Week 3

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 Learning Objective 1

Understand the basic

approach in activity-based
costing and how it differs
from conventional costing.

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 Assigning Overhead Costs to 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.

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 Plantwide Overhead Rate – 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.

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 Plantwide Overhead Rate –
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.

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 Departmental Overhead Rates –
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.

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 Departmental Overhead Rates –
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

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 Activity-Based Costing (ABC) Examples
of Activities

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 Activity-Based Costing (ABC)
Pools, Measures, Rates

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 Activity-Based Costing (ABC)
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.

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 Designing an Activity-Based 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.

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 Designing an Activity-Based Costing
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
Level Activities Activity Measure
Unit-level Processing units on machines Machine-hours
Processing units by hand Direct labor-hours
Consuming factory supplies Units produced

Batch-level Processing purchase orders Purchase orders processed

Processing production orders Production orders processed
Setting up equipment Number of setups
Handling materials Pounds of material handled

Product-level Testing new products Hours of testing time

Administering parts inventories Number of part types
Maintaining inventories of parts Hours of design time

Facility-level General factory administration Direct labor-hours

Plant building and grounds Direct labor-hours

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 Graphic Example of Activity-Based
Costing – Stage 1

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 Graphic Example of Activity-Based
Costing – Stage 2

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 Using Activity-Based Costing Comtek
Inc. – Items 1 to 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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 Using Activity-Based Costing Comtek
Inc. – Items 4 to 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.

Hours
Phones: 50,000 units @ 2 hours per unit = 100,000
GPSs: 200,000 units @ 2 hours per unit = 400,000
Total direct labor-hours 500,000

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 Using Activity-Based Costing Comtek
Inc. – Item 7
7. Unit costs for materials and labor are:

Phone GPS
Units Units
Direct materials $ 90 $ 50
Direct labor $ 20 $ 20

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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:

$10,000,000
Predetermined overhead rate   $20 per DLH
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.
Phone Unit GPS Unit
Direct materials $ 90 $ 50
Direct labor 20 20
Blank Blank

Manufacturing overhead
(2 DLHs x $20 per DLH) 40
40
Unit product cost $ $ 110
150

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 Learning Objective 2

Compute activity rates

for an activity-based
costing system.

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 Computing Activity Rates – Basic
Information
The ABC project team at Comtek has developed the
following basic information.
Activity and Activity Estimated Expected Activity Expected Activity Expected Activity
Measures Overhead Cost for Total for Phone for GPS
Labor-related (DLH) $ 800,000 500,000 100,000 400,000
Machine-related (MH) 2,100,000 1,000,000 300,000 700,000
Machine Setups 1,600,000 4,000 3,000 1,000
(setups)
Production orders 3,150,000 1,200 800 400
(orders)
Parts administration 350,000 700 400 300
(part types)
General factory (M H) 2,000,000 1,000,000 300,000 700,000
$
10,000,000

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 Computing Activity Rates – Activity
Rates
Estimated Expected Expected
Activity and Activity Overhead Activity for Activity for
Measures Cost Total Activity Rate
Labor-related (DLH) $ 800,000 ÷ 500,000 = $ 1.60 Per DLH

Machine related (MH) 2,100,000 ÷ 1,000,000 = 2.10 Per MH

Machine setups (setups) 1,600,000 ÷ 4,000 = 400.00 Per Setup

Production orders (orders) 3,150,000 ÷ 1,200 = 2,625.00 Per order

Parts administration (part 350,00 ÷ 700 = 500.00 Per Part type

types)
General factory (M H) 2,000,000 ÷ 1,000,000 = 2.00 Per MH

$ 10,000,000

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
Expected Activity
Activity and Activity Measures Activity Rate Amount
Labor-related (DLHs) 100,000 × $ 1.60 = $ 160,000

Machine-related (NHs) 300,000 × 2.10 = 630,000

Machine setups (setups) 3,000 × 400.00 = 1,200,000

Production order (order) 800 × 2625.00 = 2,100,000

Parts administration (Part type) 400 × 500.00 = 200,000

General factory (M Hs) 300,000 × 2.00 =

600,000
Total overhead cost assigned $
4,890,000
Number of units produced
50,000
Overhead cost per unit $
97.80

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 Computing Overhead Cost per Unit –
GPS Units
GPS Units
Expected Activity
Activity and Activity Measures Activity Rate Amount
Labor-related (DLHs) 400,000 × $ 1.60 = $ 640,000

Machine-related (NHs) 700,000 × 2.10 = 1,470,000

Machine setups (setups) 1,000 × 400.00 = 400,000

Production order (order) 400 × 2625.00 = 1,050,000

Parts administration (Part type) 300 × 500.00 = 150,000

General factory (MHs) 700,000 × 2.00 = 1,400,000

Total overhead cost assigned $ 5,110,000

Number of units produced 200,000

Overhead cost per unit $ 25.55

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 Learning Objective 3

Compute product costs

using activity-based costing.

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 Comparing the Two Approaches
Acitivity-
Acitivity-Based Based Direct Labor Direct Labor
Costing for Costing for G Costing for Costing for GPS
Phone Unit PS Unit Phone Unit Unit
Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
Manufacturing
overhead 97.80 25.55 40.00 40.00
Unit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00

Note that the unit product cost of a G PS 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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 Learning Objective 4

Contrast the product costs computed

under activity-based costing and
conventional costing methods.

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 Comparing the Two Approaches – GPS
Units

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 Comparing the Two Approaches –
Phone Units

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 Cost Shifting from High to Low
Volume Products

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 versus
Traditional System

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 Shifting of Overhead Cost – 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.
Phone Units GPS Units
Number of units produced per year 50,000 2,00,000
Number of production orders issued per year 800 400
Number of units processed per production order 62.5 500

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 Shifting of Overhead Cost – Production-
Order Cost per Unit
2. Compute production-order cost per unit for each product.

Phone Units GPS Units

Cost to issue a production order $ 2,625 $ 2,625
Average number of units
processed per production order 62.5 500
Production-order cost per unit $ 42.00 $ 5.25

Notice, the costs are being shifted

from the high-volume GPS systems
to the low-volume Phone systems.

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 Targeting Process Improvements
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

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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 to 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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