused capacity costs in minutes and Example: If the Activity Rate is $240 per order
employee count. (from above) and Product X requires 100 orders,
the cost assigned to Product X from that pool is:
Explanation TDABC is an advanced, efficient
$240 per order×100 orders=$24,000
evolution of ABC. Instead of relying on
subjective employee estimates ("What Total Product Cost
percentage of your time is spent on Activity
X?"), TDABC uses concrete process metrics. By The final formula to determine the total cost of
establishing a time standard for every activity, a product or customer margin is:
management can precisely measure how much Total Product Cost=Direct Materials+Direct Labo
capacity is actually being used by customer r+Shipping+∑(Overhead Cost Assigned from ea
demand versus how much is simply sitting idle ch Activity Pool)
(unused capacity), enabling better staffing and
scheduling decisions.

Summary of the Activity-Based Costing

Formula

The calculation of costs in an ABC system can

be broken down into three main formulas used
in Steps 2, 3, and 4 of the implementation
process:

Step 2: First-Stage Allocation (Assigning

Overhead to Pools)

This step uses allocation percentages (often

derived from interviews or analysis) to assign
costs from the general ledger to the activity
cost pools.

Cost Assigned to Activity Pool

=Total Overhead Cost Category *
Percentage Distribution to Pool

Step 3: Computing Activity Rates (The

Core ABC Formula)

This formula determines the cost per unit of

activity (e.g., cost per order, cost per machine-
hour).

Activity Rate=Total Activity Level (Expecte

d Usag) for the Pool
Total Cost in Activity Pool