Chapter 5 : Process Costing

Similarities Between Job-Order & Process Costing

 Both
Both systems
systems assign
assign material,
material, labor
labor and
and
overhead
overhead costs
costs to
to products
products && they
they provide
provide aa
mechanism
mechanism for for computing
computing unit
unit product
product cost.
cost.
 Both
Both systems
systems use
use the
the same
same manufacturing
manufacturing
accounts,
accounts, including
including Manufacturing
Manufacturing Overhead,
Overhead,
Raw
Raw Materials,
Materials, Work
Work inin Process,
Process, & & Finished
Finished
Goods.
Goods.
 The
The flow
flow of
of costs
costs through
through the
the manufacturing
manufacturing
accounts
accounts isis basically
basically the
the same
same in in both
both systems.
systems.
 Differences Between Job-Order
& Process Costing
 Process
Process costing
costing is is used
used when
when aa single
single product
product isis
produced
produced on on aa continuing
continuing basis
basis or
or for
for aa long
long period
period of
of
time.
time. Job-order
Job-order costing
costing isis used
used when
when many
many different
different jobs
jobs
are
are worked
worked on on each
each period.
period.
 Process
Process costing
costing systems
systems accumulate
accumulate costs
costs by
by
department.
department. Job-order
Job-order costing
costing systems
systems accumulated
accumulated
costs
costs by
by individual
individual jobs.
jobs.
 Process
Process costing
costing systems
systems use use department
department production
production
reports
reports to
to accumulate
accumulate costs.
costs. Job-order
Job-order costing
costing systems
systems
use
use job
job cost
cost sheets
sheets toto accumulate
accumulate costs.
costs.
 Process
Process costing
costing systems
systems compute
compute unit
unit costs
costs byby
department.
department. Job-order
Job-order costing
costing systems
systems compute
compute unitunit
costs
costs by
by job.
job.
 Quick Check 

Process costing is used for products that are:

a. Different and produced continuously.
b. Similar and produced continuously.
c. Individual units produced to customer
specifications.
d. Purchased from vendors.
 Quick Check 

Process costing is used for products that are:

a. Different and produced continuously.
b. Similar and produced continuously.
c. Individual units produced to customer
specifications.
d. Purchased from vendors.
What is a Processing Department?
Any location in an organization where materials,
labor or overhead are added to the product.
The activities performed in a processing
department are performed uniformly on all
units of production. Furthermore, the output of
a processing department must be
homogeneous.
 Comparing Job-Order
and Process Costing

Direct
Direct
Materials
Materials

Direct Work in Finished

Finished
Direct Labor
Labor Goods
Process Goods

Manufacturing
Manufacturing Cost
Cost of
of
Overhead
Overhead Goods
Goods
Sold
Sold
 Comparing Job-Order
and Process Costing

Costs
Costs are
are traced
traced and
and
applied
applied to
to individual
individual
Direct
Direct jobs
jobs in
in aa job-order
job-order
Materials
Materials cost
cost system.
system.

Direct Finished
Finished
Direct Labor
Labor Jobs Goods
Goods

Manufacturing
Manufacturing Cost
Cost of
of
Overhead
Overhead Goods
Goods
Sold
Sold
 Comparing Job-Order
and Process Costing

Costs
Costs areare traced
traced and
and
applied
applied toto departments
departments
Direct
Direct in
in aa process
process cost
cost
Materials
Materials system.
system.

