Ch04S - in

2/17/2020
Managerial Accounting
Eighth Edition
Weygandt Kimmel Kieso
Chapter 4
Activity-Based Costing
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Chapter Outline
Learning Objectives
LO 1 Discuss the difference between traditional costing and
activity-based costing.
LO 2 Apply activity-based costing to a manufacturer.
LO 3 Explain the benefits and limitations of activity-based costing.
LO 4 Apply activity-based costing to service industries.
Copyright ©2018 John Wiley & Sons, Inc. 2
Traditional versus Activity-Based Costing
LO1 - difference between traditional costing and

activity-based costing
Traditional Costing Systems
• Allocates overhead using a predetermined rate.
o Job order costing: direct labor cost may be the
relevant activity base.
o Process costing: machine hours may be the relevant
activity base.
LO 1 Copyright ©2018 John Wiley & Sons, Inc. 3
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Illus. of a Traditional Costing System

Atlas Co. produces two abdominal fitness products - the Ab
Bench and the Ab Coaster. Direct materials cost per unit is $40
for the Ab Bench and $30 for the Ab Coaster. Direct labor cost
is $12 per unit for each product. Both products require one
direct labor hour per unit, are allocated overhead cost of $30
per unit.
The Need for a New Approach

• Tremendous change in manufacturing and service
industries.
• Decrease in amount of direct labor usage.
• Significant increase in total overhead costs.
• Inappropriate to use plantwide predetermined overhead
rates when a lack of correlation exists.
• Complex manufacturing processes may require multiple
allocation bases (Activity-Based Costing).
Activity-Based Costing
Key Concepts
• Activity. Any event, action, transaction, or work sequence
that incurs costs when producing a product or performing a
service.
• Activity cost pool. Overhead cost attributed to a distinct
activity (e.g., ordering materials or setting up machines).
• Cost driver. Any factor or activity that has a direct cause-
effect relationship with the resources consumed.
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Activity-Based Costing – Approach & steps

o Allocates overhead to multiple activity cost pools.
o Assigns the activity cost pools to products or services by
means of cost drivers.
o 4 steps:
1. Identify and classify the activities involved in the manufacture
of specific products and assign overhead to cost pools.
2. Identify the cost driver that has a strong correlation to the
costs accumulated in each cost pool.
3. Compute the activity-based overhead rate for each cost pool.
4. Allocate overhead costs to products using the overhead rates

determined for each cost pool.
Activity-Based Costing - 2-stage process

• ABC allocates overhead in a two-stage process:
o Stage 1: Overhead costs are assigned to activity cost
pools (Step 1).
o Stage 2: Allocates overhead assigned to the activity
cost pools to products, using cost drivers (Steps 2 to 4).
• The more complex a product’s manufacturing operation,
the more activities and cost drivers are likely to be
present.
Activity-Based Costing - Cost drivers

Step 1: Identify activity
cost pools and allocate
cost to pools
Step 2: Identify cost
drivers and estimate total
usage
Step 3: Compute activity-
based overhead rate
Step 4: Assign overhead

costs to products based
on cost drivers
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Do It! 1: Costing Systems

Indicate whether the following statements are true or false.
1. A traditional costing system allocates overhead by False
means of multiple overhead rates.
2. Direct material and direct labor costs are easier to trace True
to products than overhead.
3. As manufacturing processes have become more False
automated, more companies have chosen to allocate
overhead on the basis of direct labor costs.
4. In activity-based costing, an activity is any event, True
action, transaction, or work sequence that incurs cost
when producing a product.
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ABC and Manufactures
LO2 - Apply ABC to a manufacturer

Involves the following four steps:
1. Identify and classify activities involved in the
manufacture of specific products and assign
overhead to cost pools.
2. Identify the cost driver that has a strong correlation
to the costs accumulated in each cost pool.
3. Compute the activity-based overhead rate for each
cost pool.
4. Assign overhead costs to products, using overhead
rates determined for each cost pool.
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S1: Identify activities & allocate Overhead

Overhead costs are assigned directly to the appropriate activity
cost pool.
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S2: Identify Cost Drivers

