CHAPTER REVIEW

I. Unit-Based Product Costing

A. Functional-based costing uses only unit-based drivers to assign overhead costs to

products.
a. Functional-based costing first assigns overhead costs to a functional unit,
creating plant or departmental cost pools. Next, these pooled costs are
assigned to products using only unit-based drivers.
b. Unit-based drivers are factors that cause changes in cost as the units
produced change.
 Functional-based costing uses only unit-based drivers because it
assumes that overhead consumed by products is highly correlated with
the units produced.

Review textbook Exhibit 12-1, which provides a model

of the functional-based product costing system.

B. Plantwide and Departmental Rates

1. Both plantwide rates and departmental rates are used to assign overhead costs
to products using unit-based cost drivers.
2. A plantwide rate uses a single cost pool for the entire plant.
3. Departmental rates use separate cost pools for the different departments.

Review textbook Exhibits 12-3 and 12-4, which show product unit cost
computations using plantwide rates and departmental rates, respectively.

C. The Failure of Plantwide and Departmental Rates

Using plantwide or departmental rates to assign overhead costs will produce
inaccurate product costs when:
1. The proportion of nonunit-related overhead costs to total overhead costs is
large (e.g., reaching more than 40 or 50 percent of the total).
a. Using only unit-based activity drivers to assign nonunit-based costs can
create cost distortions.
b. Nonunit-related overhead costs refer to those costs that are unrelated
to the number of units produced but more logically relate to nonunit-
based drivers.
 Nonunit-based drivers are factors, other than the number of
units produced, that measure the demands that cost objects place on
activities.
c. Examples:
(1) Setup costs relate to the number of batches of products produced.
(2) Product engineering costs depend on the number of different
engineering work orders.
(3) Material-moving costs relate to the number of moves required,
not to the number of units produced.
2. The degree of product diversity is great.
 a. Product diversity means that products consume overhead activities in
different proportions because of their differences in product size, product
complexity, setup time, and size of batches.
b. The consumption ratio measures the proportion of each activity
consumed by a product.
D. Potential users of ABC systems can be identified when these companies:
1.Produce multiple products,
2.Have a high degree of product diversity, and
3. Have a significant percentage of nonunit-level overhead in production costs.
 Review textbook Exhibit 12-5, which provides examples of
consumption ratios of various activities by different products.
Note that the special product (scented cards) uses
more setup and material-moving activities.
Learning Objective
#2
II. Activity-Based Costing System

A. An activity-based costing (ABC) system first assigns costs to activities and then
traces costs from activities to products.
1. ABC assumes that activities consume resources, and products
and other cost objects consume activities.
2. ABC cost assignment is made possible through the
identification of activities, their costs, and the use of cost drivers. Thus, it better
reflects the pattern of overhead consumption and is more accurate than
functional-based costing.

Review textbook Exhibit 12-8, which provides an activity-based costing model.

B. Six essential steps in designing an ABC system include:

Step 1: Identify, define, and classify activities and key attributes.
Step 2: Assign the cost of resources to activities.
Step 3: Assign the cost of secondary activities to primary activities.
Step 4: Identify cost objects and specify the amount of each activity
consumed by specific cost objects.
Step 5: Calculate primary activity rates.
Step 6: Assign activity costs to cost objects.
Step 1: Identify, define, and classify activities and key attributes.
1. To identify an activity means to describe the work performed by people or
equipment.
a. Use an action verb and an object that receives the action to name the
activity.
b. An activity inventory is a list of the activities that are performed
within the organization.

Review textbook Exhibit 12-10, which provides a sample

activity inventory for an electronics manufacturer.

2. To define an activity means to use activity attributes to describe it.

 Activity attributes are nonfinancial and financial information items
that describe individual activities (for example, description of the tasks that
make up the activity, resources consumed by the activity, amount or
percentage of time spent on the activity, the cost objects, and the activity
driver.)
 An activity dictionary lists the activities in an organization along with
desired attributes.
3. To classify an activity means to recognize the difference between it and other
activities for different purposes.
 a. For product costing purposes, activities can be classified as primary or
secondary.
(1) A primary activity is consumed by a final cost object (e.g., a
product or customer).
(2) A secondary activity is consumed by intermediate cost objects (e.g.,
primary activities, materials, or other secondary activities).
b. Many other useful activity classifications exist. For example, activities can
be classified as value-added or nonvalue-added, as quality-related or
environmental-related.
4. Methods to be used to gather activity information include interviews,
surveys, and observations.

Review textbook Exhibit 12-11, which provides an example of an activity dictionary.

