CHAPTER TWO

ACTIVITY BASED
COSTING AND
ACTIVITY BASED
MANAGEMENT

SINTAYEHU T.

SINTAYEHU T. 1
 LEARNING OBJECTIVES
After Studying this Chapter, you should be able to:

1. Explain the major differences between activity-based costing and a

traditional costing system.

2. Distinguish between unit-level, product-level, customer-level and

organization-sustaining activities.

3. Assign costs to cost pools using a first-stage allocation.

4. Compute activity rates for cost pools and explain how they can be used to

target process improvements.

SINTAYEHU T. 2
 LEARNING OBJECTIVES
5. Assign costs to a cost object using a second stage allocation.
6. Prepare a report showing activity-based costing product margins
from an activity view.
7. Prepare an action analysis report using activity-based costing data
and interpret the report.
8. Use the simplified approach to compute activity-based costs and
margins.
9. Record the flow of costs in an activity-based costing system.

SINTAYEHU T. 3
 Activity-based Costing: An Overview
 Activity-based costing (ABC) is a methodology that measures the
cost and performance of activities, resources, and cost objects.
 Resources are assigned to activities, then activities are assigned to
cost objects based on their use.
 Activity-based costing recognizes the causal relationships of cost
drivers to activities.
Activity-based costing is about:
♥ Measuring business process performance, activity by activity.
♥ Estimating the cost of business process outputs based on the cost
of the resources used in producing the product.
SINTAYEHU T. 4
 Activity-based Costing: An Overview

♥ Identifying opportunities to improve process efficiency and effectiveness.

♥ Activity costs are used as the quantitative measurement.
♥ If activities have unusually high costs or it they don't add value, they
become targets for re-engineering.
 Activity-based management (ABM) is a broad discipline that focuses on
achieving customer value and Company profit by managing activities.
 ABM draws on activity-based costing as a major source of information.

SINTAYEHU T. 5
 Activity-based Costing Versus Traditional Costing
 Traditional absorption costing is designed to provide data for external
financial reports, whereas activity-based costing is designed to use for
internal decision making.
 As a consequence, activity-based costing differs from traditional
absorption costing in three ways.
In activity-based costing:
1. Non-manufacturing as well as manufacturing costs may be assigned to
products, but only on a cause-and-effect basis.
2. Some manufacturing costs may be excluded from product costs.
SINTAYEHU T. 6
 Activity-based Costing Versus Traditional Costing
3. Numerous overhead cost pools are used, each of which is allocated
to products and other cost objects using its own unique measure of
activity.

SINTAYEHU T. 7
SINTAYEHU T. 8
 Activity-based Costing Versus Traditional Costing
Activity-Based
Activity-Based Costing
Costing
Both manufacturing Thereare
There are a
a number
number
Both
and nonmanufacturing of cost
of cost poolseach
pools each of
manufacturing
costs may be which of is
which is
allocated
and to
assigned allocated
using using a
a unique
product
nonmanufacturing
products. unique measure
measure of
of activity.
s. may be
costs activity.
assigned to Some
Some manufacturing
manufacturing
costs may be excluded
costs
from may be
product
excluded
[Link]
product
Allocation bases
Allocation bases costs.
Overhead
Overhead rates
rates
often
often differ from
may be based
may
traditional costing
differ from
systems. beon activity
based at
on activity
traditional costing capacity.
at capacity.
systems.

SINTAYEHU T. 9
 Activity-based Costing Versus Traditional Costing
 ABC developed for more accurate ways of assigning costs of indirect
and support resources to activities, business processes, products,
services, and customers.
 ABC systems recognize organizational resources are required not for
physical production of units of product but to provide a broad array
of support activities to enable a variety of products and services to
produced for a diverse group of customers.

SINTAYEHU T. 10
 Activity-based Costing Versus Traditional Costing

 Goal of ABC is not to allocate common costs to products.

 ABC goal is to measure and then price out all the resources used for
activities that support the production and delivery of products and
services to customers.

SINTAYEHU T. 11
 Activity Based Costing
Procedures of Activity Based Costing
1. Identify activities performed by the organization’s support resources.
2. Traces resource expenses of support resources to activities, ending up
with total cost of performing each of organization's support activities.
3. Trace activity costs to products by identifying a cost driver for each
activity called an activity cost driver.
4. Calculating an activity cost driver rate, and using this rate to drive
activity costs to products.

SINTAYEHU T. 12
 Activity Based Costing
5. For each product (or service or customer) quantity of each cost
driver used during a period is multiplied by standard cost driver rate.
The procedure may sound complicated, but actually it is quite simple to
illustrate and even to implement in practice.

SINTAYEHU T. 13
 Activity Based Costing
ABC is designed to provide managers with cost information for strategic
and other decisions that potentially affect capacity and therefore affect
ABC is a
fixed as well as of
The objective variable costs.
activity-based good supplement to
costing is to understand overhead our traditional cost
and the profitability of products system I agree!
and customers.

SINTAYEHU T. 14
 Activity Based Costing Versus Traditional Costing

LEARNING OBJECTIVES: Understand activity-based costing

and how it differs from a traditional costing system.

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 How Costs are Treated Under Activity–Based Costing
“Best
“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in three
three ways.
ways.

Manufacturing Nonmanufacturing
costs costs

Traditional ABC
product costing product costing

 ABC assigns both types of costs to

products.
SINTAYEHU T. 16
 How Costs Are Treated Under Activity–Based Costing

ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.

Manufacturing Nonmanufacturing
costs costs

Some
Mo
st,
not but
All
all

Traditional ABC
product costing product costing

 ABC does not assign all manufacturing costs to products.

SINTAYEHU T. 17
 How Costs Are Treated Under Activity–Based Costing

ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three ways.
ways.

