Traditional and

Activity-Based Costing
 Traditional Costing Systems
! Product Costs
! Direct labor
! Direct materials
! Factory Overhead
! Period Costs
! Administrative expenses
! Sales expenses
 Traditional Costing Systems
! Product Costs
! Direct labor Direct labor and direct
materials are easy to
! Direct materials trace to products.

! Factory Overhead The problem comes

with factory
! Period Costs overhead.

! Administrative expense
! Sales expense
Illustration of Full Cost Concept
Full
Production
Cost (or
Direct Prime Cost Inventory
Material Cost) Full
Cost Cost

+ + =
= +

Direct
Selling
Labor Factory Cost
Cost Overhead +
Cost General and
Administrative Cost
 Cost Accounting Principles
Cost Allocation Methods
!The total cost of producing any job order consists
of:
! Direct material
! Direct labour
! Overhead costs.
!An additional item of cost could be special tooling
or equipment purchases strictly for the job order in
question.
!This definition of total cost does not detail the
overhead cost into factory overhead, general
overhead, and marketing expenses in order to
simplify the presentation
 Cost Accounting Principles

!Materials for a given job order may include:

! Purchased parts and in-house fabricated parts
! Cost for direct materials is determined primarily
from purchase invoices.
!Direct labour time spent on job order
! Normally recorded by operators on labour time
cards
! Direct labour cost is determined by applying the
appropriate labour cost rates.
 Cost Accounting Principles

!Overhead costs typically cannot be allocated as direct

charges to any single job order and must, therefore, be
prorated among all the job orders on some rational
basis.
!Three popular methods of allocating overhead costs to
manufacturing jobs are in wide use today. They are:
! Allocation based on direct labour hours
! Allocation based on direct labour dollars
! Allocation based on direct labour dollars plus direct
material dollars (prime costs)
 Traditional Costing Systems
! Typically used one rate to allocate
overhead to products.
! This rate was often based on direct labor
dollars or direct labor hours.
! This made sense, as direct labor was a
major cost driver in early manufacturing
plants.
 Cost Accounting Principles
Allocate Overhead Based on Direct Labour Hours
1. Determine (or estimate) values for previous period direct labour hours
and overhead cost for the manufacturing unit
2. Calculate the rate per direct labour hour:

Rate = overhead cost / direct labour hours

3. Determine (or estimate) the number of direct labour hours required by

the particular job for which overhead cost is being estimated.
4. Calculate the overhead cost for the job:
Estimated overhead = rate X estimated direct labour hours
 Cost Accounting Principles

Allocate Overhead Based on Direct Labour Dollars

1. Determine (or estimate) values for previous period direct labour
dollars and overhead cost for the manufacturing unit
2. Calculate the percentage ratio of overhead cost to direct labour
dollars:

ratio = overhead cost / direct labour dollars x 100%

3. Determine (or estimate) the direct labour dollars required by the

particular job for which overhead cost is being estimated.
4. Calculate the overhead cost for the job:
Estimated overhead = ratio X estimated direct labour dollars
 Cost Accounting Principles
Allocate Overhead Based on Direct Labour Dollars and Direct Material
Dollars
1. Determine (or estimate) values for previous period direct labour dollars,
direct material dollars, and overhead cost for the manufacturing unit
2. Calculate the percentage ratio of overhead cost to direct labour dollars
plus direct material dollars:

ratio = overhead cost / (direct labour dollars + direct material dollars) x

100%

3. Determine (or estimate) the direct labour dollars and direct material
dollars required by the particular job for which overhead cost is being
estimated.
4. Calculate the overhead cost for the job:
estimated overhead = ratio x (estimated direct labour dollars + estimated
direct material dollars)
 Cost Accounting Principles – Example
The overhead allocation for a job is to be estimated. Assume
the direct labour hours for the job are estimated to be 40 hours
at a rate of RM12.50 per hour. Direct materials costs are
estimated at RM850. The overhead calculations are to be
based on the following previous period cost totals:

Total direct labour hours = 48,000

Total direct labour dollars = RM480,000
Total direct material dollars = RM600,000
Total overhead costs = RM360,000
 Cost Accounting Principles – Example
Direct labour hours:
Step 1:
Previous period direct labour hours = 48,000
Previous period overhead costs = RM360,000

Step 2:
Rate per direct labour hour = 360,000/48,000 = RM7.50/DLhour

Step 3:
Estimate direct labour hours for job = 40

Step 4:
Estimate overhead = RM7.50/DLhour * (40 DLhours) = RM300
 Cost Accounting Principles – Example

