Management Accounting
Process Costing and ABC Costing
By:
Associate Professor Dr. GholamReza Zandi
zandi@segi.edu.my
Similarities Between Job-Order
and Process Costing
• Both systems assign material, labor and
overhead costs to products and they provide a
mechanism for computing unit product cost.
• Both systems use the same manufacturing
accounts, including Manufacturing Overhead,
Raw Materials, Work in Process, and Finished
Goods.
• The flow of costs through the manufacturing
accounts is basically the same in both systems.
Differences Between Job-Order
and Process Costing
• Process costing is used when a single product is
produced on a continuing basis or for a long
period of time. Job-order costing is used when
many different jobs are worked on each period.
• Process costing systems accumulate costs by
department. Job-order costing systems
accumulated costs by individual jobs.
• Process costing systems compute unit costs by
department. Job-order costing systems compute
unit costs by job on the job cost sheet.
Quick Check 
Process costing is used for products that are:
a. Different and produced continuously.
b. Similar and produced continuously.
c. Individual units produced to customer
specifications.
d. Purchased from vendors.
Quick Check 
Process costing is used for products that are:
a. Different and produced continuously.
b. Similar and produced continuously.
c. Individual units produced to customer
specifications.
d. Purchased from vendors.
Processing Departments
Any location in an organization where materials, labor
or overhead are added to the product.
The activities performed in a processing
department are performed uniformly on all
units of production. Furthermore, the output of
a processing department must be
homogeneous.
Flow of Materials, Labor and
Overhead Costs
Direct Materials
Direct Labor
ManufacturingO
verhead
Work in
Process
Finished
Goods
Cost of
Goods
Sold
Flow of Materials, Labor and
Overhead Costs
Costs are traced and
applied to individual
jobs in a job-order
cost system.
Direct Materials
Direct Labor
ManufacturingO
verhead
Jobs
Finished
Goods
Cost of
Goods
Sold
Flow of Materials, Labor and
Overhead Costs
Direct Materials
Direct Labor
ManufacturingO
verhead
Costs are traced and
applied to departments in a
process cost system.
Processing
Department
Finished
Goods
Cost of
Goods
Sold
T-Account and Journal Entry
Views of Process Cost Flows
For purposes of this example,
assume there are two processing
departments – Departments A and
B.
We will use T-accounts and journal
entries.
Process Cost Flows
(in T-Account form)
Raw Materials
•Direct
Materials
Work in Process
Department A
•Direct
Materials
Work in Process
Department B
•Direct
Materials
Process Cost Flows
(in journal entry form)
GENERAL JOURNAL
Date
Description
Post.
Ref.
Page 4
Debit
Work in Process - Department A
XXXXX
Work in Process - Department B
XXXXX
Raw Materials
To record the use of direct material.
Credit
XXXXX
Process Cost Flows
(in T-Account form)
Salaries and Wages
Payable
•Direct
Labor
Work in Process
Department A
•Direct
Materials
•Direct
Labor
Work in Process
Department B
•Direct
Materials
•Direct
Labor
Process Cost Flows
(in journal entry form)
GENERAL JOURNAL
Date
Description
Post.
Ref.
Page 4
Debit
Work in Process - Department A
XXXXX
Work in Process - Department B
XXXXX
Salaries and Wages Payable
To record direct labor costs.
Credit
XXXXX
Process Cost Flows
(in T-Account form)
Work in Process
Department A
Manufacturing
Overhead
•Actual
Overhead
•Overhead
Applied to
Work in
Process
•Direct
Materials
•Direct
Labor
•Applied
Overhead
Work in Process
Department B
•Direct
Materials
•Direct
Labor
•Applied
Overhead
Process Cost Flows
(in journal entry form)
GENERAL JOURNAL
Date
Description
Post.
Ref.
Page 4
Debit
Work in Process - Department A
XXXXX
Work in Process - Department B
XXXXX
Manufacturing Overhead
To apply overhead to departments.
Credit
XXXXX
Process Cost Flows
(in T-Account form)
Work in Process
Department A
•Direct
Transferred
Materials
to Dept. B
•Direct
Labor
•Applied
Overhead
Work in Process
Department B
•Direct
Materials
•Direct
Labor
•Applied
Overhead
•Transferred
from Dept. A
Process Cost Flows
(in journal entry form)
GENERAL JOURNAL
Date
Description
Work in Process - Department B
Work in Process - Department A
To record the transfer of goods from
Department A to Department B.
Post.
Ref.
Page 4
Debit
Credit
XXXXX
XXXXX
Process Cost Flows
(in T-Account form)
Work in Process
Department B
•Direct
Materials
•Direct
Labor
•Applied
Overhead
•Transferred
from Dept. A
•Cost of
Goods
Manufactured
Finished Goods
•Cost of
Goods
Manufactured
Process Cost Flows
(in journal entry form)
GENERAL JOURNAL
Date
Description
Finished Goods
Work in Process - Department B
To record the completion of goods
and their transfer from Department B
to finished goods inventory.
Post.
Ref.
