Activity- Based Costing

Chapter 5
Objectives

1. Distinguish between simple and activity-based

costing systems

Describe a four-part cost hierarchy

2.

3. Cost products or services using activity-based

costing

4. Evaluate the benefits and costs of implementing

activity-based costing systems
Simple Costing Systems

 The simple costing systems allocate overhead

using a predetermined overhead rate.
• Example
▫ Job order costing: direct labor cost may be
the relevant activity base.

3
Review simple costing systems
Predetermined Overhead Rate

 The formula:

Estimated total manufacturing

overhead cost for the coming period
POHR =
Estimated total units in the
allocation base for the coming period

Ideally, the allocation base is a

cost driver that causes overhead.

• The formula is established at the beginning of the year and will be

used for allocation throughout the year.

4
 Review simple costing systems
Example
Plastim Company produces two lenses for the rear taillights of
automobiles—a simple lens called S3 and a complex lens called C5.
S3 has single color and few special features and C5 is large and has
special features: multicolor molding and a complex shape.
There are 7 activities to design, manufacture, and distribute S3 and
C5 lenses.
 Design products and processes
 Set up molding machines
 Operate molding machines to manufacturing lenses
 Clean and maintain the molds after lenses are manufactured
 Prepare batches of finished lenses for shipment
 Distribute lenses to customers
 Administer and manage all processes

5
 Review simple costing systems
Example
 The direct materials cost per unit is $18.75 for S3 and $45
for C5.
 30,000 direct labor hours are expected to make 60,000 S3
lenses and 9,750 direct labor hours are expected to make
15,000 C5 lenses. The direct labor rate is $20 per hour.
 Budgeted indirect costs are $2,385,000.

6
 The direct materials cost per unit is $18.75 for S3 and $45 for C5.
 30,000 direct labor hours are expected to make 60,000 S3 lenses and 9,750
direct labor hours are expected to make 15,000 C5 lenses. The direct labor rate
is $20 per hour.
 Budgeted indirect costs are $2,385,000.
 The direct materials cost per unit is $18.75 for S3 and $45 for C5.
 30,000 direct labor hours are expected to make 60,000 S3 lenses and 9,750
direct labor hours are expected to make 15,000 C5 lenses. The direct labor rate
is $20 per hour.
 Budgeted indirect costs are $2,385,000. Budgeted indirect cost rate is $60 per
direct labor hour.
Why do we need Activity-Based Costing
(ABC)?
 Significant increase in total overhead costs.
 Inappropriate to use plantwide predetermined
overhead rates when a lack of correlation exists.
 results in overcosting & undercosting.
 Complex manufacturing processes may require
multiple allocation bases; this approach is called
activity-based costing (ABC).

9
Activity-Based Costing

 Allocates overhead costs to multiple activity cost

pools.
 Assigns the activity cost pools to products or
services by means of cost drivers.

10
Activity-Based Costing (cont’d)

St • Identify the products that are the chosen cost

ep objects
1
St • Identify the direct costs of the products
ep
2
St • Select the activities and cost-allocation bases
ep
3
St • Identify indirect cost pools
ep
4
St
• Compute the rate per unit of each cost-allocation
ep base
5
St
• Compute the indirect costs allocated to the
ep products
6
Step 1: Identify the products - Example

S3 lenses C5 lenses

12
Step 2: Identify the direct costs of the products
- Example

13
Step 3: Select activities and cost-allocation bases
- Example
ACTIVITES COST DRIVERS COST OBJECTS

Design Parts-square feet

Molding machine Machine setup

setup hours

Molding machine Molding machine S3

operations hours and
C5
Shipment setup lenses
Shipment setup
hours

Cubic feet
Distribution
delivered

Administration Direct labor hours

Cost hierarchies

Product- Facility-
Output Batch-
sustaining sustaining
Unit-level level
level level

• Performed for each unit of production:

▫ Example: running machines

15
Cost hierarchies (cont’d)

Product- Facility-
Output Unit-
Batch-level sustaining sustaining
level
level level

• Performed every time a company produces another batch of a product,

vary with a group of units rather than with each individual unit.
▫ Example: Setting up an equipment

16
Cost hierarchies (cont’d)

Product- Facility-
Output Unit-
Batch-level sustaining sustaining
level
level level

• Performed every time a company produces a new type of product.

▫ Example: Designing a new product

17
Cost hierarchies (cont’d)

Product- Facility-
Ouput Unit-
Batch-level sustaining sustaining
level
level level

• Required to support or sustain an entire production process.

