J ohn Wiley & Sons, I nc.

2005
Prepared by
Dan R. Ward
Suzanne P. Ward
University of Louisiana at Lafayette
Managerial Accounting
Weygandt Kieso Kimmel
CHAPTER 4
ACTIVITY- BASED COSTING
CHAPTER 4
ACTIVITY-BASED COSTING
Study Objectives
ORecognize the difference between traditional
costing and activity based costing.
OIdentify the steps in the development of an
activity-based costing system.
OKnow how companies identify the activity cost
pools used in activity-based costing.


Study Objectives: Continued

OKnow how companies identify and use cost
drivers in activity-based costing.
OUnderstand the benefits and limitations of
activity-based costing.
ODifferentiate between
value-added and
non-value-added
activities.


Study Objectives:
Continued
OUnderstand the value of
using activity levels in
activity-based costing.
OApply activity-based
costing to service
industries.

PREVIEW OF CHAPTER 4
Traditional Costing and Activity-Based Costing
Traditional costing systems
The need for a new approach
Activity-based costing
Illustration of Traditional Costing
versus ABC
Unit costs under traditional costing
Unit costs under ABC
Comparing unit costs

PREVIEW OF CHAPTER 4
Continued
Activity-Based Costing: A Closer Look
Benefits/Limitations of ABC
When to use ABC
Value-added vs. Non-value-added activities
Classification of activity levels
Activity-Based Costing in Service Industries
Traditional costing example
Activity-based costing example
Appendix: Just-in-time Processing
Objective Elements - Benefits
ACTIVITY-BASED COSTING VERSUS
TRADITIONAL COSTING
Study Objective 1
Traditional Costing Systems
Allocates overhead using a single predetermined
rate.
Job order costing: direct labor cost is assumed
to be the relevant activity base.
Process costing: machine hours is the relevant
activity base.
Assumption was satisfactory when direct labor
was a major portion of total manufacturing costs.
Wide acceptance of a high correlation between
direct labor and overhead costs.

Traditional Costing Systems:
Continued
Direct labor is still often the appropriate basis
for assigning overhead costs when:
Direct labor constitutes a significant part of
total product cost
and
High correlation exists between direct labor and
changes in overhead costs.


Overhead Direct Labor Products
Costs Hours/Dollars
Need for 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).
Activity-Based Costing (ABC)

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.




Activity-Based Costing (ABC)
Terms
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: a distinct type of activity.
For example: ordering materials or setting up
machines.

Cost Drivers: any factors or activities that have a
direct cause-effect relationship with the
resources consumed.


The Logic Behind ABC

Products consume activities,
and
activities consume resources.




Activity-Based Costing (ABC) Continued
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 products manufacturing
operation, the more activities and cost drivers likely
to be present.

Activities and Related Cost Drivers
ABC System Design Lift Jack Company
Traditional Costing vs ABC

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.
Traditional Costing vs ABC
An Illustration
Study Objectives 2, 3, & 4
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 (25,000 + 5000)
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


Unit Costs Under Traditional Costing
Products

Manufacturing Costs The Boot The Club
Direct Materials $40 $30
Direct Labor 12 12
Overhead 30* 30*
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 X 1 hr. = $30)

Unit Costs Under ABC:
Step 1: Identify and Classify Activities and
Allocate Overhead to Cost Pools
Study Objective 3

Activity Cost Pools Estimated Overhead
Setting up machines $300,000
Machining 500,000
Inspecting 100,000
Total $900,000



Unit Costs Under ABC:
Step 2: Identify Cost Drivers
Study Objective 4
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



Unit Costs Under ABC:
Step 3: Compute Overhead Rates

Formula for Computing Activity-Based Overhead Rate:

Estimated Overhead Per Activity Activity-Based

Expected Use of Cost Drivers Per Activity Overhead Rate


Expected Use
Estimated of Cost Drivers Activity-Based
Activity Cost Pools Overhead Per Activity Overhead Rates
Setting up machines $300,000 1,500 setups $200 per setup
Machining 500,000 50,000 machine hrs. $ 10 per mach. hour
Inspecting 100,000 2,000 inspections $ 50 per inspection
Total $900,000


Unit Costs Under ABC:
Step 4: Assign Overhead Costs to Products
Part 1: Expected Use of Cost Driver Per Product
Expected Use
of Cost Drivers
per Product
Expected Use
Activity Cost of Cost Drivers
Pools Cost Driver Per Activity The Boot The Club
Setting up Number of
machines setups 1,500 setups 500 1,000
Machining Machine hours 50,000 hours 30,000 20,000
Inspecting Number of
inspections 2,000 inspections 500 1,500
Unit Costs Under ABC:
Step 4: Assign Overhead Costs to Products
Part 2: Assign Cost Pools to Products

The Boot
Expected Use of Activity-Based
Activity Cost Drivers X Overhead = Cost
Cost Pools per Product Rates Assigned
Setting up machines 500 $200 $100,000
Machining 30,000 10 300,000
Inspecting 500 50 25,000
Total costs assigned $425,000
Units produced 25,000
Overhead cost per unit $17

Unit Costs Under ABC:
Step 2: Assign Overhead Costs to Products
Part 2: Assign Cost Pools to Products

The Club
Expected Use of Activity-Based
Activity Cost Drivers X Overhead = Cost
Cost Pools per Product Rates Assigned
Setting up machines 1,000 $200 $200,000
Machining 20,000 10 200,000
Inspecting 1,500 50 75,000
Total costs assigned $475,000
Units produced 5,000
Overhead cost per unit $95

