Chapter
17
McGraw-Hill/Irwin
Accounting Systems For
Measuring Costs
© The McGraw-Hill Companies, Inc., 2002
Cost Accounting Systems
Determining unit
manufacturing
costs.
Planning and
control
functions.
Cost accounting systems provide information
supporting decisions making the business successful.
Assessing the
efficiency and
effectiveness
of operations.
McGraw-Hill/Irwin
Providing
products or
services to
customers.
© The McGraw-Hill Companies, Inc., 2002
Cost Accounting Systems
Evaluate and
reward
employee
performance.
Disclose
inventories
and cost of
goods sold.
Cost accounting systems are the procedures
and techniques used by management.
Manage activities
that consume
resources.
McGraw-Hill/Irwin
Track resources
consumed by
products and
services.
© The McGraw-Hill Companies, Inc., 2002
Basic Cost Accounting Procedures
Process
Costing
Job Order
Costing
 Used for production of large,
unique, high-cost items.
 Built to order rather than mass
produced.
 Many costs can be directly traced
to each job.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Basic Cost Accounting Procedures
Process
Costing
Job Order
Costing
 Typical job order cost applications:
 Special-order printing
 Building construction
 Also used in service industry
 Hospitals
 Law firms
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Basic Cost Accounting Procedures
Process
Costing
Job Order
Costing
 Used for production of small,
identical, low-cost items.
 Mass produced in automated
continuous production process.
 Costs cannot be directly traced to
each unit of product.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Basic Cost Accounting Procedures
Process
Costing
Job Order
Costing
Typical process cost applications:
 Petrochemical refinery
 Paint manufacturer
 Paper mill
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Job Order Costing
Manufacturing
overhead (OH)
Applied to each
job using a
predetermined
rate (POHR)
Direct
materials
THE JOB
Direct
labor
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Job Order Costing
The primary
document for
tracking the costs
associated with a
given job is the job
cost sheet.
Let’s investigate
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
The Job Cost Sheet
RoseCo Job Cost Sheet
Job Number A - 143
Department B3
Item Wooden cargo crate
Date Initiated 3-4-X9
Date Completed
Units Completed
Direct Materials
Direct Labor
Manufacturing Overhead
Req. No. Amount Ticket Hours Amount Hours
Rate
Amount
Cost Summary
Direct Materials
Direct Labor
Manufacturing Overhead
Total Cost
Unit Cost
McGraw-Hill/Irwin
Units Shipped
Date Number Balance
© The McGraw-Hill Companies, Inc., 2002
The Job Cost Sheet
RoseCo Job Cost Sheet
Job Number A - 143
Department B3
Item Wooden cargo crate
Date Initiated 3-4-X9
Date Completed
Units Completed
Direct Materials
Direct Labor
Manufacturing Overhead
Req. No. Amount Ticket Hours Amount Hours
Rate
Amount
X7-6890 $ 116
Cost Summary
Direct Materials
Direct Labor
Manufacturing Overhead
Total Cost
Unit Cost
McGraw-Hill/Irwin
$
116
Units Shipped
Date Number Balance
© The McGraw-Hill Companies, Inc., 2002
The Job Cost Sheet
RoseCo Job Cost Sheet
Job Number A - 143
Department B3
Item Wooden cargo crate
Date Initiated 3-4-X9
Date Completed
Accumulate
Units Completed
Direct Materials
Direct Labor
Req. No. Amount Ticket Hours Amount
X7-6890 $ 116
36
8
$
88
Cost Summary
Direct Materials
Direct Labor
Manufacturing Overhead
Total Cost
Unit Cost
McGraw-Hill/Irwin
$
$
116
88
direct labor
costs by
Manufacturing Overhead
means
of a
Hours
Rate
Amount
work record,
such as a time
ticket, for each
Units Shipped
Date Number
Balance
employee.
© The McGraw-Hill Companies, Inc., 2002
The Job Cost Sheet
RoseCo Job Cost Sheet
Apply manufacturing overhead
to jobs using a
Date Initiated 3-4-X9
predetermined overheadDate
rate
(POHR)3-5-X9
based on
Completed
Department B3 direct labor hours