Page 4
Debit
Credit
XXXXX
XXXXX
Process Cost Flows
(in T-Account form)
Work in Process
Department B
•Direct
Materials
•Direct
Labor
•Applied
Overhead
•Transferred
from Dept. A
Finished Goods
•Cost of
Goods
Manufactured
Cost of Goods Sold
•Cost of
Goods
Sold
•Cost of
Goods
Manufactured
•Cost of
Goods
Sold
Process Cost Flows
(in journal entry form)
GENERAL JOURNAL
Date
Description
Cost of Goods Sold
Finished Goods
To record cost of goods sold.
Post.
Ref.
Page 4
Debit
Credit
XXXXX
XXXXX
Equivalent Units of Production
Equivalent units are the product of the number
of partially completed units and the percentage
of completion of those units.
We need to calculate equivalent units because a
department usually has some partially completed
units in its beginning and ending inventory.
Equivalent Units – The Basic Idea
Two half completed products are equivalent
to one completed product.
+
=
1
So, 10,000 units 70% complete
are equivalent to 7,000 complete units.
Quick Check 
For the current period, Jones started 15,000 units
and completed 10,000 units, leaving 5,000 units
in process that are 30 percent complete. How
many equivalent units of production did Jones
have for the period?
a. 10,000
b. 11,500
c. 13,500
d. 15,000
Quick Check 
For the current period, Jones started 15,000 units
and completed 10,000 units, leaving 5,000 units
in process that are 30 percent complete. How
many equivalent units of production did Jones
have for the period?
a. 10,000
10,000 units + (5,000 units × 0.30)
b. 11,500
= 11,500 equivalent units
c. 13,500
d. 15,000
Calculating Equivalent Units
Equivalent units can be calculated two ways:
The First-In, First-Out Method (FIFO).
The Weighted-Average Method.
Characteristics of the
Weighted Average Method
The weighted-average method . . .
• Makes no distinction between work done in
prior or current periods.
• Blends together units and costs from prior
and current periods.
The equivalent units of production for a department
are the number of units transferred to the next
department (or finished goods) plus the equivalent
units in the department’s ending work in process
inventory.
Treatment of Direct Labor
Dollar Amount
Direct
Materials
Conversion
Direct
Labor
Type of Product Cost
Direct labor costs
may be small
in comparison to
other product
costs in process
costing systems.
Treatment of Direct Labor
Direct
Materials
Dollar Amount
Conversion
Direct labor costs
may be small
in comparison to
other product
costs in process
costing systems.
Type of Product Cost
Direct labor and manufacturing overhead may be
combined into one product cost called conversion.
Weighted-Average Example
Double Diamond Skis reported the following
activity in Shaping and Milling Department for
the month of May:
Percent Completed
Shaping and Milling Department
Beginning work in process
Units
200
Materials Conversion
55%
30%
Units started into production in May
5,000
Units completed during May and
transferred to the next department
4,800
100%
100%
400
40%
25%
Ending working process
Weighted-Average Example
The first step in calculating the equivalent units
is to identify the units completed and transferred
out of the Department in May (4,800 units).
Materials
Units completed and transferred
to the next department
4,800
Conversion
4,800
Weighted-Average Example
The second step is to identify the equivalent units of
production in ending work in process with respect to
materials for the month (160 units) and add this to the
4,800 units from step one.
Materials
Units completed and transferred
to the next department
4,800
Work in process, June 30:
400 units × 40%
Equivalent units of Production in
during the month of May
160
4,960
Conversion
4,800
Weighted-Average Example
The third step is to identify the equivalent units of production
in ending work in process with respect to conversion for the
month (100 units) and add this to
the 4,800 units from step one.
Materials
Units completed and transferred
to the next department
4,800
Conversion
4,800
Work in process, June 30:
400 units × 40%
160
400 units × 25%
Equivalent units of Production in
during the month of May
100
4,960
4,900
Weighted-Average Example
Equivalent units of production always equals:
Units completed and transferred
+ Equivalent units remaining in work in process
Materials
Units completed and transferred
to the next department
4,800
Conversion
4,800
Work in process, June 30:
400 units × 40%
160
400 units × 25%
Equivalent units of Production in
during the month of May
100
4,960
4,900
Weighted-Average Example
Materials
Beginning
Work in Process
200 Units
55% Complete
5,000 Units Started
4,800 Units Started
and Completed
4,800 Units Completed
160 Equivalent Units
4,960 Equivalent units
of production
Ending
Work in Process
400 Units
40% Complete
400 × 40%
Weighted-Average Example
Conversion
Beginning
Work in Process
200 Units
30% Complete
5,000 Units Started
4,800 Units Started
and Completed
4,800 Units Completed
100 Equivalent Units
4,900 Equivalent units
of production
Ending
Work in Process
400 Units
25% Complete
400 × 25%
Computing Cost Per Equivalent Unit
The following table includes some additional facts for Double
Diamond Skis’ Shaping and Milling Department for May.
Beginning work in process:
Materials: 55% complete
Conversion: 30% complete
200 units
$
9,600
5,575
Production started during May
5,000 units
Production completed during May 4,800 units
Costs added to production in May
Materials cost
Conversion cost
Ending work in process
Materials:
40% complete
Conversion:
25% complete
$ 368,600
350,900
400 units
Compute and Apply Costs
The formula for computing the
cost per equivalent unit is :
Cost per
equivalent
unit
=
Cost of beginning
work in process +
inventory
Cost added during
the period
Equivalent units of production
Compute and Apply Costs
Here is a schedule with the cost
and equivalent unit information.
