Handout 3

Activity based costing

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How Costs are Treated Under
Activity-Based Costing
Activity Based
Costing

Departmental
Overhead
Rates

Plantwide
Overhead
Rate

Overhead Allocation
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 Plantwide Overhead Rate

Companies tend to use direct labour

as the overhead allocation base.
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 Designing an ABC System
Cost Objects
Consumption
(e.g. products Activities
of Resources
and customers)

Cost

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 Designing an ABC System
Steps for Implementing ABC
Identify and define activities and activity pools.
Where possible, trace costs to activities and cost
objects.
Assign costs to activity cost pools.
Calculate activity rates.
Assign costs to cost objects.
Prepare management reports.
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 Identifying Activity to Include
Unit-Level Batch-Level
Activity Activity

A part of the production

process for which management
wants a separate reporting of the
costs of the activity involved.

Product-Level Customer-Level
Activity Organisation- Activity
sustaining
Activity ©The McGraw-Hill Companies, 2011
Identifying Activity to Include

££
Activity Cost £
Pool is a “bucket” £ £
£
in which costs are
accumulated that
relate to a single
activity in the ABC
system.

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 The Mechanics of ABC
At Classic Brass, the ultimate cost objects are:
Products,
Customer orders, and
Customers.

One overhead cost - shipping - can be traced

directly to customer orders.

The company’s overhead costs are shown on

the next slide.

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 Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Production Department
Indirect factory wages £ 500,000
Factory equipment depreciation 300,000
Factory utilities 120,000
Factory building lease 80,000 £ 1,000,000
Shipping costs traced to customer orders 40,000
General Administrative Department
Administrative wages and salaries 400,000
Office equipment depreciation 50,000
Administrative building lease 60,000 510,000
Marketing Department
Marketing wages and salaries 250,000
Selling expenses 50,000 300,000
Total overhead costs £ 1,850,000

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Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials labour Costs

Traced £/DLH Traced

Cost Objects:
Products, Customer Orders, Customers
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Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials labour Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

Cost Objects:
Products, Customer Orders, Customers
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Activity-Based Costing at Classic Brass

Direct Direct Shipping

Overhead Costs
Materials labour Costs

First-Stage Allocation

Order Customer Product Customer

Other
Size Orders Design Relations

Second-Stage Allocations

£/MH £/Order £/Design £/Customer

Cost Objects:
Unallocated
Products, Customer Orders, Customers
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 Assigning Costs to Activity Cost Pools

Management at Classic Brass believes

overhead should be distributed as follows:
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages 25% 40% 20% 10% 5% 100%
Factory equipment depreciation 20% 0% 60% 0% 20% 100%
Factory utilities 0% 10% 50% 0% 40% 100%
Factory building lease 0% 0% 0% 0% 100% 100%
Shipping costs traced to customer order N/A
General Administrative Department
Administrative wages and salaries 15% 5% 10% 30% 40% 100%
Office equipment depreciation 30% 0% 0% 25% 45% 100%
Administrative building lease 0% 0% 0% 0% 100% 100%
Marketing Department
Marketing wages and salaries 20% 10% 0% 60% 10% 100%
Selling expenses 10% 0% 0% 70% 20% 100%

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 Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption
of overhead, costs are assigned to activity pools.
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages £ 125,000
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total Indirect factory
wages £500,000
Percent consumed by customer orders 25%
£125,000
©The McGraw-Hill Companies, 2011
 Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption
of overhead, costs are assigned to activity pools.
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages £ 125,000
Factory equipment depreciation 60,000
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total Factory
equipment depreciation £300,000
Percent consumed by customer orders 20%
£ 60,000
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 Assigning Costs to Activity Cost Pools

Using the total costs and percentage consumption

of overhead, costs are assigned to activity pools.
Activity Cost Pools
Customer Product Order Customer
Orders Design Size Relations Other Total
Production Department
Indirect factory wages £ 125,000 £ 200,000 £ 100,000 £ 50,000 £ 25,000 £ 500,000
Factory equipment depreciation 60,000 - 180,000 - 60,000 300,000
Factory utilities - 12,000 60,000 - 48,000 120,000
Factory building lease - - - - 80,000 80,000
General Administrative Department
Administrative wages and salaries 60,000 20,000 40,000 120,000 160,000 400,000
Office equipment depreciation 15,000 - - 12,500 22,500 50,000
Administrative building lease - - - - 60,000 60,000
Marketing Department
Marketing wages and salaries 50,000 25,000 - 150,000 25,000 250,000
Selling expenses 5,000 - - 35,000 10,000 50,000
Total £ 315,000 £ 257,000 £ 380,000 £ 367,500 ####### £ 1,810,000

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 Computation of Activity Rates
The ABC team has determined that Classic Brass
has the following total activities for each
activity cost pool . . .
– 1,000 customer orders,
– 200 new designs,
– 20,000 machine-hours
– 100 customers.

Now the team can compute the

individual activity rates.

