ActivityBased Costing

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Objectives
After of plant wide 1. Describe the basicsstudying this and chapter, you should departmental overhead costing. be able to: 2. Explain why plant wide and departmental overhead costing may not be accurate. 3. Provide a detailed description of activitybased product costing. Continued
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Objectives
After studying this 4. Explain how the number should chapter, you of activity rates can be reduced. be able to: 5. Describe activity-based system concepts including an ABC relational database and ABC software.

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Unit-Level Product Costing Unit-Level Product Costing

Function-based product costing assigns only

manufacturing costs to products

Direct costs are traced Assignment of manufacturing overhead relies on driver tracing or allocation
Pooled costs are assigned to products using

predetermined overhead rates based on unit-level drivers

Overhead rate = Budgeted annual overhead Budgeted annual driver level
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Functional-Based Product Costing Model

Direct Materials Direct Labor Overhead Direct Tracing Driver Tracing Allocation Plant/Departmental Cost Pools Unit-Based Driver PRODUCTS
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Direct Tracing

Direct Tracing

Unit-Level Product Costing (continued) Unit-Level Product Costing (continued)

Unit-level drivers are factors that measure the

demands placed on unit-level activities by products

Unit-level activities are activities performed each

and every time a unit of product is produced.

Commonly used unit-level drivers include:

Units produced Direct labor hours

Direct labor dollars

Machine hours Direct material dollars
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Overhead Assignment: Plant-wide Rates

Plant-wide or departmental predetermined

overhead rates are used to assign or apply overhead costs to production as the actual production activity unfolds. The predetermined overhead rate is the basis for per-unit overhead cost calculation.
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Overhead Assignment: Plant-wide Rates

(continued)
Applied overhead is the total manufacturing

overhead assigned to actual production at any point in time.

It is computed using the following formula:
Applied overhead = Overhead rate X Actual driver usage

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Overhead Assignment: Plant-wide Rates

(continued)
The amount of overhead applied to

production usually differs from actual overhead since the predetermined overhead rate is based on estimates.
As a result, applied overhead is either over-

or under-applied

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Overhead Assignment: Plant-wide Rates

(continued)
The difference between the amount of actual

overhead and applied overhead is the overhead variance.

Under-applied overhead occurs when actual overhead is higher than applied overhead

Over-applied overhead occurs when actual overhead is lower than applied overhead
Overhead variances are disposed of in two ways

based on materiality:
If an immaterial amount: assigned to COGS If material: assigned to WIP, FG inventory and COGS
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Limitations of Plant-wide & Departmental Rates (an example)

Goodmark Company produces two products: scented and regular birthday cards.

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Limitations of Plant-wide & Departmental Rates (an example)

Note: When overhead rates are a significant percentage of total manufacturing costs a significant cost distortion can result. When this happens, plant- and departmentwide overhead rates do not work well.

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Goodmark CompanyAn Example

Product Costing Data Scented Cards Regular Cards Total 20,000 200,000 -$160,000 $1,500,000 $1,660,000 20,000 160,000 180,000 60 40 100 10,000 80,000 90,000 2,000 16,000 18,000 180 120 300

Unit produced per year Prime costs Direct labor hours Number of setups Machine hours Inspection hours Number of moves

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Goodmark CompanyAn Example

Product Costing Data Departmental Data Cutting Dept. Printing Dept. Direct labor hours: Scented cards Regular cards Total Machine hours: Scented cards Regular cads Total

Total

10,000 150,000 160,000 2,000 8,000 10,000

Continued

10,000 10,000 20,000 8,000 72,000 80,000

20,000 160,000 180,000 10,000 80,000 90,000

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Departmental Data

Cutting Dept. Printing Dept.

Overhead costs: Setting up equipment Moving materials Machining Inspecting products Total $120,000 60,000 20,000 16,000 $216,000 $120,000 60,000 180,000 144,000 $504,000

Total
$240,000 120,000 200,000 160,000 $720,000

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Goodmark CompanyAn Example

Plantwide Overhead Rate

Total overhead cost Plantwide rate = Direct labor hours $720,000 = 180,000 DLH = $4 per direct labor hour

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Goodmark CompanyAn Example

Unit Cost Computation: Plantwide Rates Scented Cards Regular Cards $160,000 $1,500,000

Prime costs Overhead costs: $4.00 x 20,000 $4.00 x 160,000 Total manufacturing costs Units of production Unit cost

80,000
$240,000 20,000 $ 12.00 640,000 $2,140,000 200,000 $ 10.70

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Goodmark CompanyAn Example

Departmental Rates

Dept. overhead cost Cutting Department rate = Cutting Dept. DLH = = $216,000 160,000 DLH

$1.35 per dlh

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Goodmark CompanyAn Example

Departmental Rates

Dept. overhead cost Printing Department rate = Printing Dept. MH = = $504,000 80,000 MH

