Activity-Based Costing

Chapter
4-1
 Study
Study Objectives
Objectives

1. Recognize the difference between traditional

costing and activity based costing.

2. Identify the steps in the development of an

activity-based costing system.

3. Know how companies identify the activity cost

pools used in activity-based costing.

4. Know how companies identify and use cost

drivers in activity-based costing.
Chapter
4-2
 Traditional
Traditional Costing
Costing

To allocate as fairly as possible the true

costs of the products.
When management has more accurate costs,
better decisions can be made.
Direct Materials and Direct Labor costs are
easiest to trace through:
Material requisitions.
Payroll time sheets.

Chapter
4-3
 Hard
Hard Part
Part of
of Determining
Determining Product
Product Costs
Costs is?
is?

Determining the proper amount of

overhead to assign to each product,
service or job.

Chapter
4-4
 Traditional
Traditional Costing
Costing and
and ABC
ABC

Chapter
4-5
 Traditional
Traditional Costing
Costing

Allocates overhead using a single predetermined

rate.
Job order costing: Direct labor cost is assumed
to be the relevant activity base.
Assumption was satisfactory when direct labor
was a major portion of total manufacturing
costs.

There should be of a high correlation

between direct labor costs and overhead
costs.

Chapter SO 1: Recognize the differences between traditional costing and

4-6 activity-based costing.
 Traditional
Traditional Costing
Costing
Allocates overhead using a single
predetermined rate.
Process Costing: Machine hours is assumed
to be the relevant activity base.

Assumption was satisfactory when machine

hours was a major portion of total
manufacturing costs.

There should be of a high correlation

between machine hours and overhead
costs.

SO 1: Recognize the differences between traditional costing and

Chapter activity-based costing.
4-7
 Why
Why Do
Do Companies
Companies Need
Need aa New
New Approach?
Approach?
Tremendous change in manufacturing and
service industries.

Decrease 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).
Chapter
SO 1: Recognize the differences between traditional costing and
4-8 activity-based costing.
 Activity-Based
Activity-Based Costing
Costing
 Is another approach (other than traditional costing) to
allocate manufacturing overhead.
 An overhead cost allocation system that allocates
overhead to multiple activity cost pools,
and
 Assigns the activity cost pools to products or services
by means of cost drivers that represent the activities
used.

Chapter
SO 1: Recognize the differences between traditional costing and
4-9 activity-based costing.
 ABC
ABC Definitions
Definitions
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: The overhead cost attributed
to a distinct type of activity.
Examples:
Purchasing materials.
Setting up machines.
Cost Drivers: Any factors or activities that have
a direct cause-effect relationship with the
resources consumed.

Chapter
4-10 SO 1: Identify the steps in management’s decision-making process.
 Activity-Based
Activity-Based Costing
Costing

Products consume activities,

and
Activities consume resources.

Chapter
4-11 SO 1: Recognize the differences between traditional costing and
activity-based costing.
 Activity-Based
Activity-Based Costing
Costing

ABC allocates overhead costs in two stages:

Stage 1: Overhead costs are allocated to activity

cost pools.

Stage 2: The overhead costs allocated to the cost

pools is assigned to products using cost drivers.

The more complex a product’s manufacturing

operation, the more activities and cost drivers
likely to be present.

Chapter
SO 1: Recognize the differences between traditional costing and
4-12 activity-based costing.
 OVERHEAD
OVERHEAD COSTS
COSTS

Illustration 17-2

Chapter
SO 1: Recognize the differences between traditional costing and
4-13 activity-based costing.
 Overhead
Overhead Costs
Costs

Illustration 17-3

Chapter SO 1: Recognize the differences between traditional costing and

4-14 activity-based costing.
 Activity-Based
Activity-Based Costing
Costing

ABC does not replace an existing job

order/process cost system.

ABC does segregate overhead into

various cost pools to provide more
accurate cost information.

ABC, thus, supplements – it does not

replace – the traditional cost system.

Chapter
4-15 SO 2 Identify the steps in the development of an activity-based system.
 Activity-Based
Activity-Based Costing
Costing
Atlas Company produces two automotive antitheft
devices:
The Boot: A high volume item with sales totaling 25,000 per year.
The Club: A low volume item with sales totaling 5,000 per year.

