ACCOUNTING FOR FACTORY

OVERHEAD AND ACTIVITY-

BASED COSTING
 Factory Overhead

• is a crucial component of cost accounting.

• describes production-related indirect expenditures that cannot
be clearly linked to a particular product unit.
• include items like rent for the production facility, utilities,
machinery depreciation, and indirect labor, are incurred to
support the manufacturing activity as a whole.
 Level one: Plant-wide Overhead rate
• Dominated industry practice, expressed either as a percentage of
direct labor cost or as an overhead cost per direct labor hour.
• Their accuracy is now being questioned because they frequently
use direct labor alone as an allocation base, which can result in
distorted unit costs
 Assumption was satisfactory when direct labor was a major portion
of total manufacturing costs.
Wide acceptance of a high correlation between direct labor and overhead
costs.
 Traditional Costing Systems:

 Direct labor is still often the appropriate basis for

assigning overhead costs when:
Direct labor constitutes a significant part of total product cost
and
High correlation exists between direct labor and changes in
overhead costs.

Overhead Direct Labor Products

Costs Hours/Dollars
 Level two: Department Overhead Rates
• "two-stage allocation process" in place of a plant-wide overhead rate.
• In the first stage, overhead expenses are allocated to cost pools
such specific departments or operations.
• The second stage involves applying costs from cost pools
(departments) to specific jobs. These applications for the second
stage are made on a variety of grounds depending on the type of
work that is done in the department.
 Departmental overhead rates
Will fail to accurately allocate overhead expenses when a company
has a variety of products with varying
• volumes,
• lot sizes, or
• production complexity.
The departmental approach's entire reliance on volume as the
primary criterion for assigning overhead costs to goods is the
cause. A volume-based overhead cost assignment will not produce
correct product costs where there is product variability.
 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.

 May be inappropriate to use plant-wide predetermined overhead

rates based on direct labor or machine hours when a lack of
correlation exists.

 Complex manufacturing processes may require multiple allocation

bases; this approach is called Activity-Based Costing (ABC).
Activity-Based Costing (ABC)

 An overhead cost allocation system that allocates

overhead to multiple activity cost pools
and
 Assigns the activity cost pools to products or
services by means of cost drivers that represent
the activities used.
 Activity-Based Costing (ABC)
Terms

 Activity: any event, action, transaction, or work sequence that

causes a cost to be incurred in producing a product or providing a
service.

 Activity Cost Pool: a distinct type of activity.

For example: ordering materials or setting up machines.

 Cost Drivers: any factors or activities that have a direct cause-effect

relationship with the resources consumed.
The Logic Behind ABC

Products consume activities,

and
activities consume resources.
Activity-Based Costing (ABC) – Continued
 ABC allocates overhead costs in two stages:

Stage 1: Overhead costs are allocated to activity

cost pools.

Stage 2: The overhead costs allocated to the cost

pools is assigned to products using cost drivers.

 The more complex a product’s manufacturing operation, the

more activities and cost drivers likely to be present.
Activities and Related Cost Drivers
ABC System Design – Lift Jack Company
 Traditional Costing vs ABC
 ABC does not replace an existing job order/process cost
system.

 ABC does segregate overhead into various cost pools to

provide more accurate cost information.

 ABC, thus, supplements – it does not replace – the

traditional cost system.
 Traditional Costing vs ABC
An Illustration
 Atlas Company produces two automotive antitheft devices:
 The Boot: a high volume item with sales totaling 25,000 per year
 The Club: a low volume item with sales totaling 5,000 per year

 Each product requires 1 hour of direct labor

 Total annual direct labor hours (DLH) 30,000 (25,000 + 5000)
 Direct labor cost P12 per unit for each product

 Expected annual manufacturing overhead costs P900,000

 Direct materials cost:

 The Boot - P40 per unit
 The Club - P30 per unit
Unit Costs Under Traditional Costing

Products

Manufacturing Costs The Boot The Club

Direct Materials P40 P30
Direct Labor 12 12
Overhead 30* 30*
Total unit cost P82 P72