$6.30 per mh

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Goodmark CompanyAn Example

Unit Cost Computation: Departmental Rates Scented Cards Regular Cards $160,000 $1,500,000

Prime costs Overhead costs: [($1.35 x 10,000) + ($6.30 x 8,000)] 63,900 [($2.35 x 150,000) + ($6.30 x 72,000)] Total manufacturing costs $223,900 Units of production 20,000 Unit cost $ 11.20 *
*Rounded to nearest cent

656,100 $2,156,100 200,000 $ 10.78 *

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Limitations of Plant-wide & Departmental Rates (continued)

As was said earlier, there are at least two major factors that can impair the ability of the unit-based plantwide and departmental rates to assign overhead costs accurately:

(1) the proportion of nonunit-related overhead costs to total overhead costs is large, and
(2) there is a great degree of product diversity.

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Goodmark CompanyAn Example

Product Diversity: Consumption Ratios Overhead Activity Scented Cards Regular Cards Activity Drivers Setups 0.60 a 0.40 a Production runs Moving materials 0.60 b 0.40 b Number of moves Machining 0.11 c* 0.89 c* Machine hours Inspection 0.11 d* 0.89 d* Inspection hours
40/100 (regular) b 180/300 (scented) and 120/300 (regular) c 10,000/90,000 (scented) and 80,000/90,000 (regular) d 2,000/18,000 (scented) and 16,000/18,000 (regular) *rounded
12-22 a 60/100 (scented) and

A Possible Solution: Activity Rates

One solution to overcoming the distortions caused

by the unit-level rates is to expand the number of rates used so that the rates reflect the actual consumption of overhead costs by the various products.
Instead of pooling the overhead costs in plant and

departmental pools, rates would be calculated for each individual overhead activity.

These rates would be based on causal factors that would measure consumption.
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Goodmark CompanyAn Example

Unit Cost Computation: Activity Rates Scented Cards Regular Cards $160,000 $1,500,000

Prime costs Overhead costs: Setting up: $2,400 x 60 $2,400 x 40 Machining: $2.20 x 10,000 $2.20 x 80,000

144,000 96,000

22,200
177,600 Continued
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Scented Cards Regular Cards Overhead costs(contd): Inspecting: $8.89 x 2,000 $8.89 x 16,000 Moving materials: $400 x 180 $400 x 120 Total manufacturing costs Units of production Unit cost

17,780
142,240 72,000 $415,980 20,000 $ 20.80

48,000 $1,963,840 200,000 $ 9.82

Rounded
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Activity-Based Costing Model

Cost of Resources
Costs assigned using driver tracing and direct tracing

Activities
Costs assigned using activity drivers

Products
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Design Steps for an ActivityBased Costing System

1. Identify, define, and classify activities and key attributes. 2. Assign the cost of resources to activities. 3. Assign the cost of secondary activities to primary activities. 4. Identify cost objects and specify the amount of each activity consumed by specific cost objects. 5. Calculate primary activity rates. 6. Assign activity costs to cost objects.
Please see the Illustrative Example on page 136 in your textbook.
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Activity-Based Costing
A primary activity is an activity that is consumed by a final cost object such as a product or customer. A secondary activity is one that is consumed by intermediate cost objects such as primary activities, materials, or other secondary activities.

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Activity Dictionary: Cardiology Ward

Activity Name Supervising nurse Activity Description Scheduling, coordinating, and performance evaluation Administering medicine and changing dressings Activity Type Secondary Cost Object(s) Activities within department Activity Driver Percentage time nurses spend on each activity Number of treatments

Treating patients

Primary

Patient types

Continued
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Activity Name
Providing hygienic care

Activity Description

Activity Type

Cost Object(s)
Patient types

Activity Driver
Labor hours

Bathing, Primary changing bedding and clothes, walking patients

Responding to Answering Primary patient calls, counseling, requests providing snacks, etc.

Patient types

Number of requests

Monitoring patients

Monitoring Primary vital signs and posting patient information

Patient types

Monitoring hours

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Cardiology Ward Example (Contd)

Percentage of Time for Each Activity

Activity Supervisor Nurses Supervising nurses 100 % 0% Treating patients 0 25 Providing hygienic care 0 20 Responding to requests 0 40 Monitoring patients 0 15

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Cardiology Ward Example (Contd)

Unbundling of General Ledger Costs Chart of Accounts View

Supervising Supplies Uniforms Salaries Computer Monitor Total

$ 50,000 40,600 8,200 300,000 1,200 80,000 $480,000

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Cardiology Ward Example (Contd)

Unbundling of General Ledger Costs ABC View Supervising nurses Treating patients Providing hygienic care Responding to requests Monitoring patients Total $ 52,280 90,000 76,600 133,200 127,920 $480,000

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Cardiology Ward Example (Contd)