Estimate the overhead cost based on:

a) Direct labour dollars

b) Direct labour dollars and direct material dollars
c) Direct material dollars
 Another example
100 units of products to be produced.
Labour rate = RM7 per hour
Material A = 50 kg at RM2 per kg
Material B = 300 liter at RM0.50 per liter
Material C = 180 pieces at RM3 per piece
Labour hours for the job = 200 hours
Total annual factory OH = RM600,000
Total annual DL = 200,000 hours
Determine the:
a) Prime costs
b) Overhead cost
c) Total cost
d) If 40% of the TC is allocated to SG&A, how much should
the selling price be in order to get 100% profit?
 Solution
a) Direct labour = 200 x RM7 = RM1,400
Direct material:
Material A = 50 x RM2 = RM100
Material B = 300 x RM0.50 = RM150
Material C = 180 x RM3 = RM540

Prime costs = DL + DM
= RM1,400 + RM790
= RM2,190
 Cont’d
b) Overhead rate = RM600,000/200,000
= RM3 per DLH

To produce 100 units, 200 labour hours

are needed.

Therefore, OH = RM3 x 200 DLH

= RM600
 Cont’d
c) Total cost = prime cost + OH
= RM2190 + RM600
= RM2790

d) 40% SG&A,
Total cost = RM2790(1.4) = RM3906
Unit cost = RM3906/100 = RM39.06

To obtain 100% profit,

Selling price = RM39.06(2) = RM78.12
 Existing Single Indirect-
Cost Pool System Example

Menara Optometry manufactures a normal lens

(NL) and a complex lens (CL).

Menara currently uses a single indirect-cost rate

job costing system.

Total lens produced: 80,000 (NL) and 20,000 (CL).

 Existing Single Indirect-
Cost Pool System Example

Normal Lenses (NL)

Direct materials RM1,520,000
Direct labour 800,000
Total direct costs RM2,320,000

Direct cost per unit: RM2,320,000÷80,000 = RM29

 Existing Single Indirect-
Cost Pool System Example

Complex Lenses (CL)

Direct materials RM920,000
Direct labour 260,000
Total direct costs RM1,180,000

Direct cost per unit: RM1,180,000÷20,000 = RM59

 Existing Single Indirect-
Cost Pool System Example

INDIRECT-COST All Indirect Costs

POOL RM2,900,000

INDIRECT 50,000 Direct

COST-ALLOCATION Labour-Hours
BASE

RM58 per Direct

Labour-Hour
 Existing Single Indirect-
Cost Pool System Example

COST OBJECT: Indirect Costs

NL AND CL
LENSES Direct Costs

DIRECT
COSTS

Direct Direct
Materials Labour
 Existing Single Indirect-
Cost Pool System Example

Menara uses 36,000 direct

labour-hours to make NL and 14,000 direct
labour-hours to make CL.

How much indirect costs are allocated

to each product?
 Existing Single Indirect-
Cost Pool System Example
NL: 36,000 × RM58 = RM2,088,000

CL: 14,000 × RM58 = RM812,000

What is the total cost of normal lenses?

Direct costs RM2,320,000 +

Allocated costs RM2,088,000=RM4,408,000

What is the cost per unit?

RM4,408,000 ÷ 80,000 = RM55.10

 Existing Single Indirect-
Cost Pool System Example

What is the total cost of complex lenses?

Direct costs RM1,180,000 + Allocated costs RM812,000 =

RM1,992,000

What is the cost per unit?

RM1,992,000 ÷ 20,000 = RM99.60

 Existing Single Indirect-
Cost Pool System Example

Normal lenses sell for RM60 each and

complex lenses for RM142 each.

Normal Complex
Revenue RM60.00 RM142.00
Cost 55.10 99.60
Income RM4.90 RM42.40
Margin 8.2% 29.9%
 Activity-Based Costing
Activity-based costing (ABC) has emerged due to the dramatic
changes occurring in the nature and characteristics of manufacturing
costs.

Historically, direct labour and direct material constituted the most

significant elements of the cost of goods.

Overhead was the smallest element and hence was allocated based
on direct labour or prime costs

In many cases today, it is no longer accurate to assume that direct

labour is the largest element in the cost pool and overhead the
smallest.

With the introduction and implementation of computer controlled and

automated manufacturing systems, it is not unusual for overhead
costs to dominate the cost of producing items. Frequently in fact,
direct labour is the least significant in the cost pool and overhead the
largest.
 Activity-Based Costing

First, costs must be identified by categories. Categories

need not (and probably should not) be associated with
products or organizational units, rather, they are
associated with clearly defined elements or cost
categories. Typical examples might include material
handling costs, energy costs, tooling costs, or
maintenance costs.

Next the activities which drive the significant cost

categories must be identified. These are the activities
which are to be monitored and controlled under activity-
based costing.

