Chapter 4

Systems Design:
Activity Based Costing

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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
When cost
cost systems
systems were
were developed
developed in
in the
the 1800s,
1800s,
the
the emphasis
emphasis was
was on
on simplicity
simplicity because:
because:
1.
1. Cost
Cost and
and activity
activity data
data had
had to
to be
be collected
collected by
by
hand
hand and
and all
all calculations
calculations were
were done
done with
with paper
paper
and
and pencil.
pencil.
2.
2. Most
Most companies
companies produced
produced aa limited
limited variety
variety of
of
similar
similar products,
products, so
so there
there was
was little
little difference
difference
in
in the
the overhead
overhead costs
costs consumed
consumed by by each
each
product.
product.
3-4

Plantwide Overhead Rate

Plantwide Overhead Rate

A single overhead rate used
throughout an entire factory.
Direct
Direct labor
labor has
has often
often been
been used
used as
as the
the allocation
allocation
base
base for
for overhead
overhead because:
because:
1.
1. Direct
Direct labor
labor information
information was
was already
already being
being recorded.
recorded.
2.
2. Direct
Direct labor
labor was
was aa large
large component
component of of product
product costs.
costs.
3.
3. Managers
Managers believed
believed direct
direct labor
labor and
and overhead
overhead costs
costs
were
were highly
highly correlated.
correlated.
 3-5

Plantwide Overhead Rate

Today, direct labor may no longer be a
satisfactory base for allocation of overhead.
1.
1. Most
Most companies
companies sell
sell aa large
large variety
variety of
of products
products that
that
consume
consume differing
differing amounts
amounts of of overhead.
overhead.
2.
2. As
As aa percentage
percentage of
of total
total costs,
costs, direct
direct labor
labor has
has been
been
shrinking
shrinking and
and overhead
overhead has
has been
been increasing.
increasing. Many
Many ofof the
the
new
new overhead
overhead costs
costs may
may not
not be
be correlated
correlated with
with direct
direct
labor.
labor.
3.
3. Technology
Technology advancements
advancements have
have reduced
reduced the
the cost
cost and
and
complexity
complexity of
of gathering
gathering diverse
diverse sources
sources of
of data.
data.
AA plantwide
plantwide overhead
overhead allocation
allocation system
system may
may not
not be
be optimal
optimal
for
for many
many companies
companies in
in today’s
today’s business
business environment.
environment.
3-6

Departmental Overhead Rates

Many
Many companies
companies have
have aa system
system in
in which
which each
each
department
department has
has its
its own
own overhead
overhead rate.
rate.
The
The allocation
allocation base
base depends
depends
on
on the
the nature
nature of
of the
the work
work
Finishing Department performed
performed in in each
each department.
department.
In
In the
the machining
machining department,
department,
Painting Department overhead
overhead may may be
be based
based on on
machine-hours,
machine-hours, but but in
in the
the
Shipping Department assembly
assembly department,
department,
overhead
overhead may may be
be based
based on on
labor-hours.
labor-hours.
3-7

Departmental Overhead Rates

Departmental rates will not correctly assign overhead

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

The
The departmental
departmental approach
approach relies
relies
exclusively
exclusively on
on volume-related
volume-related allocation
allocation bases
bases while
while
some
some overhead
overhead costs
costs may
may be
be caused
caused byby factors
factors
that
that are
are not
not related
related to
to the
the volume
volume of
of production.
production.

Activity-base
Activity-base costing
costing is
is required
required to
to account
account for
for these
these
other
other factors.
factors.
3-8

Activity-Based Costing (ABC)

A number of allocation bases are

used for assigning costs to products.
3-9

Activity-Based Costing (ABC)

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

Activities
Activities

Consumption
Consumption of
of Resources
Resources

Cost
Cost
3-10

Activity-Based Costing (ABC)

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
3-11

Activity-Based Costing (ABC)

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.
3-12
Designing an Activity-Based
Costing System

The
The challenge
challenge isis to
to select
select aa
reasonably
reasonably small
small number
number of of activities
activities
that
that explain
explain the
the bulk
bulk of
of the
the variation
variation in
in
overhead
overhead costs.
costs.
Activities
Activities are
are usually
usually chosen
chosen byby
interviewing
interviewing aa broad
broad range
range of
of managers
managers
to
to find
find out
out what
what activities
activities they
they think
think
consume
consume mostmost of
of the
the organization’s
organization’s
resources.
resources.
3-13
Designing an Activity-Based
Costing System
Related activities are
frequently combined to reduce
the amount of detail and
record-keeping costs.
For example, several activities may
be involved in handling and moving
raw materials, but these may be
combined into a single activity
entitled material handling.

