Introduction Chapter 01

1
Activity-Based Costing
2
Objectives
After studying this chapter, you should be able
to
1. Describe the basics of plant wide and
departmental overhead costing. 2. Explain why
plant wide and departmental overhead costing may
not be accurate. 3. Provide a detailed
description of activity-based product costing.
Continued
3
Objectives
4. Explain how the number of activity rates can
be reduced. 5. Describe activity-based system
concepts including an ABC relational database and
ABC software.
After studying this chapter, you should be able
to
4
Unit-Level Product Costing
Unit-Level Product Costing

• Function-based product costing assigns only
  manufacturing costs to products
• Direct costs are traced
• Assignment of manufacturing overhead relies on
  driver tracing or allocation
• Pooled costs are assigned to products using
  predetermined overhead rates based on unit-level
  drivers
• Overhead rate Budgeted annual overhead
• Budgeted annual
  driver level

5
Functional-Based ProductCosting Model
Direct Materials
Direct Labor
Overhead
PRODUCTS
6
Unit-Level Product Costing (continued)
Unit-Level Product Costing (continued)

• Unit-level drivers are factors that measure the
  demands placed on unit-level activities by
  products
• Unit-level activities are activities performed
  each and every time a unit of product is
  produced.
• Commonly used unit-level drivers include
• Units produced
• Direct labor hours
• Direct labor dollars
• Machine hours
• Direct material dollars

7
Overhead Assignment Plant-wide Rates

• Plant-wide or departmental predetermined overhead
  rates are used to assign or apply overhead costs
  to production as the actual production activity
  unfolds.
• The predetermined overhead rate is the basis for
  per-unit overhead cost calculation.

8
Overhead Assignment Plant-wide Rates (continued)

• Applied overhead is the total manufacturing
  overhead assigned to actual production at any
  point in time.
• It is computed using the following formula
• Applied overhead Overhead rate X Actual
  driver usage

9
Overhead Assignment Plant-wide Rates (continued)

• The amount of overhead applied to production
  usually differs from actual overhead since the
  predetermined overhead rate is based on
  estimates.
• As a result, applied overhead is either over- or
  under-applied

10
Overhead Assignment Plant-wide Rates (continued)

• The difference between the amount of actual
  overhead and applied overhead is the overhead
  variance.
• Under-applied overhead occurs when actual
  overhead is higher than applied overhead
• Over-applied overhead occurs when actual overhead
  is lower than applied overhead
• Overhead variances are disposed of in two ways
  based on materiality
• If an immaterial amount assigned to COGS
• If material assigned to WIP, FG inventory and
  COGS

11
Limitations of Plant-wide Departmental Rates
(an example)

• Goodmark Company produces two products scented
  and regular birthday cards.

12
Limitations of Plant-wide Departmental Rates
(an example)

• Note When overhead rates are a significant
  percentage of total manufacturing costs a
  significant cost distortion can result.
• When this happens, plant- and department-wide
  overhead rates do not work well.

13
Goodmark CompanyAn Example
Product Costing Data
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Goodmark CompanyAn Example
Product Costing Data
Departmental Data
Cutting Dept. Printing Dept. Total
Direct labor hours Scented cards 10,000 10,000
20,000 Regular cards 150,000 10,000 160,000 Tota
l 160,000 20,000 180,000 Machine hours Scented
cards 2,000 8,000 10,000 Regular cads
8,000 72,000 80,000 Total 10,000
80,000 90,000
Continued
15
Departmental Data
Cutting Dept. Printing Dept. Total
Overhead costs Setting up equipment 120,000 1
20,000 240,000 Moving materials 60,000 60,000 12
0,000 Machining 20,000 180,000 200,000 Inspectin
g products 16,000 144,000
160,000 Total 216,000 504,000 720,000
16
Goodmark CompanyAn Example
Plantwide Overhead Rate
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Goodmark CompanyAn Example
Unit Cost Computation Plantwide Rates
Scented Cards Regular Cards
Prime costs 160,000 1,500,000 Overhead
costs 4.00 x 20,000 80,000 4.00 x 160,000
640,000 Total manufacturing costs 240,000 2,140
,000 Units of production 20,000
200,000 Unit cost 12.00 10.70
18
Goodmark CompanyAn Example
Departmental Rates
19
Goodmark CompanyAn Example
Departmental Rates
20
Goodmark CompanyAn Example
Unit Cost Computation Departmental Rates
Scented Cards Regular Cards
Prime costs 160,000 1,500,000 Overhead
costs (1.35 x 10,000) (6.30 x
8,000) 63,900 (2.35 x 150,000)
(6.30 x 72,000) 656,100 Total manufacturing
costs 223,900 2,156,100 Units of production
20,000 200,000 Unit cost 11.20
10.78



