CHAPTER 5

Activity-Based Costing
and Management

Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 Learning Objectives
 LO1-Volume Based Product Costing System/Traditional
 LO2 -ABC System/Two Stage Procedure of Cost Assignment
 LO3- Cost Levels
 LO4-Product Cost based on ABC system/Application
 LO5-Volume Based Product Costing System/Traditional Vs
ABC System
 LO6-Criteria for cost drivers
 LO7- ABC Data Process
 LO8-Activity Based Management and ABC system
 LO9-Customer Profitability Analysis
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Learning Objective 1:Volume Based
Product Costing System/Traditional

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Traditional, Volume-Based Product-Costing
System
 Aerotech produces three complex printed circuit boards
referred to as Mode I, Mode II, and Mode III.
 The following information is obtained from company records:

Mode I Mode II Mode III

Production:
Units 10,000 20,000 4,000
Runs 1 run of 10,000 4 runs of 10 runs of
units 5,000 units 400 units
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Traditional, Volume-Based Product-Costing
System
Mode I Mode II Mode III
Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor 60.00 80.00 40.00
Manufacturing overhead 99.00 132.00 66.00
Total $ 209.00 $ 302.00 $ 126.00

Additional information includes:

Mode I Mode II Mode III
Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor (hr/board) 3 4 2
Setup time (hr/run) 10 10 10
Machine time (hr/board) 1 1.25 2

5 Manufacturing overhead is determined as follows

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Traditional, Volume-Based Product-Costing
System
Mode I Mode II Mode III
Units produced 10,000 20,000 4,000
Direct labor (hr/unit) 3 4 2
Total hours 30,000 80,000 8,000

Total hours required 118,000

Budgeted manufacturing overhead $3,894,000

= $33 per hour
Budgeted direct-labor hours 118,000

Mode I Mode II Mode III

Direct labor (hr/unit) 3 4 2
Overhead rate per hour $ 33 $ 33 $ 33
Overhead per unit $ 99 $ 132 $ 66
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Traditional, Volume-Based Product-Costing
System
With these product costs, Aerotech established target selling
prices (Cost × 125%).
Mode I Mode II Mode III
Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor 60.00 80.00 40.00
Manufacturing overhead 99.00 132.00 66.00
Total $ 209.00 $ 302.00 $ 126.00

Mode I Mode II Mode III

Cost per unit $ 209.00 $ 302.00 $ 126.00
Target selling price 261.25 377.50 157.50

209.00 x 1.25
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Learning Objective 2: ABC-System/Two-
Stage Procedure for cost assignment

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Activity Based Costing System (ABC)
ABC systems follow a two-stage procedure to assign overhead
costs to products.

Stage One
Identify significant activities and assign overhead costs
to each activity in proportion to resources used.
Stage Two
Identify cost drivers appropriate to each activity and
allocate overhead to the products.

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Learning Objective 3:Cost levels

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 Overhead Costs
Total budgeted cost = $3,894,000 Identification
Activity
of Activity
must be
done on Activity Cost Pools
each unit Cost
produced. Pools
Product-
Unit- Batch- Sustaining- Facility-
Level Level Level Level

Machinery Setup Engineering Facility

cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Activity Activities needed to support Activity required in order

performed an entire product line for the production
on each process to occur.
batch
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produced. 5-11
 Product-
Unit- Batch- Sustaining- Facility-
Level Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Receiving/Inspection
cost pool $200,000

Material-Handling
cost pool $600,000

Quality-Assurance
cost pool $421,000

Packaging/Shipping
cost pool $250,000
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Learning Objective 4:Product Cost based
on ABC system/Application

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 STAGE ONE

Various overhead
Maintenance Lubrication
costs related
to machinery Depreciation Electricity

Computer Support Calibration

Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1,212,600

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 STAGE TWO
Calculate Budgeted Machinery Costs = $1,212,600
the pool Budgeted Machine Hours 43,000
rate = $28.20/hour

Mode I: Mode II:

$28.20 per hr. $28.20 per hr.
1 hr. per unit 1.25 hr. per unit
Cost $28.20 per unit $35.25 per unit

Assignment
Mode III:
$28.20 per hr.
2 hr. per unit
$56.40 per unit
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 STAGE ONE
Total budgeted setup cost
Calculation of $20 per hour
total setup cost 10 hr. per setup
$200 cost per setup
15 production runs
$ 3,000 Total