An
An activity
activity dictionary
dictionary defines
defines each
each of of the
the activities
activities
that
that will
will be
be included
included in
in the
the activity-based
activity-based costing
costing
system
system andand how
how the
the activities
activities will
will be
be measured.
measured.
3-14
Hierarchy of Activities
Level Activities
Unit-level Processing units on machines
Processing units by hand
Consuming factory supplies
Batch-level Processing purchase orders
Processing production orders
Setting up equipment
Handling materials
Product-level Testing new products
Administering parts inventories
Designing products
Facility-level General factory administration
Plant building and grounds
Activity Measure
Machine-hours
Direct labor-hours
Units produced
Purchase orders processed
Production orders processed
Number of setups
Pounds of material handled
Hours of testing time
Number of part types
Hours of design time
Direct labor-hours
Direct labor-hours
3-15
Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs

First-Stage Cost Assignment

Labor Machine
Machine Setup
Setup Production Parts
Parts General
Related
Related Pool
Pool Related
Related Pool Pool
Pool Order Pool Admin.
Admin. Pool
Pool Factory Pool
3-16
Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs

First-Stage Cost Assignment

Labor Machine
Machine Setup
Setup Production Parts
Parts General
Related
Related Pool
Pool Related
Related Pool Pool
Pool Order Pool Admin.
Admin. Pool
Pool Factory Pool

Second-Stage Allocations

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

Products
Unit-Level Batch-Level Product-Level Facility-Level
Activity Activity Activity Activity
3-17
Using Activity-Based Costing
Comtek Sound, Inc.

 Comtek Sound, Inc. makes two products: CD

players and DVD players.
 The company has been losing bids to supply CD
players, its main product, to lower priced
competitors.
 The company has been winning all bids to
supply DVD players, its secondary product.
3-18
Using Activity-Based Costing
Comtek Sound, Inc.
 For the current year, Comtek has budgeted sales

of 50,000 DVD units and 200,000 CD units.

 Comtek’s traditional cost system applies
manufacturing overhead to products based on
direct labor hours.
 Both products require two direct labor-hours to
complete, for a total of 500,000 direct labor
hours. Hours
DVDs: 50,000 units @ 2 hours per unit = 100,000
CDs: 200,00 units @ 2 hours per unit = 400,000
Total direct labor-hours 500,000
3-19
Using Activity-Based Costing
Comtek Sound, Inc.

 Unit costs for materials and labor are:

DVD CD
Units Units
Direct materials $ 90 $ 50
Direct Labor $ 20 $ 20
3-20

Direct Labor-Hours as a Base

Total manufacturing 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 $10,000,000
= = $20 per DLH
overhead rate 500,000 DLHs
3-21

Direct Labor-Hours as a Base

Since
Since each
each product
product requires
requires two
two hours
hours of
of
direct
direct labor,
labor, $40
$40 of
of overhead
overhead isis assigned
assigned to
to
each
each product.
product.
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
3-22

Comparing the Two Approaches

Activity-B ased C osting D irect-Labor C osting

D V D U nit C D U nit D V D U nit C D U nit
D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00
D irect labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

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.
3-23

Learning Objective 4

Contrast the product costs

computed under activity-
based costing and
conventional costing
methods.
3-24

Comparing the Two Approaches

Activity-B ased C osting D irect-Labor C osting

D V D U nit C D U nit D V D U nit C D U nit
D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00
D irect labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

The
The ABC
ABC system
system assigns
assigns $14.45
$14.45
less
less overhead
overhead than
than the
the traditional
traditional
system
system to
to each
each CD
CD player.
player.
3-25

Comparing the Two Approaches

Activity-B ased C osting D irect-Labor C osting

D V D U nit C D U nit D V D U nit C D U nit
D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00
D irect labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

The
The ABC
ABC system
system assigns
assigns $57.80
$57.80
more
more overhead
overhead than
than the
the traditional
traditional
system
system toto each
each DVD
DVD player.
player.
3-26

Shifting of Overhead Cost

Activity-B ased C osting D irect-Labor C osting

D V D U nit C D U nit D V D U nit C D U nit
D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00
D irect labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

Low-volume product
When
When aa company
company implements activity-based costing,
overhead
overhead cost
cost often
often shifts
shifts from
from high-volume
high-volume toto low-
low-
volume
volume products
products with
with aa higher
higher unit
unit product
product cost
cost
resulting
resulting for
for the
the low-volume
low-volume products.
products.
3-27

