ACCT 200 Sabrina

Chapter 5

Activity-based Costing
Sabrina, YY XIE
LG508, Tel:28065186
YYXIE@ hksyu.edu
Case of Comtek Sound, Inc.
O Comtek Sound, Inc. makes two products: CD
players and DVD players.
O The company has been losing bids to supply CD
players, its main product, to lower priced
competitors.
O The company has been winning all bids to
supply DVD players, its secondary product.
3-2
O For the current year, Comtek has budgeted sales
of 50,000 DVD units and 200,000 CD units.
O Total manufacturing overhead costs for the current
year are estimated to be $10,000,000. Comteks
traditional cost system applies manufacturing
overhead to products based on direct labor hours.
O Both products require two direct labor-hours to
complete, for a total of 500,000 direct labor
hours.
Hours
DVDs: 50,000 units @ 2 hours per unit = 100,000
CDs: 200,000 units @ 2 hours per unit = 400,000
Total direct labor-hours 500,000
3-3
O Unit costs for materials and labor are:
DVD CD
Units Units
Direct materials 90 $ 50 $
Direct Labor 20 $ 20 $
3-4
What are the costs for DVD and CD?
DVD Unit CD Unit
Direct materials 90 $ 50 $
Direct labor 20 20
Manufacturing overhead 40 40
(2 DLHs x $20 per DLH)
Unit product cost 150 $ 110 $
3-5
Total manufacturing overhead costs based
upon labor-hours:
Total DVD Unit CD Unit
Estimated production 50,000 Unit 200,000 Unit
Estimated labor hours 500,000 hrs 100,000 hrs 400,000 hrs
Estimated Overhead $10,000,000 ? ?
Predetermined
overhead rate
= $20 per DLH =
$10,000,000
500,000 DLHs
Overhead costs include following items:
Depreciation of machines
Electricity used by machines
Several clerks in factory are hired to process
orders
A team of technicians is hired to set up
machines

70% of machine hours is used to make CD units, 30% for
DVD
Company expect to receive and process 1,200 orders, of
which, 800 orders for DVD, 400 orders for CD
Expect to have 4000 setups during the year, of which, 25%
for CD, 75% for DVD

Critical thinking: what is the problem with the
traditional costing method?
Case of Comtek Sound, Inc.
ACCT 200 Sabrina


Direct Material
Direct Labor
Overhead
Job / Process 1
Job / Process 2
Tracing
Allocation
There are two ways to allocate Overhead:
Volume based (chap 4)
Activity based Costing
ACCT 200 Sabrina
Estimated total overhead
Estimated total quantity of cost-allocation base

Volume Based Allocation (Traditional Allocation
Method)
A single overhead rate used throughout an entire factory
or department.
3-8
Indirect Costs
Product
Unit-level allocation
base
E.g., Machine hours
Direct labor hours
Direct material costs
ACCT 200 Sabrina
Activity-Based Costing (ABC)
Activity-based costing (ABC) assigns resource
costs to cost objects using a two stage method.
stage one: total overhead are assigned to each
activity.

stage two: identify cost driver for each activity;
costs of activities are assigned to cost objects
according to the cost driver.
ACCT 200 Sabrina
10
Activity-Based Costing
Indirect
Costs
Activity
Activity
Activity
Product
Cost driver
that is
associated
with a
particular
activity
(cause-and-
effect
relationship)
Cost Pool
A number of allocation bases are used for assigning
overhead to products.
There is a cause-and-effect relationship between each
activity costs and each allocation base.
ACCT 200 Sabrina
An activity is a specific task or action of work done.

An activity causes the consumption of overhead
resources.
Setting up
machines
()
Examples of Activities
Processing
production
orders
Processing
Units by
machine
Design
Products
3-11
ABC Terms
ACCT 200 Sabrina

all activities are classified into four groups according to
the way in which the activities consume resources

A unit-level activity is performed on each individual unit
of product or service of the firm (e.g. processing units on
machine)

A batch-level activity is performed for each batch ( )
or group of units of products or services (e.g., setting up
machines or placing purchase orders)

A product-level activity supports the production of a
specific product or service (e.g., Designing products)

A facility-level activity supports entire production process
(e.g., property taxes and insurance)
Hierarchy of Activities
ACCT 200 Sabrina
In class exercise:
The following activities occur at Greenwich Corporation, a company that
makes a variety of products

a. Various individuals manage the parts inventories.
b. A clerk in the factory issues purchase orders for a job.
c. The maintenance department performs periodic preventative
maintenance on general-use equipment.
d. The factorys general manager meets with other department heads to
coordinate plans.
e. Direct labor workers assemble products.
f. Engineers design new products.
g. The materials storekeeper issues raw materials to be used in jobs.