Total
Cost
Cost to be accounted for:
Work in process, May 1
Costs added in the Shipping
and Milling Department
Total cost
Equivalent units
Cost per equivalent unit
$
15,175
Materials
Conversion
$
$
9,600
5,575
719,500
368,600
350,900
$ 734,675
$ 378,200
$ 356,475
4,960
4,900
Compute and Apply Costs
Here is a schedule with the cost
and equivalent unit information.
$356,475 ÷ 4,900 units = $72.75
Total
Cost
Cost to be accounted for:
Work in process, May 1
Costs added in the Shipping
and Milling Department
Total cost
Equivalent units
$
15,175
Materials
Conversion
$
$
9,600
5,575
719,500
368,600
350,900
$ 734,675
$ 378,200
$ 356,475
4,960
4,900
Cost per equivalent unit
$ 76.25
Total cost per equivalent unit = $76.25 + $72.75 = $149.00
$
72.75
$378,200 ÷ 4,960 units = $76.25
Computing the Cost of Ending
Work in Process Inventory
Shaping and Milling Department
Cost of Ending Work in Process Inventory and the Units Transferred Out
Materials
Conversion
Total
Ending work in process inventory:
Equivalent units of production
160
100
Cost of ending work in process inventory
Units completed and transferred out:
Units transferred to the next department
Cost per equivalent unit
Cost of units transferred out
$
$
$
-
4,800
76.25
366,000
$
$
$
-
4,800
72.75
349,200
$
$
Step 1: Record the equivalent units of production
in ending work in process inventory.
-
715,200
Computing the Cost of Ending
Work in Process Inventory
Shaping and Milling Department
Cost of Ending Work in Process Inventory and the Units Transferred Out
Materials
Conversion
Total
Ending work in process inventory:
Equivalent units of production
160
100
Cost per equivalent unit
$
76.25
$
72.75
Cost of ending work in process inventory
$
12,200
$
7,275
$
19,475
Units completed and transferred out:
Units transferred to the next department
Cost per equivalent unit
Cost of units transferred out
$
$
4,800
76.25
366,000
$
$
4,800
72.75
349,200
Step 2: Record the cost per equivalent unit.
$
715,200
Computing the Cost of Ending
Work in Process Inventory
Shaping and Milling Department
Cost of Ending Work in Process Inventory and the Units Transferred Out
Materials
Conversion
Total
Ending work in process inventory:
Equivalent units of production
160
100
Cost per equivalent unit
$
76.25
$
72.75
Cost of ending work in process inventory
$
12,200
$
7,275
$
19,475
Units completed and transferred out:
Units transferred to the next department
Cost per equivalent unit
Cost of units transferred out
$
$
4,800
76.25
366,000
$
$
4,800
72.75
349,200
Step 3: Compute the cost of ending
work in process inventory.
$
715,200
Computing the Cost of
Units Transferred Out
Shaping and Milling Department
Cost of Ending Work in Porcess Inventory and the Units Transferred Out
Materials
Conversion
Total
Ending work in process inventory:
Equivalent units of production
160
100
Cost per equivalent unit
$
76.25
$
72.75
Cost of ending work in process inventory
$
12,200
$
7,275
$
19,475
Units completed and transferred out:
Units transferred to the next department
Cost per equivalent unit
Cost of units transferred out
$
$
4,800
76.25
366,000
$
$
4,800
72.75
349,200
Step 1: Record the units transferred out
to the next department.
$
715,200
Computing the Cost of
Units Transferred Out
Shaping and Milling Department
Cost of Ending Work in Porcess Inventory and the Units Transferred Out
Materials
Conversion
Total
Ending work in process inventory:
Equivalent units of production
160
100
Cost per equivalent unit
$
76.25
$
72.75
Cost of ending work in process inventory
$
12,200
$
7,275
$
19,475
Units completed and transferred out:
Units transferred to the next department
Cost per equivalent unit
Cost of units transferred out
$
$
4,800
76.25
366,000
$
$
4,800
72.75
349,200
Step 2: Record the cost per equivalent unit.
$
715,200
Computing the Cost of
Units Transferred Out
Shaping and Milling Department
Cost of Ending Work in Process Inventory and the Units Transferred Out
Materials
Conversion
Total
Ending work in process inventory:
Equivalent units of production
160
100
Cost per equivalent unit
$
76.25
$
72.75
Cost of ending work in process inventory
$
12,200
$
7,275
$
19,475
Units completed and transferred out:
Units transferred to the next department
Cost per equivalent unit
Cost of units transferred out
$
$
4,800
76.25
366,000
$
$
4,800
72.75
349,200
Step 3: Compute the cost of units transferred out.
$
715,200
Reconciling Costs
Shaping and Milling Department
Cost Reconciliation
Costs to be accounted for:
Cost of beginning work in process inventory
$
Costs added to production during the period
Total cost to be accounted for
$
15,175
719,500
734,675
Step 1: Compute the costs to be accounted for by
adding the cost of beginning work in process
and the production costs added in May.
