Chapter 4 - Activity-Based Costing

(through page 196 only)

Traditional Plantwide Overhead Rate
 In Chapter 3 we learned how to use a Predetermined Overhead Rate (POHR)
o Based on estimates made at the beginning of
the year
POHR = Total Estimated Overhead
Total Estimated Allocation Base
o One rate used to allocate manufacturing
overhead to jobs and products produced during the year
o Use of POHR developed in early 1900’s manufacturing was labor intensive

Refining Cost Systems

 As companies diversify their product lines and manufacturing processes, a single
plantwide overhead rate may not be useful
 Cost Distortion results when some products are overcosted and some are undercosted
by the cost allocation system

DEPARTMENTAL OVERHEAD RATES

 Separate predetermined manufacturing overhead rates for each department
 Useful when
o Departments incur different amounts and types of MOH
o Different jobs or products use the department resources to a different extent
 Each department has a separate overhead pool and may have a different allocation
base

Brewing Bottling Packaging

 4 Steps are similar to the steps used in Chapter 3, but are done for each department
1) Estimate total overhead
2) Estimate total allocation base
3) Calculate POHR
4) Allocate overhead costs to cost object:
POHR x ACTUAL amount of allocation base
Donovan’s Fine Furnishings manufactures upscale custom furniture and currently uses a
plantwide overhead rate based on direct labor hours.
Plantwide Information:
Total Estimated Overhead $1,150,000
Total Estimated Direct Labor Hours 25,000 DLH
The owner and CEO is considering refining the company’s costing system by using
departmental overhead rates and has determined the following:
Departmental Information:
Department Estimated Overhead Estimate Allocation Base
Machining $825,000 13,750 machine hours
Finishing $325,000 13,000 direct labor hours

Information pertaining to two jobs completed on May 15 follows:

Machining Dept. Finishing Dept.
Job 450 2 MH 1 DLH 4 DLH
Job 455 5 MH 2 DLH 3 DLH

Req. 1

Plant-wide = $1,150,000
allocation rate = 25,000 DLH

=$46 per DLH

Req. 2
Machining Dept. $825,000
=
overhead rate 13,750 MH

= $60 per MH

Finishing Dept. = $325,000

overhead rate 13,000 DLH

= $25 per DLH

Req. 3
Overhead allocation based on single, plant-wide rate:
Job 450 Job 455
Total direct labor hours 5 5
× Plant-wide allocation rate  $46 per DLH  $46 per DLH
Overhead allocation $230 $230
Req. 4
Overhead allocation based on departmental rates:
Job 450 Job 455
Machining Department:
Departmental allocation rate $60 per MH $60 per MH
× Machine hours used by Job  2  5
Overhead allocation $120 $300

Finishing Department:
Departmental allocation rate $25 per DLH $25 per DLH
× DL hours used by Job  4  3
Overhead allocation $100 $75

Total overhead allocation (from $220 $375

both departments
Req. 5 Does the plantwide overhead rate over or undercost either job?
Job 455 was overcosted by $10, however, job 455 was undercosted by $145

ACTIVITY-BASED COSTING (ABC)

 Focuses on ACTIVITIES instead of just departments
 Not limited to inventoriable product costing – often used for full costs along all value
chain elements (total cost definition from Chapter 2)
 Further refines the costing system

Manufacturing
Activities

Machine Materials Fabricating Supervising Inspecting Packaging

Setup Handling Parts Assembly Products Products

 Four Steps:
1) Identify activities and estimate the overhead costs of each for the year
2) Select activity allocation base for each activity and estimate total amount for the
year
3) Calculate activity cost rate
4) Allocate costs: Activity cost rate x Actual amount of activity allocation base
  Allocation base should be the COST DRIVER:
Activities: Possible Cost Drivers:
Material purchasing # of purchase orders
Material handling # of parts
Production scheduling # of batches
Quality inspections # of inspections
Photocopying # of pages copied
Warranty service # of service calls