Direct Processing
Processing Finished
Finished
Direct Labor
Labor Goods
Department
Department Goods

Manufacturing
Manufacturing Cost
Cost of
of
Overhead
Overhead Goods
Goods
Sold
Sold
 Process Cost Flows
(in T-account form)
Work in Process
Raw Materials Department A
• Direct • Direct
Materials Materials

Work in Process
Department B
• Direct
Materials
 Process Cost Flows
(in T-account form)
Work in Process
Department A
Wages Payable
• Direct
• Direct Materials
Labor • Direct
Labor

Work in Process
Department B
• Direct
Materials
• Direct
Labor
 Process Cost Flows
(in T-account form)
Work in Process
Department A
Manufacturing • Direct
Overhead Materials
• Direct
• Actual • Overhead Labor
Overhead Applied to • Applied
Work in Overhead
Process
Work in Process
Department B
• Direct
Materials
• Direct
Labor
• Applied
Overhead
 Process Cost Flows
(in T-account form)

Work in Process Work in Process

Department A Department B
• Direct Transferred • Direct
Materials to Dept. B Materials
• Direct • Direct
Labor Labor
• Applied • Applied
Overhead Overhead
• Transferred
from Dept. A
 Process Cost Flows
(in T-account form)

Work in Process
Department B Finished Goods
• Direct • Cost of • Cost of
Materials Goods Goods
• Direct Manufactured Manufactured
Labor
• Applied
Overhead
• Transferred
from Dept. A
 Process Cost Flows
(in T-account form)

Work in Process
Department B Finished Goods
• Direct • Cost of • Cost of • Cost of
Materials Goods Goods Goods
• Direct Manufactured Manufactured Sold
Labor
• Applied
Overhead
• Transferred
from Dept. A Cost of Goods Sold
• Cost of
Goods
Sold
 Equivalent Units of Production
Equivalent units are the (multiplication) product
of the number of partially completed units and the
percentage
of completion of those units.
OR number of partially completed unites X %age of
completion

We need to calculate equivalent units because a

department usually has some partially completed units
in its beginning and ending inventory.
Equivalent Units – The Basic Idea

Two half completed products are

equivalent to one completed product.

+ = 1

So,
So, 10,000
10,000 units
units 70%
70% complete
complete
are
are equivalent
equivalent to
to 7,000
7,000 complete
complete units.
units.
 Quick Check 

For the current period, Jones started 15,000 units and

completed
completed 10,000
10,000 units,
units, leaving
leaving 5,000
5,000 units
units in
in process
process that
that
are
are 30
30 percent
percent complete.
complete. How How many
many equivalent
equivalent units
units of
of
production
production did
did Jones
Jones have
have for
for the
the period?
period?
a.
a. 10,000
10,000
b.
b. 11,500
11,500
c.
c. 13,500
d.
d. 15,000
15,000
 Quick Check 

For
For the
the current
current period,
period, Jones
Jones started
started 15,000
15,000
units
units and completed 10,000 units,units, leaving
leaving
5,000
5,000 units
units in
in process
process that
that are
are 3030 percent
percent
complete.
complete. HowHow many
many equivalent
equivalent units
units of
of
production
production did
did Jones
Jones have
have for
for the
the period?
period?
a.
a. 10,000
10,000
10,000 units + (5,000 units × 0.30)
b. 11,500
b. 11,500 = 11,500 equivalent units
c.
c. 13,500
13,500
d.
d. 15,000
15,000
 Equivalent Units of Production
Weighted-Average Method
The weighted-average method . . .
• Makes no distinction between work done in prior or
current periods.
• Blends together units & costs from prior and
current periods.

Cost per Costs for the period

equivalent = Equivalent units of production
for the period
unit
 Process Costing and Direct Labor
Direct
Materials Direct
Direct labor
labor costs
costs
Dollar Amount may
may bebe small
small
Manufacturing in
in comparison
comparison to to
overhead cost other
other product
product
Direct
costs
costs in
in process
process
Labor cost
cost systems.
systems.

Type of Product Cost

 Process Costing and Direct Labor
Direct
Materials Direct
Direct labor
labor costs
costs
Conversion
may
may bebe small
small
in
in comparison
comparison to
Dollar Amount
to
other
other product
product
costs
costs in
in process
process
cost
cost systems.
systems.

