Activity Based Costing

Activity-Based
Costing Systems
McGrawHill/Irwin The McGrawHill Companies, Inc. 2006
4-2
Traditional Costing Systems
Traditional
Traditional cost
cost systems
systems were
were created
created when
when
manufacturing
manufacturing processes
processes were
were labor
labor intensive.
intensive.
A
Asingle
single company-wide
company-wide overhead
overhead rate,
rate,
based
based on on direct
direct labor
labor hours,
hours, may
may be
be
used
used to to allocate
allocate overhead
overhead toto products
products
in
in these
these labor
labor intensive
intensive processes.
processes.
4-3
Job 1 Job 2
Labor Hours 2 6
Overhead
Overheadisisallocated
allocated toto jobs
jobsusing
usingdirect
direct
labor
laborhours.
hours. IfIf overhead
overheadis is$120,
$120, how
howmuch
much
overhead
overheadis isallocated
allocatedto toeach
eachjob?
job?
4-4
Job 1 Job 2
Labor Hours 2 6
Overhead
$ 30 $ 90
Allocation
Overhead Rate = $120 ÷ 8 direct labor hours

Overhead Rate = $15 per direct labor hour
Job 1 = 2 hours × $15 per hour = $30

4-5
Automation increases
overhead from $120 to $420
and reduces the Job 2 labor
hours from 6 to 1. Allocate
the $420 overhead to the
two jobs using direct labor.
4-6
Automation
o Robots
Robots
o Computer-aided
Computer-aided design
design (CAD)
(CAD)
o Computer-aided
Computer-aided manufacturing
manufacturing (CAM)
(CAM)
4-7
Job 1 Job 2
Labor Hours 2 1
Overhead
$ 280 $ 140
Allocation
Overhead Rate = $420 ÷ 3 direct labor hours

Overhead Rate = $140 per direct labor hour

Job 2 = 1 hour × $140 per hour = $140
4-8
Job 1 Job 2
Labor Hours 2 1
Overhead
$ 280 $ 140
Allocation
Is this reasonable?
Automation benefited Job 2, but Job 1 is
allocated more overhead. Clearly, we need
another cost driver to allocate overhead.
4-9
Single Plant-wide Overhead Rate
Dole Company has two factories Alpha and Beta. Alpha

is a highly automated factory while Beta is a labor-
intensive factory. The company uses a single plant-wide
overhead rate based upon labor hours.
Alpha Beta
Annual Budget Data Division Division Total
Budgeted overhead $ 400,000 $ 200,000 $ 600,000
Budgeted labor hours 10,000 50,000 60,000
Budgeted machine hours 20,000 40,000 24,000
Single Plant-wide $600,000

= = $10 per labor hour
Overhead Rate 60,000
4-10
During the first month of operations the company has the

following information for it two products Widget and Gidget
Alpha
Alpha Beta
Beta
Division
Division Division
Division
Widget:
Widget:
Labor
Labor hours
hours 500
500 4,000
4,000
Machine
Machine hours
hours 800
800 200
200
Gidget:
Gidget:
Labor
Labor hours
hours 500
500 1,000
1,000
Machine
Machine hours
hours 1,200
1,200 400
400
4-11
Using the plant-wide rate, factory overhead is applied to the

two products as shown below.
Widget Gidget
Alpha:
$10 x 500 $ 5,000
$10 x 500 $ 5,000
Beta:
$10 x 4,000 40,000
$10 x 1,000 10,000
Overhead applied $ 45,000 $ 15,000
4-12
Departmental Overhead Rates
To obtain more accurate product costing the company

decided to use departmental overhead rates. The overhead
in Alpha is to based on machine hours, and Beta will use
labor hours.
Alpha’s Departmental $400,000

