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PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPACopyri ght 2013 by The McGraw-H il l Companies, In c. All ri ghts reserved.McGraw-Hill/Irwin
Activity-Based Costing
Chapter 03
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When cost systems were developed in the 1800s, theemphasis was on simplicity because:
1. Cost and activity data had to be collected byhand and all calculations were done with paperand pencil.
2. Most companies produced a limited variety of
similar products, so there was little differencein the overhead costs consumed by eachproduct.
Assigning Overhead Costs to Products
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Plantwide Overhead Rate
Plantwide Overhead RateA single overhead rate usedthroughout an entire factory.
Direct labor has often been used as the allocationbase for overhead because:
1. Direct labor information was already being recorded.
2. Direct labor was a large component of product costs.
3. Managers believed direct labor and overhead costswere highly correlated.
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Plantwide Overhead Rate
A plantwide overhead allocation system may not be optimal
for many companies in todays business environment.
Today, direct labor may no longer be a satisfactory basefor allocation of overhead.
1. Most companies sell a large variety of products thatconsume differing amounts of overhead.
2. As a percentage of total costs, direct labor has beenshrinking and overhead has been increasing. Many ofthese growing overhead costs may not be correlatedwith direct labor.
3. Technology advancements have reduced the cost andcomplexity of gathering diverse sources of data.
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Departmental Overhead Rates
Machining Department
Shipping Department
Assembly Department
Many companies have a system in which eachdepartment has its own overhead rate.
The allocation base dependson the nature of the work
performed in each department.In the machining department,
overhead may be based onmachine-hours, but in theassembly department,
overhead may be based on
labor-hours.
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Activity-based costing is required to account for
these other factors.
The departmental approach reliesexclusively on volume-related allocation bases while
some overhead costs may be caused by factorsthat are not related to the volume of production.
Departmental rates will not correctly assign overheadin situations where a company has a range of
products and complex overhead costs.
Departmental Overhead Rates
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A number of allocation bases are usedfor assigning costs to products.
Activity-Based Costing (ABC)
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Cost
Activity-Based Costing (ABC)
Consumption of Resources
Activities
Cost Objects(e.g., products and customers)
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ActivityAn event that causesthe consumption ofoverhead resources
Setting upmachines
Examples of Activities
Admittinghospitalpatients
Opening abank account
Billingcustomers
Activity-Based Costing (ABC)
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ActivityCost Pool
A cost bucket in whichcosts related to a particular
activity are accumulated.
ActivityMeasure
Expresses how much of theactivity is carried out and isused as the allocation base
for applying overhead costs.
Activity-Based Costing (ABC)
ActivityRate
A predetermined overheadrate for each activitycost pool.
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Activity-Based Costing (ABC)
For each activity inisolation, this system works exactly
like the job-order costing systemdescribed in Chapter 2.
A predetermined overhead rate is computed foreach activity and then applied to jobs andproducts based on the amount of activity
consumed by the job or product.
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Designing an Activity-BasedCosting System
The challenge is to select a reasonably
small number of activities that explain thebulk of the variation in overhead costs.
Activities are usually chosen by interviewing abroad range of managers to find out whatactivities they think consume most of the
organizations resources.
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An activity dictionary defines each of the activitiesthat will be included in the activity-based costing
system and how the activities will be measured.
For example, several actions maybe involved in handling and moving
raw materials, but these may be
combined into a single activitytitled material handling.
Designing an Activity-BasedCosting System
Related activities arefrequently combined to reduce
the amount of detail andrecord-keeping costs.
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Hierarchy of Activities
Level Activities Activity MeasureUnit-level Processing units on machines Machine-hours
Processing units by hand Direct labor-hours
Consuming factory supplies Units produced
Batch-level Processing purchase orders Purchase orders processedProcessing production orders Production orders processed
Setting up equipment Number of setups
Handling materials Pounds of material handled
Product-level Testing new products Hours of testing time
Administering parts inventories Number of part typesDesigning products Hours of design time
Facility-level General factory administration Direct labor-hours
Plant building and grounds Direct labor-hours
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Graphic Example ofActivity-Based Costing
Various Manufacturing Overhead Costs
LaborRelated Pool
MachineRelated Pool
SetupPool
ProductionOrder Pool
GeneralFactory Pool
PartsAdmin. Pool
First-Stage Cost Assignment
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3-16Unit-LevelActivity
Batch-LevelActivit
Facility-LevelActivit
Product-LevelActivit
Graphic Example ofActivity-Based Costing
Various Manufacturing Overhead Costs
Products
$/DLH $/MH $/Setup $/Order $/MH$/Part Type
Second-Stage Allocations
LaborRelated Pool
MachineRelated Pool
SetupPool
ProductionOrder Pool
GeneralFactory Pool
PartsAdmin. Pool
First-Stage Cost Assignment
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Using Activity-Based CostingComtek Sound, Inc.