Cost driver must accurately measure the actual
consumption of the activity by the various products.
Illustration 4.7: Cost drivers that Atlas Company
identifies and their total expected use per activity cost pool.
Estimated Use of Cost
Activity Cost Pools Cost Drivers Drivers per Activity
Manufacturing Machine hours 50,000 machine hours
Setups Number of setups 2,000 setups
Purchase ordering Number of purchase 2,500 purchase orders
orders
Product development Products developed 2 products developed
Facility management Square footage 25,000 square feet
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S3: Compute Activity-Based Overhead Rates

Estimated Overhead per Activity
= Activity - Based Overhead Rate
Expected Use of Cost Drivers per Activity
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S4: Assign Overhead Costs to products

Estimated use of cost drivers (EUCD) for each product. Atlas
Company produces 25,000 Ab Benches and 5,000 Ab Coasters.
Because of its low volume & higher number of components, the Ab
Coaster requires more setups & purchase orders than the Ab Bench.
EUCD per EUCD per
Activity Cost product for product for Ab
Pools Cost Drivers EUCD per Activity Ab Bench Coaster
Manufacturing Machine hours 50k machine 30,000 20,000
hours
Setups No. of setups 2k setups 500 1,500
Purchase No. of purchase 2,500 purchase 750 1,750
ordering orders orders
Product Products 2 Products 1 1
development developed developed
PP&E Square feet 25k Square feet 10,000 15,000
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S4: Assign Overhead Costs to products (Cont.)

To allocate overhead costs, Atlas multiplies the activity-
based overhead rates per cost driver (Ill. 4-9) by the number
of cost drivers expected to be used per product (Ill. 4-10).
MO cost
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S4: Assign Overhead Costs to products (Cont.)

To allocate overhead costs, Atlas multiplies the activity-
based overhead rates per cost driver (Ill. 4-9) by the number
of cost drivers expected to be used per product (Ill. 4-10).
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Comparing Unit Costs
• Likely consequence of differences in assigning overhead.

o Overpricing the Ab Bench and possibly losing market
share to competitors.
o Sacrificing profitability by underpricing the Ab Coaster.
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Do It! 2: Apply ABC to Manufacturer

Casey Company has five activity cost pools and two products.
It expects to produce 200,000 units of its automobile scissors
jack and 80,000 units of its truck hydraulic jack. Having
identified its activity cost pools and the cost drivers for each
cost pool, Casey Company accumulated the following data
relative to those activity cost pools and cost drivers.
Using the data provided,
a. Prepare a schedule showing the computations of the
activity-based overhead rates per cost driver.
b. Prepare a schedule assigning each activity’s overhead cost
to the two products.
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c. Compute the overhead cost per unit for each product.
d. Comment on the comparative overhead cost per unit.
LO 2 20
20

a. Prepare a schedule showing the computations of the
activity-based overhead rates per cost driver.
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b. Prepare a schedule assigning each activity’s overhead
cost to the two products.
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c. Compute the overhead cost per unit for each product.
Scissor Jack Hydraulic Jack
Total costs assigned $2,560,000 S2,740,000
Total units produced 2,00,000 80,000
Overhead cost per unit $12.80 $34.25
d. Comment on the comparative overhead cost per unit
These data show that the total overhead assigned to 80,000
hydraulic jacks exceeds the overhead assigned to 200,000
scissors jacks. The overhead cost per hydraulic jack is $34.25. It
is only $12.80 per scissors jack.
23
ABC Benefits and Limitations
LO3 - Benefits and limitations of ABC

ABC has three primary benefits:
1. More cost pools, therefore more accurate product
costing.
2. Enhanced control over overhead costs.
3. Better management decisions.
• Multiple cost pools
o Used instead of one plantwide pool and a single cost
driver.
o Numerous activity cost pools with more relevant cost
drivers.
• Costs allocated on basis of cost drivers used to produce
each product.
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The Advantage of Multiple Cost Pools

