3-1

Activity-Based Costing
Chapter 4
 3-2

Learning Objective 1

Understand the basic

approach in activity-based
costing and how it differs
from conventional costing.
 3-3

Assigning Overhead Costs to Products

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.
 3-4

Plantwide Overhead Rate - Definition

Plantwide Overhead Rate

A single overhead rate that is used
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.
 3-5

Plantwide Overhead Rate - Disadvantages

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 declining and overhead has been increasing.
Many of these growing overhead costs may not be
correlated with direct labor.
Technology advancements
A plantwide overhead have
allocation reduced
system thebe
may not cost and
optimal
complexity
for manyof gatheringindiverse
companies sources environment.
today’s business of data.
 3-6

Departmental Overhead Rates - Definition

Many companies have a system in which each

department has its own overhead rate.

The allocation base depends

on the nature of the work
Machining Department performed in each department.
In the machining department,
Assembly Department overhead may be based on
machine-hours, but in the
Shipping Department assembly department,
overhead may be based on
direct labor-hours.
 3-7

Departmental Overhead Rates - Disadvantages

Departmental rates will not correctly assign overhead in

situations where a company has a range of products and
complex overhead costs.

The departmental approach relies on a single

measure of activity as allocation base while some
overhead costs may be caused by factors
that are not directly proportional to the volume of
production.

Activity-based costing is used to account for these other

factors and more accurately assigns overhead costs to
products.
 3-8

Activity-Based Costing (ABC) - Definition

 A technique that attempts to assign overhead

costs more accurately to products.
 It uses multiple allocation bases for assigning
costs to products.
 Each base represents a major activity.
 Activity is an event that causes consumption of
overhead resources.
 3-9

Activity-Based Costing - Process

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

Activities

Consumption of Resources

Consumption of Resources Incurs Cost

 3-10

Activity-Based Costing - Process

 3-11

Activity-Based Costing (ABC)

Examples of Activities
An event that causes
Activity the consumption of
overhead resources.

Examples of Activities

Admitting
Setting up Billing Opening a
hospital
machines customers bank account
patients
 3-12

Activity-Based Costing (ABC)

Pools, Measures, Rates
A “cost bucket” in which
Activity
costs related to a particular
Cost Pool activity are accumulated.

Expresses how much of the

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

A predetermined overhead
Activity
rate for each activity
Rate cost pool.
 3-13

Activity-Based Costing (ABC)

Similarities to Job-Order Costing
For each activity in
isolation, this system works exactly
like the job-order costing system
described in previous chapters.

A predetermined overhead rate is computed for

each activity and then applied to jobs and
products based on the amount of activity
consumed by the job or product.
 3-14

Designing an Activity-Based
Costing System - Challenges

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

broad range of managers to find out what activities
they think consume most of the organization’s
resources.
 3-15

Designing an Activity-Based Costing

System – Combining Activities
Related activities are
frequently combined to reduce
the amount of detail and
record-keeping costs.

For example, several actions may

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

An activity dictionary defines each of the activities

that will be included in the activity-based costing
system and how the activities will be measured.
 3-16

Hierarchy of Activities

Level Activities Activity Measure

Unit-level Processing units on machines Machine-hours
Processing units by hand Direct labor-hours
Consuming factory supplies Units produced
Batch-level Processing purchase orders Purchase orders processed
Processing production orders Production orders processed
Setting up equipment Number of setups
Handling materials Pounds of material handled
Product-level Testing new products Hours of testing time
Administering parts inventories Number of part types
Maintaining inventories of parts Hours of design time
Facility-level General factory administration Direct labor-hours
Plant building and grounds Direct labor-hours
 3-17

Graphic Example of
Activity-Based Costing – Stage 1
Various Manufacturing Overhead Costs

First-Stage Cost Assignment

Labor- Machine- Machine Production Parts General

Related Pool Related Pool Setup Pool Order Pool Admin. Pool Factory Pool
 3-18

Graphic Example of
Activity-Based Costing – Stage 2
Various Manufacturing Overhead Costs

First-Stage Cost Assignment

$450,000

Labor- Machine- Machine Production Parts General

Related Pool Related Pool Setup Pool Order Pool Admin. Pool Factory Pool

Second-Stage Allocations
1,200 Orders

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

$375/Order

Products
Unit-Level Batch-Level Product-Level Facility-Level
Activity Activity Activity Activity
 3-19

Activity-Based Costing - Summary

Activity-based costing differs from traditional
costing in two ways:
1. The activity based approach uses more cost pools than
a traditional approach.

