Name : Nabila Ika Sari

ID Number : 008201900007
Summary Managerial Accounting Chapter 4 Activity-Based Product Costing

Activity-Based Product Costing

Unit Costs
The unit cost is the total cost associated with the units produced divided by the number of
units produced. For example, if BelRing produces 100 phones of the same model and the
total cost for these phones is $6,000, then the cost of each phone is $60 ($6,000/100)).
Similarly, for the credit department of SpringBanc, if the total cost of servicing 1,000
platinum credit cards is $50,000 per year, then the servicing cost per card is $50
($50,000/1,000). The first question is answered by defining what is meant by «product
cost». Recall that the product cost definition depends on the managerial objective being
served. This product cost definition is mandated for external financial reporting
and, therefore, plays a key role in valuing inventories and determining income.
Total production costs must be measured, and then these costs must be associated with
the units produced. Cost measurement consists of determining the dollar amounts of direct
materials, direct labor, and overhead used in production. The process of associating the
costs, once measured, with the units produced is called cost assignment.

Importance of Unit Product Costs

A cost accounting system measures and assigns costs so that the unit cost of a product
or service can be determined. Unit cost is a critical piece of information for both
manufacturing and service firms. For example, bidding is a common requirement in the
markets for specialized products and services . It is virtually impossible to submit a
meaningful bid without knowing the unit costs of the products or services to be produced.

Production of Unit Cost Information

Two possible measurement systems are actual costing and normal costing. Actual
costing assigns the actual costs of direct materials, direct labor, and overhead to products. In
practice, strict actual costing systems are rarely used, because they cannot provide accurate
unit cost information on a timely basis. Predetermined overhead rate budgeted cost/estimated
activity usage. How overhead rates are used to assign costs to products will become clear as
the specifics of functional- and activity-based costing are discussed.

Functional-Based Product Costing

Specifically, functional-based costing uses unitlevel activity drivers to assign overhead
costs to products. Unit-level activity drivers are factors that cause changes in cost as the units
produced change. A functional-based predetermined overhead rate requires specification of a
unitlevel driver, an estimation of the capacity measured by the driver, and an estimation of
the expected overhead.

Plantwide Rates
An example
Budgeted overhead $360,000
Expected activity (in direct labor hours) 100,000
Actual activity (in direct labor hours) 100,000
Actual overhead $380,000
Predetermined overhead rate = Budgeted overhead/Expected activity
 =$360,000/100,000 direct labor hours (DLH)
=$3.60 per DLH
Applied overhead = Overhead rate / Actual activity
= $3.60/100,000 DLH
= $360,000
The difference between the actual overhead and the applied overhead is called an overhead
variance. For BelRing, the overhead variance is $20,000 ($380,000 $360,000). If the actual
overhead is greater than the applied overhead, the variance is called underapplied overhead.

Departmental Rates
In the first stage, the plantwide overhead costs are divided up and assigned to individual
production departments, creating departmental overhead cost pools. Products passing through
the departments are assumed to consume overhead resources in proportion to the
department’s unitbased drivers . Thus, in the second stage, overhead is assigned to products
by multiplying the departmental rates by the amount of the driver used in the respective
departments. Some producing departments may be more «overhead-intensive» than other
producing departments.

Computation of Departmental Rates

The Springdale plant has two production departments: fabrication and assembly. Data
relating to the departments for the year 2006 are given in Exhibit 4-5. Notice that fabrication
is machine intensive (compare expected machine hours), while assembly tends to be labor
intensive. Two overhead rates are calculated as follows:
Fabrication rate = Budgeted overhead/Expected machine hours
= $252,000/40,000 = $6.30 per MHr
Assembly rate = Budgeted overhead/Expected direct labor hours
=$108,000/80,000 = $1.35 per DLH