Type of Product Cost

Direct
Direct labor
labor &
& manufacturing
manufacturing overhead
overhead may
may be
be
combined
combined into
into one
one product
product cost
cost called
called conversion.
conversion.
 Weighted-Average Example

S. Company reported the following activity in

Department A for the month of June:

Percent Completed
Units Materials Conversion
Work in process, June 1 300 40% 20%

Units started into production in June 6,000

Units completed & transferred out 5,400

of Department A during June

Work in process, June 30 900 60% 30%

 Weighted-Average Example
The first step in calculating the equivalent units is to
identify the units completed & transferred out of
Department A in June (5,400 units)

Materials Conversion
Units completed and transferred
out of Department A in June 5,400 5,400
 Weighted-Average Example

The second step is to identify the equivalent units of

production in ending work in process with respect
to materials for the month (540 units) and add this
to the 5,400 units fromMaterials
step one.Conversion
Units completed and transferred
out of Department A in June 5,400 5,400
Work in process, June 30:
900 units × 60% 540

Equivalent units of Production in

Department A during June 5,940
 Weighted-Average Example
The third step is to identify the equivalent units of
production in ending work in process with respect
to conversion for the month (270 units) & add this
to the 5,400 units from step one.
Materials Conversion
Units completed and transferred
out of Department A in June 5,400 5,400
Work in process, June 30:
900 units × 60% 540
900 units × 30% 270
Equivalent units of Production in
Department A during June 5,940 5,670
 Weighted-Average Example
Equivalent
Equivalent units
units of
of production
production always
always equals:
equals:
Units
Units completed
completed & & transferred
transferred
++ Equivalent
Equivalent units
units remaining
remaining inin work
work in
in process
process

Materials Conversion
Units completed and transferred
out of Department A in June 5,400 5,400
Work in process, June 30:
900 units × 60% 540
900 units × 30% 270
Equivalent units of Production in
Department A during June 5,940 5,670
 Weighted-Average Example

Materials 6,000 Units Started

Beginning Ending
Work in Process 5,100 Units Started Work in Process
300 Units and Completed 900 Units
40% Complete 60% Complete

5,400 Units Completed

540 Equivalent Units 900 × 60%
5,940 Equivalent units
of production
 Weighted-Average Example

Conversion
Conversion 6,000 Units Started

Beginning Ending
Work in Process 5,100 Units Started Work in Process
300 Units and Completed 900 Units
20% Complete 30% Complete

5,400 Units Completed

900 × 30%
270 Equivalent Units
5,670 Equivalent units
of production
Production Report – Weighted-Average

Production Report

AA quantity
quantity schedule
schedule
showing
showing the
the flow
flow of
of units
units
Section 1 and
and the
the computation
computation ofof
equivalent
equivalent units.
units.


AA computation
computation of
of
Section 2 cost
cost per
per equivalent
equivalent unit.
unit.

Section 3
 Production Report

Production Report

Section 1

Section 2

 Cost
Cost Reconciliation
Reconciliation
section
section shows
shows the
the
reconciliation
reconciliation of
of all
all cost
cost
Section 3 flows
flows into
into and
and out
out of
of the
the
department
department during
during the
the
period.
period.
 Production Report Example

Assume
Assume thatthat Double
Double D.D. co.
co. uses
uses the
the
weighted-average
weighted-average method
method ofof process
process costing
costing
to
to determine
determine unit
unit costs
costs in
in itit Shaping
Shaping and
and
Milling
Milling Department.
Department.
 Production Report Example

Work
Work in
in process,
process, May
May 1:
1: 200
200 units
units
Materials:
Materials: 55%
55% complete
complete $$ 9,6009,600
Conversion:
Conversion: 30%
30% complete
complete 5,575
5,575

Production
Production started
started during
during May
May 5,000
5,000 units
units
Production
Production completed
completed during
during May
May 4,800
4,800 units
units

Costs
Costs added
added to
to production
production in
in May
May
Materials
Materials cost
cost $$ 368,600
368,600
Conversion
Conversion cost
cost 350,900
350,900

Work
Work in
in process,
process, May
May 31
31 400
400 units
units
Materials:
Materials: 40%
40% complete
complete
Conversion:
Conversion: 25%
25% complete
complete
 Learning Objective
LO3

To prepare a quantity
schedule using the
weighted-average method.
 Production Report Example

Step1: Prepare Quantity Schedule with Equivalent Units.

