When cost systems were developed in the 1800s, the emphasis was on simplicity because:

1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil.

2.   Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product.

When cost systems were developed in the 1800s, the emphasis was on simplicity because:

1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil.

2.   Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product.

Assigning Overhead Costs to Products

3-1

Plantwide Overhead Rate

Plantwide Overhead RatePlantwide Overhead RateA single overhead rate usedA single overhead rate used

throughout an entire factory. throughout an entire factory.

Plantwide Overhead RatePlantwide Overhead RateA single overhead rate usedA single overhead rate used

throughout an entire factory. throughout an entire factory.

Direct labor has often been used as the allocation base 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 costs were highly correlated.

Direct labor has often been used as the allocation base 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 costs were highly correlated.

3-2

Today, direct labor may no longer be a satisfactory base for allocation of overhead.

1. Most companies sell a large variety of products that consume differing amounts of overhead.

2. As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of the new overhead costs may not be correlated with direct labor.

3. Technology advancements have reduced the cost and complexity of gathering diverse sources of data.

Today, direct labor may no longer be a satisfactory base for allocation of overhead.

1. Most companies sell a large variety of products that consume differing amounts of overhead.

2. As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of the new overhead costs may not be correlated with direct labor.

3. Technology advancements have reduced the cost and complexity of gathering diverse sources of data.

Plantwide Overhead Rate

A plantwide overhead allocation system may not be optimalA plantwide overhead allocation system may not be optimalfor many companies in today’s business environment.for many companies in today’s business environment.

A plantwide overhead allocation system may not be optimalA plantwide overhead allocation system may not be optimalfor many companies in today’s business environment.for many companies in today’s business environment.

3-3

Departmental Overhead Rates

Machining Department

Shipping Department

Assembly Department

Many companies have a system in which each department has its own overhead rate.

Many companies have a system in which each department has its own overhead rate.

The allocation base depends on the nature of the work

performed in each department. In the machining department,overhead may be based on machine-hours, but in the

assembly department, overhead may be based on

labor-hours.

The allocation base depends on the nature of the work

performed in each department. In the machining department,overhead may be based on machine-hours, but in the

assembly department, overhead may be based on

labor-hours.

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Activity-base costing is required to account for these other factors.

Activity-base 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.

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 overhead in situations where a company has a range of

products and complex overhead costs.

Departmental rates will not correctly assign overhead in situations where a company has a range of

products and complex overhead costs.

Departmental Overhead Rates

3-5

A number of allocation bases are used for assigning costs to products.

Activity-Based Costing (ABC)

3-6

CostCostCostCost

Activity-Based Costing (ABC)

Consumption of ResourcesConsumption of ResourcesConsumption of ResourcesConsumption of Resources

ActivitiesActivitiesActivitiesActivities

Cost ObjectsCost Objects(e.g., products and customers)(e.g., products and customers)

Cost ObjectsCost Objects(e.g., products and customers)(e.g., products and customers)

3-7

ActivityAn event that causes the consumption of overhead resources

Setting upmachines

Examples of Activities

Admitting hospitalpatients

Opening a bank account

Billingcustomers

Activity-Based Costing (ABC)

3-8

Activity Cost Pool

A “cost bucket” in which costs related to a particular

activity are accumulated.

Activity Measure

Expresses how much of the activity is carried out and is used as the allocation base

for applying overhead costs.

Activity-Based Costing (ABC)

Activity Rate

A predetermined overhead rate for each activity

cost 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.

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.

3-10

Related activities arefrequently combined to reduce

the amount of detail andrecord-keeping costs.

An activity dictionary defines each of the activitiesthat will be included in the activity-based costingsystem and how the activities will be measured.

An activity dictionary defines each of the activitiesthat will be included in the activity-based costingsystem and how the activities will be measured.

For example, several activities maybe involved in handling and moving

raw materials, but these may becombined into a single activity

entitled material handling.

