ABC Oh Costs

Activity Based Costing Page 1
4. Activity-Based Costing
In this chapter we will study in more detail the process of applying Manufacturing
Overhead to a firms products and services. In particular, we will see that dividing your
Manufacturing Overhead into separate cost pools can lead to a more accurate
application of Manufacturing Overhead. We will discuss the possibility of separating a
firm into different production departments and applying Manufacturing Overhead
separately by department. Alternatively, we will discuss dividing a firms operations into
different activities, and applying the Manufacturing Overhead associated with each
activity separately.
Manufacturing Overhead Variance
In Chapter 5, we saw that if Manufacturing Overhead was over-applied or under-

applied, then the Manufacturing Overhead Variance ultimately ends up in Cost of Goods
Sold. Thus, when all of the goods produced by a company have been completed and
sold, then all of the variance should be added to Cost of Goods Sold. If, however, you
have units that are unfinished (in Work in Process) and/or unsold (in Finished Goods) at
the end of the period, then the misapplication of Manufacturing Overhead (that is
evidenced by the variance) affects the units in Work In Process and Finished Goods, as
well as, Cost of Goods Sold. In Chapter 5, we placed the entire Manufacturing
Overhead Variance in Cost of Goods Sold even if some of the units were not completed
or sold. This treatment is justified under the concept of Materiality.
As you will recall from your introductory accounting class, Generally Accepted
Accounting Principles (GAAP) include the concept of Materiality. Materiality allows you
to use an incorrect accounting treatment provided that the improper treatment would not
affect anyones decision making. For example, it is common to consider the
Manufacturing Overhead Variance to be immaterial when the improper treatment
changes Net Income by less than 1% or 2%.
If the Manufacturing Overhead Variance is material, then the variance should be

prorated (allocated) among the units in Cost of Goods Sold, Finished Goods and Work
in Process. This allocation of the variance can be accomplished a number of ways. For
example, you can apportion the variance between the three accounts: (i) using the
relative ending balances of the three accounts (before allocating the variance) or (ii)
using the relative amount of Manufacturing Overhead that is retained in each account.
The effect on Net Income is often so small that the Manufacturing Overhead Variance is
considered immaterial, and it is closed to Cost of Goods Sold. This is because most of
the units that are started are, in fact, completed and sold during the current period.
Please send comments and corrections to me at mconstas@csulb.edu

For example, assume that Madonna, Inc.

had a Net Income of $1,000,000 and a
Manufacturing Overhead Variance of
$100,000 (underapplied). You might think
that a variance that is 10% of Net Income
should be considered material. The size of
the mistaken accounting treatment (not the
size of the variance) is key to determining
materiality. If all of the variance were
added to Cost of Goods Sold, then Cost of
Goods Sold would increase by $100,000.
Assume that 90% of units that Madonna
Materiality Girl began were completed and sold, and the
other 10% are still in Work In Process and/or Finished Goods. As noted above, it is
proper to allocate the Manufacturing Overhead Variance among Work In Process,
Finished Goods, and Cost of Goods Sold by their relative ending balances. Such an
allocation would add $90,000 of the variance to Cost of Goods Sold (90% x $100,000
variance). Note that this accurate allocation of the variance ($90,000) is $10,000 less
than the inaccurate allocation described above ($100,000). Thus, only $10,000 was
added to Cost of Goods Sold improperly. The $10,000 improper increase in Cost of
Goods Sold has the effect of decreasing Net Income by $10,000, which is 1% of
Madonnas Net Income. This is probably immaterial.
Assuming that there is a material variance where Manufacturing Overhead is under-

applied, then the general journal entry used to close the Manufacturing Overhead
account is as follows:
D. Cost of Goods Sold $ XXX

Finished Goods XXX
Work In Process XXX
Cr. Manufacturing Overhead $ XXX
Assuming that there is a material variance where Manufacturing Overhead is over-

applied, then the general journal entry used to close the Manufacturing Overhead
account is as follows:
D. Manufacturing Overhead $ XXX

Cr. Cost of Goods Sold $ XXX
Finished Goods XXX
Work In Process XXX

Cost Pools
As we mentioned in Chapter 5, in a manufacturing situation, there are three

components to cost:
Direct Labor,
Direct Materials, and
Manufacturing Overhead.
As noted previously, it is relatively easy to allocate Direct Labor and Direct Materials to
the products produced, but it is difficult to allocate Manufacturing Overhead costs.
Because of this, we have Normal Costing and the allocation of Manufacturing Overhead
using Predetermined Overhead Rates.
In Chapter 5, we used a single, Predetermined Overhead Rate to allocate the

Manufacturing Overhead costs to the products being produced. If all of the products are
similar, this approach may produce a fairly accurate allocation of Manufacturing
Overhead.
On the other hand, if you have widely diversified product lines and production
operations, then a Plant-Wide Application Rate may not be very accurate. You may find
that some products are being under-costed and others are being over-costed. In this
case, you might obtain more accuracy in the allocation of Manufacturing Overhead to
the units that generated it by using more than one overhead cost pools. The number of
cost pools to use always involves a cost-benefit analysis, because of the additional
record keeping involved.
Why should you care whether your products being over-costed or under-costed?
Having more accurate cost information can lead to an improvement in your bidding
process. If you base your customer bid prices on your costs, you could charge the
wrong amounts. If you charge more than your competitors, then you will lose business.
If you charge less than your competitors, you will get more business, but your profits will
be less than you expected because you are not charging your customers enough.
Having more accurate cost information could improve a firms product mix. Even if your
prices are not based on your costs (e.g., set by the free market), you still may have
problems. For example, you may not actively go after certain business because you
don't think it is very profitable when that business actually is profitable. Similarly, you
may go after other business that you believe is very profitable, when it is not profitable
or less profitable than you believe.
Another way that over-costing or under-costing can affect a business is in the decision
whether to offer a product or discontinue a product. Having misinformation on the
profitability of a product may cause a product to be improperly discontinued (or retained
when it should be discontinued). For example, a firm may incorrectly outsource the

