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Managerial Accounting, Fourth Edition

ACTIVITY-BASED COSTING
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 VERSUS
TRADITIONAL COSTING

@raditional Costing Systems

Allocates overhead using a single predetermined
rate.
Job order costing: direct labor cost is assumed
to be the relevant activity base.
Process costing: machine hours is the relevant
activity base.

Assumption was satisfactory when direct labor

was a major portion of total manufacturing costs.
Wide acceptance of a high correlation between
direct labor and overhead costs.
 Traditional Costing Systems
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irect labor is still often the appropriate basis for

assigning overhead costs when:

irect labor constitutes a significant part of total product cost

O

High correlation exists between direct labor and changes in overhead costs

Overhead irect Labor Products

Costs Hours/ollars
 Need for a New Approach
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@remendous change in manufacturing and service
industries.

ecrease in amount of direct labor usage.

Significant increase in total overhead costs.

May be inappropriate to use plant-wide

predetermined overhead rates based on direct labor
or machine hours when a lack of correlation exists.

Complex manufacturing processes may require

multiple allocation bases; this approach is called
Activity-Based Costing (ABC).
 Activity-Based Costing (ABC)
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An overhead cost allocation system that allocates

overhead to multiple activity cost pools
O

Assigns the activity cost pools to products or
services by means of cost drivers that represent the
activities used.
 Activity-Based Costing (ABC)
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Terms

Activity: any event, action, transaction, or work

sequence that causes a cost to be incurred in
producing a product or providing a service.

Activity Cost Pool: a distinct type of activity.

For example: ordering materials or setting up
machines.

Cost rivers: any factors or activities that have a

direct cause-effect relationship with the
resources consumed.
 The Logic Behind ABC
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 Activity-Based Costing (ABC)
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ABC allocates overhead costs in two stages:

Stage 1: Overhead costs are allocated to activity

cost pools.

Stage 2: @he overhead costs allocated to the cost

pools is assigned to products using cost
drivers.

@he more complex a product¶s manufacturing

operation, the more activities and cost drivers likely
to be present.
Activities and Related Cost Drivers
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ABC System Design ² Lift Jack Company
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 |

Traditional Costing

vs. ABC

ABC


 replace an existing job

order/process cost system.

ABC

 segregate overhead into various

cost pools to provide more accurate cost
information.

ABC, thus, supplements ± 


  O ±

the traditional cost system.
 Traditional Costing

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 vs. ABC
An Illustration

Atlas Company produces two automotive antitheft devices:

 @he Boot: a high volume item with sales totaling 25,000 per year
 @he Club: a low volume item with sales totaling 5,000 per year

Each product requires 1 hour of direct labor

 @otal annual direct labor hours (LH) 30,000 (25,000 + 5000)
 irect labor cost $12 per unit for each product

Expected annual manufacturing overhead costs $900,000

irect materials cost:

 @he Boot - $40 per unit
 @he Club - $30 per unit
Unit Costs Under Traditional Costing
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Products

Manufacturing Costs @he Boot @he Club

Direct Materials $40 $30
Direct Labor 12 12
Overhead 30* 30*
@otal unit cost $82 $72

* Predetermined overhead rate: $900,000/30,000 DLH = $30 per DLH

Overhead = predetermined overhead rate times direct labor hours
($30 X 1 hr. = $30)
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 Unit Costs Under ABC:
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Step 1: Identify
Activities and
and Classify
Allocate Overhead to Cost Pools

Activity Cost Pools Estimated Overhead

|etting up machines $300,000
Machining 500,000
Inspecting 100,000
Total $900,000
 Unit Costs Under

|
 ABC:
Step 2: Identify Cost Drivers

Expected Use
of Cost rivers
Activity Cost Pools Cost rivers Per Activity
|etting up machines Number of setups 1,500
Machining Machine hours 50,000
Inspecting Number of
Inspections 2,000
 Unit Costs Under

|
 ABC:
Step 3: Compute Overhead Rates

Formula for Computing Activity-Based Overhead Rate:

Estimated Overhead Per Activity Activity-Based

Expected Use of Cost rivers Per Activity Overhead Rate

Expected Use
Estimated of Cost rivers Activity-Based
Activity Cost Pools Overhead Per Activity Overhead Rates
|etting up machines $300,000 1,500 setups $200 per setup
Machining 500,000 50,000 machine hrs. $ 10 per mach. hour
Inspecting 100,000 2,000 inspections $ 50 per inspection
Total $900,000
 Unit Costs Under ABC:
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Step 4: Assign Overhead Costs to Products
Part 1: Expected Use of Cost Driver Per Product

