1. Activity-Based Costing Chapter 3
Introduction to Managerial Accounting, Brewer, Garrison,Noreen
Power Points from website - adapted by Cynthia Fortin, CPA, CMA
Chapter 3: Activity-Based Costing
Overhead costs cannot be easily traced to products. Using a plantwide predetermined overhead rate as described in Chapter 2 is simple but using such a rate may inaccurately assign costs to products. Activity-based costing is an alternative that attempts to accurately assign overhead costs to products for financial reporting and other purposes.

2. Activity–Based Costing (ABC): Key Definition
ABC is a costing method designed to provide managers with cost information for strategic and other decisions that potentially affect capacity, and therefore, “fixed” as well as variable costs. It is ordinarily used as a supplement to, rather than as a replacement for, the company’s usual costing system.

3. Allocation of Overhead
Conventional Method (chap. 2)
Factory overhead applied to production using some type of averaging - labor-hours, machine-hours, etc.

4. Why Broad Averaging? Historically Simplicity
limited variety of goods indirect costs were relatively small compared to direct costs
Simplicity
To use broad averages to allocate costs uniformly regardless of how they are actually incurred

5. Conventional Costing leads to
Overcosting Job actually consumed a low level of resources but allocated high costs per unit because the allocation base is not the relevant cost driver (does not cause the cost) Undercosting Consumed a high level of resources but is allocated low costs per unit.

6. The overcosted products are subsidizing the undercosted products

7. ABC proposes to refine a costing system, how?
1. Direct-cost tracing
Analyze costs in overhead and classifying them as direct costs. Could also use costs from non-manufacturing activities.
2. Indirect-cost pools
Expand the number of indirect-cost pools until the costs in each pool have a similar cause & effect relationship

8. Refining a Costing System
3. Cost-allocation bases
Consider using a different cost-allocation base for each indirect-cost pool.
Choose allocation base based on what causes the cost pool to change.

9. Not one but many allocation bases are used for assigning costs to products.
Activity based costing is a technique that uses numerous allocation bases in an attempt to assign overhead costs more accurately to products than the plantwide or departmental approaches discussed thus far.

10. Activity-Based Costing (ABC)
Cost Objects
Activities
The basic idea of ABC is as follows. A customer order triggers a number of activities. Performing the activities consumes resources. The consumption of resources incurs costs.
What causes the activities
(e.g. number of orders, set-ups,)
Cost

11. Activity-Based Costing (ABC)
An event that causes the consumption of overhead resources
Examples of Activities
Part I
An activity in activity-based costing is an event that causes the consumption of overhead resources.
Part II
Examples of activities include:
a.     Setting up machines
b.     Admitting patients to a hospital
c.     Billing customers
d.     Opening an account at a bank
Setting up machines
Admitting hospital patients
Billing customers
Opening a bank account

12. Activity-Based Costing (ABC)
Activity Cost Pool
A “cost bucket” accumulating costs of a particular activity
Activity Measure
Measures how much of the activity is carried out
Used as the allocation base for applying overhead costs.
Part I
An activity cost pool can be thought of as a “cost bucket” in which costs related to a particular activity are accumulated.
Part II
An activity measure expresses how much of the activity is carried out and it is used as the allocation base for applying overhead costs to products and services. Activity measures may or may not be related to volume.
Part III
An activity rate is a predetermined overhead rate in an activity-based costing system. Each activity cost pool has its own activity rate that is used to apply overhead costs to cost objects.
Activity Rate
A predetermined overhead rate for each activity cost pool.
Same process as conventional costing but more than one pool

13. Why establish an Hierarchy of Activities?
Hundreds of activities cause overhead costs:
Rent
Indirect labour: engineers, managers, maintenance, security, cleaning
Depreciation of equipment, of infrastructure
Utilities: gas, electric
Telecom
Taxes, insurance
A common framework for combining activities in manufacturing companies is as follows:
Unit-level activities are performed each time a unit is produced. For example, providing power to run processing equipment is a unit-level activity.
Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, setting up equipment and shipping customer orders are batch-level activities.
Product-level activities relate to specific products and must be carried out, regardless of how many batches are run or units produced and sold. For example, designing or advertising a product are product-level activities.
Facility-level activities are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices are facility-level activities.

14. Why establish an Hierarchy of Activities?
The challenge in designing ABC is to identify a small number of activities that cover most overhead costs. This is done by talking to managers and asking:
What are the most important activities?
The hierarchy serves as a guide in simplifying ABC system.

