Supplementary Slides
- Activity Based Costing
Systems Design:
Activity Based Costing
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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:
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 the
new 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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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)
Activities
Consumption of Resources
Cost
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Activity-Based Costing (ABC)
An event that causes
the consumption of
overhead resources
Activity
Examples of Activities
Setting up
machines
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Admitting
hospital
patients
Billing
customers
Opening a
bank account
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Activity-Based Costing (ABC)
Activity
Cost Pool
A “cost bucket” in which
costs related to a particular
activity are accumulated
Activity
Measure
Expresses how much of the
activity is carried out and is
used as the allocation base
for applying overhead costs
Activity
Rate
A predetermined overhead
rate for each activity
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.
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 activities may
be involved in handling and moving
raw materials, but these may be
combined into a single activity
entitled 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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Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs
First-Stage Cost Assignment
Labor
Related Pool
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Machine
Related Pool
Setup
Pool
Production
Order Pool
Parts
Admin. Pool
General
Factory Pool
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Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs
First-Stage Cost Assignment
Labor
Related Pool
Machine
Related Pool
Setup
Pool
Production
Order Pool
Parts
Admin. Pool
General
Factory Pool
Second-Stage Allocations
$/DLH
$/MH
$/Setup
$/Order
$/Part Type
$/MH
Products
Unit-Level
Activity
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Batch-Level
Activity
Product-Level Facility-Level
Activity
Activity
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Using Activity-Based Costing
Comtek Sound, Inc.
 Comtek Sound, Inc. makes two products: CD
players and DVD players.
 The company has been losing bids to supply CD
players, its main product, to lower priced
competitors.
 The company has been winning all bids to
supply DVD players, its secondary product.
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Using Activity-Based Costing
Comtek Sound, Inc.
 For the current year, Comtek has budgeted sales
of 50,000 DVD units and 200,000 CD units.
 Comtek’s traditional cost system applies
manufacturing overhead to products based on
direct labor hours.
 Both products require two direct labor-hours to
complete, for a total of 500,000 direct labor
hours.
Hours
DVDs: 50,000 units @ 2 hours per unit = 100,000
CDs: 200,00 units @ 2 hours per unit = 400,000
Total direct labor-hours
500,000
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Using Activity-Based Costing
Comtek Sound, Inc.
 Unit costs for materials and labor are:
Direct materials
Direct Labor
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DVD
Units
$ 90
$ 20
CD
Units
$ 50
$ 20
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Direct Labor-Hours as a Base
Total manufacturing overhead costs for the
current year are estimated to be $10,000,000.
The company develops the following overhead
rate based upon labor-hours:
Predetermined
$10,000,000
=
overhead rate
500,000 DLHs
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= $20 per DLH
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Direct Labor-Hours as a Base
Since each product requires two hours of
direct labor, $40 of overhead is assigned to
each product.
Direct materials
Direct labor
Manufacturing overhead
DVD Unit
$
90
20
40
CD Unit
$
50
20
40
$
$
(2 DLHs x $20 per DLH)
Unit product cost
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150
110
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Learning Objective 2
Compute activity rates for an
activity-based costing
system.
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Computing Activity Rates
The ABC project team at Comtek has
developed the following basic information.
Activity and Activity Measures
Estimated
Overhead
Cost
Labor related (DLH)
$
800,000
Machine related (MH)
2,100,000
Machine setups (setups)
1,600,000
Production orders (orders)
3,150,000
Parts administration (part types)
350,000
General factory (MH)
2,000,000
$ 10,000,000
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Expected Activity
Total
DVD
CD
500,000
100,000
400,000
1,000,000
300,000
700,000
4,000
3,000
1,000
1,200
800
400
700
400
300
1,000,000
300,000
700,000
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Computing Activity Rates
We can calculate the following activity rates:
Estimated
Overhead
Activity and Activity Measures
Cost
Labor related (DLHs)
$
800,000
Machine related (MHs)
2,100,000
Machine setups (setups)
1,600,000
Production orders (orders)
3,150,000
Parts administration (part types)
350,000
General factory (MHs)
2,000,000
$ 10,000,000
÷
÷
÷
÷
÷
÷
Total
Expected
Activity
500,000
1,000,000
4,000
1,200
700
1,000,000
=
=
=
=
=
=
Activity Rate
$
1.60 per DLH
2.10 per MH
400.00 per setup
2,625.00 per order
500.00 per part type
2.00 per MH
Using the new activity rates, let’s assign overhead
to the two products based upon expected activity.