Units Completed
(DLH). 2
Job Number A - 143
Item Wooden cargo crate
Direct Materials
Direct Labor
Manufacturing Overhead
Req. No. Amount Ticket Hours Amount Hours
Rate
Amount
X7-6890 $ 116
36
8
$
88
8
$
4 $
32
Cost Summary
Direct Materials
Direct Labor
Manufacturing Overhead
Total Cost
Unit Cost
McGraw-Hill/Irwin
$
$
$
$
$
116
88
32
236
118
Units Shipped
Date Number Balance
© The McGraw-Hill Companies, Inc., 2002
Job Order Costing
Document Flow Summary
Let’s summarize
the document
flow we have
been discussing
in a job order
costing system.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Job Order Costing
Document Flow Summary
The materials
requisition
indicates the
cost of direct
material
to charge to
jobs
and the cost of
indirect material
to charge to
overhead.
McGraw-Hill/Irwin
Direct
materials
JobCost
Cost
Job
Job
Cost
Sheets
Job
Cost
Sheets
Sheets
Sheets
Materials
Materials
Ledger
Cards
Materials
Ledger
Cards
Materials
Ledger Cards
Requisition
Indirect
materials
Manufacturing
Overhead
Account
© The McGraw-Hill Companies, Inc., 2002
Job Order Costing
Document Flow Summary
Direct
Employee time
Labor
tickets indicate
the cost of direct
Employee Time
labor
Employee
Time
Ticket
Employee
Time
to charge to Employee
Ticket
Time
Ticket
jobs
Ticket
and the cost
of indirect labor
to charge to
Indirect
Labor
overhead.
McGraw-Hill/Irwin
JobCost
Cost
Job
Job
Cost
Sheets
Job
Cost
Sheets
Sheets
Sheets
Manufacturing
Overhead
Account
© The McGraw-Hill Companies, Inc., 2002
Job Order Costing
Document Flow Summary
Employee
Time Ticket
Other
Actual OH
Charges
Materials
Requisition
McGraw-Hill/Irwin
Indirect
Labor
Manufacturing
Overhead
Account
Overhead
Applied
with
POHR
Job Cost
Sheets
Indirect
Material
© The McGraw-Hill Companies, Inc., 2002
Flow of Costs in Job Costing
Flow of Costs in Job Costing
Let’s examine the
cost flows in a
job order costing
system. We will
use T-accounts
and start with
materials.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Flow of Costs in Job Costing
Materials Inventory
•Material
•Direct
Purchases Material
•Indirect
Material
Work in Process
(Job Cost Sheet)
•Direct
Material
Mfg. Overhead
•Indirect
Material
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Flow of Costs in Job Costing
Next let’s add
labor costs and
applied
manufacturing
overhead to the
job order cost
flows. Are you
with me?
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Flow of Costs in Job Costing
Labor
•Direct
Labor
•Indirect
Labor
Mfg. Overhead
•Indirect •Overhead
Material Applied to
Work in
•Indirect
Process
Labor
McGraw-Hill/Irwin
Work in Process
(Job Cost Sheet)
•Direct
Material
•Direct
Labor
•Overhead
Applied
When
Actual
Applied
factory = factory
overhead
overhead
the difference is closed
to cost of goods sold.
/
© The McGraw-Hill Companies, Inc., 2002
Closing Under- or Overapplied
Manufacturing Overhead
If Manufacturing
Overhead is . . .
Effect of Closing to
Cost of Goods Sold
UNDERAPPLIED
(Applied OH is less
than actual OH)
INCREASE
Cost of Goods Sold
OVERAPPLIED
(Applied OH is greater
than actual OH)
DECREASE
Cost of Goods Sold
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Flow of Costs in Job Costing
Now let’s
complete the
goods and sell
them. Still with
me?
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Flow of Costs in Job Costing
Work in Process
(Job Cost Sheet)
•Direct
•Cost of
Material
Goods
•Direct
Mfd.
Labor
•Overhead
Applied
Finished Goods
•Cost of
Goods
Mfd.
•Cost of
Goods
Sold
Cost of Goods Sold
•Cost of
Goods
Sold
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Process Costing
 Used for production of small,
identical, low-cost items.
 Mass produced in automated
continuous production process.
 Costs cannot be directly traced
to each unit of product.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Comparing Job and Process Costing
Job Costing
Process Costing