Each product requires 1 hour of direct labor

Total annual direct labor hours (DLH) 30,000 (25,000 + 5000).
Direct labor cost $12 per unit for each product.

Expected annual manufacturing overhead costs

$900,000
Direct materials cost:
The Boot - $40 per unit.
The Club - $30 per unit.

Chapter
SO 1: Recognize the differences between traditional costing and
4-16 activity-based costing.
 Costing
Costing Under
Under Traditional
Traditional Costing
Costing

Products
Manufacturing Costs The Boot The Club
Direct Materials $40 $30
Direct Labor $12 $12
Overhead $30 $ 30*
Total unit cost $82 $72

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

Overhead = predetermined overhead rate times direct labor hours
($30 × 1 hr. = $30)

Chapter
4-17 SO 2 Identify the steps in the development of an activity-based system.
 Four
Four Steps
Steps of
of Activity-Based
Activity-Based Costing
Costing

Identify and classify the major activities

and allocate manufacturing overhead costs
to the appropriate cost pools.

Identify the cost driver that has a strong

correlation to the costs in the cost pool.

Compute the overhead rate for each pool.

Assign overhead costs for each cost pool to

products using the overhead rates.
Chapter
4-18 SO 2 Identify the steps in the development of an activity-based system.
 Activity
Activity Cost
Cost Pools
Pools and
and Estimated
Estimated
Overhead
Overhead

Activity Cost Pools Estimated Overhead

Setting up machines $300,000
Machining $500,000
Inspecting $100,000
Total $900,000

Illustration 17-4

Chapter
SO 3 Know how companies identify the activity cost pools
4-19 and use activity-based costing.
 Identify
Identify Cost
Cost Drivers
Drivers

Expected Use
of Cost Drivers
Activity Cost Pools Cost Drivers Per
Activity
Setting up machines $300000 Number of setups 1,500
Machining $500000 Machine hours 50,000
Inspecting $1,00,000 Number of Inspection
2,000

Illustration 17-5

SO 4 Know how companies identify and use cost drivers in

Chapter activity-based costing
4-20
 Formula
Formula for
for Computing
Computing Activity-Based
Activity-Based
Overhead
Overhead Rate
Rate

Estimated Overhead Per Activity

= Activity-Based Overhead Rate
Expected Use of Cost Drivers Per Activity

Illustration 17-6

Expected Use
Estimated of Cost Drivers Activity-Based
Activity Cost Pools Overhead Per Activity Overhead Rates
Setting 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

Chapter Illustration 17-7

4-21
SO 4 Know how companies identify and use cost drivers in activity-based costing
 Expected
Expected Use
Use of
of Costs
Costs to
to Products
Products

Illustration 17-8

SO 4 Know how companies identify and use cost drivers in

Chapter activity-based costing
4-22
 Assignment
Assignment of
of Activity
Activity Cost
Cost Pools
Pools to
to
Products
Products

Illustration 17-9

SO 4 Know how companies identify and use cost drivers in

Chapter
4-23
activity-based costing
 Unit
Unit Product
Product Costs
Costs Under
Under Traditional
Traditional
and
and ABC
ABC Costing
Costing Methods
Methods

The Boot The Club

Trad. Trad.
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

Oversstated Understated
$13 $65

Illustration 7-11

SO 4 Know how companies identify and use cost drivers in

Chapter activity-based costing
4-24
 Results
Results of
of Using
Using ABC
ABC

Under ABC, overhead costs are shifted

from the high volume product (The Boot) to
the low volume product (The Club) because:
Low volume products often require more
special handling.
Assigning overhead using ABC will usually
increase the cost per unit of low volume
products.

SO 4 Know how companies identify and use cost drivers

Chapter in activity-based costing
4-25
 Benefits
Benefits of
of Activity-Based
Activity-Based Costing
Costing

More accurate product costing through:

Use of more cost pools to assign overhead
costs.
Enhanced control over overhead costs.
Better management decisions.

