Chapter 3-1
Chapter 3
Systems Design:
Activity-Based Costing
McGraw-Hill /Irwin
© The McGraw-Hill Companies, Inc., 2007
Learning Objective
LO1
To understand the basic
approach in activitybased costing and how
it differs from
conventional costing.
3-2
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.
3-3
Chapter 3-2
Assigning Overhead Costs to Products
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.
3-4
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.
3-5
Departmental Overhead Rates
Many companies have a system in which
each department has its own overhead rate.
Finishing Department
Painting Department
Shipping Department
The allocation bases depend 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.
3-6
Chapter 3-3
Departmental Overhead Rates
Unfortunately, even 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.
Some overhead costs may be caused by factors
that are not related to the volume of production.
A more sophisticated approach, such as activity-based
costing, is required to account for these other factors.
3-7
Activity-Based Costing (ABC)
A number of
allocation bases are
used for assigning
costs to products.
3-8
Activity-Based Costing (ABC)
A number of
allocation bases
are used for
assigning costs
to products.
Cost Objects
(e.g., products and customers)
Activities
Consumption of Resources
Cost
3-9
Chapter 3-4
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
3-10
Activity-Based Costing (ABC)
Activity
An event that causes the
consumption of overhead
resources
Activity
Cost Pool
A “cost bucket” in which
costs related to a particular
activity measure are
accumulated
Activity
Measure
Expresses how much of the
activity is carried out and is
used as the allocation base
for applying overhead costs
3-11
Activity-Based Costing (ABC)
Activity
An event that causes the
consumption of overhead
resources
Activity
Cost Pool
A “cost bucket” in which
costs related to a particular
activity measure 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
Chapter 3-5
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
In most companies, hundreds or even thousands
of different activities cause overhead costs.
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
Chapter 3-6
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
Chapter 3-7
Using Activity-Based Costing
Comtek Sound, Inc.
n Comtek Sound, Inc. makes two products that are sold to
automobile manufacturers, a radio with a built-in CD
player and a radio with a built-in DVD player.
o The company has been losing bids to supply CD players,
its main product, to lower price competitors.
p The company has been winning all bids to supply DVD
players, its secondary product.
3-19
Using Activity-Based Costing
Comtek Sound, Inc.
q For the current year, Comtek has budgeted sales of
50,000 DVD units and 200,000 CD units.
r Comtek’s traditional cost system applies manufacturing
overhead to products based on direct labor hours.
s Both products require two direct labor-hours to
complete, for a total of 500,000 direct labor hours.
DVDs:
DVDs: 50,000
50,000 units
units@
@ 22 hours
hoursper
per unit
unit ==
CDs:
CDs: 200,00
200,00 units
units@
@ 22 hours
hoursper
per unit
unit ==
Total
Total direct
direct labor-hours
labor-hours
Hours
Hours
100,000
100,000
400,000
400,000
500,000
500,000
3-20
Using Activity-Based Costing
Comtek Sound, Inc.
t Unit costs for materials and labor are:
Direct
Direct materials
materials
Direct
Direct Labor
Labor
DVD
DVD
Units
Units
$$ 90
90
$$ 20
20
CD
CD
Units
Units
$$ 50
50
$$ 20
20
3-21
Chapter 3-8
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
LO2
To compute activity
rates for an activitybased costing system.
3-24
Chapter 3-9
Computing Activity Rates
The ABC project team at Comtek has
developed the following basic information.
Activity
Activityand
andActivity
ActivityMeasures
Measures
Estimated
Estimated
Overhead
Overhead
Cost
Cost
Labor
$$ 800,000
Laborrelated
related(DLH)
(DLH)
800,000
Machine
2,100,000
Machinerelated
related(MH)
(MH)
2,100,000
Machine
1,600,000
Machinesetups
setups(setups)
(setups)
1,600,000
Production
3,150,000
Productionorders
orders(orders)
(orders)
3,150,000
Parts
350,000
Partsadministration
administration (part
(parttypes)
types)
350,000
General
2,000,000
Generalfactory
factory(MH)
(MH)
2,000,000
$$10,000,000
10,000,000
Expected
Expected Activity
Activity
Total
DVD
CD
Total
DVD
CD
500,000
100,000
400,000
500,000
100,000
400,000
1,000,000
300,000
700,000
1,000,000
300,000
700,000
4,000
3,000
1,000
4,000
3,000
1,000
1,200
800
400
1,200
800
400
700
400
300
700
400
300
1,000,000
300,000
700,000
1,000,000
300,000
700,000
3-25
Computing Activity Rates
We can calculate the following activity rates:
Estimated
Total
Overhead
Expected
Activity and Activity Measures
Cost
Activity
Labor related (DLHs)
$
800,000 ÷
500,000
Machine related (MHs)
2,100,000 ÷ 1,000,000
Machine setups (setups)
1,600,000 ÷
4,000
Production orders (orders)
3,150,000 ÷
1,200
Parts administration (part types)
350,000 ÷
700
General factory (MHs)
2,000,000 ÷ 1,000,000
$ 10,000,000
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
LO3
To compute product
costs using activitybased costing.