A more detailed view of manufacturing activities
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Classification of Activity Levels - Unit-level
• Unit-level:
o Performed for each unit of production.
• Example: Assembly of cell phones.
• Batch-level.
• Product-level.
• Facility-level.
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Classification of Activity Levels – Batch-level
• Unit-level.
• Batch-level:
o Performed every time a company produces another
batch of a product.
• Example: Batch of ice cream.
• Product-level.
• Facility-level.
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Classification of Activity Levels – Product-level
• Unit-level.
• Batch-level.
• Product-level:
o Performed every time a company produces a new type
of product.
• Example: Time spent testing a new drug by a
pharmaceutical company.
• Facility-level.
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Classification of Activity Levels - Facility level
• Unit-level.
• Batch-level.
• Product-level.
• Facility-level:
o Required to support or sustain an entire production
process.
• Example: A hospital.
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Unit-Level Activities
Four Levels Types of Activities Examples of Cost
Drivers
Unit-Level
Activities
Machine-related Machine hours
Drilling, cutting,
milling, trimming,
pressing
Labor-related Direct labor hours or
Assembling, painting, cost
sanding, sewing
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Batch-Level and Product-Level Activities
Four Levels Types of Activities Examples of Cost Drivers
Batch-Level Activities Equipment setups Number of setups or setup
Purchase ordering time
Inspection Number of purchase orders
Materials handling Number of setups
Number of material moves
Product- Level Product design Number of product designs
Activities Engineering changes Number of changes
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Facility-Level Activities
Four Levels Types of Activities Examples of Cost

Drivers
Facility-Level Plant management Number of employees
Activities salaries managed
Plant depreciation Square footage
Property taxes Square footage
Utilities Square footage
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The Advantage of Enhanced Cost Control

Value-Added Activities
• Increase the perceived value of a product or service to
customers, such as:
Manufacturing Company Service Company

• Engineering design. • Performing surgery.
• Machining. • Legal research.
• Assembly. • Delivering packages.
• Painting.
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The Advantage of Enhanced Cost Control

Non-Value-Added Activities
• Adds cost to, or increases the time spent on, a
product/service without increasing its perceived value,
such as:
Manufacturing Company Service Company
• Storage of inventory. • Taking appointments.
• Moving inventory. • Reception.
• Inspections. • Bookkeeping and billing.
• Fixing defective goods. • Traveling.
• Ordering supplies.
• Advertising.
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Advantage of Better Management Decisions

Activity-based management (ABM), management tool
that focuses on reducing costs and improving processes and
decision-making.
Managers use ABC via ABM
• for both strategic and operational decisions or
perspectives.
• to help managers evaluate employees, departments, and
business units.
• to establish performance standards, as well as benchmark
against other companies.
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Limitations and Knowing When to Use ABC

Limitations
• Expensive to use.
• More complex than traditional systems.
• Arbitrary allocations remain.
When to Use
1. Product lines differ in volume and manufacturing
complexity.
2. Product lines are numerous and diverse.
3. Overhead costs constitute a significant portion of total costs.
4. Manufacturing process or the number of products has
changed significantly.
5. Production or marketing managers are ignoring data.
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Do It! 3: Classify Activity Levels

Morgan Toy Company manufactures 6 primary product lines in its
factory. The accounting department has identified eight activity cost
pools. Each of the toy products is produced in large batches, with the
whole plant devoted to one product at a time. Classify each of the
following activities as either unit-level, batch-level, product-level, or
facility-level:
a. Engineering design a. Product-level
b. Machine setup b. Batch-level
c. Toy design c. Product-level
d. Interviews of prospective employees d. Facility-level
e. Inspections after each setup e. Batch-level
f. Polishing parts f. Unit-level
g. Assembling parts g. Unit-level
h. Facility-level
h. Health and safety
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ABC and Service Industries
LO4 - Apply ABC to service industries

Overall objective: Identify key activities that generate costs
and keep track of how many of those activities are completed
for each service performed.
• General approach is to identify activities, cost pools, and
cost drivers.
• Labeling of activities as value-added or non-value-added.
• Sometimes, a larger proportion of overhead costs are
company-wide costs that cannot be directly traced to
specific services provided by the company.
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Traditional Costing Example