manufacture of a part or product because it wrongly believes that it is cheaper to

purchase the part or product rather than manufacture it.
Department Allocations of Overhead
A simple way to have multiple cost pools is to pool Manufacturing Overhead costs
separately by production department. This is especially true if the departments are very
different (e.g., one is labor intensive, and the other is automated).
You calculate a separate Predetermined Overhead Rate for each departments

Manufacturing Overhead. When using Departmental Application Rates, it is possible to
use different Cost Drivers for different departments.
Departmental Application Rate Example
Ajax Inc. produces standard model trophies, as well as, custom

designed trophies. Ajaxs plant has two production departments: (i)
the Design Department and (ii) the Manufacturing Department. The
standard model trophies are made in the Manufacturing Department
without any Design Department services. Custom designed trophies
are designed in the Design Department and then manufactured in the
Manufacturing Department.
The Design Department uses 10,000 Direct Labor Hours, and the
Manufacturing Department uses 90,000 Direct Labor Hours. Ajax
currently allocates its Manufacturing Overhead using one Plant-Wide
Application Rate using Direct Labor Hours as the Cost Driver.
The Manufacturing Overhead for the plant is as follows:
Indirect Costs Design Manufacturing Total

Rent $20,000 $ 80,000 $100,000
Depreciation ---- 200,000 200,000
Supervisors 50,000 50,000 100,000
Maintenance 20,000 80,000 100,000
Total $90,000 $410,000 $500,000
Recently, Ajax bid on two different jobs. Job 1 involves a unique product design, and it
requires 20 Direct Labor Hours of Design services and 20 Direct Labor Hours of
Manufacturing services. Job 2 involves a standard model, and it involves no Design
services. Job 2 only requires 20 Direct Labor Hours of Manufacturing services. Both
jobs require $200 of Direct Materials, and the Direct Labor Cost is $5 per Direct Labor
Hour. Ajax prices its products using a cost plus 20% profit margin method.

Even though Ajax's costs are no different than its competitors, the customer, who
received the Job 2 bid, asked Ajax to lower its bid stating that Ajaxs competitors
charged lower prices for similar work. On the other hand, the customer, who received
the Job 1 bid, did not hesitate to accept that bid.
Plant-Wide Application Rate
Ajaxs current Plant-Wide Application Rate is calculated as follows:
$500,000 / 100,000 = $5 per Direct Labor Hour
Using this application rate resulted in the following Manufacturing Overhead cost
calculation for Jobs 1 and 2:
Job 1: 40 hours x $5 per DLH = $200.

Job 2: 20 hours x $5 per DLH = $100.
Using these costs, Ajax bid the two jobs as follows:
Job 1 Job 2
Direct Materials $200 $200
Direct Labor $200 $100
Manufacturing Overhead $200 $100
Total Cost $600 $400
Profit $120 $80
Price Bid $720 $480
Departmental Application Rates
If Ajax were to use separate Departmental Application Rates, the following rates would
be used:
Design Department: $90,000/10,000 = $9.00 per DLH

Manufacturing Department: $410,000/90,000 = $4.55 per DLH
If Ajax had used Departmental Application Rates to calculate the Manufacturing

Overhead costs of Jobs 1 and 2 the following costs would have resulted:
Job 1 Job 2
Design Department 20 hours x $9 = $180
Manufacturing Department 20 hours x $4.55 = $91 20 hours x $4.55 = $91
Total Overhead $271 $91

If Ajax had used these Manufacturing Overhead costs, the two jobs would have been
priced as follows:
Job 1 Job 2
Direct Materials $200.00 $200.00
Direct Labor $200.00 $100.00
Manufacturing Overhead $271.00 $91.00
Total Cost $671.00 $391.00
Profit $134.20 $78.20
Price Bid $805.20 $469.20
Comparison
As you can see, when compared to Departmental Application Rates, the use of a Plant-
Wide Application Rate produces a lower bid for Job 1 and a higher bid for Job 2:
Job 1 Job 2
Plant-Wide Rate $720.00 $480.00
Departmental Rates $805.20 $469.20
Difference -$85.20 $10.80
Assuming that Ajaxs competitor uses Departmental Application Rates, you can see why
the competitor was able to offer a cheaper bid for Job 2.
The reason why these differences exist can be seen by comparing the Plant-Wide
Application Rate with the Departmental Application Rates:
Plant-Wide Rate $5.00

Design Department Rate $9.00
Manufacturing Department Rate $4.55
The Design services use a great deal of Manufacturing Overhead. When you use a
Plant-Wide Application Rate, the Design overhead costs are spread over all of the units
being produced. When Departmental Application Rates are used, then the
Manufacturing Overhead associated with the Design services are borne by only those
units that require Design services. This treatment results in the units accurately
reflecting the Manufacturing Overhead costs incurred to produce them.

