Chapter
4-1
CHAPTER 4
Activity-Based Costing
Managerial Accounting, Fifth Edition
Chapter
4-2
Study Objectives
1.
Recognize the difference between traditional
costing and activity based costing.
2.
Identify the steps in the development of an
activity-based costing system.
3.
Know how companies identify the activity cost
pools used in activity-based costing.
4.
Know how companies identify and use cost
drivers in activity-based costing.
Chapter
4-3
Study Objectives
5. Understand the benefits and limitations of
activity-based costing.
6. Differentiate between value-added and
non-value-added activities.
7. Understand the value of using activity
levels in activity-based costing.
8. Apply activity-based costing to service
industries.
Chapter
4-4
Traditional Costing
To allocate as fairly as possible the true
costs of the products.
When management has more accurate costs,
better decisions can be made.
Direct Materials and Direct Labor costs are
easiest to trace through:
Material requisitions.
Payroll time sheets.
Chapter
4-5
SO 1: Recognize the differences between traditional costing and
activity-based costing.
Hard Part of Determining Product Costs is?
Determining the proper amount of
overhead to assign to each product,
service or job.
Chapter
4-6
Traditional Costing and ABC
Chapter
4-7
Traditional Costing
Allocates overhead using a single
predetermined rate.
Job order costing: Direct labor cost is
assumed to be the relevant activity base.
Assumption was satisfactory when direct
labor was a major portion of total
manufacturing costs.
There should be of a high correlation
between direct labor costs and
overhead costs.
Chapter
4-8
SO 1: Recognize the differences between traditional costing and
activity-based costing.
Traditional Costing
Allocates overhead using a single
predetermined rate.
Process Costing: Machine hours is assumed
to be the relevant activity base.
Assumption was satisfactory when
machine hours was a major portion of
total manufacturing costs.
There should be of a high correlation
between machine hours and overhead
costs.
Chapter
4-9
SO 1: Recognize the differences between traditional costing and
activity-based costing.
Why Do Companies Need a New Approach?
Tremendous change in manufacturing and
service industries.
Decrease in amount of direct labor usage.
Significant increase in total overhead costs.
May be inappropriate to use plant-wide
predetermined overhead rates based on direct
labor or machine hours when a lack of
correlation exists.
Complex manufacturing processes may require
multiple allocation bases; this approach is called
Activity-Based Costing (ABC).
Chapter
4-10
SO 1: Recognize the differences between traditional costing and
activity-based costing.
Activity-Based Costing



Chapter
4-11
Is another approach (other than traditional costing) to
allocate manufacturing overhead.
An overhead cost allocation system that allocates
overhead to multiple activity cost pools,
and
Assigns the activity cost pools to products or services
by means of cost drivers that represent the activities
used.
SO 1: Recognize the differences between traditional costing and
activity-based costing.
ABC Definitions
Activity: Any event, action, transaction, or work
sequence that causes a cost to be incurred in
producing a product or providing a service.
Activity Cost Pool: The overhead cost attributed
to a distinct type of activity.
Examples:
Purchasing materials.
Setting up machines.
Cost Drivers: Any factors or activities that have
a direct cause-effect relationship with the
resources consumed.
Chapter
4-12
SO 1: Identify the steps in management’s decision-making process.
Activity-Based Costing
Products consume activities,
and
Activities consume resources.
Chapter
4-13
SO 1: Recognize the differences between traditional costing and
activity-based costing.
Activity-Based Costing
ABC allocates overhead costs in two stages:
Stage 1: Overhead costs are allocated to
activity cost pools.
Stage 2: The overhead costs allocated to the
cost pools is assigned to products using
cost drivers.
The more complex a product’s manufacturing
operation, the more activities and cost drivers
likely to be present.
Chapter
4-14
SO 1: Recognize the differences between traditional costing and
activity-based costing.
OVERHEAD COSTS
Illustration 4-2
Chapter
4-15
SO 1: Recognize the differences between traditional costing and
activity-based costing.
Overhead Costs
Illustration 4-3
Chapter
4-16
SO 1: Recognize the differences between traditional costing and
activity-based costing.
Activity-Based Costing
ABC does not replace an existing job
order/process cost system.
ABC does segregate overhead into
various cost pools to provide more
accurate cost information.
ABC, thus, supplements – it does not
replace – the traditional cost system.
Chapter
4-17
SO 2 Identify the steps in the development of an activity-based system.
Activity-Based Costing
Atlas Company produces two automotive antitheft
devices:
The Boot: A high volume item with sales totaling 25,000 per
year.