Level of complexity
Activity–Based
Activity–Based
Costing
Costing

Departmental
Departmental
Overhead
Overhead
Rates
Rates
Plantwide
Plantwide
Overhead
Overhead
Rate
Rate

Number of cost pools

 ABC uses more cost pools.
SINTAYEHU T. 18
How Costs Are Treated Under Activity-Based Costing

Activity
Activity Based
Based
Costing

Departmenta
ll Overhead ity
Rates
Overhea lex
d Rates p
om
Plantwide f C
Plantwid o
e e l
e v
Overhead
Overhea L
Rate
d Rate
Overhead
Allocation
SINTAYEHU T. 19
 Alternative Methods of Overhead Allocation

Three methods of overhead allocation:

1. The single plantwide overhead rate method,
2. The departmental overhead rate method, and
3. The activity-based costing method.
 The plantwide overhead rate method and the departmental
overhead rate method use volume- based measures such as direct
labor hours or machine hours to allocate overhead costs to products.
The plantwide method uses a single rate for allocating overhead
costs, and the departmental rate method uses at least two rates.
 The departmental method arguably provides more accurate cost
allocations than the plantwide method.
SINTAYEHU T. 20
 Alternative Methods of Overhead Allocation

 Activity-based costing focuses on activities (not just volume) and

their costs. Rates based on these activities are used to assign
overhead to products in proportion to the amount of activity required
to produce them.
 Activity-based costing typically uses more overhead allocation rates
than the plantwide and departmental methods.

SINTAYEHU T. 21
 Plantwide Overhead Rate

 The first method of allocating overhead costs to products is the single plantwide overhead
rate method, or simply the plantwide overhead rate method.
 The overhead rate is determined using a volume-related measure such as direct labor
hours or machine hours, both of which are readily available in most manufacturing
settings.
 In some industries, overhead costs are closely related to these volume-related measures.
 If so, it is logical to use this method to assign overhead costs to products.

 Single plantwide overhead rate method, total budgeted overhead costs are divided by the

chosen allocation base, such as total direct labor hours, to arrive at a single plantwide
overhead rate.

 This rate then is applied to assign overhead costs to all products based on their actual
SINTAYEHU T. 22
usage of the allocation base.
 Plantwide Overhead Rate

Plantwide Overhead Rate Method

SINTAYEHU T. 23
 Plantwide Overhead Rate

Companies tend to use direct labour as the overhead allocation base.

SINTAYEHU T. 24
 Departmental Overhead Rate Method

 Many companies have several departments that produce various

products using different amounts of overhead.
 Under such circumstances, a single plantwide overhead rate can
produce cost assignments that do not reflect the cost to manufacture
products.
 Multiple overhead rates can result in better overhead cost allocations
and improve management decisions.
 The departmental overhead rate method uses a different overhead
rate for each production department.
SINTAYEHU T. 25
 Departmental Overhead Rate Method

This is usually done through a four-step process

1. Assign overhead costs to departmental cost pools.

2. Select an allocation base for each department.
3. Compute overhead allocation rates for each department.
4. Use departmental overhead rates to assign overhead costs to cost
objects (products).
The departmental overhead method uses several departments and
several overhead rates.
 This allows each department to have its own overhead rate and its own allocation
SINTAYEHU T. 26
base
 Departmental Overhead Rate Method

Departmental Overhead Rate Method

SINTAYEHU T. 27
 Departmental Overhead Rates

Finishing
Department A two
A twostage
stage process
process isis
necessary
necessary because
because costs
Painting costs
are are allocated
allocated to
to departments
departments and then
and then to products.
Department to products.

Shipping

Department

SINTAYEHU T. 28
 Departmental Overhead Rates

Indirect
Indirec Indirect Other
t Material
Material Overhea
Overhea
Labour s s d d

Departmen Departmen Departmen

Stage One: Costs assigned to pools
t 1 t 2 t 3
Cost pools

SINTAYEHU T. 29
 Comparing Plantwide and Departmental Overhead Rate Methods

The plantwide and departmental overhead rate methods have three key
advantages:

a. They are based on readily available information, like direct labor hours.
b. They are easy to implement.
c. They are consistent with GAAP and can be used for external reporting.

Both suffer from an important disadvantage, in that overhead costs are

frequently too complex to be explained by only one factor like direct labor
hours or machine hours.

SINTAYEHU T. 30
 Activity-Based Costing (ABC)

Activity-based costing (ABC) attempts to more accurately assign

overhead costs by focusing on activities.
 Unlike the plantwide rate method, ABC uses more than a single rate.
 Unlike the departmental rate method, ABC focuses on activities
rather than departments.
The basic principle underlying activity-based costing is that an activity,
which is a task, operation, or procedure, is what causes costs to be
incurred.
SINTAYEHU T. 31
 Differences Between ABC and Multiple Departmental
Rates
 Using ABC differs from using multiple departmental rates in how
overhead cost pools are identified and in how overhead cost in each
pool is allocated.
 When using multiple departmental rates, each department is a cost
pool, and overhead cost allocated to each department is assigned to
products using a volume-based factor (such as direct labor hours or
machine hours).
 This assumes that overhead costs in each department are directly
proportional to the volume-based factor.
SINTAYEHU T. 32
 Differences Between ABC and Multiple Departmental
Rates
 ABC, on the other hand, recognizes that overhead costs are more
complex.
 ABC emphasizes activities and costs of carrying out these activities.
 Therefore, ABC arguably better reflects the complex nature of
overhead costs and how these costs are used in making products.

SINTAYEHU T. 33
 How Costs Are Treated Under Activity–Based Costing

ABC
ABC differs
differs from
from traditional
traditional cost
cost accounting
accounting in
in three
three
ways.
ways.
Each
Each ABC
ABC cost
cost pool
pool has
has its
its own
own unique
unique measure
measure of of activity.
activity.

Traditional
Traditional cost
cost systems
systems usually
usually rely
rely on
on volume
volume measures
measures such
such as
as direct
direct lab
lab
and/or
and/or machine
machine hours
hours to
to Allocate
Allocate all
all overhead
overhead costs
costs to
to products.
products.

 ABC uses more cost pools.

SINTAYEHU T. 34
 How Costs Are Treated Under Activity–Based Costing

An event that causes the

Activity consumption of
overhead resources.
A “cost bucket” in which
costs related to a
Activity
particular activity
Cost Pool measure are
$$ accumulated.
$
$$$

SINTAYEHU T. 35
How Costs Are Treated Under Activity–Based Costing

Activity
Activity The
The term
term cost
cost driver
driver is
is
Measure
Measure also
also used
used toto refer
refer to
to an
an
activity
activity measure.
measure.
An
An allocation
allocation base
base
in
in an
an activity-based
activity-based
costing
costing system.
system.

SINTAYEHU T. 36
 How Costs Are Treated Under Activity–Based Costing

Two common types of activity

measures:
Transaction Duration
driver driver

Simple count A measure

of the number of of the amount
times an activity of time needed
occurs. for an activity.

SINTAYEHU T. 37
 How Costs Are Treated Under Activity–Based Costing

ABC defines
five levels of activity
that largely do not relate
to the volume of units
produced.