Activity-Based Costing
With Activity-Based Costing (ABC), you divide

your Manufacturing Overhead into different cost
pools based upon the different activities within
the plant. These activities are not sub-divisions of
a department. Activities can span more than one
department. For example, CSULBs College of
Business is divided into five departments,
Accounting, Finance, Marketing, Management
and Information Systems, but the College could
be divided into activities of such as lecturing,
computer lab usage, copying, word processing,
counseling, and office hours. These activities
transcend multiple departments.
In a manufacturing operation, you might have the following activities:
Perform Engineering Work;

Plan Production;
Purchase Materials;
Receive and Handle Materials;
Manage Production;
Setup Machinery;
Store Final Product; and
Ship Final Product.
With ABC, you will calculate a Predetermined Application Rate for each activity, and
apply it to your products, activity by activity, using appropriate Cost Drivers.
A major disadvantage of ABC is that it requires more work to implement, maintain and
use. The initial analysis of a firms activities and the costs associated with those
activities is extensive, and this analysis must be updated in order to maintain the
accuracy of the ABC system. Moreover, the record keeping necessary to use an ABC
system is greater than other systems because of the increase in the number of Cost
Drivers employed.
Another problem that is commonly reported when implementing ABC is institutional

resistance. While managers are familiar with applying Manufacturing Overhead based
upon common drivers (e.g., Direct Labor Hours or Cost) because of its widespread use;
these managers have no experience with ABC. Internal personnel may have trouble
understanding or adapting to ABC. Similar problems may be experienced with outside
personnel, who use your reported costs (e.g., regulatory bodies that approve rate hikes,
or government bodies that are purchasing products at prices based on costs). Firms
may find that it is easier to use a more traditional technique for applying Manufacturing
Overhead rather than educating these managers as to the need for ABC.

An advantage of ABC is that it that the detailed cost calculations and analysis provide
businesses with important information regarding how costs are incurred. This
information provides insight into how costs can be controlled. For example, an analysis
of activities might identify the fact that your firm spends a great deal of money on
Material Handling, which uses the number of parts as its Cost Driver. With this
information, you may discover that you can reduce your Material Handling Costs by
reengineering your product to have less parts. Making management decisions based
upon ABC data is called Activity-Based Management (also called Activity Based Cost
Management).
Direct Labor Costs may also be incorporated into the ABC system by including
production activities (e.g., assembly and finishing) within the list of activities. When
Direct Labor and Manufacturing Overhead Costs are combined they are referred to as
Conversion Costs. The thought is that these costs convert Direct Materials into the
finished product.
ABC can also be used to determine the allocation of non-manufacturing costs (e.g.,
selling, general and administrative expenses). This is not GAAP, however, and such
financial information is for internal use only.
ABC Example
Lutz, Inc. produces three products: Quality, Superior, and Superb. The Lutz cost
accounting system applied Conversion Costs using a Plant-Wide Application Rate using
Direct Labor Hours as the Cost Driver. Lutz is thinking of employing an ABC system for
Conversion Costs.
Lutz concluded that its plant had six activities with the following Cost Drivers and costs
budgeted for the upcoming year:
Activity Area Budgeted Costs Cost Driver

Material Handling $ 258,400 Number of parts
Production Scheduling 114,000 Number of prod. orders
Setups 160,000 Number of prod. setups
Machinery Cost & Maintenance 3,510,000 Machine hours
Finishing 1,092,000 Direct Labor Hours
Packaging & Shipping 190,000 Number of orders shipped
Total $5,324,400

The following information summarizes Lutz projections of the Cost Drivers listed above
down by product type.
Cost Driver Quality Superior Superb

Units to be produced 10,000 5,000 800
Number of parts per unit 30 50 120
Production orders 300 70 200
Production setups 100 50 50
Machine hours per unit 7 7 15
Direct Labor Hours per unit 2 5 12
Orders shipped 1,000 2,000 800
It is estimated that there will be 54,600 Direct Labor Hours in the upcoming year.
Calculation of Application Rates
Using this information, you can calculate the Predetermined Application Rates for each
activity:
Activity Calculation Application Rate

Material Handling $258,400 / [(30 x10,000)+(50 x 5,000)+(120 x 800)] 40 / part
Prod. Scheduling $114,000 / [300 + 70 + 200] $200 / prod order
Setups $160,000 / [100 + 50 + 50] $800 / prod setup
Machinery $3,510,000 / [(7 x 10,000) + (7 x 5,000) + 15(800)] $30 / mach hour
Finishing $1,092,000 / [(2 x 10,000)+(5 x 5,000) + (12 x 800)] $20 / DLH
Packng & Shipng $190,000 / [1,000+2,000+800] $50 per order shpd
The more traditional, Plant-Wide Application Rate for Conversion Costs using Direct
Labor Hours as the Cost Driver would be calculated as follows:
Estimated Overhead $5,324,400

= = $97.52 (rounded)
Estimated DLHs 54,600
Application of Conversion Costs
Let us calculate the budgeted Conversion Cost for the budgeted production described
above. Because activities can represent batch costs (costs incurred in the production
of products in groups) and product costs (cost incurred at the product line level) as
opposed to unit-level costs, it is best to calculate the total Conversion Cost for the entire
product line and then divide that total by the budgeted production level in order to get a
Conversion Cost per unit.

