ACCT103

Chapter 8
Activity-Based
Costing
Assigning Overhead Costs to Products

Plantwide Overhead Rate

A single overhead rate used throughout
an entire factory. A simple method,
but one that can distort unit product costs.

Direct labor has often used as the

allocation base for overhead.
Plantwide Overhead Rate
Today,
Today, direct
direct labor
labor may
may no
no longer
longer be
be aa
satisfactory
satisfactory base
base forfor allocation
allocation of
of overhead.
overhead.

Direct
Direct labor
labor may
may no
no longer
longer be
be highly
highly correlated
correlated
with
with overhead
overhead costs.
costs.

No
No single
single allocation
allocation basis
basis may
may be
be able
able to
to
adequately
adequately reflect
reflect the
the demands
demands that
that products
products
place
place on
on overhead.
overhead.
Departmental Overhead Rates
The
The allocation
allocation bases
bases depend
depend on on
the
the nature
nature ofof the
the work
work
Finishing Department performed
performed in in each
each department.
department.
In
In the
the machining
machining department,
department,
Painting Department overhead
overhead may may bebe based
based on on
machine-hours,
machine-hours, but but in
in the
the
Shipping Department assembly
assembly department
department
overhead
overhead is is based
based on on labor-
labor-
hours.
hours.

Unfortunately, even departmental rates will not correctly

assign overhead in situations where a company has a
range of products and complex overhead costs.
Departmental Overhead Rates
Indirect Indirect Other
Labor Materials Overhead
Stage One:
Costs assigned
to pools
Department Department Department
Cost pools
1 2 3
Departmental Overhead Rates
Indirect Indirect Other
Labor Materials Overhead
Stage One:
Costs assigned
to pools
Department Department Department
Cost pools
1 2 3

Stage Two:
Costs applied
to products
Products
Departmental Overhead Rates
Indirect Indirect Other
Labor Materials Overhead
Stage One:
Costs assigned
to pools
Department Department Department
Cost pools
1 2 3
Direct Machine Raw
Stage Two: Labor Hours Materials
Costs applied Hours Cost
to products
Products

Departmental Allocation Bases

Activity-Based Costing (ABC)

A number of Cost
Cost Objects
Objects
(e.g.,
(e.g., products
products and
and customers)
customers)
allocation bases
are used for
assigning costs
Activities
Activities
to products.

Consumption
Consumption of
of Resources
Resources

Cost
Cost
Activity-Based Costing (ABC)

Activity
Activity Cost
Cost Pool
Pool
aa “cost
“cost bucket”
bucket” inin which
which
costs
costs related
related toto aa
particular
particular activity
activity are
are
accumulated
accumulated

Each
Each activity
activity has
has its
its own
own activity
activity rate
rate
that
that is
is used
used to
to apply
apply overhead
overhead costs.
costs.
Designing an ABC System
Steps
Steps for
for Implementing
Implementing ABC
ABC

 Identify
Identify and
and define
define activities
activities and
and activity
activity pools
pools and
and
develop
develop anan activity
activity dictionary.
dictionary.
 Trace
 Trace or
or assign
assign costs
costs to
to activities
activities and
and cost
cost objects.
objects.
 Calculate
 Calculate activity
activity rates.
rates.
 Assign
 Assign costs
costs to
to cost
cost objects.
objects.
 Prepare
 Prepare necessary
necessary reports.
reports.
Hierarchy of Activities

Level
Level Activities
Activities Activity
ActivityMeasure
Measure
Unit-level
Unit-level Processing
Processing units
unitson
onmachines
machines Machine-hours
Machine-hours
Processing
Processing units
unitsby
byhand
hand Direct
Directlabor-hours
labor-hours
Consuming
Consuming factory
factorysupplies
supplies Units
Unitsproduced
produced
Batch-level
Batch-level Processing
Processing purchase
purchaseorders
orders Purchase
Purchaseorders
ordersprocessed
processed
Processing
Processing production
production orders
orders Production
Productionorders
ordersprocessed
processed
Setting
Setting up
upequipment
equipment Number
Numberofofsetups
setups
Handling
Handlingmaterials
materials Pounds
Poundsofofmaterial
materialhandled
handled
Product-level
Product-level Testing
Testingnew
new products
products Hours
Hoursof
oftesting
testing time
time
Administering
Administering parts
partsinventories
inventories Number
Numberofofpart
parttypes
types
Designing
Designingproducts
products Hours
Hoursof
ofdesign
design time
time
Facility-level
Facility-level General
Generalfactory
factoryadministration
administration Direct
Directlabor-hours
labor-hours
Plant
Plantbuilding
building and
and grounds
grounds Direct
Directlabor-hours
labor-hours
 Graphic Example of Activity-Based Costing
Various Manufacturing Overhead Costs