Custom orders

Repetitive production

Heterogeneous products

Homogeneous products

Low production volume

High production volume

High product flexibility

Low product flexibility

Low to medium
standardization

High standardization
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Job and Process Costing
The Work in Process
account consists of
individual jobs in
job costing.
Direct
Materials
Direct
Labor
Factory
Overhead
McGraw-Hill/Irwin
Jobs
Finished
Goods
Cost per
unit for
each job
© The McGraw-Hill Companies, Inc., 2002
Job and Process Costing
Direct
Materials
Direct
Labor
Factory
Overhead
McGraw-Hill/Irwin
The Work in Process
account consists of
specific processes in
process costing.
Processes
Finished
Goods
Cost per
unit
processed
© The McGraw-Hill Companies, Inc., 2002
Job and Process
Costing Similarities
Same objective: to determine
the cost of products
Same inventory accounts: raw materials,
work in process, and finished goods
Same overhead assignment method:
predetermined rate times actual activity
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Work in Process Accounts —
The Key to Process Costing
Indirect
Materials
Direct
Work in
Process
Assembly
Indirect
Factory
Applied
Overhead Overhead
Labor
McGraw-Hill/Irwin
Direct
Work in
Process
Packaging
Finished
Goods
Delivered
to
Customers
© The McGraw-Hill Companies, Inc., 2002
Computing Unit Cost
Costs are accumulated for a period of time
by process or department.
Unit cost is computed by dividing the
accumulated costs by the number of
units produced in the period.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Computing Unit Cost
Costs are accumulated for a period of time
by process or department.
Unit cost is computed by dividing the
accumulated costs by the number of
units produced in the period.
If partially complete units remain in
process, we must use equivalent units
as the divisor to obtain unit costs.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Computing and Using Equivalent
Units of Production
Equivalent units is a concept expressing a
number of partially completed units as a
smaller number of fully completed units.
Two one-half full pitchers are
equivalent to one full pitcher.
+
McGraw-Hill/Irwin
=
1
© The McGraw-Hill Companies, Inc., 2002
Question
For the current period, PencilCo started
15,000 units and completed 10,000 units,
leaving 5,000 units in process 30 percent
complete. How many equivalent units of
production did PencilCo have for the period?
a. 10,000
b. 11,500
c.
1,500
d. 15,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Question
For the current period, PencilCo started
15,000 units and completed 10,000 units,
leaving 5,000 units in process 30 percent
complete. How many equivalent units of
production did PencilCo have for the period?
a. 10,000
b. 11,500
c.
10,000 units + (5,000 units × .30)
= 11,500 equivalent units
1,500
d. 15,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Cost Per Equivalent Unit
Cost per
equivalent
unit
McGraw-Hill/Irwin
Product costs for the period
=
Equivalent units for the period
© The McGraw-Hill Companies, Inc., 2002
Question
Now assume that PencilCo incurred
$27,600 in production costs. What was
PencilCo’s cost per unit for the period?
a.
b.
c.
d.
$1.84
$2.40
$2.76
$2.90
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Question
Now assume that PencilCo incurred
$27,600 in production costs. What was
PencilCo’s cost per unit for the period?
a.
b.
c.
d.
$1.84
$2.40
$2.76
$2.90
McGraw-Hill/Irwin
$27,600 ÷ 11,500 equivalent units
= $2.40 per equivalent unit
© The McGraw-Hill Companies, Inc., 2002
Equivalent Units
40% of
Material
Stage 1
25% of
Labor and
Overhead
Equivalent units may be
different for material and labor
and overhead at different
stages of a process.
At completion of Stage 1 of the process, material
is 40% complete, but labor and overhead are only
25% complete.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Equivalent Units
40% of
Material
+
60% of
Material
Stage 1
Stage 2
25% of
Labor and
Overhead
25% of
Labor and
Overhead
McGraw-Hill/Irwin
+
=
100%
=
50%
© The McGraw-Hill Companies, Inc., 2002
Equivalent Units
40% of
Material
60% of
Material
Stage 1
Stage 2
Stage 3
25% of
Labor and
Overhead
25% of
Labor and
Overhead
50% of
Labor and
Overhead
The process is now complete.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Process Costing and
Equivalent Units
Owl Inc uses FIFO
process costing
in its Fabrication
Department
where a product
called Strata is
made.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Process Costing and
Equivalent Units
Owl Inc Fabrication Department Data For April 2002