Activity Quality Superior Superb

Mat Hand ((30 x 10,000) x .40) $120,000 (50 x 5,000) x $.40) $100,000 ((120 x 800) x $.40) $38,400
Prod Sch (300 x $200) 60,000 (70 x $200) 14,000 (200 x $200) 40,000
Setups (100 x $800) 80,000 (50 x $800) 40,000 (50 x $800) 40,000
Machinery ((7 x 10,000) x $30) 2,100,000 ((7 x 5,000) x $30) 1,050,000 ((15 x 800) x $30) 360,000
Finishing ((2 x 10,000) x $20) 400,000 ((5 x 5,000) x $20) 500,000 ((12 x 800) x $20) 192,000
Pck & Shp (1,000 x $50) 50,000 (2,000 x $50) 100,000 (800 x $50) 40,000
Ttl Conv. $2,810,000 $1,804,000 $710,400

Conv./Unit ($2,810,000/ 10,000) $281.00 ($1,804,000/ 5,000) $360.80 ($710,400/ 800) $888.00
If you compare Conversion Cost applied to each unit using ABC versus the Plant-Wide
Application Rate, you can see the results are different:
Quality Superior Superb

Plant-Wide (2 x $97.52) $195.04 (5 x $97.52) $487.60 (12 x $97.52) $1,170.24
ABC $281.00 $360.80 $888.00
Difference -$85.96 $126.80 $282.24
Assuming that ABC presents a more accurate Conversion Cost for each product, under
the traditional, Plant-Wide Application Rate, the Quality units are under-costed and the
Superior and Superb units are over-costed.
Real Life ABC Examples
Laporte Industries, Ltd.
Laporte Industries, Ltd., a British specialty chemicals and materials producer,

implemented ABC in one of its Divisions in the 1990s. The Division produced cleaning
chemicals for use in businesses where hygiene is important. The Divisions sales force
tended to focus on big-name customers, such as large food and drink producers, at the
expense of smaller ones, such as farmers. The prices charged to the larger customers
were higher than the prices charged to the smaller ones. The overhead allocation
system previously employed made the sales to the larger customers appear more
profitable than the sales to the smaller ones. After implementing ABC, the Division
realized that it was focusing on the wrong customers.
When overhead was accurately allocated using ABC, it turned out that the Operating
Profit margins on the smaller customer sales were actually higher than those on sales to
larger customers.
Smaller customers did not generate many overhead costs. These smaller customers
placed orders by telephone and required with little contact with the sales force. In
contrast, big-name customers required: (i) constant contact with the sales force, (ii) 24-
hour technical support, (iii) loans of equipment at no charge, and (iv) other concessions.

After implementing ABC, the awareness of actual costs led to a change in sales mixes
and prices bid. The Divisions Operating Profits increased as a result of these changes.
Mobil Oil
Mobils implementation of ABC at its US Lubricants Division in the early 1990s,

highlighted thousands of unprofitable product lines and an inefficient relationship with its
suppliers. As a result of this analysis, the Division reduced the number of its products
from around 12,000 to 5,000 within eight years of adopting ABC, and cut the number of
its suppliers from over 2,000 to around 500 in that same period. The Divisions after-tax
profit increased from zero to $150 million within that same eight-year period.
The Boeing Company
Although Boeing does not use ABC as part of its accounting system, it has
experimented with Activity Based Management (ABM). As noted above, ABM involves
the use of ABC data in management decisions. In 2000, Boeing tested ABM in two
operations at its Wichita plant.
One of the operations studied was Boeings Phase I preassembly chemical bath
operation. It found that:
Boeing incorrectly calculated the in-house cost of that operation at $7 per part.
As a result, Boeing outsourced that operation at a cost of $4 per part.
Boeing found that it could actually conduct some of those outsourced operations
in house at a cost of $3.50 per part.
Boeing identified additional costs that were associated with the outsourced
operation.
Boeings analysis of the activities that made up its Phase II structural bonding operation
highlighted the fact that rework orders were an important Cost Driver for Manufacturing
Overhead costs. An examination of the rework orders revealed that parts were being
unnecessarily reworked. By introducing standardized quality criteria, Boeing was able
to reduce the number of rework orders and thereby reduced its rework cost by 20%.

Questions
E-1. Jennifer Company has two products: A and B. The company uses Activity-Based
Costing. The estimated total cost and expected activity for each of the company's
three activity cost pools are as follows:
Estimated Expected Activity

Activity Cost Pool Cost Product A Product B Total
Activity 1................ $23,500 400 100 500
Activity 2................ $18,000 500 200 700
Activity 3................ $34,600 600 300 900
The activity rate under the Activity-Based Costing system for Activity 3 is closest
to:
A) $36.24.
B) $38.44.
C) $84.56.
D) $115.33.
E-2. Reach Consulting Corporation has its headquarters in Chicago and operates
from three branch offices in Portland, Dallas, and Miami. Reach's headquarter
activities are assigned to two activity cost pools: General Service and Research
Service. These costs are then allocated to the three branch offices. Information
for next year related to this Activity-Based Costing system is as follows:
Estimated
Activity Cost Pool Activity Measure Overhead Cost
General service......... % of time devoted to branch $700,000
Research service....... Computer time $140,000
Estimated branch data for next year is as follows:
% of time
devoted to
branch Computer Time
Portland 30% 200,000 minutes
Dallas 60% 150,000 minutes
Miami 10% 50,000 minutes
How much of the headquarters cost allocation should Dallas expect to receive
next year?
A) $280,000
B) $409,500
C) $472,500
D) $504,000

E-3. Matt Company uses Activity-Based Costing. The company has two products: A
and B. The annual production and sales of Product A is 8,000 units and of
Product B is 6,000 units. There are three activity cost pools, with estimated total
cost and expected activity as follows:
Estimated Expected Activity