Traditional
Traditional cost
cost systems
systems usually
usually rely
rely on
on volume
volume measures
measures such
such as
as direct
direct lab
lab
hours
hours and/or
and/or machine
machine hours
hours to
to allocate
allocate all
all overhead
overhead costs
costs to
to products.
products.

SINTAYEHU T. 38
 Activity Levels and Cost Management: Cost
Hierarchies
Activities causing overhead costs can be separated into four levels:
1. Unit-level activities,
2. Batch-level activities,
3. Product-level activities, and
4. Facility-level activities.
These four activities are described as follows.

SINTAYEHU T. 39
 Activity Levels and Cost Management : Cost
Hierarchies

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 Activity Levels and Cost Management : Cost
Hierarchies

SINTAYEHU T. 41
 How Costs Are Treated Under Activity–Based Costing
Unit-Level Batch-Level
Activity Activity

Manufacturing
companies typically
combine
their activities into
five
classifications.
Product-Level Customer-Level
Activity Organization- Activity
sustaining
SINTAYEHU T.
Activity 42
 Designing
Three essential an Activity Based
characteristics Costing(ABC)
of a successful System
activity-based costing
implementation.
1. Top managers must strongly support ABC implementation because
their leadership is instrumental in properly motivating all employees
to embrace need to change.
2. Top managers should ensure that ABC data is linked to how people
are evaluated and rewarded.
3. Cross-functional team should be created to design and implement
ABC system.

SINTAYEHU T. 43
 Characteristics of Successful ABC Implementations

Strong
Strong top
top
management
management support
support
Link
Link to
to evaluations
evaluations
and
and rewards
rewards

Cross-functional
Cross-functional
involvement
involvement
SINTAYEHU T. 44
 Classic Brass – An ABC Example

Classic Brass
Income Statement
Year Ended December 31, 2005

Sales
Cost of goods sold $ 3,200,000
Direct materials $ 975,000
Direct labor 351,250
Manufacturing overhead 1,000,000 2,326,250
Gross margin 873,750
Selling and administrative expenses
Shipping expenses 65,000
Marketing expenses 300,000
General administrative expenses 510,000 875,000
Net operating
operating income
loss $ (1,250)

Manufacturing
Manufacturing overhead
overhead is
is allocated
allocated to
to products
products using
using aa single
single plantwide
plantwide overhead
overhead
rate
rate [Link]
SINTAYEHU based on
on machine
machine hours.
hours. 45
 Designing an Activity Based Costing(ABC) System

SINTAYEHU T. 46
 Advantages of Activity-Based Costing

While activity-based costing can improve the accuracy of overhead cost allocations
to products, it too has limitations.
a. More Effective Overhead Cost Control:

ABC can be used to identify activities that can benefit from process improvement by
focusing on activities instead of focusing only on direct labor or machine hours.

b. Better Production and Pricing Decisions

ABC can provide more accurate overhead cost allocation. This is because
ABC uses more cost pools and activity rates than other methods.
SINTAYEHU T. 47
 Advantages of Activity-Based Costing

c. Additional Uses ABC has uses beyond determining product costs.

 Allocate the selling and administrative costs expensed by GAAP to activities.
 Determine the profitability of various market segments or customers.

SINTAYEHU T. 48
 Disadvantages of Activity-Based Costing

a. Costs to Implement and Maintain ABC

Designing and implementing an ABC system is costly.
[Link] Product Cost Distortion Remains
Even with ABC, product costs can be distorted
[Link] with Decisions Remains
Managers must interpret ABC data with caution in making decisions.

SINTAYEHU T. 49
 Designing an Activity Based Costing(ABC) System
Steps for Implementing Activity-Based Costing:
1. Define activities, activity cost pools, and activity measures.
2. Assign overhead costs to activity cost pools.
3. Calculate activity rates.
4. Assign overhead costs to cost objects using the activity rates and
activity measures.
5. Prepare management reports.

SINTAYEHU T. 50
 Define Activities, Activity Cost Pools, and Activity
Measures
At Classic Brass, the ABC team, selected the following activity cost pools
and activity measures:

SINTAYEHU T. 51
 Define Activities, Activity Cost Pools, and Activity
Measures
 Customer Orders: assigned all costs of resources that are consumed by taking and
processing customer orders.

 Product Designs: assigned all costs of resources consumed by designing products.

 Order Size: assigned all costs of resources consumed as a consequence of the

number of units produced.

 Customer Relations: assigned all costs associated with maintaining relations with
customers.

 Other: assigned all overhead costs that are not associated with the other cost
pools.
SINTAYEHU T. 52
 Assign Costs to Cost Pools

LEARNING OBJECTIVE : Assign costs to cost pools

using a first-stage allocation

SINTAYEHU T. 53
 Assign Overhead Costs to Activity Cost Pools

SINTAYEHU T. 54
 Assign Overhead Costs To Activity Cost Pools

Direct materials, direct labor, and shipping are excluded because C

Brass’ existing cost system can directly trace these costs to produc
customer orders.
SINTAYEHU T. 55
 Assign Overhead Costs To Activity Cost Pools
At Classic Brass the following distribution of resource consumption
across activity cost pools is determined.

SINTAYEHU T. 56
 Assign Overhead Costs To Activity Cost Pools
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses Indirect
Indirect factory
factory wages
wages $500,000
$500,000
Total Percent
Percent consumed
consumed by by customer
customer orders
orders 25%
25%
$125,000
$125,000
SINTAYEHU T. 57
 Assign Overhead Costs To Activity Cost Pools
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000
Factory equipment depreciation 60,000
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

Factory
Factory equipment
equipment depreciation
depreciation $300,000
$300,000
Percent
Percent consumed
consumed by
by customer
customer orders
orders 20%
20%
$$ 60,000
60,000
SINTAYEHU T. 58
 Assign Overhead Costs To Activity Cost Pools
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000 $ 200,000 $ 100,000 $ 50,000 $ 25,000 $ 500,000
Factory equipment depreciation 60,000 - 180,000 - 60,000 300,000
Factory utilities - 12,000 60,000 - 48,000 120,000
Factory building lease - - - - 80,000 80,000
General Administrative Department
Administrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000
Office equipment depreciation 15,000 - - 12,500 22,500 50,000
Administrative building lease - - - - 60,000 60,000
Marketing Department
Marketing wages and salaries 55,000 20,000 - 150,000 25,000 250,000
Selling expenses 5,000 - - 35,000 10,000 50,000
Total $ 320,000 $ 252,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000

SINTAYEHU T. 59
 Compute Activity Rates for Cost Pools

LEARNING OBJECTIVE: Compute activity rates for cost pools.

