Chapter Eight

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Activity-Based Costing
Chapter 8
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Learning Objectives

1. Understand the potential effects of using
   reported product costs for decision making.

1. Explain how a two-stage product costing system
   works.

1. Compare and contrast plantwide and department
   allocation methods.

1. Explain how activity-based costing and a
   two-stage product system are related.

1. Compute product costs using activity-based
   costing.

1. Compare activity-based product costing to
   traditional department product costing methods.

1. Demonstrate the flow of costs through accounts
   using activity-based costing.

1. Apply activity-based costing to marketing and
   administrative services.

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Product Costs and Decision Making
L.O. 1 Understand the potential effects of using
reported product costs for decision making.
Remember Sammys Skis and Boards?
Sammy is considering dropping snowboards.
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Sammys Skis and Boards
Sammys costs without snowboards.
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Sammys Skis and Boards
Look at overhead
Sammy allocates 18,000 overhead to the
Snowboards.
Only 5,400 of the overhead is avoided if
Snowboards are not produced.
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Two-Stage Allocation Systems
L.O. 2. Explain how a two-stage product costing
system works.
Allocate overhead costs to departments.
Stage One
Allocate department overhead costs to the
products or services.
Stage Two
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Two-Stage Cost Allocation Continued
Cost Pool
Overhead
Intermediate Cost Pools
Department A
Department B
Cost Allocation Rule
Direct Labor Hours
Machine Hours
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Plantwide versus Department Allocation Method
L.O. 3 Compare and contrast plantwide and
department allocation methods.
Plantwide Allocation Method
All overhead costs are recorded in one cost pool
and applied to products using one overhead
allocation rate.
One cost pool for the factory
One allocation rate
Factory Overhead Costs
Products
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Department Allocation
Overhead costs traced to separate departments and
applied to products using a department allocation
rate.
One cost pool for each department
Each department has an allocation rate
Assembly Department Overhead Costs
Packaging Department Overhead Costs
Products
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Cost Allocation An Example
Production and Cost Data
Port Arthur Manufacturing Facility
Third Quarter
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Cost Allocation An Example
Production and Cost Data
Port Arthur Manufacturing Facility
Third Quarter
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Cost Allocation An Example Continued
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Two-Stage Cost Allocation Continued
Cost Pool
Overhead
Intermediate Cost Pools
Assembly
Packaging
Cost Allocation Rule
Machine Hours
Direct Labor Cost
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Cost Allocation An Example Continued
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Choice of Cost Allocation Method
Which cost allocation method is appropriate?
Similar products using same resources
Plantwide Allocation
Multiple products using resources differently
Department Allocation
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Activity-Based Costing (ABC)
L.O. 4 Explain how activity-based costing and a
two-stage product system are related.
Activity-Based Costing
Costing method that first assigns costs to
activities and then allocate them to products
based on the products consumption of activities.
Stage One
Assign costs to activities
Stage Two
Allocate costs to products based on the use of
each activity
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ABC Continued
Why ABC?
Activities consume resources
Products consume activities
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Developing Activity-Based Costing

1. Identify the activities that consume resources
   and assign costs to them.

1. Identify the cost driver(s) associated with each
   activity.

1. Compute a cost rate per cost driver unit or
   transaction.

1. Allocate costs to products by multiplying the
   cost driver rate by the volume of cost driver
   units consumed by the product.

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Cost Drivers
Factors that cause or drive an activitys costs.
Identified activity
Identified cost driver
Preparing cafeteria food Number of students in the dorm
Taking customer orders Number of orders
Setting up equipment Number of set-ups
Purchasing materials Number of purchase orders
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Cost Allocation Pools
Plantwide
One pool
Department
As many pools as departments
ABC
As many pools as activities and cost drivers
identified
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Cost Allocation Pools ABC
Cost Flow Diagram Activity-Based Costing System
Assign costs to activities
Allocate costs to products based on the use of
each activity
Set-up hours
Production runs
Machine hours
Shipments
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Cost Hierarchy
Classification of cost drivers into general
levels of activity volume, batch, product and so
on.
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Cost Hierarchy
Classification of cost drivers into general
levels of activity volume, batch, product and so
on.
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Cost Hierarchy
Classification of cost drivers into general
levels of activity volume, batch, product and so
on.
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Cost Hierarchy
Classification of cost drivers into general
levels of activity volume, batch, product and so
on.
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Cost Hierarchy
Classification of cost drivers into general
levels of activity volume, batch, product and so
on.
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ABC Example
L.O. 5 Compute product costs using activity-based
costing.
Production and Cost Data
Port Arthur Manufacturing Facility
Third Quarter
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ABC Example Continued
Identify the activities
Step 1
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ABC Example Continued
Identify the cost drivers and the expected volume
of each cost driver.
Step 2
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ABC Example Continued
Compute the Cost Driver Rates
Step 3
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ABC Example Continued
Step 4
Allocate costs to products
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ABC Example Continued
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Cost Flow Diagram
Cost Flow Diagram
Activity-Based Costing System
Port Arthur Manufacturing Facility
Direct costs
Overhead costs
Assembly
Packaging
Assemble
Handle Material
Set-up
Inspect Pack
Ship
J3MP
J5MP
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Product Cost Methods A Comparison
L.O. 6 Compare activity-based product costing to
traditional department product costing methods.
Comparison of Reported Unit Product Costs
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Overhead Costs using ABC
L.O. 7 Demonstrate the flow of costs through
accounts using activity-based costing.
Lets see ABC cost flow for the Assembly
Department
Its T Account time
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Direct Material Costs
Assembly WIP J3MP
DM1,500,000
Material Inventory
1,500,000
2,400,000
Assembly WIP J5MP
DM2,400,000
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Direct Labor Costs
Assembly WIP J3MP
DM1,500,000
Wages Payable
DL 750,000
750,000
600,000
Assembly WIP J5MP
DM2,400,000
DL 600,000
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Overhead Costs
Assembling
Assembly WIP J3MP
180,000
DM1,500,000
900,000
DL 750,000
Setting up Machines
OH 240,000
36,000
Assembly WIP J5MP
360,000
DM2,400,000
Handling Material
DL 600,000
24,000
OH1,380,000
120,000
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Transfer from Assembly to Packaging
Assembly WIP J3MP
Packaging WIP J3MP
DM1,500,000
2,490,000
2,490,000
DL 750,000
OH 240,000
Assembly WIP J5MP
Packaging WIP J5MP
DM2,400,000
4,380,000
4,380,000
DL 600,000
OH1,380,000
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ABC in Administration
L.O. 8 Apply activity-based costing to marketing
and administrative services.
The same four-step process

1. Identify the activities that consume resources.

1. Identify the cost driver associated with each
   activity.

1. Compute a cost rate per cost driver for each unit
   or transaction.

1. Allocate costs to the marketing or administration
   activity by multiplying the cost driver rate by
   the volume of cost driver units consumed by that
   activity.

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Chapter 8
The End