Expected Use
of Cost rivers
per Product
Expected Use
Activity Cost of Cost rivers
Pools Cost river Per Activity @he Boot @he Club
|etting up Number of
machines setups 1,500 setups 500 1,000
Machining Machine hours 50,000 hours 30,000 20,000
Inspecting Number of
inspections 2,000 inspections 500 1,500
 Unit Costs Under

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 ABC:
Step 4: Assign Overhead Costs to Products
Part 2: Assign Cost Pools to Products

@he Boot

Expected Use of Activity-Based

Activity Cost rivers X Overhead = Cost
Cost Pools per Product Rates Assigned
|etting up machines 500 $200 $100,000
Machining 30,000 10 300,000
Inspecting 500 50 25,000
Total costs assigned $425,000
Units produced 25,000
Overhead cost per unit $17
 Unit Costs Under ABC:
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Step 2: Assign
 to Products
Overhead Costs
Part 2: Assign Cost Pools to Products

@he Club

Expected Use of Activity-Based

Activity Cost rivers X Overhead = Cost
Cost Pools per Product Rates Assigned
|etting up machines 1,000 $200 $200,000
Machining 20,000 10 200,000
Inspecting 1,500 50 75,000
Total costs assigned $475,000
Units produced 5,000
Overhead cost per unit $95
 |

Comparison
Costs
of Unit
Traditional vs. ABC

@he Boot @he Club

@raditional @raditional
Manufacturing Costs Costing ABC Costing ABC
Direct Materials $40 $40 $30 $30
Direct Labor 12 12 12 12
Overhead 30 17 30 95
Total Cost per Unit $82 $69 $72 $137

Overstated Understated
$13 $65
 Comparison of Unit Costs
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Traditional vs. ABC




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 |
 Costing:
Activity-Based

A Closer Look

More accurate product costing through:

XUse of more cost pools to assign overhead costs
XEnhanced control over overhead costs
XBetter management decisions
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Activity-Based Costing:

A Closer Look
Limitations of ABC

 Can be expensive to use

 Some arbitrary allocations continue
 Activity-Based Costing:
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Closer Look
Use ABC When One or More of the Following Exist:
Products differ greatly in volume/manufacturing complexity
Products lines are
 umerous
 iverse
 Require different degrees of support services
Overhead costs are a significant portion of total costs
Significant change in manufacturing process or number of
products
Managers ignore data from existing system and instead use
³bootleg´ costing data
 | Let·s Review




Activity-based costing (ABC):

a. Can be used only in a process cost system

b. Focuses on units of production
c. Focuses on activities performed to
produce a product
d. Uses only a single basis of allocation
 | Let·s Review




Activity-based costing (ABC):

a. Can be used only in a process cost system

b. Focuses on units of production
c. Focuses on activities performed to
produce a product
d. Uses only a single basis of allocation
 | Value-Added vs.



Non-Value-Added Activities

Activity Based Management (ABM):

An extension of ABC from a product costing

system to a management function
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A refinement of ABC used in ABM classifies
activities as either value-added or non-value-
added.
 Value-Added vs.
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Non-Value-Added Activities

Ôalue-Added Activity
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Manufacturing Company Service Company
engineering design performing surgery
machining legal research services
assembly delivering packages
painting
packaging
 Value-Added vs.
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Non-Value-Added Activities

on-Ôalue-Added Activities
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Manufacturing Company Service Company
Repair of machines @aking appointments
Storage of inventory Reception
Moving of raw materials, Bookkeeping/billing
assemblies, and finished goods @raveling
Building maintenance Ordering supplies
Inspections
Inventory Control
 CLASSIFICATION OF
|ACTIVITY



LEVELS

Unit-level activities:
Performed for each unit of production
Batch-level activities:
Performed for each batch of product
Product-level activities:
Performed in support of an entire product line, but
not always performed every time a new unit or
batch is produced
Facility-level activities:
Required to support or sustain an entire production
process
 Hierarchy of Activity Levels
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Four Levels @ypes of Activities Cost rivers
Unit-Level Activities Machine-related Machine Hours
Drilling, cutting, milling
Labor-related Direct labor hours/cost
Assembling, painting
Batch-Level Activities Equipment setups Number of setups/setup time
Purchase ordering Number of purchase orders
Inspection Number of inspections or
inspection time
Material handling Number of material moves
Product-Level Activities Product design Number of product designs
Engineering changes Number of changes
Facility-Level Activities Plant management Number of employees
salaries managed
Plant Building depreciation |quare footage
Property taxes |quare footage
Utilities |quare footage
 Activity-Based Costing
|in