Comtek Sound, Inc., makes two products: CD playersand DVD players.
The company has been losing bids to supply CDplayers to lower-priced competitors.
The company has been winning all bids to supplyDVD players.
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Using Activity-Based CostingComtek Sound, Inc.
For the current year, Comtek has budgeted salesof 50,000 DVD units and 200,000 CD units.
Comteks traditional cost system appliesmanufacturing overhead to products based on direct-labor hours.
Both products require two direct labor-hours tocomplete, for a total of 500,000 direct labor-hours.
Hours
DVDs: 50,000 units @ 2 hours per unit = 100,000
CDs: 200,00 units @ 2 hours per unit = 400,000
Total direct labor-hours 500,000
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Using Activity-Based CostingComtek Sound, Inc.
Unit costs for materials and labor are:DVD CD
Units Units
Direct materials 90$ 50$
Direct labor 20$ 20$
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Total manufacturing overhead costs for thecurrent year are estimated to be $10,000,000.The company develops the following overhead
rate based upon labor-hours:
Predetermined
overhead rate = $20 per DLH=
$10,000,000
500,000 DLHs
Direct Labor-Hours as a Base
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DVD Unit CD Unit
Direct materials 90$ 50$
Direct labor 20 20Manufacturing overhead 40 40
(2 DLHs x $20 per DLH)
Unit product cost 150$ 110$
Direct Labor-Hours as a Base
Since each product requires two hours ofdirect labor, $40 of overhead is assigned to
each product.
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The ABC project team at Comtek hasdeveloped the following basic information.
Activity and Activity Measures
Estimated
OverheadCost
Total DVD CD
Labor-related (DLH) 800,000$ 500,000 100,000 400,000
Machine-related (MH) 2,100,000 1,000,000 300,000 700,000
Machine setups (setups) 1,600,000 4,000 3,000 1,000
Production orders (orders) 3,150,000 1,200 800 400Parts administration (part types) 350,000 700 400 300
General factory (MH) 2,000,000 1,000,000 300,000 700,000
10,000,000$
Expected Activity
Computing Activity Rates
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Activity and Activity Measures
Estimated
Overhead
Cost
Total
Expected
Activity
Labor-related (DLHs) 800,000$ 500,000 = 1.60$ per DLH
Machine-related (MHs) 2,100,000 1,000,000 = 2.10 per MH
Machine setups (setups) 1,600,000 4,000 = 400.00 per setup
Production orders (orders) 3,150,000 1,200 = 2,625.00 per order
Parts administration (part types) 350,000 700 = 500.00 per part type
General factory (MHs) 2,000,000 1,000,000 = 2.00 per MH
10,000,000$
Activity Rate
We can calculate an activity rate for each of the six activitiesby dividing the estimated overheard for an activity by the
total expected activity.
Computing Activity Rates
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Computing Overhead Cost per Unit
Activity and Activity Measures
Expected
Activity
Activity
Rate
Labor-related (DLHs) 100,000 1.60$ = 160,000$Machine-related (MHs) 300,000 2.10 = 630,000Machine setups (setups) 3,000 400.00 = 1,200,000Production orders (orders) 800 2,625.00 = 2,100,000Parts administration (part types) 400 500.00 = 200,000General factory (MHs) 300,000 2.00 = 600,000Total overhead cost assigned 4,890,000$
Number of units produced 50,000
Overhead cost per unit 97.80$
Amount
DVD Units
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Computing Overhead Cost per Unit
Activity and Activity Measures
Expected
Activity
Activity
Rate
Labor-related (DLHs) 400,000 1.60$ = 640,000$Machine-related (MHs) 700,000 2.10 = 1,470,000Machine setups (setups) 1,000 400.00 = 400,000Production orders (orders) 400 2,625.00 = 1,050,000Parts administration (part types) 300 500.00 = 150,000
General factory (MHs) 700,000 2.00 = 1,400,000Total overhead cost assigned 5,110,000$Number of units produced 200,000
Overhead cost per unit 25.55$
Amount
CD Units
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Note that the unit product cost of a CDunit decreased from $110 to $95.55 . . . .
. . . . while the unit cost of a DVD unit
increased from $150 to $207.80.
