Slide Chương 2 KTQTNC

1/16/2022
Chapter 2
System Design:
Activity Based Costing
Source: Garrison, R. H, Noreen, E. W. & Brewer, P. C. (2015). Managerial

Accounting (15th Edition). United States of America: McGraw-Hill Education.
Learning Objectives
1. Understand the basic approach in activity-based
costing and how it differs from conventional costing.
2. Compute activity rates for an activity-based costing
system.
3. Compute product costs using activity-based costing.
4. Contrast the product costs computed under activity-
based costing and conventional costing methods.
5. Understand benefits and limitations of activity-
based costing.
6. Record the flow of costs in an activity-based costing
system.
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Learning Objective 1
Understand the basic

approach in activity-based
costing and how it differs from
conventional costing.
3-4
Assigning Overhead Costs to

Products
When cost systems were developed in the 1800s, the
emphasis was on simplicity because:
1. Cost and activity data had to be collected by
hand and all calculations were done with paper
and pencil.
2. Most companies produced a limited variety of
similar products, so there was little difference
in the overhead costs consumed by each
product.
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Plantwide Overhead Rate

A single overhead rate used
throughout an entire factory.
Direct labor has often been used as the allocation
base for overhead because:
1. Direct labor information was already being recorded.
2. Direct labor was a large component of product costs.
3. Managers believed direct labor and overhead costs
were highly correlated.
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Today, direct labor may no longer be a
satisfactory base for allocation of overhead.
1. Most companies sell a large variety of products that
consume differing amounts of overhead.
2. As a percentage of total costs, direct labor has been
shrinking and overhead has been increasing. Many of the
new overhead costs may not be correlated with direct
labor.
3. Technology advancements have reduced the cost and
complexity of gathering diverse sources of data.
A plantwide overhead allocation system may not be optimal
for many companies in today’s business environment.
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Departmental Overhead Rates

Many companies have a system in which each
department has its own overhead rate.
The allocation base depends

on the nature of the work
Machining Department performed in each department.
In the machining department,
Assembly Department overhead may be based on
machine-hours, but in the
Shipping Department assembly department,
overhead may be based on
labor-hours.
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Departmental Overhead Rates

Departmental rates will not correctly assign overhead
in situations where a company has a range of
products and complex overhead costs.
The departmental approach relies

exclusively on volume-related allocation bases while
some overhead costs may be caused by factors
that are not related to the volume of production.
Activity-base costing is required to account for these

other factors.
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Activity-Based Costing (ABC)
A number of allocation bases are

used for assigning costs to products.
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Cost Objects
(e.g., products and customers)
Activities
Consumption of Resources
Cost
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An event that causes
Activity the consumption of
overhead resources
Examples of Activities
Admitting
Setting up Billing Opening a
hospital
machines customers bank account
patients
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A “cost bucket” in which
Activity
costs related to a particular
Cost Pool activity are accumulated.
Expresses how much of the

Activity activity is carried out and is
Measure used as the allocation base
for applying overhead costs.
A predetermined overhead
Activity
rate for each activity
Rate cost pool.
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For each activity in

isolation, this system works exactly
like the job-order costing system
A predetermined overhead rate is computed for

each activity and then applied to jobs and
products based on the amount of activity
consumed by the job or product.
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Designing an Activity-Based
Costing System
The challenge is to select a reasonably

small number of activities that explain the
bulk of the variation in overhead costs.
Activities are usually chosen by interviewing a

broad range of managers to find out what
activities they think consume most of the
organization’s resources.
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Designing an Activity-Based
Costing System
Related activities are
frequently combined to reduce
the amount of detail and
record-keeping costs.
For example, several activities may
be involved in handling and moving
raw materials, but these may be
combined into a single activity
entitled material handling.
An activity dictionary defines each of the activities
that will be included in the activity-based costing
system and how the activities will be measured.
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Hierarchy of Activities
Level Activities Activity Measure
Unit-level Processing units on machines Machine-hours
Processing units by hand Direct labor-hours
Consuming factory supplies Units produced
Batch-level Processing purchase orders Purchase orders processed
Processing production orders Production orders processed
Setting up equipment Number of setups
Handling materials Pounds of material handled
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 labor-hours
Plant building and grounds Direct labor-hours
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Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs
First-Stage Cost Assignment
Labor Machine Setup Production Parts General