SINTAYEHU T. 60
 Calculate Activity Rates
The ABC team determines that Classic Brass will have these total
activities for each activity cost pool . . .
1,000 customer orders,
400 new designs,
20,000 machine-hours,
250 customer relations activities.

Now
Now thethe team
team can can compute
compute thethe individual
individual activity
activity rates
rates byby
dividing
dividing the
the total
total cost
cost for
for each
each activity
activity by
by the
the total
total activity
activity levels.
levels.

SINTAYEHU T. 61
 Calculate Activity Rates
Computation of Ac tivity Rates
(a) (b) (a) ÷ (b)
Activity Cost Pools Total Cost Total Activity Activity Rate
Customer orders $ 320,000 1,000 orders $320 per order
Product design 252,000 400 designs $630 per design
Order size 380,000 20,000 MHs $19 per MH
Customer relations 367,500 250 customer $1,470 per customer
Other 490,500 Not applicable Not applicable

SINTAYEHU T. 62
 Activity-based Costing at Classic Brass
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

Traced
Traced Traced
Traced Traced
Traced

Cost Objects:
Products, Customer Orders, Customers
SINTAYEHU T. 63
 Activity-based Costing At Classic Brass
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations
$490,500
$320,000 $252,000 $380,000 $367,500

Cost Objects:
Products, Customer Orders, Customers

SINTAYEHU T. 64
 Activity-based Costing at Classic Brass
Direct Direct Shipping
Overhead Costs
Materials Labor Costs

First-Stage Allocation

Customer Product Order Customer

Other
Orders Design Size Relations

Second-Stage Allocations

$320/Order
$320/Order $630/Design
$630/Design $19/MH
$19/MH $1,470/Customer
$1,470/Customer

Cost Objects:
Unallocated
Unallocated
Products, Customer Orders, Customers
SINTAYEHU T. 65
 Assign Costs to Cost Object

LEARNING OBJECTIVE: Assign costs to a cost object using a

second-stage allocation.

SINTAYEHU T. 66
 Assigning Overhead Costs to Products
Classic Brass Information

Standard
Standard Stanchions
Stanchions
1.
1. This
This product
product line
line does
does not
not require
require any
any new
new design
design resources.
resources.
2.
2. 30,000
30,000 units
units were
were ordered
ordered during
during the
the year,
year, comprising
comprising 600
600 separate
separate orders.
orders.
3.
3. Each
Each stanchion
stanchion requires
requires 35
35 minutes
minutes of
of machine
machine time
time for
for aa total
total of
of 17,500
17,500 machine-hou
machine-hou

Custom
Custom Compass
Compass Housing
Housing
1.
1. Requires
Requires new
new design
design resources.
resources.
2.
2. 400
400 separate
separate orders.
orders.
3.
3. 400
400 custom
custom designs
designs prepared.
prepared.
4.
4. 1,250
1,250 compass
compass housings
housings produced,
produced, requiring
requiring 22 machine-hours
machine-hours each
each for
for aa total
total of
of 2,500
2,500

SINTAYEHU T. 67
 Assigning Overhead to Products
Overhead Cost for the Standard Stanchions Overhead Cost for the Custom Housing
(a) (b) (a) × (b) (a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 320 600 $ 192,000 Customer orders $ 320 400 $ 128,000
Product design 630 0 - Product design 630 400 252,000
Order size 19 17500 332,500 Order size 19 2500 47,500
Total $ 524,500 Total $ 427,500

Note: Determined the applied amounts of Overhead costs to each

products of the Company.

SINTAYEHU T. 68
 Assigning Overhead Costs to Customers

Let’s take a look at how Classic Brass system works for just one of the
250 customers – Windward Yachts who placed a total of three orders.
Orders
Orders
1.
1. Two
Two orders
orders for
for 150
150 standard
standard stanchions
stanchions per
per order.
order.
2.
2. One
One order
order for
for aa custom
custom compass
compass housing.
housing.

Machine-hours
Machine-hours
1.
1. The
The 300
300 standard
standard stanchions
stanchions required
required 175
175 machine-hours.
machine-hours.
2.
2. The
The custom
custom compass
compass housing
housing required
required 22 machine
machine hours.
hours.

SINTAYEHU T. 69
 Assigning Overhead Costs to Customers
Overhead C ost for Winward Yac hts
(a) (b) (a) × (b)
Activity Cost Pools Activity Rate Activity ABC Cost
Customer orders $ 320 3 $ 960
Product design 630 1 630
Order size 19 177 3,363
Customer relations 1,470 1 1,470
Total $ 6,423

SINTAYEHU T. 70
 Compute Product and Customer Margins

LEARNING OBJECTIVE: Use activity-based costing to

compute product and customer margins.

SINTAYEHU T. 71
 Prepare Management Reports
Product Margin Calculations
The first step in computing product margins is to gather each product’s
sales and direct cost data.

Custom
Standard Compass
Stanchions Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Direct costs
Direct material 905,500 69,500 975,000
Direct labor 263,750 87,500 351,250
Shipping 60,000 5,000 65,000

SINTAYEHU T. 72
 Prepare Management Reports
Product Margin Calculations
The second step in computing product margins is to incorporate the
previously computed activity-based cost assignments pertaining to each
product.
Custom
Standard Compass
Stanchions Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Direct costs
Direct material 905,500 69,500 975,000
Direct labor 263,750 87,500 351,250
Shipping 60,000 5,000 65,000
ABC cost assignments
Customer orders 192,000 128,000 320,000
Product design 252,000 252,000
Order size 332,500 47,500 380,000

SINTAYEHU T. 73
 Prepare Management Reports

Product Margin Calculations

The third step in computing product margins is to deduct each product’s
direct and indirect costs from sales.
Custom
Standard Stanchions Compass Housings
Sales $ 2,660,000 $ 540,000
Costs
Direct material $ 905,500 $ 69,500
Direct labor 263,750 87,500
Shipping 60,000 5,000
Customer orders 192,000 128,000
Product design 252,000
Order size 332,500 47,500
Total cost 1,753,750 589,500
Product margin $ 906,250 (49,500)

SINTAYEHU T. 74
 Prepare Management Reports
Product Margin Calculations
The product margins can be reconciled with the company’s net
operating income as follows:

