Activity-Based Costing

1
 Factory Overhead
• those costs that are not conveniently
identified with particular orders or units of
prodcuts
• all factory costs other than direct materials
and direct labor
• cost pool used to accumulate all indirect
manufacturing costs.

2
 Indirect Materials
• factory supplies
• lubricants
• cleaning supplies
• small tools
• packaging materials
• other items used in small amounts in
manufacturing

3
 Indirect Labor
• factory supervisors
• factory clerical workers
• factory payroll clerks
• receiving clerks
• storeroom clerks
• storeroom supervisors
• purchasing clerks
• overtime premium (unless the time is identified
with a specific job)
4
 Other manufacturing overhead
• employee fringe benefits
• employer contributions
• worker’s compensation insurance
• factory utilities
• rent of factory building, warehouse and equipment
• depreciation of factory building and equipment
• property taxes
• fire insurance
• repairs and maintenance
• inventory shortage
• spoiled goods 5
 Cost Management Information Systems

• Unit-based costing system

• Activity-based costing system

6
Unit-based Product Costing model

Hansen/Mowen, Cornerstones of Cost Management, 4 th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Unit-Level Product Costing (1 of 2)
• Overhead costs are assigned to functional units
o Creates pooled costs, which is assigned to products using
predetermined overhead rates
• Predetermined overhead rate
o Calculated at the beginning of the year

Hansen/Mowen, Cornerstones of Cost Management, 4 th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Unit-Level Product Costing (2 of 2)
• Unit-level drivers: Factors that measure the
demands placed on unit-level activities by products
• Commonly used unit-level drivers
o Units produced
o Direct labor hours
o Direct labor dollars
o Machine hours
o Direct material dollars

Hansen/Mowen, Cornerstones of Cost Management, 4 th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Activity-Based Costing System 11
Overhead Variances (1 of 2)

• Difference between actual overhead and applied

overhead
o Underapplied overhead: Variance that occurs when actual
overhead is greater than applied overhead
o Overapplied overhead: Variance that occurs when actual
overhead is less than applied overhead

Hansen/Mowen, Cornerstones of Cost Management, 4 th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Overhead Variances (2 of 2)
• Disposal of variance
o If immaterial, it is assigned to cost of goods sold
o If material, it is allocated among work-in-process
inventory, finished goods inventory, and cost of
goods sold

Hansen/Mowen, Cornerstones of Cost Management, 4 th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Activity-Based Costing System 14
Activity-Based Costing System 15
Overhead Application: Departmental Rates

• Overhead costs are assigned to individual production

departments, creating departmental overhead cost pools
• Unit-level drivers are used to compute predetermined
overhead rates for each department
• Overhead is assigned to products by multiplying the
departmental rates by the amount of the driver used in the
respective departments

Hansen/Mowen, Cornerstones of Cost Management, 4 th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Activity-Based Costing System 17
Activity-Based Costing System 18
Activity-Based Costing System 19
 The
Concept
Activity-Based Costing
In contrast to traditional/absorption costing system, ABC system first
accumulates overheads costs for each organizational activity, and then
assigns the costs of the activities to the products, services, or customers
(cost objects) causing that activity.

Activity-Based Costing System 20

Activity-Based Costing

An overhead cost allocation system that focuses on

activities performed in producing a product.
 ABC System: More that one basis of allocating activity
costs to products is needed.
 Assumptions of ABC: All overhead costs related to the
activity
► must be driven by the cost driver used to assign costs to
products.
► should respond proportionally to changes in the activity
level of the cost driver.

LO 5
 Activity-Based Costing

Illustration 21-25
Activities and cost
drivers in ABC

LO 5
LEARNING APPENDIX 21A: Apply activity-based costing to a
OBJECTIVE 6 manufacturer.

Activity-Based Costing
Involves the following four steps.
1. Identify and classify the activities involved in the
manufacture of specific products and assign overhead to
cost pools.

2. Identify the cost driver that has a strong correlation to the

costs accumulated in each cost pool.

3. Compute the activity-based overhead rate for each cost

pool.

4. Allocate overhead costs to products, using the overhead

rates determined for each cost pool. LO 6
Identify and Classify Activities and Allocate
Overhead to Cost Pools (Step 1)

Overhead costs are assigned directly to the appropriate activity

cost pool. Illustration 21A-2
Activity cost pools and
estimated overhead

LO 6
 Identify Cost Drivers (Step 2)

Cost driver must accurately measure the actual

consumption of the activity by the various products.
Illustration 21A-3: Cost drivers that Atlas Company
identifies and their total expected use per activity cost pool.

