Managerial Accounting

Eighth Edition

Weygandt Kimmel Kieso

Chapter 4

Activity-Based Costing
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Chapter Outline
Learning Objectives
LO 1 Discuss the difference between traditional costing and
activity-based costing.
LO 2 Apply activity-based costing to a manufacturer.
LO 3 Explain the benefits and limitations of activity-based costing.
LO 4 Apply activity-based costing to service industries.

Copyright ©2018 John Wiley & Sons, Inc. 2

 phân bổ mannu overhead lại (bởi vì with techno thì manu over head cost đang nhiều hơn direct labour cost)

Traditional versus Activity-Based Costing

LEARNING OBJECTIVE 1
Discuss the difference between traditional costing and
activity-based costing.
Traditional Costing Systems
• Allocates overhead using a predetermined rate.
o Job order costing: direct labor cost may be the relevant
activity base.
o Process costing: machine hours may be the relevant activity
base.

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Illustration of a Traditional Costing System
Atlas Company produces two abdominal fitness products—the Ab
Bench and the Ab Coaster. Direct materials cost per unit is $40 for
the Ab Bench and $30 for the Ab Coaster. Direct labor cost is $12
per unit for each product. Both products require one direct labor
hour per unit, are allocated overhead cost of $30 per unit.

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 The Need for a New Approach
• Tremendous change in manufacturing and service
industries.
• Decrease in amount of direct labor usage.
• Significant increase in total overhead costs.
• Inappropriate to use plantwide predetermined overhead
rates when a lack of correlation exists.
• Complex manufacturing processes may require
multiple allocation bases (Activity-Based Costing).

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 Activity-Based Costing
• An approach for allocating overhead costs.
o Allocates overhead to multiple activity cost pools.
o Assigns the activity cost pools to products or services by
means of cost drivers.
Key Concepts
Activity. Any event, action, transaction, or work sequence that
incurs costs when producing a product or performing a service.
Activity cost pool. Overhead cost attributed to a distinct activity
(e.g., ordering materials or setting up machines).
Cost driver. Any factor or activity that has a direct cause-effect
relationship with the resources consumed.
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 Activity-Based Costing
Four Steps
1. Identify and classify the activities involved in the manufacture of
specific products and assign overhead to cost pools.
2. Identify the cost driver that has a strong correlation to the costs
accumulated in each cost pool.
3. Compute the activity-based overhead rate for each cost pool.

4. Allocate overhead costs to products using the overhead rates

determined for each cost pool.

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 Activity-Based Costing
Two-stage process
• ABC allocates overhead in a two-stage process:
o Stage 1: Overhead costs are assigned to activity cost pools
(Step 1).
o Stage 2: Allocates overhead assigned to the activity cost pools
to products, using cost drivers (Steps 2 to 4).

• The more complex a product’s manufacturing operation,

the more activities and cost drivers are likely to be
present.

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 Activity-Based Costing
Activities and related cost drivers
Step 1: Identify
activity cost pools and
allocate cost to pools

Step 2: Identify cost

drivers and estimate
total usage

Step 3: Compute
activity-based
overhead rate
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 Activity-Based Costing
Activities and related cost drivers continued

Step 4: Assign
overhead costs to
products based on
use of cost drivers

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 Do It! 1: Costing Systems
Indicate whether the following statements are true or false.
1. A traditional costing system allocates overhead by means of
multiple overhead rates. F

2. Direct material and direct labor costs are easier to trace to

products than overhead. T

3. As manufacturing processes have become more automated, more

companies have chosen to allocate overhead on the basis of direct
labor costs. F

4. In activity-based costing, an activity is any event, action,

transaction, or work sequence that incurs cost when producing a
product. T

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ABC and Manufactures

LEARNING OBJECTIVE 2

Apply activity-based costing to a manufacturer.

Involves the following four steps.

1. Identify and classify activities involved in the manufacture
of specific products and assign overhead to cost pools.
2. Identify the cost driver that has a strong correlation to the
costs accumulated in each cost pool.
3. Compute the activity-based overhead rate for each cost
pool.
4. Assign overhead costs to products, using overhead rates
determined for each cost pool.
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 Identify and Classify Activities
Allocate Overhead to Cost Pools
Overhead costs are assigned directly to the appropriate activity cost
pool.

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 Identify Cost Drivers
Cost driver must accurately measure the actual consumption of
the activity by the various products.
Illustration 4.7: Cost drivers that Atlas Company identifies and
their total expected use per activity cost pool.
Estimated Use of Cost
Activity Cost Pools Cost Drivers Drivers per Activity
Manufacturing Machine hours 50,000 machine hours
Setups Number of setups 2,000 setups
Purchase ordering Number of purchase orders 2,500 purchase orders
Product development Products developed 2 products developed
Facility management Square footage 25,000 square feet

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Compute Activity-Based Overhead Rates
Next, the company computes an activity-based overhead rate per
cost driver.