Custom
Standard Compass
Stanchions Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Total costs 1,753,750 589,500 2,343,250
Product margins $ 906,250 $ (49,500) $ 856,750

Less costs not assigned to products:

Customer relations 367,500
Other 490,500
Total 858,000
Nett operating income
loss $ (1,250)

SINTAYEHU T. 75
 Prepare Management Reports

Customer Profitability Analysis

The first step in computing Windward Yachts’ customer margin is to
gather its sales and direct cost data.
W indw a rd
Ya chts
Sa le s $ 11,350
Dire ct costs
Dire ct ma te ria l 2,123
Dire ct la bor 1,900
Shipping 205

SINTAYEHU T. 76
 Prepare Management Reports

Customer Profitability Analysis

The second step is to incorporate Windward Yachts’ previously
computed activity-based cost assignments.
W indw a rd
Ya chts
Sa le s $ 11,350
Dire ct costs
Dire ct ma te ria l 2,123
Dire ct la bor 1,900
Shipping 205
ABC cost a ssignme nts
Custome r orde rs 960
Product de sign 630
Orde r size 3,363
Custome r re la tions 1,470

SINTAYEHU T. 77
 Prepare Management Reports
Customer Profitability Analysis
The third step is to compute Windward Yachts’ customer margin ($699)
by deducting all its direct and indirect costs from its sales.
W indw a rd Ya chts
Sa le s $ 11,350
Dire ct costs
Dire ct ma te ria l $ 2,123
Dire ct la bor 1,900
Shipping 205
Custome r orde rs 960
Product de sign 630
Orde r size 3,363
Custome r re la tions 1,470 10,651
Custome r ma rgin $ 699

SINTAYEHU T. 78
 Comparison of Traditional and ABC Product Costs
 The ABC team used a two-step process to compare its traditional and
ABC product costs.
 First, the team reviewed the product margins reported by the
traditional cost system.
 Then, it contrasted the differences between the traditional and ABC
product margins.

SINTAYEHU T. 79
Product Margins Computed Using the Traditional Cost
System
The first step in computing product margins is to gather each product’s
sales and direct cost data.
Custom
Standard Compass
Stanchions Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Direct costs
Direct material 905,500 69,500 975,000
Direct labor 263,750 87,500 351,250

Classic Brass’s traditional cost system assigns only manufacturing

costs to products, this includes direct materials, direct labor, and
manufacturing overhead. Selling and administrative costs are not
assigned to products.
SINTAYEHU T. 80
Product Margins Computed Using the Traditional Cost
System
The second step in computing product margins is to compute the
plantwide overhead rate.
Manufacturing Overhead Costs at Classic Brass
Production Department
Indirect factory wages $ 500,000
Factory equipment depreciation 300,000
Factory utilities 120,000
Factory building lease 80,000
Total manufacturing overhead $ 1,000,000

Plantwide manufacturing $1,000,000

= = $50 per machine-hour
overhead rate 20,000 MH

Machine-hours
Standard Stanchions 17,500
Custom compass Housings 2,500
Total machine-hours 20,000
SINTAYEHU T. 81
Product Margins Computed Using The Traditional Cost
System
The third step in computing product margins is allocate manufacturing
overhead to each product.
Machine Overhead Overhead
Hours Rate Allocated
Standard Stanchions 17,500 $ 50.00 $ 875,000
Custom Compass Housings 2,500 50.00 125,000
Total overhead allocated to products $ 1,000,000

17,500
17,500 hours
hours ×
× $50
$50 per
per hour
hour =
= $875,000
$875,000

SINTAYEHU T. 82
 Product Margins Computed Using The Traditional Cost System

The fourth step is to actually compute the product margins.

Custom
Standard Stanchions Compass Housings Total
Sales $ 2,660,000 $ 540,000 $ 3,200,000
Cost of goods sold
Direct materials $ 905,500 $ 69,500 $ 975,000
Direct labor 263,750 87,500 351,250
Manufacturing overhead 875,000 2,044,250 125,000 282,000 1,000,000 2,326,250
Product margin $ 615,750 258,000 873,750
Selling and administrative 875,000
Nett operating
operating income
loss $ (1,250)

Shipping expenses $ 65,000

Marketing expenses 300,000
General administrative expenses 510,000
$ 875,000
SINTAYEHU T. 83
The Differences Between ABC and Traditional Product
Costs
Standard Custom
Stanchions Compass Housings
Product margins – traditional $ 615,750 $ 258,000
Product margins – ABC 906,250 (49,500)
Change in reported margins $ 290,500 $ (307,500)

The traditional cost The traditional cost

system overcosts the system undercosts the
standard stanchions custom compass
and reports a lower housings and reports
product margin a higher product
for this product. margin for this product.

SINTAYEHU T. 84
The Differences Between ABC and Traditional Product
Costs
The traditional cost system overcosts the standard stanchions and
consequently reports an artificially low product margin for this product.
The switch to an activity based view of product profitability increases
the product margin on standard stanchions by $290,500. In contrast,
the traditional cost system undercosts the custom compass housings
and reports an artificially high product margin for this product. The
switch to activity-based costing decreases the product margin on
custom compass housings by $307,500.

SINTAYEHU T. 85
The Differences Between ABC and Traditional Product
Costs
There are three reasons why the traditional and activity-based costing systems report
different product margins. First, Classic Brass’s traditional cost system allocates all
manufacturing overhead costs to products. This forces both products to absorb all
manufacturing overhead costs regardless of whether they actually consumed the costs
that were allocated to them. The ABC system does not assign the manufacturing
overhead costs consumed by the Customer Relations activity to products because these
costs are caused by customers, not specific products. It also does not assign the
manufacturing overhead costs included in the Other activity to products because these
organization-sustaining and unused capacity costs are not caused by any particular
product. From an ABC point of view, assigning these costs to products is inherently
arbitrary and counterproductive.
SINTAYEHU T. 86
 Differences Between ABC and Traditional Product
Costs

There are three reasons why the reported product margins for the two costi
differ from one another.

Traditional costing allocates all manufacturing overhead to products. ABC

only assigns manufacturing overhead costs consumed by products to those

SINTAYEHU T. 87
 Differences Between ABC And Traditional Product
Costs

There are three reasons why the reported product margins for the two cos
from one another.

 Traditional costing allocates all manufacturing overhead costs using a

allocation base. ABC costing also uses non-volume related allocation ba

SINTAYEHU T. 88
 Differences Between ABC And Traditional Product
Costs

There are three reasons why the reported product margins for the two costi
from one another.

