Chapter 04

Chapter 4
Activity-Based Costing
Hansen/Mowen, Cornerstones of Cost Management, 4 th Edition. © 2018 Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Learning Objectives
• Describe the basics of plantwide and departmental overhead costing
• Explain why plantwide and departmental overhead costing may not be
accurate
• Provide a detailed description of activity-based product costing
• Explain how ABC can be simplified
Hansen/Mowen, Cornerstones of Cost Management, 4 th Edition. © 2018 Cengage. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Exhibit 4.1 - Unit-based Product Costing model
Unit-Level Product Costing (1 of 2)
• Overhead costs are assigned to functional units
o Creates pooled costs, which is assigned to products using predetermined
overhead rates
• Predetermined overhead rate
o Calculated at the beginning of the year
Unit-Level Product Costing (2 of 2)
• Unit-level drivers: Factors that measure the demands placed on unit-level
activities by products
• Commonly used unit-level drivers
o Units produced
o Direct labor hours
o Direct labor dollars
o Machine hours
o Direct material dollars
Overhead Variances (1 of 2)
• Difference between actual overhead and applied overhead
o Underapplied overhead: Variance that occurs when actual overhead is greater
than applied overhead
o Overapplied overhead: Variance that occurs when actual overhead is less than
applied overhead
Overhead Variances (2 of 2)
• Disposal of variance
o If immaterial, it is assigned to cost of goods sold
o If material, it is allocated among work-in-process inventory, finished goods
inventory, and cost of goods sold
Overhead Application: Departmental Rates
• Overhead costs are assigned to individual production departments, creating
departmental overhead cost pools
• Unit-level drivers are used to compute predetermined overhead rates for
each department
• Overhead is assigned to products by multiplying the departmental rates by
the amount of the driver used in the respective departments
Limitations of Plantwide and Departmental Rates
• Non-unit-based drivers: Factors, other than the number of units produced,
that measure the demands that cost objects place on activities
• Product diversity: Products consume overhead activities in different
proportions
o Caused by differences in product size, complexity, setup time, and batch size
o Consumption ratio: Proportion of each activity consumed by a product
Problems with Costing Accuracy
• Assumption that machine hours and/or direct labor hours drive or cause all
overhead costs
• Consumption ratios are simply the proportion of each activity consumed by
a product
o Assumed consumption ratios can also be calculated for the plantwide and
overhead rates
Activity Rates: A Better Approach (1 of 2)
• Instead of using a single pool or department pools based on units, expand
the number of pools and rates and base them on activities
• Rates are based on causal factors that measure consumption
o Includes both unit- and non-unit level activity drivers
• Costs are assigned to each product by multiplying the activity rates by the
amount consumed by each activity
Activity Rates: A Better Approach (2 of 2)
• Activity-based cost assignment is more accurate than unit overhead and
unit-based costs
o Follows a cause-and-effect pattern of overhead consumption
• Using only unit-based activity drivers can lead to one product subsidizing
another
o Occurs when significant non-unit overhead costs and product diversity are
present
EXHIBIT 4.5 - Activity-based costing model
• Cost of Resources
o Costs assigned using driver tracing and direct tracing
• Activities
o Costs assigned using activity drivers
• Products
Design Steps for an ABC System
• Identify, define, and classify activities and key attributes
• Assign the cost of resources to activities
• Assign the cost of secondary activities to primary activities
• Identify cost objects and specify the amount of each activity consumed by
specific cost objects
• Calculate primary activity rates
• Assign activity costs to cost objects
Activity-Based Costing System (1 of 2)
• Activity inventory: Simple list of activities identified
• Activity attributes: Nonfinancial and financial information items that
describe individual activities
Activity-Based Costing System (2 of 2)
• Activity dictionary: Lists the activities in an organization along with desired
attributes
o Primary activity: Consumed by a final cost object
o Secondary activity: Consumed by intermediate cost objects
o Interviews, questionnaires, surveys, and observation are means of gathering data
for an ABC system
Assigning costs to activities
• Cost of an activity is the resources consumed by that activity
• If a resource is exclusive to an activity, assign 100% of the cost to the activity
• If the resource is split between more than one activity, determine a resource
driver
o Resource drivers: Factors that measure the consumption of resources by
activities
Identify cost objects
• Assign costs of primary activities in proportion to their usage of the activity as

measured by the activity drivers
o Transaction drivers: Measure the number of times an activity is performed
o Duration drivers: Measure the demands in terms of the amount of time it takes
to perform an activity
Activity-Based Costing System
• Bill of activities: Specifies the product, expected product quantity, activities,

and amount of each activity expected to be consumed by each product
Calculate primary activity rates
• Primary activity rates are computed by dividing the budgeted activity costs by
practical activity capacity
o Practical activity capacity is the activity output that can be produced when the
activity is performed efficiently
Assign activity costs to cost objects
• Multiply the activity rate by the actual number of activity drivers consumed
• Classify activities into categories, which aids in product costing
o Cost behavior differs by level
Categories of Activities
• Unit-level: Performed each time a unit is produced
• Batch-level: Performed each time a batch is produced
• Product-level: Enable the various products of a company to be produced
• Facility-level: Sustain a factory’s general manufacturing processes
Before-the-Fact Simplification: TDABC
• Time-Driven Activity-Based Costing (TDABC)
o Eliminates the need to identify resource drivers thus eliminating the need for
much of the detailed implementation interviews
• It calculates total operating cost of a department or process for supplying resource
capacity
• It calculates a capacity cost rate by dividing the total resource cost by the practical
capacity of the resources supplied
• It estimates the time to perform one unit of activity
After-the-Fact Simplification
• Approximately Relevant ABC Systems
o Calculate the cost of activities
o Combine the less expensive activity costs into the more expensive activity costs
making fewer categories
• Equally Accurate Reduced ABC Systems
o Use expected consumption ratios to reduce the number of drivers
o Expected global consumption ratio: Proportion of the total activity costs
consumed by a given product

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• Assign costs of primary activities in proportion to their usage of the activity as

• Bill of activities: Specifies the product, expected product quantity, activities,

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