Note that the activity dictionary names the activity, describes
the tasks that make up the activity, classifies the activity as primary or
secondary, lists the cost object(s), and identifies the activity driver.

Step 2: Assign the cost of resources to activities.

1. Costs may be assigned to activities using:
a. Direct tracing, when resources are exclusive to the activity.
b. Driver tracing, when resources are shared by several activities.
2. Resource drivers are the factors that measure the consumption of resources
by activities.
a. Resource driver data can be collected using interviews, survey forms,
questionnaires, and timekeeping systems.
b. A work distribution matrix helps identify the amount of labor consumed
by each activity. It is a means of collecting the data required to assign labor
resource costs to activities.
Step 3: Assign the cost of secondary activities to primary activities.
If there are secondary activities, then the costs of those must be assigned to the
primary activities.

Review textbook Exhibit 12-13, which provides an example of the cost of a

secondary activity (supervising nurses) being reassigned to the primary activities.

Compare the costs of the primary activities after the reassignment

(Exhibit 12-13) with those before the reassignment (Exhibit 12-12).

Step 4: Identify cost objects and specify the amount of each activity consumed by
specific cost objects.
1. Costs can be assigned to products or other cost objects in proportion to their
usage of the activity by:
a. Identifying the cost objects.
b. Measuring the demand that cost objects place on the activities.
2. Activity drivers measure the demands that cost objects place on activities.
3. Most ABC system designs choose between two types of activity drivers:
a. Transaction drivers measure the number of times an activity is
performed.
  Examples: Number of treatments, number of requests
b. Duration drivers measure the time it takes to perform an activity.
 Duration drivers should be used when the time required to
perform an activity varies from transaction to transaction.
 Examples: Hours of hygienic care, monitoring hours
4. A bill of activities can be created to specify the product, expected product
quantity, activities, and amount of each activity expected to be consumed by
each product.

Review textbook Exhibit 12-14, which provides an example of a bill of activity for a
cardiology
ward. It includes activities, activity drivers, and types of services that consume
activities.

Learning Objective #3
Step 5: Calculate primary activity rates.
Primary activity rates are computed by dividing the budgeted activity costs by
practical activity capacity.
Step 6: Assign activity costs to cost objects.
Using the primary activity rates, costs are assigned to the cost objects.

Review textbook Exhibit 12-15, which illustrates the final assignment of costs to cost
objects.

C. Materials as an Intermediate Cost Object

1. Material-related activities, such as purchasing, inspecting, and moving
materials, are secondary activities because they are not directly consumed
by the final cost objects.
2. The cost of material-related secondary activities will be first assigned to
materials (an intermediate cost object) and then to the final cost objects
through direct tracing.

III. Homogeneous Pools of Activities

In the final stage of ABC, homogeneous cost pools can be used to reduce the number of
activity rates because fewer rates may
 Produce more readable and manageable product cost reports.
 Reduce the perceived complexity of an ABC system and increase its
likelihood of managerial acceptance.
 Increase the accuracy of cost assignments.
A. Activity Classification: The Key for Reducing the Number of Rates
1. Activities can be grouped in homogeneous sets if
a. They are logically related, and
b. They have the same consumption ratios for all products.
2. A homogenous cost pool is the collection of overhead costs associated with
a set of activities that has the same process, the same activity level, and can use
the same driver to assign cost to products.
 The pool rate is the cost per unit of the chosen activity driver that can
be computed as:
 Homogeneous pool costs
Pool rate = Activity driver s practical
’ capacity
3. Attributes that are useful for grouping activities into homogeneous cost pools
include process, activity-level, and activity-driver classifications.
a. Using process classification to create homogeneous cost pools.
(1) A process is a series of activities that are linked to perform a specific
objective.
(2) The key to grouping activities is the notion of sharing a common
objective or purpose.
(3) Example: The procurement process’ common objective is to
obtain parts for production. Activities that can be linked together
include purchasing, receiving, and paying suppliers.

Review textbook Exhibit 12-17, which illustrates process classification.

b. Using activity-level classification to create homogeneous cost pools.

(1) Activities can be grouped together if they are performed at the same
general activity level (same activity-level attribute).
(2) Classifying activities by the activity level helps management identify
the appropriate activity drivers because the costs of activities
associated with the different levels respond to different types of
activity drivers.
(3) Four general activity categories include:
 Unit-level activities are those that are performed each time a
unit is produced.
 Batch-level activities are those that are performed each time a
batch is produced.
 Examples: Setup, inspections (if done by sampling units
from a batch), purchasing, material handling
 Product-level activities are those performed that enable the
various products of a company to be produced.
 Examples: Engineering changes to products, developing
product-testing procedures, introducing new products,
expediting goods