15. Hierarchy of Activities
A common framework for combining activities in manufacturing companies is as follows:
Unit-level activities are performed each time a unit is produced. For example, providing power to run processing equipment is a unit-level activity.
Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, setting up equipment and shipping customer orders are batch-level activities.
Product-level activities relate to specific products and must be carried out, regardless of how many batches are run or units produced and sold. For example, designing or advertising a product are product-level activities.
Facility-level activities are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices are facility-level activities.

16. Example of Activity-Based Costing
Various Manufacturing Overhead Costs
Labor Related Pool
Machine Related Pool
Setup Pool
Production Order Pool
General Factory Pool
Parts Admin. Pool
First-Stage Cost Assignment
Using activity-based costing, the manufacturing overhead costs are allocated to products using a two-stage process. In the first stage, overhead costs are assigned to the six activity cost pools shown on the slide. For example, the production order cost pool may include the salaries of engineers who modify products for individual orders and the costs of scheduling and monitoring orders. In the examples and assignments in this book, the first-stage cost assignments have already been completed.

17. Graphic Example of Activity-Based Costing
Various Manufacturing Overhead Costs
Unit-Level Activity
Batch-Level Activity
Facility-Level Activity
Product-Level Activity
Labor Related Pool
Machine Related Pool
Setup Pool
Production Order Pool
General Factory Pool
Parts Admin. Pool
First-Stage Cost Assignment
Products
$/DLH
$/MH
$/Setup
$/Order
$/Part Type
Second-Stage Allocations
In the second stage, the costs in the activity cost pools are allocated to products, using activity rates and activity measures. For example, if the total cost in the production order cost pool was $450,000 and the company expected to process 1,200 orders, the activity rate would be $375 per order. Each order would be charged $375 for production order costs.
Notice, the example shown on the slide includes two unit-level activities, two batch-level activities, one product-level activity, and one facility-level activity.

18. Using Activity-Based Costing Comtek Sound, Inc.
 Comtek Sound, Inc., makes two products: CD players and DVD players.
 The company has been losing bids to supply CD players to lower-priced competitors.
 The company has been winning all bids to supply DVD players.
Comtek Sound, Inc., makes two products: CD players and DVD players. Recently, the company has been losing bids to supply CD players to lower- priced competitors. The company has been winning all bids to supply DVD players.

19. Comtek Sound, Inc.
 For the current year, Comtek has budgeted sales of 50,000 DVD units and 200,000 CD units.
 Comtek’s traditional cost system applies manufacturing overhead to products based on direct-labor hours.
 Both products require two direct labor-hours to complete, for a total of 500,000 direct labor-hours.
For the current year, Comtek has budgeted sales of 50,000 DVD units and 200,000 CD units. Comtek’s traditional cost system applies manufacturing overhead to products based on direct labor-hours. Both products require two direct labor-hours to complete. The DVD players and CD players consume 100,000 and 400,000 direct labor-hours, respectively, for a total of 500,000 direct labor-hours.

20. Conventional Costing Cost objects CD DVD Direct costs Labor 20 20
Materials
3.Cost allocation base: labor-hours
4.Overhead Pool $10,000,000
5. Total hours 250,000*2= 500,000
6. O/H rate 10,000,000/500,000=$
7. Total cost $110 $150

21. Computing Activity Rates
The ABC project team at Comtek has developed the following basic information.
The ABC project team at Comtek has identified six activity cost pools and activity measures:
A labor-related cost pool based on the activity measure of direct labor-hours;
A machine-related cost pool based on the activity measure of machine-hours;
A machine setups cost pool based on the activity measure of number of setups;
A production orders cost pool based on the activity measure of number of orders;
A parts administration cost pool based on the activity measure of part types; and
A general factory cost pool based on the activity measure of machine-hours.
The ABC team also has estimated the amount of overhead for each activity cost pool, the total number of activities for each cost pool, and the number of activities for each product as shown.
Notice that the total overhead is still $10,000,000. D E A B

22. Computing Activity RatesB C
We calculate an activity rate for each of the six activities by dividing the estimated overhead for an activity by the total expected activity. For example, the activity rate for production orders is $3,150,000 of overhead divided by 1,200 orders, resulting in an activity rate of $2,625 per order.