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 Computation of Activity Rates
Activity Cost Pools
20,000
1,000 200 machine- 100
Orders Designs hours Customers Other
Production Department
Indirect factory wages £ 125
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Custom er
Administrative wages and salaries Orders
Office equipment depreciation Indirect factory wages £ 125,000
Administrative building lease Number of orders ÷ 1,000
Marketing Department
Indirect factory wages/order £ 125
Marketing wages and salaries
Selling expenses
Total

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 Computation of Activity Rates
Activity Cost Pools
20,000
1,000 200 machine- 100
Orders Designs hours Customers Other
Production Department
Indirect factory wages £ 125 £ 1,000 £ 5 £ 500 N/A
Factory equipment depreciation 60 - 9 -
Factory utilities - 60 3 -
Factory building lease - - - -
General Administrative Department
Administrative wages and salaries 60 100 2 1,200
Office equipment depreciation 15 - - 125
Administrative building lease - - - -
Marketing Department
Marketing wages and salaries 50 125 - 1,500
Selling expenses 5 - - 350
Total £ 315 £ 1,285 £ 19 £ 3,675

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Assigning Costs to Cost Objects

Let’s take a look at how our system works for

just one customer - Windward Yachts.
– Windward ordered two products - Stanchions and
customer compass housings. Here are the details:
Standard Stanchions (no design required)
1. 400 units ordered with 2 separate orders.
2. Each stanchion required 0.5 machine-hours.
3. Selling price is £34 each.
4. Direct materials total £2,110.
5. Direct labour totals £1,850.
6. Shipping costs total £180.
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 Assigning Costs to Cost Objects
Let’s take a look at how our system works for
just one customer - Windward Yachts.
– Windward ordered two products - Stanchions and
customer compass housings. Here are the details:

Custom Compass Housing (requires new design)

1. One order during the year.
2. Each housing required 4 machine-hours.
3. Selling price is £650 each.
4. Direct materials total £13.
5. Direct labour totals £50.
6. Shipping costs total £25.

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 Assigning Costs to Cost Objects
Overhead cost of two orders for standard stanchions.
Activity Cost Pools
200
No new machine
2 Orders design hours N/A Total
Production Department
Indirect factory wages £ 250
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total £125 per order × 2 orders = £250
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 Assigning Costs to Cost Objects
Overhead cost of two orders for standard stanchions.
Activity Cost Pools
200
No new machine
2 Orders design hours N/A Total
Production Department
Indirect factory wages £ 250 £ - £ 1,000 £ - £ 1,250
Factory equipment depreciation 120 - 1,800 - 1,920
Factory utilities - - 600 - 600
Factory building lease - - - -
General Administrative Department
Administrative wages and salarie 120 - 400 - 520
Office equipment depreciation 30 - - - 30
Administrative building lease - - - -
Marketing Department
Marketing wages and salaries 100 - - - 100
Selling expenses 10 - - - 10
Total £ 630 £ - £ 3,800 £ - £ 4,430

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 Assigning Costs to Cost Objects
Overhead cost of one order for custom compass housing.
Activity Cost Pools
4
1 new machine
1 Order design hours N/A Total
Production Department
Indirect factory wages £ 125
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department £125 per order × 1 order =
Marketing wages and salaries £125
Selling expenses
Total

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 Assigning Costs to Cost Objects
Overhead cost of one order for custom compass housing.
Activity Cost Pools
4
1 new machine
1 Order design hours N/A Total
Production Department
Indirect factory wages £ 125 £ 1,000 £ 20 £ - £ 1,145
Factory equipment depreciation 60 - 36 - 96
Factory utilities - 60 12 - 72
Factory building lease - - - -
General Administrative Department
Administrative wages and salaries 60 100 8 - 168
Office equipment depreciation 15 - - - 15
Administrative building lease - - - -
Marketing Department
Marketing wages and salaries 50 125 - - 175
Selling expenses 5 - - - 5
Total £ 315 £ 1,285 £ 76 £ - £ 1,676

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 Product Margins
Standard Stanchions
Sales £ 13,600
Cost:
Direct materials £ 2,110
Direct labour 1,850
Shipping costs 180
Customer orders 630
Product design -
Order size 3,800 8,570
Product margin £ 5,030

Custom Compass Housing

Sales £ 650
Cost:
Direct materials £ 13
Direct labour 50
Shipping costs 25
Customer orders 315
Product design 1,285
Order size 76 1,764
Product margin £1,114

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Product Margins/Customer Profitability
Standard Stanchions
Sales £ 13,600
Cost:
Direct materials £ 2,110
Direct labour 1,850
Shipping costs 180
Customer orders 630
Product design -
Order size 3,800 8,570
Product margin £ 5,030

Custom Compass Housing

Sales £ 650
Windward Yachts Cost:
Direct materials £ 13
Product margins: Direct labour 50
Standard stanchion Shipping£costs5,030 25
Custom compass housing
Customer (1,114)
orders 315
Total product margin Product design
3,916 1,285
Order size 76 1,764
Less: Customer relations
Product margin 3,675 £1,114
Customer margin £ 241

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 Product Margins
Traditional Cost Accounting System
Standard Compass
Stanchions Housing
Sales £ 13,600 £ 650
Costs
Direct materials (2,110) (13)
Direct labour (1,850) (50)
Manufacturing overhead (10,000) (200)
Product margin £360 £ 387

Predetermined manufacturing £1,000,000

= = £50/MH
overhead rate 20,000 MH

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 Product Margins

Traditional Cost Accounting System

Standard Compass
Stanchions Housing
Sales £ 13,600 £ 650
Costs
Direct materials (2,110) (13)
Direct labour (1,850) (50)
Manufacturing overhead (10,000) (200)
Product margin £360 £ 387

400 units x 0.5 MH/unit x £50/MH = £10,000

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 Difference Between ABC and
Traditional Product Costs
• Under the old cost system the costs of
designing products were spread across
all products without regard to whether
they actually required design work.
• The Customer Orders costs, which are
batch-level costs, were applied on the
basis of machine-hours, a unit-level
base, under the old cost system.
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 Difference Between ABC and
Traditional Product Costs

ABC will ordinarily shift

batch-level and
product-level
overhead costs from
high-volume
products produced
in large batches to
low-volume products
produced in small
batches.
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