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Chapter 9

Activity-Based Costing

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives
L.O. 1 Understand the potential effects of using externally reported

L.O. 2 L.O. 3
L.O. 4

L.O. 5 L.O. 6
L.O. 7 L.O. 8

product costs for decision making. Explain how a two-stage product costing system works. Compare and contrast plantwide and department allocation methods. Explain how activity-based costing and a two-stage product system are related. Compute product costs using activity-based costing. Compare activity-based product costing to traditional department product costing methods. Demonstrate the flow of costs through accounts using activity-based costing. Apply activity-based costing to marketing and administrative services.
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Product Costs and Decision Making


L.O. 1 Understand the potential effects of using externally
reported product costs for decision making.

Units produced Direct labor-hours Costs: Direct materials Direct labor Manufacturing overhead (@ 120%) Total
Cost per unit

C-27s 10 2,000
$ 40,000 72,000 86,400 $198,400 $ 19,840

C-20s 30 3,000
$ 36,000 78,000 93,600 $207,600 $ 6,920

Total 40 5,000
$ 76,000 150,000 180,000 $406,000

Grange is considering dropping C-27s.


9-3

LO1

Product Costs and Decision Making


The accountant estimated that overhead will be $163,800.
Original C-20s only 1,800 1,300 15,600 54,900 29,550 40,050 20,600 $163,800 $

Manufacturing overhead: Utilities Supplies Training Supervision Machine depreciation Plant depreciation Miscellaneous Total overhead

2,400 2,500 30,000 54,900 29,550 40,050 20,600 $180,000

9-4

LO1

Product Costs and Decision Making


Original Direct materials Direct labor Manufacturing overhead Total costs $ 76,000 150,000 180,000 $406,000 C-20s only $ 36,000 78,000 163,800 $277,800

The cost per unit for the C-20s will increase from $6,920 to $9,260.

9-5

LO1

The Death Spiral


This is a process that begins by attempting to increase price to meet reported product cost.
This may result in demand for even fewer units.

9-6

Two-Stage Cost Allocation


L.O. 2
Explain how a two-stage product costing system works.

Allocate overhead costs to departments.

Allocate department overhead costs to the products or services.

9-7

LO2

Two-Stage Cost Allocation


Cost pool

Overhead

Intermediate cost pools

Department A

Department B

Cost allocation rule

Direct labor hours

Machine hours

9-8

LO2

Two-Stage Cost Allocation


Third Quarter Production and Cost Data J25P Number of units Machine hours Assembly Direct materials Direct labor Assembly Direct labor Packaging Total direct labor Total direct cost Overhead costs: Assembly Packaging Total overhead Total costs 100,000 6,000 $1,500,000 $ 750,000 990,000 $1,740,000 $3,240,000 J40X 40,000 30,000 $2,400,000 $ 600,000 360,000 $ 960,000 $3,360,000 Total 140,000 36,000 $3,900,000 $1,350,000 1,350,000 $2,700,000 $6,600,000 $1,620,000 810,000 $2,430,000 $9,030,000

The cost system allocates manufacturing overhead to products based on direct labor costs.
9-9

LO2

Two-Stage Cost Allocation


Third Quarter Unit Cost Report J25P J40X

Units produced
Direct material Direct labor: Assembly Packaging Total direct labor Direct cost Applied overhead (@ 90% of direct labor costs)

100,000
$ 15.00 $ 7.50 9.90 $ 17.40 $ 32.40 15.66 $ 48.06

40,000
$ 60.00 $ 15.00 9.00 $ 24.00 $ 84.00 21.60 $105.60

9-10

LO2

Two-Stage Cost Allocation


Third Quarter Two-Stage Overhead Allocation J25P Units produced Direct material Direct labor: Assembly Packaging Total direct labor Direct cost Applied overhead: Assembly @ $45/machine hour Packaging @ 60% of direct labor cost Total overhead Unit costs 100,000 $ 15.00 $ 7.50 9.90 $ 17.40 $ 32.40 $ 2.70 5.94 $ 8.64 $ 41.04 J40X 40,000 $ 60.00 $ 15.00 9.00 $ 24.00 $ 84.00 $ 33.75 5.40 $ 39.15 $123.15

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Plantwide versus Department-Specific Rates


L.O. 3 Compare and contrast plantwide and
department allocation methods.