Reconciling Costs
Shaping and Milling Department
Cost Reconciliation
Costs to be accounted for:
Cost of beginning work in process inventory
$
Costs added to production during the period
Total cost to be accounted for
$
15,175
719,500
734,675
Cost accounted for as follows:
Cost of ending work in process inventory
Cost of units transferred out
Total cost accounted for
19,475
715,200
734,675
$
$
Step 2: Compute the costs to accounted for by
adding the cost of ending work in process
and the cost of units transferred out in May.
FIFO vs. Weighted-Average Method
The FIFO method (generally considered more
accurate that the weighted-average method)
differs from the weighted-average method in
two ways:
1. The computation of equivalent units.
2. The way in which the costs of beginning
inventory are treated.
Equivalent Units – FIFO Method
Let’s revisit the Double Diamond Skis example.
Assume the following activity is reported in the
Shaping and Milling Department for May:
Percent Completed
Units
Work in process, June 1
200
Units started into production in June
5,000
Units completed and transferred out
of Department A during June
4,800
Work in process, June 30
400
Materials Conversion
55%
30%
40%
25%
Equivalent Units – FIFO Method
Step 1: Determine equivalent units needed
to complete beginning inventory.
Materials
To complete beginning work in process:
Materials: 200 units × (100% - 55%)
Conversion: 200 units × (100% - 30%)
Conversion
90
140
Equivalent Units – FIFO Method
Step 2: Determine units started and
completed during the period.
Materials
To complete beginning work in process:
Materials: 200 units × (100% - 55%)
90
Conversion: 200 units × (100% - 30%)
Units started and completed during May
Conversion
140
4,600
4,600
Equivalent Units – FIFO Method
Step 3: Add the equivalent units in ending
working in process inventory.
Materials
To complete beginning work in process:
Materials: 200 units × (100% - 55%)
90
Conversion: 200 units × (100% - 30%)
Units started and completed during May
Conversion
140
4,600
4,600
Ending work in process
Materials: 400 units × 40% complete
Conversion: 400 units × 25% complete
Equivalent units of production
160
100
4,850
4,840
FIFO Example
Materials
Beginning
Work in Process
200 Units
55% Complete
200 × 45%
5,000 Units Started
4,600 Units Started
and Completed
90 Equivalent Units
4,600 Units Completed
160 Equivalent Units
4,850 Equivalent units
of production
Ending
Work in Process
400 Units
40% Complete
400 × 40%
FIFO Example
Conversion
Beginning
Work in Process
200 Units
30% Complete
200 × 70%
5,000 Units Started
4,600 Units Started
and Completed
140 Equivalent Units
4,600 Units Completed
100 Equivalent Units
4,840 Equivalent units
of production
Ending
Work in Process
400 Units
25% Complete
400 × 25%
Equivalent Units:
Weighted Average vs. FIFO
As shown below, the equivalent units in beginning
inventory are subtracted from the equivalent units of
production per the weighted-average method to
obtain the equivalent units
of production under the FIFO method.
Equivalent units - weighted average method
Less equivalent units in beginning inventory:
200 units × 55%
200 units × 30%
Equivalent units - FIFO method
Materials
4,960
Conversion
4,900
110
4,850
60
4,840
Cost per Equivalent Unit - FIFO
The following table includes some additional facts for Double
Diamond Skis’ Shaping and Milling Department for May.
Beginning work in process:
Materials: 55% complete
Conversion: 30% complete
200 units
$
9,600
5,575
Production started during May
5,000 units
Production completed during May 4,800 units
Costs added to production in May
Materials cost
Conversion cost
Ending work in process
Materials:
40% complete
Conversion:
25% complete
$ 368,600
350,900
400 units
Cost per Equivalent Unit - FIFO
The formula for computing the cost per equivalent
unit under FIFO method is:
Cost per
equivalent
unit
=
Cost added during the period
Equivalent units of production
Cost per Equivalent Unit - FIFO
Total
Cost
Costs added in the Shaping
and Milling Department
Equivalent units
$ 719,500
Materials
Conversion
$ 368,600
4,850
$ 350,900
4,840
Cost per equivalent unit
$ 76.00
Total cost per equivalent unit = $76.00 + $72.50 = $148.50
$
72.50
Computing the Cost of Ending
Work in Process Inventory
Step 1: Record the equivalent units of production
in ending work in process inventory.
Shaping and Milling Department
Cost of Ending Work in Process Inventory and the Units Transferred Out
Materials
Conversion
Total
Ending work in process inventory:
Equivalent units of production
160
100
Cost per equivalent unit
$
76.25
$
72.75
Cost of ending work in process inventory
$
12,200
$
7,275
$
19,475
Units completed and transferred out:
Units transferred to the next department
Cost per equivalent unit
Cost of units transferred out
$
$
4,800
76.25
366,000
$
$
4,800
72.75
349,200
$
715,200
Computing the Cost of Ending
Work in Process Inventory
Step 2: Record the cost per equivalent unit.
Shaping and Milling Department
Cost of Ending Work in Process Inventory and the Units Transferred Out
Materials
Conversion
Total
Ending work in process inventory:
Equivalent units of production
160
100
Cost per equivalent unit
$
76.00
$
72.50
Cost of ending work in process inventory
$
12,160
$
7,250
$
19,410
Units completed and transferred out:
Units transferred to the next department
Cost per equivalent unit
Cost of units transferred out
$
$
4,800
76.25
366,000
$
$
4,800
72.75
349,200
$
715,200
Computing the Cost of Ending
Work in Process Inventory
Step 3: Compute the cost of ending
work in process inventory.
