Chapter 3
System Design:
Activity Based Costing
PowerPoint Authors:
Jon A. Booker, Ph.D., CPA, CIA
Charles W. Caldwell, D.B.A., CMA
Susan Coomer Galbreath, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
3-2
Learning Objective 1
Understand the basic
approach in activity-based
costing and how it differs from
conventional costing.
3-3
Assigning Overhead Costs to
Products
When cost systems were developed in the 1800s, the
emphasis was on simplicity because:
1. Cost and activity data had to be collected by
hand and all calculations were done with paper
and pencil.
2. Most companies produced a limited variety of
similar products, so there was little difference
in the overhead costs consumed by each
product.
3-4
Plantwide Overhead Rate
Plantwide Overhead Rate
A single overhead rate used
throughout an entire factory.
Direct labor has often been used as the allocation
base for overhead because:
1.
Direct labor information was already being recorded.
2.
Direct labor was a large component of product costs.
3.
Managers believed direct labor and overhead costs
were highly correlated.
3-5
Plantwide Overhead Rate
Today, direct labor may no longer be a
satisfactory base for allocation of overhead.
1. Most companies sell a large variety of products that
consume differing amounts of overhead.
2. As a percentage of total costs, direct labor has been
shrinking and overhead has been increasing. Many of the
new overhead costs may not be correlated with direct
labor.
3. Technology advancements have reduced the cost and
complexity of gathering diverse sources of data.
A plantwide overhead allocation system may not be optimal
for many companies in today’s business environment.
3-6
Departmental Overhead Rates
Many companies have a system in which each
department has its own overhead rate.
Machining Department
Assembly Department
Shipping Department
The allocation base depends
on the nature of the work
performed in each department.
In the machining department,
overhead may be based on
machine-hours, but in the
assembly department,
overhead may be based on
labor-hours.
3-7
Departmental Overhead Rates
Departmental rates will not correctly assign overhead
in situations where a company has a range of
products and complex overhead costs.
The departmental approach relies
exclusively on volume-related allocation bases while
some overhead costs may be caused by factors
that are not related to the volume of production.
Activity-base costing is required to account for these
other factors.
3-8
Activity-Based Costing (ABC)
A number of allocation bases are
used for assigning costs to products.
3-9
Activity-Based Costing (ABC)
Cost Objects
(e.g., products and customers)
Activities
Consumption of Resources
Cost
3-10
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
3-11
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.
3-12
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.
3-13
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.
3-14
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.
3-15
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
3-16
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
3-17
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
Second-Stage Allocations
$/DLH
$/MH
$/Setup
$/Order
$/Part Type
$/MH
Products
Unit-Level
Activity
Batch-Level
Activity
Product-Level Facility-Level
Activity
Activity
3-18
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.
3-19
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
complete, for a total of 500,000 direct labor
hours.
Hours
DVDs: 50,000 units @ 2 hours per unit = 100,000
CDs: 200,00 units @ 2 hours per unit = 400,000
Total direct labor-hours
500,000
3-20
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
3-21
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
$10,000,000
=
overhead rate
500,000 DLHs
= $20 per DLH
3-22
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
3-23
Learning Objective 2
Compute activity rates for an
activity-based costing
system.
3-24
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
3-25
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.
3-26
Learning Objective 3
Compute product costs using
activity-based costing.
3-27
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
3-28
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
3-29
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.
3-30
Learning Objective 4
Contrast the product costs
computed under activitybased costing and
conventional costing
methods.
3-31
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
3-32
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
3-33
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.
3-34
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).
3-35
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
3-36
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.
3-37
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.
3-38
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.
3-39
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.
3-40
Limitations of 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.
3-41
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.
3-42
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.
3-43
Learning Objective 5
Record the flow of costs in an
activity-based costing
system.
3-44
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
3-45
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
3-46
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
3-47
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.
3-48
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
3-49
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
3-50
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
3-51
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
3-52
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
3-53
Cost Flows in an ABC System
Manufacturing Overhead
(b)
(c)
(d)
(e)
Bal.
90,000 (g) 761,000
275,000
180,000
230,000
14,000
Underapplied
Overhead Costs
3-54
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.
3-55
End of Chapter 3