Chapter 5

Activity-Based
Costing and
Management
 Traditional, Volume-Based
Product-Costing System
•• Aerotech
Aerotech produces
produces three
three complex
complex printed
printed circuit
circuit boards
boards referred
referred to
to as
as Mode
Mode I,I, Mode
Mode II,
II, and
and Mode
Mode
III.
III.
•• The
The following
following information
information is
is obtained
obtained from
from company
company records:
records:

Mode I Mode II Mode III

Production:
Units 10,000 20,000 4,000
Runs 1 run of 10,000 4 runs of 10 runs of
units 5,000 units 400 units

Mo d e I Mo d e I I Mo d e I I I
Direct mat erials $ 50.00 $ 90.00 $ 20.00
Direct lab o r (h r/b o ard ) 3 4 2
S et u p t ime (h r/ru n ) 10 10 10
Mac h in e t ime (h r/b o ard ) 1 1.25 2

Manufacturing overhead is determined as follows 5-2

 Traditional, Volume-Based
Product-Costing System

Budgeted manufacturing overhead $3,894,000

= $33 per hour
Budgeted direct-labor hours 118,000

5-3
 Traditional, Volume-Based
Product-Costing System
With these product costs, Aerotech established
target selling prices (Cost × 125%).

209.00 x 1.25
5-4
Activity Based Costing System
(ABC)
ABC systems follow a two-stage procedure
to assign overhead costs to products.
Stage One
Identify significant activities and assign overhead costs
to each activity in proportion to resources used.
Stage Two
Identify cost drivers appropriate to each activity and
allocate overhead to the products.

5-5
 Overhead Costs
Total budgeted cost = $3,894,000 Identification
Identification
Activity
must be
of
of Activity
Activity
done on Cost
Cost Pools
Pools
each unit Activity
produced. Cost
Pools
Product-
Unit Batch Sustaining Facility
Level Level Level Level

Machinery Setup Engineering Facility

cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Activity Activities needed to support Activity required in order

performed an entire product line for the production
on each process to occur.
batch
produced. 5-6
 Product-
Unit Batch Sustaining Facility
Level Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400

Receiving/Inspection
cost pool $200,000

Material-Handling
cost pool $600,000

Quality-Assurance
cost pool $421,000

Packaging/Shipping
cost pool $250,000
5-7
 STAGE ONE

Various overhead
Maintenance Lubrication
costs related
to machinery Depreciation Electricity

Computer Support Calibration

Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1,212,600

5-8
 STAGE TWO
Calculate Budgeted Machinery Costs = $1,212,600
the pool Budgeted Machine Hours 43,000
rate = $28.20/hour

Cost
Assignment

5-9
 STAGE ONE

Calculation of
total setup cost

Activity
cost Setup Cost Pool
pool Total budgeted cost = $3,000

5-10
 STAGE TWO
Calculate Budgeted Setup Costs = $3,000
the pool Planned Production Runs 15 runs
rate = $200 per run

Cost
Assignment

5-11
 STAGE ONE
Various overhead Engineering salaries Engineering software
costs related
to engineering Engineering supplies Depreciation

Activity
cost Engineering Cost Pool
pool Total budgeted cost = $700,000

5-12
 STAGE TWO
Allocate based Engineering Cost Pool
on engineering Total budgeted cost = $700,000
transactions

Cost
Assignment

5-13
 STAGE ONE
Various overhead Plant depr. Property taxes
costs related
Plant mgmt. Insurance
to general
operations Plant maint. Security

Activity
cost Facility Cost Pool
pool Total budgeted cost = $507,400

5-14
 STAGE TWO
Calculate Budgeted Facilities Cost = $507,400
the pool Budgeted Direct-Labor Hours 118,000
rate = $4.30/hour

Cost
Assignment

5-15
 Other Overhead Costs
Receiving and Inspection Cost Pool
Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode II I 200,000 × 70% ÷ 4,000 = 35.00

Material-Handling Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
$14.82 Mode I $ 600,000 × 7% ÷ 10,000 = $ 4.20
Mode II 600,000 × 30% ÷ 20,000 = 9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50

Quality-Assurance Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode II I 421,000 × 40% ÷ 4,000 = 42.10

Packaging and Shipping Cost Pool

Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
Mode III 250,000 × 66% ÷ 4,000 = 41.25
5-16
 Product Cost from ABC
These are the new product costs when Aerotech
uses ABC.