Activity Cost Pool Cost Product A Product B Total
Activity 1................ $20,000 100 400 500
Activity 2................ $37,000 800 200 1,000
Activity 3................ $91,200 800 3,000 3,800
The cost per unit of Product A under Activity-Based Costing is closest to:
A) $2.40.
B) $3.90.
C) $10.59.
D) $6.60.
Use the following to answer questions E-4 through E-7:
Adelberg Company has two products: A and B. The annual production and sales of
Product A is 500 units and of Product B is 1,000 units. The company has traditionally
used Direct Labor Hours as the basis for applying all Manufacturing Overhead to
products. Product A requires 0.4 Direct Labor Hours per unit and Product B requires 0.2
Direct Labor Hours per unit. The total estimated overhead for next period is $68,756.
The company is considering switching to an Activity-Based Costing system for the

purpose of computing unit product costs for external reports. The new Activity-Based
Costing system would have three overhead activity cost pools--Activity 1, Activity 2, and
General Factory--with estimated overhead costs and expected activity as follows:
Estimated
Overhead Expected Activity
Activity Cost Pool Costs Product A Product B Total
Activity 1 ................ $31,031 1,000 300 1,300
Activity 2 ................ $22,249 1,600 300 1,900
General Factory....... $15,476 200 200 400
Total ........................ $68,756
(Note: The General Factory activity cost pool's costs are allocated on the basis of Direct
Labor Hours.)

E-4. The Predetermined Overhead Rate under the traditional costing system is
closest to:
A) $11.71.
B) $38.69.
C) $171.89.
D) $23.87.
E-5. The overhead cost per unit of Product B under the traditional costing system is
closest to:
A) $2.34.
B) $7.74.
C) $4.77.
D) $34.38.
E-6. The Predetermined Overhead Rate (i.e., activity rate) for Activity 2 under the
Activity-Based Costing system is closest to:
A) $13.91.
B) $11.71.
C) $74.16.
D) $36.19.
E-7. The overhead cost per unit of Product B under the Activity-Based Costing system
is closest to:
A) $45.84.
B) $7.74.
C) $34.38.
D) $18.41.
P-1. Refer to Chapter 5 P-1. Assume that the Manufacturing Overhead Variance of
$2,150 is material. What would be the journal entry to close out Manufacturing
Overhead at the end of the month?
Overhead at the end of the month? Also assume that the following accounts
contained the indicated amounts of Manufacturing Overhead applied during the
period in question:
Work In Process: $ 2,700

Finished Goods: 5,400
Cost of Goods Sold: 63,900

P-6. Rainbow, Inc. manufactures two wigs, the Yul Brynner model and Dolly Parton
model. Rainbow, Inc. manufactures wigs in two departments, Manufacturing and
Styling. The total Manufacturing Overhead costs for the two departments are
$200,000 for Manufacturing and $100,000 for the Styling department. It currently
applies Manufacturing Overhead using a Plant-Wide Application Rate using
number of units produced as the Cost Driver. King and I enthusiasts have asked
Rainbow to adopt Departmental Application Rates. They suggest that the Cost
Driver for the Manufacturing Department should be units produced, and Direct
Labor Hours should be the Cost Driver in the Styling Department. The following
information applies to the production of the two wigs:
Direct Labor Hours in Styling Number of Units

Yul Brynner: 10,000 5,000
Dolly Parton: 40,000 5,000
What would be the difference in the amount of Manufacturing Overhead allocated

using a Plant-Wide Application Rate and Departmental Allocation Rates?
P-7 Aloha Co. manufactures paint in two processes: Mixing and Cooking. Total costs
incurred in the Mixing and Cooking Departments are as follows:
Direct Materials Direct Labor

Mixing Department: $60,000 $80,000
Cooking Department: $25,000 $50,000
Manufacturing Overhead costs were $90,000 for the Mixing Department and
$180,000 for the Cooking Department. Aloha manufactures two products,
Superior Paint and Deluxe Paint.
Costs are allocated to these products in the following proportions:
Mixing Department Cooking Department
D. Materials D. Labor D. Materials D. Labor

Superior: 40% 70% 50% 40%
Deluxe: 60% 30% 50% 60%
All Products: 100% 100% 100% 100%

Manufacturing Overhead cost is allocated in proportion to the Direct Labor cost

within each department. What are the total costs allocated to each product line?
P-8. Specialty Products Inc. manufactures household items sold at trade shows. The
items, classified as either Trinkets or Widgets, are manufactured on a common
assembly line. Although different Direct Materials are used and the machinery is
retooled for each product, the direct laborers are the same for each product line.
The use of a Plant-Wide Overhead Rate is no longer acceptable. The production

manager has heard about Activity-Based Costing (ABC) and as assembled some
information for use in changing the cost system to an ABC system.
With the help of the accounting department, the manager has been able to
establish the following relationships between production costs and some
production data for the two product lines:
Activity Used In:

Activity Cost Driver App. Rate Trinkets Widgets
Material Handling: Number of Parts $2/ Part 700 500
Machining: Machine Hours $30/Mach.Hr. 200 100
Assembly: Units Started $3.20/Unit 600 700
Inspection: Number Tested $4/ Unit 200 600
Direct Costs:
Direct Labor: $24,000 $18,000
Direct Materials: 7,610 5,000
Determine the total production cost of each of the two product lines, and the cost
per unit, assuming that all of the units that were started were completed.