= = $20 per machine hour
Beta’s Departmental $200,000

= = $4 per labor hour
4-13
Departmental Overhead Rates
4-16
Limitations of Traditional
Costing Systems
A departmental rate
provides more detailed cost
measures, particularly if
the departments perform
quite different activities.
4-17
Limitations of Traditional
Costing Systems
I need to know more about
activity-based costing before I
make my decision. It looks like
my decision will be based on a
careful cost-benefit analysis.
4-18
Activity-Based Costing
Direc
t l a bo
ABC r hou
ABC is
is aa costing
costing rs
Mac
approach
approach that
that hin
eh
our
assigns
assigns costs
costs to
to z e s
Lot si
products
products oror services
services f s e t ups
b e r o
based Nu m
based onon their
their
Numb
consumption
consumption of of the
the engine er of
ering
resource
resource caused
caused by by Num
hours
the ber
the activities.
activities. of la
yers
4-19
s
D i r ect Proces
labor setups
hours
Mac
hine
hou
rs
4-20
Activity-Based Costing (ABC)
AA costing
costing method
method that
that first
first assigns
assigns costs
costs to
to
activities,
activities, then
then assigns
assigns costs
costs to to products
products based
based
on
on their
their use
use of
of the
the activities.
activities.
Products Activities
Require Consume
Activities Resources
People
Manage
Activities
4-21
Both
Both manufacturing
manufacturing ABC
ABC isis aa good
good
and
and nonmanufacturing
nonmanufacturing supplement
supplement
costs
costs may
may be
be to
to our
our traditional
traditional
assigned
assigned to
to cost
cost system.
system.
products.
products.
A
Allocation
Allocation bases
differ
bases often
differ from
from
often B C for
ABC
ABC is is used
for decision
used primarily
primarily
decision making,
making, not
not
traditional
traditional costing
costing for
for inventory
inventory valuation
valuation
systems.
systems. for
for external
external reporting.
reporting.
4-24

Traditional Costing Activity-Based Costing
Resource Costs Resource Costs
Directly traced Directly traced

or allocated or allocated
Cost Pools: Cost Pools:

Plants or Activities or
Departments Activity Centers
Predetermined Cost driver

overhead rates for
rate each activity
Cost Objects Cost Objects
4-25
Costs
An Activity Cost
Pool is a $$
“container” in $
which costs are $ $
accumulated $
that relate to a
single activity in
the ABC system.
4-26
When Is an Activity-Based Costing

System Needed?
ABC should be implemented when . . .
 the cost of measuring the activities and their costs
is reduced, perhaps because of computerized
scheduling systems on the production floor.
 stronger competition increases the cost of errors
caused by erroneous pricing.
 product diversity is high in volume, size, or
complexity.
4-27
Four Steps in the ABC Process

 Identify
Identify and
and classify
classify the
the activities
activities
related
related to
to the
the company’s
company’s
products
products oror services.
services.

 Estimate
Estimate the
the cost
cost of
of each
each activity
activity
identified
identified in
in .
.

 Calculate
Calculate aa cost-driver
cost-driver rate
rate for
for
each
each activity.
activity.

 Assign
Assign activity
activity costs
costs to
to products
products
using
using the
the cost-driver
cost-driver rate.
rate.
4-28
 Identify and Classify Activities

UNIT-LEVEL ACTIVITES
Resources acquired and activities performed for individual units.
BATCH-LEVEL ACTIVITES
Resources acquired and activities performed for a group or batch of
similar products or services.
PRODUCT - LEVEL ACTIVITES

Resources acquired and activities performed to produce and sell a
specific product or service.
CUSTOMER- LEVEL ACTIVITES

Resources acquired and activities performed to serve specific customers.
FACILITY-LEVEL ACTIVITIES
Resources acquired and activities performed to provide general capacity to
produce goods or services.
4-29
Categories of Activities
 Unit-level activity – An activity that is performed

for each unit of production (direct materials, direct
labor hours, inserting a component)
 Batch-level activity – An activity that is performed
for each batch of products rather than for each
unit of production (machine setup, purchase
ordering, production scheduling)
4-30
Categories of Activities
 Product-sustaining activity – An activity that is

