ACCT 2302
Fundamentals of Accounting II
Spring 2011
Lecture 9
Professor Jeff Yu
Chapter 8: Activity–Based Costing
Activity-based Costing (ABC) vs. Traditional Absorption Costing
Purposes: ABC is for internal decision making (e.g. drop or retain a segment),
while absorption costing is for external reporting (e.g. value inventory, CGS).
Product Cost: ABC assigns some manufacturing (excluding e.g. factory
manager’s office supplies) & some nonmanufacturing costs (e.g. shipping
costs, sales commissions) to products on a cause-and-effect basis, while
absorption costing assigns all manufacturing costs and none of the
nonmanufacturing costs to products.
Overhead cost pool: ABC uses many overhead cost pools, each with
unique cost driver, while absorption costing typically has only one plantwide cost pool and uses either DLH or MH as the single cost driver.
Basic Concepts of Activity-based Costing
Activity
An event that causes the
consumption of overhead cost.
Activity
Cost Pool
A “cost bucket” in which
overhead costs caused by a
particular activity measure are
accumulated.
Activity Measure
$
$
An allocation base (cost driver).
5 levels of Activity in ABC system
1. Unit-level activities: performed each time a unit is produced, so
costs are proportional to # of units produced. e.g., providing power.
2. Batch-level activities: performed each time a batch is handled,
so costs depend on the number of batches. e.g., setting up machine
for batch processing, or processing an online order.
3. Product-level activities: e.g., designing / advertising a product.
4. Customer-level activities: e.g., sales calls, general tech
support.
5. Organization-sustaining activities: e.g., providing a companywide computer network.
Classic Brass – An ABC Example
Classic Brass
Income Statement
Year Ended December 31, 2005
Sales
Cost of goods sold
Direct materials
Direct labor
Manufacturing overhead
Gross margin
Selling and administrative expenses
Shipping expenses
Marketing expenses
General administrative expenses
Net operating income
loss
$ 3,200,000
$
975,000
351,250
1,000,000
2,326,250
873,750
65,000
300,000
510,000
$
875,000
(1,250)
Manufacturing overhead is allocated to products using
a single plantwide overhead rate based on machine hours.
Step 1: define activity cost pools & activity measures
Classic Brass combined correlated activities within a level
and identified the following activity cost pools:
 Order Size - assigned all costs incurred as a
consequence of the number of units produced.
 Customer Orders - assigned all costs that are
incurred by taking and processing customer orders.
 Product Designs - assigned all costs that are incurred
by designing products.
 Customer Relations – assigned all costs associated
with maintaining relations with customers.
 Other – assigned all overhead costs that are not
associated with the other cost pools.
Step 1: define activity cost pools & activity measures
At Classic Brass, the ABC team, selected the following
activity measures for the identified activity cost pools:
Activity Cost Pool
Activity Measure
Order Size
Machine hours
Customer Orders
Number of customer orders
Product Design
Number of product designs
Customer Relations
Number of active customers
Other
Not applicable
Step 2: Assign Overhead Costs to Activity Cost Pools
At the beginning of the period, the ABC team obtains from each department
the estimated overhead costs (both manufacturing and nonmanufacturing
costs that are not directly traceable to each product) and their distribution
of resource consumption across activity cost pools.
Step 2: Assign Overhead Costs to Activity Cost Pools
Indirect factory wages
Percent consumed by customer orders
$500,000
25%
$125,000
Step 2: Assign Overhead Costs to Activity Cost Pools
Step 3: Calculate Activity Rates
The estimated total activities for each activity cost pool are:
1,000 customer orders, 400 new designs, 20,000 machine
hours and 250 customer relations activities.
Practice Problem
Leap Co. uses Activity-based costing system with the following data:
Overhead
Costs
Distribution of resource consumption
across Activity Cost Pools
Fabrication
Order Processing
Other
Wages
$360,000
35%
40%
25%
Depreciation
$140,000
5%
55%
40%
Occupancy
$160,000
30%
45%
25%
Q: If the total activity level for Order Processing is 200 orders, what is the
activity rate for the Order processing activity cost pool?