Required

1. Classify each of the activities as a unit-level, batch-level, product-
sustaining, or facility-sustaining activity.
2. Identify a proper cost driver for each activity in requirement 1.
ACCT 200 Sabrina
Examples of Activities
Level Activities Drivers
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
Designing products Hours of design time
Facility-level General factory administration
Plant building and grounds
3-14
ACCT 200 Sabrina
Graphic Example of Activity-Based Costing
Various Overhead Costs
Labor
Related Pool
Machine
Related Pool
Setup
Pool
Production
Order Pool
General
Factory Pool
Parts
Admin. Pool
First-Stage Cost Assignment
3-15
ACCT 200 Sabrina
Unit-Level
Activity
Batch-Level
Activity
Facility-Level
Activity
Product-Level
Activity
Various Overhead Costs
Products
$/DLH $/MH $/Setup $/Order $/MH $/Part Type
Second-Stage Allocations
Labor
Related Pool
Machine
Related Pool
Setup
Pool
Production
Order Pool
General
Factory Pool
Parts
Admin. Pool
First-Stage Cost Assignment
3-16
Graphic Example of Activity-Based Costing
Activity-Based Costing (ABC)
For each activity in
isolation, this system works exactly
like the job costing system
described in Chapter 4.
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.
3-17
Volume-Based vs. ABC
Example: Comtek Sound, Inc.
O Comtek Sound, Inc. makes two products: CD
players and DVD players.
O The company has been losing bids to supply CD
players, its main product, to lower priced
competitors.
O The company has been winning all bids to
supply DVD players, its secondary product.
3-18
O For the current year, Comtek has budgeted sales
of 50,000 DVD units and 200,000 CD units.
O Comteks traditional cost system applies
manufacturing overhead to products based on
direct labor hours.
O Both products require two direct labor-hours to
complete, for a total of 500,000 direct labor
hours.
Hours
DVDs: 50,000 units @ 2 hours per unit = 100,000
CDs: 200,000 units @ 2 hours per unit = 400,000
Total direct labor-hours 500,000
3-19
Volume-Based vs. ABC
Example: Comtek Sound, Inc.
O Unit costs for materials and labor are:
DVD CD
Units Units
Direct materials 90 $ 50 $
Direct Labor 20 $ 20 $
3-20
Volume-Based vs. ABC
Example: Comtek Sound, Inc.
Total overhead costs for the current year are
estimated to be $10,000,000. The company
develops the following overhead rate based
upon labor-hours:
Predetermined
overhead rate
= $20 per DLH =
$10,000,000
500,000 DLHs
Volume-Based: Direct Labor-Hours as a Base
3-21
DVD Unit CD Unit
Direct materials 90 $ 50 $
Direct labor 20 20
Overhead 40 40
(2 DLHs x $20 per DLH)
Unit product cost 150 $ 110 $
Since each product requires two hours of
direct labor, $40 of overhead is assigned to
each product.
3-22
Volume-Based: Direct Labor-Hours as a Base
The ABC project team at Comtek has
developed the following basic information.
Activity and Activity Measures
Estimated
Overhead
Cost
Total DVD CD
Labor related (DLH) 800,000 $ 500,000 100,000 400,000
Machine related (MH) 2,100,000 1,000,000 300,000 700,000
Machine setups (setups) 1,600,000 4,000 3,000 1,000
Production orders (orders) 3,150,000 1,200 800 400
Parts administration (part types) 350,000 700 400 300
General factory (MH) 2,000,000 1,000,000 300,000 700,000
10,000,000 $
Expected Activity
Activity as a Base
3-23
We can calculate the following activity rates:
Activity and Activity Measures
Estimated
Overhead
Cost
Total
Expected
Activity
Labor related (DLHs) 800,000 $ 500,000 = 1.60 $ per DLH
Machine related (MHs) 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 (MHs) 2,000,000 1,000,000 = 2.00 per MH
10,000,000 $
Activity Rate
Using the new activity rates, lets assign overhead
to the two products based upon expected activity.
3-24
Activity as a Base
Activity and Activity Measures
Expected
Activity
Activity
Rate
Labor related (DLHs) 100,000 1.60 $ = 160,000 $
Machine related (MHs) 300,000 2.10 = 630,000
Machine setups (setups) 3,000 400.00 = 1,200,000
Production orders (orders) 800 2,625.00 = 2,100,000
Parts administration (part types) 400 500.00 = 200,000
General factory (MHs) 300,000 2.00 = 600,000
Total overhead cost assigned 4,890,000 $
Number of units produced 50,000
Overhead cost per unit 97.80 $
Amount
DVD Units
3-25
Computing Overhead Cost per Unit
Computing Overhead Cost per Unit
Activity and Activity Measures
Expected
Activity
Activity
Rate
Labor related (DLHs) 400,000 1.60 $ = 640,000 $
Machine related (MHs) 700,000 2.10 = 1,470,000
Machine setups (setups) 1,000 400.00 = 400,000
Production orders (orders) 400 2,625.00 = 1,050,000
Parts administration (part types) 300 500.00 = 150,000
General factory (MHs) 700,000 2.00 = 1,400,000
Total overhead cost assigned 5,110,000 $
Number of units produced 200,000
Overhead cost per unit 25.55 $
Amount
CD Units
3-26
Note that the unit product cost of a CD
unit decreased from $110 to $95.55 . . . .
. . . . while the unit cost of a DVD unit
increased from $150 to $207.80.
Comparing the Two Approaches
DVD Unit CD Unit DVD Unit CD 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 $
Activity-Based Costing Direct-Labor Costing
3-27
DVD Unit CD Unit DVD Unit CD 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 $
Activity-Based Costing Direct-Labor Costing
Comparing the Two Approaches
The ABC system assigns $14.45
less overhead than the traditional
system to each CD player.
3-28
DVD Unit CD Unit DVD Unit CD 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 $
Activity-Based Costing Direct-Labor Costing
Comparing the Two Approaches
The ABC system assigns $57.80
more overhead than the traditional
system to each DVD player.
3-29
DVD Unit CD Unit DVD Unit CD 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 $
Activity-Based Costing Direct-Labor Costing
Volume-based costing tends to undercost low-
volume products and overcost high-volume
products. (referred to as product cost cross-
subsidization)
Low-volume product
3-30
Comparing the Two Approaches
Comparing the Two Approaches
DVD Unit CD Unit DVD Unit CD Unit
Unit selling price 200.00 $ 150.00 $ 200.00 $ 150.00 $
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 $
Profit margin (7.80) $ 54.45 $ 50.00 $ 40.00 $
Activity-Based Costing Direct-Labor Costing
3-31
ACCT 200 Sabrina
Benefits of ABC Systems
ABC improves the accuracy of product costing
Better profitability measures due to more
accurate costs
Improved cost estimation
Activity-based costing also highlights activities
that could benefit most from process improvement
Better decision making: identification of
value-added vs. non-value-added activities
and associated costs
Information for process
ACCT 200 Sabrina