Shaping and Milling Department
Cost of Ending Work in Process Inventory and the Units Transferred Out
Materials
Conversion
Total
Ending work in process inventory:
Equivalent units of production
160
100
Cost per equivalent unit
$
76.00
$
72.50
Cost of ending work in process inventory
$
12,160
$
7,250
$
19,410
Units completed and transferred out:
Units transferred to the next department
Cost per equivalent unit
Cost of units transferred out
$
$
4,800
76.25
366,000
$
$
4,800
72.75
349,200
$
715,200
Computing the Cost of
Units Transferred Out
Step 1: Record the cost in beginning
work in process inventory.
Shaping and Milling Department
Cost of Ending Work in Process Inventory and the Units Transferred Out
Materials
Conversion
Units transferred out:
Cost in beginning work in process (WIP)
$
9,600
$
5,575
Cost to complete beginning WIP:
Equivalent units to complete
90
140
Cost per equivalent unit
$
76.00
$
72.50
Cost to complete beginning WIP
$
6,840
$
10,150
Cost of units started and completed in May
Units started and completed in May
4,600
4,600
Cost per equivalent unit
$
76.00
$
72.50
Cost of units started and completed in May
$ 349,600
$
333,500
Cost of units transferred out
Total
$
15,175
$
16,990
$
$
683,100
715,265
Computing the Cost of
Units Transferred Out
Step 2: Determine the cost to complete the units
in beginning work in process inventory.
Shaping and Milling Department
Cost of Ending Work in Process Inventory and the Units Transferred Out
Materials
Conversion
Units transferred out:
Cost in beginning work in process (WIP)
$
9,600
$
5,575
Cost to complete beginning WIP:
Equivalent units to complete
90
140
Cost per equivalent unit
$
76.00
$
72.50
Cost to complete beginning WIP
$
6,840
$
10,150
Cost of units started and completed in May
Units started and completed in May
4,600
4,600
Cost per equivalent unit
$
76.00
$
72.50
Cost of units started and completed in May
$ 349,600
$
333,500
Cost of units transferred out
Total
$
15,175
$
16,990
$
$
683,100
715,265
Computing the Cost of
Units Transferred Out
Step 3: Determine the cost of units started
and completed this period.
Shaping and Milling Department
Cost of Ending Work in Process Inventory and the Units Transferred Out
Materials
Conversion
Total
Units transferred out:
Cost in beginning work in process (WIP)
$
9,600
$
5,575
$
15,175
Cost to complete beginning WIP:
Equivalent units to complete
90
140
Cost per equivalent unit
$
76.00
$
72.50
Cost to complete beginning WIP
$
6,840
$
10,150
$
16,990
Cost of units started and completed in May
Units started and completed in May
4,600
4,600
Cost per equivalent unit
$
76.00
$
72.50
Cost of units started and completed in May
$ 349,600
$
333,500
$ 683,100
Computing the Cost of
Units Transferred Out
Step 4: Determine the total cost of units transferred out.
Shaping and Milling Department
Cost of Ending Work in Process Inventory and the Units Transferred Out
Materials
Conversion
Units transferred out:
Cost in beginning work in process (WIP)
$
9,600
$
5,575
Cost to complete beginning WIP:
Equivalent units to complete
90
140
Cost per equivalent unit
$
76.00
$
72.50
Cost to complete beginning WIP
$
6,840
$
10,150
Cost of units started and completed in May
Units started and completed in May
4,600
4,600
Cost per equivalent unit
$
76.00
$
72.50
Cost of units started and completed in May
$ 349,600
$
333,500
Cost of units transferred out
Total
$
15,175
$
16,990
$
$
683,100
715,265
Reconciling Costs
Shaping and Milling Department
Cost Reconciliation
Costs to be accounted for:
Cost of beginning work in process inventory
Costs added to production during the period
Total cost to be accounted for
Cost accounted for as follows:
Cost of ending work in process inventory
Cost of units transferred out
Total cost accounted for
$
15,175
719,500
$ 734,675
$
19,475
715,200
$ 734,675
Reconciling Costs
Shaping and Milling Department
Cost Reconciliation
Costs to be accounted for:
Cost of beginning work in process inventory
Costs added to production during the period
Total cost to be accounted for
Cost accounted for as follows:
Cost of ending work in process inventory
Cost of units transferred out
Total cost accounted for
15,175
719,500
$ 734,675
$
19,410
715,265
$ 734,675
$
A Comparison of Costing Methods
In a lean production environment, FIFO and
weighted-average methods yield similar
unit costs.
When considering cost control, FIFO is superior to
weighted-average because it does not mix costs of
the current period with costs of the prior period.
Activity-Based Costing (ABC)
Cost Objects
(e.g., products and customers)
Activities
Consumption of Resources
Cost
Activity-Based Costing (ABC)
A number of allocation bases are used
for assigning costs to products.