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Learning Objective 3
Compute product costs using
activity-based costing.
McGraw-Hill /Irwin
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Computing Overhead Cost per Unit
DVD Units
Expected
Activity and Activity Measures
Activity
Labor related (DLHs)
100,000
Machine related (MHs)
300,000
Machine setups (setups)
3,000
Production orders (orders)
800
Parts administration (part types)
400
General factory (MHs)
300,000
Total overhead cost assigned
Number of units produced
Overhead cost per unit
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×
×
×
×
×
×
Activity
Rate
$ 1.60
2.10
400.00
2,625.00
500.00
2.00
=
=
=
=
=
=
Amount
$ 160,000
630,000
1,200,000
2,100,000
200,000
600,000
$ 4,890,000
50,000
$
97.80
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Computing Overhead Cost per Unit
CD Units
Expected
Activity and Activity Measures
Activity
Labor related (DLHs)
400,000
Machine related (MHs)
700,000
Machine setups (setups)
1,000
Production orders (orders)
400
Parts administration (part types)
300
General factory (MHs)
700,000
Total overhead cost assigned
Number of units produced
Overhead cost per unit
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×
×
×
×
×
×
Activity
Rate
$
1.60
2.10
400.00
2,625.00
500.00
2.00
=
=
=
=
=
=
Amount
$ 640,000
1,470,000
400,000
1,050,000
150,000
1,400,000
$ 5,110,000
200,000
$
25.55
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Comparing the Two Approaches
Activity-Based Costing
DVD Unit
CD Unit
Direct material
$ 90.00
$ 50.00
Direct labor
20.00
20.00
Manufacturing overhead
97.80
25.55
Unit product cost
$ 207.80
$ 95.55
Direct-Labor Costing
DVD Unit
CD Unit
$ 90.00 $ 50.00
20.00
20.00
40.00
40.00
$ 150.00 $ 110.00
Note that the unit product cost of a CD
unit decreased from $110 to $95.55 . . . .
. . . . while the unit cost of a DVD unit
increased from $150 to $207.80.
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Shifting of Overhead Cost
Activity-Based Costing
DVD Unit
CD Unit
Direct material
$ 90.00
$ 50.00
Direct labor
20.00
20.00
Manufacturing overhead
97.80
25.55
Unit product cost
$ 207.80
$ 95.55
Direct-Labor Costing
DVD Unit
CD Unit
$ 90.00 $ 50.00
20.00
20.00
40.00
40.00
$ 150.00 $ 110.00
Low-volume product
When a company implements activity-based costing,
overhead cost often shifts from high-volume to lowvolume products with a higher unit product cost
resulting for the low-volume products.
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Shifting of Overhead Cost
Activity-Based Costing
DVD Unit
CD Unit
Direct material
$ 90.00
$ 50.00
Direct labor
20.00
20.00
Manufacturing overhead
97.80
25.55
Unit product cost
$ 207.80
$ 95.55
Direct-Labor Costing
DVD Unit
CD Unit
$ 90.00 $ 50.00
20.00
20.00
40.00
40.00
$ 150.00 $ 110.00
High-volume product
The traditional system assigns the same amount of
all overhead costs to each CD or DVD player
($40 per unit).
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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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Benefits of Activity-Based Costing
ABC improves the accuracy of product costing by:
 Increasing the number of cost pools used to accumulate
overhead costs.
 Using activity cost pools that are more homogeneous than
departmental cost pools.
 Assigning overhead costs using activity measures that
cause those costs, rather than relying solely on direct
labor hours.
Activity-based costing also highlights activities
that could benefit most from process
improvement efforts, such as Six Sigma.
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Limitations Activity-Based Costing
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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