5-17
 Distorted Product Costs
Both original and ABC target selling prices are
based on (Cost × 125%).

The selling price of Mode I and II are reduced

and the selling price for Mode III is increased.
[$209.00 × 1.25] [$183.44 × 1.25]
5-18
 Distorted Product Costs
Can you identify any problems Aerotech is likely
to face as a result of this distortion?

Traditional costing understates the cost

of complex, low volume products.

5-19
 Two Key Points

A
A large
large proportion
proportion of of non-
non- Product
Product diversity
diversity
unit-level
unit-level activities
activities When
When the
the consumption
consumption
A
A unit-level
unit-level cost
cost driver,
driver, ratios
ratios differ
differ widely
widely
such
such asas direct
direct labor,
labor, between
between activities,
activities, no
no
machine
machine hours,
hours, or
or single
single cost
cost driver
driver will
will
throughput,
throughput, will
will not
not be
be accurately
accurately assign
assign the
the
able
able to
to assign
assign the
the costs
costs resulting
resulting overhead
overhead costs.
costs.
of
of non-unit-level
non-unit-level activities
activities
accurately.
accurately.

5-20
 Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs.

5-21
 Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .

Degree of
Correlation

5-22
 Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .

Degree of
Correlation

Cost of
Measurement

5-23
 Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .

Degree of Behavioral
Correlation Effects

Cost of
Measurement

5-24
Interviewing and Paper Trails
The information for ABC systems initially comes
from interviews with employees in the support
departments and a review of each department’s
records.

5-25
 Storyboarding
A procedure used to develop a detailed
process flow chart, which visually
represents activities and the relationships
among activities.
Step
Step These
These are
are the
the steps
steps wewe
11 follow
Step follow to
to build
build aa
Step memory
22 memory board.
board.
Step
Step
33
Step
Step
44

5-26
 Direct versus Indirect Costs
Volume-Based
Volume-Based Costing
Costing Activity-Based
Activity-Based Costing
Costing
All
All production
production costs
costs An effort
effort is
is made
made to
to
except
except direct
direct account
account for
for as
as many
many
materials
materials and
and direct
direct costs
costs as
as possible
possible as
as
labor
labor are
are lumped
lumped direct costs of
together
together in
in one
one production.
production.
overhead
overhead cost
cost pool.
pool.

Indirect
Costs

5-27
 Indicators of Need for ABC
Direct
Direct labor
labor is
is aa Product-line
Product-line profit
profit
small
small percentage
percentage margins
margins are
are hard
hard
of
of total
total costs
costs to
to explain
explain

Line
Line managers
managers dodo not
not
Sales
Sales are
are increasing,
increasing, believe
believe the
the product
product
but
but profits
profits are
are declining.
declining. costs
costs reports
reports

Some
Some products
products that
that
Marketing
Marketing does
does not
not have
have reported
reported high
high
use
use costs
costs reports
reports for
for profit
profit margins
margins are
are not
not
pricing
pricing decisions
decisions sold
sold by
by competitors
competitors
5-28
 Exh.
5-13

Optimal Product-Costing System

Cost
Total Cost
High

Cost of
inferior
decisions
resulting Design, implementation
from and maintenance costs
inaccurate
information.

Information
Low
System
Low High Accuracy
Optimal
system
 30
Activity-based costing (ABC) vs. volume-
based costing

– Volume-based costing is often inadequate because indirect

costs do not always occur in proportion to output volume
– Volume-based costing generally causes miscosting of
outputs (i.e., some products will be overcosted and others
uundercosted)
– Volume-based costing can create inappropriate incentives
for managers (i.e., more volume equates to more overhead
expense)
– Activity-based costing uses detailed information about the
activities that make up indirect (support) costs so that
outputs are charged only for resources consumed

5-30