2. The activity-based approach includes some batch-level

and product-level activities and activity measures that
do not relate to the volume of units produced, whereas
the traditional approach relies exclusively on volume-
related overhead allocation.
 3-20

Activity-Based Costing - Steps

1. Identify activities that consume resources and define
cost pools
2. Map resource expenses to activities (First-Stage Cost
Assignment)
(wherever possible, directly trace overhead costs to activities and
cost objects. If not, allocate indirect costs to activity cost pools)

3. Identify cost drivers for each cost pool and calculate

activity cost driver rates
4. Trace costs from activities to products (Second-Stage
Cost Assignment)
 3-21

Quick Check 1
Would the following activities at a manufacturer of canned
soup be best classified as unit-level, batch-level, product-
level, or facility-level activities?
Researching new recipes Shipping orders to grocery stores
A) Unit Unit
B) Batch Batch
C) Product Unit
D) Product Batch

A. Option A
B. Option B
C. Option C
D. Option D
 3-22

Quick Check 2
Millner Corporation has provided the following data from its
activity-based costing accounting system:
Activity Cost Pools Total Cost Total Activity
Designing products $1,372,448 7,798 product design hours
Setting up batches $33,300 740 batch set-ups
Assembling products $126,160 6,640 assembly hours

The activity rate for the Designing Products activity cost pool is
closest to:
A. $101 per product design hour
B. $1,372,448 per product design hour
C. $176 per product design hour
D. $57 per product design hour
 3-23

Using Activity-Based Costing

Comtek, Inc. – Items 1-3

Comtek, Inc., makes two products: GPS systems

and Phone systems.
 The company has been losing bids to supply
GPS systems to lower-priced competitors.
 The company has been winning all bids to
supply Phone systems.
 3-24

Using Activity-Based Costing

Comtek, Inc. – Items 4-6
For the current year, Comtek has budgeted sales
of 50,000 phone units and 200,000 GPS 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.

Hours
Phones: 50,000 units @ 2 hours per unit = 100,000
GPSs: 200,000 units @ 2 hours per unit = 400,000
Total direct labor-hours 500,000
 3-25

Using Activity-Based Costing

Comtek, Inc. – Item 7

Unit costs for materials and labor are:

Phone GPS
Units Units
Direct materials $ 90 $ 50
Direct labor $ 20 $ 20
 3-26

Direct Labor-Hours as a Base - DLH

Total manufacturing overhead costs for the

current year are estimated to be $10,000,000.
The company develops the following overhead
rate based upon direct labor-hours:

Predetermined $10,000,000
= = $20 per DLH
overhead rate 500,000 DLHs
 3-27

Direct Labor-Hours as a Base – Total

Unit Cost
Since each product requires two hours of
direct labor, $40 of overhead is assigned to
each product.

Phone Unit GPS Unit

Direct materials $ 90 $ 50
Direct labor 20 20
Manufacturing overhead 40 40
(2 DLHs x $20 per DLH)
Unit product cost $ 150 $ 110
 3-28

Learning Objective 2

Compute activity rates for

an activity-based costing
system.
 3-29

Computing Activity Rates – Basic Information

The ABC project team at Comtek has

developed the following basic information.
Estimated
Overhead
Activity and Activity Measures Cost Expected Activity
Total Phone GPS
Labor-related (DLH) $ 800,000 500,000 100,000 400,000
Machine-related (MH) 2,100,000 1,000,000 300,000 700,000
Machine setups (setups) 1,600,000 4,000 3,000 1,000
Production orders (orders) 3,150,000 1,200 800 400
Parts administration (part types) 350,000 700 400 300
General factory (MH) 2,000,000 1,000,000 300,000 700,000
$ 10,000,000
 3-30

Computing Activity Rates – Activity Rates

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

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

by dividing the estimated overheard for an activity by the
total expected activity.
 3-31

Learning Objective 3

Compute product costs

using activity-based costing.
 3-32

Computing Overhead Cost per Unit Phone

Units
Phone Units
Expected Activity
Activity and Activity Measures Activity Rate Amount
Labor-related (DLHs) 100,000 × $ 1.60 = $ 160,000
Machine-related (MHs) 300,000 × 2.10 = 630,000
Machine setups (setups) 3,000 × 400.00 = 1,200,000
Production orders (orders) 800 × 2,625.00 = 2,100,000
Parts administration (part types) 400 × 500.00 = 200,000
General factory (MHs) 300,000 × 2.00 = 600,000
Total overhead cost assigned $ 4,890,000
Number of units produced 50,000
Overhead cost per unit $ 97.80
 3-33

Computing Overhead Cost per Unit GPS Units

GPS Units
Expected Activity
Activity and Activity Measures Activity Rate Amount
Labor-related (DLHs) 400,000 × $ 1.60 = $ 640,000
Machine-related (MHs) 700,000 × 2.10 = 1,470,000
Machine setups (setups) 1,000 × 400.00 = 400,000
Production orders (orders) 400 × 2,625.00 = 1,050,000
Parts administration (part types) 300 × 500.00 = 150,000
General factory (MHs) 700,000 × 2.00 = 1,400,000
Total overhead cost assigned $ 5,110,000
Number of units produced 200,000
Overhead cost per unit $ 25.55
 3-34

Comparing the Two Approaches

Activity-Based Costing Direct Labor Costing

Phone Unit GPS Unit Phone Unit GPS Unit
Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

Note that the unit product cost of a GPS

unit decreased from $110 to $95.55 . . . .
. . . . while the unit cost of a phone unit
increased from $150 to $207.80.
 3-35