Limitations of Functional-Based Cost Accounting Systems

As firms operating in this competitive environment adopt new strategies to achieve
competitive excellence, their cost accounting systems often must change to keep
pace. Specifically, the need for more accurate product costs has forced many companies to
take a serious look at their costing procedures. Cost accounting systems that worked
reasonably well in the past may no longer be acceptable. Often organizations experience
certain symptoms indicating that their cost accounting system is outdated.
For example, if costs are distorted and severe overcosting of a major, high-volume
product is the outcome, then bids will be systematically lost, even when the company feels it
is pursuing an aggressive bidding strategy. On the flip side, if competitors’ prices seem
unrealistically low, it should cause managers to wonder about the accuracy of their costing
systems. Yet, it may find operational managers want ing to drop some of these «niche»
products. Organizations that have experienced some or all of these symptoms have found that
their plantwide or departmental rates are simply no longer capable of accurately assigning
overhead costs to individual products.
Product Diversity
Product diversity simply means that products consume overhead activities in
systematically different proportions. Products might consume overhead in different
proportions for several reasons. For example, differences in product size, product complexity,
setup time, and size of batches all can cause products to consume overhead at different rates.
Regardless of the nature of the product diversity, product cost will be distorted whenever the
quantity of unit-based overhead that a product consumes does not vary in direct proportion to
the quantity consumed of non-unitbased overhead.

An Example Illustrating the Failure of Unit-Based Overhead Rates

To illustrate how traditional unit-based overhead rates can distort product costs, we
going back to BelRing, this time providing more detailed information on overhead activities
that determine total overhead costs.

Problems with Costing Accuracy

The activity usage data in Exhibit 4-8 reveals some serious problems with plant-wide or
departmental rates for setting overhead costs. A major problem with any of the procedures is
the assumption that the machine hours or man-hours directly drive or cause all of the
overhead. From Display 4-8, we know that producing a regular, high-volume product uses
nine times more direct labor hours than producing a cordless, low-volume product. So if the
factory-wide rates were used, a regular telephone would incur nine times as much overhead
as a cordless phone.
An examination of the data in Exhibit 4-8 shows that most overhead costs are not driven
or caused by direct hours of work. For example, the demand for each product for material
preparation and handling activities is more logically related to the number of production
processes and the number of moves. Note that the low-volume product, the cordless phone,
uses twice as much operation as a regular telephone and twice as much movement.
The consumption ratio is simply the proportion of each activity consumed by a product.
This shift is in the wrong direction, emphasizing the failure of the unit-based activity driver at
either the factory or departmental level to accurately reflect any product demand for material
preparation and handling costs.

Solving the Problem of Cost Distortion

The cost distortion just described can be solved by the use of activity rates. in Exhibit 4-9
and the data provided in Exhibit 4-8, activity rates are computed below.
Setup rate : $120,000/30 runs $4,000 per run
Material-handling rate : $60,000/90 moves $666.67 per move
Machining rate : $100,000/50,000 machine hours $2 per machine hour
Testing rate : $80,000/100,000 direct labor hours $0.80 per direct labor hour

Comparison of Functional-Based and Activity-Based Product Costs

The unit cost from activity-based costing is compared with the unit
costs produced by functional-based costing using either a plantwide or a departmental rate.
This comparison clearly illustrates the effects of using only unit-based activity drivers to
assign overhead costs. . Activity-based product costing reveals that functionalbased costing
undercosts the cordless phones and overcosts the regular phones.

Activity-Based Product Costing: Detailed Description

Activities are identified and defined through the use of interviews and surveys. This
information allows an activity dictionary to be constructed. The activity dictionary lists
activities and potential activity drivers, classifies activities as primary or secondary, and
provides any other attributes deemed to be important. Resource costs are assigned to
activities by using direct tracing and resource drivers. The costs of secondary activities are
ultimately assigned to primary activities using activity drivers. Finally, the costs of primary
activities are assigned to products, customers, and other cost objects. Thus, the cost
assignment process is described by the following general steps:
1. identifying the major activities and building an activity dictionary,
2. determining the cost of those activities,
3. identifying a measure of consumption for activity costs (activity drivers),
4. calculating an activity rate,
5. measuring the demands placed on activities by each product, and
6. calculating product costs.
Activity Dictionary
Based on the answers to the survey, an activity dictionary can now be prepared. The
activity dictionary names the activity , describes the tasks that make up the activity, classifies
the activity as primary or secondary, lists the users , and identifies a measure of activity
output . A primary activity is an activity that is consumed by a product or customer. A
secondary activity is one that is consumed by other primary and secondary activities.