performed to support the production of a given
product (product design, parts administration,
issuance of engineering change orders,
expediting)
 Facility-sustaining activity – An activity that is
performed to sustain the production of products in
general (security, safety, maintenance, plant
management)
4-31
and Management
Materials
Materials consumption
consumption
Direct
Direct labor
labor support
support
Machine operation
Machine operation
Identify
Identify these
these
Setup
Setup activities
activities asas unit,
unit,
Production
Production order
order batch,
batch, product
product oror
Materials
Materials handling
handling facility.
facility.
Parts
Parts administration
administration
General
General andand admin-
admin-
istrative
istrative
4-32
and Management
Materials
Materials consumption
consumption Unit
Direct
Direct labor
labor support
support Unit
Machine
Machine operation
operation Unit
Setup
Setup Batch
Production
Production order
order Batch
Materials
Materials handling
handling Batch
Parts
Parts administration
administration Product
General
General andand admin-
admin-
istrative
istrative Facility
4-33
 Identify and Classify Activities
TOP
TOPDOWN
DOWNAPPROACH
APPROACH
ABC
ABCteams
teamsofof middle-
middle-
management
managementor or above
above
develop
developthe
theactivity
activity
dictionary.
dictionary.
INTERVIEW
INTERVIEW OR
OR
RECYCLING
RECYCLING PARTICIPATIVE
PARTICIPATIVE
APPROACH
APPROACH APPROACH
APPROACH
Reuses
Reusesdocumentation
documentation ABC
ABCteams
teamsinclude
includeor
or
of
of processes
processesused
usedfor
for interview
interviewoperating
operating
other
otherpurposes.
purposes. employees.
employees.
4-34
 Estimate the Cost of Activities
The
TheABC
ABCteams
teamsshould
shouldgather
gatherdata
data on
on the
the costs
costsof
ofall
all
the
theactivities
activities identified
identified in
inStep
Step1.1.
Examine
Examine Ask
Askemployees
employees
accounting
accounting to
to indicate
indicatehow
how
records
recordsfor
for much
muchtime
time
recorded
recordedcost
cost they
theywork
workonon
information.
information. various
various
activities.
activities.
4-35
 Calculate Cost-Driver Rates for

Activities
Two
Twopieces
piecesofof
information
informationare are
required
requiredto tocompute
compute
the
thecost-driver
cost-driverrate:
rate:
••Activity
ActivityCost
Cost
••Activity
ActivityVolume
Volume
MAY
MAYCompany
Companyhas has44employees
employeesin inits
itsQuality
QualityControl
Control
Department.
Department.Salaries
Salariesand
andcosts
costs for
for the
thedepartment
department total
total
$360,000
$360,000per
peryear.
year. MAY
MAYproduces
produces500,000
500,000 units
units of
of
product
product aayear.
year. What
Whatis isthe
thecost-driver
cost-driver rate
rateper
perunit?
unit?
$360,000
$360,000÷÷500,000
500,000 units
units== $.72
$.72per
perunit
unit
4-36

Activities
MAY
MAYhas hasaacustomer
customer service
servicecenter
centerwhere
where
customers
customerscancan call
call to
to ask
askquestions.
questions.
Customers
Customerspaypayaafixed
fixedfee feefor
foreach
each call
call
they
theymake
maketoto the
theservice
servicecenter.
center.ItIt costs
costs
MAY
MAY$1,260,000
$1,260,000aa year
year to to operate
operatethe the
center.
center. The
Thecenter
center receives
receives120,000
120,000calls
calls
per
per year.
year. The
Thecenter
center handles
handles1,000,000
1,000,000
minutes
minutesof of calls.
calls.
What
Whatis
isthe
theappropriate
appropriatecost
cost driver;
driver;total
total
minutes
minutesfor
forall
all calls
callsor
ornumber
numberof of calls?
calls?
What
What isis the
thecost-driver
cost-driver rate?
rate?
4-37

Activities
Since
Sincecustomers
customersarearecharged
charged“per
“percall”,
call”,the
the
proper
proper activity
activityin
inthis
thiscase
caseis
isthe
thenumber
numberof of
calls
callshandled
handledby bythe
thecenter.
center.
The
Thecost-driver
cost-driver rate
ratewould
would be:
be:
$1,260,000
$1,260,000 ÷÷ 120,000
120,000 units
units==$10.50
$10.50per
per call
call
4-38