First-Stage Cost Assignment

Labor
Labor Machine
Machine Setup
Setup Production
Production Parts General
Related
Related Pool
Pool Related Pool Pool
Pool Order Pool Admin. Pool Factory
Factory Pool
Pool

Second-Stage Allocations

$/DLH $/MH $/Setup $/Order $/Part Type $/MH

Products
Unit-Level Batch-Level Product-Level Facility-Level
Activity Activity Activity Activity
Using Activity-Based Costing
 Comtek
 Comtek Sound,
Sound, Inc.
Inc. makes
makes two
two products
products that
that are
are sold
sold to
to
automobile
automobile manufacturers,
manufacturers, aa radio
radio with
with aa built-in
built-in CD
CD
player
player and
and aa radio
radio with
with aa built-in
built-in DVD
DVD player.
player.
 For
 For the
the current
current year,
year, Comtek
Comtek has
has budgeted
budgeted sales
sales of
of
50,000
50,000 DVD
DVD units
units and
and 200,000
200,000 CD
CD units.
units.
 Both
 Both products
products require
require two
two direct
direct labor-hours
labor-hours to
to complete,
complete,
for
for aa total
total of
of 500,000
500,000 direct
direct labor
labor hours.
hours.
 Unit
 Unit costs
costs for
for Material
Material and
and labor
labor are:
are:
DVD
DVD CD
CD
Units
Units Units
Units
Direct
Directmaterials
materials $$ 90
90 $$ 50
50
Direct
DirectLabor
Labor $$ 20
20 $$ 20
20
Direct Labor-Hours as a Base
Total manufacturing overhead costs for the
current year are estimated to be $10,000,000.
The company develops the following
overhead rate based upon labor-hours:
Predetermined $10,000,000
overhead rate = 500,000 DLH = $20 per DLH

CD
CDUnit
Unit Tape
TapeUnit
Unit
Direct
Directmaterials
materials $$ 90
90 $$ 50
50
Direct
Directlabor
labor 20
20 20
20
Manufacturing
Manufacturingoverhead
overhead 40
40 40
40
(2
(2DLH
DLHxx$20/DLH)
$20/DLH)
Unit
Unitproduct
productcost
cost $$ 150
150 $$ 110
110
Computing Activity Rates
The ABC project team at Comtek has
developed the following basic information.
Estimated
Estimated
Overhead
Overhead
Activity
Activityand
andActivity
ActivityMeasures
Measures Cost
Cost Expected
ExpectedActivity
Activity
Total
Total DVD
DVD CD
CD
Labor
Laborrelated
related(DLH)
(DLH) $$ 800,000
800,000 500,000
500,000 100,000
100,000 400,000
400,000
Machine
Machinerelated
related(MH)
(MH) 2,100,000
2,100,000 1,000,000
1,000,000 300,000
300,000 700,000
700,000
Machine
Machinesetups
setups(setups)
(setups) 1,600,000
1,600,000 4,000
4,000 3,000
3,000 1,000
1,000
Production
Productionorders
orders(orders)
(orders) 450,000
450,000 1,200
1,200 400
400 800
800
Product
Producttesting
testing(tests)
(tests) 1,700,000
1,700,000 20,000
20,000 16,000
16,000 4,000
4,000
Material
Materialreceipts
receipts(receipts)
(receipts) 1,000,000
1,000,000 5,000
5,000 1,800
1,800 3,200
3,200
Parts
Partsadministration
administration(part
(parttypes)
types) 350,000
350,000 700
700 400
400 300
300
General
Generalfactory
factory(MH)
(MH) 2,000,000
2,000,000 1,000,000
1,000,000 300,000
300,000 700,000
700,000
$$10,000,000
10,000,000
Computing Activity Rates
We can calculate the following activity rates:
Estimated Total
Overhead Expected
Activity and Activity Measures Cost Activity Activity Rate
Labor related (DLH) $ 800,000 ÷ 500,000 = $ 1.60 per DLH
Machine related (MH) 2,100,000 ÷ 1,000,000 = 2.10 per MH
Machine setups (setups) 1,600,000 ÷ 4,000 = 400.00 per setup
Production orders (orders) 450,000 ÷ 1,200 = 375.00 per order
Product testing (tests) 1,700,000 ÷ 20,000 = 85.00 per test
Material receipts (receipts) 1,000,000 ÷ 5,000 = 200.00 per receipt
Parts administration (part types) 350,000 ÷ 700 = 500.00 per part type
General factory (MH) 2,000,000 ÷ 1,000,000 = 2.00 per MH
$ 10,000,000