Not all costs have appropriate or unambiguous
activity drivers: e.g. facility-level costs

Developing and implementing ABC system
requires substantial resources.

Limitations of Activity-Based Costing
3-33
ACCT 200 Sabrina
gathering data from existing documents and records, as well as
collecting additional data using questionnaires, observations, or
interviews of key personnel




Sample questions include:
What work or activities do you do?
How much time do you spend performing these activities?
What resources are required to perform these activities?
What value does the activity have or the product, service, customer, or
organization?
Developing an ABC System
Activities are usually chosen by interviewing a broad
range of managers to find out what activities they
think consume most of the organizations resources.
ACCT 200 Sabrina
Produce inaccurate product costs
when more factory overhead costs such as setup and
materials handling costs are not volume-based
when firms produce a diverse mix of products with
different volume, sizes, and complexities.
Separating product costs and activities.
Limitations of Volume-based costing systems
Benefit of Volume-based costing systems
Lower costs in developing and implementing the costing
system
ACCT 200 Sabrina
Volume-Based Costing or ABC ?
Depends on industry, products, and information needs
volume-based costing may be a good strategic choice
for some firms
direct costs are the major cost of the product or
service
and the activities are relatively simple, low-cost, and
homogeneous across different product lines
Example: paper product manufacturers, producers of
agricultural products, other commodity firms, and
professional service firms
ACCT 200 Sabrina
High-value-added activities:

Increase significantly the value of the product or
service, necessary to meet customer requirements,
contribute to customer satisfaction, and are critical
steps in a business process

removal would reduce the value of the product or
service
Activity Based Management
Focuses on managing activities to eliminate
waste and reduce delays and defects.
ACCT 200 Sabrina
Low-value-added activities:

Consume time, resources, or space and add little or
nothing to satisfying customer needs

Can be eliminated without affecting the
form/fit/function of the product or service
Activity Based Management eliminate low-value-
added activities, focus on high-value-added activities
Activity Based Management
ACCT 200 Sabrina
1. Allocate overhead based on activities

2. Compare volume-based costing and activity-based
costing

3. ABC Management
Outline
ACCT 200 Sabrina
5-53
The CCO has been using machine hours as the basis to
determine overhead costs for all products. An ABC
project team points out that the firm manufactures several
products. Each of which use different factory supporting
resources. The team suggests the following overhead cost
pools, cost drivers, and estimated cost driver levels for
manufacturing overheads:

Estimated Cost
Driver Level
Budgeted
Overhead OH Cost Pool Cost Driver
Machine setups Number of setups 100 $100,000
Materials handling Number of barrels 8,000 $80,000
Quality control Number of inspections 1,000 $200,000
Other overhead cost Machine-hours 10,000 $100,000
ACCT 200 Sabrina
Number of Cost Driver Units
Overhead Cost Pool P5 G23
Machine setups 1 50
Materials handling (barrels) 500 500
Quality inspections 2 20
Machine-hours 1,000 1,000
CCO has recently completed production of 500 barrels each of P5 and
G23. P5 and G23 are two of the firms many products. The production
requires the following operations:
P5 G23
Direct Materials $50.00 $30.00
Direct labor $20.00 $10.00
Price $170 $160
The direct labor and direct materials cost per barrel are as follows:
ACCT 200 Sabrina
Required
1. Determine the overhead cost per barrel of P5 and G23 using the
current single cost driver system based on machine-hours.
2. Determine the overhead cost per barrel of P5 and G23 using the
ABC costing system.
3. Eexplain how the choice of costing system help the firm.
4. What is the least profitable and the most profitable product under
both the current and the ABC costing systems?


ACCT 200 Sabrina
End of Chapter 5
2-43