23. Computing Overhead Cost per Unit
DVD Units C D
We assign overhead to each product by multiplying individual activity rates by the expected number of activities. For example, for machine setups, we multiply the 3,000 expected machine setups by the activity rate of $400 per machine setup, resulting in $1,200,000 of overhead assigned to DVD units based on the machine setup activity.
We complete the same overhead assignment for the other five activities. We then add the overhead for the six activities to determine the total overhead of $4,890,000, which will be assigned to DVD units.
Next, we calculate the overhead cost per DVD unit by dividing $4,890,000 of overhead by 50,000 DVD units. The result is $97.80 of overhead cost per DVD unit.

24. Computing Overhead Cost per Unit
CD Units
We follow the same procedure for CD units. For example, we multiply the activity rate of $400 per machine setup by 1,000 machine setups, resulting in $400,000 of overhead assigned to CD units based on the machine setup activity.
We use the same overhead assignment for the other five activities and then add the amounts to find that we have assigned a total of $5,110,000 of overhead to CD units.
Next, we calculate the overhead cost per CD unit by dividing $5,110,000 of overhead by 200,000 CD units. The result is $25.55 of overhead cost per CD unit.

25. Comparing the Two Approaches
Note that assigning overhead using activity-based costing results in a decrease in the unit product cost of a CD unit from $ to $95.55 and an increase in the unit cost of a DVD unit from $ to $
Note that direct material and direct labor costs under the two approaches are the same. The differences in the total unit product cost are a result of the two different approaches to assigning overhead costs.
Note that the unit product cost of a CD unit decreased from $110 to $
while the unit cost of a DVD unit increased from $150 to $

26. Comparing the Two Approaches
The ABC system assigns $14.45 less overhead than the traditional system to each CD player ($40.00-$25.55 = $14.45).
The ABC system assigns $ less overhead than the conventional system to each CD player.

27. Comparing the Two Approaches
The ABC system assigns $57.80 more overhead than the traditional system to each DVD player ($97.80-$40.00 = $57.80).
The ABC system assigns $ more overhead than the conventional system to each DVD player.

28. Shifting of Overhead Cost
Low-volume product
Activity-based costing shifts costs from high-volume products produced in large batches to low-volume products produced in small batches. This occurs because of the existence of batch-level and product-level costs.
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.

29. Targeting Process Improvements
Activity-Based Management Focuses on managing activities to eliminate waste and reduce delays and defects.
One of the great benefits derived from an ABC system is that it can help identify areas where the company can benefit from improving its current processes.
Activity-based management focuses on managing activities to eliminate waste, and reduce delays and defects. Activity-based management is used in organizations as diverse as manufacturing companies, hospitals, and the U.S. Marine Corps.
Note: for real implementation read case study of Xu Ji Electric Co. Ltd

30. Targeting Process Improvements
The first step in any improvement program is deciding what to improve.
The Theory of Constraints approach targets the highest impact improvement opportunities.
Benchmarking can be used to compare activity cost information with world-class standards of performance achieved by other organizations.
Activity rates can be used to target areas where costs seem excessively high.
The first step in any improvement program is to decide what to improve.
The Theory of Constraints approach discussed in the Prologue is one tool for targeting the highest impact improvement opportunities.
Activity-based management provides another approach. Activity-rates can be used to target areas where costs seem excessively high.
Benchmarking can also be used to compare activity cost information with world-class standards of performance achieved by other organizations.

31. Benefits of Activity-Based Costing
ABC improves the accuracy of product costing by:
Increasing the number of cost pools.
Using activity cost pools that are more uniform than departmental cost pools.
Using activity measures that cause those costs.
Activity-based costing improves the accuracy of product costs in three ways: 
It increases the number of cost pools used to accumulate overhead costs.
It uses activity cost pools that are more homogeneous than departmental cost pools.
It assigns overhead costs using activity measures that cause those costs, rather than relying solely on direct labor-hours. Some activity measures may be unit-level in nature, while others may be batch-level, product-level, or facility-level in nature.
In addition, activity-based costing highlights the activities that could benefit most from process improvement efforts, such as Six Sigma.

32. Costs of implementing an ABC system may outweigh the benefits
The cost of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when: 
Products differ substantially in volume, batch size, and in the activities they require.
Conditions have changed substantially since the existing cost system was established.
3.  Overhead costs are high and increasing and no one seems to understand why.
4.  Management does not trust the existing cost system and it ignores data from it when making decisions.

33. Benefits more likely to be worth the costs when:
Products differ substantially volume, batch size, and in activities required.
Conditions have changed substantially since the existing cost system was established.
Overhead costs are high and increasing and no one seems to understand why.
Management does not trust the existing cost system and it ignores data from it when making decisions.
Benefits
Costs