Activity-Based Costing (ABC)
An event that causes the
consumption of
overhead resources
Activity
Examples of Activities
Setting up
machines
Admitting
hospital
patients
Billing
customers
Opening a
bank account
Activity-Based Costing (ABC)
Activity Cost
Pool
A “cost bucket” in which costs
related to a particular activity
are accumulated
Activity
Measure
Expresses how much of the
activity is carried out and is used
as the allocation base for
applying overhead costs
Activity Rate
A predetermined overhead rate
for each activity
cost pool.
Activity-Based Costing (ABC)
For each activity in
isolation, this system works exactly
like the job-order costing system
described in Chapter 2.
A predetermined overhead rate is computed for
each activity and then applied to jobs and
products based on the amount of activity
consumed by the job or product.
Designing an Activity-Based
Costing System
The challenge is to select a reasonably
small number of activities that explain the
bulk of the variation in overhead costs.
Activities are usually chosen by interviewing a
broad range of managers to find out what
activities they think consume most of the
organization’s resources.
Designing an Activity-Based
Costing System
Related activities are
frequently combined to reduce
the amount of detail and
record-keeping costs.
For example, several activities may
be involved in handling and moving
raw materials, but these may be
combined into a single activity
entitled material handling.
An activity dictionary defines each of the activities
that will be included in the activity-based costing
system and how the activities will be measured.
Hierarchy of Activities
Level
Activities
Activity Measure
Unit-level
Processing units on machines
Processing units by hand
Consuming factory supplies
Machine-hours
Direct labor-hours
Units produced
Batch-level
Processing purchase orders
Processing production orders
Setting up equipment
Handling materials
Purchase orders processed
Production orders processed
Number of setups
Pounds of material handled
Product-level
Testing new products
Administering parts inventories
Designing products
Hours of testing time
Number of part types
Hours of design time
Facility-level
General factory administration
Plant building and grounds
Direct labor-hours
Direct labor-hours
Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs
First-Stage Cost Assignment
Labor
Related Pool
Machine
Related Pool
Setup
Pool
Production
Order Pool
Parts
Admin. Pool
General
Factory Pool
Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs
First-Stage Cost Assignment
Labor
Related Pool
Machine
Related Pool
Setup
Pool
Production
Order Pool
Parts
Admin. Pool
General
Factory Pool
$/Part Type
$/MH
Second-Stage Allocations
$/DLH
$/MH
$/Setup
$/Order
Products
Unit-Level
Activity
Batch-Level
Activity
Product-Level
Activity
Facility-Level
Activity
Using Activity-Based Costing
Comtek Sound, Inc.
 Comtek Sound, Inc. makes two products: CD
players and DVD players.
 The company has been losing bids to supply CD
players, its main product, to lower priced
competitors.
 The company has been winning all bids to
supply DVD players, its secondary product.
Using Activity-Based Costing
Comtek Sound, Inc.
 For
the current year, Comtek has budgeted
sales
of 50,000 DVD units and 200,000 CD units.
 Comtek’s traditional cost system applies
manufacturing overhead to products based on
direct labor hours.
 Both products require two direct labor-hours
to
Hours
complete, for a total of 500,000 direct
labor
DVDs: 50,000 units @ 2 hours per unit = 100,000
hours.
CDs: 200,00 units @ 2 hours per unit =
Total direct labor-hours
400,000
500,000
Using Activity-Based Costing
Comtek Sound, Inc.
 Unit costs for materials and labor are:
Direct materials
Direct Labor
DVD
Units
$ 90
$ 20
CD
Units
$ 50
$ 20
Direct Labor-Hours as a Base
Total manufacturing overhead costs for the current
year are estimated to be $10,000,000. The
company develops the following overhead rate
based upon labor-hours:
Predetermined
overhead rate
=
$10,000,000
500,000 DLHs
= $20 per DLH
Direct Labor-Hours as a Base
Since each product requires two hours of direct
labor, $40 of overhead is assigned to each
product.
Direct materials
Direct labor
Manufacturing overhead
DVD Unit
$
90
20
40
CD Unit
$
50
20
40
$
$
(2 DLHs x $20 per DLH)
Unit product cost
150
110
Computing Activity Rates
The ABC project team at Comtek has
developed the following basic information.
Activity and Activity Measures
Estimated
Overhead
Cost
Labor related (DLH)
$
800,000
Machine related (MH)
2,100,000
Machine setups (setups)
1,600,000
Production orders (orders)
3,150,000
Parts administration (part types)
350,000
General factory (MH)
2,000,000
$ 10,000,000
Expected Activity
Total
DVD
CD
500,000
100,000
400,000
1,000,000
300,000
700,000
4,000
3,000
1,000
1,200
800
400
700
400
300
1,000,000
300,000
700,000
Computing Activity Rates
We can calculate the following activity rates:
Estimated
Overhead
Activity and Activity Measures
Cost
Labor related (DLHs)
$
800,000
Machine related (MHs)
2,100,000
Machine setups (setups)
1,600,000
Production orders (orders)
3,150,000
Parts administration (part types)
350,000
General factory (MHs)
2,000,000
$ 10,000,000
÷
÷
÷
÷
÷
÷
Total
Expected
Activity
500,000
1,000,000
4,000
1,200
700
1,000,000
=
=
=
=
=
=
Activity Rate
$
1.60 per DLH
2.10 per MH
400.00 per setup
2,625.00 per order
500.00 per part type
2.00 per MH
Using the new activity rates, let’s assign overhead
to the two products based upon expected activity.
