Activity-Based Costing

Chapter 03

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Assigning Overhead Costs to Products

When cost systems were developed in the 1800s,

the emphasis was on simplicity because:
1. Cost and activity data had to be collected by
hand and all calculations were done with paper
and pencil.
2.   Most companies produced a limited variety of
similar products, so there was little difference
in the overhead costs consumed by each
product.

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Plantwide Overhead Rate
Plantwide Overhead Rate
A single overhead rate used
throughout an entire factory.
Direct labor has often been used as the allocation
base for overhead because:
1.    Direct labor information was already being recorded.
2.    Direct labor was a large component of product costs.
3. Managers believed direct labor and overhead costs
were highly correlated.

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 Plantwide Overhead Rate
Today, direct labor may no longer be a satisfactory base
for allocation of overhead.
1. Most companies sell a large variety of products that
consume differing amounts of overhead.
2. As a percentage of total costs, direct labor has been
shrinking and overhead has been increasing. Many of
these growing overhead costs may not be correlated
with direct labor.
3. Technology advancements have reduced the cost and
complexity of gathering diverse sources of data.

A plantwide overhead allocation system may not be optimal

for many companies in today’s business environment.
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 Departmental Overhead Rates
Many companies have a system in which each
department has its own overhead rate.
The allocation base depends
on the nature of the work
Machining Department
performed in each department.
In the machining department,
Assembly Department overhead may be based on
machine-hours, but in the
Shipping Department assembly department,
overhead may be based on
labor-hours.
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 Departmental Overhead Rates
Departmental rates will not correctly assign overhead
in situations where a company has a range of
products and complex overhead costs.

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Activity-Based Costing (ABC)

A number of allocation bases are used

for assigning costs to products.

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Activity-Based Costing (ABC)
Cost Objects
(e.g., products and customers)

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Activity-Based Costing (ABC)
An event that causes
Activity the consumption of
overhead resources

Examples of Activities

Admitting
Setting up Billing Opening a
hospital
machines customers bank account
patients
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Activity-Based Costing (ABC)
A “cost bucket” in which
Activity
costs related to a particular
Cost Pool activity are accumulated.

Expresses how much of the

Activity activity is carried out and is
Measure used as the allocation base for
applying overhead costs.

A predetermined overhead
Activity
rate for each activity
Rate cost pool.

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Activity-Based Costing (ABC)

For each activity in

isolation, this system works exactly
like the job-order costing system
described in Chapter 2.

A predetermined overhead rate is computed for

each activity and then applied to jobs and
products based on the amount of activity
consumed by the job or product.
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Designing an Activity-Based
Costing System

The challenge is to select a reasonably

small number of activities that explain the
bulk of the variation in overhead costs.

Activities are usually chosen by interviewing a

broad range of managers to find out what
activities they think consume most of the
organization’s resources.
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Designing an Activity-Based
Costing System
Related activities are
frequently combined to reduce
the amount of detail and
record-keeping costs.

For example, several actions may

be involved in handling and moving
raw materials, but these may be
combined into a single activity
titled material handling.

An activity dictionary defines each of the activities

that will be included in the activity-based costing
system and how the activities will be measured. 3-13
 Hierarchy of Activities
Level Activities
Unit-level Processing units on machines
Processing units by hand
Consuming factory supplies
Batch-level Processing purchase orders
Processing production orders
Setting up equipment
Handling materials
Product-level Testing new products
Administering parts inventories
Designing products
Facility-level General factory administration
Plant building and grounds
Activity Measure
Machine-hours
Direct labor-hours
Units produced
Purchase orders processed
Production orders processed
Number of setups
Pounds of material handled
Hours of testing time
Number of part types
Hours of design time
Direct labor-hours
Direct labor-hours
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 Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs

First-Stage Cost Assignment

Labor Machine Setup Production Parts General

Related Pool Related Pool Pool Order Pool Admin. Pool Factory Pool

Second-Stage Allocations

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

Products
Unit-Level Batch-Level Product-Level Facility-Level
Activity Activity Activity Activity 3-15
Targeting Process Improvements

An ABC system can help identify

areas where the company can benefit
from improving its current processes.

Activity-Based Management
Focuses on managing activities to eliminate
waste and reduce delays and defects.

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End of Chapter 03

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