Rounded to nearest cent
21
Limitations of Plant-wide Departmental Rates
(continued)
As was said earlier, there are at least two major
factors that can impair the ability of the
unit-based plantwide and departmental rates to
assign overhead costs accurately (1) the
proportion of nonunit-related overhead costs to
total overhead costs is large, and (2) there is
a great degree of product diversity.
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Goodmark CompanyAn Example
Product Diversity Consumption Ratios
Overhead Activity Scented Cards Regular Cards
Activity Drivers
Setups 0.60 0.40 Production runs Moving
materials 0.60 0.40 Number of moves Machining 0.11
0.89 Machine hours Inspection 0.11 0.89 Inspectio
n hours
a a b
b c c d
d
a b c d
60/100 (scented) and 40/100 (regular) 180/300
(scented) and 120/300 (regular) 10,000/90,000
(scented) and 80,000/90,000 (regular) 2,000/18,000
(scented) and 16,000/18,000 (regular)
rounded
23
A Possible Solution Activity Rates

• One solution to overcoming the distortions caused
  by the unit-level rates is to expand the number
  of rates used so that the rates reflect the
  actual consumption of overhead costs by the
  various products.
• Instead of pooling the overhead costs in plant
  and departmental pools, rates would be calculated
  for each individual overhead activity.
• These rates would be based on causal factors that
  would measure consumption.

24
Goodmark CompanyAn Example
Unit Cost Computation Activity Rates
Scented Cards Regular Cards
Prime costs 160,000 1,500,000 Overhead
costs Setting up 2,400 x 60 144,000 2,400
x 40 96,000 Machining 2.20 x
10,000 22,200 2.20 x 80,000 177,600
Continued
25
Scented Cards Regular Cards
Overhead costs(contd) Inspecting 8.89 x
2,000 17,780 8.89 x 16,000 142,240 Moving
materials 400 x 180 72,000 400 x
120 48,000 Total manufacturing
costs 415,980 1,963,840 Units of production
20,000 200,000 Unit cost 20.80
9.82
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Activity-Based Costing Model
Cost of Resources
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Design Steps for an Activity-Based Costing System

• 1. Identify, define, and classify activities and
  key attributes.
• 2. Assign the cost of resources to activities.
• 3. Assign the cost of secondary activities to
  primary activities.
• 4. Identify cost objects and specify the amount
  of each activity consumed by specific cost
  objects.
• 5. Calculate primary activity rates.
• Assign activity costs to cost objects.
• Please see the Illustrative Example on page 136
  in your textbook.

28
Activity-Based Costing

• A primary activity is an activity that is
  consumed by a final cost object such as a product
  or customer.
• A secondary activity is one that is consumed by
  intermediate cost objects such as primary
  activities, materials, or other secondary
  activities.

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Activity Dictionary Cardiology Ward
Activity Description
Activity Name
Activity Type
Cost Object(s)
Activity Driver
Supervising Scheduling, Secondary Activities Perce
ntage nurse coordinating, within time
nurses and performance department spend
on evaluation each activity Treating Admi
nistering Primary Patient types Number
of patients medicine and treatments changing d
ressings
Continued
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Activity Description
Activity Name
Activity Type
Cost Object(s)
Activity Driver
Providing Bathing, Primary Patient types Labor
hours hygienic care changing bedding
and clothes, walking patients Responding
to Answering Primary Patient types Number
of patient calls, counseling, requests requests
providing snacks, etc. Monitoring Monitoring Pri
mary Patient types Monitoring patients vital
signs hours and posting patient information
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Cardiology Ward Example (Contd)
Percentage of Time for Each Activity

• Activity Supervisor
  Nurses
• Supervising nurses 100 0
• Treating patients 0 25
• Providing hygienic care 0 20
• Responding to requests 0 40
• Monitoring patients 0 15

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Cardiology Ward Example (Contd)
Unbundling of General Ledger Costs Chart of
Accounts View
Supervising 50,000 Supplies 40,600 Uniforms 8,2
00 Salaries 300,000 Computer 1,200 Monitor
80,000 Total 480,000
33
Unbundling of General Ledger Costs ABC View
Cardiology Ward Example (Contd)

• Supervising nurses 52,280
• Treating patients 90,000
• Providing hygienic care 76,600
• Responding to requests 133,200
• Monitoring patients 127,920
• Total 480,000

34

Cardiology Ward Example (Contd)
Assignment of Secondary Activity Costs to Primary
Activities
90,000 (0.25 x 52,280)

