Activity-Based Costing

Chapter 03

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 1
Understand the basic
approach in activitybased costing and how
it differs from
conventional costing.

3-2

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.
3-3

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.
3-4

Plantwide Overhead Rate

Today,
Today, direct
direct labor
labor may
may no
no longer
longer be
be aa satisfactory
satisfactory base
base
for
for allocation
allocation of
of overhead.
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 of
of
these
these growing
growing 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.
AAplantwide
plantwide overhead
overhead allocation
allocation system
system may
may not
not be
be optimal
optimal
for
for many
many companies
companies in
in today
todayss business
business environment.
environment.

3-5

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.

Machining Department

Assembly Department
Shipping Department

The
The allocation
allocation base
base depends
depends
on
on the
the nature
nature of
of the
the work
work
performed
performed in
in each
each department.
department.
In
In the
the machining
machining department,
department,
overhead
overhead may
may be
be based
based on
on
machine-hours,
machine-hours, but
but in
in the
the
assembly
assembly department,
department,
overhead
overhead may
may be
be based
based on
on
labor-hours.
labor-hours.

3-6

Departmental Overhead Rates

Departmental rates will not correctly assign overhead
in situations where a company has a range of
products and complex overhead costs.

3-7

Activity-Based Costing (ABC)

A number of allocation bases are used
for assigning costs to products.

3-8

Activity-Based Costing (ABC)

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

3-9

Activity-Based Costing (ABC)

An event that causes
the consumption of
overhead resources

Activity

Examples of Activities

Setting up
machines

Admitting
hospital
patients

Billing
customers

Opening a
bank account
3-10

Activity-Based Costing (ABC)

Activity
Cost Pool

A cost bucket in which

costs related to a particular
activity are accumulated.

Activity
Measure

Expresses how much of the

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

Activity
Rate

A predetermined overhead
rate for each activity
cost pool.

3-11

Activity-Based Costing (ABC)

For each activity in
isolation, this system works exactly
like the job-order costing system
described in Chapter 2.

AA predetermined
predetermined overhead
overhead rate
rate is
is computed
computed for
for
each
each activity
activity and
and then
then applied
applied to
to jobs
jobs and
and
products
products based
based on
on the
the amount
amount of
of activity
activity
consumed
consumed by
by the
the job
job or
or product.
product.
3-12

Designing an Activity-Based
Costing System
The
The challenge
challenge is
is 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 by
by 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 most
most of
of the
the
organizations
organizations 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 actions may
be involved in handling and moving
raw materials, but these may be
combined into a single activity
titled 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 and
and how
how the
the activities
activities will
will be
be measured.
measured.

3-14

Hierarchy of Activities
Level
Level

Activities
Activities

Activity
Activity Measure
Measure

Unit-level
Unit-level

Processing
Processing units
unitson
on machines
machines
Processing
Processing units
unitsby
byhand
hand
Consuming
Consuming factory
factorysupplies
supplies

Machine-hours
Machine-hours
Direct
Directlabor-hours
labor-hours
Units
Unitsproduced
produced

Batch-level
Batch-level

Processing
Processing purchase
purchaseorders
orders
Processing
Processing production
production orders
orders
Setting
Setting up
up equipment
equipment
Handling
Handling materials
materials

Purchase
Purchaseorders
ordersprocessed
processed
Production
Production orders
ordersprocessed
processed
Number
Numberof
ofsetups
setups
Pounds
Poundsof
ofmaterial
materialhandled
handled

Product-level
Product-level

Testing
Testing new
new products
products
Administering
Administering parts
partsinventories
inventories
Designing
Designing products
products

Hours
Hours of
oftesting
testing time
time
Number
Numberof
ofpart
parttypes
types
Hours
Hours of
ofdesign
design time
time

Facility-level
Facility-level

General
Generalfactory
factoryadministration
administration
Plant
Plantbuilding
building and
and grounds
grounds

Direct
Directlabor-hours
labor-hours
Direct
Directlabor-hours
labor-hours
3-15

Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs
First-Stage Cost Assignment

Labor
Related
Related Pool
Pool

Machine
Machine
Related
Related Pool

Setup
Setup
Pool
Pool

Production
Production
Order
Order Pool
Pool

Parts
Parts
Admin. Pool

General
General
Factory
Factory Pool
Pool

3-16

Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs
First-Stage Cost Assignment

Labor
Related
Related Pool
Pool

Machine
Machine
Related
Related Pool

Setup
Setup
Pool
Pool

Production
Production
Order
Order Pool
Pool

Parts
Parts
Admin. Pool

General
General
Factory
Factory Pool
Pool

Second-Stage Allocations
$/DLH

$/MH

$/Setup

$/Order

$/Part Type

$/MH

Products
Unit-Level
Activity

Batch-Level
Activity

Product-Level Facility-Level
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 to lower-priced competitors.
The company has been winning all bids to supply
DVD players.

