2. Activity-Based Costing Managerial Accounting, Fifth Edition
CHAPTER 4
Activity-Based Costing
Managerial Accounting, Fifth Edition

3. Study Objectives
Recognize the difference between traditional costing and activity based costing.
Identify the steps in the development of an activity-based costing system.
Know how companies identify the activity cost pools used in activity-based costing.
Know how companies identify and use cost drivers in activity-based costing.

4. Study Objectives
5. Understand the benefits and limitations of activity-based costing.
6. Differentiate between value-added and
non-value-added activities.
7. Understand the value of using activity levels in activity-based costing.
8. Apply activity-based costing to service industries.

5. Traditional Costing
To allocate as fairly as possible the true costs of the products.
When management has more accurate costs, better decisions can be made.
Direct Materials and Direct Labor costs are easiest to trace through:
Material requisitions.
Payroll time sheets.
SO 1: Recognize the differences between traditional costing and
activity-based costing.

6. Hard Part of Determining Product Costs is?
Determining the proper amount of overhead to assign to each product, service or job.

7. Traditional Costing and ABC

8. Traditional Costing
Allocates overhead using a single predetermined rate.
Job order costing: Direct labor cost is assumed to be the relevant activity base.
Assumption was satisfactory when direct labor was a major portion of total manufacturing costs.
There should be of a high correlation between direct labor costs and overhead costs.
SO 1: Recognize the differences between traditional costing and
activity-based costing.

9. Traditional Costing
Allocates overhead using a single predetermined rate.
Process Costing: Machine hours is assumed to be the relevant activity base.
Assumption was satisfactory when machine hours was a major portion of total manufacturing costs.
There should be of a high correlation between machine hours and overhead costs.
SO 1: Recognize the differences between traditional costing and
activity-based costing.

10. Why Do Companies Need a New Approach?
Tremendous change in manufacturing and service industries.
Decrease in amount of direct labor usage.
Significant increase in total overhead costs.
May be inappropriate to use plant-wide predetermined overhead rates based on direct labor or machine hours when a lack of correlation exists.
Complex manufacturing processes may require multiple allocation bases; this approach is called Activity-Based Costing (ABC).
SO 1: Recognize the differences between traditional costing and
activity-based costing.

11. Activity-Based Costing
Is another approach (other than traditional costing) to allocate manufacturing overhead.
An overhead cost allocation system that allocates overhead to multiple activity cost pools,
and
Assigns the activity cost pools to products or services by means of cost drivers that represent the activities used.
ABC
SO 1: Recognize the differences between traditional costing and
activity-based costing.

12. ABC Definitions
Activity: Any event, action, transaction, or work sequence that causes a cost to be incurred in producing a product or providing a service.
Activity Cost Pool: The overhead cost attributed to a distinct type of activity.
Examples:
Purchasing materials.
Setting up machines.
Cost Drivers: Any factors or activities that have a direct cause-effect relationship with the resources consumed.
SO 1: Identify the steps in management’s decision-making process.

13. Activity-Based Costing
Products consume activities,
and
Activities consume resources.
SO 1: Recognize the differences between traditional costing and
activity-based costing.

14. Activity-Based Costing
ABC allocates overhead costs in two stages:
Stage 1: Overhead costs are allocated to activity cost pools.
Stage 2: The overhead costs allocated to the cost pools is assigned to products using cost drivers.
The more complex a product’s manufacturing operation, the more activities and cost drivers likely to be present.
SO 1: Recognize the differences between traditional costing and
activity-based costing.

15. OVERHEAD COSTS Illustration 4-2
SO 1: Recognize the differences between traditional costing and
activity-based costing.

16. Overhead Costs Illustration 4-3
SO 1: Recognize the differences between traditional costing and
activity-based costing.

17. Activity-Based Costing
ABC does not replace an existing job order/process cost system.
ABC does segregate overhead into various cost pools to provide more accurate cost information.
ABC, thus, supplements – it does not replace – the traditional cost system.
SO 2 Identify the steps in the development of an activity-based system.