Designing an Activity-BasedCosting System

3-11

Hierarchy of Activities

Level Activities Activity MeasureUnit-level Processing units on machines Machine-hours

Processing units by hand Direct labor-hoursConsuming factory supplies Units produced

Batch-level Processing purchase orders Purchase orders processedProcessing production orders Production orders processedSetting up equipment Number of setupsHandling materials Pounds of material handled

Product-level Testing new products Hours of testing timeAdministering parts inventories Number of part typesDesigning products Hours of design time

Facility-level General factory administration Direct labor-hoursPlant building and grounds Direct labor-hours

Level Activities Activity MeasureUnit-level Processing units on machines Machine-hours

Processing units by hand Direct labor-hoursConsuming factory supplies Units produced

Batch-level Processing purchase orders Purchase orders processedProcessing production orders Production orders processedSetting up equipment Number of setupsHandling materials Pounds of material handled

Product-level Testing new products Hours of testing timeAdministering parts inventories Number of part typesDesigning products Hours of design time

Facility-level General factory administration Direct labor-hoursPlant building and grounds Direct labor-hours

3-12

Graphic Example of Activity-Based Costing

Various Manufacturing Overhead CostsVarious Manufacturing Overhead Costs

LaborLaborRelated PoolRelated Pool

LaborLaborRelated PoolRelated Pool

MachineMachineRelated PoolRelated Pool

MachineMachineRelated PoolRelated Pool

SetupSetupPoolPool

SetupSetupPoolPool

ProductionProductionOrder PoolOrder PoolProductionProductionOrder PoolOrder Pool

GeneralGeneralFactory PoolFactory Pool

GeneralGeneralFactory PoolFactory Pool

PartsPartsAdmin. PoolAdmin. Pool

PartsPartsAdmin. PoolAdmin. Pool

First-Stage Cost Assignment

3-13

Unit-LevelActivity

Batch-LevelActivity

Facility-LevelActivity

Product-LevelActivity

Graphic Example ofActivity-Based Costing

Various Manufacturing Overhead CostsVarious Manufacturing Overhead Costs

ProductsProducts

$/DLH$/DLH $/MH$/MH $/Setup$/Setup $/Order$/Order $/MH$/MH$/Part Type$/Part Type

Second-Stage Allocations

LaborLaborRelated PoolRelated Pool

LaborLaborRelated PoolRelated Pool

MachineMachineRelated PoolRelated Pool

MachineMachineRelated PoolRelated Pool

SetupSetupPoolPool

SetupSetupPoolPool

ProductionProductionOrder PoolOrder PoolProductionProductionOrder PoolOrder Pool

GeneralGeneralFactory PoolFactory Pool

GeneralGeneralFactory PoolFactory Pool

PartsPartsAdmin. PoolAdmin. Pool

PartsPartsAdmin. PoolAdmin. Pool

First-Stage Cost Assignment

3-14

Using Activity-Based CostingComtek Sound, Inc.

Comtek Sound, Inc. makes two products: CD players and DVD players.

The company has been losing bids to supply CD players, its main product, to lower priced competitors.

The company has been winning all bids to supply DVD players, its secondary product.

Comtek Sound, Inc. makes two products: CD players and DVD players.

The company has been losing bids to supply CD players, its main product, to lower priced competitors.

The company has been winning all bids to supply DVD players, its secondary product.

3-15

Note that the unit product cost of a CD Note that the unit product cost of a CD unit decreased from $110 to $95.55 . . . .unit decreased from $110 to $95.55 . . . .Note that the unit product cost of a CD Note that the unit product cost of a CD unit decreased from $110 to $95.55 . . . .unit decreased from $110 to $95.55 . . . .

. . . . while the unit cost of a DVD unit . . . . while the unit cost of a DVD unit increased from $150 to $207.80.increased from $150 to $207.80.

. . . . while the unit cost of a DVD unit . . . . while the unit cost of a DVD unit increased from $150 to $207.80.increased from $150 to $207.80.

Comparing the Two Approaches

DVD Unit CD Unit DVD Unit CD UnitDirect 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 CostingDVD 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

3-16

Activity-Based ManagementActivity-Based ManagementFocuses on managing activities to eliminate Focuses on managing activities to eliminate

waste and reduce delays and defects.waste and reduce delays and defects.

Activity-Based ManagementActivity-Based ManagementFocuses on managing activities to eliminate Focuses on managing activities to eliminate

waste and reduce delays and defects.waste and reduce delays and defects.

Targeting Process Improvements

An ABC system can help identifyareas where the company can benefitfrom improving its current processes.

An ABC system can help identifyareas where the company can benefitfrom improving its current processes.

3-17

The first step in any improvementThe first step in any improvementprogram is deciding what to improve.program is deciding what to improve.