 Traditional costing disregards selling and administrative expenses becau

assumed to be period expenses. ABC costing directly traces shipping costs
includes nonmanufacturing overhead costs caused by products in the activi
are assigned to products.

SINTAYEHU T. 89
 Targeting Process Improvement
Activity-based management is used in conjunction with ABC to
identify areas that would benefit from process improvements.

While the theory of constraints approach is a

powerful tool for targeting improvement efforts,
activity rates can also provide valuable clues on
where to focus improvement efforts.

Benchmarking
Benchmarking can
can be
be used
used to
to compare
compare activity
activity cost
cost
information
information with
with world-class
world-class standards
standards of
of performance
performance
achieved
achieved by
by other
other organizations.
organizations.
SINTAYEHU T. 90
 Activity-based Costing and External Reporting

Most companies do not use ABC for external reporting

because . . .
1.
1. External
External reports
reports are
are less
less detailed
detailed than
than internal
internal reports.
reports.
2.
2. ItIt may
may be
be difficult
difficult to
to make
make changes
changes toto the
the company’s
company’s accounting
accounting
system.
system.
3.
3. ABC
ABC does
does not
not conform
conform to to GAAP.
GAAP.
4.
4. Auditors
Auditors may
may bebe suspect
suspect of of the
the subjective
subjective allocation
allocation process
process based
based on
on
interviews
interviews with
with employees.
employees.

SINTAYEHU T. 91
 ABC Limitations
Substantial resources Resistance to
required to implement unfamiliar numbers
and maintain. and reports.

Desire to fully Potential

allocate all costs misinterpretation of
to products. unfamiliar numbers.

Does not conform to

GAAP. Two costing
systems may be needed.
SINTAYEHU T. 92
 Report Activity-based Costing Data and Interpret
Reports
LEARNING OBJECTIVE: Prepare an action analysis
report using activity-based costing data and
interpret the report.

SINTAYEHU T. 93
 ABC Action Analysis

Conventional
Conventional ABCABC analysis
analysis does
does not
not identify
identify potentially
potentially relevant
relevant
costs.
costs. An
An action
action analysis
analysis report
report helps
helps because
because it: it:
•• Shows
Shows what
what costs
costs have
have been
been assigned
assigned to to aa cost
cost object.
object.
•• Indicates
Indicates how
how difficult
difficult itit would
would be be toto adjust
adjust those
those costs
costs in
in
response
response toto changes
changes inin the
the level
level of
of activity.
activity.

SINTAYEHU T. 94
 ABC Action Analysis

Constructing an action analysis report begins with the first-

stage allocation process.
In addition to computing an overall activity rate for each
activity cost pool, an activity rate is computed for each type of
overhead cost that is consumed supporting a given activity.
Let’s revisit the stage-one allocations from the Classic Brass
example that we discussed earlier.

SINTAYEHU T. 95
 ABC Action Analysis
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages $ 125,000 $ 200,000 $ 100,000 $ 50,000 $ 25,000 $ 500,000
Factory equipment depreciation 60,000 - 180,000 - 60,000 300,000
Factory utilities - 12,000 60,000 - 48,000 120,000
Factory building lease - - - - 80,000 80,000
General Administrative Department
Administrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000
Office equipment depreciation 15,000 - - 12,500 22,500 50,000
Administrative building lease - - - - 60,000 60,000
Marketing Department
Marketing wages and salaries 55,000 20,000 - 150,000 25,000 250,000
Selling expenses 5,000 - - 35,000 10,000 50,000
Total $ 320,000 $ 252,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000

$125,000 ÷ 1,000 orders = $125 per order

Other entries in the table are computed similarly.
SINTAYEHU T. 96
 $125 per order × 600 orders = $75,000
Other entries in the table are computed similarly.
SINTAYEHU T. 97
 Action Analysis Cost Matrix for Custom Compass Housing
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Total
Total activity for compass housing 400 400 2,500 N/A
Production Department
Indirect factory wages $ 50,000 $ 200,000 $ 12,500 $ 262,500
Factory equipment depreciation 24,000 - 22,500 46,500
Factory utilities - 12,000 7,500 19,500
Factory building lease - - - -
General Administrative Department - -
Administrative wages and salaries 24,000 20,000 5,000 49,000
Office equipment depreciation 6,000 - - 6,000
Administrative building lease - - - -
Marketing Department - -
Marketing wages and salaries 22,000 20,000 - 42,000
Selling expenses 2,000 - - 2,000
Total $128,000 $ 252,000 $ 47,500 $ 427,500

$125 per order × 400 orders = $50,000

Other entries in the table are computed similarly.
SINTAYEHU T. 98
 ABC Action Analysis
Next,
Next, label
label each
each cost
cost using
using an
an ease
ease ofof adjustment
adjustment code:code:
 Green
Green costs
costs adjust
adjust more
more or
or less
less automatically
automatically to to changes
changes inin
activity
activity level
level without
without any
any action
action by
by managers.
managers.
 Yellow
Yellow costs
costs can
can be
be adjusted
adjusted to
to changes
changes in in activity
activity level,
level, but
but itit
would
would require
require management
management action
action to
to realize
realize the
the change
change inin cost.
cost.
 Red
Red costs
costs can
can be
be adjusted
adjusted to
to changes
changes in in activity
activity level
level only
only with
with
aa great
great deal
deal difficulty
difficulty and
and with
with management
management intervention.
intervention.

SINTAYEHU T. 99
 ABC Action Analysis
Action Ana lysis of Custom Compa ss Housing

Sa le s $ 540,000
Gre e n costs
Dire ct ma te ria ls $ 69,500
Shipping costs 5,000 74,500
Gre e n ma rgin $ 465,500
Ye llow costs
Dire ct la bor 87,500
Indire ct fa ctory w a ge s 262,500
Fa ctory utilitie s 19,500
Administra tive w a ge s a nd sa la rie s 49,000
Office e quipme nt de pre cia tion 6,000
Ma rke ting w a ge s a nd sa la rie s 42,000
Se lling e x pe nse s 2,000 468,500
Ye llow ma rgin $ (3,000)
Re d costs
Fa ctory e quipme nt de pre cia tion 46,500
Fa ctory building le a se -
Administra tive building le a se - 46,500
Re d ma rgin $ (49,500)

SINTAYEHU T. 100
 Activity Based Costing for External Reporting

Using a Modified form of Activity-Based Costing to

Determine Product costs for External Reports

SINTAYEHU T. 101
 Activity-based Costing Techniques to Report for Externals

LEARNING OBJECTIVE: Use activity-based costing techniques to

compute unit product costs for external reports.