18. Activity-Based Costing
Atlas Company produces two automotive antitheft devices:
The Boot: A high volume item with sales totaling 25,000 per year.
The Club: A low volume item with sales totaling 5,000 per year.
Each product requires 1 hour of direct labor
Total annual direct labor hours (DLH) 30,000 (25, ).
Direct labor cost $12 per unit for each product.
Expected annual manufacturing overhead costs $900,000
Direct materials cost:
The Boot - $40 per unit.
The Club - $30 per unit.
SO 1: Recognize the differences between traditional costing and
activity-based costing.

19. Costing Under Traditional Costing
Products
Manufacturing Costs The Boot The Club
Direct Materials $40 $30
Direct Labor 12 12
Overhead *
Total unit cost $82 $72
* Predetermined overhead rate: $900,000 ÷ 30,000 DLH = $30 per DLH
Overhead = predetermined overhead rate times direct labor hours
($30 × 1 hr. = $30)
Illustration 4-10
SO 2 Identify the steps in the development of an activity-based system.

20. Four Steps of Activity-Based Costing
Identify and classify the major activities and allocate manufacturing overhead costs to the appropriate cost pools.
Identify the cost driver that has a strong correlation to the costs in the cost pool.
Compute the overhead rate for each pool.
Assign overhead costs for each cost pool to products using the overhead rates.
SO 2 Identify the steps in the development of an activity-based system.

21. Activity Cost Pools and Estimated Overhead
Activity Cost Pools Estimated Overhead
Setting up machines $300,000
Machining 500,000
Inspecting ,000
Total $900,000
Illustration 4-4
SO 3 Know how companies identify the activity cost pools and use activity-based costing.

22. Identify Cost Drivers Expected Use of Cost Drivers
Activity Cost Pools Cost Drivers Per Activity
Setting up machines Number of setups 1,500
Machining Machine hours 50,000
Inspecting Number of Inspections 2,000
Illustration 4-5
SO 4 Know how companies identify and use cost drivers in activity-based costing

23. Formula for Computing Activity-Based Overhead Rate
Expected Use
Estimated of Cost Drivers Activity-Based
Activity Cost Pools Overhead Per Activity Overhead Rates
Setting up machines $300, ,500 setups $200 per setup
Machining , ,000 machine hrs. $ 10 per mach. hour
Inspecting , ,000 inspections $ 50 per inspection
Total $900,000
Estimated Overhead Per Activity
= Activity-Based Overhead Rate
Expected Use of Cost Drivers Per Activity
Illustration 4-6
Illustration 4-7
SO 4 Know how companies identify and use cost drivers in activity-based costing

24. Expected Use of Costs to Products
Illustration 4-8
SO 4 Know how companies identify and use cost drivers in activity-based costing

25. Assignment of Activity Cost Pools to Products
Illustration 4-9
SO 4 Know how companies identify and use cost drivers in activity-based costing

26. Unit Product Costs Under Traditional and ABC Costing Methods
The Boot The Club
Traditional Traditional
Manufacturing Costs Costing ABC Costing ABC
Direct Materials $40 $40 $30 $30
Direct Labor
Overhead
Total Cost per Unit $82 $69 $72 $137
Overstated Understated
$13 $65
Illustration 4-11
SO 4 Know how companies identify and use cost drivers in activity-based costing

27. Results of Using ABC
Under ABC, overhead costs are shifted from the high volume product (The Boot) to the low volume product (The Club) because:
Low volume products often require more special handling.
Assigning overhead using ABC will usually increase the cost per unit of low volume products.
SO 4 Know how companies identify and use cost drivers in activity-based costing

28. Benefits of Activity-Based Costing
More accurate product costing through:
Use of more cost pools to assign overhead costs.
Enhanced control over overhead costs.
Better management decisions.
SO 5 Understand the benefits and limitations of activity-based costing

29. Limitations of Activity-Based Costing
Can be expensive to use (Cost/Benefit).
Some arbitrary allocations continue.
SO 5 Understand the benefits and limitations of activity-based costing