Activities
Cause and effect
relationship between Measurable
activity and costs
Appropriate
cost-driver
base
Based on resource’s Predict or explain
practical capacity to an activity’s use
support activities of resources
4-39
Practical Capacity Note
When
Whenestimating
estimatingthe the
cost EXAMPLE
EXAMPLE
cost of
of anan activity,
activity,
only
onlythethecosts
costs Suppose
Supposewe we rent
rentaa 1,000
1,000
associated
associatedwith withthe
the square
squarefootfoot warehouse
warehousefor for
product
productshould
shouldbe be $1,000
$1,000perpermonth.
month. Only
Only800800
used
used (practical
(practical sq.
sq.ft.
ft.are
are used
used to
to store
store
capacity).
capacity). TheThecost
cost Product
ProductA. A. The
Therest
restofofthe
the
of
of“unused
“unusedcapacity”
capacity” warehouse
warehouseis is“unused”.
“unused”.
should
shouldnot not be
be How
Howmuch
muchrentrentcost
costshould
shouldbe be
applied
appliedto to products.
products. allocated
allocatedto toProduct
ProductA? A?
4-40
Practical Capacity Note
80%, or $800 20%, or $200 should

should be assigned be assigned to
to Product A “unused capacity”
4-41
 Assign Activity Costs to Products
1.
1.Identify
Identifyall
all 2.
2.Determine
Determine 3.
3.Assign
Assign costs
costs
the
theactivities
activities how
howmany
many to
to products
products
related
relatedtotoaa units
units of
of each
each using
using the
thecost-
cost-
given
givenproduct
product activity
activityare
are driver
driverrates
ratesfor
for
or
orservice.
service. used
used per
per unit
unit each
eachactivity.
activity.
of
of product.
product.
4-42
Activity Driver
Materials purchasing Material cost
Direct labor support Direct labor cost
Machine operation Machine hours
Setup Setup hours
Production hour Number of orders
Material handling Number of loads
Part administration Number of parts
General and administrative Amount of value-added
4-43
Example: Yazz, Inc. produces 130,000 units of Product A

and 400,000 units for Product B. Using the following
cost information, how much overhead should be
allocated to Product A?
4-44
4-45
Comparison of Traditional and