Shifting of Overhead Cost

Activity-B ased C osting D irect-Labor C osting

D V D U nit C D U nit D V D U nit C D U nit
D irect material $ 90.00 $ 50.00 $ 90.00 $ 50.00
D irect labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
U nit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

High-volume product

The
The traditional
traditional system
system assigns
assigns the
the same
same amount
amount of
of
all
all overhead
overhead costs
costs to
to each
each CD
CD oror DVD
DVD player
player
($40
($40 per
per unit).
unit).
3-28

Shifting of Overhead Cost

Production
Production Orders
Orders Activity
Activity Cost
Cost Pool
Pool
(a
(a batch-level
batch-level cost
cost pool)
pool)
The
The ABC
ABC system
system assigns
assigns different
different amounts
amounts of of
Production
Production Order-related
Order-related overhead
overhead costscosts to
to each
each product.
product.
This
This fact
fact can
can be
be illustrated
illustrated in
in aa two-step
two-step process.
process.

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

DVD Units CD 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
3-29

Shifting of Overhead Cost

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

DVD Units CD 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

Notice,
Notice, the
the costs
costs are
are being
being shifted
shifted from
from the
the high
high
volume
volume CDCD players
players to
to the
the low
low volume
volume DVDDVD players.
players.
3-30

Targeting Process Improvements

An ABC system can help identify

areas where the company can benefit
from improving its current processes.

Activity-Based
Activity-Based Management
Management
Focuses
Focuses on
on managing
managing activities
activities to
to eliminate
eliminate
waste
waste and
and reduce
reduce delays
delays and
and defects.
defects.
3-31

Targeting Process Improvements

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

The
The Theory
Theory of
of Constraints
Constraints Activity
Activity rates
rates can
can be
be
approach
approach targets
targets the
the used
used toto target
target areas
areas
highest
highest impact
impact where
where costs
costs seem
seem
improvement
improvement opportunities.
opportunities. excessively
excessively high.
high.

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.
3-32

Benefits of Activity-Based Costing

ABC
ABC improves
improves the
the accuracy
accuracy of
of product
product costing
costing by:
by:
 Increasing
 Increasing the
the number
number of
of cost
cost pools
pools used
used to
to accumulate
accumulate
overhead
overhead costs.
costs.

 Using
Using activity
activity cost
cost pools
pools that
that are
are more
more homogeneous
homogeneous thanthan
departmental
departmental cost
cost pools.
pools.

 Assigning
Assigning overhead
overhead costs
costs using
using activity
activity measures
measures that
that
cause
cause those
those costs,
costs, rather
rather than
than relying
relying solely
solely on
on direct
direct
labor
labor hours.
hours.

Activity-based
Activity-based costing
costing also
also highlights
highlights activities
activities
that
that could
could benefit
benefit most
most from
from process
process
improvement
improvement efforts,
efforts, such
such asas Six
Six Sigma.
Sigma.
3-33

Limitations Activity-Based Costing

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.
3-34
Activity-Based Costing
Critical Assumption

The
The cost
cost in
in each
each activity
activity pool
pool is
is strictly
strictly
proportional
proportional to
to its
its activity
activity measure
measure.. When
When this
this
assumption
assumption isis violated,
violated, the
the accuracy
accuracy ofof ABC
ABC
data
data can
can be be called
called into
into question.
question.

For
For example,
example, managers
managers should
should be
be particularly
particularly
alert
alert to
to product
product costs
costs that
that contain
contain allocated
allocated
facility-level
facility-level costs
costs..
3-35

Modifying the ABC Model

The
The illustrations
illustrations inin the
the chapter
chapter assume
assume
that
that ABC
ABC is is being
being used
used for
for external
external reporting
reporting
purposes.
purposes. IfIf the
the system
system is is used
used for
for internal
internal
decision-making
decision-making purposes,
purposes, two two important
important
modifications
modifications should
should bebe made:
made:
1.
1. Selling
Selling and
and administrative
administrative costs
costs should
should be
be
assigned
assigned to to products,
products, where
where appropriate.
appropriate.
2.
2. Facility-level
Facility-level costs
costs should
should bebe removed
removed
from
from product
product costs.
costs.
3-36

Cost Flows in an ABC System

The flow of costs

through Raw Materials,
Work in Process, and
other accounts is the
same under activity
based costing.
The only difference in
activity based costing is
that more than one
predetermined
overhead rate is used to
apply costs to products.
3-37

End of Chapter 4