▫ Example: cleaning factory executive offices

18
Exercise 1

Adamson Company manufactures four lines of garden tools. As a result of

an activity analysis, the accounting department has identified eight activity
cost pools. Each of the product lines is produced in large batches, with the
whole plant devoted to one product at a time. Classify each of the following
activities or costs as either unit-, batch-, product-, or facility level.
 Product design
 Plant maintenance
 Machine setup
 Assembling parts
 Purchasing raw materials
 Property taxes
 Painting of the tools

19
 Adamson Company manufactures four lines of garden tools. As a result of an
activity analysis, the accounting department has identified eight activity cost
pools. Each of the product lines is produced in large batches, with the whole
plant devoted to one product at a time.
Batch Product Facility
Unit level
level level level
Product design x
Plant maintenance x
Machine setup x
Assembling parts x
Purchasing raw materials x
Property taxes x
Painting of the tools x
 Cost hierarchies - Example

ACTIVITES COST HIERARCHIES COST DRIVERS

Design Product sustaining Parts-square feet

Molding machine Machine setup

Batch-level hours
setup

Molding machine Molding machine

Output unit-level hours
operations

Shipment setup
Shipment setup Batch-level hours

Cubic feet
Distribution Output unit-level delivered

Administration Facility sustaining Direct labor hours

Step 4: Identify the indirect costs associated
with each cost-allocation base - Example
 Based on a cause-and-effect relationship between the
identified cost-allocation base for an activity and the
individual indirect costs.
 Directly identified with a particular activity.
 Allocated across activities.
Exercise 2
Hải Yến Company provides a door-to-door service by Limousine. They identify
4 activities: Driving, pick-up and drop-off, customer service, and others. Total
cost are accumulated as follows:
Drivers' salaries 72,000
Gas and oil 28,000
Car depreciation 12,000
Customer service repreresentatives' salaries 16,000
Office supplies 3,000
Administration 32,000
Total 163,000
Resource consumption for activities is summarized in the table below.
Pick-up & Customer
Driving Others Total
drop-off service
Drivers' salaries 50% 35% 10% 5% 100%
Gas and oil 70% 5% 0% 25% 100%
Car depreciation 60% 15% 0% 25% 100%
Customer service repreresentatives' salaries 0% 0% 90% 10% 100%
Office supplies 0% 20% 30% 50% 100%
Administration 0% 5% 60% 35% 100%
Assign costs to identified activities.
Exercise 3

Hải Yến Company provides a door-to-door service by

Limousine. They identify 4 activities: Driving, pick-up and
drop-off, customer service, and others.
Identify cost drivers for each activity.
Exercise 4

25
Step 5: Compute the rate per unit of
each cost-allocation base - Example
 Exercise 5

Fox Hunting Gear manufactures two products: camouflage jackets and camouflage
hats. The company makes 50,000 jackets and 20,000 hats each year. Information
for overhead costs and for the two products appears below.
Estimated
Total
Activity Driver Jackets Hats
Overhead
Cost
Setups # of setups $200,000 500 setups 1,500 setups
Ordering parts # of parts 300,000 60,000 parts 40,000 parts
# of machine
Machining 600,000 12,000 machine hrs. 6,000 machine hrs.
hours
Inspections # of inspections 400,000 10,000 inspections 40,000 inspections
Shipping # of shipments 300,000 10,000 shipments 10,000 shipments
Total overhead 1,800,000
Assume that activity-based costing is used. What is the rate per setup that should
be used to assign setup cost to hats?
A. $100 per setup
B. $200,000 per setup
C. $133.33 per setup
D. $900 per setup
Step 6: Compute the indirect costs
allocated to the product - Example
Budgeted quantity of cost-allocation
base per product
Activity cost pools
S3 C5
Design 30 70 Parts-sq.ft.
Machine setup
Molding machine setup 500 1,500
hours
Molding
Molding machine operations 9,000 3,750
machine hours
Shipment setup
Shipment setup 750 750
hours
Cubic feet
Distribution 45,000 22,500
delivered
Direct labor
Administration 30,000 9,750
hours
 Budgeted quantity of cost-allocation base
Activity cost pools
S3 C5
Design 30 70 Parts-sq.ft.
Molding machine setup 500 1,500 Machine setup hours
Molding machine
9,000 3,750 Molding machine hours
operations
Shipment setup 750 750 Shipment setup hours
Distribution 45,000 22,500 Cubic feet delivered
Administration 30,000 9,750 Direct labor hours

Simple lenses (S3)

Budgeted
quantity of Indirect
Activity cost pool x =
cost-allocation Rate per unit of cost-allocation costs
base base allocated
Design $4,500 per part-square foot
Molding machine setup $150 per machine setup hour
Molding machine
operations $50 per molding machine hour
Shipment setup $54 per shipment setup hour
Distribution $5.80 per cubic foot delivered
Administration $6.4151 per direct labor hour
Total indirect costs allocated (a)
Units to be produced (b) 60,000
Indirect cost per unit [(a)/(b)]

Step 5
29
 Budgeted quantity of cost-allocation base
Activity cost pools
S3 C5
Design 30 70 Parts-sq.ft.
Molding machine setup 500 1,500 Machine setup hours
Molding machine
9,000 3,750 Molding machine hours
operations
Shipment setup 750 750 Shipment setup hours
Distribution 45,000 22,500 Cubic feet delivered
Administration 30,000 9,750 Direct labor hours

Complex lenses (C5)