Activity-Based Systems
Northern High-Tech, Inc.
4-46
Northern High-Tech provides the following
information about the two products it sells.
Deluxe Regular
Production volume 5,000 15,000
25,000 + 75,000 = 100,000
Selling price $400 $200
Unit direct material and
labor costs $200 $80
Direct labor-hours 25,000 75,000
Budgeted
Overhead Rate Cost Pool Activity Driver
Engineering $ 125,000 Engineering hours
$2,000,000
Setups 300,000 Number of setups
100,000 = $20 DLH Machine running 1,500,000 Machine-hours
Packing 75,000 Number of packing orders
$ 2,000,000
4-47
Northern High-Tech provides the following
information about the two products it sells.
Deluxe Regular
Production volume 5,000 15,000
Selling price $400 $200
Unit direct material and Deluxe Model
Model
Regular Model
Model
labor costs $200 $80×× 25,000 = $500,000
$20
$20 $500,000 total
total overhead
overhead
$20
$20 × 75,000 == $1,500,000
$1,500,000 total
total overhead
overhead
Direct labor-hours
$1,500,000 25,000 75,000
$500,000
$500,000 ÷÷ 5,000
5,000 units
units == $100 per unit
$1,500,000 ÷ 15,000
15,000 units
units == $100
$100 per unit
Budgeted
Cost Pool Activity Driver
Engineering $ 125,000 Engineering hours
Setups 300,000 Number of setups
Machine running 1,500,000 Machine-hours
Packing 75,000 Number of packing orders
$ 2,000,000
4-48
Here are the actual activity units or
transactions for both products:
Activity Comsumption
Activity Driver Deluxe Regular Total
Engineering hours 5,000 7,500 12,500
Number of setups 200 100 300
Machine-hours 50,000 100,000 150,000
Number of packing orders 5,000 10,000 15,000
4-49
Calculate the activity rate for each activity cost driver.
Activity-Based Costing Analysis
Activity Activity
Activity Driver Cost Comsumption Rate
Engineering hours $ 125,000 12,500 $ 10
Number of setups 300,000 300 1,000
Machine-hours 1,500,000 150,000 10
Number of packing orders 75,000 15,000 5
$125,000 ÷ 12,500 = $10 per engineering hour
4-50
Deluxe Model
Number of
Activity Driver Activity Rate Activities Total OH Unit OH
Engineering hours $ 10 5,000 $ 50,000 $ 10
Number of setups 1,000 200 200,000 40
Machine-hours 10 50,000 500,000 100
Number of packing orders 5 5,000 25,000 5
Production volume = 5,000 units $ 775,000 $ 155
$50,000 ÷ 5,000 = $10 per unit
4-51
Regular Model
Number of
Activity Driver Activity Rate Activities Total OH Unit OH
Engineering hours $ 10 7,500 $ 75,000 $ 5.00
Number of setups 1,000 100 100,000 6.67
Machine-hours 10 100,000 1,000,000 66.67
Number of packing orders 5 10,000 50,000 3.33
Production volume = 15,000 units $ 1,225,000 $ 81.67
$75,000 ÷ 15,000 = $5.00 per unit
Product Profitability
4-52
Deluxe Regular
Unit selling price $ 400 $ 200
Unit production costs:
Direct material and labor 200 80
Factory overhead 100 100
Cost per unit 300 180
Product margin $ 100 $ 20
Product Profitability
4-53
Deluxe Regular
Unit selling price $ 400.00 $ 200.00
Unit production costs:
Direct material and labor 200.00 80.00
Factory overhead 155.00 81.67
Cost per unit 355.00 161.67
Product margin $ 45.00 $ 38.33
Total overhead of $275,000 would be shifted from the

Regular to the Deluxe Model when using activity-based
costs in this case. This shifting accounts for the change
in product margins.
4-54
Activity-Based Costing Example
Let’s look at an
example from the
Bilson Company.
4-55
 Bilson,
Bilson, Inc.
Inc.manufactures
manufacturesandandsells
sells5,000
5,000units
unitsof
of
Product
ProductAA(deluxe
(deluxe model),
model), and
and25,000
25,000units
unitsof
of Product
Product BB
(standard
(standardmodel)
model)each
eachyear.
year.
 Product
ProductAArequires
requires3.0
3.0DLH
DLHandandProduct
Product BBrequires
requires2.5
2.5
DLH
DLHtotoproduce.
produce.
 Employing
Employingaatraditional
traditional costing
costingsystem,
system,Bilson
Bilsonassigns
assigns
overhead
overheadcostcostto
toproducts
productsusing
usingdirect
directlabor
labor hours.
hours.
 The
Thepredetermined
predeterminedoverhead
overheadrate
rateis:
is:
Mfg. overhead cost $1,550,000
= = $20/DLH
Direct labor hours 77,500
4-56
Bilson’s unit product costs using

traditional costing are:
Product A Product B
Direct material $ 40.00 $ 29.00
Direct labor 30.00 25.00
Manufacturing overhead
3.0 DLH × $20/DLH 60.00
2.5 DLH × $20/DLH 50.00
Total unit product cost $ 130.00 $ 104.00
Bilson marks its products up by 50 percent and allocates

its $500,000 customer service costs based on revenue.
4-57
$130.00 × 1.50
Traditional Costing
Product A Product B
Volume 5,000 25,000
Sales Price $ 195.00 $ 156.00
Sales Revenue $ 975,000 $ 3,900,000

Direct Material $ 40.00 200,000 $ 29.00 725,000
Direct Labor 30.00 150,000 25.00 625,000
Overhead 60.00 300,000 50.00 1,250,000
Gross Margin $ 65.00 $ 325,000 $ 52.00 $ 1,300,000
Customer Service Costs 100,000 400,000
Product operating income $ 225,000 $ 900,000
$975,000 ÷ ($975,000 +$3,900,000) × $500,000

