2-1

Our Agenda Chapters 1,2,3,4.

u Quiz on Chapter 4 u Introduction to managerial accounting

u Submission of Chapter 3 and 4 Project u Cost concepts
u Next Assignment on-deck: Mid-Term Test (BlackBoard u Job costing
Platform: bring a device if possible).
u Process costing
u Other housekeeping?
u Review of previous material
u Create a mind-map of where we have been, with the
u Chapter 5 Lecture: Activity Based Costing most important concepts highlighted. Concepts that
overlap between chapters warrant increased attention.

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Learning Objectives

1. Explain the basics of activity-based costing.

CHAPTER 5
2. Apply activity-based costing.
Activity-Based 3. Understand the benefits and limitations of
Costing activity-based costing.
4. Explain cost flows in an activity-based costing
system.
5. Understand quality costs.
Prepared by
Heather Cornish,
CPA-CA, MBA
NAIT JR Shaw School
of Business

© 2017 McGraw-Hill Education © 2017 McGraw-Hill Education 4

Assigning Overhead Costs to

Cost Objects Problems:
Plant-wide Overhead Rate
Plant-wide Overhead Rate Today, direct labour may no longer be
A single overhead rate used throughout
a satisfactory base for allocation of
an entire factory. A simple method,
overhead.
but one that can distort unit product costs.
ΠDirect labour may no longer be highly
correlated with overhead costs because
Direct labour is often used as the it is no longer a significant component of
allocation base for overhead. the total conversion costs
 No single allocation basis may be able to
adequately reflect the demands that
This is what we have been using… products place on overhead.
© 2017 McGraw-Hill Education 5 © 2017 McGraw-Hill Education 6
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Departmental Overhead A solution:

Rates Activity-Based Costing
The allocation bases depend on
the nature of the work
(ABC) Part 1
Finishing Department performed in each department.
In the machining department, A number of
Painting Department
overhead may be based on allocation bases are
machine-hours, but in the
used for assigning
assembly department
Shipping Department overhead is based on direct costs to products.
labour-hours. The key is to find
Unfortunately, even departmental rates will not correctly assign what drives the
overhead in situations where a company has a range of products activity in a
and complex overhead costs… still not perfect
department.

© 2017 McGraw-Hill Education 7 © 2017 McGraw-Hill Education 8

Activity-Based Costing ABC: Examples of Activities

(ABC) Part 2

Activity Cost Pool

“cost bucket in which costs related to a

particular activity are accumulated”

Each activity has its own activity rate

that is used to apply overhead costs.

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Hierarchy of Activities

Steps in Designing an ABC System Level Activities Activity Measure

1. Identify activities and create an activity dictionary. Unit-level Processing units on machines Machine-hours
2. Create activity cost pools. Processing units by hand Direct labour-hours
3. Identify the resources consumed by individual activity cost Consuming factory supplies Units produced
pools.
Batch-level Processing purchase orders Purchase orders processed
4. Identify the activity measure for each activity cost pool.
Processing production orders Production orders processed
5. Estimate the total activity volume for each measure.
Setting up equipment Number of setups
6. Compute a predetermined activity rate for each activity cost
Handling materials Pounds of material handled
pool.
7. Allocate activity costs to desired cost objects. Product-level Testing new products Hours of testing time
Administering parts inventories Number of part types
Designing products Hours of design time
Facility-level General factory administration Direct labour-hours
© 2017 McGraw-Hill Education 11 Plant building and grounds
© 2017 McGraw-Hill Education Direct labour-hours 12