Units to be accounted for:

Work in process, May 1 200
Started into production 5,000
Total units 5,200

Equivalent units
Materials Conversion
Units accounted for as follows:
Completed and transferred 4,800 4,800 4,800
Work in process, May 31 400
 Production Report Example

Step1: Prepare Quantity Schedule with Equivalent Units.

Units to be accounted for:

Work in process, May 1 200
Started into production 5,000
Total units 5,200

Equivalent units
Materials Conversion
Units accounted for as follows:
Completed and transferred 4,800 4,800 4,800
Work in process, May 31 400
Materials 40% complete 160

5,200 4,960
 Production Report Example

Step1: Prepare Quantity Schedule with Equivalent Units.

Units to be accounted for:

Work in process, May 1 200
Started into production 5,000
Total units 5,200

Equivalent units
Materials Conversion
Units accounted for as follows:
Completed and transferred 4,800 4,800 4,800
Work in process, May 31 400
Materials 40% complete 160
Conversion 25% complete 100
5,200 4,960 4,900
 Learning Objective
LO4

To compute the costs per

equivalent unit using the
weighted-average method.
 Step 2: Calculating the
Costs Per Equivalent Unit

To calculate the cost per equivalent unit

for the period:

Cost per Costs for the period

equivalent = Equivalent units of production
for the period
unit
 Production Report Example
Step 2: Compute the cost per equivalent unit.

Total
Cost Materials Conversion
Cost to be accounted for:
Work in process, May 1 $ 15,175 $ 9,600 $ 5,575
Costs added in the Shipping
and Milling Department 719,500 368,600 350,900
Total cost $ 734,675 $ 378,200 $ 356,475

Equivalent units 4,960 4,900

Cost per equivalent unit
 Production Report Example
Step 2: Compute the cost per equivalent unit.

Total
Cost Materials Conversion
Cost to be accounted for:
Work in process, May 1 $ 15,175 $ 9,600 $ 5,575
Costs added in the Shipping
and Milling Department 719,500 368,600 350,900
Total cost $ 734,675 $ 378,200 $ 356,475

Equivalent units 4,960 4,900

Cost per equivalent unit $ 76.25

$378,200 ÷ 4,960 units = $76.25

 Production Report Example
Step 2: Compute the cost per equivalent unit.

Total
Cost Materials Conversion
Cost to be accounted for:
Work in process, May 1 $ 15,175 $ 9,600 $ 5,575
Costs added in the Shipping
and Milling Department 719,500 368,600 350,900
Total cost $ 734,675 $ 378,200 $ 356,475

Equivalent units 4,960 4,900

Cost per equivalent unit $ 76.25 $ 72.75
Total cost per equivalent unit = $76.25 + $72.75 = $149.00

$356,475 ÷ 4,900 units = $72.75

 Learning Objective
LO5

To prepare a cost
reconciliation using the
weighted-average method.
 Production Report Example
Step 3: Prepare a Cost Reconciliation

Total Equivalent Units

Cost Materials Conversion
Cost accounted for as follows:
Transferred out during May 4,800 4,800
Work in process, May 31:
Materials 160
Conversion 100
Total work in process, May 31
Total cost accounted for
 Production Report Example
Step 3: Prepare a Cost Reconciliation

Total Equivalent Units

4,800 units @ $149.00 Cost Materials Conversion
Cost accounted for as follows:
Transferred out during May $ 715,200 4,800 4,800
Work in process, May 31:
Materials 160
Conversion 100
Total work in process, May 31
Total cost accounted for
 Production Report Example
Step 3: Prepare a Cost Reconciliation