4-58

Sales
Salesofof Product
ProductAAhave
have increased
increasedsteadily
steadily since
sinceintroduction,
introduction,
but
butcompany
companyincome
income has
hasdeclined.
declined.Management
Management at atBilson
Bilsonisis
unhappy
unhappywith
withthe
thetraditional
traditionalcosting
costingsystem
systemandandthey
theyhave
have
decided
decided to
totry
tryactivity-based
activity-based costing.
costing.
In
Inaddition,
addition,management
managementhas has
observed
observedthat thatthe
thecost
cost of
ofdirect
direct
labor
labor isisrelatively
relativelystable.
stable.
Since
Sincelabor
labor does
doesnot
notbehave
behave
like
likeaaunit-level
unit-levelcost,
cost,labor
labor will
will
be
becombined
combinedwith withoverhead
overheadand and
the
thetotal
totalconversion
conversion cost
cost
will
willbe
beassigned
assignedusing
usingABC.
ABC.
4-59

The
Thetotal
totalconversion
conversioncost
costis:
is:
Traditional
Traditionaloverhead
overhead $1,550,000
$1,550,000
Labor
Labor(77,500
(77,500hours
hours@ @ $10)
$10) 775,000
775,000
Total
Total $2,325,000
$2,325,000
In
Inaddition,
addition,management
managementhas has
observed
observedthat thatthe
thecost
cost of
ofdirect
direct
labor
labor isisrelatively
relativelystable.
stable.
Since
Sincelabor
labor does
doesnot
notbehave
behave
like
likeaaunit-level
unit-levelcost,
cost,labor
labor will
will
be
becombined
combinedwith withoverhead
overheadand and
the
thetotal
totalconversion
conversion cost
cost
will
willbe
beassigned
assignedusing
usingABC.
ABC.
4-60
Management has identified the following five activities

and costs in the production of its two products:
Activity Cost
Machine setups $ 800,000
Quality inspections 450,000
Production orders 225,000
Machine-hours worked 650,000
Material receipts 200,000
Total $ 2,325,000
Total conversion cost

4-61

The following transaction data has been
complied by management of Bilson:
Activity Total Product A Product B

Machine setups 5,000 3,000 2,000
Quality inspections 9,000 6,000 3,000
Production orders 600 200 400
Machine-hours worked 50,000 15,000 35,000
Material receipts 800 150 650
4-62
These data can be used to develop predetermined

cost-driver rates for each of the five activities:
Total Rate per
Activity Costs Transactions Transaction
Machine setups $ 800,000 5,000 $ 160.00 per setup
Quality inspections 450,000 9,000 50.00 per inspection
Production orders 225,000 600 375.00 per order
Machine-hours worked 650,000 50,000 13.00 per hour
Material receipts 200,000 800 250.00 per receipt
Total $ 2,325,000
$ 800,000 ÷ 5,000 Machine setups = $160.00 per setup

4-63
The activity-based overhead rates we just calculated

can be used to assign conversion costs to Bilson’s
two products.
Product A
Activity ABC Rate Transactions Amount
Machine setups $ 160.00 3,000 $ 480,000
Quality inspections 50.00 6,000 300,000
Production orders 375.00 200 75,000
Machine-hours worked 13.00 15,000 195,000
Material receipts 250.00 150 37,500
Total overhead assigned $ 1,087,500
Number of units produced ÷ 5,000
Conversion per unit $217.50
4-64

two products.
Product B
Machine setups $160.00 2,000 $ 320,000
Number of units produced ÷ 25,000
Conversion per unit $ 49.50
4-65

two products.
Product B
Machine setups $160.00 2,000 $ 320,000
Total conversion
Number assigned
of units to Product A
produced $ 1,087,500 ÷ 25,000
Total conversionper
Overhead assigned
unit to Product B 1,237,500 $ 49.50
Total overhead $ 2,325,000
4-66
Let’s compute the product cost for A and B

using our ABC overhead rates:
Activity Based Costing Product A Product B

Direct materials $ 40.00 $ 29.00
Conversion 217.50 49.50
Total unit product cost $ 257.50 $ 78.50
These amounts did not

change as a result of
using ABC.
4-67
Now compare the unit product costs using the

traditional costing system and our ABC system.
Costing Method Product A Product B