Illustration 21A-3
Cost drivers and their
expected use

LO 6
Compute Activity-Based Overhead Rates
(Step 3)
Next, the company computes an activity-based overhead rate
per cost driver.
Illustration 21A-4

Illustration 21A-5

LO 6
 Allocate Overhead Costs to Products (Step
4)

In allocating overhead costs, it is necessary to know the

expected use of cost drivers for each product. Because of its
low volume and higher number of components, the Ab Coaster
requires more setups and purchase orders than the Ab Bench.

Illustration 21A-6
Expected use of cost
drivers per product

LO 6
Allocate Overhead Costs to Products

To allocate overhead costs, Atlas multiplies the activity-based

overhead rates per cost driver (Ill. 21A-5) by the number of
cost drivers expected to be used per product (Ill. 21A-6).
Illustration 21A-7
Allocation of
activity cost pools
to products

LO 6
Allocate Overhead Costs to Products

To allocate overhead costs, Atlas multiplies the activity-based

overhead rates per cost driver (Ill. 21A-5) by the number of
cost drivers expected to be used per product (Ill. 21A-6).

Illustration 21A-7 LO 6
 Comparing Unit Costs

Illustration 17-10

Illustration 21A-8
Likely consequence of differences in assigning overhead. Comparison of unit
product costs

 Overpricing the Ab Bench and possibly losing market

share to competitors.
 Sacrificing profitability by underpricing the Ab Coaster.
LO 6
 Definitions
ABC is a cost attribution to cost units on the basis of benefit received from
indirect activities.
Terminologies
An activity is an event that incurs costs.
A cost object is defined as anything for which a separate measure of cost is
desired/required.
An activity cost pool: The overheads cost allocated to a distinct type of
activity or related activities.
A cost driver is any factor or activity that has a direct cause and effect
relationship with the resources consumed.
Cost Unit: An item of production or a service for which it is useful to have
cost information.
Cost accounting: The process of identifying, analyzing, summarizing,
recording and reporting costs associated with business operations.
Direct costs: Those costs that are directly associated with the manufacturing
process.
Indirect/overheads costs: Those costs that are not directly identifiable with
a unit of production.

Activity-Based Costing System 31

 Related Concepts
Direct Costing System
A system of costing the products where direct costs (also referred to as variable costs) are assigned
to products only. It reflects the contribution to indirect costs. The system is considered
appropriate for decision-making purposes. It is recommended in the circumstances where indirect
costs are a low proportion of a company’s total costs.

Traditional or Absorption Costing System

It reflects full cost pertaining to a product. It is easy to use and, therefore, is practiced widely. The
allocation of overhead costs under the system is based on a rate determined by either a
percentage of direct labor cost or number of labor hours worked or another. Therefore, the
reported allocation of overheads for a given product may be incorrect. It is the main defect of
absorption costing.

Activity-Based Costing System

It also reflects full cost pertaining to a product. ABC system establishes relationships between
overheads costs and activities so that we can better allocate overheads costs. It reflects the
more accurate use of overheads costs based on their relevant activity levels achieved. The system
has eliminated the defects of traditional/absorption costing system.

Activity-Based Costing System 32

 The Defect of Traditional Costing
System

Spreads overheads cost over entire product range. A single overheads recovery
rate (also known as predetermined overheads rate or overheads absorption rate) is
used to absorb total overheads cost to all production. For instance,
For job order costing, overheads cost absorption rates are normally based on direct labor cost or
direct labor hours
For process costing, overheads cost absorption rates are normally based on machine hours worked

Results of the defect:

Each product appeared to cost the same, as far as overheads cost is concerned
Products with high profit margins subsidized products with low profit margins
In-accurate cost accumulation led to inaccurate profit planning of products
A product cannot compete in the market if its cost is not accurately accumulated and
reflected in costing records

33
Activity-Based Costing System
 ABC System
An overheads cost allocation system that:
allocates overheads cost 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.

Activity-Based Costing System 34

Process
Product
(A,B,C,D,…,N)

Cost Pools
(I,II,III,IV,V….,N)

Cost Drivers
(1,2,3,4,…N)

Activities (1,2,3,4,…
N)
Activity-Based Costing System 35
 Design
& Implementation
Step 1 Identify Cost Objects i.e. Product A,B,C

Step 2 Identify direct costs i.e. Direct Materials, Direct Labor, Direct expense

Step 3 Select the cost allocation bases to be used for overheads cost i.e. # of set-
ups, # of units, etc.