West Horizon uses ABC to account for its chrome wheel manufacturing process. Company managers have
identified the following activity cost pools and the expected amounts of the allocation base for each:

Activity Estimated Cost Allocation Base

Materials handling $13,200 Number of Parts
Machine setup $5,200 Number of Setups
Insertion of parts $49,500 Number of Parts
Finishing $86,100 Finishing Direct Labor Hours
Total $154,000
The company expects to produce 1,000 chrome wheels during the year. The wheels are expected to use
3,300 parts, require 20 setups, and 2,100 hours of finishing time.
The following is the actual results of two Jobs completed during the coming year:

Number of Parts Number of Setups Finishing DLH

Job 420 100 3 140
Job 510 425 6 350

Req. 1 Compute the allocation rate for each activity

West Horizon
Computation of Indirect Cost Allocation Rates
Estimated
Quantity of
Total Cost Activity
Estimated Allocation Cost Allocation
Activity Cost Base Rate
Materials handling $13,200/ 3300 parts = $4 per part
Machine setups $5,200/ 20 setups = $260 per setup
Insertion of parts $49,500/ 3300 parts = $15 per part
Finishing $86,100/ 2100 DLH = $41 per DLH
Req. 2 Compute the manufacturing overhead for Job 420

Activity MOH Cost

Materials handling. 100 parts * $4 $400
Machine setup. 3 setups * $260 $780
Insertion of parts. 100 parts * $15 $1,500
Finishing. 140 DLH * $41 $5,740
Total 8,420

Req. 3 Compute the manufacturing overhead for Job 510

Activity MOH Cost

Materials handling
Machine setup COST HIERARCHY –
Insertion of parts  System used by
Finishing companies to
Total $23,985 assist in
establishing
activity cost pools
 Allows managers to combine many different activities that behave the same way into
manageable costs pools
o Company may identify 100 activities, but can group them together into 10 or 15
cost pools

Classifies costs into 4 different levels:

Unit-level activities
 activities and costs incurred for every unit
 Examples: inspecting and packaging each unit

Batch-level activities
 activities and costs incurred for every batch, regardless of the number of units in the
batch
 Example: machine set-ups, ordering materials for a specific batch of product

Product-level activities
 activities and costs incurred for a product, regardless of the number of units or
batches of the product produced
 Examples: cost to research, develop, and market new products

Facility-level activities
 activities and costs incurred regardless of volume of production
  Example: depreciation, insurance, property tax, and maintenance on the production
plant, CEO salary

ACTITY-BASED MANAGEMENT (ABM)

 Using ABC to make decisions to improve profitability

Pricing and Product Mix

• Change the prices for products after identifying the different total cost
• Decide to market the higher profitability product
• Shift the product mix away from less-profitable products

Cutting Costs
 Value-Added Activities - customers are willing to pay for because
these activates add value
 Non-Value-Added Activities- or waste activities; do not enhance the
product
 Value-Engineering-
 Improve value-added activities
 Eliminate or Reduce non-value-activities
Which of the following would be considered a value-added activity?
A) storage of raw materials
B) movement of parts to production floor
C) sanding and finishing wood rockers
D) janitorial services

Planning and Control

 Uses the costs of activities to create budgets
 Compare with actual activities to see if goals are being met

Service and Merchandising Companies

 Benefit from implementing ABC systems as well
o Used ABC to allocate operating costs among its product or service lines

COST / BENEFIT TEST

Cost of implementing ABC
 May be significant
 Generally lower with
 accounting and information system expertise to develop the system
 information technology exists to compile cost driver data

Do the benefits of adopting ABC/ABM exceed the costs?

• Benefits are higher when:
 Companies are in competitive markets
 Accurate cost information exists
 Cutting costs leads to profits

 Risk of cost distortion is high

 Many different products using many different resources
 High indirect costs (high MOH costs that must be allocated)
 High volumes of some products, low volumes of others

Warning signs that cost system is outdated

o Managers don’t understand costs
 Companies lose bids they expected to win
 Competitors price similar products much higher or lower
o Company has reengineered or diversified products and still using old
system