Activity-based costing $ 257.50 $ 78.50
Traditional costing 130.00 104.00
Remember, we used one overhead

rate based on direct labor hours.
4-68


Adopting activity-based costing usually results

in a shift of batch-level and product-level
overhead costs from high-volume standard
products to low-volume, more complex products.
4-69


Can you see how different allocation

methods might lead to making
different management decisions?
4-70

Based on these results Bilson also decides to use ABC to assign
Its $500,000 customer service costs. The applicable activity is
number of customer consultations. Customers buying Product A,
the deluxe model, require more consultations than those buying
Product B, the standard model.
Product A Product B Total
Sales Volume 5,000 25,000
Consultations per
Unit Sold 10 3
Total Consultations 50,000 75,000 125,000
Cost per Consultation $ 4.00 $ 4.00
Cost per Product $ 200,000 $ 300,000 500,000
Cost per consultation = $500,000 ÷ 125,000 consultations = $4.00

4-71

No change in sales price
ABC Costing
Product A Product B
Volume 5,000 25,000
Sales Price $ 195.00 $ 156.00
Sales Revenue $ 975,000 $ 3,900,000

Direct Material $ 40.00 200,000 $ 29.00 725,000
Conversion 217.50 1,087,500 49.50 1,237,500
Gross Margin $ (62.50) $ (312,500) $ 77.50 $ 1,937,500
Product operating income $ (512,500) $ 1,637,500
Let’s
Let’scompare
compareproduct
productincome
incomeusing
usingtraditional
traditionaland
andABC
ABCcosting.
costing.
4-72
Product A Product B
Volume 5,000 25,000
Sales Price $ 195.00 $ 156.00
ABC
Sales Revenue $ 975,000 $ 3,900,000
Direct Material $ 40.00 200,000 $ 29.00 725,000 Costing
Conversion 217.50 1,087,500 49.50 1,237,500
Gross Margin $ (62.50) $ (312,500) $ 77.50 $ 1,937,500
Product operating income $ (512,500) $ 1,637,500
Product A Product B
Volume 5,000 25,000
Sales Price $ 195.00 $ 156.00
Sales Revenue $ 975,000 $ 3,900,000

Traditional
Direct Material $ 40.00 200,000 $ 29.00 725,000 Costing
Direct Labor 30.00 150,000 25.00 625,000
Overhead 60.00 300,000 50.00 1,250,000
Gross Margin $ 65.00 $ 325,000 $ 52.00 $ 1,300,000
Product operating income $ 225,000 $ 900,000
4-73

Should Bilson
drop Product A?
Should Bilson Should Bilson

increase the price reduce the price
of Product A? of Product B?
4-74
 The price of Product A, the deluxe model, should

probably be increased. Customers who buy
deluxe models may buy based on features
instead of price.
 The price of Product B, the standard model, may
be too high. Customers who buy standard
models are price sensitive. Decreasing
the price would increase volume,
possibly resulting in more income.
4-75
ABC– Benefits and Limitations

 More
 More accurate
accurate and
and informative
informative
product
product costs
costs lead
lead to
to better
better
decisions.
decisions.
 More
More accurate
accurate measurements
measurements of of the
the
activities
activities driving
driving costs.
costs.
 Provides
Provides managers
managers withwith easier
easier
access
access to to relevant
relevant costs.
costs.
An
AnABC
ABC system
system isis very
very expensive
expensive
to
to develop
develop and
and implement;
implement; itit is
is
also
also very
very time-consuming.
time-consuming.
4-76
Benefits Limitations
 ItIt provides
provides more
more accurate
accurate  Some
Some costs
costs may
may require
require
and
and informative
informative product
product allocations
allocations to
to
costs.
costs. departments
departments and and
 ItIt provides
provides more
more accurate
accurate products.
products.
measurements
measurements of of activity
activity  Some
Some costs
costs that
that can
can be
be
driving
driving costs.
costs. identified
identified with
with specific
specific
 ItIt provides
provides managers
managers with
with products
products are
are omitted.
omitted.
easier
easier access
access to
to relevant
relevant  Expensive
Expensive to to develop
develop and
and
costs.
costs. implement;
implement; itit is
is also
also very
very
time-consuming.
time-consuming.
4-77
When Should a Company Use ABC?