Beginning Inventory:
Units of product
30,000
Percentage of completion - direct material
100%
Percentage of completion - direct labor
40%
Percentage of completion - overhead
40%
Units started in April
90,000
Units transferred from grinding to mixing
100,000
Ending Inventory:
Units of product
20,000
Percentage of completion - direct material
100%
Percentage of completion - direct labor
25%
Percentage of completion - overhead
25%
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Process Costing and
Equivalent Units
Owl Inc Fabrication Department Data For April 2002
Beginning Inventory:
Units of product
30,000
Percentage of completion - direct material
100%
Percentage of completion - direct labor
40%
Percentage of completion - overhead
40%
Units started in April
90,000
Material is added at the
Units transferred from grinding to mixing
beginning of the process so
Ending Inventory:
it is always 100% complete.
100,000
Units of product
20,000
Percentage of completion - direct material
100%
Percentage of completion - direct labor
25%
Percentage of completion - overhead
25%
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Process Costing and
Equivalent Units
Owl Inc Fabrication Department Data For April 2002
Beginning Inventory:
Units of product
30,000
Percentage of completion - direct material
100%
Percentage of completion - direct labor
40%
Percentage of completion - overhead
40%
Units started in April
90,000
Overhead is applied on the basis
Units transferred from grinding to mixing
of labor, so both are at the
Ending Inventory:
same percentage of completion.
100,000
Units of product
20,000
Percentage of completion - direct material
100%
Percentage of completion - direct labor
25%
Percentage of completion - overhead
25%
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Physical Flow of Units
April Fabrication Department Physical Flow
Units to account for:
Beginning inventory
30,000
Units started during April
90,000
120,000
Total number of units
Units accounted for as:
Units transferred from Fabrication to Mixing
Ending inventory
Total number of units
McGraw-Hill/Irwin
100,000
20,000
120,000
© The McGraw-Hill Companies, Inc., 2002
Computing Equivalent
Units of Production
Fabrication Department
Direct Material Equivalent Units of Production - April 2002
Units of Percent Added Equivalent
Product
This Period
Units
Beginning goods in process
30,000
0%
0
Goods started and completed
70,000
100%
70,000
20,000
120,000
100%
20,000
90,000
Ending work in process
Total units
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Computing Equivalent
Units of Production
Since materials are added at the
beginning of the process, no additional
materials are necessary to complete the
beginning inventory.
Fabrication Department
Direct Material Equivalent Units of Production - April 2002
Units of Percent Added Equivalent
Product
This Period
Units
Beginning goods in process
30,000
0%
0
Goods started and completed
70,000
100%
70,000
20,000
120,000
100%
20,000
90,000
Ending work in process
Total units
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Computing Equivalent
Units of Production
100,000 units completed
and transferred.
Fabrication Department
Direct Material Equivalent Units of Production - April 2002
Units of Percent Added Equivalent
Product
This Period
Units
Beginning goods in process
30,000
Goods started and completed
70,000
Ending work in process
Total units
McGraw-Hill/Irwin
20,000
120,000
}
0%
0
100%
70,000
100%
20,000
90,000
100,000
© The McGraw-Hill Companies, Inc., 2002
Computing Equivalent
Units of Production
Fabrication Department Direct Labor and Factory
Overhead Equivalent Units of Production - April 2002
Units of Percent Added Equivalent
Product
This Period
Units
Beginning goods in process
30,000
60%
18,000
Goods started and completed
70,000
100%
70,000
20,000
120,000
25%
5,000
93,000
Ending work in process
Total units
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Computing Equivalent
Units of Production
Since labor and overhead were 40
percent complete in the beginning
inventory, 60 percent of the work must
be Direct
completed
inand
April.
Fabrication Department
Labor
Factory
Overhead Equivalent Units of Production - April 2002
Units of Percent Added Equivalent
Product
This Period
Units
Beginning goods in process
30,000
60%
18,000
Goods started and completed
70,000
100%
70,000
20,000
120,000
25%
5,000
93,000
Ending work in process
Total units
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Computing Equivalent
Units of Production
Fabrication Department Direct Labor and Factory
Overhead Equivalent Units of Production - April 2002