The public accounting firm of Check and Doublecheck
prepares the following condensed annual budget.
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Traditional Costing Example

Assume that Check and Doublecheck records $140,000 of
actual direct professional labor cost during its audit of Plano
Molding Company, which was billed an audit fee of $260,000.
Under traditional costing, using 50% as the rate for applying
overhead to the job, Check and Doublecheck would compute
applied overhead and operating income as shown.
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Activity-Based Costing Example

Check and Doublecheck distributes its estimated annual
overhead costs of $600,000 to three activity cost pools.
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ABC Example in a service industry
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Activity-Based Costing Example

Comparison of traditional with ABC costing
Under activity-based costing, Check and Doublecheck assigns
overhead costs of $57,200 as compared to $70,000 under
traditional costing.
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Do It! 4: Apply ABC to Service Company

We Carry It, Inc. is a trucking company. It provides local, short-
haul, and long-haul services. The company has developed the
following the cost pools
Estimated Expected Use of Cost
Activity Cost pools Cost Drivers Overhead Drivers Per Activity
Loading & unloading No. of pieces $ 70,000 100,000 pieces
Travel Miles driven 250,000 500,000 miles
Logistics Hours 60,000 2,000 hours
(a) Computer the activity-based overhead rates for each pool

(b) Determine the overhead allocated to Job A 1027 which has 150
pieces, require 200 miles of driving, and 0.75 hours of logistics
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Do It! 4: Apply ABC to Service Company

(a) Computer the activity-based overhead rates for each pool
Expected Activity-
Use of Cost Based
Estimated Drivers Per Overhead
Activity Cost pools Overhead ÷ Activity = Rate
Loading & unloading $ 70,000 100k pieces $0.70 per piece
Travel 250,000 500k miles $0.50 per mile
Logistics 60,000 2k hours $30 per hour
(b) Determine the overhead allocated to Job A which has 150

pieces, require 200 miles of driving, and 0.75 hours of logistics
(150 × $0.70) + (200 × $0.50) + (0.75 × $30) = $227.50
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2/17/2020

Weygandt Kimmel Kieso

Copyright ©2018 John Wiley & Sons, Inc. 2

Traditional versus Activity-Based Costing

LO1 - difference between traditional costing and

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 3

Illus. of a Traditional Costing System

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 4

The Need for a New Approach

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 5

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 6

Activity-Based Costing – Approach & steps

4. Allocate overhead costs to products using the overhead rates

Activity-Based Costing - 2-stage process

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 8

Activity-Based Costing - Cost drivers

Step 4: Assign overhead

Do It! 1: Costing Systems

LO 1 Copyright ©2018 John Wiley & Sons, Inc. 10

ABC and Manufactures

LO2 - Apply ABC to a manufacturer

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 11

S1: Identify activities & allocate Overhead

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 12

S2: Identify Cost Drivers

S3: Compute Activity-Based Overhead Rates

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 14

S4: Assign Overhead Costs to products

S4: Assign Overhead Costs to products (Cont.)

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 16

S4: Assign Overhead Costs to products (Cont.)

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 17

Comparing Unit Costs

• Likely consequence of differences in assigning overhead.

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 18

Do It! 2: Apply ABC to Manufacturer

Do It! 2: Apply ABC to Manufacturer

Do It! 2: Apply ABC to Manufacturer

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 21

Do It! 2: Apply ABC to Manufacturer

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 22

Do It! 2: Apply ABC to Manufacturer

LO 2 Copyright ©2018 John Wiley & Sons, Inc. 23

ABC Benefits and Limitations

LO3 - Benefits and limitations of ABC

The Advantage of Multiple Cost Pools

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 25

The Advantage of Multiple Cost Pools

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 26

The Advantage of Multiple Cost Pools

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 27

The Advantage of Multiple Cost Pools

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 28

The Advantage of Multiple Cost Pools

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 29

The Advantage of Multiple Cost Pools

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 30

The Advantage of Multiple Cost Pools

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 31

The Advantage of Multiple Cost Pools

Four Levels Types of Activities Examples of Cost

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 32

The Advantage of Enhanced Cost Control