P-9. Alpha Radio Co. manufactures radios. The information below relates to the
operations of the St. Louis plant, which is the Alphas first plant to implement an
integrated Activity-Based Costing system. The data in the table are for Job #200.
App. Driver OH
Activity Cost Allocation Driver Rate Quantity Applied
Initialize Job No. of Radio Shells $4 A $8
Radio Insertion No. of Radio Parts Inserted 30 110 B
Shell Insertion No. of Shell Parts Inserted C 64 $32
Control Knob No. of Control Knobs Inserted D 30 $36
Parts Soldered No. of Boards Soldered $9 E $18
Back Connections No. of Contacts Inserted F 16 $30.40
Quality Review Budgeted Time Radio is Tested $30 1.5 G
What are the correct answers for the unknowns?
What is the amount of Manufacturing Overhead cost allocated to Job 200?
P-10. Stewart Marketing Inc. manufactures two products, A and B. Presently, the
company uses a single Plant-Wide Application Rate for allocating Manufacturing
Overhead to products. However management is considering moving to a
multiple department rate system for allocating overhead.
Direct Labor Hours/Product

Overhead Direct Labor Hours A B
Painting Dept. $248,000 10,000 DLH 16 DLH 4 DLH
Finishing Dept. $72,000 10,000 DLH 4 DLH 16 DLH
Total $320,000 20,000 DLH 20 DLH 20 DLH
a. From the preceding information, determine the application rate in the

Painting Department if the company uses a multiple department rate
system.
b. From the preceding information, determine the application rate in the

Finishing Department if the company uses a multiple department rate
system.
c. From the preceding information, determine the Manufacturing Overhead

from both production departments allocated to each unit of Product A if the
company uses a multiple department rate system.
d. From the preceding information, determine the Manufacturing Overhead

from both production departments allocated to each unit of Product B if the
company uses a multiple department rate system.

P-11. Phelan Systems Corporation is estimating activity costs associated with

producing disk drives, tape drives, and wires drives. The Indirect Labor can be
traced to four separate activity pools. The budgeted activity cost and activity
base information, along with the estimated activity-base information, is provided
below.
Activity Activity Cost Activity Base

Procurement $360,000 Number of purchase orders
Scheduling $240,000 Number of production orders
Materials handling $480,000 Number of moves
Product development $720,000 Number of engineering changes
Production $1,420,000 Machine hours
No. of No. of No. of

Purchase Production No. of Engineering Machine No. of
Product Orders Orders Moves Changes Hours Units
Disk Drives 4,000 300 1400 10 2,000 2,000
Tape Drives 2,000 150 600 5 8,000 4,000
Wire Drives 12,000 800 4000 25 10,000 2,500
a. Determine the activity rate for procurement.

b. Determine the activity rate for scheduling.
c. Determine the activity rate for materials handling.
d. Determine the activity rate for product development.
e. Determine the activity rate for production.
f. Determine the activity-based cost for each disk drive unit.
g. Determine the activity-based cost for each tape drive unit.
h. Determine the activity-based cost for each wire drive unit.
i. Assume that Phelan uses the traditional approach (using Machine Hours
as the driver). What are the differences in cost of each product using
Activity Based Costing and the traditional approach?
Solutions
E-1. The correct answer is B. To calculate the activity rate for activity 3, you would
divide:
Estimated Cost / Estimated Driver

$34,600 / 900
$38.44

E-2. C is correct. You dont have to do this with this problem, but I like to calculate an
activity rate (application rate) for each activity:
Activity Cost Driver Information

Portland Dallas Miami Total
General Service $700,000 30% 60% 10% 100%
Research Service $140,000 200K mins 150K mins 50K mins 400K mins
General Service = $7,000 per percentage point ($700,000/100%).

Research Service = 35 cents per minute ($140,000/ 400,000).
Dallas would receive:
Activity Cost Allocated to Dallas

General Service $420,000 $7,000 x 60(% points)
Research Service 52,500 .35 x 150,000
Total Cost $472,500
E-3. D is correct. First, calculate an activity rate (application rate) for each activity:

A B Total
Activity 1 $20,000 100 400 500
Activity 2 $37,000 800 200 1000
Activity 3 $91,200 800 3000 3800
Activity 1 = $40 per driver unit ($20,000/500).

Activity 2 = $37 per driver unit ($37,000/1,000).
Activity 3 = $24 per driver unit ($91,200/3800).
Product A would receive:
Activity Cost Allocated to Product A

Activity 1 $4,000 $40 x 100
Activity 2 $29,600 $37 x 800
Activity 3 19,200 $24 x 800
Total Cost $52,800
The cost per unit of Product A is $6.60 ($52,800/8,000).

E-4. C is correct. The traditional approach would have a single plant-wide

predetermined application rate. The rate is calculated as follows:
Estimated Overhead/ Estimated Driver
You are told that the estimated overhead is $68,756 and that the driver for
General Factory is direct labor hours.
$68,756/400 = $171.89
E-5. D is correct. You are told that Product B take .2 direct labor hours per unit. So,
you would calculate the overhead cost per unit as follows:
.2 x $171.89 = $34.378
E-6. B is correct. First, calculate an activity rate (application rate) for each activity:

A B Total
Activity 1 $31,031 1000 300 1300
Activity 2 $22,249 1600 300 1900
General Factory $15,476 200 200 400
Activity 1 = $23.87 per driver unit ($31,031/1300).

Activity 2 = $11.71 per driver unit ($22,249/1900).
General Factory = $38.69 per driver unit ($15,476/400).
E-7. D is correct. Product B would receive:
Activity Cost Allocated to Product B

Activity 1 $7,161 $23.87 x 300
Activity 2 $3,513 $11.71 x 300
Activity 3 7,738 $38.69 x 200
Total Cost $18,412
The cost per unit of Product B is $18.41 ($18,412/1,000).