Assignment of Secondary Activity Costs to Primary Activities

Treating patients $90,000 + (0.25 x $52,280) Providing hygienic care $76,600 + (0.20 x $52,280) Responding to requests $133,200 + (0.40 x $52,280) Monitoring patients + (0.15 x $52,280) $127,920

$103,070 87,056 154,112 135,762

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Cardiology Ward Example (Contd)

Rate Calculations Treating patients: $103,070/30,000 = $3.44 per treatment

Providing hygienic care: $87,056/16,000

= $5.44 per hour of care Responding to requests: $154,112/80,000 = $1.93 per request Monitoring patients: $135,762/200,000 = $0.68 per monitoring hour
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Cardiology Ward Example (Contd)

Bill of Activities
Activity Driver Patient days Intensive Care Total 3,000

Activity Production (output)

Normal 10,000

Intermediate 5,000

Treating patients
Providing hygienic care Responding to requests Monitoring patients

Treatments
Hygienic hours Requests

5,000
5,000 30,000

10,000
2,500 40,000 60,000

15,000
8,500 10,000

30,000
16,000 80,000

Monitoring hours 20,000

120,000 200,000

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Cardiology Ward Example (Contd)

Assigning Cost: Final Cost Objects

Normal
Treating patients: $3.44 x 5,000 Providing hygientic care: $5.44 x 5,000 Responding to requests: $1.93 x 30,000 Monitoring patients: $0.68 x 20,000 Total cost Units Nursing cost per patient day $ 17,200 27,200 57,900 13,600 $115,900 10,000 $ 11.59
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Cardiology Ward Example (Contd)

Assigning Cost: Final Cost Objects

Intermediate
Treating patients: $3.44 x 10,000 Providing hygientic care: $5.44 x 2,500 Responding to requests: $1.93 x 40,000 Monitoring patients: $0.68 x 60,000 Total cost Units Nursing cost per patient day $ 34,400 13,600 77,200 40,800 $166,000 5,000 $ 33.20
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Cardiology Ward Example (Contd)

Assigning Cost: Final Cost Objects

Intensive Care
Treating patients: $3.44 x 15,000 Providing hygientic care: $5.44 x 8,500 Responding to requests: $1.93 x 10,000 Monitoring patients: $0.68 x 120,000 Total cost Units Nursing cost per patient day $ 51,600 46,240 19,300 81,600 $198,740 3,000 $ 66.25
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Activity-Level Classification
Unit-level activities are those that are performed each time a unit is produced. Examples: Power and machine hours are used each time a unit is produced. Direct materials and direct labor activities are also unit-level activities, even though they are not overhead costs.

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Activity-Level Classification
Batch-level activities are those that are performed each time a batch of products is produced. Examples: Setups, inspections, purchasing, and material handling.

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Activity-Level Classification
Product-level (sustaining) activities are those activities performed that enable the various products of a company to be produced. These activities and their costs tend to increase as the number of different products increases.

Examples:

Engineering changes, developing product-testing procedures, introducing new products, and expediting goods.

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Activity-Level Classification
Facility-level activities are those that sustain a factory's general manufacturing processes.

Examples: Plant management, landscaping, maintenance, security, property taxes, and plant depreciation.

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Activities Classification and Homogeneous Sets

A1 A2 A3
Proces sLevel Filter

A4

A5

Activity

Processed classified 1 P activities

P2

P3

P4

To activity filter

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From processed-classification activities

Activit y Level Filter

Unit Level Drive Levelr Classification Filter activities Set 1 Set 2

Batch Level Drive r Filter Set 3 Set 4

Product Level

Facility Level

Drive r Homogenous sets Filter Set 5 Set 6 Set 7

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Reducing the Size and Complexity of an ABC System

ABC requires an activity rate for each

activity.
However, an organization may have

hundreds of activities and activity rates, increasing the costs of calculating and keeping track of them, and creating complexity in reporting.
Question: is more always better?

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Reducing the Size and Complexity of an ABC System

Not always: a few activity rates may be preferable to a

large number, resulting in an approximately relevant ABC System rather than a precisely useless one! The example on pages 144-146 shows how a few activity drivers can sometimes be as effective as using a lot.
In this example, manufacturing overhead was assigned as follows: Allocation Method Wafer A Wafer B Plant-wide: $1,400,000 $600,000 12 Activities $800,000 $1,200,000 4 Activities* $820,000 $1,180,000 2 Activities** $800,000 $1,200,000 *Reduced ABC System Assignment ** Reduced equally accurate ABC System Assignment
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ABC System Concepts

The emergence of ABC as a viable alternative to existing cost management systems is largely due to significant advances in information technology. ABC requires the development of an ABC Database and use of an ABC Software program (such as an ERP System).

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ABC Database
An ABC database is the collected data sets that are organized and interrelated for use by an organizations activity-based costing information system.

A data set is a grouping of logically related data.

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