Chapter 5
Activity-Based Costing
Overcosting and Undercosting
Plant-wide rate versus departmental rate versus ABC
Example 1 (text – pages 133 to 134)
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 (example 3 – at the end of these notes)
ABC for customer profitability analysis (example 4 – at the end of these
notes)
Strategic cost management
Over and under-costing example
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
Demski Company has used a two-stage cost allocation system for many years. In the first stage,
plant overhead costs are allocated to two production departments, P1 and P2 based on
machine hours. In the second stage, Demski uses direct labor hours to assign overhead
costs from the production departments to individual products A and B.
Budgeted factory overhead costs for the year are $300,000. Both the budgeted and actual
machine hours in P1 and P2 are 12,000 and 28,000 hours, respectively.
After attending a seminar to learn the potential benefits of adopting an activity-based
costing system (ABC), Ted Demski, the president of Demski Company, is considering
implementing an ABC system. Upon his request, the controller at Demski Company has
compiled the following information for analysis:
Cost Pool
Machine setup
Inspection
Power
Supervision
Total overhead cost
Factory
overhead costs
$100,000
50,000
50,000
100,000
$300,000
Activity cost
driver
Setup hours
Inspection hours
Kilowatt hours
Direct labor hours
Expected
activity level
1,000
2,500
25,000
10,000
Demski manufactures two types of product A and B, for which the following information
is available:
A
B
Units produced and sold
5,000
10,000
Direct materials
$200,000 $250,000
Direct labor costs
$80,000
150,000
Direct labor hours in P1
1,500
3,000
Direct labor hours in P2
1,500
4,000
Setup hours
700
300
Inspection hours
1,500
1,000
Power (kilowatt hours)
12,500
12,500
Required:
(a) Determine the unit cost for each of the two products using the traditional two-stage
allocation method.
(b) Determine the unit cost for each of the two products using the proposed ABC system.
(c) Compare the unit manufacturing costs for product A and product B computed in
requirements a and b.
(1) Why do two the cost systems differ in their total cost for each product?
(2) Why might these differences be important to the Demski Company?
Example 3
The Wolfson Group (WG) provides tax advice to multinational firms. WG charges
clients for (a) direct professional time (at an hourly rate), and (b) support services (at
30%) of the direct professional costs billed). The three professionals in WG and their
rates per professional hour are:
Professional
Myron Wolfson
Ann Brown
John Anderson
Billing Rate per Hour
$500
120
80
WG has just prepared the May 1999 bills for two clients. The hours of professional
time spent on each client are as follows:
Professional
Wolfson
Brown
Anderson
Total
Hours per client
Seattle
Tokyo
Dominion
Enterprises
15
2
3
8
22
30
40
40
a. What amounts did WG bill to Seattle Dominion and Tokyo Enterprises for May
1999?
b. Suppose support services were billed at $50 per professional labor-hour (instead of
30% of professional labor costs). How would this change the amounts WG billed to
the two clients for May 1999?
c. What rate per professional labor-hour must WG charge in order for the total overhead
allocation to be the same under the two approaches?
Example 4
Grabbler Company has gathered the following data pertaining to activities it performed for two of
its major customers.
Number of orders
Units per order
Sales returns:
Number of returns
Total units returned
Number of sales calls
Thomas Inc.
Inc.
10
500
Balky Company.
4
40
10
10
200
4
30
200
Grabbler sells its products at $500 per unit, net 30. The firm's gross margin ratio is 20
percent. Both Thomas Inc. and Balky Company pay their accounts promptly and no
accounts receivable is over 30-days. Vikki Smith, the controller of Grabbler has
determined the following activity costs:
Activity
Sales calls
Order processing
Deliveries
Sales returns
Sales salary
Cost Driver and Rate
$1,000 per visit
$ 300 per order
$ 500 per order
$100 per return and $5 per unit returned
$100,000 per month
Required
1. Classify activity costs into cost categories and compute the total cost for Grabbler
Company to service Thomas and Balky.
2. Compare the profitability of these two customers (ignore cost of funds).