Example of an ABC System
Flow Chart
© 2017 McGraw-Hill Education
Direct Labour-Hours as a Base
Total manufacturing overhead costs for the current
year are estimated to be $10,000,000. The company
develops the following overhead rate based upon
labour-hours:
Predetermined $10,000,000
overhead rate = 500,000 DLH = $20 per DLH
© 2017 McGraw-Hill Education
Computing Activity Rates:
Changing the game with ABC
The ABC project team at Comtek has
developed the following basic information…
Note, the total manufacturing overhead
($10,000,000) has not changed, we are just
allocating it differently.
© 2017 McGraw-Hill Education
2-3
Using Activity-Based Costing:
Cost this product… (per unit)
Comtek Sound, Inc. makes two products, a radio with a CD
player and one with a DVD player. For the current year,
Comtek has a budget for sales of 50,000 Blu-ray disc
players and 200,000 DVD players.
1. Each product requires two direct labour-hours to
complete.
2. The company plans to work 500,000 hours (DLH) to
meet the budgeted production.
3. All production is sold to auto manufacturers for
installation in new cars and trucks.
4. Direct materials cost $90 per unit for the Blu-ray
disc player and $50 for the DVD player.
5. Direct labour costs (at $10 per hour) are $20 for
both the Blu-ray disc player and the DVD player.
6. Total manufacturing overhead costs for the current
year are estimated to be $10,000,000.
13 © 2017 McGraw-Hill Education 14
In the previous example…
u Both the DVD Player and the Blu-Ray
Player were assigned the same
manufacturing overhead, because they
take the same amount of DLH to
assemble.
u Is there a better way? What other
measures of activity might help us assign
manufacturing overhead more accurately?
15 © 2017 McGraw-Hill Education 16
17 © 2017 McGraw-Hill Education 18
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Example of an ABC System

Calculating Activity Rates Flow Chart
for an ABC System
u Using the previous information, we can
calculate activity rates, and allocate them
more accurately using activity cost pools,
and what best drives the activity.

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Computing Activity Rates Computing Activity Rates

Using the new activity rates, let’s assign overhead to the two ABC overhead rate per
products based upon activity. unit
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Computing Activity Rates Shifting of Overhead Cost

Notice that the unit product cost of a DVD Player

decreased from $110 to $96.70 . . . . .

Low-volume product
When a company implements activity-based costing,
overhead cost often shifts from high-volume to low-
. . . while the unit cost of a Blu-ray Disc Player volume products with a higher unit product cost
increased from $150 to $203.20. resulting for the low-volume products.

© 2017 McGraw-Hill Education 23 © 2017 McGraw-Hill Education 24

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ABC and Nonmanufacturing Evaluation of

Organizations Activity-Based Costing

Activity-based costing has Benefits of ABC:

been implemented in a wide o Accurate costing.
variety of service industries o Cost estimation.
including railroads, hospitals, o Activity-based
banks, and data service management.
companies.

© 2017 McGraw-Hill Education 25 © 2017 McGraw-Hill Education 26

Evaluation of Cost Flows in an ABC System

Activity-Based Costing

Benefits of ABC Limitations of ABC The flow of costs in an ABC system is

ü Accurate costing. o Cost of essentially the same as in a traditional
ü Cost estimation. implementation cost system.
may exceed
ü Activity based
benefits. The only difference is that an ABC system
management.
o Product costs are consists of multiple predetermined
not always activity rates as compared to a single
relevant when predetermined overhead rate in the
making decisions. traditional system.
© 2017 McGraw-Hill Education 27 © 2017 McGraw-Hill Education 28

Four Categories of Quality Costs:

AppendixCosts
Prevention Costs:
5B: Cost of Quality
associated with activities aimed at preventing future
defects/errors Cost of Quality Report
Appraisal Costs Costs associated with quality inspection activities

Internal Failure Costs
External Failure Costs
Costs associated with activities carried out when the defect
is discovered before the product is delivered to the
customer
shows the details of quality costs under
the four categories mentioned above.
Costs associated with activities undertaken after the
defect/error is discovered by the customer.
Typically, an organization might
experience 10% in quality costs (% of
Revenue), but experts say it should be
closer to 2% to 4%

© 2017 McGraw-Hill Education 29 © 2017 McGraw-Hill Education 30

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Chapter Summary

q ABC Costing differs from traditional costing in

that multiple allocation bases are used to
assign overhead costs and the activity cost
pools are diverse.
q Overhead is allocated to jobs using an
estimated allocation rate and multiplying by
the actual allocation base used.
q ABC costing provides more accurate costs,
better cost estimation and cost management…
but it can be complex.

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Activity Based Costing Exercise

u Let’s take the time to work
through a detailed activity based
costing example.

© 2017 McGraw-Hill Education 33