Using the new activity rates, let’s assign overhead

to the two products based upon activity.
Computing Overhead Cost per Unit
DVD Units
Expected
Expected Activity
Activity
Activity
Activity and
and Activity
Activity Measures
Measures Activity
Activity Rate
Rate Amount
Amount
Labor
Laborrelated
related (DLH)
(DLH) 100,000
100,000 ×× $$ 1.60
1.60 == $$ 160,000
160,000
Machine
Machine related
related (MH)
(MH) 300,000
300,000 ×× 2.10
2.10 == 630,000
630,000
Machine
Machine setups
setups (setups)
(setups) 3,000
3,000 ×× 400.00
400.00 == 1,200,000
1,200,000
Production
Production orders
orders (orders)
(orders) 400
400 ×× 375.00
375.00 == 150,000
150,000
Product
Producttesting
testing (tests)
(tests) 16,000
16,000 ×× 85.00
85.00 == 1,360,000
1,360,000
Material
Materialreceipts
receipts (receipts)
(receipts) 1,800
1,800 ×× 200.00
200.00 == 360,000
360,000
Parts
Parts administration
administration (part
(parttypes)
types) 400
400 ×× 500.00
500.00 == 200,000
200,000
General
Generalfactory
factory (MH)
(MH) 300,000
300,000 ×× 2.00
2.00 == 600,000
600,000
Total
TotalOverhead
Overhead cost
costassigned
assigned $$4,660,000
4,660,000
Number
Numberof ofunits
units produced
produced 50,000
50,000
Overhead
Overhead costcostper
per unit
unit $$ 93.20
93.20
Computing Overhead Cost per Unit
CD Units
Expected
Expected Activity
Activity
Activity
Activity and
and Activity
Activity Measures
Measures Activity
Activity Rate
Rate Amount
Amount
Labor
Laborrelated
related (DLH)
(DLH) 400,000
400,000 ×× $$ 1.60
1.60 == $$ 640,000
640,000
Machine
Machine related
related (MH)
(MH) 700,000
700,000 ×× 2.10
2.10 == 1,470,000
1,470,000
Machine
Machine setups
setups (setups)
(setups) 1,000
1,000 ×× 400.00
400.00 == 400,000
400,000
Production
Production orders
orders (orders)
(orders) 800
800 ×× 375.00
375.00 == 300,000
300,000
Product
Producttesting
testing (tests)
(tests) 4,000
4,000 ×× 85.00
85.00 == 340,000
340,000
Material
Materialreceipts
receipts (receipts)
(receipts) 3,200
3,200 ×× 200.00
200.00 == 640,000
640,000
Parts
Parts administration
administration (part
(parttypes)
types) 300
300 ×× 500.00
500.00 == 150,000
150,000
General
Generalfactory
factory (MH)
(MH) 700,000
700,000 ×× 2.00
2.00 == 1,400,000
1,400,000
Total
TotalOverhead
Overhead costcostassigned
assigned $$5,340,000
5,340,000
Number
Numberof ofunits
units produced
produced 200,000
200,000
Overhead
Overhead costcostper
per unit
unit $$ 26.70
26.70
Computing Product Costs
Activity-Based
Activity-Based Costing
Costing Direct-Labor
Direct-LaborCosting
Costing
DVD
DVD Units
Units CD CD Units
Units DVD
DVD Units
Units CDCD Units
Units
Direct
Directmaterial
material $$ 90.00
90.00 $$ 50.00
50.00 $$ 90.00
90.00 $$ 50.00
50.00
Direct
Directlabor
labor 20.00
20.00 20.00
20.00 20.00
20.00 20.00
20.00
Manufacturing
Manufacturing overhead
overhead 93.20
93.20 26.70
26.70 40.00
40.00 40.00
40.00
Unit
Unitproduct
productcost
cost $$ 203.20
203.20 $$ 96.7096.70 $$ 150.00
150.00 $$ 110.00
110.00

Notice that the unit product cost of a CD unit decreased

from $110 to $96.70 . . . . .