Chapter
4-26
SO 5 Understand the benefits and limitations of activity-based costing
 Limitations
Limitations of
of Activity-Based
Activity-Based Costing
Costing

Can be expensive to use (Cost/Benefit).

Some arbitrary allocations continue.

Chapter
4-27 SO 5 Understand the benefits and limitations of activity-based costing
 Use
Use ABC
ABC When
When One
One or
or More
More of
of the
the
Following
Following Exist:
Exist:
Products differ greatly in volume/manufacturing
complexity.
Products lines are:
Numerous.
Diverse.
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 “bootleg” costing data.
Chapter SO 5 Understand the benefits and limitations of activity-based costing
4-28
 Let’s
Let’s Review
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.

Chapter
4-29
SO 5 Understand the benefits and limitations of activity-based costing
 Activity-Based
Activity-Based Management
Management (ABM)
(ABM)

An extension of ABC from a product

costing system to a management function
that focuses on reducing costs and
improving processes and decision making.
A refinement of ABC used in ABM
classifies activities as either value-added
or non-value-added.

Chapter
4-30 SO 6 Differentiate between value-added and non-value activities
 Value-
Value- Added
Added Activities
Activities
An activity that increases the worth
of a product or service such as:
Manufacturing Company Service Company
Engineering design Performing surgery
Machining Legal research services
Assembly Delivering packages
Painting
Packaging

Chapter
4-31 SO 5 Understand the benefits and limitations of activity-based costing
 Non-Value
Non-Value Activities
Activities
An activity that adds cost to, or increases the
time spent on, a product/service without increasing
its market value such as:
Manufacturing Company Service Company
Repair of machines Taking appointments
Storage of inventory Reception
Moving of raw materials, Bookkeeping/billing
assemblies, and Traveling
finished goods Ordering supplies
Building maintenance
Inspections
Inventory Control

Chapter
4-32
 Classification
Classification of
of Activity
Activity Levels
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.

Chapter
4-33
 Hierarchy
Hierarchy of
of Activity
Activity Levels
Levels

Illustration 17-13

Chapter
4-34 SO 7 Understand the value of using activity levels in activity-based costing.
 Activity-Based
Activity-Based Costing
Costing In
In Service
Service
Industries
Industries

Similarities with Manufacturing Firms

Overall objective:
Identify key cost-generation activities and keep
track of quantity of activities performed for
each service provided.

General 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.
Chapter
4-35 SO 8 Apply activity-based costing to service industries.
 Major
Major Difficulty
Difficulty of
of Implementing
Implementing ABC
ABC

A larger proportion of
overhead costs are
company-wide costs that
cannot be directly
traced to specific
services.
Chapter
4-36
 Condensed
Condensed Budget
Budget of
of Service
Service Company
Company
under
under Traditional
Traditional Costing
Costing
CHECK AND DOUBLECHECK, 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 Costs

$1,200,000
= 200%
$600,000

Chapter Illustration 17-14

4-37
SO 8 Apply activity-based costing to service industries.
 Overhead
Overhead Applied
Applied Under
Under Traditional
Traditional
Costing
Costing

CHECK AND DOUBLECHECK, CPAs

Plano Molding Company Audit

Revenue $260,000
Less: Direct professional labor $ 70,000
Applied Overhead (200% × $70,000) 140,000 210,000
Operating Income $ 50,000

Illustration 17-15

Chapter
4-38 SO 8 Apply activity-based costing to service industries.
 Activity-Based
Activity-Based Costing
Costing Budget
Budget

CHECK AND DOUBLECHECK, CPAs

Annual Overhead Budget
Expected
Use of Activity-Based
Estimated Cost Drivers Overhead
Activity Cost Pools Cost Drivers Overhead Per Activity Rates
Secretarial support Direct Prof. hours $ 210,000 30,000 $7 per hour
Direct labor Fringe benefits Direct 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
Telephone and postage None (traced directly) 71,000 N/A Based on usage
Legal support Hours used 129,000 860 $150 per hour
Insurance
(professional liability, etc.) Revenue billed 120,000 $2,000,000 $0.06 per $1 rev.
Recruiting and training Direct Prof. Hours __ 210,000 30,000 $7 per hour
$1,200,000