Service Industries

Similarities with Manufacturing Firms

Overall objective:
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0eneral approach is to identify activities, cost pools,

and cost drivers

Labeling of activities as value-added or non-value-

added

Reduction of non-value-added activities

    
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 |
 Costing
Activity-Based

in Service Industries

Major difficulty to implementing

ABC:
A larger proportion of overhead
costs are company-wide costs
that O
 be directly traced to
specific services.
 Activity-Based Costing in Service Industries:
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@raditional Costing Example

CHECK A OUBLECHECK, CPAs

Annual Budget

Revenue $2,000,000
Direct labor $ 600,000
Overhead (expected) 1,200,000
Total Costs 1,800,000
Operating income $ 200,000

Estimated overhead
= Predetermined overhead rate
Direct labor cost

$1,200,000
= 200%
$600,000
 Activity-Based Costing in Service Industries:
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@raditional Costing Example

CHECK A OUBLECHECK, CPAs

Plano Molding Company Audit

Revenue $260,000
Less: Direct professional labor $ 70,000
Applied Overhead (200% x $70,000) 140,000 210,000
Operating Income $ 50,000
 Activity-Based Costing in Service Industries:
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ABC Costing Example
CHECK A OUBLECHECK, CPAs
Annual Overhead Budget
Expected Use
Activity Cost Estimated ÷ of Cost rivers = Activity-Based
Pools Cost rivers Overhead Per Activity Overhead Rates
Secretarial support irect Prof. hours $ 210,000 30,000 $7 per hour
irect labor Fringe benefits irect labor cost 240,000 $ 600,000 $0.40 per $1 labor
Printing and photocopying Working paper pages 20,000 20,000 $1 per page
Computer support CPU minutes 200,000 50,000 $4 per minute
@elephone and postage one (traced directly) 71,000 /A Based on usage
Legal support Hours used 129,000 860 $150 per hour
Insurance Revenue billed 120,000 $2,000,000 $0.06 per $1 rev.
Recruiting and training irect Prof. Hours __210,000 30,000 $7 per hour
$1,200,000
 Activity-Based Costing in Service Industries:
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ABC Costing Example
CHECK A OUBLECHECK, CPAs
Plano Molding Company Audit
Activity-
Based-
Activity Cost Actual Use Overhead
Pools Cost rivers of rivers Rates Cost Assigned
Secretarial support irect Professional hours 3,800 $ 7.00 $ 26,600
irect labor Fringe benefits irect labor cost $ 70,000 $ 0.40 28,000
Printing and photocopying Working paper pages 1,800 $ 1.00 1,800
Computer support CPU minutes 8,600 $ 4.00 34,400
@elephone and postage one (traced directly) 8,700
Legal support Hours used 156 $150.00 23,400
Insurance Revenue billed $260,000 $ 0.06 15,600
Recruiting and training irect Prof. Hours 3,800 $ 7.00 26,600
$165,100
Activity-Based Costing in Service Industries:
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ABC Costing Example
CHECK A OUBLECHECK, CPAs

Plano Molding Company Audit

@raditional Costing ABC

Revenues $260,000 $260,000
Expenses
irect professional labor $ 70,000 $ 70,000
Applied overhead 140,000 165,100
@otal expenses 210,000 235,100
Operating income $ 50,000 $ 24,900

Profit Margin 19.2% 9.6%

 Appendix
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Just-In-@ime Processing (JI@)

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 JUST |
IN


TIME PROCESSING
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 | JIT Processing



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Elements of JI@:
X ependable suppliers
X Multi-skilled work force
X @otal quality control system

Benefits of JI@:
X Reduced inventory
X Enhanced product quality
X Reduced rework and storage costs
X Savings from improved flow of goods
 Let¶s Review
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An activity that adds costs to the product but

does not increase market value is a
a. Value-added activity
b. Cost driver
c. Cost-benefit activity
d. Nonvalue-added activity
 Let¶s Review
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An activity that adds costs to the product but

does not increase market value is a
a. Value-added activity
b. Cost driver
c. Cost-benefit activity
d. Nonvalue-added activity

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