ACCT 202: Managerial Accounting

Chapter 4
Activity-Based Costing

05/18/2021
Traditional Cost System
• The traditional cost systems allocate overhead using a
predetermined overhead rate.

• Example
▫ Job order costing: direct labor cost may be
the relevant activity base.

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Review POHR (Chapter 2)
• The formula:

Estimated total manufacturing

overhead cost for the coming period
POHR =
Estimated total units in the
allocation base for the coming period

Ideally,
Ideally, the
the allocation
allocation base
base is
is aa
cost
cost driver
driver that
that causes
causes overhead.
overhead.

• The formula is established at the beginning of the year and will be

used for allocation throughout the year.

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Example
• Atlas Company produces two abdominal fitness products—the Ab
Bench and the Ab Coaster. The direct materials cost per unit is $40
for the Ab Bench and $30 for the Ab Coaster. The direct labor cost is
$12 per unit for each product. Both products require one direct labor
hour per unit, both products are allocated overhead cost of $30 per
unit.

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Activity-Based Costing
• Why do we need activity-based costing (ABC)?
▫ Significant increase in total overhead costs.
▫ Inappropriate to use plantwide predetermined overhead rates when a
lack of correlation exists.
▫ Complex manufacturing processes may require multiple allocation bases;
this approach is called activity-based costing (ABC).

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Activity-Based Costing (cont’d)
• Activity-based costing (ABC)
▫ Allocates overhead costs to multiple activity cost pools.
▫ Assigns the activity cost pools to products or services by means of cost
drivers.

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Activity-Based Costing (cont’d)
• Four steps:

1. Identify and classify the activities involved in the manufacture of specific

products and assign overhead to cost pools.

2. Identify the cost driver that has a strong correlation to the costs
accumulated in each cost pool.

3. Compute the activity-based overhead rate for each cost pool.

4. Allocate overhead costs to products using the overhead rates determined

for each cost pool.
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Example
• Step 1: Identify and classify activities and allocate overhead to cost
pools
▫ Overhead costs are assigned directly to the appropriate activity cost pool.

ATLAS COMPANY
Activity Cost Pools Estimated Overhead
Manufacturing $500,000
Setups 100,000
Purchase ordering 50,000
Product development 200,000
Property and plant 50,000
Total $900,000

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Example (cont’d)
• Step 2: Identify cost drivers for each cost pool
▫ Cost driver must accurately measure the actual consumption of the
activity by the various products.

• Cost drivers that Atlas Company identifies and their total expected
use per activity cost pool are listed below:

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Example (cont’d)
• Step 3: Compute activity-based overhead rates

• The company computes an activity-based overhead rate per cost

driver

Step 1 Step 2 11
Example (cont’d)
• Step 4: Allocate overhead costs to products
▫ In allocating overhead costs, it is necessary to know the use of cost
drivers for each product.

• Because of its low volume and higher number of components, the

Ab Coaster requires more setups and purchase orders than the Ab
Bench.

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Example (cont’d)
• Allocate overhead costs to Ab Bench:
▫ Atlas multiplies the activity-based overhead rates per cost driver by the
number of cost drivers to be used per product.

Step 3 Given

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Example (cont’d)
• Allocate overhead costs to Ab Coaster :
▫ Atlas multiplies the activity-based overhead rates per cost driver by the
number of cost drivers to be used per product.

Given

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Example (cont’d)
• Comparison between traditional costing and ABC:

• Consequence of using traditional costing instead of ABC:

▫ Overprice the Ab Bench  lose market shares to competitors.
▫ Underprice the Ab Coaster  Sacrifice profitability.

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Exercise 2
• Performance Products Corporation makes two products, titanium Rims and Posts. Data
regarding the two products follow:
Direct Labor-Hours per Unit Annual Production
Rims 0.40 20,000 units
Posts 0.20 80,000 units
• Additional information about the company follows
▫ Rims require $17 in direct materials in unit, and Posts require $10.
▫ The direct labor wage rate is $16 per hour.
▫ The ABC system has the following activity cost pools:

Activity Cost Pool (and activity measure) Estimated Activity

Overhead Cost Rims Posts Total

Machine setups (number of setups) $21,600 100 80 180

Special processing (machine-hours) $180,000 4,000 0 4,000
General factory (direct labor-hours) $288,000 8,000 16,000 24,000

• Required:
a) Compute the activity rate for each activity cost pool.
b) Compute the manufacturing overhead cost per unit for Rims.
c) Determine the unit product cost of Rims according to the ABC system.
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Benefits of ABC
• ABC has three primary benefits:
▫ More accurate product costing by classifying more cost pools.
▫ Enhanced control over overhead costs.
▫ Better management decisions.

