Chapter 5
Activity-Based Costing
Overcosting and Undercosting (Example 1 at the end of these notes)
Distortions from inaccurate costing
Activities/Resources/Cost Drivers
Steps in ABC
Identify resources and activities
Assign costs to activities
Assign costs to cost objects
Types of cost-pools and drivers:
Unit based (volume)
Batch-level
Product-sustaining level
Facility-sustaining level
Comparison of volume-based (POHR) allocation and ABC
Example 2 (at the end of these notes)
Activity analysis and value-added activities
ABC for a service firm
ABC for customer profitability analysis
Strategic cost management
Example 1
Orange networks makes network hubs. They have two types: C (complex) and S
(simple). They are the industry leader – and have been for years in making hubs like the
S hub. But they find that they are not currently price competitive in making these
anymore. Their strategy is to mark up their products 30% on full cost – which is about as
much as the market for this type of product will allow. Here is a summary of their unit
manufacturing costs:
Direct materials
Direct labor
Overhead
Total
C
$120.00
40.00
97.78
$257.78
S
$90.00
$20.00
48.89
$158.89
Selling prices are, thus set at: $205 for S and $335 for C. The “market” price for C is
$198 and for S is $375.
Direct labor is $20 per hour and overhead is applied based upon the rate of $48.89 per
DLH.
After investigation, they noted that there were two cost pools. There was a volume-based
cost pool that totaled $120,000 and a batch-based cost pool that totaled $100,000. There
are 2 units of C or 10 units of S in a batch and DLH is still considered an appropriate
driver for the volume based cost pool. Orange networks plans to produce 1,000 units of
C and 2,500 units of S. What is the appropriate unit cost for each of these products and
what is the appropriate selling price to obtain a 30% markup on full cost?
Example 2
College Supply Company (CSC) makes three types of drinking glasses: short, medium, and
tall. It presently applies overhead using a predetermined overhead rate based on direct
labor-hours. A group of company employees recommended that CSC switch to activitybased costing and identified the following activities, cost drivers, estimated costs and
estimated cost driver units for Year 5 for each activity center.
Activity pool
Setting up
production
Processing
orders
Handling
materials
Using machines
Quality control
Packing and
shipping
Recommended Cost
Driver
Number of
production runs
Number of orders
Estimated
Cost
$24,000
Estimated
Cost Driver Units
100
runs
40,000
200
orders
Pounds of materials
16,000
8,000
pounds
Machine-hours
Number of
inspections
Units produced
48,000
40,000
10,000
40
hours
inspections
32,000
20,000
units
$200,000
In addition, management estimated 2,000 direct labor-hours for year 5.
Assume the following cost driver volumes occurred in February of Year 5:
Short
Medium
Tall
Number of units produced
1,000
500
400
Direct materials costs
$4,000
$2,500
$2,000
Direct labor-hours
100
120
110
Number of orders
8
8
4
Number of production runs
2
4
8
Pounds of material
400
800
200
Machine-hours
500
300
300
Number of inspections
2
2
2
Units shipped
1,000
500
300
Direct labor costs were $20.00 per hour.
1.
Compute the production cost per unit of each product using Direct Labor-Hours to
allocate overhead (indirect costs)
2. Compute the production cost per unit of each product using Activity-Based Costing to
allocate overhead (indirect costs).
3. Compute Cost of Goods Sold using each method.
Example 3
The controller for Wolfe Machining has established the following overhead cost pools and
cost drivers:
Budgeted
Overhead
Cost
Overhead Cost Pool
Machine setups
$240,000
Cost Driver
Budgeted Activity
Number of setups
200 setups
Material handling
$90,000
Units of raw material
Quality control inspections
$48,000
Number of inspections
Other overhead costs
$160,000
Machine hours
60,000 units
1,200 inspections
20,000 machine hours
Order no. 715 has the following production requirements:
Machine
setups:
Raw
material:
Inspections:
Machine
hours:
7
11,200
16
850
Required:
A. Compute the total overhead that should be assigned to order no. 715 by using activitybased costing.
B. Suppose that Wolfe were to use a single, predetermined overhead rate based on machine
hours. Compute the rate per hour and the total overhead assigned to order no. 715.