SINTAYEHU T. 102
 Activity-Based Costing for External Reports

AA modified
modified form
form of
of activity-based
activity-based costing
costing can
can be
be used
used to
to develop
develop produc
produ
costs
costs for
for external
external financial
financial reports.
reports.

ABC
ABC product
product costs:
costs:
•• Include
Include organization-sustaining
organization-sustaining costs
costs and
and unused
unused capacity
capacity costs.
costs.
•• Exclude
Exclude nonmanufacturing
nonmanufacturing costs
costs even
even ifif they
they are
are caused
caused by
by the
the produc
produc

SINTAYEHU T. 103
 Activity-Based Costing for External Reports

Maxtar
Maxtar Industries
Industries provides
provides thethe following
following information
information for
for the
the
company
company as as aa whole
whole and
and for
for its
its only
only two
two products—premium
products—premium and
and
standard
standard smoker/barbecue
smoker/barbecue units.
units.
Total
Total estimated
estimated manufacturing
manufacturing overhead
overhead $
$ 1,520,000
1,520,000
Total
Total estimated
estimated direct
direct labor
labor hours
hours 400,000
400,000

Premium
Premium Standard
Standard
Direct
Direct materials
materials cost
cost per
per unit
unit $
$ 40.00
40.00 $
$ 30.00
30.00
Direct
Direct labor
labor cost
cost per
per unit
unit $
$ 24.00
24.00 $
$ 18.00
18.00
Direct
Direct labor
labor hours
hours per
per unit
unit 2.0
2.0 1.5
1.5
Units
Units produced
produced 50,000
50,000 200,000
200,000

SINTAYEHU T. 104
 Activity-Based Costing for External Reports

Assuming that Maxtar’s traditional cost system relies on one

predetermined plantwide overhead rate with direct labor-hours
(DLHs) as the allocation base, then its plantwide overhead rate is
computed as follows:

Predetermined $1,520,000
overhead rate = 400,000 DLHs = $3.80 per DLH

SINTAYEHU T. 105
 Activity-Based Costing for External Reports

Maxtar’s
Maxtar’s traditional
traditional cost
cost system
system would
would report
report unit
unit
product
product costs
costs as
as follows:
follows:
Premium
Premium Standard
Standard
Direct
Direct materials
materialscost
cost per
per unit
unit $$ 40.00
40.00 $$ 30.00
30.00
Direct
Direct labor
labor cost
cost per
per unit
unit 24.00
24.00 18.00
18.00
Manufacturing
Manufacturing overhead
overhead perper unit
unit 7.60
7.60 5.70
5.70
Unit
Unit product
product cost
cost $$ 71.60
71.60 $$ 53.70
53.70

2.0 DLH × $3.80 per DLH

1.5 DLH × $3.80 per DLH

SINTAYEHU T. 106
 Activity-Based Costing for External Reports
The ABC project team at Maxtar has developed the following basic
information.
Estimated
Estimated
Overhead
Overhead
Activity
Activity and
and Activity
Activity Measures
Measures Cost
Cost Expected
Expected Activity
Activity
Premium
Premium Standard
Standard Total
Total
Direct
Directlabor
laborsupport
support(DLHs)
(DLHs) $$ 800,000
800,000 100,000
100,000 300,000
300,000 400,000
400,000
Machine
Machine setups
setups (setups)
(setups) 480,000
480,000 600
600 200
200 800
800
Parts
Parts administration
administration (part
(parttypes)
types) 240,000
240,000 140
140 60
60 200
200
Total
Totalmanufacturing
manufacturing overhead
overhead $$ 1,520,000
1,520,000

SINTAYEHU T. 107
 Activity-Based Costing for External Reports
We can calculate the following activity rates:

Estimated Total
Overhead Expected
Activity and Activity Measures Cost Activity Activity Rate
Direct labor support (DLHs) $ 800,000 ÷ 400,000 = $ 2 per DLH
Machine setups (setups) 480,000 ÷ 800 = $ 600 per setup
Parts administration (part types) 240,000 ÷ 200 = $ 1,200 per part type
Total manufacturing overhead $ 1,520,000

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

SINTAYEHU T. 108
 Activity-Based Costing for External Reports
Premium Product
Expected
Expected Activity
Activity
Activity
Activity and
and Activity
Activity Measures
Measures Activity
Activity Rate
Rate Amount
Amount
Direct
Direct labor
labor support
support (DLHs)
(DLHs) 100,000
100,000 ×
× $$ 22 == $$ 200,000
200,000
Machine
Machine setups
setups (setups)
(setups) 600
600 ×
× $$ 600
600 == 360,000
360,000
Parts
Parts administration
administration (part
(part types)
types) 140
140 ×
× $$ 1,200
1,200 == 168,000
168,000
Total
Total overhead
overhead cost
cost assigned
assigned $$ 728,000
728,000

Standard Product
Expected
Expected Activity
Activity
Activity
Activity and
and Activity
Activity Measures
Measures Activity
Activity Rate
Rate Amount
Amount
Direct
Direct labor
labor support
support (DLHs)
(DLHs) 300,000
300,000 ×
× $$ 22 =
= $$ 600,000
600,000
Machine
Machine setups
setups (setups)
(setups) 200
200 ×
× $$ 600
600 =
= 120,000
120,000
Parts
Parts administration
administration (part
(part types)
types) 60
60 ×
× $$ 1,200
1,200 =
= 72,000
72,000
Total
Total overhead
overhead cost
cost assigned
assigned $$ 792,000
792,000

SINTAYEHU T. 109
 Activity-Based Costing for External Reports

Activity-based
Activity-based unit
unit product
product costs
costs for
for both
both
product
product lines
lines

Premium
Premium Standard
Standard
Direct
Direct materials
materials cost
cost per
per unit
unit $$ 40.00
40.00 $$ 30.00
30.00
Direct
Direct labor
labor cost
cost per
per unit
unit 24.00
24.00 18.00
18.00
Manufacturing
Manufacturing overhead
overhead perper unit
unit 14.56
14.56 3.96
3.96
Unit
Unit product
product cost
cost $$ 78.56
78.56 $$ 51.96
51.96