 Indirect
Indirectcosts
costsare
aresignificant
significantin
in proportion
proportion to
todirect
direct costs.
costs.
 Goods
Goodsareare complex,
complex, requiring
requiringmany
many inputs
inputs and
andprocesses.
processes.
 Complex,
Complex, low-volume
low-volumeproducts
products are areprofitable
profitablewhile
while
standard,
standard, high-volume
high-volume products
productsare arenot.
not.
 Different
Differentdepartments
departmentsbelieve
believe costs
costsare
areassigned
assigned
inaccurately.
inaccurately.
 The
Thecompany
companyloses
losesbids
bidsititthought
thought were
werelow,
low,and
andwins
winsbids
bids
itit thought
thoughtwere
werehigh.
high.
 Operations
Operationshave havechanged
changed significantly,
significantly, but
but the
thecosting
costing
system
system hashasnot
notchanged.
changed.
 Introduction
Introductionof ofnew
newmodels
modelsresult
resultin
inhigher
highersales,
sales, apparent
apparent
profits
profitsper
per unit,
unit, but
butan
anoverall
overallincome
incomedecline.
decline.
4-78
End of Chapter

Activity Based Costing

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Activity-Based

Traditional Costing Systems

Traditional Costing Systems

Traditional Costing Systems

Overhead Rate = $120 ÷ 8 direct labor hours

Job 1 = 2 hours × $15 per hour = $30

Traditional Costing Systems

Traditional Costing Systems

Overhead Rate = $420 ÷ 3 direct labor hours

Job 1 = 2 hours × $140 per hour = $280

Traditional Costing Systems

Single Plant-wide Overhead Rate

Dole Company has two factories Alpha and Beta. Alpha

Single Plant-wide $600,000

Single Plant-wide Overhead Rate

During the first month of operations the company has the

Single Plant-wide Overhead Rate

Using the plant-wide rate, factory overhead is applied to the

Departmental Overhead Rates

To obtain more accurate product costing the company

Alpha’s Departmental $400,000

Beta’s Departmental $200,000

Departmental Overhead Rates

Activity-Based Costing (ABC)

Activity-Based Costing (ABC)

Activity-Based Costing (ABC)

Directly traced Directly traced

Cost Pools: Cost Pools:

Predetermined Cost driver

Activity-Based Costing (ABC)

When Is an Activity-Based Costing

Four Steps in the ABC Process

 Identify and Classify Activities

PRODUCT - LEVEL ACTIVITES

CUSTOMER- LEVEL ACTIVITES

 Unit-level activity – An activity that is performed

 Product-sustaining activity – An activity that is

 Identify and Classify Activities

 Estimate the Cost of Activities

 Calculate Cost-Driver Rates for

 Calculate Cost-Driver Rates for

 Calculate Cost-Driver Rates for

 Calculate Cost-Driver Rates for

Practical Capacity Note

Practical Capacity Note

80%, or $800 20%, or $200 should

 Assign Activity Costs to Products

 Assign Activity Costs to Products

Example: Yazz, Inc. produces 130,000 units of Product A

 Assign Activity Costs to Products

Comparison of Traditional and

Northern High-Tech, Inc.

$125,000 ÷ 12,500 = $10 per engineering hour

$50,000 ÷ 5,000 = $10 per unit

$75,000 ÷ 15,000 = $5.00 per unit

Traditional Costing Systems

Total overhead of $275,000 would be shifted from the

Activity-Based Costing Example

Activity-Based Costing Example

Activity-Based Costing Example

Bilson’s unit product costs using

Bilson marks its products up by 50 percent and allocates

Activity-Based Costing Example

Sales Revenue $ 975,000 $ 3,900,000