Budgeted
quantity of Indirect
Activity cost pool x =
cost-allocation Rate per unit of cost-allocation costs
base base allocated
Design $4,500 per part-square foot
Molding machine setup $150 per machine setup hour
Molding machine
operations $50 per molding machine hour
Shipment setup $54 per shipment setup hour
Distribution $5.80 per cubic foot delivered
Administration $6.4151 per direct labor hour
Total indirect costs allocated (a)
Units to be produced (b) 15,000
Indirect cost per unit [(a)/(b)]
Step 5
30
 Comparing alternative costing systems
Budgeted quantity of cost-allocation base
Plastim Company plan to produce Activity cost pools
S3 C5
60,000 simple S3 lenses and Design 30 70 Parts-sq.ft.
15,000 complex C5 lenses. Molding machine setup 500 1,500 Machine setup hours
Molding machine
9,000 3,750 Molding machine hours
operations
Shipment setup 750 750 Shipment setup hours
Distribution 45,000 22,500 Cubic feet delivered
Administration 30,000 9,750 Direct labor hours

Simple costing ABC system

system
S3 C5 S3 C5
Direct Materials $18.75 $45.00 $18.75 $45.00
Direct labor 10.00 13.00 10.00 13.00
Mold cleaning and maintenance 2.00 10.00
Indirect costs (including mold cleaning &
30.00 39.00 19.23 64.07
maintenance under the simple costing system)
Total costs per unit $58.75 $97.00 $49.98 $132.07
over-allocated under-
allocated
 Exercise 6

Fox Hunting Gear manufactures two products: camouflage jackets and camouflage
hats. The company makes 50,000 jackets and 20,000 hats each year. Information
for overhead costs and for the two products appears below.
Estimated
Total
Activity Driver Jackets Hats
Overhead
Cost
Setups # of setups $200,000 500 setups 1,500 setups
Ordering parts # of parts 300,000 60,000 parts 40,000 parts
# of machine
Machining 600,000 12,000 machine hrs. 6,000 machine hrs.
hours
Inspections # of inspections 400,000 10,000 inspections 40,000 inspections
Shipping # of shipments 300,000 10,000 shipments 10,000 shipments
Total overhead 1,800,000
Assume that activity-based costing is used. How much is the overhead cost of
each hat if all overhead is assigned using ABC?
A. $159.33 per hat
B. $24.00 per hat
C. $100.00 per hat
D. $47.00 per hat
Exercise 7
 Performance Products Corporation makes two products, titanium Rims and Posts. Data
regarding the two products follow:
Direct Labor-Hours per Unit Annual Production
Rims 0.40 20,000 units
Posts 0.20 80,000 units

 Additional information about the company follows

 Rims require $17 in direct materials in unit, and Posts require $10.
 The direct labor wage rate is $16 per hour.
 The ABC system has the following activity cost pools:
Activity Cost Pool (and activity measure) Estimated Activity
Overhead Cost Rims Posts Total

Machine setups (number of setups) $21,600 100 80 180

Special processing (machine-hours) $180,000 4,000 0 4,000
General factory (direct labor-hours) $288,000 8,000 16,000 24,000

 Required:
a) Compute the activity rate for each activity cost pool.
b) Compute the manufacturing overhead cost per unit for Rims.
c) Determine the unit product cost of Rims according to the ABC system. 33
 Exercise 8
Unique Finds sells fine collectible statues and has implemented activity-based
costing. Costs in the shipping department have been divided into three cost pools.
The first cost pool contains costs that are related to packaging and shipping. The
second cost pool is made up of costs related to the final inspection of each item
before it is shipped. The final cost pool is used for general operations of the
department. Information about the activities is summarized below:

Estimated Estimated Annual

Cost Pool Cost Driver
Total Costs Activity
Packaging and shipping $67,200 Number of boxes shipped 16,000 boxes
Number of individual items
Final inspection 200,000 100,000 items
inspected
General operations 85,000 Number of orders 10,000 orders
A new customer orders two items that can be shipped in a single box. What is the
total shipping department cost that will be allocated to this order?
A. $16.70
B. $14.70
C. $8.20
D. None of these answer choices are correct.
Benefits of ABC

 More accurate product costing by classifying

more cost pools.
 Enhanced control over overhead costs.
 Better management decisions.

35
Benefits of ABC (cont’d)

 More accurate product costing by classifying

more cost pools.
 Instead of one plantwide pool and a single cost
driver, multiple cost pools are used.
 More relevant cost drivers can be assigned to
each cost pool.

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Benefits of ABC (cont’d)

 Enhanced control over overhead costs.

▫ Under ABC, companies can better trace overhead

costs to activities.
▫ In developing an ABC, managers increase their
awareness of the activities performed by the company
in its production and supporting process. This
awareness helps managers classify activities as value-
added- or non-value-added activities.

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Benefits of ABC (cont’d)

 Better management decisions

 Pricing and product mix decisions
 Cost reduction and process improvement
decisions
 Design decisions

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Limitations of ABC

 ABC has two limitations:

 Expensive to use
 Arbitrary allocations remain.

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Learning Materials

 Chapter 5 (Horngren’s Cost Accounting)

 Exercises:5-18 5-27, 5-34  5-37