Related Pool Related Pool Pool Order Pool Admin. Pool Factory Pool
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Graphic Example of
Various Manufacturing Overhead Costs
First-Stage Cost Assignment
Labor Machine Setup Production Parts General

Related Pool Related Pool Pool Order Pool Admin. Pool Factory Pool
Second-Stage Allocations
$/DLH $/MH $/Setup $/Order $/Part Type $/MH
Products
Unit-Level Batch-Level Product-Level Facility-Level
Activity Activity Activity Activity
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Using Activity-Based Costing

Comtek Sound, Inc.
 Comtek Sound, Inc. makes two products: CD
players and DVD players.
 The company has been losing bids to supply CD
players, its main product, to lower priced
competitors.
 The company has been winning all bids to
supply DVD players, its secondary product.
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Comtek Sound, Inc.
 For the current year, Comtek has budgeted sales
of 50,000 DVD units and 200,000 CD units.
 Comtek’s traditional cost system applies
manufacturing overhead to products based on
direct labor hours.
 Both products require two direct labor-hours to
complete, for a total of 500,000 direct labor
hours.
Hours
DVDs: 50,000 units @ 2 hours per unit = 100,000
CDs: 200,000 units @ 2 hours per unit = 400,000
Total direct labor-hours 500,000
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Comtek Sound, Inc.
 Unit costs for materials and labor are:
DVD CD
Units Units
Direct materials $ 90 $ 50
Direct Labor $ 20 $ 20
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Direct Labor-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 labor-hours:
Predetermined $10,000,000
= = $20 per DLH
overhead rate 500,000 DLHs
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Direct Labor-Hours as a Base

Since each product requires two hours of
direct labor, $40 of overhead is assigned to
each product.
DVD Unit CD Unit

Direct materials $ 90 $ 50
Direct labor 20 20
Manufacturing overhead 40 40
(2 DLHs x $20 per DLH)
Unit product cost $ 150 $ 110
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Compute activity rates for an

activity-based costing
system.
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Computing Activity Rates

The ABC project team at Comtek has
developed the following basic information.
Estimated
Overhead
Activity and Activity Measures Cost Expected Activity
Total DVD CD
Labor related (DLH) $ 800,000 500,000 100,000 400,000
Machine related (MH) 2,100,000 1,000,000 300,000 700,000
Machine setups (setups) 1,600,000 4,000 3,000 1,000
Production orders (orders) 3,150,000 1,200 800 400
Parts administration (part types) 350,000 700 400 300
General factory (MH) 2,000,000 1,000,000 300,000 700,000
$ 10,000,000
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Computing Activity Rates

We can calculate the following activity rates:
Estimated Total
Overhead Expected
Activity and Activity Measures Cost Activity Activity Rate
Labor related (DLHs) $ 800,000 ÷ 500,000 = $ 1.60 per DLH
Machine related (MHs) 2,100,000 ÷ 1,000,000 = 2.10 per MH
Machine setups (setups) 1,600,000 ÷ 4,000 = 400.00 per setup
Production orders (orders) 3,150,000 ÷ 1,200 = 2,625.00 per order
Parts administration (part types) 350,000 ÷ 700 = 500.00 per part type
General factory (MHs) 2,000,000 ÷ 1,000,000 = 2.00 per MH
$ 10,000,000
Using the new activity rates, let’s assign overhead

to the two products based upon expected activity.
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Compute product costs using

activity-based costing.
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Computing Overhead Cost per Unit

DVD Units
Expected Activity
Activity and Activity Measures Activity Rate Amount
Labor related (DLHs) 100,000 × $ 1.60 = $ 160,000
Machine related (MHs) 300,000 × 2.10 = 630,000
Machine setups (setups) 3,000 × 400.00 = 1,200,000
Production orders (orders) 800 × 2,625.00 = 2,100,000
Parts administration (part types) 400 × 500.00 = 200,000
General factory (MHs) 300,000 × 2.00 = 600,000
Total overhead cost assigned $ 4,890,000
Number of units produced 50,000
Overhead cost per unit $ 97.80
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Computing Overhead Cost per Unit