The first step in any improvementThe first step in any improvementprogram is deciding what to improve.program is deciding what to improve.

Targeting Process Improvements

TheThe Theory of Constraints Theory of Constraintsapproach targets theapproach targets the

highest impacthighest impactimprovement opportunities.improvement opportunities.

TheThe Theory of Constraints Theory of Constraintsapproach targets theapproach targets the

highest impacthighest impactimprovement opportunities.improvement opportunities.

Activity ratesActivity rates can be can beused to target areasused to target areaswhere costs seemwhere costs seemexcessively high.excessively high.

Activity ratesActivity rates can be can beused to target areasused to target areaswhere costs seemwhere costs seemexcessively high.excessively high.

Benchmarking Benchmarking can be used to compare activity cost can be used to compare activity cost information with world-class standards of performance information with world-class standards of performance

achieved by other organizations.achieved by other organizations.

Benchmarking Benchmarking can be used to compare activity cost can be used to compare activity cost information with world-class standards of performance information with world-class standards of performance

achieved by other organizations.achieved by other organizations.

3-18

Benefits of Activity-Based Costing

ABC improves the accuracy of product costing by:• Increasing the number of cost pools used to accumulate

overhead costs.• Using activity cost pools that are more homogeneous than

departmental cost pools.• Assigning overhead costs using activity measures that

cause those costs, rather than relying solely on direct labor hours.

ABC improves the accuracy of product costing by:• Increasing the number of cost pools used to accumulate

overhead costs.• Using activity cost pools that are more homogeneous than

departmental cost pools.• Assigning overhead costs using activity measures that

cause those costs, rather than relying solely on direct labor hours.

Activity-based costing also highlights activities that could benefit most from process

improvement efforts, such as Six Sigma.

Activity-based costing also highlights activities that could benefit most from process

improvement efforts, such as Six Sigma.

3-19

Costs of implementing an ABC system may outweighthe benefits. However, the benefits are more likely to be worth the costs when:

1. Products differ substantially in volume, batch size, and in activities required.

2. 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.

Costs of implementing an ABC system may outweighthe benefits. However, the benefits are more likely to be worth the costs when:

1. Products differ substantially in volume, batch size, and in activities required.

2. 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.

Limitations of Activity-Based Costing

3-20

Activity rates are determined as follows:Activity rates are determined as follows:

Activity Cost Pool

Estimated Overhead

Cost

Total Expected Activity

Machine related 175,000$ ÷ 5,000 MHs = 35$ per MHPurchase orders 63,000 ÷ 700 orders = 90$ per orderMachine setups 92,000 ÷ 460 setups = 200$ per setupProduct testing 160,000 ÷ 200 tests = 800$ per testGeneral factory 300,000 ÷ 25,000 DLH = 12$ per DLH

790,000$

Activity RateActivity Cost Pool

Estimated Overhead

Cost

Total Expected Activity

Machine related 175,000$ ÷ 5,000 MHs = 35$ per MHPurchase orders 63,000 ÷ 700 orders = 90$ per orderMachine setups 92,000 ÷ 460 setups = 200$ per setupProduct testing 160,000 ÷ 200 tests = 800$ per testGeneral factory 300,000 ÷ 25,000 DLH = 12$ per DLH

790,000$

Activity Rate

Cost Flows in an ABC System

3-21

Overhead is applied on the basis of actual activities during the year.

Overhead is applied on the basis of actual activities during the year.

Activity Cost PoolActivity

RateActual Activity

Applied Overhead

CostMachine related $35/MH × 4,600 MHs = 161,000$ Purchase orders $90/order × 800 orders = 72,000 Machine setups $200/setup × 500 setups = 100,000 Product testing $800/test × 190 tests = 152,000 General factory $12/DLH × 23,000 DLHs = 276,000 Total Overhead Applied 761,000$

Activity Cost PoolActivity

RateActual Activity

Applied Overhead

CostMachine related $35/MH × 4,600 MHs = 161,000$ Purchase orders $90/order × 800 orders = 72,000 Machine setups $200/setup × 500 setups = 100,000 Product testing $800/test × 190 tests = 152,000 General factory $12/DLH × 23,000 DLHs = 276,000 Total Overhead Applied 761,000$

Cost Flows in an ABC System

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