3-27
Chapter 3-10
Computing Overhead
Cost per Unit
DVD Units
Expected
Expected
Activity
Activity
Activity and
and Activity
Activity Measures
Measures
Activity
Labor
100,000
Labor related
related (DLHs)
(DLHs)
100,000
Machine
300,000
Machine related
related (MHs)
(MHs)
300,000
Machine
3,000
Machine setups
setups (setups)
(setups)
3,000
Production
800
Production orders
orders (orders)
(orders)
800
Parts
400
Parts administration
administration (part
(part types)
types)
400
General
300,000
Generalfactory
factory (MHs)
(MHs)
300,000
Total
Totaloverhead
overhead cost
cost assigned
assigned
Number
Number of
of units
units produced
produced
Overhead
Overhead cost
costper
per unit
unit
××
××
××
××
××
××
Activity
Activity
Rate
Rate
$$ 1.60
1.60
2.10
2.10
400.00
400.00
2,625.00
2,625.00
500.00
500.00
2.00
2.00
Amount
Amount
== $$ 160,000
160,000
==
630,000
630,000
== 1,200,000
1,200,000
== 2,100,000
2,100,000
==
200,000
200,000
==
600,000
600,000
$$4,890,000
4,890,000
50,000
50,000
$$
97.80
97.80
3-28
Computing Overhead
Cost per Unit
CD Units
Expected
Expected
Activity
Activity
Activity and
and Activity
Activity Measures
Measures
Activity
Labor
400,000
Labor related
related (DLHs)
(DLHs)
400,000
Machine
700,000
Machine related
related (MHs)
(MHs)
700,000
Machine
1,000
Machine setups
setups (setups)
(setups)
1,000
Production
400
Production orders
orders (orders)
(orders)
400
Parts
300
Parts administration
administration (part
(part types)
types)
300
General
700,000
Generalfactory
factory (MHs)
(MHs)
700,000
Total
Totaloverhead
overhead cost
costassigned
assigned
Number
of
units
produced
Number of units produced
Overhead
Overhead cost
cost per
perunit
unit
××
××
××
××
××
××
Activity
Activity
Rate
Rate
$$ 1.60
1.60
2.10
2.10
400.00
400.00
2,625.00
2,625.00
500.00
500.00
2.00
2.00
Amount
Amount
== $$ 640,000
640,000
== 1,470,000
1,470,000
==
400,000
400,000
== 1,050,000
1,050,000
==
150,000
150,000
== 1,400,000
1,400,000
$$5,110,000
5,110,000
200,000
200,000
$$
25.55
25.55
3-29
Comparing the Two Approaches
Activity-Based
Activity-Based Costing
Costing
DVD
CD
DVD Unit
Unit
CD Unit
Unit
Direct
$$ 90.00
Directmaterial
material
90.00 $$ 50.00
50.00
Direct
20.00
20.00
Directlabor
labor
20.00
20.00
Manufacturing
97.80
25.55
Manufacturing overhead
overhead
97.80
25.55
Unit
$$ 207.80
Unitproduct
productcost
cost
207.80 $$ 95.55
95.55
Direct-Labor
Direct-LaborCosting
Costing
DVD
DVD Unit
Unit CD
CD Unit
Unit
$$ 90.00
90.00 $$ 50.00
50.00
20.00
20.00
20.00
20.00
40.00
40.00
40.00
40.00
$$ 150.00
150.00 $$ 110.00
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
Chapter 3-11
Learning Objective
LO4
To contrast the product
costs computed under
activity-based costing
and conventional
costing methods.
3-31
Comparing the Two Approaches
Activity-Based
Activity-Based Costing
Costing
DVD
CD
DVD Unit
Unit
CD Unit
Unit
Direct
$$ 90.00
Directmaterial
material
90.00 $$ 50.00
50.00
Direct
20.00
20.00
Directlabor
labor
20.00
20.00
Manufacturing
97.80
25.55
Manufacturing overhead
overhead
97.80
25.55
Unit
$$ 207.80
Unitproduct
productcost
cost
207.80 $$ 95.55
95.55
Direct-Labor
Direct-LaborCosting
Costing
DVD
DVD Unit
Unit CD
CD Unit
Unit
$$ 90.00
90.00 $$ 50.00
50.00
20.00
20.00
20.00
20.00
40.00
40.00
40.00
40.00
$$ 150.00
150.00 $$ 110.00
110.00
The ABC system assigns $14.45
less overhead than the traditional
system to each CD player.