The Club: A low volume item with sales totaling 5,000 per year.
Each product requires 1 hour of direct labor
Total annual direct labor hours (DLH) 30,000 (25,000 + 5000).
Direct labor cost $12 per unit for each product.
Expected annual manufacturing overhead costs
$900,000
Direct materials cost:
The Boot - $40 per unit.
The Club - $30 per unit.
Chapter
4-18
SO 1: Recognize the differences between traditional costing and
activity-based costing.
Costing Under Traditional Costing
Manufacturing Costs
Direct Materials
Direct Labor
Overhead
Total unit cost
Products
The Boot The Club
$40
$30
12
12
30
30*
$82
$72
* Predetermined overhead rate: $900,000 ÷ 30,000 DLH = $30 per DLH
Overhead = predetermined overhead rate times direct labor hours
($30 × 1 hr. = $30)
Chapter
4-19
Illustration 4-10
SO 2 Identify the steps in the development of an activity-based system.
Four Steps of Activity-Based Costing
Identify and classify the major activities
and allocate manufacturing overhead costs
to the appropriate cost pools.
Identify the cost driver that has a strong
correlation to the costs in the cost pool.
Compute the overhead rate for each pool.
Assign overhead costs for each cost pool to
products using the overhead rates.
Chapter
4-20
SO 2 Identify the steps in the development of an activity-based system.
Activity Cost Pools and Estimated
Overhead
Activity Cost Pools
Setting up machines
Machining
Inspecting
Total
Estimated Overhead
$300,000
500,000
100,000
$900,000
Illustration 4-4
Chapter
4-21
SO 3 Know how companies identify the activity cost pools
and use activity-based costing.
Identify Cost Drivers
Activity Cost Pools
Setting up machines
Machining
Inspecting
Expected Use
of Cost Drivers
Cost Drivers
Per Activity
Number of setups
1,500
Machine hours
50,000
Number of Inspections
2,000
Illustration 4-5
Chapter
4-22
SO 4 Know how companies identify and use cost drivers in
activity-based costing
Formula for Computing Activity-Based
Overhead Rate
Estimated Overhead Per Activity
= Activity-Based Overhead Rate
Expected Use of Cost Drivers Per Activity
Illustration 4-6
Expected Use
Estimated
of Cost Drivers
Activity-Based
Activity Cost Pools OverheadPer Activity
Overhead Rates
Setting up machines
$300,000
1,500 setups
$200 per setup
Machining
500,000
50,000 machine hrs.
$ 10 per mach. hour
Inspecting
100,000
2,000 inspections
$ 50 per inspection
Total
$900,000
Illustration 4-7
SO 4 Know how companies identify and use cost drivers in activity-based costing
Chapter
4-23
Expected Use of Costs to Products
Illustration 4-8
Chapter
4-24
SO 4 Know how companies identify and use cost drivers in
activity-based costing
Assignment of Activity Cost Pools to
Products
Illustration 4-9
Chapter
4-25
SO 4 Know how companies identify and use cost drivers in
activity-based costing
Unit Product Costs Under Traditional
and ABC Costing Methods
Manufacturing Costs
Direct Materials
Direct Labor
Overhead
Total Cost per Unit
The Boot
Traditional
Costing
ABC
$40
$40
12
12
30
17
$82
$69
Overstated
$13
The Club
Traditional
Costing
ABC
$30
$30
12
12
30
95
$72
$137
Understated
$65
Illustration 4-11
Chapter
4-26
SO 4 Know how companies identify and use cost drivers in
activity-based costing
Results of Using ABC
Under ABC, overhead costs are shifted
from the high volume product (The Boot) to
the low volume product (The Club) because:
Low volume products often require
more special handling.
Assigning overhead using ABC will
usually increase the cost per unit of low
volume products.
Chapter
4-27
SO 4 Know how companies identify and use cost drivers
in activity-based costing
Benefits of Activity-Based Costing
More accurate product costing through:
Use of more cost pools to assign overhead
costs.
Enhanced control over overhead costs.
Better management decisions.
Chapter
4-28
SO 5 Understand the benefits and limitations of activity-based costing
Limitations of Activity-Based Costing
Can be expensive to use
(Cost/Benefit).
Some arbitrary allocations continue.
Chapter
4-29
SO 5 Understand the benefits and limitations of activity-based costing
Use ABC When One or More of the
Following Exist:
Products differ greatly in volume/manufacturing
complexity.
