Activity-Based Costing

CHAPTER 5
Learning Objectives
1. Explain how broad averaging undercosts and
overcosts products or services
2. Distinguish between simple and activity-based
costing systems
3. Describe a four-part cost hierarchy
4. Cost products or services using activity-based
costing
Learning Objective 1

Explain undercosting
and overcosting of
products and services.
Undercosting and
Overcosting Example
Jose, Roberta, and Nancy order
separate items for lunch.

Jose’s order amounts to $14

Roberta consumed 30
Nancy’s order is 16
Total $60
What is the average cost per lunch?
Undercosting and
Overcosting Example

$60 ÷ 3 = $20

Jose and Nancy Roberta is

are overcosted. undercosted.
Learning Objective 2

Distinguish between the

traditional and the
activity-based costing
approaches to designing
a costing system.
Existing Single Indirect-
Cost Pool System Example
Plastim Corporation manufactures a Simple lens
(SL) and a Complex lens (CL).

Indirect Cost is $2,385,000

Plastim currently uses a single indirect-cost rate
: Manufacturing Labor Hours
Total Manufacturing Labor Hours used: 39,750
Cost objects: 60,000 units (SL) and 15,000 units (CL).
Existing Single Indirect-
Cost Pool System Example

Simple Lenses (SL)

Direct materials $1,125,000
Direct mfg. labor 600,000
Total direct costs $1,725,000

Direct cost per unit: $ 1,725,000 ÷ 60,000 = $28.75

Existing Single Indirect-
Cost Pool System Example
Complex Lenses (CL)
Direct materials $ 675,000
Direct mfg. labor 195,000
Total direct costs $870,000

Direct cost per unit: $870,000 ÷ 15,000 = $59

Existing Single Indirect-
Cost Pool System Example
INDIRECT-COST All Indirect Costs
POLL $2,385,000

INDIRECT 39,750 Direct

COST-ALLOCATION Manufacturing
BASE Labor-Hours

Predetermined OH Rate $60 per Direct

Manufacturing
Labor-Hour
Existing Single Indirect-
Cost Pool System Example
COST OBJECT: Indirect Costs
SL AND CL
LENSES Direct Costs

DIRECT
COSTS
Direct
Direct
Manufacturing
Materials Labor
Existing Single Indirect-
Cost Pool System Example
Plastim uses 30,000 direct manufacturing
labor-hours to make SL and 9750 direct
manufacturing labor-hours to make CL.
How much indirect costs are allocated
to each product?
SL: 30,000 × $60 = $1,800,000
CL: 9750 × $60 = $585,000
Existing Single Indirect-
Cost Pool System Example

Simple Lenses (SL)

Direct materials $1,125,000
Direct mfg. labor 600,000
Total direct costs $1,725,000
Indirect Cost Allocated 1,800,000
$3,525,000
Direct cost per unit: $ 1,725,000 ÷ 60,000 = $28.75
Total cost per unit: $ 1,800,000 ÷ 60,000 = $58.75
Existing Single Indirect-
Cost Pool System Example
Complex Lenses (CL)
Direct materials $ 675,000
Direct mfg. labor 195,000
Total direct costs $870,000
Indirect Cost Allocated 585,000
$1,455,000
Direct cost per unit: $870,000 ÷ 15,000 = $59
Total cost per unit: $ 1,455,000 ÷ 15,000 = $97
 Existing Single Indirect-
Cost Pool System Example
Simple lenses sell for $58.75 each and
Complex lenses for $97each.
Simple Complex
Revenue $63.00 $137.00
Cost 58.75 97.00
Income $ 4.25 $ 40.00
Margin 6.75% 29.2%
Small
Margin
As they continue to gather information, Plastim’s managers begin to ponder
why the profit margins are under so much pressure for the Simple lens,
where the company has strong capabilities, but not on the newer, less-
established Complex lens.
Cost Hierarchies

A cost hierarchy is a categorization

of costs into different cost pools.
Cost drivers bases (cost-allocation bases)
Degrees of difficulty in determining
cause-and-effect relationships
Cost Hierarchies

ABC systems commonly use a

four-part cost hierarchy to
identify cost-allocation bases:
1. Unit-level costs
2. Batch-level costs
3. Product-sustaining costs
4. Facility-sustaining costs
 DESIGNING AN ACTIVITY-BASED COSTING SYSTEM

Hierarchy of Activities

1. Unit Level Cost

Unit-level activities Activities Measure

Performed each time a unit is produced. Processing units on machines Machine-hours

The costs of unit-level activities should be Processing units by hand Direct labor-hours
proportional to the number of units
Consuming factory supplies Units produced
produced.

2. Batch Level Cost

Batch-level activities Activities Measure

Tasks that are performed each time a
batch is processed, such as processing
purchase orders, setting up equipment,
packing shipments to customers, and
handling material.
Processing purchase orders Purchase orders processed
Processing production orders Production orders processed
Setting up equipment Number of setups
Handling materials Pounds of material handled

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 DESIGNING AN ACTIVITY-BASED COSTING SYSTEM

Hierarchy of Activities

3. Product-sustaining Cost
Product-level activities
Activities Measure
Related to specific products and
typically must be carried out Testing new products Hours of testing time
regardless of how many batches or Administering parts inventories Number of part types
units of the product are manufactured. Designing products Hours of design time

4. Facility-sustaining Cost
Facility-level activities
Activities Measure
Activities that are carried out
regardless of which products are General factory administration Direct labor-hours
produced, how many batches are run, Plant building and grounds Direct labor-hours
or how many units are made.

page 20
Activity-Based Costing
System (ABC)
ABC systems follow a Assigning
overhead to
two-stage procedure products is a
to assign overhead difficult process.
I agree!
costs to products.
 Activity-Based Costing
System (ABC)
ABC systems follow a Let’ begin
two-stage procedure by identifying
our major
to assign overhead activities.
costs to products.

Stage One
Identify significant
activities and assign overhead
costs to each activity in
proportion to resources used.
Activity-Based Costing
System
A cross-functional team at Plastim
Corporation identified six activities:
1.Design products and processes.
2.Set up molding machine.
3.Operate machines to manufacture lenses.
Activity-Based Costing
System

4.Set up batches of finished lenses for shipment.

5.Distribute lenses to customers.
6.Administer and manage all processes.
 Activity-Based Costing
System (ABC)
ABC systems follow a two- Overhead costs
stage procedure to assigned to activities
assign overhead costs to are called “activity cost
products. pools.”

Stage Two
Identify cost drivers
appropriate to each activity
and allocate overhead to
the products.
Plastim and ABC Illustrated
Plastim and ABC Rate Calculation
Plastim and ABC Product Costs
Plastim: Simple & ABC Compared
Traditional Single Indirect-Cost Pool

Simple Complex
Revenue $63.00 $137.00
Cost 58.75 97.00 Simple lenses sell for $58.75 each and
Complex lenses for $97each.
Income $ 4.25 $ 40.00
Margin 6.75% 29.2%

Activity Based Costing

Simple Complex
Revenue $63.00 $137.00
Cost 49.98 132.07
Income $ 13.02 $ 4.93
Margin 20.67% 3.59%
Plastim: Activity Based
Costing Profitability Analysis

Simple Complex
Revenue $63.00 $137.00
Cost 49.98 132.07
Income $ 13.02 $ 4.93
Margin 20.67% 3.59%