Estimated Overhead per Activity

= Activity - Based Overhead Rate
Expected Use of Cost Drivers per Activity

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 Assign Overhead Costs to Products
Estimated use of cost drivers per product
In allocating overhead costs, it is necessary to know the expected use of
cost drivers for each product. Atlas Company produces 25,000 Ab
Benches and 5,000 Ab Coasters. Because of its low volume and higher
number of components, the Ab Coaster requires more setups and purchase
orders than the Ab Bench.
Expected Use of Expected Use of
Cost Drivers per Cost Drivers per
Expected Use of Cost Product for Ab Product for Ab
Activity Cost Pools Cost Drivers Drivers per Activity Bench Coaster
Manufacturing Machine hours 50,000 machine hours 30,000 20,000

Setups Number of setups 2,000 setups 500 1,500

Purchase ordering Number of purchase 2,500 purchase orders 750 1,750

orders
Product development Products developed 2 Products developed 1 1

Property and plant Square feet 25,000 Square feet 10,000 15,000

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 Assign Overhead Costs to Products
Allocation of activity cost pools to products
To allocate overhead costs, Atlas multiplies the activity-based
overhead rates per cost driver (Ill. 4-9) by the number of cost drivers
expected to be used per product (Ill. 4-10).

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Allocate Overhead Costs to Products
Allocation of activity cost pools to products (cont).
To allocate overhead costs, Atlas multiplies the activity-based
overhead rates per cost driver (Ill. 4-9) by the number of cost
drivers expected to be used per product (Ill. 4-10).

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 Comparing Unit Costs

• Likely consequence of differences in assigning overhead.

o Overpricing the Ab Bench and possibly losing market share
to competitors.
o Sacrificing profitability by underpricing the Ab Coaster.

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Do It! 2: Apply ABC to Manufacturer

Casey Company has five activity cost pools and two products. It
expects to produce 200,000 units of its automobile scissors jack and
80,000 units of its truck hydraulic jack. Having identified its
activity cost pools and the cost drivers for each cost pool, Casey
Company accumulated the following data relative to those activity
cost pools and cost drivers.

80
500
2.5

0.6
20

2 560 000 2 740 000

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Do It! 2: Apply ABC to Manufacturer
Instructions
Casey Company has five activity cost pools and two products. It expects
to produce 200,000 units of its automobile scissors jack and 80,000 units
of its truck hydraulic jack. Having identified its activity cost pools and the
cost drivers for each cost pool, Casey Company accumulated the
following data relative to those activity cost pools and cost drivers.
Using the data provided,
a. Prepare a schedule showing the computations of the activity-based overhead
rates per cost driver.
b. Prepare a schedule assigning each activity’s overhead cost to the two products.
c. Compute the overhead cost per unit for each product.
d. Comment on the comparative overhead cost per unit.

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 ABC Benefits and Limitations

LEARNING OBJECTIVE 3

Explain the benefits and limitations of activity-based

costing.

ABC has three primary benefits:

1. More cost pools, therefore more accurate product
costing.
2. Enhanced control over overhead costs.
3. Better management decisions.

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 The Advantage of Multiple Cost Pools
• Multiple cost pools
o Used instead of one plantwide pool and a single cost
driver.
o Numerous activity cost pools with more relevant cost
drivers.
• Costs allocated on basis of cost drivers used to produce
each product.

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 The Advantage of Multiple Cost Pools
A more detailed view of manufacturing activities

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 The Advantage of Multiple Cost Pools
Classification of Activity Levels - Unit-level
• Unit-level
o Performed for each unit of production.
• Example: Assembly of cell phones
• Batch-level
• Product-level
• Facility-level

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 The Advantage of Multiple Cost Pools
Classification of Activity Levels – Batch-level
• Unit-level
• Batch-level
o Performed every time a company produces another batch
of a product.
• Example: Batch of ice cream
• Product-level
• Facility-level

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 The Advantage of Multiple Cost Pools
Classification of Activity Levels – Product-level
• Unit-level
• Batch-level
• Product-level
o Performed every time a company produces a new type of
product.
• Example: Time spent testing a new drug by a
pharmaceutical company
• Facility-level

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 The Advantage of Multiple Cost Pools
Classification of Activity Levels - Facility level
• Unit-level
• Batch-level
• Product-level
• Facility-level
o Required to support or sustain an entire production
process.
• Example: A hospital

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 The Advantage of Multiple Cost Pools
Unit-Level Activities

Four Levels Types of Activities Examples of Cost Drivers

Unit-Level Activities
Machine-related Machine hours
Drilling, cutting, milling,
trimming, pressing
Labor-related Direct labor hours or cost
Assembling, painting,
sanding, sewing

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The Advantage of Multiple Cost Pools
Batch-Level and Product-Level Activities
Four Levels Types of Activities Examples of Cost Drivers
Batch-Level Activities Equipment setups Number of setups or setup time
Purchase ordering Number of purchase orders
Inspection Number of setups
Materials handling Number of material moves

Product- Level Activities Product design Number of product designs

Engineering changes Number of changes

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 The Advantage of Multiple Cost Pools
Facility-Level Activities

Four Levels Types of Activities Examples of Cost Drivers

Facility-Level Activities Plant management salaries Number of employees managed
Plant depreciation Square footage
Property taxes Square footage
Utilities Square footage