. . . . . while the unit cost of a DVD unit increased from

$150 to $203.20.
Shifting of Overhead Cost
Activity-Based
Activity-Based Costing
Costing Direct-Labor
Direct-LaborCosting
Costing
DVD
DVD Units
Units CD CD Units
Units DVD
DVD Units
Units CDCD Units
Units
Direct
Directmaterial
material $$ 90.00
90.00 $$ 50.00
50.00 $$ 90.00
90.00 $$ 50.00
50.00
Direct
Directlabor
labor 20.00
20.00 20.00
20.00 20.00
20.00 20.00
20.00
Manufacturing
Manufacturing overhead
overhead 93.20
93.20 26.70
26.70 40.00
40.00 40.00
40.00
Unit
Unitproduct
productcost
cost $$ 203.20
203.20 $$ 96.7096.70 $$ 150.00
150.00 $$ 110.00
110.00

Low-volume product
When
When aa company
company implements
implements activity-based
activity-based costing,
costing,
overhead
overhead cost
cost often
often shifts
shifts from
from high-volume
high-volume to to low-
low-
volume
volume products
products with
with aa higher
higher unit
unit product
product cost
cost
resulting
resulting for
for the
the low-volume
low-volume products
products..
Targeting Process Improvements

Activity-Based
Activity-Based Management
Management
involves
involves focusing
focusing onon activities
activities to
to eliminate
eliminate waste,
waste,
decrease
decrease processing
processing time,
time, and
and reduce
reduce defects.
defects.

Benchmarking
Benchmarking
is
is aa systematic
systematic approach
approach to to identifying
identifying the
the activities
activities
with
with the
the greatest
greatest room
room for
for improvement.
improvement. ItIt is
is based
based
on
on comparing
comparing thethe performance
performance in in an
an organization
organization
with
with the
the performance
performance of of other,
other, similar
similar organizations
organizations
known
known for
for their
their outstanding
outstanding performance.
performance.
Evaluation of Activity-Based Costing
Benefits
Benefits of
of ABC
ABC
 Improves
 Improves the
the accuracy
accuracy
of
of product
product costs.
costs.
 Activity
 Activity cost
cost pools
pools are
are
more
more homogeneous
homogeneous
than
than departmental
departmental cost
cost
pools.
pools.
 Allocates
 Allocates overhead
overhead on
on
the
the basis
basis of
of activities
activities
that
that cause
cause overhead
overhead
costs.
costs.
Evaluation of Activity-Based Costing
Benefits
Benefits of
of ABC
ABC Limitations
Limitations of
of ABC
ABC
 Improves
 Improves the
the accuracy
accuracy  Cost
 Cost of
of
of
of product
product costs.
costs. implementation
implementation may
may
exceed
exceed benefits.
benefits.
 Activity
 Activity cost
cost pools
pools are
are
more
more homogeneous
homogeneous  Products
 Products costs
costs are
are
than
than departmental
departmental cost
cost not
not always
always relevant
relevant
pools.
pools. when
when making
making
decisions.
decisions.
 Allocates
 Allocates overhead
overhead on
on
the
the basis
basis of
of activities
activities
that
that cause
cause overhead
overhead
costs.
costs.
Difference Between ABC and Traditional
Product Costs
Batch-level
Batch-level or
or product-
product- Under ABC both
level
level costs
costs willwill manufacturing and
ordinarily
ordinarily shift
shift nonmanufacturing
overhead
overhead costs
costs from
from costs may be assigned
high-volume
high-volume products
products to products.
produced
produced in in large
large Organization-
batches
batches toto low-volume
low-volume sustaining costs and
products
products produced
produced in in the costs of idle
small
small batches.
batches. capacity are not
assigned to products.
Activity-Based Costing and External Reporting

Most companies do not use ABC for external reporting because . . .

1. External reports are less detailed than internal
reports.
2. It may be difficult to make changes to the company’s
accounting system.
3. ABC does not conform to GAAP.
4. Auditors may be suspect of the subjective allocation
process based on interviews with employees.
Activity-Based Costing
and Service Industries
Activity-based
Activity-based costing
costing has
has been
been
implemented
implemented in in aa wide
wide variety
variety of
of service
service
industries
industries including
including railroads,
railroads, hospitals,
hospitals,
banks,
banks, and
and data
data service
service companies.
companies.