Units of Percent Added Equivalent
Product
This Period
Units
Beginning goods in process
30,000
Goods started and completed
70,000
Ending work in process
Total units
McGraw-Hill/Irwin
20,000
120,000
}
100,000
60%
Transferred
100%
18,000
25%
5,000
93,000
70,000
© The McGraw-Hill Companies, Inc., 2002
Computing Equivalent
Units of Production
Summary of Fabrication Department
Equivalent Units of Production - April 2002
Activities during April 2002
Units from beginning inventory
processed in current period
Direct
Material
Direct
Labor
Factory
Overhead
0
18,000
18,000
Units started and completed
in current period
70,000
70,000
70,000
Units in ending inventory at
end of current period
20,000
5,000
5,000
Equivalent units of production
for period
90,000
93,000
93,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Process Costing and
Equivalent Units
Fabrication Department
April Work in Process Costs
Beginning work in process
Costs added in April:
Direct material
Direct labor
Overhead
Total costs to account for
McGraw-Hill/Irwin
$
22,380
45,000
11,160
44,640
$ 123,180
© The McGraw-Hill Companies, Inc., 2002
Cost per Equivalent Unit
Fabrication Department
Cost Per Equivalent Unit - April 2002
Direct
Materials
Total cost of resource for
April
$ 45,000
Equivalent units of production
in April
÷
Cost per equivalent unit for
April
= $
McGraw-Hill/Irwin
Direct
Labor
Factory
Overhead
$ 11,160
90,000 ÷
$ 44,640
93,000 ÷
0.50 = $
0.12 = $
93,000
0.48
© The McGraw-Hill Companies, Inc., 2002
Cost Reconciliation
We will account for all costs incurred
by assigning unit costs to the:
A. 100,000 units completed and
transferred.
B. 20,000 units remaining in ending
work in process inventory.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Fabrication Department Work in Process
Cost Summary for April 2002
Cost of completed units
From beginning work in process
April 1 balance
Costs to complete April 1 inventory
Direct material
Direct labor
Overhead
$ 22,380
Started and completed
Total completed and transferred
Cost of ending work in process
Direct material
Direct labor
Overhead
Total cost accounted for
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Fabrication Department Work in Process
Cost Summary for April 2002
Cost of completed units
From beginning work in process
April 1 balance
Costs to complete April 1 inventory
Direct material
Direct labor (18,000 × $0.12)
Overhead (18,000 × $0.48)
$ 22,380
$
0
2,160
8,640
10,800
Started and completed
Total completed and transferred
Cost of ending work in process
Direct material
Direct labor
Overhead
Total cost accounted for
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Fabrication Department Work in Process
Cost Summary for April 2002
Cost of completed units
From beginning work in process
April 1 balance
Costs to complete April 1 inventory
Direct material
Direct labor (18,000 × $0.12)
Overhead (18,000 × $0.48)
$ 22,380
$
0
2,160
8,640
Started and completed (70,000 × $1.10)
Total completed and transferred (100,000 units)
Cost of ending work in process
Direct material
Direct labor
Overhead
Total cost accounted for
McGraw-Hill/Irwin
10,800
77,000
$ 110,180
$0.12 + $0.48 + $0.50 = $1.10
© The McGraw-Hill Companies, Inc., 2002
Fabrication Department Work in Process
Cost Summary for April 2002
Cost of completed units
From beginning work in process
April 1 balance
Costs to complete April 1 inventory
Direct material
Direct labor (18,000 × $0.12)
Overhead (18,000 × $0.48)
$ 22,380
$
0
2,160
8,640
Started and completed (70,000 × $1.10)
Total completed and transferred (100,000 units)
Cost of ending work in process
Direct material (20,000 × $0.50)
Direct labor (5,000 × $0.12)
Overhead (5,000 × $0.48)
Total cost accounted for
McGraw-Hill/Irwin
$ 10,000
600
2,400
10,800
77,000
$ 110,180
13,000
$ 123,180
© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing (ABC)
A
B C
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing (ABC)
One of the most
difficult tasks in
computing accurate
unit costs lies in
determining the
proper amount of
overhead cost to
assign to each job.
McGraw-Hill/Irwin
Assigning
overhead is
difficult.
I agree!
© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing (ABC)
Activity-Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
Overhead Allocation
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing (ABC)
A
B C
McGraw-Hill/Irwin
In the ABC method,
we recognize that many
activities within a
department drive
overhead costs.
© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing (ABC)
Identify activities and assign indirect costs to
those activities.
Central idea . . .