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The Advantage of Enhanced Cost Control
Value-Added Activities
• Increase the perceived value of a product or service to
customers, such as:

Manufacturing Company Service Company

• Engineering design • Performing surgery
• Machining • Legal research
• Assembly • Delivering packages
• Painting

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The Advantage of Enhanced Cost Control
Non-Value-Added Activities
• Adds cost to, or increases the time spent on, a
product/service without increasing its perceived value, such
as:

Manufacturing Company Service Company

• Storage of inventory • Taking appointments
• Moving inventory • Reception
• Inspections • Bookkeeping and billing
• Fixing defective goods • Traveling
• Ordering supplies
• Advertising
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Advantage of Better Management Decisions

Activity-based management (ABM), management tool that

focuses on reducing costs and improving processes and
decision-making.
Managers use ABC via ABM
• for both strategic and operational decisions or perspectives.
• to help managers evaluate employees, departments, and
business units.
• to establish performance standards, as well as benchmark
against other companies.

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Limitations and Knowing When to Use ABC
Limitations
• Expensive to use.
• More complex than traditional systems.
• Arbitrary allocations remain.

When to Use
1. Product lines differ in volume and manufacturing complexity.
2. Product lines are numerous and diverse.
3. Overhead costs constitute a significant portion of total costs.
4. Manufacturing process or the number of products has changed
significantly.
5. Production or marketing managers are ignoring data.

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 Do It! 3: Classify Activity Levels
Morgan Toy Company manufactures six primary product lines in its Morganville
plant. As a result of an activity analysis, the accounting department has identified
eight activity cost pools. Each of the toy products is produced in large batches,
with the whole plant devoted to one product at a time. Classify each of the
following activities as either unit-level, batch-level, product-level, or facility-level:

a. Engineering design
b. Machine setup
c. Toy design
d. Interviews of prospective employees
e. Inspections after each setup
f. Polishing parts
g. Assembling parts
h. Health and safety

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 ABC and Service Industries

LEARNING OBJECTIVE 4

Apply activity-based costing to service industries.

Overall objective: Identify key activities that generate costs and keep track of
how many of those activities are completed for each service performed.
• General approach is to identify activities, cost pools, and cost
drivers.
• Labeling of activities as value-added or non-value-added.
• Sometimes, a larger proportion of overhead costs are company-
wide costs that cannot be directly traced to specific services
provided by the company.

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 Traditional Costing Example
The public accounting firm of Check and Doublecheck prepares the
following condensed annual budget.

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 Traditional Costing Example
Overhead applied under traditional costing
Assume that Check and Doublecheck records $140,000 of actual
direct professional labor cost during its audit of Plano Molding
Company, which was billed an audit fee of $260,000. Under
traditional costing, using 50% as the rate for applying overhead to
the job, Check and Doublecheck would compute applied overhead
and operating income as shown.

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 Activity-Based Costing Example
Check and Doublecheck distributes its estimated annual overhead
costs of $600,000 to three activity cost pools.

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 Activity-Based Costing Example
Assigning overhead in a service industry

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 Activity-Based Costing Example
Comparison of traditional with ABC costing
Under activity-based costing, Check and Doublecheck assigns
overhead costs of $57,200 as compared to $70,000 under traditional
costing.

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Do It! 4: Apply ABC to Service Company
We Carry It, Inc. is a trucking company. It provides local, short-haul, and long-
haul services. The company has developed the following the cost pools

Estimated Expected Use of Cost Drivers

Activity Cost pools Cost Drivers Overhead Per Activity
Loading and unloading Number of pieces $ 70,000 100,000 pieces
Travel Miles driven 250,000 500,000 miles
Logistics Hours 60,000 2,000 hours

(a) Computer the activity-based overhead rates for each pool

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Do It! 4: Apply ABC to Service Company
continued
We Carry It, Inc. is a trucking company. It provides local, short-haul, and long-
haul services. The company has developed the following the cost pools
Estimated Expected Use of Cost Activity- Based
Activity Cost pools Overhead ÷ Drivers Per Activity = Overhead Rate
Loading and unloading $ 70,000 100,000 pieces $0.70 per piece
Travel 250,000 500,000 miles $0.50 per mile
Logistics 60,000 2,000 hours $30 per hour

(b) Determine the overhead allocated to Job A 1027 which has 150 pieces,
require 200 miles of driving, and 0.75 hours of logistics

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Appendix 4A: Just-in-Time Processing

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 Just-in-Time Processing
Objective of JIT Processing
• To eliminate all manufacturing inventories.

Elements of JIT Processing

• Dependable suppliers.
• Multiskilled work force.
• Total quality control system.

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 Just-in-Time Processing
continued
Benefits of JIT Processing
• Significant reduction or elimination of manufacturing
inventories.
• Enhanced product quality.
• Reduction or elimination of rework costs and inventory
storage costs.
• Production cost savings from the improved flow of goods
through the processes.

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Copyright
Copyright © 2018 John Wiley & Sons, Inc.
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Copyright ©2018 John Wiley & Sons, Inc. 48