P-1. Because this variance is material, you have to close it out to Work In Process,
Finished Goods and Cost of Goods Sold.
One way to so allocate the Manufacturing Overhead Variance is to use the

relative ending balances of the three accounts:

Cost of Goods Sold : 665,000
Total of Three Accounts: $715,000
Work In Process = 30,000/715,000 = 4.196%

Finished Goods = 20,000/715,000 = 2.797%
Cost of Goods Sold = 665,000/715,000 = 93.007%
D. Manufacturing Overhead $2,150

Cr. Work In Process $ 90
Finished Goods 60
Cost of Goods Sold 2,000
P-2. Because the Manufacturing Overhead Variance is material, we will close out the
Manufacturing Overhead account to Work In Process, Finished Goods and Cost
of Goods Sold. We will use the relative amount of applied Manufacturing
Overhead appearing in each account.

Work In Process = 2,700/72,000 = 3.75%

Finished Goods = 5,400/72,000 = 7.5%
D. Work In Process $300

Finished Goods 600
Cr. Manufacturing Overhead $8,000

P-3. Because the Manufacturing Overhead Variance is material, we will allocate the
variance to the three accounts using their ending balances:

Work In Process = 32,000/314,000 = 10.2%

Finished Goods = 57,000/314,000 = 18.2%

Finished Goods 364
Cost of Goods Sold 1432
variance to the three accounts using their ending balances. Here, we have not
been given the ending balances of Work In Process, Finished Goods and Cost of
Goods Sold.
We already know that Cost of Goods Sold is $137,000., but we must calculate
the ending balances of Work In Process and Finished Goods Inventory:
WORK IN PROCESS
12,000 (Beginning Balance) 160,000 (Completed Production)
48,000 (Direct Materials)
86,000 (Direct Labor)
60,200 (Manufacturing Overhead)
46,200
FINISHED GOODS
22,000 (Beginning Balance) 137,000 (Cost of Goods Sold)
160,000 (From Work In Process)
45,000
Work In Process = 46,200 / 228,200 = 20.245%

Finished Goods = 45,000 / 228,200 = 19.720%
Cost of Goods Sold = 137,000 / 228,200 = 60.040%

D. Work In Process $1984

Finished Goods 1933
Cost of Goods Sold 5883
Cr. Manufacturing Overhead $9800
variance to the three accounts using their ending balances:

Cost of Goods Sold: 171,600
Work In Process = 23,000 / 236,600 = 9.72%

Finished Goods = 42,000 / 236,600 = 17.75%
Cost of Goods Sold = 171,600 / 236,600 = 72.53%

Finished Goods 1,615
P-6. Plant-Wide
Plant-Wide Application Rate: $300,000/10,000 wigs = $30 per wig.
By Department
Departmental Application Rates:
Manufacturing Department $200,000/10,000 = $20

Styling Department $100,000/50,000 = $2
Amount Allocated To Each Wig:
Yul Brynner Manufacturing $20 x 5,000 = $100,000

Styling $2 x 10,000 = 20,000
Total $120,000 ($24 per unit)
Dolly Parton Manufacturing $20 x 5,000 = $100,000
Styling $2 x 40,000 = 80,000
Total $180,000 ($36 per unit)

P-7
Superior Deluxe
Direct Materials - Mixing ($60,000x.4) $24,000 ($60,000x.6) $36,000
Direct Labor - Mixing ($80,000x.7) $56,000 ($80,000x.3) $24,000
Direct Materials - Cooking ($25,000x.5) $12,500 ($25,000x.5) $12,500
Direct Labor - Cooking ($50,000x.4) $20,000 ($50,000x.6) $30,000
Overhead - Mixing ($90,000x.7) $63,000 ($90,000x.3) $27,000
Overhead - Cooking ($180,000x.4) $72,000 ($180,000x.6) $108,000
Total Cost $247,500 $237,500
P-8
Trinkets Widgets
Direct Materials: $24,000 $18,000
Direct Labor: 7,610 5,000
Overhead:
Mat. Handling: ($2x700) 1,400 ($2x500) 1,000
Machining: ($30x200) 6,000 ($30x100) 3,000
Assembly: ($3.20x600) 1,920 ($3.20x700) 2,240
Inspection: ($4x200) 800 ($4x600) 2,400
$41,730 $31,640
Units: 600 700
Per Unit Cost: $69.55 $45.20
P-9. The Unknowns:
A $4 x A = $8 A = $8/$4 2 Radio Shells

B 30 x 110 = B $33
C C x 64 = $32 C = $32/64 50
D D x 30 = $36 D = $36/30 $1.20
E $9 x E = $18 E = $18/$9 2 Boards
F F x 16 = $30.40 F = $30.40/16 $1.90
G $30 x 1.5 = G $45

Job 200 Manufacturing Overhead Allocation:
Activity OH Allocation
Initialize Job $8.00
Radio Insertion $33.00
Shell Insertion $32.00
Control Knob $36.00
Parts Soldered $18.00
Back Connections $30.40
Quality Review $45.00
OH Allocated $202.40
P-10.
(a) Painting Department: $248,000/10,000 = $24.80 per DLH.
(b) Finishing Department: $72,000/10,000 = $7.20 per DLH.
(c) Product A: [$24.80 x 16 = $396.80] + [$7.20 x 4 = $28.80] = $425.60 per
unit
(d) Product B: [$24.80 x 4 = $99.20] + [$7.20 x 16 = $115.20] = $214.40 per
unit
P-11
(a) Procurement: $360,000/(4,000+2,000+12,000)
= $360,000/18,000 = $20 per purchase order
(b) Scheduling: $240,000/(300+150+800)
= $240,000/1250 = $192 per production order
(c) Materials Handling: $480,000/(1,400+600+4,000)
= $480,000/6,000 = $80 per move
(d) Production Development: $720,000/(10+5+25)
= $720,000/40 = $18,000 per engineering change
(e) Production: $1,420,000/(2,000+8,000+10,000)
= $1,420,000/20,000 = $71 per machine hour
(f) Disk Drive Unit:
Procurement $20 x 4,000 $80,000