30. Use ABC When One or More of the Following Exist:
Products differ greatly in volume/manufacturing complexity.
Products lines are:
Numerous.
Diverse.
Require different degrees of support services.
Overhead costs are a significant portion of total costs.
Significant change in manufacturing process or number of products.
Managers ignore data from existing system and instead use “bootleg” costing data.
SO 5 Understand the benefits and limitations of activity-based costing

31. Let’s Review Activity-based costing (ABC):
Can be used only in a process cost system.
Focuses on units of production.
Focuses on activities performed to produce a product.
Uses only a single basis of allocation.
SO 5 Understand the benefits and limitations of activity-based costing

32. Activity-Based Management (ABM)
An extension of ABC from a product costing system to a management function
that focuses on reducing costs and improving processes and decision making.
A refinement of ABC used in ABM classifies activities as either value-added or non-value-added.
SO 6 Differentiate between value-added and non-value activities

33. Value- Added Activities
An activity that increases the worth
of a product or service such as:
Manufacturing Company Service Company
Engineering design Performing surgery
Machining Legal research services
Assembly Delivering packages
Painting
Packaging
SO 5 Understand the benefits and limitations of activity-based costing

34. Non-Value Activities
An activity that adds cost to, or increases the time spent on, a product/service without increasing its market value such as:
Manufacturing Company Service Company
Repair of machines Taking appointments
Storage of inventory Reception
Moving of raw materials, Bookkeeping/billing
assemblies, and Traveling
finished goods Ordering supplies
Building maintenance
Inspections
Inventory Control

35. Classification of Activity Levels
Unit-level activities:
Performed for each unit of production.
Batch-level activities:
Performed for each batch of product.
Product-level activities:
Performed in support of an entire product line, but not always performed every time a new unit or batch is produced.
Facility-level activities:
Required to support or sustain an entire production process.

36. Hierarchy of Activity Levels
Illustration 4-13
SO 7 Understand the value of using activity levels in activity-based costing.

37. Activity-Based Costing In Service Industries
Similarities with Manufacturing Firms
Overall objective:
Identify key cost-generation activities and keep track of quantity of activities performed for each service provided.
General approach is to identify activities, cost pools, and cost drivers.
Labeling of activities as value-added or non-value-added .
Reduction of non-value-added activities.
SO 8 Apply activity-based costing to service industries.

38. Major Difficulty of Implementing ABC
A larger proportion of overhead costs are company-wide costs that cannot be directly traced to specific services.

39. Condensed Budget of Service Company under Traditional Costing
CHECK AND DOUBLECHECK, CPAs
Annual Budget
Revenue $2,000,000
Direct labor $ 600,000
Overhead (expected) 1,200,000
Total Costs 1,800,000
Operating income $ 200,000
Estimated Overhead
= Predetermined overhead rate
Direct Labor Costs
$1,200,000
= 200%
$600,000
Illustration 4-14
SO 8 Apply activity-based costing to service industries.

40. Overhead Applied Under Traditional Costing
CHECK AND DOUBLECHECK, CPAs
Plano Molding Company Audit
Revenue $260,000
Less: Direct professional labor $ 70,000
Applied Overhead (200% × $70,000) 140, ,000
Operating Income $ 50,000
Illustration 4-15
SO 8 Apply activity-based costing to service industries.

41. Activity-Based Costing Budget
CHECK AND DOUBLECHECK, CPAs
Annual Overhead Budget
Expected
Use of Activity-Based
Estimated Cost Drivers Overhead
Activity Cost Pools Cost Drivers Overhead Per Activity Rates
Secretarial support Direct Prof. hours $ 210,000 30,000 $7 per hour
Direct labor Fringe benefits Direct labor cost 240,000 $ 600,000 $0.40 per $1 labor
Printing and photocopying Working paper pages 20,000 20,000 $1 per page
Computer support CPU minutes 200,000 50,000 $4 per minute
Telephone and postage None (traced directly) 71,000 N/A Based on usage
Legal support Hours used 129, $150 per hour
Insurance
(professional liability, etc.) Revenue billed 120,000 $2,000,000 $0.06 per $1 rev.
Recruiting and training Direct Prof. Hours __ 210, ,000 $7 per hour
$1,200,000
Illustration 4-16
SO 8 Apply activity-based costing to service industries.

