Chap04 PPT

4-1
Activity-Based Costing
CHAPTER 4
Introduction to
Managerial Accounting
Ninth edition
Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.
Assigning Overhead Costs to
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Products
When cost systems were developed in the
1800s, the emphasis was on simplicity
because:
◦ Cost and activity data had to be collected by
hand and all calculations were done with
paper and pencil.
◦ Most companies produced a limited variety of
similar products, so there was little difference
in the overhead costs consumed by each
product.
Plantwide Overhead Rate –
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Definition
A plantwide overhead rate is a single
overhead rate that is used throughout an
entire factory.
Direct labor has often been used as the
allocation base for overhead because:
◦ Direct labor information was already being
recorded.
◦ Direct labor was a large component of product
costs.
◦ Managers believed direct labor and overhead
costs were highly correlated.
Plantwide Overhead Rate –
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Disadvantages
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 declining 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.
Departmental Overhead Rates –
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Definition
Many companies have a system in which each
department has its own overhead rate.
Examples:
◦ Machining Department
◦ Assembly Department
◦ Shipping Department
The allocation base depends on the nature of the
work performed in each department. In the
machining department, overhead may be based
on machine-hours, but in the assembly
department, overhead may be based on direct
labor-hours.
Departmental Overhead Rates –
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Disadvantages
Departmental rates will not correctly assign
overhead in situations where a company has a
range of products and complex overhead costs.
The departmental approach relies on a single
measure of activity as the allocation base while
some overhead costs may be caused by factors
that are not directly proportional to the volume of
production.
Activity-based costing is used to account for
these other factors and more accurately assigns
overhead costs to products.
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Activity-Based Costing Process

Cost Objects
(e.g., products and customers)
Activities
Activities Consume Resources
Consumption of Resources Incur Cost
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Activity-Based Costing (ABC)

Examples of Activities
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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Pools, Measures, Rates
A “cost bucket” in which costs

Activity Cost
related to a particular activity
Pool 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 rate

Activity Rate for each
activity cost pool.
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Similarities to Job-Order Costing

For each activity in isolation, this system
works exactly like the job-order costing
system described in previous chapters.
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.
Designing an Activity-Based
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Costing System – Challenges

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.
Designing an Activity-Based Costing
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System – Combining Activities

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.
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Hierarchy of Activities
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Graphic Example of
Activity-Based Costing – Stage 1
Various Manufacturing Overhead Costs
First-Stage Cost Assignment
Labor- Machine- Machine Production Parts General

Related Pool Related Pool Setup Pool Order Pool Admin. Pool Factory Pool
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Graphic Example of
Activity-Based Costing – Stage 2
Various Manufacturing Overhead Costs
First-Stage Cost Assignment

$450,000
Labor- Machine- Machine Production Parts General

Related Pool Related Pool Setup Pool Order Pool Admin. Pool Factory Pool
1,200 Orders
Second-Stage Allocations
$375/Order
$/DLH $/MH $/Setup $/Order $/Part Type $/MH
Products
Unit-Level Batch-Level Product-Level Facility-Level
Activity Activity Activity Activity
Using Activity-Based Costing
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Comtek Inc. – Items 1–3

1. Comtek Inc. makes two products: GPS
systems and Phone systems.
2. The company has been losing bids to
supply GPS systems to lower-priced
competitors.
3. The company has been winning all bids
to supply Phone systems.
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Comtek Inc. – Items 4–6

4. For the current year, Comtek has
budgeted sales of 50,000 phone units and
200,000 GPS units.
5. Comtek’s traditional cost system applies
manufacturing overhead to products
based on direct labor-hours.
6. Both products require two direct labor-
hours to complete.
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Comtek Inc. – Item 7

7.Unit costs for materials and labor are:
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Direct Labor-Hours as a Base – DLH

Total manufacturing overhead costs for the
current year are estimated to be
$10,000,000.
The company develops the following
overhead rate based upon direct labor-
hours:
Predetermined $10,000,000
= = $20 per DLH
overhead rate 500,000 DLHs
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Direct Labor-Hours as a Base –

Total Unit Cost
Since each product requires two hours of
direct labor, $40 of overhead is assigned to
each product.
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Computing Activity Rates – Basic

Information
The ABC project team at Comtek has
developed the following basic information.
Computing Activity Rates – Activity
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Rates
We can calculate an activity rate for each of the

six activities by dividing the estimated overheard
for an activity by the total expected activity.

