Chapter 4 Activity-Based Product Costing

Learning Objectives

1. Discuss the importance of unit costs.

Objective 1 Discuss the importance of unit costs.

Unit costs

Functional-based and activity-based costing assigns costs to cost objects such as procucts, customers,
suppliers, materials, and marketing channels. The unit cost is the total cost associated with the units
produced divided by the number of units produced.

For example :

If belRing produces 100 phones of the same model and the total cost for these phones is $6,000, then
the cost of each phone is $60 ($6,000/100).

Cost measurement consists of determining the dollar amounts of direct materials, direct labor, and
overhead used in production. The dollar amounts may be the actual amounts expended for the
manufacturing inputs or they may be estimated amounts, The process of associating the costs, once
measured, with the units produced is called cost assignment,

Functional and activity based approaches are two compteting ways of assigning costs to products.

Importance of Unit Product Costs

A cost accounting system measures and assigns costs so that the unit cost of a product or service can be
determined. Unit cost is a critical piece of information for both manufacturing and service firms.

For example :

Bidding is a common requirement in the markets for specialized products and services (consider bids for
special tools, audits, and medical tests and procedures). Decisions concerning product and service
design and introduction of a new products and services are affected by expected unit costs. Decisions to
make or buu a product or service, to accept or reject a special order, or to keep or drop a product or
service require unit cost information. Because unit cost information is so vital, it's accuracy is essential.
Distorted unit product costs are not acceptable.

Production of Unit Cost Information

To produce unit cost information, a product cost definition, cost measurement, and cost assignment are
required. Two possible measurement systems are actual costing and normal costing.
Actual costing assigns the actual costs of direct materials, direct labor, and overhead to products.
Normal costing assigns the actual costs of direct mateials and direct labor to products; however,
overhead costs are assigned to products using predetermined rates. A predetermined overhead rate is
a rate based on estimated data and computed using the following formula :

Predetermined overhead rate = Budgeted (estimated) cost/Estimated activity usage

How overhead rates ae used to assign costs to products will become clear as the specifics of functional
and activity base costing are discussed.

Functional-Based Product Costing

Functional-based product costing assigns the cost of direct materials and direct labor to products using
direct tracing. Overhead costs, on the other hand, are assigned using driver tracing and allocation.
Specifically, functional-based costing uses unit-level activity drivers to assign overhead costs to products.
Unit-level activity drivers are factors that cause changes in costs as the units produced change.

A functional-based predetermined overhead rate requires specification of a unit-level driver, an

1. Units produced
2. Dirct labor hours
3. Direct labor dollars
4. Machine hours
5. Direct material dollars

After choosing a unit-level driver, the next step is to determine the activity capacity that the driver
measures. Although any reasonable capacity level could be chosen, the four usual candidates are
expected capacity, normal capacity, theoretical capacity, and practical capacity.

Expected activity capacity is the activity output the firm expects to attain for the coming yar. Normal
activity capacity is the average activity output that a firm experiences in the long term (normal volume
is computed over more than one period). Theoretical activity capacity is the absolute maximum activity
output that can be realized assuming everything operates perfectly. Practical activity capacity is the
maximum output that can be realized if everything operates efficiently.

Plantwide Rates
This calculation consists of two stages. First, budgeted overhead costs are accumulated in one large
plantwide pool (first-stage cost assignment). Finally overhead costs are assigned to products, multiplying the rate by
the actual total direct labor hours used by each product.
 Activity Capacity Measures

Functional-Based Costing: Plantwide Rate

Computation of a plantwide Rate

The computation of a plantwide rate is best illustrated with the costing approach used by
BeRing before Henderson Associates changed its costing system, int its Springdale plant, BelRing
produces two telephones: a cordless phone and a regular model. The company has the following
estimated and actual data for the year 200:

Budgted overhead $360,000

Expedted activity (in direct labor hours) $100,000

Actual activity (in direct labor hours) $100,000

Actual overhead $30,000

Predetermined overhead rate = Budgeted overhead/Expected activity

= $360,000/100,000 direct labor hours (DLH)

= $3.60 per DLH

Aplied Overhead

The total overhead assigned to actual production at any point in time is called
applied overhead and is computed using the following formula:
Applied overhead = Overhead rate x Actual activity output
Using the overhead rate, applied overhead for the year is
Applied overhead = Overhead rate x Actual activity

= $3.60 100,000 DLH