• Treating patients 103,070
• Providing hygienic care 87,056
• Responding to requests 154,112
• Monitoring patients 135,762

76,600 (0.20 x 52,280)
133,200 (0.40 x 52,280)
127,920 (0.15 x 52,280)
35

Cardiology Ward Example (Contd)
Rate Calculations

• Treating patients 103,070/30,000 3.44 per
  treatment
• Providing hygienic care 87,056/16,000
  5.44 per hour of
• care
• Responding to requests 154,112/80,000
  1.93 per request
• Monitoring patients 135,762/200,000
  0.68 per monitoring hour

36

Cardiology Ward Example (Contd)
Bill of Activities
Activity
Intensive
Activity Driver
Normal Intermediate Care
Total Production (output) Patient
days 10,000 5,000 3,000 Treating
patients Treatments 5,000 10,000 15,000 30,000 Pro
viding hygienic care Hygienic hours 5,000 2,500 8,
500 16,000 Responding to requests Requests 30,000
40,000 10,000 80,000 Monitoring
patients Monitoring hours 20,000 60,000 120,000 20
0,000
37

Cardiology Ward Example (Contd)
Assigning Cost Final Cost Objects
Normal
Treating patients 3.44 x 5,000
17,200 Providing hygientic care 5.44 x
5,000 27,200 Responding to requests 1.93 x
30,000 57,900 Monitoring patients 0.68 x
20,000 13,600 Total cost 115,900 Units
10,000 Nursing cost per patient day 11.59
38

Cardiology Ward Example (Contd)
Assigning Cost Final Cost Objects
Intermediate
Treating patients 3.44 x 10,000
34,400 Providing hygientic care 5.44 x
2,500 13,600 Responding to requests 1.93 x
40,000 77,200 Monitoring patients 0.68 x
60,000 40,800 Total cost 166,000 Units
5,000 Nursing cost per patient day 33.20
39

Cardiology Ward Example (Contd)
Assigning Cost Final Cost Objects
Intensive Care
Treating patients 3.44 x 15,000
51,600 Providing hygientic care 5.44 x
8,500 46,240 Responding to requests 1.93 x
10,000 19,300 Monitoring patients 0.68 x
120,000 81,600 Total cost 198,740 Units
3,000 Nursing cost per patient day 66.25
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Activity-Level Classification

• Unit-level activities are those that are
  performed each time a unit is produced.
• Examples Power and machine hours are used each
  time a unit is produced. Direct materials and
  direct labor activities are also unit-level
  activities, even though they are not overhead
  costs.

41
Activity-Level Classification

• Batch-level activities are those that are
  performed each time a batch of products is
  produced.
• Examples Setups, inspections, purchasing, and
  material handling.

42
Activity-Level Classification
Product-level (sustaining) activities are those
activities performed that enable the various
products of a company to be produced. These
activities and their costs tend to increase as
the number of different products increases.
Examples Engineering changes, developing
product-testing procedures, introducing new
products, and expediting goods.
43
Activity-Level Classification
Facility-level activities are those that sustain
a factory's general manufacturing processes.
Examples Plant management, landscaping,
maintenance, security, property taxes, and
plant depreciation.
44
Activities Classification and Homogeneous Sets
Processed classified activities
45
From processed-classification activities
Activity Level Filter
Level-Classification activities
Homogenous sets
46
Reducing the Size and Complexity of an ABC System

• ABC requires an activity rate for each activity.
• However, an organization may have hundreds of
  activities and activity rates, increasing the
  costs of calculating and keeping track of them,
  and creating complexity in reporting.
• Question is more always better?

47
Reducing the Size and Complexity of an ABC System

• Not always a few activity rates may be
  preferable to a large number, resulting in an
  approximately relevant ABC System rather than a
  precisely useless one!
• The example on pages 144-146 shows how a few
  activity drivers can sometimes be as effective as
  using a lot.
• In this example, manufacturing overhead was
  assigned as follows
• Allocation Method Wafer
  A Wafer B
• Plant-wide
  1,400,000 600,000
• 12 Activities
  800,000 1,200,000
• 4 Activities
  820,000 1,180,000
• 2 Activities
  800,000 1,200,000
• Reduced ABC System Assignment
• Reduced equally accurate ABC System Assignment

48
ABC System Concepts

• The emergence of ABC as a viable alternative to
  existing cost management systems is largely due
  to significant advances in information
  technology.
• ABC requires the development of an ABC Database
  and use of an ABC Software program (such as an
  ERP System).

49
ABC Database

• An ABC database is the collected data sets that
  are organized and interrelated for use by an
  organizations activity-based costing information
  system.
• A data set is a grouping of logically related
  data.