Products require activities.

Activities consume resources.
McGraw-Hill/Irwin
A
B C
© The McGraw-Hill Companies, Inc., 2002
The Benefits of ABC
More detailed measures of costs.
 Better understanding of activities.
 More accurate product costs for . . .

Pricing decisions.
 Product elimination decisions.
 Managing activities that cause costs.


Benefits should always be compared to
costs of implementation.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Identifying Cost Drivers
Most cost drivers are related to either volume
or complexity of production.

Examples: machine time, machine setups,
purchase orders, production orders.
Three factors are considered in choosing a
cost driver:

Causal relationship.

Benefits received.

Reasonableness.
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Activity-Based Costing
Procedures

Identify activities that consume resources.
 Assign costs to a cost pool for each activity.
 Identify cost drivers associated with each activity.
 Compute overhead rate for each cost pool:
Estimated overhead costs in activity cost pool
Rate =
Estimated number of activity units

Assign costs to products:
Overhead
×
Rate
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Actual
Activity
© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing
Let’s look at an
example comparing
traditional costing
with ABC.
We will start with
traditional costing.
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Traditional Costing vs. ABC
Example
Pear Company manufactures a product in regular and
deluxe models. Overhead is assigned on the basis of
direct labor hours. Budgeted overhead for the current
year is $2,000,000. Other information:
Direct Material
Direct Labor Cost
Direct Labor Time
Expected Volume (units)
Deluxe
Model
$
150
16
1.6 hours
5,000
Regular
Model
$
112
8
0.8 hours
40,000
First, determine the unit cost of each model using
traditional costing methods.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Traditional Costing
Deluxe Model
Regular Model
5,000 units @ 1.6 hours
40,000 units @ 0.8 hours
Direct
Labor Hours
8,000
32,000
Total Direct Labor Hours (DLH)
40,000
Overhead = Estimated overhead costs
Rate
Estimated activity
Overhead = $2,000,000 = $50 per DLH
Rate
40,000 DLH
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Traditional Costing
ABC will have different
overhead per unit.
Direct Material
Direct Labor
Manufacturing Overhead
$50 per hour × 1.6 hours
$50 per hour × 0.8 hours
Total Unit Cost
McGraw-Hill/Irwin
Deluxe
Model
$ 150
16
Regular
Model
$ 112
8
80
$
246
$
40
160
© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing
Pear Company plans to adopt activity-based
costing. Using the following activity center data,
determine the unit cost of the two products using
activity-based costing.
Activity
Center
Purchasing
Scrap Rework
Testing
Machine Related
Total Overhead
McGraw-Hill/Irwin
Cost
Driver
Orders
Orders
Tests
Hours
Overhead
Cost for
Activity
$
84,000
216,000
450,000
1,250,000
$ 2,000,000
Units of Activity
Deluxe Regular
400
800
300
600
4,000
11,000
20,000
30,000
© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing
Activity
Center
Purchasing
Scrap Rework
Testing
Machine Related
Total Overhead
Cost
Driver
Orders
Orders
Tests
Hours
Overhead
Cost for
Activity
$
84,000
216,000
450,000
1,250,000
$ 2,000,000
Units
of
Activity
1,200
900
15,000
50,000
Rate
400 deluxe + 800 regular = 1,200 total
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing
Activity
Center
Purchasing
Scrap Rework
Testing
Machine Related
Total Overhead
Cost
Driver
Orders
Orders
Tests
Hours
Overhead
Cost for
Activity
$
84,000
216,000
450,000
1,250,000
$ 2,000,000
Units
of
Activity
1,200
900
15,000
50,000
Rate
$ 70 per order