Total Equivalent Units

160 units @ $76.25 Cost Materials
100 units @ Conversion
$72.75
Cost accounted for as follows:
Transferred out during May $ 715,200 4,800 4,800
Work in process, May 31:
Materials 12,200 160
Conversion 7,275 100
Total work in process, May 31 19,475 All costs
Total cost accounted for $ 734,675 accounted for
 Exercise
 In March, K. Company had the following unit production costs: materials $10
and conversion costs $8. On March 1, it had zero work in process. During
March, K. co. transferred out 22,000 units. As of March 31, 4,000 units that
were 40% complete as to conversion costs and 100% complete as to materials
were in ending work in process.
 (a) Compute the total units to be accounted for.
 (b) Compute the equivalent units of production.
 (c) compute cost of production(Cost Reconciliation) .
 materials conversion cost Total cost

 Costs accounted for

 Transferred out (22,000*18) 396,000
 Work in process, march 31
 Materials (4000*10) 40000
 Conversion costs (2400*8) 19200
 Chapter 6
Activity Based Costing (ABC)
Allocation of Overhead Costs
• Costs that are not directly related to the a product or
a service are called overhead costs.
• How do we allocate such costs?
• What are the approaches used to allocate such costs?
• There are two different approaches to allocate
overhead costs. These are:
• Traditional Approach
• Activity Based Costing Approach

Ermias M 48
Allocation of Overhead Costs (Cont…)
i. Traditional Approach
• A single predetermined overhead rate is used to
apply (allocate) manufacturing overhead costs.
• The total manufacturing overhead cost
represents one cost pool.
• and volume based costs, such as:
• direct labor costs,
• direct material costs,
• machine costs
represent the direct cost components of the
production/product.
Ermias M 49
 Allocation of Overhead Costs (Cont…)
• Then overhead cost could be applied based on either:
• Direct labour hours
• Machine hours
How is it calculated?
 Overhead Cost Per Direct Labour Hour =Total Budgeted
Overhead Costs/Total Budgeted Direct Labour Hours for the
period.

 Overhead Cost per Machine Hour=total Budgeted Overhead

Costs/Total Manufacturing Hours for the period.

Ermias M 50
Allocation of Overhead Costs (Cont…)
Example:
• Suppose a Sony TV set manufacturer produces
14” and 21” color TV sets.
• They are using the application of one cost pool
of overhead costs to the two product lines.
• Suppose Sony prefer machine hours to allocate
overhead costs.
• For the next year, the overhead costs are
expected to amount to $300,000 and
• the total machine hours worked are expected
to be 30,000 hours. Ermias M 51
Allocation of Overhead Costs (Cont…)
• Using this information we can easily estimate
overhead cost per machine hour as follows:
• OHC per Machine Hr = Budgeted Total OHC/Total
Machine Hours
OHC per machine hour = $300,000/30,000 = $10

• As next step we will allocate the overhead costs to

each product.
• For that purpose we need additional information.

Ermias M 52
Allocation of Overhead Costs (Cont…)
• During the year, 10,000 machine hours were
used to produce 5,000, 14-inch TV sets
and 20,000 machine hours were used to
produce 4,000, 21-inch TV sets.
• Sony uses the predetermined overhead rate
of $10 per machine hour to allocate the
overhead costs.
• The portion of manufacturing overhead costs
allocated to the 14-inch TV sets =
$10/MH x 10,000 MH = $100,000
Ermias M 53
Allocation of Overhead Costs (Cont…)
For each 14 –inch TV set overhead cost will be
$100,000/5,000 = $ 20 per unit
• The portion applied to 21-inch TV sets totaled
$10/MHr x 20,000 M/hr = $200,000 or
For each 21-inch TV set = $50 ($200,000/
4,000units)
• If we want to calculate the product unit
cost during the accounting period, we need
the direct cost of each product.
Ermias M 54
Allocation of Overhead Costs (Cont…)
The corporation supplied the following data for the
two product lines:
14 inch 21inch
Actual direct material $70 $ 80
Actual direct labor 30 40
Overhead cost 20 50
Total unit cost $120 $170