Activity
cost Setup Cost Pool
pool Total budgeted cost = $3,000

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 STAGE TWO
Calculate Budgeted Setup Costs = $3,000
the pool Planned Production Runs 15 runs
rate = $200 per run

Mode I: (1 Run) Mode II: (4 Runs)

$200 per run $200 per run
10,000 units per run 5,000 units per run
Cost = $.02 per unit = $.04 per unit
Assignment
Mode III: (10 Runs)
$200 per run
400 units per run
= $.50 per unit
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 STAGE ONE
Various overhead Engineering salaries Engineering software
costs related
to engineering Engineering supplies Depreciation

Activity
cost Engineering Cost Pool
pool Total budgeted cost = $700,000

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 STAGE TWO
Allocate based Engineering Cost Pool
on engineering Total budgeted cost = $700,000
transactions

Mode I: Mode II:

25% × $700,000 45% × $700,000
10,000 units 20,000 units
Cost = $17.50 per unit = $15.75 per unit
Assignment
Mode III:
30% × $700,000
4,000 units
= $52.50 per unit
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 STAGE ONE
Various overhead Plant depr. Property taxes
costs related
Plant mgmt. Insurance
to general
operations Plant maint. Security

Activity
cost Facility Cost Pool
pool Total budgeted cost = $507,400

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 STAGE TWO
Calculate Budgeted Facilities Cost = $507,400
the pool Budgeted Direct-Labor Hours 118,000
rate = $4.30/hour

Mode I: Mode II:

$4.30 per hr. $4.30 per hr.
× 3 hr. per unit × 4 hr. per unit
Cost $12.90 per unit $17.20 per unit
Assignment
Mode III:
$4.30 per hr.
× 2 hr. per unit
$8.60 per unit
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 Other Overhead Costs
Receiving and Inspection Cost Pool
Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00

Material-Handling Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 600,000 × 7% ÷ 10,000 = $ 4.20
Mode II 600,000 × 30% ÷ 20,000 = 9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50

Quality-Assurance Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10

Packaging and Shipping Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
22 Mode III 250,000 × 66% ÷ 4,000 = 41.25
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 Other Overhead Costs
Receiving and Inspection Cost Pool
Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00

Material-Handling Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
$14.82 Mode I $ 600,000 × 7% ÷ 10,000 = $ 4.20
Mode II 600,000 × 30% ÷ 20,000 = 9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50

Quality-Assurance Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10

Packaging and Shipping Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
23 Mode III 250,000 × 66% ÷ 4,000 = 41.25
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 Product Cost from ABC
These are the new product costs when Aerotech uses ABC.

Mode I Mode II Mode III

Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor 60.00 80.00 40.00
Machinery 28.20 35.25 56.40
Setup 0.02 0.04 0.50
Engineering 17.50 15.75 52.50
Facilities 12.90 17.20 8.60
Other 14.82 23.57 212.85
Total $ 183.44 $ 261.81 $ 390.85
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 Quiz

25
 Quiz cntd
A. $29.25.
B. $10.00.
C. $15.00.
D. $4.00.

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 Learning Objective 5:Volume Based
Product Costing System/Traditional Vs
ABC System

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Distorted Product Costs
Both original and ABC target selling prices are based on
(Cost × 125%).

Mode I Mode II Mode III

Traditional costing $ 209.00 $ 302.00 $ 126.00
ABC costing 183.44 261.81 390.85

Original target selling price 261.25 377.50 157.50

ABC target selling price 229.30 327.26 488.56

The selling price of Mode I and II are decreased,

while the selling price for Mode III is increased.
[$209.00 × 1.25] [$183.44 × 1.25]
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 Distorted Product Costs
Can you identify any problems Aerotech is likely to face as
a result of this distortion?
Mode I Mode II Mode III
Traditional costing $ 209.00 $ 302.00 $ 126.00
ABC costing 183.44 261.81 390.85
Cost distortion per unit 25.56 40.19 (264.85)
Units produced 10,000 20,000 4,000
Total cost distortion 255,600 803,800 (1,059,400)

Traditional costing understates the cost

of complex, low volume products.
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Two Key Points
A large proportion of non-unit-
level activities
A unit-level cost driver, such
as direct labor, machine
hours, or throughput, will
not be able to assign the costs
of non-unit-level activities
accurately.
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Product diversity
When the consumption
ratios differ widely
between activities, no
single cost driver will
accurately assign the
resulting overhead costs.
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 Quiz
 The use of activity-based costing normally results in
A. Substantially lower unit costs for low-volume products
than is reported by traditional product costing.
B. Equalizing setup costs for all product lines.
C. Substantially greater unit costs for low-volume products
than is reported by traditional product costing.
D. Decreased setup costs being charged to low-volume
products.