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.
Comteks traditional cost system applies
manufacturing overhead to products based on directlabor hours.
Both products require two direct labor-hours to
complete, for a total of 500,000 direct labor-hours.

Hours
Hours
DVDs:
DVDs: 50,000
50,000 units
units @
@ 22 hours
hours per
per unit
unit == 100,000
100,000
CDs:
CDs: 200,00
200,00 units
units @
@ 22 hours
hours per
per unit
unit == 400,000
400,000
Total
500,000
Total direct
direct labor-hours
labor-hours
500,000
3-19

Using Activity-Based Costing

Comtek Sound, Inc.
Unit costs for materials and labor are:

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
=
overhead rate

$10,000,000
500,000 DLHs

= $20 per DLH

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 is
is assigned
assigned to
to
each
each product.
product.
Direct
Directmaterials
materials
Direct
Directlabor
labor
Manufacturing
Manufacturing overhead
overhead

DVD
DVD Unit
Unit
$$
90
90
20
20
40
40

CD
CD Unit
Unit
$$
50
50
20
20
40
40

$$

$$

(2
(2DLHs
DLHsxx$20
$20per
perDLH)
DLH)

Unit
Unitproduct
productcost
cost

150
150

110
110
3-22

Learning Objective 2
Compute activity rates
for an activity-based
costing system.

3-23

Computing Activity Rates

The ABC project team at Comtek has
developed the following basic information.

3-24

Computing Activity Rates

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.
3-25

Learning Objective 3
Compute product costs
using activity-based
costing.

3-26

Computing Overhead Cost per Unit

DVD Units

3-27

Computing Overhead Cost per Unit

CD Units

3-28

Comparing the Two Approaches

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.

3-29

Learning Objective 4
Contrast the product
costs computed under
activity-based costing
and conventional
costing methods.

3-30

Comparing the Two Approaches

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.
3-31

Comparing the Two Approaches

The
The ABC
ABC system
system assigns
assigns $57.80
$57.80
more
more overhead
overhead than
than the
the traditional
traditional
system
system to
to each
each DVD
DVD player.
player.
3-32

Shifting of Overhead Cost

Low-volume product

When
When aa company
company implements
implements activity-based
activity-based
costing,
costing, overhead
overhead cost
cost often
often shifts
shifts from
from highhighvolume
volume to
to low-volume
low-volume products
products with
with aa higher
higher unit
unit
product
product cost
cost resulting
resulting for the low-volume products.
3-33

Shifting of Overhead Cost

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 or
or DVD
DVD player
player
($40
($40 per
per unit).
unit).
3-34

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 costs
costs 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.
Number
Number of
of units
unitsproduced
produced per
per year
year
Number
Number of
of production
production orders
ordersissued
issued per
per year
year
Number
Number of
of units
unitsprocessed
processed per
per production
production order
order

DVD
DVD Units
Units
50,000
50,000
800
800
62.5
62.5

CD
CD Units
Units
200,000
200,000
400
400
500
500
3-35

Shifting of Overhead Cost

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

Cost
Costto
to issue
issue aa production
production order
order
Average
Average number
number of
ofunits
unitsprocessed
processed per
per
production
production order
order
Production
Production order
order cost
costper
per unit
unit

DVD
DVDUnits
Units CD
CDUnits
Units
$$ 2,625
2,625 $$ 2,625
2,625

$$

62.5
62.5
42.00
42.00 $$

500
500
5.25
5.25

Notice,
Notice, the
the costs
costs are
are being
being shifted
shifted from
from the
the highhighvolume
volume CD
CD players
players to
to the
the low-volume
low-volume DVD
DVD players.
players.
3-36

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.
3-37

Targeting Process Improvements

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

3-38

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.Assigning overhead costs using activity measures that
cause those costs, rather than relying solely on direct labor
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 as
as Six
Six Sigma.
Sigma.
3-39

Limitations of 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.
3-40

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 is
is violated,
violated, the
the accuracy
accuracy of
of 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
allocated
contain allocated
facility-level
facility-level costs
costs..
3-41

Modifying the ABC Model

The
The illustrations
illustrations in
in 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 be
be 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 be
be removed
removed
from
from product
product costs.
costs.
3-42

End of Chapter 03

3-43