$240 per order
$ 30 per test
$ 25 per hour
Rate = Overhead Cost for Activity ÷ Units of Activity
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© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing
Activity
Purchasing
Scrap Rework
Testing
Machine Related
Total Overhead
McGraw-Hill/Irwin
Rate
$ 70/order
$240/order
$ 30/test
$ 25/hour
Deluxe Model
Actual
Cost
Units of
Allocated
Activity to Product
400
?
300
?
4,000
?
20,000
?
?
Regular Model
Actual
Cost
Units of
Allocated
Activity
to Product
800
?
600
?
11,000
?
30,000
?
?
© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing
Activity
Purchasing
Scrap Rework
Testing
Machine Related
Total Overhead
Rate
$ 70/order
$240/order
$ 30/test
$ 25/hour
Deluxe
Actual
Units of
Activity
400
300
4,000
20,000
Model
Cost
Allocated
to Product
$ 28,000
?
?
?
?
Regular Model
Actual
Cost
Units of
Allocated
Activity
to Product
800 $
56,000
600
?
11,000
?
30,000
?
?
Cost Allocated to Product = Actual Units of Activity × Rate
McGraw-Hill/Irwin
Let’s complete
the table.
© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing
Activity
Purchasing
Scrap Rework
Testing
Machine Related
Total Overhead
Rate
$ 70/order
$240/order
$ 30/test
$ 25/hour
Deluxe
Actual
Units of
Activity
400
300
4,000
20,000
Model
Cost
Allocated
to Product
$ 28,000
72,000
120,000
500,000
$ 720,000
Regular Model
Actual
Cost
Units of
Allocated
Activity
to Product
800 $
56,000
600
144,000
11,000
330,000
30,000
750,000
$ 1,280,000
Cost Allocated to Product = Actual Units of Activity × Rate
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© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing
Deluxe Model
Regular Model
Actual + $1,280,000
Cost
Actual
Cost
Total overhead = $720,000
= $2,000,000
Units of
Allocated
Units of
Allocated
Recall
that
$2,000,000
was
the
original
amount
of
Activity
Rate
Activity to Product
Activity
to Product
overhead assigned
products
Purchasing
$ 70/order to the400
$ 28,000using traditional
800 $
56,000
Scrap Rework
$240/order
300costing.
72,000
600
144,000
overhead
Testing
$ 30/test
4,000
120,000
11,000
330,000
Machine Related $ 25/hour
20,000
500,000
30,000
750,000
Total Overhead
$ 720,000
$ 1,280,000
Cost Allocated to Product = Actual Units of Activity × Rate
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing
Overhead Costs Assigned to Products:
Deluxe Model $720,000 ÷ 5,000 units = $144 per unit
Regular Model $1,280,000 ÷ 40,000 units = $32 per unit
Direct Materials
Direct Labor
Manufacturing Overhead
Total Unit Cost
McGraw-Hill/Irwin
Deluxe
Model
$
150
16
144
$
310
Regular
Model
$
112
8
32
$
152
© The McGraw-Hill Companies, Inc., 2002
Activity-Based Costing
Traditional Costing
Deluxe
Regular
Model
Model
Direct materials $
150
$
112
Direct labor
16
8
Overhead
80
40
Total cost
$
246
$
160
ABC
Deluxe
Regular
Model
Model
$
150
$
112
16
8
144
32
$
310
$
152
This result is not uncommon when activity-based
costing is used. Many companies have found that lowvolume, specialized products have greater overhead
costs than previously realized.
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© The McGraw-Hill Companies, Inc., 2002
Costs and Cost Drivers in
Activity-Based Costing
Cost
Materials purchasing
Materials handling
Personnel processing
Equipment depreciation
Quality inspection
Indirect labor for
equipment setups
Engineering costs for
product modifications
McGraw-Hill/Irwin
Cost Driver
Number of purchase orders
Number of materials
requisitions
Number of employees hired
or laid off
Number of products
produced or hours of use
Number of units inspected
Number of setups required
Number of modifications
© The McGraw-Hill Companies, Inc., 2002
End of Chapter 17
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002