Step 4 Identify the overheads cost associated with the bases selected

Step 5 Compute the rate per unit

Step 6 Compute overheads cost for allocation to products

Step 7 Compute costs of products

Activity-Based Costing System 36

 Allocation Stage
Departments

Activity Design Setup Shipping

Overheads Cost
Pool

Cost No. of No. of No. of

Allocation employees Setup Shipments
Hours
Base

Cost
Objects Product A Product B Product C

Activity-Based Costing System 37

 Cost Pools & Cost Drivers
Activity Cost Pools Activity Cost Drivers

a) Number of units
 Production b) Number of set-ups
c) Number electricity units consumed

a) Number of sales personnel

 Marketing b) Number of sales orders

a) Number of research projects

 Research & Development b) Personnel hours spend on projects
c) Technical complexities of the projects

a) Number of service calls

 Customer Service b) Number of products serviced
c) Hours spend on servicing products

 Purchasing a) Number of purchase orders

 Material Handling a) Number
Activity-Based of material
Costing System requisitions 38
Activity-Based Costing System 39
Activity-Based Costing System 40
Activity-Based Costing System 41
 Illustration
King Company produces two products: Product X and
Product Y. Product X is a high-volume item totaling
50,000 units annually while Product Y is a low-volume
item totaling only 10,000 units per year. Both products
require on hour of direct labor to complete. Therefore,
total annual direct labor hours is 60,000. Estimated
manufacturing costs is P3,600,000.

The direct materials cost per unit is P80 for Product X

and P60 for Product Y with direct labor cost for both
products of P24 per unit.
Activity-Based Costing System 42
 Traditional Costing

Manufacturing Cost Product X Product Y

Direct materials P80 P60

Direct labor 24 24

Overhead 60 60

Total Unit Cost P164 P144

Activity-Based Costing System 43

 Unit Costs under ABC
To compute the unit costs under ABC, the following
three procedures are to be used:
1. Identify the major activities that pertain to the
manufacture of specific products and allocate
manufacturing overhead costs to activity centers
2. Identify the cost drivers that accurately measure
each activity’s contribution to the finished product
and compute the activity based overhead rate
3. Allocate manufacturing costs for each activity
centers to products using the activity-based
overhead rates (cost per driver)
Activity-Based Costing System 44
Step 1: Identifying Activities and Allocating Overhead to Activity Centers

Illustration
King Company identified three activity centers: setting
up machines, machining and inspecting.

The estimated overhead costs per activity center are as

follows:

Setting up machines 1,200,000

Machining 2,000,000
Inspecting 400,000
Total overhead cost 3,600,000
45
Step 2: Identifying Cost Drivers and Computing Overhead Rates

Illustration
The cost drivers identified by King and their total
expected use per activity center are shown below:
Expected Use of Cost
Activity Centers Cost Drivers Drivers per Activity
Setting up machines Number of setups 3,000 set ups

Machining Machine hours 100,000 machine hours

Inspecting Number of inspections 4,000 inspections

Activity-based overhead rate = Estimated overhead per activity

Estimated use of cost drivers per activity
46
Step 2: Identifying Cost Drivers and Computing Overhead Rates

Illustration
King Company computes its activity-based overhead rate by using
total estimated overhead per activity center and the total expected
use of cost drivers per activity

Expected Use of
Activity Centers Estimated Cost Driver Per Activity-Based
Overhead Activity Overhead Rates

Setting up machines P1,200,000 3,000 set ups P400 per setup

Machining 2,000,000 100,000 machine hours P20 per machine hour

Inspecting 400,000 4,000 inspections P100 per inspection

Total P3,600,000

47
Step 3: Allocating Overhead Costs to Products

King Company
Expected Use of Cost Drivers per Product

Expected Use of Cost

Expected Use of Driver per Product
Activity Centers Cost Drivers Cost Driver Per
Activity Product X Product Y

Setting up machines Number of setups 3,000 set ups 1,000 2,000

Machining Machine hours 100,000 machine hours 60,000 40,000

Number of
Inspecting inspections
4,000 inspections 1,000 3,000

48
Step 3: Allocating Overhead Costs to Products

King Company
Allocation of Overhead Cost to Product X

Expected Use of
Activity Centers Cost Drivers per Activity-Based Allocated
Product Overhead Rates Overhead Costs

Setting up machines 1,000 P400 P400,000

Machining 60,000 P20 1,200,000
Inspecting 1,000 P100 100,000

Total allocated costs P1,700,000

Units produced 50,000

Overhead cost per unit P 34

49
Step 3: Allocating Overhead Costs to Products

King Company
Allocation of Overhead Cost to Product Y

Expected Use of
Activity Centers Cost Drivers per Activity-Based Allocated
Product Overhead Rates Overhead Costs

Setting up machines 2,000 P400 P800,000

Machining 40,000 P20 800,000
Inspecting 3,000 P100 300,000

Total allocated costs P1,900,000

Units produced 10,000

Overhead cost per unit P 190

50
Activity-Based Costing System 51
Activity-Based Costing System 52
Benefits and Limitations of ABC

Benefits
1. More cost pools, therefore more accurate product costing.
2. Enhanced control over overhead costs.
3. Better management decisions.

Limitations
4. Expensive to use.
5. Some arbitrary allocations remain.

LO 6