Ermias M 55
Allocation of Overhead Costs (Cont…)
• This total cost represents the minimum price of
the product.
• If the company wants to make 10% of the total
cost as profit margin, the price can be
determined as follows:
• 14-inch TV set =0.1*$120 = $12 + 120 = $ 132
• 21-inch TV set =0.1*$170 = $17 + 170 = $ 187

Ermias M 56
Overhead Allocation Using Activity Based
Costing (ABC)
ii/ Activity Based Costing Approach
• Another method of cost allocation is the activity based
costing approach.
• Activity–Based Costing (ABC) costs products more
accurately.
• It will:
• Categorize all indirect costs by activity,
• Trace the indirect costs to those activities and then
assign them to the products.
• ABC will improve the accuracy of product costing for
organizations that sell many different types of products.
Ermias M 57
 Activity-Based Costing
• Activity-based costing (ABC) allocates overhead to multiple activity
cost pools & assigns the activity cost pools to production by means of
cost drivers.
• In ABC, an activity is any event, action, transaction, or work
sequence that causes the incurrence of cost in the production of a
product or rendering of a service.
• A cost driver is any factor or activity that has a direct cause/effect
relationship with the resources consumed.
Activity-Based Costing
• ABC first allocates costs to activities, and then to the products
based on each product’s use of those activities.
• The reasoning behind ABC cost allocation is simple: products
consume activities; activities consume resources.
Activity-based costing involves the following four steps

1. Identify and classify the activities involved in the

manufacture of specific products, and allocate overhead to
cost pools.
2. Identify the cost driver that has a strong correlation to
the costs accumulated in the cost pool.
3. Compute the activity-based overhead rate for each cost
driver.
4. Assign overhead costs to products, using the overhead
rates determined for each cost pool (cost per driver)
Ermias M 60
 Identify and Define Activities and Activity Cost Pools

Activity Cost Pool is a “bucket” in

which costs are accumulated that
relate to a single activity measure in
the ABC system. $$
$
$ $
$
 Activity-Based Costing
• Not all products or services share equally in activities.
• The more complex a product’s manufacturing operation, the
more activities and cost drivers it is likely to have.
• If there is little or no correlation between changes in the cost driver
and consumption of the overhead cost, inaccurate product costs are
inevitable.
• The next slide shows an illustration of an activity-based costing
system with seven activity cost pools and correlated cost drivers.
Activity-Based Costing System

Overhead Costs

Ordering
Setting Inspecting
and Assem- Super-
Up Machining and Painting
Receiving bling vising
Machines Cost Pool Testing Cost Pool
Materials Cost Pool Cost Pool Cost Pool
Cost Pool
Cost Pool

Numbe Numbe Numbe Numbe Numbe Direct

Machin
r of r of r of r of r of Labor
e Hours
POs Setups Parts Tests Parts Hours

Products
 When to Switch to ABC
The presence of the following factors indicates ABC as the
superior costing system:
1. Product lines are numerous, diverse, and require differing
degrees of support services.
2. Product lines differ greatly in volume & manufacturing
complexity.
Overhead Allocation Using Activity Based
Costing (ABC)
• Under this approach we need to identify production-
related activities and events, such as:
 Number of materials orders
 Number of machine setups
 Number of inspections,
 Number of maintenance hours, etc
• As a result, from the single manufacturing overhead
cost pool,
• a number of smaller activity pools are created.
• For each activity pool, predetermined overhead rate or
activity cost rate is determined.
Ermias M 65
Overhead Allocation Using Activity Based
Costing (ABC)
• Thus, ABC assigns overhead costs based on the relative use
of overhead resources.
Consider the previous example
• Sony used traditional approach for assigning manufacturing
overhead costs to two kinds of TV sets.
• The cost difference between the two TV sets is wide
($50).
• The company wanted to revise its cost estimation.
• No error was found in estimating the direct material &
labour costs.
Ermias M 66
 Overhead Allocation Using Activity Based Costing (ABC)