Products lines are:
Numerous.
Diverse.
Require different degrees of support services.
Overhead costs are a significant portion of total costs.
Significant change in manufacturing process or number of
products.
Managers ignore data from existing system and instead
use “bootleg” costing data.
Chapter
4-30
SO 5 Understand the benefits and limitations of activity-based costing
Let’s Review
Activity-based costing (ABC):
A.
B.
C.
D.
Chapter
4-31
Can be used only in a process cost
system.
Focuses on units of production.
Focuses on activities performed to
produce a product.
Uses only a single basis of allocation.
SO 5 Understand the benefits and limitations of activity-based costing
Activity-Based Management (ABM)
An extension of ABC from a product
costing system to a management function
that focuses on reducing costs and
improving processes and decision making.
A refinement of ABC used in ABM
classifies activities as either value-added
or non-value-added.
Chapter
4-32
SO 6 Differentiate between value-added and non-value activities
Value- Added Activities
An activity that increases the worth
of a product or service such as:
Manufacturing Company
Engineering design
Machining
Assembly
Painting
Packaging
Chapter
4-33
Service Company
Performing surgery
Legal research services
Delivering packages
SO 5 Understand the benefits and limitations of activity-based costing
Non-Value Activities
An activity that adds cost to, or increases
the time spent on, a product/service without
increasing its market value such as:
Manufacturing Company
Chapter
4-34
Repair of machines
Storage of inventory
Moving of raw materials,
assemblies, and
finished goods
Building maintenance
Inspections
Inventory Control
Service Company
Taking appointments
Reception
Bookkeeping/billing
Traveling
Ordering supplies
Classification of Activity Levels
Unit-level activities:
Performed for each unit of production.
Batch-level activities:
Performed for each batch of product.
Product-level activities:
Performed in support of an entire product
line, but not always performed every time
a new unit or batch is produced.
Facility-level activities:
Required to support or sustain an entire
production process.
Chapter
4-35
Hierarchy of Activity Levels
Illustration 4-13
Chapter
4-36
SO 7 Understand the value of using activity levels in activity-based costing.
Activity-Based Costing In Service
Industries
Similarities with Manufacturing Firms
Overall objective:
Identify
key cost-generation activities and keep
track of quantity of activities performed for
each service provided.
General approach is to identify activities,
cost pools, and cost drivers.
Labeling of activities as value-added or nonvalue-added .
Reduction of non-value-added activities.
Chapter
4-37
SO 8 Apply activity-based costing to service industries.
Major Difficulty of Implementing ABC
A larger proportion of
overhead costs are
company-wide costs that
cannot be directly
traced to specific
services.
Chapter
4-38
Condensed Budget of Service Company
under Traditional Costing
CHECK AND DOUBLECHECK, CPAs
Annual Budget
Revenue
Direct labor
Overhead (expected)
Total Costs
Operating income
Estimated Overhead
Direct Labor Costs
$1,200,000
$600,000
Chapter
4-39
$ 600,000
1,200,000
$2,000,000
1,800,000
$ 200,000
= Predetermined overhead rate
= 200%
Illustration 4-14
SO 8 Apply activity-based costing to service industries.
Overhead Applied Under Traditional
Costing
CHECK AND DOUBLECHECK, CPAs
Plano Molding Company Audit
Revenue
$260,000
Less: Direct professional labor
$ 70,000
Applied Overhead (200% × $70,000) 140,000
210,000
Operating Income
$ 50,000
Illustration 4-15
Chapter
4-40
SO 8 Apply activity-based costing to service industries.
Activity-Based Costing Budget
CHECK AND DOUBLECHECK, CPAs
Annual Overhead Budget
Activity Cost Pools
Secretarial support
Direct labor Fringe benefits
Printing and photocopying
Computer support
Telephone and postage
Legal support
Insurance
(professional liability, etc.)
Recruiting and training
Cost Drivers
Direct Prof. hours
Direct labor cost
Working paper pages
CPU minutes
None (traced directly)
Hours used
Revenue billed
Direct Prof. Hours
Estimated
Overhead
$ 210,000
240,000
20,000
200,000
71,000
129,000
120,000
__ 210,000
$1,200,000
Expected
Use of
Cost Drivers
Per Activity
30,000
$ 600,000
20,000
50,000
N/A
860
$2,000,000
30,000
Activity-Based
Overhead
Rates
$7 per hour
$0.40 per $1 labor
$1 per page
$4 per minute
Based on usage
$150 per hour
$0.06 per $1 rev.