Comparison of Unit Costs
Traditional vs ABC

The Boot The Club
Traditional Traditional
Manufacturing Costs Costing ABC Costing ABC
Direct Materials $40 $40 $30 $30
Direct Labor 12 12 12 12
Overhead 30 17 30 95
Total Cost per Unit $82 $69 $72 $137


Overstated Understated
$13 $65
Activity-Based Costing:
A Closer Look
Study Objective 5
More accurate product costing through:
Use of more cost pools to assign overhead costs
Enhanced control over overhead costs
Better management decisions
Activity-Based Costing: A Closer Look
Limitations of ABC

Can be expensive to use
Some arbitrary allocations continue



Activity-Based Costing:
A Closer Look
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
Lets Review
Activity-based costing (ABC):

a. Can be used only in a process cost system
b. Focuses on units of production
c. Focuses on activities performed to
produce a product
d. Uses only a single basis of allocation
Lets Review
Activity-based costing (ABC):

a. Can be used only in a process cost system
b. Focuses on units of production
c. Focuses on activities performed to
produce a product
d. Uses only a single basis of allocation
Value-Added vs.
Non-Value-Added Activities
Study Objective 6
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.



Value-Added vs.
Non-Value-Added Activities
Value-Added Activity
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


Value-Added vs.
Non-Value-Added Activities
Non-Value-Added 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 finished goods Traveling
Building maintenance Ordering supplies
Inspections
Inventory Control

CLASSIFICATION OF
ACTIVITY LEVELS
Study Objective 7
OUnit-level activities:
Performed for each unit of production
OBatch-level activities:
Performed for each batch of product
OProduct-level activities:
Performed in support of an entire product line, but
not always performed every time a new unit or
batch is produced
OFacility-level activities:
Required to support or sustain an entire production
process

Hierarchy of Activity Levels
Four Levels Types of Activities Cost Drivers
Unit-Level Activities Machine-related: Machine Hours
Drilling, cutting, milling
Labor-related Direct labor hours/cost
Assembling, painting
Batch-Level Activities Equipment setups Number of setups/setup time
Purchase ordering Number of purchase orders
Inspection Number of inspections or
inspection time
Material handling Number of material moves
Product-Level Activities Product design Number of product designs
Engineering changes Number of changes
Facility-Level Activities Plant management Number of employees
salaries managed
Plant depreciation Square footage
Property taxes Square footage
Utilities Square footage
Activity-Based Costing
in Service Industries
Study Objective 8
Similarities with Manufacturing Firms
Overall objective:
I dentify 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


Activity-Based Costing
in Service Industries
Study Objective 8

Major difficulty to implementing
ABC:
A larger proportion of overhead
costs are company-wide costs
that cannot be directly traced to
specific services.
Activity-Based Costing in Service
Industries: Traditional Costing Example
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 cost

$1,200,000
= 200%
$600,000




Activity-Based Costing in Service
Industries:
ABC Costing Example
CHECK AND DOUBLECHECK, CPAs
Plano Molding Company Audit

Revenue $260,000
Less: Direct professional labor $ 70,000
Applied Overhead (200% x $70,000) 140,000 210,000
Operating Income $ 50,000




Activity-Based Costing in Service Industries:
ABC Costing Example
CHECK AND DOUBLECHECK, CPAs
Annual Overhead Budget
Expected Use
Activity Cost Estimated + of Cost Drivers = Activity-Based
Pools Cost Drivers Overhead Per Activity Overhead 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 $ 71,000 Based on usage
Legal support Hours used 129,000 860 $150 per hour
Insurance Revenue billed 120,000 $2,000,000 $0.06 per $1 rev.
Recruiting and training Direct Prof. Hours __210,000 30,000 $7 per hour
$1,200,000
Activity-Based Costing in Service Industries:
ABC Costing Example
CHECK AND DOUBLECHECK, CPAs
Plano Molding Company Audit
Activity-
Based-
Activity Cost Actual Use Overhead
Pools Cost Drivers of Drivers Rates Cost Assigned
Secretarial support Direct Professional hours 3,800 $ 7.00 $ 26,600
Direct labor Fringe benefits Direct labor cost $ 70,000 $ 0.40 28,000
Printing and photocopying Working paper pages 1,800 $ 1.00 1,800
Computer support CPU minutes 8,600 $ 4.00 34,400
Telephone and postage None (traced directly) 8,700
Legal support Hours used 156 $150.00 23,400
Insurance Revenue billed $260,000 $ 0.06 15,600
Recruiting and training Direct Prof. Hours 3,800 $ 7.00 26,600
$165,100
Activity-Based Costing in Service
Industries: ABC Costing Example
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 140,000 165,100
Total expenses 210,000 235,100
Operating income $ 50,000 $ 24,900

Profit Margin 19% 10%
Summary of Study Objectives
O 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.

O 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.


Summary of Study Objectives
O Know how companies identify cost pools used in ABC.
Analyze each operation or process, document and time every task,
action, or transaction.

O 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.

O 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



Summary of Study Objectives

O 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.

O 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.



Summary of Study Objectives
O 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



Appendix
Just-In-Time Processing (JIT)
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.







Just-In-Time Processing
Goods Manufactured
Sales Order
Received
100 pairs of
sneakers...
got it!
Send rubber and
shoe laces directly
to the factory.
JIT Processing
Objective of J I T:
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

Lets 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. Nonvalue-added activity
Lets 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. Nonvalue-added activity
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