42. Assigning Overhead in a Service Company
CHECK AND DOUBLECHECK, CPAs
Plano Molding Company Audit
Activity-
Actual Based
Use of Overhead Cost
Activity Cost Pools Cost Drivers Drivers Rates Assigned
Secretarial support Direct Professional hours 3,800 $ $ 26,600
Direct labor Fringe benefits Direct labor cost $ 70,000 $ ,000
Printing and photocopying Working paper pages 1,800 $ ,800
Computer support CPU minutes 8,600 $ ,400
Telephone and postage None (traced directly) 8,700
Legal support Hours used 156 $ ,400
Insurance Revenue billed $260,000 $ ,600
Recruiting and training Direct Prof. Hours 3,800 $ ,600
$165,100
Illustration 4-17
SO 8 Apply activity-based costing to service industries.

43. Comparison of Traditional and ABC
CHECK AND DOUBLECHECK, CPAs
Plano Molding Company Audit
Traditional Costing ABC
Revenues $260,000 $260,000
Expenses
Direct professional labor $ 70,000 $ 70,000
Applied overhead 140, ,100
Total expenses , ,100
Operating income $ 50,000 $ 24,900
Profit Margin 19.2% 9.6%
Illustration 4-18
SO 8 Apply activity-based costing to service industries.

44. Review
Recognize the difference between traditional and activity-based costing.
Traditional system allocates overhead to products using predetermined unit-based output rate.
ABC allocates overhead to activity cost pools and assigns cost to products using cost drivers.
Identify the steps in the development of an activity-based costing system.
Step 1: Identify the major activities and allocate the overhead costs to cost pools.
Step 2: Identify the cost driver highly correlated to the cost pool.
Step 3: Compute the overhead rate per cost driver.
Step 4: Assign cost pools to products or services using the overhead rates.

45. Review Know how companies identify cost pools used in ABC.
Analyze each operation or process, document and time every task, action, or transaction.
Know how companies identify and use cost drivers in ABC.
Cost drivers identified for assigning activity cost pools must:
Accurately measure the consumption of the activity.
Have related data easily available.
Understand the benefits and limitations of ABC:
Benefits:
Enhanced control over overhead costs.
Better management decisions.
Limitations:
Higher costs accompany multiple activity centers and cost drivers.
Some costs must still be allocated arbitrarily.

46. in distorted product costing.
Review
Differentiate between value-added and non-value-added activities.
Value-added activities increase the worth of a product or service.
Non-value-added activities add cost to, or increase the time spent on, a product or service without increasing its market value.
Understand the value of using activity levels in ABC.
Activities may be classified as:
Unit-level
Batch-level
Product-level
Facility-level
Failure to recognize this classification can result
in distorted product costing.

47. Review Apply ABC to service industries.
Same objective – improved costing of services provided.
The general approach to costing is also the same:
Analyze operations.
Identify activities.
Accumulate overhead costs by activity cost pools.
Identify and use cost drivers to assign cost to services.

48. Just-in-Time
A processing system dedicated to having the right amount of materials, products, or parts arrive as they are needed, thereby reducing the amount of inventory.

49. JUST-in-TIME PROCESSING.
Sales Order Received
100 pairs of sneakers... got it!
Send rubber and shoe laces directly to the factory.
Goods Shipped to Customer
Susan’s
Soccer
Sneakers
Goods Manufactured
Illustration 4-A1

50. JIT Just-in-Time Objective of JIT: Elements of JIT: Benefits of JIT:
Eliminate all manufacturing inventories.
Elements of JIT:
Dependable suppliers.
Multi-skilled work force.
Total quality control system.
Benefits of JIT:
Reduced inventory.
Enhanced product quality.
Reduced rework and storage costs.
Savings from improved flow of goods.
JIT

51. Let’s Review
An activity that adds costs to the product but does not increase market value is a:
a. Value-added activity.
b. Cost driver.
c. Cost-benefit activity.
d. Non-value-added activity.

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55. COPYRIGHT
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