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Learning Objective 6: Criteria for Cost
Drivers

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Cost Drivers
A characteristic of an event or activity that results in the
incurrence of costs. In selecting a cost driver, we must
consider . . .

Degree of Behavioral
Correlation Effects

Cost of
Measurement
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Learning Objective 7: ABC Data Process

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 COLLECTING ABC DATA
INTERVIEWS AND PAPER TRAILS - The information
for ABC systems initially comes from interviews with
employees in the support departments and a review of each
department’s records.

STORYBOARDING - A procedure used to develop a

detailed process flow chart, which visually represents activities
and the relationships among activities.

MULTIDISCIPLINARY ABC PROJECT TEAMS – To

gather information from all facets of an organization’s
operations, it is essential to involve personnel from a variety of
functional areas..

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 Learning Objective 8: Activity Based
Management and Two-Dimensional ABC

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Activity-Based Management

The use of
ABC costing
information
to help
management
make decisions
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Activity-Based Management
Activity-based costing establishes relationships
between overhead costs and activities so that
we can better allocate overhead costs.
Activity-based management focuses
on managing activities to reduce costs.

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Two-Dimensional ABC and Activity-Based
Management
Cost Assignment View

Resource costs
Process View
Activity Analysis Activity Evaluation

Root Activity Performance

Causes Triggers Activities Measures

Cost Objects
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Elimination of Non-Value-Added Costs
Activities

Non-value-
added
activities
Unnecessary Necessary

Reduce or Continually Evaluate

Eliminate and Improve
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Using ABM to Eliminate Non-Value-Added
Activities and Costs
1. Identify Activities.
2. Identify Non-Value-Added Activities.
3. Understand Activity Linkages, Root Causes, and
Triggers.

Inspect Rework
Specify Select Receive Produce
finished defective
parts vendor parts goods
goods products

4. Establish Performance Measures.

5. Report Non-Value-Added Costs.

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Using ABM to Eliminate Non-Value-Added
Activities and Costs

Process time

Inspection time Storage time

Move time Waiting time

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Learning Objective 9: Customer
Profitability Analysis

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Customer Profitability Analysis

Customer profitability analysis uses

activity-based costing to determine
the activities, costs, and profit associated
with serving particular customers.

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 Customer Profitability Analysis
Required
special
packaging
Orders Demand
small fast
quantities service

Often
Orders
changes
frequently
orders

A costly customer
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 Customer Profitability Analysis
Cost Drive
Customer-Related Activities Cost Driver Base Rate
Order processing Purchase orders $ 150
Sales contacts (phone calls, faxes, etc.) Contacts 100
Sales visits Visits 1,000
Shipment processing Shipments 200
Billing and collection Invoices 160
Design/engineering change orders Design changes 4,000
Special packaging Units packaged 40
Special handling Units handled 60

A company may use these customer

related costs to help determine the
profitability of each customer.
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 Customer Profitability Analysis
Customer Profitability
Cumulative Operating Income as a % of Total

125.0%

100.0%
Operating Income

75% of actual operating income

75.0%

50% of actual operating income

50.0%

25% of actual operating income

25.0%

0.0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
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 Exercise 1

48
 Solution
1. Material handling Cost per mirror:=

2. Material handling Cost per mirror:=

3. Material handling Cost per mirror*:=

4. Material handling Cost per lenses*:=

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 Exercise 2

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 Solution
 1a. Traditional:

 1b. ABC:

 2

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 Quiz- Comprehensive

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 Quiz cntd

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 What we learnt
 LO1-Volume Based Product Costing System/Traditional
 LO2 -ABC System/Two Stage Procedure of Cost Assignment
 LO3- Cost Levels
 LO4-Product Cost based on ABC system/Application
 LO5-Volume Based Product Costing System/Traditional Vs
ABC System
 LO6-Criteria for cost drivers
 LO7- ABC Data Process
 LO8-Activity Based Management and ABC system
 LO9-Customer Profitability Analysis
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End of Chapter 5
This is
my kind of cost
pool!

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