Computing Overhead Cost per Unit
DVD Units
Expected
Activity and Activity Measures
Activity
Labor related (DLHs)
100,000
Machine related (MHs)
300,000
Machine setups (setups)
3,000
Production orders (orders)
800
Parts administration (part types)
400
General factory (MHs)
300,000
Total overhead cost assigned
Number of units produced
Overhead cost per unit
×
×
×
×
×
×
Activity
Rate
$ 1.60
2.10
400.00
2,625.00
500.00
2.00
=
=
=
=
=
=
Amount
$ 160,000
630,000
1,200,000
2,100,000
200,000
600,000
$ 4,890,000
50,000
$
97.80
Computing Overhead Cost per Unit
CD Units
Expected
Activity and Activity Measures
Activity
Labor related (DLHs)
400,000
Machine related (MHs)
700,000
Machine setups (setups)
1,000
Production orders (orders)
400
Parts administration (part types)
300
General factory (MHs)
700,000
Total overhead cost assigned
Number of units produced
Overhead cost per unit
×
×
×
×
×
×
Activity
Rate
$
1.60
2.10
400.00
2,625.00
500.00
2.00
=
=
=
=
=
=
Amount
$ 640,000
1,470,000
400,000
1,050,000
150,000
1,400,000
$ 5,110,000
200,000
$
25.55
Comparing the Two Approaches
Activity-Based Costing
DVD Unit
CD Unit
Direct material
$ 90.00
$ 50.00
Direct labor
20.00
20.00
Manufacturing overhead
97.80
25.55
Unit product cost
$ 207.80
$ 95.55
Direct-Labor Costing
DVD Unit
CD Unit
$ 90.00 $ 50.00
20.00
20.00
40.00
40.00
$ 150.00 $ 110.00
Note that the unit product cost of a CD unit
decreased from $110 to $95.55 . . . .
. . . . while the unit cost of a DVD unit
increased from $150 to $207.80.
Comparing the Two Approaches
Activity-Based Costing
DVD Unit
CD Unit
Direct material
$ 90.00
$ 50.00
Direct labor
20.00
20.00
Manufacturing overhead
97.80
25.55
Unit product cost
$ 207.80
$ 95.55
The ABC system assigns $14.45
less overhead than the traditional
system to each CD player.
Direct-Labor Costing
DVD Unit
CD Unit
$ 90.00 $ 50.00
20.00
20.00
40.00
40.00
$ 150.00 $ 110.00
Comparing the Two Approaches
Activity-Based Costing
DVD Unit
CD Unit
Direct material
$ 90.00
$ 50.00
Direct labor
20.00
20.00
Manufacturing overhead
97.80
25.55
Unit product cost
$ 207.80
$ 95.55
The ABC system assigns $57.80
more overhead than the traditional
system to each DVD player.
Direct-Labor Costing
DVD Unit
CD Unit
$ 90.00 $ 50.00
20.00
20.00
40.00
40.00
$ 150.00 $ 110.00
Shifting of Overhead Cost
Activity-Based Costing
DVD Unit
CD Unit
Direct material
$ 90.00
$ 50.00
Direct labor
20.00
20.00
Manufacturing overhead
97.80
25.55
Unit product cost
$ 207.80
$ 95.55
Direct-Labor Costing
DVD Unit
CD Unit
$ 90.00 $ 50.00
20.00
20.00
40.00
40.00
$ 150.00 $ 110.00
Low-volume product
When a company implements activity-based costing,
overhead cost often shifts from high-volume to lowvolume products with a higher unit product cost resulting
for the low-volume products.
Shifting of Overhead Cost
Activity-Based Costing
DVD Unit
CD Unit
Direct material
$ 90.00
$ 50.00
Direct labor
20.00
20.00
Manufacturing overhead
97.80
25.55
Unit product cost
$ 207.80
$ 95.55
Direct-Labor Costing
DVD Unit
CD Unit
$ 90.00 $ 50.00
20.00
20.00
40.00
40.00
$ 150.00 $ 110.00
High-volume product
The traditional system assigns the same amount of all
overhead costs to each CD or DVD player
($40 per unit).
Shifting of Overhead Cost
Production Orders Activity Cost Pool
(a batch-level cost pool)
The ABC system assigns different amounts of
Production Order-related overhead costs to each product.
This fact can be illustrated in a two-step process.
1. Compute the number of units processed
per production order for each product.
Number of units produced per year
Number of production orders issued per year
Number of units processed per production order
DVD Units
50,000
800
62.5
CD Units
200,000
400
500
Shifting of Overhead Cost
2. Compute production order cost per unit for each product.
Cost to issue a production order
Average number of units processed per
production order
Production order cost per unit
DVD Units CD Units
$
2,625 $
2,625
$
62.5
42.00 $
500
5.25
Notice, the costs are being shifted from the high
volume CD players to the low volume DVD players.
Targeting Process Improvements
An ABC system can help identify
areas where the company can benefit
from improving its current processes.
Activity-Based Management
Focuses on managing activities to eliminate waste
and reduce delays and defects.
Targeting Process Improvements
The first step in any improvement
program is deciding what to improve.
The Theory of Constraints
approach targets the
highest impact
improvement opportunities.