All overhead costs are recorded in one cost pool and applied to products using one overhead allocation rate.

9-12

LO3

Plantwide versus Department-Specific Rates

Overhead costs are traced to separate departments and applied to products using a department allocation rate.

9-13

LO3

Choice of Allocation Methods

Similar products using same resources Multiple products using resources differently

Plantwide allocation Department allocation

9-14

Activity-Based Costing (ABC)


L.O. 4 Explain how activity-based costing and
a two-stage product system are related.

ABC is a costing method that first assigns costs to activities and then assigns them to products based on the products consumption of activities. Assign costs to activities.

Assign costs to products based on the use of each activity


9-15

LO4

Activity-Based Costing (ABC)

Products consume activities

Activities consume resources

9-16

LO4

Developing Activity-Based Costs


Step 1: Identify the activities that consume resources and assign costs to them.

Step 2: Identify the cost driver(s) associated with each activity.


Step 3: Compute a cost rate per cost driver unit or transaction. Step 4: Assign costs to products by multiplying the cost driver rate by the volume of cost driver units consumed by the product.

9-17

LO4

Cost Drivers
Cost drivers are factors that cause or drive an activitys costs. Identified Activity Setting up machines Handling material Machining Packaging and shipping Identified Cost Driver Number of hours Number of production runs Number of machine hours Number of shipments

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LO4

Cost Hierarchies
This is the classification of cost driversinto general levels of activity; volume, batch, product, and so on.
Hierarchy Level Cost Example Cost Driver Example

9-19

LO4

Cost Hierarchies
This is the classification of cost driversinto general levels of activity; volume, batch, product, and so on.
Hierarchy Level Volume related Cost Example Supplies Lubricating oil Machine repair Cost Driver Example Direct labor costs Machine hours Number of units

9-20

LO4

Cost Hierarchies
This is the classification of cost driversinto general levels of activity; volume, batch, product, and so on.
Hierarchy Level Volume related Cost Example Supplies Lubricating oil Machine repair Setup costs Material handling Shipping costs Cost Driver Example Direct labor cost Machine-hours Number of units Setup hours Production runs Number of shipments

Batch related

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LO4

Cost Hierarchies
This is the classification of cost driversinto general levels of activity; volume, batch, product, and so on.
Hierarchy Level Volume related Cost Example Supplies Lubricating oil Machine repair Setup costs Material handling Shipping costs Compliance costs Design and specification costs Cost Driver Example Direct labor cost Machine-hours Number of units Setup hours Production runs Number of shipments Number of products

Batch related

Product related

9-22

LO4

Cost Hierarchies
The cost hierarchy in any ABC system depends on the cost category and its cost driver.
Hierarchy Level Volume related Cost Example Supplies Lubricating oil Machine repair Setup costs Material handling Shipping costs Compliance costs Design and specification costs General plant costs Plant admin. costs Cost Driver Example Direct labor cost Machine-hours Number of units Setup hours Production runs Number of shipments Number of products

Batch related

Product related

Facility related

Direct costs Value added


9-23

Activity-Based Costing Illustrated


L.O. 5
Compute product costs using activity-based costing.
Third Quarter Production and Cost Data J25P Number of units Machine hours Assembly
Direct materials Direct labor Assembly Direct labor Packaging Total direct labor Total direct cost Overhead costs: Assembly Packaging Total overhead Total costs

J40X 40,000 30,000


$2,400,000 $ 600,000 360,000 $ 960,000 $3,360,000

Total 140,000 36,000


$3,900,000 $1,350,000 1,350,000 $2,700,000 $6,600,000 $1,620,000 810,000 $2,430,000 $9,030,000
9-24

100,000 6,000
$1,500,000 $ 750,000 990,000 $1,740,000 $3,240,000

LO5

Activity-Based Costing Illustrated Step 1: Identify the Activities

Assembly Department Setting up machines Handling material Product Assembly

Packaging Department Inspection Packing Shipping

9-25

LO5

Activity-Based Costing Illustrated Step 2: Identify the Cost Drivers


Cost Driver Volume

Activity
Assembly building: Assembling Setting up machines Handling material Packaging building: Inspecting and packing Shipping

