Activity-Based Costing

Chapter 03

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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.
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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. 2. 3. Direct labor information was already being recorded. Direct labor was a large component of product costs. Managers believed direct labor and overhead costs were highly correlated.
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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 these growing 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 todays business environment.
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Departmental Overhead Rates

Many companies have a system in which each department has its own overhead rate.
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.
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Machining Department

Assembly Department Shipping Department

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-based costing is required to account for these other factors.

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Activity-Based Costing (ABC)

A number of allocation bases are used for assigning costs to products.

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Activity-Based Costing (ABC)

Cost Objects (e.g., products and customers)

Activities

Consumption of Resources

Cost
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Activity-Based Costing (ABC)

Activity
An event that causes the consumption of overhead resources

Examples of Activities

Setting up machines

Admitting hospital patients

Billing customers

Opening a bank account

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Activity-Based Costing (ABC)

Activity Cost Pool Activity Measure
A cost bucket in which costs related to a particular activity are accumulated. Expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs. A predetermined overhead rate for each activity cost pool.

Activity Rate

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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.
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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 organizations resources.
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Designing an Activity-Based Costing System

Related activities are frequently combined to reduce the amount of detail and record-keeping costs. For example, several actions may be involved in handling and moving raw materials, but these may be combined into a single activity titled 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.

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Hierarchy of Activities
Level
Unit-level

Activities
Processing units on machines Processing units by hand Consuming factory supplies Processing purchase orders Processing production orders Setting up equipment Handling materials Testing new products Administering parts inventories Designing products General factory administration Plant building and grounds

Activity Measure
Machine-hours Direct labor-hours Units produced Purchase orders processed Production orders processed Number of setups Pounds of material handled Hours of testing time Number of part types Hours of design time Direct labor-hours Direct labor-hours

Batch-level

Product-level

Facility-level

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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

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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 3-16

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 to lower-priced competitors. The company has been winning all bids to supply DVD players.

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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.
Comteks traditional cost system applies manufacturing overhead to products based on directlabor 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
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Using Activity-Based Costing Comtek Sound, Inc.

Unit costs for materials and labor are:
DVD Units $ 90 $ 20 CD Units $ 50 $ 20

Direct materials Direct labor

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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

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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
(2 DLHs x $20 per DLH)

DVD Unit $ 90 20 40 $ 150

CD Unit $ 50 20 40 $ 110
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Unit product cost

Computing Activity Rates

The ABC project team at Comtek has developed the following basic information.
Activity and Activity Measures Estimated Overhead Cost Total 500,000 1,000,000 4,000 1,200 700 1,000,000 Expected Activity DVD 100,000 300,000 3,000 800 400 300,000

CD 400,000 700,000 1,000 400 300 700,000

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

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Computing Activity Rates

Estimated Overhead Cost $ 800,000 2,100,000 1,600,000 3,150,000 350,000 2,000,000 $ 10,000,000 Total Expected Activity 500,000 1,000,000 4,000 1,200 700 1,000,000

Activity and Activity Measures Labor-related (DLHs) Machine-related (MHs) Machine setups (setups) Production orders (orders) Parts administration (part types) General factory (MHs)

= = = = = =

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

We can calculate an activity rate for each of the six activities by dividing the estimated overheard for an activity by the total expected activity.
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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

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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

= = = = = =

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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.
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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

The ABC system assigns $14.45 less overhead than the traditional system to each CD player.
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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

The ABC system assigns $57.80 more overhead than the traditional system to each DVD player.
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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.
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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).
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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.
DVD Units 50,000 800 62.5 CD Units 200,000 400 500
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Number of units produced per year Number of production orders issued per year Number of units processed per production order

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 highvolume CD players to the low-volume DVD players.
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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.
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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.
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Benefits of Activity-Based Costing

ABC improves the accuracy of product costing by: 1. Increasing the number of cost pools used to accumulate overhead costs. 2. Using activity cost pools that are more homogeneous than departmental cost pools. 3. 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.
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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.
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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.
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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.

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End of Chapter 03

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