Graphic Illustration of ABC at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Traced
Customer
Orders
Product
Design
Order
Size
Customer
Relations
Other
Second-Stage Allocations
$/Order
$/Design
$/MH
Cost Objects:
$/Customer
Products, Customer Orders, Customers
Unallocated
Step 4: Assigning Overhead to Products
Standard Stanchions
1. Requires no new design resources.
2. Received 600 customer orders.
3. Produced 30,000 units for these orders,
consuming a total of 17,500 machine-hours
Step 4: Assigning Overhead to Products
Custom Compass Housing
1. Requires new design resources.
2. 400 product designs prepared for 400 customer orders
3. 1,250 compass housings produced, requiring 2
machine-hours each for a total of 2,500 machine-hours.
Step 5: Prepare Management Reports
Product Margin for each product
= sales – costs directly traceable to the product
– overhead costs assigned using ABC
Sales
Costs
Direct material
Direct labor
Shipping
Assigned Overhead
Total cost
Product margin
Custom
Compass Housings
$
540,000
Standard Stanchions
$ 2,660,000
$
905,500
263,750
60,000
524,500
$
1,753,750
$
906,250
69,500
87,500
5,000
427,500
589,500
(49,500)
Practice Problem
Feld Co. uses Activity-based costing system with the following data:
Activity Cost Pool
Assembly
Total OH Cost
$1,137,360
Total Activity
84,000 machines hours
Order Processing
$28,479
1,100 orders
Inspection
$97,155
1,270 inspection hours
The company makes 470 units of product W26B a year, requiring a total
of 660 machine hours, 50 orders and 40 inspection hours per year.
The product ‘s price is $118 per unit, direct material cost is $40.30
per unit and direct labor cost is $42.22 per unit.
Q: What is the product margin for product W26B?
Assigning Overhead to Customers
One customer of Classic Brass, Windward Yachts, placed a total of 3
orders during the year: two orders for standard stanchions, 150 units
per order; and one order for 1 custom compass housing. These 3
orders consumed a total of 177 machine hours.
Prepare Management Reports
Customer Margin
= sales – costs directly traceable to the customer
– overhead costs assigned to the customer using ABC
Sales
Direct costs
Direct material
Direct labor
Shipping
Assigned Overhead
Customer margin
Windward Yachts
$ 11,350
$
2,123
1,900
205
6,423
10,651
$
699
Practice Problem
DFW Co. uses Activity-based costing system with the following data:
Activity Cost Pool
Total Overhead Cost Total Activity
Order Size
$6,000
3,000 direct labor hours
Order Processing
$10,000
500 orders
Customer Relations
$40,000
400 customers
A customer, Mr. Websley, made 6 orders and bought a total of 40 units of
product M2B during 2009. Each unit of product M2B is sold at $90, costs
$50 in direct material and consumes 1.5 direct labor hours. The direct labor
rate is $10 per hour.
Q: What is the customer margin for Mr. Websley in 2009?
For Next Class
 Finish activity based costing
 Start Chapter 9: profit planning
Homework Question 1
Holden Co. uses Activity-based costing system with the following data:
Activity Cost Pool
Total Overhead Cost Total Activity
Assembly
$80,000
4,000 machines hours
Order Processing
$40,000
1,000 orders
Inspection
$20,000
1,000 inspection hours
Other
$10,000
N/A
The company makes 1,000 units of product W26A a year, requiring a total of
25 inspection hours, 100 machine hours and 50 orders per year.
Q: How much overhead cost would be assigned to each unit of product
W26A?
Homework Question 2
Fogerty Co. makes 2 products (Hubs & Sprockets) with data below:
DM/unit
DLH/unit
Hubs
$32
0.8 hour
$15/hour
10,000 units
Sprockets
$18
0.4 hour
$15/hour
40,000 units
Activity Cost
Pool
Est. total OH Activity
Cost Measure
Machine Setup
DL Rate Annual Production
$72,000 # of setups
Activity: Activity:
Hubs
Sprockets
100
300
Special
Processing
$200,000 Machine hours
5,000
0
General Factory
$816,000 DL hours
8,000
16,000
Q: If the price of Hubs is $120 per unit, what is the product margin for Hubs?
Homework Question 3
Advanced Products Co. uses ABC system with the following data:
Est. total OH Costs
Distribution of resource consumption across
Activity Cost Pools
DL Support
Order
Processing
Customer
Support
Other
Wages
$300,000
40%
30%
20%
10%
Other OH
$100,000
30%
10%
20%
40%
20,000 DLHs
400 orders
200 customers
N/A
Est. Total Activities
During the year, it completed one order for a new customer, SZE. SZE ordered
10 units of the product. Each unit is sold at $300, costs $180 in DM, $50 in DL
and consumes 2 DLHs.
Q: What is the customer margin for SZE?