Scheduling $192 x 300 57,600
Materials Handling $80 x 1,400 112,000
Production Development $18,000 x 10 180,000
Production $71 x 2,000 142,000
$571,600
Units 2,000
Cost Per Unit $571,600/2,000 $285.80

(g) Tape Drive Unit:
Procurement $20 x 2,000 $40,000

Scheduling $192 x 150 28,800
Materials Handling $80 x 600 48,000
Production $71 x 8,000 568,000
$774,800
Units 4,000
Cost Per Unit $774,800/4,000 $193.70
(h) Wire Drive Unit:
Procurement $20 x 12,000 $240,000

Scheduling $192 x 800 153,600
Materials Handling $80 x 4,000 320,000
Production $71 x 10,000 710,000
$1,873,600
Units 2,500
Cost Per Unit $1,873,600/2,500 $749.44
(i) Traditional Approach:
Take Total Overhead Costs:
Activity Cost
$360,000
$240,000
$480,000
$720,000
$1,420,000
$3,220,000
Pick Appropriate Driver (Assume Machine Hours): 20,000 Total Machine

Hours
Calculate Predetermined Overhead Rate:
$3,220,000/20,000 = $161.00

Cost of Each Product:
O/H Rate Cost of Total Cost / Unit

X Driver Product Line Number of Units Cost
Disk Drives $161 x 2,000 $322,000 $322,000/2,000 $161
Tape Drives $161 x 8,000 $1,288,000 $1,288,000/4,000 $322
Wire Drives $161 x 10,000 $1,610,000 $1,610,000/2,500 $644
Traditional Cost ABC Cost Difference

Disk Drives $161 $285.80 -$124.80
Tape Drives $322 $193.70 $128.30
Wire Drives $644 $749.44 -$105.44

ABC Oh Costs

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Activity Based Costing Page 1

Manufacturing Overhead Variance

In Chapter 5, we saw that if Manufacturing Overhead was over-applied or under-

If the Manufacturing Overhead Variance is material, then the variance should be

Please send comments and corrections to me at mconstas@csulb.edu

For example, assume that Madonna, Inc.

Assuming that there is a material variance where Manufacturing Overhead is under-

D. Cost of Goods Sold $ XXX

Assuming that there is a material variance where Manufacturing Overhead is over-

D. Manufacturing Overhead $ XXX

Please send comments and corrections to me at mconstas@csulb.edu

As we mentioned in Chapter 5, in a manufacturing situation, there are three

In Chapter 5, we used a single, Predetermined Overhead Rate to allocate the

Please send comments and corrections to me at mconstas@csulb.edu

manufacture of a part or product because it wrongly believes that it is cheaper to

Department Allocations of Overhead

You calculate a separate Predetermined Overhead Rate for each departments

Departmental Application Rate Example

Ajax Inc. produces standard model trophies, as well as, custom

The Manufacturing Overhead for the plant is as follows:

Indirect Costs Design Manufacturing Total

Please send comments and corrections to me at mconstas@csulb.edu

Plant-Wide Application Rate

Ajaxs current Plant-Wide Application Rate is calculated as follows:

$500,000 / 100,000 = $5 per Direct Labor Hour

Job 1: 40 hours x $5 per DLH = $200.

Using these costs, Ajax bid the two jobs as follows:

Departmental Application Rates

Design Department: $90,000/10,000 = $9.00 per DLH

If Ajax had used Departmental Application Rates to calculate the Manufacturing

Please send comments and corrections to me at mconstas@csulb.edu

Plant-Wide Rate $5.00

Please send comments and corrections to me at mconstas@csulb.edu

With Activity-Based Costing (ABC), you divide

In a manufacturing operation, you might have the following activities:

Perform Engineering Work;

Another problem that is commonly reported when implementing ABC is institutional

Please send comments and corrections to me at mconstas@csulb.edu

Activity Area Budgeted Costs Cost Driver

Please send comments and corrections to me at mconstas@csulb.edu

Cost Driver Quality Superior Superb

Calculation of Application Rates

Activity Calculation Application Rate

Estimated Overhead $5,324,400

Application of Conversion Costs

Please send comments and corrections to me at mconstas@csulb.edu

Activity Quality Superior Superb

Ttl Conv. $2,810,000 $1,804,000 $710,400

Quality Superior Superb

Real Life ABC Examples

Laporte Industries, Ltd.

Laporte Industries, Ltd., a British specialty chemicals and materials producer,

Please send comments and corrections to me at mconstas@csulb.edu

Mobils implementation of ABC at its US Lubricants Division in the early 1990s,

The Boeing Company

Please send comments and corrections to me at mconstas@csulb.edu

Estimated Expected Activity

Estimated branch data for next year is as follows:

Please send comments and corrections to me at mconstas@csulb.edu

Estimated Expected Activity

Use the following to answer questions E-4 through E-7:

The company is considering switching to an Activity-Based Costing system for the

Please send comments and corrections to me at mconstas@csulb.edu

Work In Process: $ 2,700