Detailed Classification of Activities

For product-costing purposes, activities can be classified into one of the following
four general activity categories:
(1) unit level,
(2) batch level,
(3) product level, and
(4) facility level. Classifying activities into these general categories facilitates product
costing because the costs of activities associated with the different levels respond to different
types of drivers (cost behavior differs by level).
Reducing the Size and Complexity of the Activity-Based Costing System
In the first stage of activity-based costing, activities are identified, costs are associated
with individual activities, and activities are classified as primary or secondary. In the
intermediate stage, costs of secondary activities are reassigned to primary activities. In the
final stage, costs of primary activities are assigned to products or customers. Assigning costs
to other activities or assigning costs to products and customers requires the use of activity
rates.
Reducing Rates Using Consumption Ratios
For example, suppose that a BelRing plant uses has seven activities, two of which are testing
products and packing products, costing $44,000 and $36,000, respectively. Two models of
telephones are produced.
Activity Driver Consumption of Activity
Standard Model Luxury Model
Testing products Testing hours 4,000 6,000
Packing products Packing hours 7,200 10,800
The activity rates for each activity are $4.40 per testing hour ($44,000/10,000) and $2.00 per
packing order ($36,000/18,000). The amount of cost assigned to the Standard Model is
$32,000 [($4.40 × 4 ,000) ($2.00 ×7,200)] and the amount assigned to the Luxury Model is
$48,000 [$4.40 × 7,200) ($2.00 × 10,800)]. Notice that the consumption ratios are equal for
each activity: 0.40 and 0.60 (the Standard Model consumes 40 percent of each activity and
the Luxury Model consumes 60 percent). if testing hours are used, then the activity rate is
$8.00 per testing hour ($80,000/10,000). The amount assigned to the Standard Model is
$32,000 ($8.00 × 4,000) and the amount assigned to the Luxury Model is $48,000 ($8.00 ×
6,000), exactly the same assignment as using the two separate rates.

Reducing Rates by Approximating ABC

An approximately relevant ABC system may make an organization better off than
precisely useless one. One way to reduce the number of rates is to use only the most
expensive activities and their drivers to assign costs to products.The costs of the less
expensive activities are allocated to the cost pools of the selected expensive activities.
In this way, most costs are assigned to the products accurately. The costs of the most
expensive activities are assigned using the appropriate cause-and-effect drivers, while
the costs the less expensive activities are assigned somewhat arbitrarily. This
approach is simple and easy to understand and often leads to a good approximation
of the ABC assignments.
Comparison with Functional-Based Costing
In a functional-based system, the consumption of overhead by products is assumed to
be explained only by unit-based activity drivers. Unit-based costing systems allocate fixed
overhead to individual products, using fixed overhead rates, and assign variable
overhead, using variable overhead rates. From the perspective of activity-based costing, the
variable overhead is appropriately traced to individual products . However, assigning fixed
overhead costs using unit-based activity drivers can be arbitrary and may not reflect the
activities actually consumed by the products.
Many of the costs assigned in the traditional fixed overhead category are, in
reality, batch-level, product-level, and facility-level costs that vary with drivers other than
unit-level drivers. Activity-based costing systems improve product costing accuracy by
recognizing that many of the so-called fixed overhead costs vary in proportion to changes
other than production volume. Additionally, this large pool of fixed overhead costs is no
longer so mysterious.