3-32
Comparing the Two Approaches
Activity-Based
Activity-Based Costing
Costing
DVD
CD
DVD Unit
Unit
CD Unit
Unit
Direct
$$ 90.00
Directmaterial
material
90.00 $$ 50.00
50.00
Direct
20.00
20.00
Directlabor
labor
20.00
20.00
Manufacturing
97.80
25.55
Manufacturing overhead
overhead
97.80
25.55
Unit
$$ 207.80
Unitproduct
productcost
cost
207.80 $$ 95.55
95.55
Direct-Labor
Direct-LaborCosting
Costing
DVD
DVD Unit
Unit CD
CD Unit
Unit
$$ 90.00
90.00 $$ 50.00
50.00
20.00
20.00
20.00
20.00
40.00
40.00
40.00
40.00
$$ 150.00
150.00 $$ 110.00
110.00
The ABC system assigns $57.80
more overhead than the traditional
system to each DVD player.
3-33
Chapter 3-12
Shifting of Overhead Cost
Activity-Based
Activity-Based Costing
Costing
DVD
CD
DVD Unit
Unit
CD Unit
Unit
Direct
$$ 90.00
Directmaterial
material
90.00 $$ 50.00
50.00
Direct
20.00
20.00
Directlabor
labor
20.00
20.00
Manufacturing
97.80
25.55
Manufacturing overhead
overhead
97.80
25.55
Unit
$$ 207.80
Unitproduct
productcost
cost
207.80 $$ 95.55
95.55
Direct-Labor
Direct-LaborCosting
Costing
DVD
DVD Unit
Unit CD
CD Unit
Unit
$$ 90.00
90.00 $$ 50.00
50.00
20.00
20.00
20.00
20.00
40.00
40.00
40.00
40.00
$$ 150.00
150.00 $$ 110.00
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
Activity-Based Costing
Costing
DVD
CD
DVD Unit
Unit
CD Unit
Unit
Direct
$$ 90.00
Directmaterial
material
90.00 $$ 50.00
50.00
Direct
20.00
20.00
Directlabor
labor
20.00
20.00
Manufacturing
97.80
25.55
Manufacturing overhead
overhead
97.80
25.55
Unit
$$ 207.80
Unitproduct
productcost
cost
207.80 $$ 95.55
95.55
Direct-Labor
Direct-LaborCosting
Costing
DVD
DVD Unit
Unit CD
CD Unit
Unit
$$ 90.00
90.00 $$ 50.00
50.00
20.00
20.00
20.00
20.00
40.00
40.00
40.00
40.00
$$ 150.00
150.00 $$ 110.00
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
Consider the 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
Number of
of units
unitsproduced
produced per
per year
year
Number
Number of
of production
production orders
ordersissued
issued per
per year
year
Number
of
units
processed
per
Number of units processed per production
production order
order
DVD
DVD Units
Units
50,000
50,000
800
800
62.5
62.5
CD
CD Units
Units
200,000
200,000
400
400
500
500
3-36
Chapter 3-13
Shifting of Overhead Cost
2. Compute production order cost per unit for each product.
Cost
Costto
to issue
issue aa production
production order
order
Average
Average number
number of
ofunits
unitsprocessed
processed per
per
production
order
production order
Production
order
cost
per
unit
Production order cost per unit
DVD
DVDUnits
Units CD
CDUnits
Units
$$ 2,625
2,625 $$ 2,625
2,625
$$
62.5
62.5
42.00
42.00 $$
500
500
5.25
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
One of the great benefits derived from using
an ABC system is that it can help identify
areas where the company can benefit
from improving its current processes.
Activity-Based Management
involves focusing on activities to eliminate waste,
decrease processing time, and reduce 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
Chapter 3-14
Benefits of Activity-Based Costing
ABC Improves the accuracy of product costing by:
Š Increasing the number of cost pools used to accumulate
overhead costs.
Š Using activity cost pools that are more homogeneous than
departmental cost pools.
Š 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 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
Chapter 3-15
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
LO5
To record the flow of
costs in an activitybased 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
Cost
Activity Cost Pool Activity Measure
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
Chapter 3-16
Cost Flows in an ABC System
Activity rates are determined as follows:
Activity Cost Pool
Machine related
Purchase orders
Machine setups
Product testing
General factory
Estimated
Overhead
Cost
$ 175,000
63,000
92,000
160,000
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
Chapter 3-17
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
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
Accounts Payable
Debit
230,000
Credit
230,000
3-51
Chapter 3-18
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
Chapter 3-19
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
3-56