Cost Driver
Machine-hours Setup hours Production runs

J25P

J40X

Total

6,000 30,000 36,000 40 400 440 8 40 48

Direct labor hours 60,000 22,800 82,800 No. of shipments 100 200 300

9-26

LO5

Activity-Based Costing Illustrated Step 3: Compute the Cost Driver Rates


Overhead Cost Cost Driver Volume Cost Driver Rate $ 30/machine hour $ 900/setup hour $3,000/run

Building and Activity Assembly building: Assembling Setting up machines Handling material Total assembly overhead Packaging building: Inspecting and packing Shipping Total packaging overhead Total overhead

$1,080,000 36,000 machine hour 396,000 440 hours 144,000 48 runs $1,620,000

$ 414,000 82,800 direct labor hour $ 5/direct labor hour 396,000 300 shipments $ 1,320/shipment $ 810,000 $2,430,000

9-27

LO5

Activity-Based Costing Illustrated Step 4: Assign Costs Using ABC


Overhead J25P
$180,000 36,000 24,000

J40X
$ 900,000 360,000 120,000

Assembly building: Assembling @ $30/machine hour Machine setup @ $900/setup hour Handling material @ $3,000/run Packaging building: Inspection and packaging @ $5/direct labor hour Shipping @ $1,320/ shipment Total ABC overhead

300,000 132,000 $672,000

114,000 264,000 $1,758,000

9-28

LO5

Cost Flow Diagram ABC System


Direct costs
Directly assigned

Manufacturing overhead

Assembly building

Packaging building

Assembling
Machine hours

Setup
Setup hours

Handling material
Runs

Inspecting/ packaging
Direct LH

Shipping
Shipments

J25P

J40X

9-29

LO5

Activity Based Costing Illustrated


J25P J40X
$2,400,000 $ 600,000 360,000 $ 960,000 $3,360,000 $1,500,000 $ 750,000 990,000 $1,740,000 $3,240,000

Direct material Direct labor: Assembly Packaging Total direct labor Direct costs Overhead: Assembly building: Assembling @ $30 per machine hour Machine setup @ $900 per setup hour Handling material @ $3,000 per run Package building: Inspecting and packing @ $5 per direct labor hour Shipping @ $1,320 per shipment Total ABC overhead Total ABC cost Number of units Unit cost

$ 180,000 36,000 24,000 300,000 132,000 $ 672,000 $3,912,000 100,000 $ 39.12

$ 900,000 360,000 120,000 114,000 264,000 $1,758,000 $5,118,000 40,000 $ 127.95


9-30

Unit Costs Compared


L.O. 6 Compare activity-based product costing to
traditional department product costing methods.

Comparison of Reported Unit Product Costs

J25P
Plantwide rate Department (building) rate Activity-based costing $48.06 $41.04 $39.12

J40X
$105.60 $123.15 $127.95

9-31

Cost Flows through Accounts


L.O. 7 Demonstrate the flow of costs through
accounts using activity-based costing.

Lets see ABC cost flow for the Assembly Department.


It's T-account time!

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LO7

Direct Materials Costs


Materials Inventory 1,500,000 2,400,000 Assembly WIP J25P
DM

1,500,000

Assembly WIP J40X DM 2,400,000

9-33

LO7

Direct Labor Costs


Wages Payable 750,000 600,000
DL

Assembly WIP J25P


DM

1,500,000 750,000

Assembly WIP J40X DM 2,400,000


DL

600,000

9-34

LO7

Overhead Costs
Assembling 1,080,000 180,000 900,000 Setting Up 396,000 36,000 360,000 Assembly WIP J25P
DM

1,500,000 DL 750,000 OH 240,000

Handling Material 144,000 24,000 120,000

Assembly WIP J40X DM 2,400,000


DL OH

600,000 1,380,000

9-35

LO7

Transfer from Assembly to Packaging


Assembly WIP J25P
DM

Packaging WIP J25P 2,490,000

1,500,000 2,490,000 DL 750,000 OH 240,000

Assembly WIP J40X DM 2,400,000 4,380,000


DL

Packaging WIP J40X 4,380,000

600,000 OH1,380,000

9-36

ABC Costing in Administration


L.O. 8 Apply activity-based costing to marketing
and administrative services.

Step 1: Identify the activities that consume resources.

Step 2: Identify the cost driver associated with each activity.


Step 3: Compute a cost rate per cost driver for each unit or transaction. Step 4: Assign costs to the marketing or administration activity by multiplying the cost driver rate by the volume of cost driver units consumed by the product.
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End of Chapter 9

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.