SINTAYEHU T. 110
 Activity-Based Costing for External Reports

Activity-based
Activity-based unit
unit product
product costs
costs for
for both
both
product
product lines
lines
Premium
Premium Standard
Standard
Direct
Direct materials
materialscost
cost per
per unit
unit $$ 40.00
40.00 $$ 30.00
30.00
Direct
Direct labor
labor cost
cost per
per unit
unit 24.00
24.00 18.00
18.00
Manufacturing
Manufacturing overhead
overhead perper unit
unit 14.56
14.56 3.96
3.96
Unit
Unit product
product cost
cost $$ 78.56
78.56 $$ 51.96
51.96

$728,000 ÷ 50,000 units

$792,000 ÷ 200,000 units

SINTAYEHU T. 111
 Activity-Based Costing for External Reports
Comparing the two approaches

Activity-Based
Activity-Based Costing
Costing Traditional
Traditional Costing
Costing
Premium
Premium Standard
Standard Premium
Premium Standard
Standard
Direct
Direct material
material $$ 40.00
40.00 $
$ 30.00
30.00 $
$ 40.00
40.00 $$ 30.00
30.00
Direct labor
Direct labor 24.00
24.00 18.00
18.00 24.00
24.00 18.00
18.00
Manufacturing
Manufacturing overhead
overhead 14.56
14.56 3.96
3.96 7.60
7.60 5.70
5.70
Unit product cost
Unit product cost $$ 78.56
78.56 $
$ 51.96
51.96 $
$ 71.60
71.60 $$ 53.70
53.70

Note that the unit product cost of a Standard unit decreased

from $53.70 to $51.96 . . . . .

. . . . . while the unit cost of a Premium unit increased from

$71.60 to $78.56.

SINTAYEHU T. 112
 Cost Flows in an Activity- Based Costing
System

SINTAYEHU T. 113
 Predetermined Overhead Rates

Calculate the predetermined overhead rate for each activity center

based on the following formula:
Predetermined overhead rate =
Estimated overhead cost associated with the activity center
Expected activity level of the cost driver

SINTAYEHU T. 114
 Journal Entries

Record purchase of raw materials

Dr Raw Materials
Cr Accounts Payable
Record transfer of raw material to work in process
Dr Work In Process (direct material)
Dr Manufacturing overhead (indirect material)
Cr Raw
Materials

SINTAYEHU T. 115
 Cont’d
Record labour costs
Dr Work In Process (direct labour)
Dr Manufacturing Overhead (indirect labour)
Cr Salaries and Wages Payable
Record overhead costs
Dr Manufacturing Overhead
Cr Accumulated Amortization
Cr Property Taxes Payable
Cr Prepaid Insurance
Cr Accounts Payable

SINTAYEHU T. 116
 Cont’d
Record applied overhead
Dr Work In Process
Cr Manufacturing Overhead

Applied overhead for each activity center is calculated by

multiplying each of the individual predetermined overhead
rates by the actual level of cost driver activity incurred. Then,
sum all these individual totals to determine the total applied
overhead for the company.

SINTAYEHU T. 117
 Cont’d
Record transfer to finished goods
Dr
Finished Goods
Cr Work In Process
Record sale of goods
Dr Accounts Receivable
Cr Sales
and
Dr Cost of Goods Sold
Cr Finished Goods

SINTAYEHU T. 118
 CHAPTER SUMMARY
C1: Distinguish between the plantwide overhead rate method, the
departmental overhead rate method, and the activity-based costing
method. Overhead costs can be assigned to cost objects using a
plantwide rate that combines all overhead costs into a single rate, usually
based on direct labor hours, machine hours, or direct labor cost. Multiple
departmental overhead rates that include overhead costs traceable to
departments are used to allocate overhead based on departmental
functions. ABC links overhead costs to activities and assigns overhead
based on how much of each activity is required for a product.
SINTAYEHU T. 119
 CHAPTER SUMMARY
C2 Explain cost flows for activity-based costing. With ABC, overhead costs are first traced to
the activities that cause them, and then cost pools are formed combining costs caused by
the same activity. Overhead rates based on these activities are then used to assign overhead
to products in proportion to the amount of activity required to produce them.
C3Describe the four types of activities that cause overhead costs. The four types of
activities that cause overhead costs are: (1) unit-level activities, (2) batch-level activities, (3)
product-level activities, and (4) facility-level activities. Unit level activities are performed on
each unit, batch-level activities are performed only on each group of units, and product-level
activities are performed only on each product line. Facility-level activities are performed to
sustain facility capacity and are not caused by any specific product. Understanding these
types of activities can help in applying activity-based costing.
SINTAYEHU T. 120
 CHAPTER SUMMARY
A1 Identify and assess advantages and disadvantages of the plantwide
overhead and departmental overhead rate methods. A single plantwide
overhead rate is a simple way to assign overhead cost. A disadvantage is that it
can inaccurately assign costs when costs are caused by multiple factors and
when different products consume different amounts of inputs. Overhead costing
accuracy is improved by use of multiple departmental rates because differences
across departmental functions can be linked to costs incurred in departments.
Yet, accuracy of cost assignment with departmental rates suffers from the same
problems associated with plantwide rates because the activities required for
each product are not identified with the costs of providing those activities.
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 CHAPTER SUMMARY
A2 Identify and assess advantages and disadvantages of activity-based
costing. ABC improves product costing accuracy and draws management
attention to relevant factors to control. The cost of constructing and
maintaining an ABC system can sometimes outweigh its value.
P1 Allocate overhead costs to products using the plantwide overhead rate
method. The plantwide overhead rate equals total budgeted overhead divided
by budgeted plant volume, the latter often measured in direct labor hours or
machine hours. This rate multiplied by the number of direct labor hours (or
machine hours) required for each product provides the overhead assigned to
each product.
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 CHAPTER SUMMARY
P2 Allocate overhead costs to products using the departmental overhead rate method.
When using multiple departmental rates, overhead costs must first be traced to each
department and then divided by the measure of output for that department to yield
the departmental overhead rate. Overhead is applied to products using this rate as
products pass through each department.
P3 Allocate overhead costs to products using activity based costing. With ABC,
overhead costs are matched to the activities that cause them. If there is more than
one cost with the same activity, these costs are combined into pools. An overhead
rate for each pool is determined by dividing total cost for that pool by its activity
measure. Overhead costs are assigned to products by multiplying the ABC pool rate by
the amount of the activity required for each product.
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 END OF CHAPTER TWO

I call this
quality
time!

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