• However, the management accounting division believes that

the traditional approach to assign manufacturing overhead
costs could be misleading.
• So the division wants to use Activity Based Costing to obtain
more accurate product costs.
• The corporation analyzed the production related activities
and decided that the estimated $300,000 in manufacturing
overhead cost should be grouped into four activity pools.

Ermias M 67
Overhead Allocation Using Activity Based
Costing (ABC)
These are:
1. Setup: preparing machines for production of
each batch.
• The estimated total costs of this activity
are $100,000 for indirect manufacturing
costs.
2.Inspection: This constitutes costs of testing
the products at different stage.
• This includes $90,000 for salaries, costs of
indirect materials, indirect labor and
depreciation on testing equipment.
Ermias M 68
Overhead Allocation Using Activity Based
Costing (ABC)
3. Packaging: This cost includes estimated total
costs of $65,000 for indirect materials,
indirect labor, and equipment depreciation
related to packaging.
4. The last activity is Others: This includes:
• wages,
• property taxes,
• insurance,
• security and all other costs not related
to the first three activities with costs of
$45,000.
Ermias M 69
Allocation of Overhead Costs (Cont…)
• After identifying activity pools, and
estimating activity pool costs.
• then estimate the cost drivers, that are the
levels of each activity performed.
• We use this information to determine activity
rate.
Activity OHC rate = Activity cost/cost driver
• Cost driver can be:
• Number of setups
• Number of inspections
• Packaging hours
• Machine/labour hours
Ermias M 70
Overhead Allocation Using Activity Based
Costing (ABC)
Estimated Cost Driver Level
Cost driver 14inch 21inch Total
Number of setups 500 500 1,000
No of inspections 250 350 600
Packaging hours 1,200 1,300 2,500
Other (labor 14,000 16,000 30,000
hours )

Ermias M 71
Activity Driver
pool level Cost Cost rate
Number of 1,000 $100,000 $100,000/1,000 $100 per
setups setup
Number of 600 $90,000 $90,000/ 600 $150 per
inspections inspection
Packaging 2,500 $65,000 $65,000/2,500 $26 per
hours packaging
hr
Labor 30,000 $45,000 $45,000/30,000 $1.5. per
hours labour hr
Ermias M 72
Exercise
• Mordica Company identifies three activities in its manufacturing process:
machine setups,
machining, and
 inspections.
• Estimated annual overhead cost for each activity is $150,000, $325,000,
and $87,500, respectively.
• The cost driver for each activity and the expected annual usage are:
• number of setups 2,500,
• machine hours 25,000, and
• number of inspections 1,750.
• Compute the overhead rate for each activity

Ermias M 73
Overhead Allocation Using Activity Based
Costing (ABC)
Application of Manufacturing Overhead Costs
to Products
• How do we apply manufacturing overhead costs
to products?
• Applying the manufacturing overhead to the
products involves:
• the activity pool rate is multiplied by
the actual cost driver used by the
products.