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Computing Overhead Cost

per Unit – Phone Units
Phone Units
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Computing Overhead Cost per Unit –

GPS Units
GPS Units
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Comparing the Two Approaches
Note that the unit product cost of a GPS unit

decreased from $110 to $95.55 . . .
. . . while the unit cost of a phone unit
increased from $150 to $207.80.
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Comparing the Two Approaches – GPS

Units
The ABC system assigns $14.45

less overhead than the traditional
system to each GPS unit.
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Comparing the Two Approaches –

Phone Units
The ABC system assigns $57.80

more overhead than the traditional
system to each phone unit.
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Cost Shifting from High to Low

Volume Products
Low-volume product
When a company implements activity-based costing,
overhead cost shifts from high-volume to low-volume products
with a higher unit product cost
resulting for the low-volume products.
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Shifting of Overhead Cost –

ABC vs. Traditional System
High-volume product
The traditional system assigns the same amount
of all overhead costs to each Phone or GPS unit
($40 per unit).
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Production-Orders Cost Pool
Production-Orders Activity Cost Pool
(a batch-level cost pool)
The ABC system assigns different amounts of
Production-Order-related overhead costs to each product.
This fact can be illustrated in a two-step process.
1. Compute the number of units processed
per production order for each product.
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Production-Order Cost per Unit
2. Compute production-order cost per unit for each product.
Notice, the costs are being shifted

from the high-volume GPS systems
to the low-volume Phone systems.
Targeting Process Improvements
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Activity-Based Management
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 processing time and defects.
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Targeting Process Improvements –

Step 1
The first step in any improvement
program is deciding what to improve.
Activity rates can be Benchmarking can be used

used to target areas to compare activity cost
where costs seem information with world-
excessively high. class standards of
performance achieved by
other organizations.
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Benefits of Activity-Based Costing

ABC improves the accuracy of product costing by:
1. Increasing the number of cost pools used to
accumulate overhead costs.
2. Using activity cost pools that are more
homogeneous than departmental cost pools.
3. Assigning overhead costs using activity
measures that cause those costs, rather than
relying solely on direct labor-hours.
4. Activity-based costing also highlights activities
that could benefit most from process
improvement efforts.
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Limitations of ABC Model – (1–4)

Costs of implementing an ABC system may
outweigh the benefits. However, the benefits are
more likely to be worth the costs when:
1. Products differ substantially in volume, batch
size, and in activities required.
2. Conditions have changed substantially since
the existing cost system was established.
3. Overhead costs are high and increasing and no
one seems to understand why.
4. Management does not trust the existing cost
system and it ignores data from it when making
decisions.
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Limitations of the ABC Model – (5)

5. The cost in each activity pool is strictly
proportional to its activity measure. When this
assumption is violated, the accuracy of ABC
data can be called into question.
◦ For example, managers should be
particularly alert to product costs that contain
allocated facility-level costs.
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Modifying the ABC Model

The illustrations in the chapter assume that
ABC is being used for external reporting
purposes. If the system is used for internal
decision-making purposes, two important
modifications should be made:
1. Selling and administrative costs should
be assigned to products, where
appropriate.
2. Facility-level costs should be removed
from product costs.

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4-1

Activity-Based Costing Process

Activities Consume Resources

Consumption of Resources Incur Cost

Activity-Based Costing (ABC)

Activity-Based Costing (ABC)

A “cost bucket” in which costs

Expresses how much of the

A predetermined overhead rate

Similarities to Job-Order Costing

Costing System – Challenges

System – Combining Activities

Various Manufacturing Overhead Costs

First-Stage Cost Assignment

Labor- Machine- Machine Production Parts General

First-Stage Cost Assignment

Labor- Machine- Machine Production Parts General

Comtek Inc. – Items 1–3

Comtek Inc. – Items 4–6

Comtek Inc. – Item 7

Direct Labor-Hours as a Base – DLH

Direct Labor-Hours as a Base –

Computing Activity Rates – Basic

We can calculate an activity rate for each of the

for an activity by the total expected activity.

Computing Overhead Cost

Computing Overhead Cost per Unit –

Comparing the Two Approaches

Note that the unit product cost of a GPS unit

Comparing the Two Approaches – GPS

The ABC system assigns $14.45

Comparing the Two Approaches –

The ABC system assigns $57.80

Cost Shifting from High to Low

Shifting of Overhead Cost –

Shifting of Overhead Cost –

Shifting of Overhead Cost –

Notice, the costs are being shifted

Targeting Process Improvements –

Activity rates can be Benchmarking can be used

Benefits of Activity-Based Costing

Limitations of ABC Model – (1–4)

Limitations of the ABC Model – (5)

Modifying the ABC Model

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