Learning Objective 4

Contrast the product costs

computed under activity-
based costing and
conventional costing
methods.
 3-36

Comparing the Two Approaches – GPS Units

Activity-Based Costing Direct Labor Costing

Phone Unit GPS Unit Phone Unit GPS Unit
Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

The ABC system assigns $14.45

less overhead than the traditional
system to each GPS unit.
 3-37

Comparing the Two Approaches – Phone

Units
Activity-Based Costing Direct Labor Costing
Phone Unit GPS Unit Phone Unit GPS Unit
Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

The ABC system assigns $57.80

more overhead than the traditional
system to each phone unit.
 3-38

Quick Check 3
Cabat Company manufactures two products, Product C and Product D.
The company estimated it would incur $177,910 in manufacturing
overhead costs during the current period. Overhead currently is applied
to the products on the basis of direct labor-hours. Data concerning the
current period's operations appear below:
Product C Product D
Estimated volume 3,800 units 3,000 units
Direct labor-hours per unit 1.20 hours 0.80 hour
Direct materials cost per unit $11.60 $23.70
Direct labor cost per unit $10.80 $7.20
Compute the predetermined overhead rate under the current method.
a. $25.56 per DLH
b. $26.16 per DLH
c. $46.81 per DLH
d. $59.30 per DLH
 3-39

Quick Check 4
Now, compute the unit product cost of each product
for the current year under current costing system.

Product C Product D

a. $47.96 $51.35

b. $47.96 $56.46

c. $53.07 $51.35

d. $53.07 $56.46
 3-40

Quick Check 5
Cabat company is considering using an activity-based costing system to
compute unit product costs for external financial reports instead of its
traditional system based on direct labor-hours. The activity-based costing
system would use three activity cost pools. Data relating to these
activities for the current period are given below:
Estimated Expected Activity
Activity Cost Pools Overhead
Costs Product C Product D Total

Machine setups $12,190 110 120 230

Purchase orders 75,240 820 1,160 1,980
General factory 90,480 4,560 2,400 6,960
Total $177,910

Determine the unit product cost of Product C using the ABC approach.
a. $47.73 per unit
b. $53.07 per unit
c. $58.11 per unit
 3-41

Quick Check 6
Determine the unit product cost of Product D using the ABC approach.
a. $47.73 per unit
b. $53.07 per unit
c. $58.11 per unit
 3-42

Shifting of Overhead Cost

ABC vs. Traditional System
Activity-Based Costing Direct Labor Costing
Phone Unit GPS Unit Phone Unit GPS Unit
Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

The traditional system assigns the same amount of

all overhead costs to each Phone or GPS unit
($40 per unit).
 3-43

Shifting of Overhead Cost

Volume Products
Activity-Based Costing Direct Labor Costing
Phone Unit GPS Unit Phone Unit GPS Unit
Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

Low-volume product High-volume product

When a company implements activity-based

costing, overhead cost shifts from high-volume to
low-volume products with a higher unit product cost
resulting for the low-volume products.
 3-44

Shifting of Overhead Cost – Production-

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

The ABC system assigns different amounts of

Production-Order-related overhead costs to each product.
The costs are being shifted from the high-volume
GPS systems to the low-volume Phone systems.
This fact can be illustrated in a two-step process.
 3-45

Shifting of Overhead Cost – Production-

Orders Cost Pool
1. Compute the number of units processed per production
order for each product.
Phone Units GPS Units
Number of units produced per year 50,000 200,000
Number of production orders issued per year 800 400
Number of units processed per production order 62.5 500

2. Compute production-order cost per unit for each product.

Phone Units GPS Units

Cost to issue a production order $ 2,625 $ 2,625
Average number of units processed per
production order 62.5 500
Production-order cost per unit $ 42.00 $ 5.25
 3-46

Targeting Process Improvements

Activity-Based Management
An ABC system can
help identify
areas where the
company can benefit
from improving its
current processes.

Activity-Based Management
Focuses on managing activities to eliminate
waste and reduce processing time and defects.
 3-47

Targeting Process Improvements – Step 1

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

Activity rates can be Benchmarking can be used

used to target areas to compare activity cost
where costs seem information with world-
excessively high. class standards of
performance achieved by
other organizations.
 3-48

Benefits of Activity-Based Costing

ABC improves the accuracy of product costing by:

1. Increasing the number of cost pools used to
accumulate overhead costs.
2. Using activity cost pools that are more
homogeneous than departmental cost pools.
3. Activity-based costing also highlights activities that
could benefit most from process improvement
efforts.
 3-49

When to use ABC?

Costs of implementing an ABC system may outweigh

the benefits. However, the benefits are more likely to be
worth the costs when:
1. Products differ substantially in volume, batch size, and in
activities required.
2. Conditions have changed substantially since the existing
cost system was established.
3. Overhead costs are high and increasing and no one seems
to understand why.
4. Management does not trust the existing cost system and it
ignores data from it when making decisions.
 3-50

Limitations of ABC

The cost in each activity pool is strictly

proportional to its activity measure. When
this assumption is violated, the accuracy of
ABC data can be called into question.

For example, managers should be particularly

alert to product costs that contain allocated
facility-level costs.
 3-51

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.
 3-52

End of Chapter 4