Ermias M 74
 14 inch
Activity Activity cost Cost Driver Cost applied
pool rate level
Set up $100 per set 500 set ups 500*100=
up $50,000
Packing $26 per 1,200 packing 1200*26=
packing hour hour $31,200
Inspectio $150 per Ins 250 inspections $37,500
n
$1.5 per 14,000 Machine $21,000
Others Machine hour hrs

Total $139,700
Number of units
Ermias M
5,000 75
 21 inch
Activity Activity cost Cost Driver Cost
pool rate level applied
Set up $100 per set *500 set ups
up $50,000
Inspection $150 per Ins 350 inspections $52,500

Packing $26 per *1,300 packing

packing hour hour $33,800
Others $1.5 per *16,000
Machine hour Machine hour $24,000
Total $160,300
Number of units
Ermias M $ 4,000 76
 Unit Product Costs

• Product cost per unit:

• 14inch 21inch
• Direct materials $ 70 $ 80
• Direct labor 30 40
• Manufacturing overhead 28 40
• Product unit cost $128 $160

Ermias M 77
 Allocation of Overhead Costs
(Cont…)
• The unit product cost is $128 for 14-inch model
and $160 for the 21-inch model.
• Management accountant presented the following
information for decision
Model 14-inch 21-
inch
1. One manufacturing overhead $ 120 $170
Cost pool (traditional approach)
2. Product unit cost: ABC with
four activity pools $128 $ 160
Differences: Decrease (increase)
Ermias M $ (8) $ 10 78
 Exercise

Sino-Afro Optics produces two types of eyeglasses – standard & deluxe.

Operational data for 2018 is provided below
items standard deluxe
unit direct material cost 900.00 1,200.00
unit direct labor cost 144.00 192.00
unit direct labor hour 0.6 0.8
estimated annual production units 70,000.00 10,000.00

The company has a traditional costing system in which manufacturing

overhead is applied to units based on direct labor-hours. Data concerning
manufacturing overhead and direct labor-hours for 2018 appear below:

estimated total manufacturing overhead 290,000

estimated total direct labor hours 50,000

Ermias M 79
 Exercise …
Required:
1. Determine unit product costs of the Standard & Deluxe products
under the company’s traditional costing system.
2. The company is considering replacing its traditional costing
system with an activity-based costing system. Below is data
relevant to the activity-based costing system which has three
activity cost pools:
expected activity
activity and activity measures estimated
overhead cost standard deluxe total
supporting direct labor (direct labor hrs) Br.150,000 42,000 8,000 50,000
batch setups (setups) 60,000 50 200 250
safety testing (tests) 80,000 20 80 100
total manufacturing overhead cost Br.290,000      

Determine unit product costs of Deluxe and Standard under the

activity-based costing system.
Ermias M 80
Solution
• Product cost per unit:
• standard Deluxe
• Direct materials $ 900 $ 1200
• Direct labor 144 192
• Manufacturing overhead 5.8*.6=3.48 5.8*.8=4.64
• Product unit cost $1047.48 1396.64

• * OH rate =$290,000/50,000DLhrs=$5.8/DLhrs.

Ermias M 81
 Soln=cost per activity
expected activity
activity and activity Cost per
measures estimated overhead
cost standard deluxe total activity
supporting direct 150000/5000=3
labor (direct labor
hrs) Br.150,000 42,000 8,000 50,000
batch setups (setups) 60,000 50 200 250 60000/250=240
safety testing (tests) 80,000 20 80 100 80000/100=800
total manufacturing
overhead cost Br.290,000      

Ermias M 82
 Soln..
standard
Activity pool Activity cost rate Cost Driver level Cost applied
supporting direct labor (direct
labor hrs) $3 per hr 42,000 126,000
$240 per setup 12,000
batch setups (setups) 50

safety testing (tests) $800 per test 20 16,000

Total $154,000
Number of units 70,000
Manufacturing overhead costs per unit $ 2.2
Unit cost = 900+144+2.2=1046.20

Ermias M 83
 solu
Deluxe
Activity pool Activity cost rate Cost Driver level Cost applied
supporting direct labor (direct
labor hrs) $3 per hr 8,000 24,000
batch setups (setups) $240 per setup 200 48,000
safety testing (tests) $800 per test 80 64,000
Total $136,000
Number of units 10,000
Manufacturing overhead costs per unit $ 13.6
Unit cost = 1200+192+13.6=1405.6

Ermias M 84