Comparing the Two Approaches
DVD Unit CD Unit DVD Unit CD Unit
Direct material 90.00$ 50.00$ 90.00$ 50.00$
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost 207.80$ 95.55$ 150.00$ 110.00$
Activity-Based Costing Direct Labor Costing
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DVD Unit CD Unit DVD Unit CD Unit
Direct material 90.00$ 50.00$ 90.00$ 50.00$
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost 207.80$ 95.55$ 150.00$ 110.00$
Activity-Based Costing Direct Labor Costing
Comparing the Two Approaches
The ABC system assigns $14.45less overhead than the traditional
system to each CD player.
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DVD Unit CD Unit DVD Unit CD Unit
Direct material 90.00$ 50.00$ 90.00$ 50.00$
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost 207.80$ 95.55$ 150.00$ 110.00$
Activity-Based Costing Direct Labor Costing
Comparing the Two Approaches
The ABC system assigns $57.80more overhead than the traditional
system to each DVD player.
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DVD Unit CD Unit DVD Unit CD Unit
Direct material 90.00$ 50.00$ 90.00$ 50.00$
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00Unit product cost 207.80$ 95.55$ 150.00$ 110.00$
Activity-Based Costing Direct Labor Costing
When a company implements activity-based costing,overhead cost often shifts from high-volume to low-
volume products with a higher unit product cost
resulting for the low-volume products.
Low-volume product
Shifting of Overhead Cost
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DVD Unit CD Unit DVD Unit CD Unit
Direct material 90.00$ 50.00$ 90.00$ 50.00$
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost 207.80$ 95.55$ 150.00$ 110.00$
Activity-Based Costing Direct Labor Costing
High-volume product
Shifting of Overhead Cost
The traditional system assigns the same amountof all overhead costs to each CD or DVD player
($40 per unit).
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Shifting of Overhead Cost
DVD Units CD Units
Number of units produced per year 50,000 200,000
Number of production orders issued per year 800 400
Number of units processed per production order 62.5 500
1. Compute the number of units processedper production order for each product.
Production Orders Activity Cost Pool(a batch-level cost pool)
The ABC system assigns different amounts ofProduction Order-related overhead costs to each product.
This fact can be illustrated in a two-step process.
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Shifting of Overhead Cost
2. Compute production order cost per unit for each product.
DVD Units CD UnitsCost to issue a production order 2,625$ 2,625$
Average number of units processed per
production order 62.5 500
Production order cost per unit 42.00$ 5.25$
Notice, the costs are being shifted from the high-volume CD players to the low-volume DVD players.
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Activity-Based ManagementFocuses on managing activities to eliminate
waste and reduce delays and defects.
Targeting Process Improvements
An ABC system can help identifyareas where the company can benefit
from improving its current processes.
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The first step in any improvementprogram is deciding what to improve.
Targeting Process Improvements
The Theory of Constraintsapproach targets the
highest impactimprovement opportunities.
Activity rates can beused to target areaswhere costs seemexcessively high.
Benchmarking can be used to compare activity costinformation with world-class standards of performance
achieved by other organizations.
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Benefits of Activity-Based Costing
ABC improves the accuracy of product costing by:
1. Increasing the number of cost pools used to accumulateoverhead costs.
2. Using activity cost pools that are more homogeneousthan departmental cost pools.
3. Assigning overhead costs using activity measures thatcause those costs, rather than relying solely on directlabor hours.
Activity-based costing also highlights activitiesthat could benefit most from process
improvement efforts, such as Six Sigma.
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Costs of implementing an ABC system may outweighthe benefits. However, the benefits are more likely to beworth the costs when:
1. Products differ substantially in volume, batch size, and inactivities required.
2. Conditions have changed substantially since the existingcost system was established.
3. Overhead costs are high and increasing and no one seemsto understand why.
4. Management does not trust the existing cost system and itignores data from it when making decisions.
Limitations of Activity-Based Costing
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The cost in each activity pool is strictlyproportional to its activity measure. When this
assumption is violated, the accuracy of ABCdata can be called into question.
Activity-Based CostingCritical Assumption
For example, managers should be particularlyalert to product costs that contain allocated
facility-level costs.
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Modifying the ABC Model
The illustrations in the chapter assumethat ABC is being used for external reportingpurposes. If the system is used for internal
decision-making purposes, two importantmodifications should be made:
1. Selling and administrative costs should beassigned to products, where appropriate.
2. Facility-level costs should be removedfrom product costs.
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End of Chapter 03