Dr. Bob’s 256 Notes, 8-1
CHAPTER 8
ACTIVITY-BASED COSTING –
A TOOL TO AID DECISION MAKING
I.
OBJECTIVES OF CHAPTER 8:
 Activity-Based Costing (ABC)
 Understand the difference between ABC & conventional costing methods
 Steps in designing an ABC system
 Determine when ABC is appropriate - benefits and limitations
 Compute the cost of a product unit using ABC
 Using ABC to aid in product decisions
II.
SYSTEMS FOR ASSIGNING OVERHEAD
A.
Plantwide Overhead Rate (Level 1)
 Single rate applied uniformly throughout the plant (e.g., Total Mfg. OH / Direct Labor
Hours)
 Traditional and most popular method
 Best used when ...
B.
Departmental Overhead Rates (Level 2)
 Uses a different overhead rate for each production department
 Employs a 2-stage allocation process:
Projected
Overhead
Department
1
Department
2
Products
 Problem with this type of allocation system:
Department
3
Dr. Bob’s 256 Notes, 8-2
C.
Activity-Based Costing (Level 3)
 Also uses a 2-stage allocation process, but...
Projected
Overhead
Products
 Main difference in allocation process (vs. Departmental Overhead Rates)
III.
MECHANICS OF ABC
A.
Process Value Analysis
 Flowchart the process of making the product or performing the service
B.
Identify Activity Centers
 Cost hierarchy
1.
Unit-level
2.
Batch-level
3.
Product-level
4.
Facility-level
Dr. Bob’s 256 Notes, 8-3
Demo: Classify each of the following activities for Mana Company as either a unit-level, batchlevel, product-level, or organization-sustaining activity.
Activity
Design work for new products
Activity Level
Possible Cost Driver
Materials requisition into
product line
Direct labor workers
assembling various products
Equipment setups
Occupancy of the general
plant building
C.
Assign Costs to Activity Cost Pools
D.
Select a Cost Driver for Each Activity
 A cost driver is a quantifiable measure of what causes the costs to be incurred
 Examples:
 Machine setups
 Maintenance requests
 Purchase orders
 Material shipments received
 Product inspections
 Power consumed
Demo: Return to the Mana Company Activity Level Classification example. What might be
some examples of cost drivers for each activity?
Dr. Bob’s 256 Notes, 8-4
IV.
PRODUCT COSTING IN ABC
Demo Problem:
 Carver Company anticipates manufacturing 4,000 units of Product A and 20,000 units of
Product B this year.
 The company currently has a traditional cost system in which direct labor-hours is used to
assign overhead to products. The predetermined overhead rate is:
Manufacturing overhead cost
Direct labor hours
=
$900,000
50,000 dlh
= $18 / dir. lab. hr.

Product A requires 2.5 direct labor hours and Product B requires 2.0 direct labor hours.
According to the current cost system, the unit product costs are:
Product A
Product B
Direct materials
$36.00
$30.00
Direct labor
17.50
14.00
Manufacturing overhead:
2.5 dlh x $18/dlh
45.00
2.0 dlh x $18/dlh
36.00
Unit product cost
$98.50
$80.00

After an analysis of the $900,000 projected overhead costs, Carver determines that the
overhead costs are actually caused the following 5 activities. Expected activity levels and
expected costs are below:
Activity Center
Machine setups
Quality inspections
Production orders
Machine-hours worked
Material receipts
Total
Overhead
Costs
$255,000
160,000
81,000
314,000
90,000
$900,000
 Develop activity center overhead rates
Activity Center
Machine setups
Quality inspections
Production orders
Machine-hours worked
Material receipts
Overhead Costs
$255,000
160,000
81,000
314,000
90,000
Expected for
Product A
3,000
5,000
200
12,000
150
Expected for
Product B
2,000
3,000
400
28,000
600
Dr. Bob’s 256 Notes, 8-5

Apply overhead rates to products
Product A
Activity Center
Machine setups
Quality inspections
Production orders
Machine-hours worked
Material receipts
Product B
Activity Center
Machine setups
Quality inspections
Production orders
Machine-hours worked
Material receipts
 Comparison of Product Costs under the Two Methods:
Product costs using old costing system:
Product A
Direct materials
$36.00
Direct labor
17.50
Manufacturing overhead:
45.00
Unit product cost
$98.50
Product B
$30.00
14.00
36.00
$80.00
Product costs using ABC:
Direct materials
Direct labor
Manufacturing overhead:
Unit product cost
Product A
$36.00
17.50
$
.
Product B
$30.00
14.00
$
 Recap of what just happened (typical pattern) of adopting ABC:
.
Dr. Bob’s 256 Notes, 8-6
V.
USING ABC TO AID IN PRODUCT DECISIONS
 Most common management report prepared with ABC data is the product
profitability (product margin) report.
 Product Margin Reports: Assume the sales prices for the products were based on a
uniform markup of 25%, based on the old costing system. Thus, Product A’s sales
price is $123 ($98.50 x 125%, rounded to the nearest whole dollar); Product B’s
Sales price is $100 ($80 x 125%)
Product margins using old costing system:
Product A
(4,000 units)
Sales
Product costs:
Direct materials
Direct labor
Manufacturing overhead:
Total product cost
Product B
$492,000
$2,000,000
$2,492,000
394,000
1,600,000
1,994,000
$98,000
$400,000
$498,000
$144,000
70,000
180,000
Product Margin
$600,000
280,000
720,000
Product margins using ABC system:
Product A
Product B
(4,000 units)
(20,000 units)
Sales
Product costs:
Direct materials
Direct labor
Manufacturing overhead:
Total product cost
Product Margin
$492,000
$144,000
70,000
Total
(20,000 units)
$2,000,000
Total
$2,492,000
$600,000
280,000
1,994,000
$498,000