Examples of cost-driving activities include machine hours

for energy costs, material moves or truck hours for material
handling costs, and machine hours or production volume
for tooling and maintenance costs.
 Examples of Activities

1. Processing purchase orders.

2. Handling materials and parts.
3. Inspecting incoming material and parts.
4. Setting up equipment.
5. Producing goods using manufacturing
equipment.
6. Supervising assembly workers.
7. Inspecting finished goods.
8. Packing customer orders.
 Examples of Cost Drivers

1. Number of purchase orders processed.

2. Number of material requisitions.
3. Number of receipts.
4. Number of setups.
5. Number of machine hours.
6. Number of assembly labor hours.
7. Number of inspections.
8. Number of boxes shipped.
 Activity-Based Costing

ABC attempts to provide a more realistic allocation

of costs than was previously possible. In many
cases, ABC-generated process and product
redesigns have been impressive when measured in
terms of cost reduction and profit improvement.
A more complex example
 Traditional, Volume-Based
Product-Costing System
! Aerotech produces three complex printed circuit
boards referred to as Mode I, Mode II, and Mode III.
! The total budgeted overhead cost is $3,894,000
! The following information is obtained from company
records:

Mode I Mode II Mode III

Production:
Units 10,000 20,000 4,000
Runs 1 of 10,000 4 of 5,000 10 of 400
 Traditional, Volume-Based
Product-Costing System
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

Mode I Mode II Mode III

Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor ($20/hr) 60.00 80.00 40.00
Manufacturing overhead 99.00 132.00 66.00
Total $ 209.00 $ 302.00 $ 126.00

Manufacturing overhead is determined as follows

 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-labour 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
 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
 Traditional, Volume-Based
Product-Costing System
Aerotech wishes to see what target selling
prices would be suggested when using
activity-based costing.

Let’s see how ABC works.

 Activity Based Costing System
(ABC)
ABC systems follow
Assigning
a two-stage overhead to
procedure to products is a
difficult process.
assign overhead I agree!

costs to products.
 Activity Based Costing System
(ABC)
ABC systems follow
Let’s begin
a two-stage by identifying
procedure to our major
activities.
assign overhead
costs to products.
Stage One
Identify significant
activities and assign overhead
costs to each activity in
proportion to resources used.
 Activity Based Costing System
(ABC)
ABC systems follow
a two-stage Overhead assigned to
activities are called
procedure to “activity cost pools.”
assign overhead
costs to products.
Stage Two
Identify cost drivers
appropriate to each activity
and allocate overhead to
the products.
 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
produced.
 Overhead Costs
Total budgeted cost = $3,894,000 Identification
of Activity
Activity Cost Pools
Cost
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

More
Cost
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

Receiving/Inspection
cost pool $200,000

Material-Handling
cost pool $600,000

Quality-Assurance
cost pool $421,000

Packaging/Shipping
cost pool $250,000
 STAGE ONE
Maintenance Lubrication
Various overhead
costs related Depreciation Electricity
to machinery Computer Support Calibration

Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1,212,600
 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
 Traditional, Volume-Based
Product-Costing System
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

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
 STAGE ONE
Total budgeted setup cost
Calculation of $20 per hour
10 hr. per setup
total setup cost
$200 cost per setup
15 production runs
$ 3,000 Total

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

Assume 25% for Mode I, 45% for Mode 2 and 30% for Mode III
 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
 STAGE ONE
Various overhead Plant depr. Property taxes
costs related
to general Plant mgmt. Insurance
operations Plant maint. Security

Activity
cost Facility Cost Pool
pool Total budgeted cost = $507,400
 STAGE TWO
Calculate Budgeted Facilities Cost = $507,400
the pool Budgeted Direct-labour 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
 Product Cost from ABC
Here are the new product costs so far . . .
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 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
Mode III 250,000 × 66% ÷ 4,000 = 41.25
 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
Mode III 250,000 × 66% ÷ 4,000 = 41.25
 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
 Product Diversity
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 reduced

and the selling price for Mode III is increased.
[$209.00 × 1.25] [$183.44 × 1.25]
 Product Diversity
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.
 ABC: Some Key Issues
The Past The Present
! Small number of ! Numerous products
products which did with more and
not differ much in complicated
required production
manufacturing requirements.
support. ! labour is becoming
! labour was the an ever smaller part
dominant element in component of total
the cost structure. production costs.
 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
 Indicators of Need for ABC
Direct labour is a Product-line profit
small percentage margins are hard
of total costs to explain

Line managers do not

Sales are increasing,
believe the product
but profits are declining.
costs reports

Some products that

Marketing does not
have reported high
use costs reports for
profit margins are not
pricing decisions
sold by competitors
 This is
real value-added
time!