Activity rates can be
used to target areas
where costs seem
excessively high.
Benchmarking can be used to compare activity cost
information with world-class standards of performance
achieved by other organizations.
Benefits of Activity-Based Costing
ABC improves the accuracy of product costing by:
•
•
•
Increasing the number of cost pools used to accumulate
overhead costs.
Using activity cost pools that are more homogeneous than
departmental cost pools.
Assigning overhead costs using activity measures that cause
those costs, rather than relying solely on direct labor hours.
Activity-based costing also highlights activities
that could benefit most from process
improvement efforts, such as Six Sigma.
Limitations Activity-Based Costing
Costs of implementing an ABC system may outweigh
the benefits. However, the benefits are more likely to be
worth the costs when:
1. Products differ substantially in volume, batch size, and in
activities required.
2. Conditions have changed substantially since the existing
cost system was established.
3. Overhead costs are high and increasing and no one seems
to understand why.
4. Management does not trust the existing cost system and it
ignores data from it when making decisions.
Activity-Based Costing
Critical Assumption
The cost in each activity pool is strictly proportional to
its activity measure. When this assumption is
violated, the accuracy of ABC data can be called into
question.
For example, managers should be particularly alert to
product costs that contain allocated facility-level
costs.
Modifying the ABC Model
The illustrations in the chapter assume
that ABC is being used for external reporting
purposes. If the system is used for internal
decision-making purposes, two important
modifications should be made:
1. Selling and administrative costs should be
assigned to products, where appropriate.
2. Facility-level costs should be removed
from product costs.
Cost Flows in an ABC System
Sarvik Company uses activity-based costing. The
company has five cost pools shown below.
Estimated
Overhead
Activity Cost Pool Activity Measure
Cost
Machine related
Machine hours
$ 175,000
Purchase orders Number of orders
63,000
Machine setups
Number of setups
92,000
Product testing
Number of tests
160,000
General factory
Direct labor hours
300,000
$ 790,000
Expected Activity
5,000 MHs
700 orders
460 setups
200 tests
25,000 DLHs
Cost Flows in an ABC System
Activity rates are determined as follows:
Estimated
Overhead
Activity Cost Pool
Cost
Machine related
$ 175,000
Purchase orders
63,000
Machine setups
92,000
Product testing
160,000
General factory
300,000
$ 790,000
÷
÷
÷
÷
÷
Total
Expected
Activity
5,000 MHs
700 orders
460 setups
200 tests
25,000 DLH
=
=
=
=
=
Activity Rate
$ 35 per MH
$ 90 per order
$ 200 per setup
$ 800 per test
$ 12 per DLH
Cost Flows in an ABC System
Overhead is applied on the basis of actual
activities during the year.
Activity
Activity Cost Pool
Rate
Machine related
$35/MH
Purchase orders $90/order
Machine setups
$200/setup
Product testing
$800/test
General factory
$12/DLH
Total Overhead Applied
×
×
×
×
×
Actual
Activity
4,600 MHs
800 orders
500 setups
190 tests
23,000 DLHs
=
=
=
=
=
Applied
Overhead
Cost
$ 161,000
72,000
100,000
152,000
276,000
$ 761,000
Cost Flows in an ABC System
Selected transactions recorded by the company:
a. Raw materials purchased on account, $915,000.
b. Raw materials used in production, $900,000 ($810,000
direct and $90,000 indirect).
c. Factory labor costs, $370,000 ($95,000 direct and
$275,000 indirect).
d. Depreciation of factory assets, $180,000.
e. Miscellaneous manufacturing overhead costs
incurred on account, $230,000.
f. Manufacturing overhead applied, $761,000.
g. Goods costing $1,650,000 were manufactured.
Cost Flows in an ABC System
The following journal entries would be used
to record transactions (a) and (b).
Description
a. Raw Materials
Accounts Payable
Debit
915,000
b. Work in Process
Manufacturing Overhead
Raw Materials
810,000
90,000
Credit
915,000
900,000
Cost Flows in an ABC System
The following journal entries would be used
to record transactions (c) and (d).
Description
c. Work in Process
Manufacturing Overhead
Salaries and Wages Payable
Debit
95,000
275,000
d. Manufacturing Overhead
Accumulated Depreciation
180,000
Credit
370,000
180,000
Cost Flows in an ABC System
The following journal entry would be used to record
transaction (e).
Description
e. Manufacturing Overhead
Cash/Accounts Payable
Debit
230,000
Credit
230,000
Cost Flows in an ABC System
The following journal entry would be used to record
transaction (f).
f.
Description
Work in Process
Manufacturing Overhead
Debit
761,000
Credit
761,000
Cost Flows in an ABC System
The following journal entry would be used to record
transaction (g).
Description
g. Finished Goods
Work in Process
Debit
1,650,000
Credit
1,650,000
Cost Flows in an ABC System
Manufacturing Overhead
(b)
(c)
(d)
(e)
90,000
275,000
180,000
230,000
Bal.
14,000
(g) 761,000
Underapplied
Overhead Costs
Cost Flows in an ABC System
The flow of costs through
Raw Materials, Work in
Process, and other
accounts is the same
under activity based
costing.
The only difference in
activity based costing is
that more than one
predetermined overhead
rate is used to apply costs
to products.
The End