$7 per hour
Illustration 4-16
Chapter
4-41
SO 8 Apply activity-based costing to service industries.
Assigning Overhead in a Service Company
CHECK AND DOUBLECHECK, CPAs
Plano Molding Company Audit
Actual
Use of
Activity Cost Pools
Cost Drivers
Drivers
Secretarial support
Direct Professional hours 3,800
Direct labor Fringe benefits Direct labor cost
$ 70,000
Printing and photocopying
Working paper pages
1,800
Computer support
CPU minutes
8,600
Telephone and postage
None (traced directly)
Legal support
Hours used
156
Insurance
Revenue billed
$260,000
Recruiting and training
Direct Prof. Hours
3,800
ActivityBased
Overhead
Rates
$ 7.00
$ 0.40
$ 1.00
$ 4.00
$150.00
$ 0.06
$ 7.00
Cost
Assigned
$ 26,600
28,000
1,800
34,400
8,700
23,400
15,600
26,600
$165,100
Illustration 4-17
Chapter
4-42
SO 8 Apply activity-based costing to service industries.
Comparison of Traditional and ABC
CHECK AND DOUBLECHECK, CPAs
Plano Molding Company Audit
Traditional Costing
$260,000
Revenues
Expenses
Direct professional labor $ 70,000
Applied overhead
140,000
Total expenses
Operating income
Profit Margin
ABC
$260,000
$ 70,000
165,100
210,000
$ 50,000
19.2%
235,100
$ 24,900
9.6%
Illustration 4-18
Chapter
4-43
SO 8 Apply activity-based costing to service industries.
Review
Recognize the difference between traditional and
activity-based costing.
Traditional system allocates overhead to products using
predetermined unit-based output rate.
ABC allocates overhead to activity cost pools and assigns
cost to products using cost drivers.
Identify the steps in the development of an activitybased costing system.
Step 1: Identify the major activities and allocate the
overhead costs to cost pools.
Step 2: Identify the cost driver highly correlated to the
cost pool.
Step 3: Compute the overhead rate per cost driver.
Step 4: Assign cost pools to products or services using the
overhead rates.
Chapter
4-44
Review
Know how companies identify cost pools used in ABC.
Analyze each operation or process, document and time
every task, action, or transaction.
Know how companies identify and use cost drivers in ABC.
Cost drivers identified for assigning activity cost pools
must:
Accurately measure the consumption of the activity.
Have related data easily available.
Chapter
4-45
Understand the benefits and limitations of ABC:
Benefits:
Enhanced control over overhead costs.
Better management decisions.
Limitations:
Higher costs accompany multiple activity centers and
cost drivers.
Some costs must still be allocated arbitrarily.
Review
Differentiate between value-added and non-value-added
activities.
Value-added activities increase the worth of a product or
service.
Non-value-added activities add cost to, or increase the time
spent on, a product or service without increasing its market
value.
Understand the value of using activity levels in ABC.
Activities may be classified as:
Unit-level
Batch-level
Product-level
Facility-level
Failure to recognize this classification can result
in distorted product costing.
Chapter
4-46
Review
Apply ABC to service industries.
Same objective – improved
costing of services provided.
The general approach to costing is
also the same:
Analyze operations.
Identify activities.
Accumulate overhead costs by
activity cost pools.
Identify and use cost drivers to
assign cost to services.
Chapter
4-47
Just-in-Time
A processing system dedicated to
having the right amount of materials,
products, or parts arrive as they are
needed, thereby reducing the amount
of inventory.
Chapter
4-48
JUST-in-TIME PROCESSING
.
100 pairs of
sneakers...
got it!
Send rubber and
shoe laces directly to
the factory.
Sales Order
Received
Goods Manufactured
Chapter
4-49
Illustration 4-A1
Just-in-Time
Objective of JIT:
Eliminate all manufacturing inventories.
Elements of JIT:
Dependable suppliers.
Multi-skilled work force.
Total quality control system.
Benefits of JIT:
Reduced inventory.
Enhanced product quality.
Reduced rework and storage costs.
Savings from improved flow of goods.
Chapter
4-50
Let’s Review
An activity that adds costs to the product
but does not increase market value is a:
a. Value-added activity.
b. Cost driver.
c. Cost-benefit activity.
d. Non-value-added activity.
Chapter
4-51
ALL ABOUT YOU
Chapter
4-52
ALL ABOUT YOU
Chapter
4-53
ALL ABOUT YOU
Chapter
4-54
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Chapter
4-55