Illustration 17-16

Chapter
4-39 SO 8 Apply activity-based costing to service industries.
 Assigning
Assigning Overhead
Overhead in
in aa Service
Service Company
Company
CHECK AND DOUBLECHECK, CPAs
Plano Molding Company Audit

Activity-
Actual Based
Use of Overhead Cost
Activity Cost Pools Cost Drivers Driver Rate Assigned
Secretarial support Direct Professional hours 3,800 $ 7.00 $ 26,600
Direct labor Fringe benefits Direct 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
Telephone and postage None (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 Direct Prof. Hours 3,800 $ 7.00 26,600
$165,100

Illustration 17 -17
Chapter
4-40 SO 8 Apply activity-based costing to service industries.
 Comparison
Comparison of
of Traditional
Traditional and
and ABC
ABC
CHECK AND DOUBLECHECK, CPAs
Plano Molding Company Audit

Traditional Costing ABC .

Revenues $260,000 $260,000
Expenses
Direct professional labor $ 70,000 $ 70,000
Applied overhead 140,000 165,100
Total expenses 210,000 235,100
Operating income $ 50,000 $ 24,900
Profit Margin 19.2% 9.6%

Illustration 17-18
Chapter
4-41
SO 8 Apply activity-based costing to service industries.
 Review
Review
Recognize the difference between traditional and
activity-based costing.
Traditional system allocates overhead to products using
predetermined unit-based output rate.
ABC allocates overhead to activity cost pools and assigns cost to
products using cost drivers.

Identify the steps in the development of an activity-

based costing system.
Step 1: Identify the major activities and allocate the
overhead costs to cost pools.
Step 2: Identify the cost driver highly correlated to the cost
pool.
Step 3: Compute the overhead rate per cost driver.
Step 4: Assign cost pools to products or services using the
overhead rates.
Chapter
4-42
 Review
Review
Know how companies identify cost pools used in ABC.
Analyze each operation or process, document and time every
task, action, or transaction.

Know how companies identify and use cost drivers in ABC.

Cost drivers identified for assigning activity cost pools must:
Accurately measure the consumption of the activity.
Have related data easily available.
Understand the benefits and limitations of ABC:
Benefits:
Enhanced control over overhead costs.
Better management decisions.
Limitations:
Higher costs accompany multiple activity centers and cost
drivers.
Some costs must still be allocated arbitrarily.

Chapter
4-43
 Review
Review
Differentiate between value-added and non-value-added
activities.
Value-added activities increase the worth of a product or service.
Non-value-added activities add cost to, or increase the time spent
on, a product or service without increasing its market value.

Understand the value of using activity levels in ABC.

Activities may be classified as:
Unit-level
Batch-level
Product-level
Facility-level

Failure to recognize this classification can result

in distorted product costing.

Chapter
4-44
 Review
Review

Apply ABC to service industries.

Same objective – improved costing of
services provided.

The general approach to costing is also

the same:
Analyze operations.
Identify activities.
Accumulate overhead costs by activity
cost pools.
Identify and use cost drivers to assign
cost to services.

Chapter
4-45
 Just-in-Time
Just-in-Time

A processing system dedicated to

having the right amount of materials,
products, or parts arrive as they are
needed, thereby reducing the amount
of inventory.

Chapter
4-46
 JUST-in-TIME
JUST-in-TIME PROCESSING
PROCESSING
. 100 pairs of Send rubber and
sneakers... shoe laces directly to
got it! the factory.

Sales Order
Received

’s
Susane
Socc sr
r
Sneake

d to C u stomer
Goods Manufactured pe
Chapter Go ods Ship
4-47 Illustration 17-A1
 Just-in-Time
Just-in-Time
Objective of JIT:
Eliminate all manufacturing inventories.

Elements of JIT:
Dependable suppliers.
Multi-skilled work force.
Total quality control system.

Benefits of JIT:
Reduced inventory.
Enhanced product quality.
Reduced rework and storage costs.
Savings from improved flow of goods.
Chapter
4-48
 Let’s
Let’s Review
Review

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. Non-value-added activity.

Chapter
4-49
 COPYRIGHT
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Chapter
4-50