CD Units
Expected Activity
Activity and Activity Measures Activity Rate Amount
Labor related (DLHs) 400,000 × $ 1.60 = $ 640,000
Machine related (MHs) 700,000 × 2.10 = 1,470,000
Machine setups (setups) 1,000 × 400.00 = 400,000
Production orders (orders) 400 × 2,625.00 = 1,050,000
Parts administration (part types) 300 × 500.00 = 150,000
General factory (MHs) 700,000 × 2.00 = 1,400,000
Total overhead cost assigned $ 5,110,000
Number of units produced 200,000
Overhead cost per unit $ 25.55
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Comparing the Two Approaches

Activity-Based Costing Direct-Labor Costing
DVD Unit CD Unit DVD Unit CD Unit
Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost $ 207.80 $ 95.55 $ 150.00 $ 110.00
Note that the unit product cost of a CD

unit decreased from $110 to $95.55 . . . .
. . . . while the unit cost of a DVD unit
increased from $150 to $207.80.
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Contrast the product costs

computed under activity-
based costing and
conventional costing
methods.
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Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
The ABC system assigns $14.45

less overhead than the traditional
system to each CD player.
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Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
The ABC system assigns $57.80

more overhead than the traditional
system to each DVD player.
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Shifting of Overhead Cost

Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
Low-volume product
When a company implements activity-based costing,
overhead cost often shifts from high-volume to low-
volume products with a higher unit product cost
resulting for the low-volume products.
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Shifting of Overhead Cost

Direct material $ 90.00 $ 50.00 $ 90.00 $ 50.00
Direct labor 20.00 20.00 20.00 20.00
High-volume product
The traditional system assigns the same amount of

all overhead costs to each CD or DVD player
($40 per unit).
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Understand benefits and

limitations of activity-based
costing
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Benefits of Activity-Based Costing

ABC improves the accuracy of product costing by:
• Increasing the number of cost pools used to accumulate
overhead costs.
• Using activity cost pools that are more homogeneous than
departmental cost pools.
• Assigning overhead costs using activity measures that
cause those costs, rather than relying solely on direct
labor hours.
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Limitations of Activity-Based Costing

Costs of implementing an ABC system may outweigh
the benefits. However, the benefits are more likely to be
worth the costs when:
1. Products differ substantially in volume, batch size, and in
activities required.
2. Conditions have changed substantially since the existing
cost system was established.
3. Overhead costs are high and increasing and no one seems
to understand why.
4. Management does not trust the existing cost system and it
ignores data from it when making decisions.
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Critical Assumption
The cost in each activity pool is strictly
proportional to its activity measure. When this
assumption is violated, the accuracy of ABC
data can be called into question.
For example, managers should be particularly

alert to product costs that contain allocated
facility-level costs.
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Modifying the ABC Model

The illustrations in the chapter assume
that ABC is being used for external reporting
purposes. If the system is used for internal
decision-making purposes, two important
modifications should be made:
1. Selling and administrative costs should be
assigned to products, where appropriate.
2. Facility-level costs should be removed
from product costs.
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Record the flow of costs in an

activity-based costing
system.
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Cost Flows in an ABC System