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Benefits of ABC (cont’d)
• More accurate product costing by classifying more cost pools.
▫ Instead of one plantwide pool and a single cost driver, multiple cost pools
are used.
▫ More relevant cost drivers can be assigned to each cost pool.

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Benefits of ABC (cont’d)
• Classification of activity levels:

Batch- Product- Facility-

Unit-level
level level level

• Performed for each unit of production:

▫ Example: Assembly of cell phones

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Benefits of ABC (cont’d)
• Classification of activity levels:

Product-
Unit-level Batch-level Facility-level
level

• Performed every time a company produces another batch of a

product :
▫ Example: Setting up an equipment

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Benefits of ABC (cont’d)
• Classification of activity levels:

Product-
Unit-level Batch-level Facility-level
level

• Performed every time a company produces a new type of product :

▫ Example: Designing a new product

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Benefits of ABC (cont’d)
• Classification of activity levels:

Product-
Unit-level Batch-level Facility-level
level

• Required to support or sustain an entire production process:

▫ Example: cleaning factory executive offices

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Benefits of ABC (cont’d)
• Classification of activity levels:

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Exercise 3
• Adamson Company manufactures four lines of garden tools. As a result of
an activity analysis, the accounting department has identified eight activity
cost pools. Each of the product lines is produced in large batches, with the
whole plant devoted to one product at a time. Classify each of the following
activities or costs as either unit-, batch-, product-, or facility level.

a) Product design.
b) Plant maintenance.
c) Machine setup.
d) Assembling parts.
e) Purchasing raw materials.
f) Property taxes.
g) Painting of the tool.

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Exercise 4
Benefits of ABC (cont’d)
• Enhanced control over overhead costs.
▫ Under ABC, companies can better trace overhead costs to activities.
▫ In developing an ABC, managers increase their awareness of the
activities performed by the company in its production and supporting
process. This awareness helps managers classify activities as value-
added- or non-value-added activities.

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Benefits of ABC (cont’d)
• Value-added activities increase the perceived value of a product or
service to customers.
▫ Example: Engineering design (manufacturing) and performing surgery
(service).

• Non-value-added activities add costs to, or increase the time spent

on, a product/service without increasing its perceived value.
▫ Example: Storage of inventory (manufacturing) and taking appointments
(service).

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Benefits of ABC (cont’d)
• Better management decisions
▫ Companies experience the benefits of activity-based costing by applying
it to a broader range of management activities.

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Limitations of ABC
• ABC has two limitations:
▫ Expensive to use
▫ Arbitrary allocations remain.

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Applying ABC to Service Industries
• The general approach to identifying activities, activity cost pools,
and cost drivers is the same for service industries and for
manufacturers.

• What makes implementation of ABC sometimes difficult, compared

to manufacturers, is that a larger proportion of overhead costs are
company-wide costs that cannot be directly traced to specific
services.

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Example
• The public accounting firm of Check and Doublecheck prepares the
following condensed annual budget. Assuming direct labor cost is
the activity base:

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Example (cont’d)
• Assume that Check and Doublecheck records $140,000 of actual
direct professional labor cost during its audit of Plano Molding
Company, which was billed an audit fee of $260,000. Under
traditional costing, using 50% as the rate for applying overhead to
the job, Check and Doublecheck would compute applied overhead
and operating income as shown below:

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Example (cont’d)

• Under ABC, Check and Doublecheck distributes its estimated

annual overhead costs of $600,000 to three activity cost pools.

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Example (cont’d)
• Assigning overhead costs to a service using ABC based on the
information below:

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Example (cont’d)
• Under activity-based costing, Check and Doublecheck assigns
overhead costs of $57,200 as compared to $70,000 under
traditional costing.

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Exercise 5
• We Carry Inc. is a trucking company. It provides short-haul, and
long-haul services. The company has developed the following three
cost pools.

a) Compute the activity-based overhead rate for each pool.

b) Determine the overhead allocated to Job A1027 which has 150
pieces, requires 200 miles of driving, and 0.75 hours of logistics.

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