Sarvik Company uses activity-based costing.
The company has five cost pools shown below.
Estimated
Overhead
Activity Cost Pool Activity Measure Cost Expected Activity
Machine related Machine hours $ 175,000 5,000 MHs
Purchase orders Number of orders 63,000 700 orders
Machine setups Number of setups 92,000 460 setups
Product testing Number of tests 160,000 200 tests
General factory Direct labor hours 300,000 25,000 DLHs
$ 790,000
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Activity rates are determined as follows:
Estimated Total
Overhead Expected
Activity Cost Pool Cost Activity Activity Rate
Machine related $ 175,000 ÷ 5,000 MHs = $ 35 per MH
Purchase orders 63,000 ÷ 700 orders = $ 90 per order
Machine setups 92,000 ÷ 460 setups = $ 200 per setup
Product testing 160,000 ÷ 200 tests = $ 800 per test
General factory 300,000 ÷ 25,000 DLH = $ 12 per DLH
$ 790,000
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Overhead is applied on the basis of
actual activities during the year.
Applied
Activity Actual Overhead
Activity Cost Pool Rate Activity Cost
Machine related $35/MH × 4,600 MHs = $ 161,000
Purchase orders $90/order × 800 orders = 72,000
Machine setups $200/setup × 500 setups = 100,000
Product testing $800/test × 190 tests = 152,000
General factory $12/DLH × 23,000 DLHs = 276,000
Total Overhead Applied $ 761,000
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Selected transactions recorded by the company:
a. Raw materials purchased on account, $915,000.
b. Raw materials used in production, $900,000 ($810,000
direct and $90,000 indirect).
c. Factory labor costs, $370,000 ($95,000 direct and
$275,000 indirect).
d. Depreciation of factory assets, $180,000.
e. Miscellaneous manufacturing overhead costs
incurred on account, $230,000.
f. Manufacturing overhead applied, $761,000.
g. Goods costing $1,650,000 were manufactured.
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The following journal entries would be used
to record transactions (a) and (b).
Description Debit Credit

a. Raw Materials 915,000
Accounts Payable 915,000
b. Work in Process 810,000
Manufacturing Overhead 90,000
Raw Materials 900,000
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The following journal entries would be used
to record transactions (c) and (d).

c. Work in Process 95,000
Salaries and Wages Payable 370,000
d. Manufacturing Overhead 180,000
Accumulated Depreciation 180,000
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The following journal entry would be used to
record transaction (e).

e. Manufacturing Overhead 230,000
Cash/Accounts Payable 230,000
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record transaction (f).

f. Work in Process 761,000
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record transaction (g).

g. Finished Goods 1,650,000
Work in Process 1,650,000
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Manufacturing Overhead
(b) 90,000 (g) 761,000
(c) 275,000
(d) 180,000
(e) 230,000
Bal. 14,000
Underapplied
Overhead Costs
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The flow of costs through Raw
Materials, Work in Process, and other
accounts is the same under activity
based costing as it was when using a
job-order costing
The only difference in

activity based costing is
that more than one
predetermined
overhead rate is used to
apply costs to products.
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End of Chapter 2
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1/16/2022

Source: Garrison, R. H, Noreen, E. W. & Brewer, P. C. (2015). Managerial

Understand the basic

Assigning Overhead Costs to

Plantwide Overhead Rate

Plantwide Overhead Rate

Departmental Overhead Rates

The allocation base depends

Departmental Overhead Rates

The departmental approach relies

Activity-base costing is required to account for these

Activity-Based Costing (ABC)

A number of allocation bases are

Activity-Based Costing (ABC)

Activity-Based Costing (ABC)

Activity-Based Costing (ABC)

Expresses how much of the

Activity-Based Costing (ABC)

For each activity in

A predetermined overhead rate is computed for

The challenge is to select a reasonably

Activities are usually chosen by interviewing a

First-Stage Cost Assignment

Labor Machine Setup Production Parts General

First-Stage Cost Assignment

Labor Machine Setup Production Parts General

$/DLH $/MH $/Setup $/Order $/Part Type $/MH

Using Activity-Based Costing

Using Activity-Based Costing

Using Activity-Based Costing

Direct Labor-Hours as a Base

Direct Labor-Hours as a Base

DVD Unit CD Unit

Compute activity rates for an

Computing Activity Rates

Computing Activity Rates

Using the new activity rates, let’s assign overhead

Compute product costs using

Computing Overhead Cost per Unit

Computing Overhead Cost per Unit

Comparing the Two Approaches

Note that the unit product cost of a CD

Contrast the product costs

Comparing the Two Approaches

The ABC system assigns $14.45

Comparing the Two Approaches

The ABC system assigns $57.80

Shifting of Overhead Cost

Shifting of Overhead Cost

The traditional system assigns the same amount of

Understand benefits and

Benefits of Activity-Based Costing

Limitations of Activity-Based Costing

For example, managers should be particularly

Modifying the ABC Model

Record the flow of costs in an

Cost Flows in an ABC System

Cost Flows in an ABC System

Cost Flows in an ABC System

Cost Flows in an ABC System

Cost Flows in an ABC System

Description Debit Credit