* Predetermined overhead rate: P900,000/30,000 DLH = P30 per DLH

Overhead = predetermined overhead rate times direct labor hours
(P30 X 1 hr. = P30)
Unit Costs Under ABC:
Step 1: Identify and Classify Activities and Allocate Overhead to Cost
Pools

Activity Cost Pools Estimated Overhead

Setting up machines P300,000
Machining 500,000
Inspecting 100,000
Total P900,000
Unit Costs Under ABC:
Step 2: Identify Cost Drivers

Expected Use
of Cost Drivers
Activity Cost Pools Cost Drivers Per Activity
Setting up machines Number of setups 1,500
Machining Machine hours 50,000
Inspecting Number of
Inspections 2,000
 Unit Costs Under ABC:
Step 3: Compute Overhead Rates
Formula for Computing Activity-Based Overhead Rate:

Estimated Overhead Per Activity Activity-Based

Expected Use of Cost Drivers Per Activity Overhead Rate

Expected Use
Estimated of Cost Drivers Activity-Based
Activity Cost Pools Overhead Per Activity Overhead Rates
Setting up machines P300,000 1,500 setups P200 per setup
Machining 500,000 50,000 machine hrs. P 10 per mach. hour
Inspecting 100,000 2,000 inspections P 50 per inspection
Total P900,000
 Unit Costs Under ABC:
Step 4: Assign Overhead Costs to Products
Part 1: Expected Use of Cost Driver Per Product
Expected Use
of Cost Drivers
per Product
Expected Use
Activity Cost of Cost Drivers
Pools Cost Driver Per Activity The Boot The
Club
Setting up Number of
machines setups 1,500 setups 500 1,000
Machining Machine hours 50,000 hours 30,000 20,000
Inspecting Number of
inspections 2,000 inspections 500 1,500
 Unit Costs Under ABC:
Step 4: Assign Overhead Costs to Products
Part 2: Assign Cost Pools to Products

The Boot

Expected Use of Activity-Based

Activity Cost Drivers X Overhead = Cost
Cost Pools per Product Rates Assigned
Setting up machines 500 P200 P100,000
Machining 30,000 10 300,000
Inspecting 500 50 25,000
Total costs assigned P425,000
Units produced 25,000
Overhead cost per unit P17
 Unit Costs Under ABC:
Step 2: Assign Overhead Costs to Products
Part 2: Assign Cost Pools to Products

The Club

Expected Use of Activity-Based

Activity Cost Drivers X Overhead = Cost
Cost Pools per Product Rates Assigned
Setting up machines 1,000 P200 P200,000
Machining 20,000 10 200,000
Inspecting 1,500 50 75,000
Total costs assigned P475,000
Units produced 5,000
Overhead cost per unit P95
 Comparison of Unit Costs
Traditional vs ABC
The Boot The Club
Traditional Traditional
Manufacturing Costs Costing ABC Costing ABC
Direct Materials P40 P40 P30 P30
Direct Labor 12 12 12 12
Overhead 30 17 30 95
Total Cost per Unit P82 P69 P72 P137

Overstated Understated
P13 P65
Activity-Based Costing:
A Closer Look

More accurate product costing through:

 Use of more cost pools to assign overhead costs
 Enhanced control over overhead costs
 Better management decisions
Activity-Based Costing: A Closer Look
Limitations of ABC

 Can be expensive to use

 Some arbitrary allocations continue
Activity-Based Costing:
A Closer Look
Use ABC When One or More of the Following Exist:
 Products differ greatly in volume/manufacturing complexity
 Products lines are
 Numerous
 Diverse
 Require different degrees of support services
 Overhead costs are a significant portion of total costs
 Significant change in manufacturing process or number of
products
 Managers ignore data from existing system and instead use
“bootleg” costing data
 Value-Added vs.
Non-Value-Added Activities
Activity Based Management (ABM):

 An extension of ABC from a product costing system to a

management function
that focuses on reducing costs and improving processes and decision
making
 A refinement of ABC used in ABM classifies activities as either
value-added or non-value-added.
Value-Added vs.
Non-Value-Added Activities
Value-Added Activity
An activity that increases the worth
of a product or service such as:

Manufacturing Company Service Company

engineering design performing surgery
machining legal research services
assembly delivering packages
painting
packaging
Value-Added vs.
Non-Value-Added Activities
Non-Value-Added Activities
An activity that adds cost to, or increases the time
spent on, a product/service without increasing its
market value such as:
Manufacturing Company Service Company
Repair of machines Taking appointments
Storage of inventory Reception
Moving of raw materials, Bookkeeping/billing
assemblies, and finished goods Traveling
Building maintenance Ordering supplies
Inspections
Inventory Control
 CLASSIFICATION OF
ACTIVITY LEVELS

 Unit-level activities:
Performed for each unit of production
 Batch-level activities:
Performed for each batch of product
 Product-level activities:
Performed in support of an entire product line, but
not always performed every time a new unit or batch is produced
 Facility-level activities:
Required to support or sustain an entire production
process
Hierarchy of Activity Levels
Four Levels Types of Activities Cost Drivers
Unit-Level Activities Machine-related: Machine Hours
Drilling, cutting, milling
Labor-related Direct labor hours/cost
Assembling, painting
Batch-Level ActivitiesEquipment setups Number of setups/setup time
Purchase ordering Number of purchase orders
Inspection Number of inspections or
inspection time
Material handling Number of material moves
Product-Level Activities Product design Number of product designs
Engineering changes Number of changes
Facility-Level Activities Plant management salaries Number of employees managed
Plant depreciation Square footage
Property taxes Square footage
Utilities Square footage
Activity-Based Costing
in Service Industries
Similarities with Manufacturing Firms
 Overall objective:
Identify key cost-generation activities and keep track of
quantity of activities performed for each service provided

 General approach is to identify activities, cost pools,

and cost drivers

 Labeling of activities as value-added or non-value-

added

 Reduction of non-value-added activities

Activity-Based Costing
in Service Industries

Major difficulty to implementing

ABC:
A larger proportion of overhead
costs are company-wide costs
that cannot be directly traced to
specific services.
Activity-Based Costing in Service
Industries: Traditional Costing Example
CHECK AND DOUBLECHECK, CPAs
Annual Budget
Revenue P2,000,000
Direct labor P 600,000
Overhead (expected) 1,200,000
Total Costs 1,800,000
Operating income P 200,000

Estimated overhead
= Predetermined overhead rate
Direct labor cost
P1,200,000
= 200%
P600,000
Activity-Based Costing in Service
Industries:
ABC Costing Example

CHECK AND DOUBLECHECK, CPAs

Plano Molding Company Audit

Revenue P260,000
Less: Direct professional labor P 70,000
Applied Overhead (200% x P70,000) 140,000
210,000
Operating Income P 50,000
Activity-Based Costing in Service Industries:
ABC Costing Example
CHECK AND DOUBLECHECK, CPAs
Annual Overhead Budget
Expected Use
Activity Cost Estimated + of Cost Drivers = Activity-Based
Pools Cost Drivers Overhead Per Activity Overhead
Rates
Secretarial support Direct Prof. hours P 210,000 30,000 P7 per hour
Direct labor Fringe benefits Direct labor cost 240,000 P 600,000 P0.40 per P1 labor
Printing and photocopying Working paper pages 20,000 20,000 P1 per page
Computer support CPU minutes 200,000 50,000 P4 per minute
Telephone and postage None (traced directly) 71,000 P 71,000 Based on usage
Legal support Hours used 129,000 860 P150 per hour
Insurance Revenue billed 120,000 P2,000,000 P0.06 per P1 rev.
Recruiting and training Direct Prof. Hours __210,000 30,000 P7 per hour
P1,200,000
Activity-Based Costing in Service Industries:
ABC Costing Example
CHECK AND DOUBLECHECK, CPAs
Plano Molding Company Audit
Activity-
Based-
Activity Cost Actual Use Overhead
Pools Cost Drivers of Drivers Rates Cost Assigned
Secretarial support Direct Professional hours 3,800 P 7.00 P 26,600
Direct labor Fringe benefits Direct labor cost P 70,000 P 0.40 28,000
Printing and photocopying Working paper pages 1,800 P 1.00 1,800
Computer support CPU minutes 8,600 P 4.00 34,400
Telephone and postage None (traced directly) 8,700
Legal support Hours used 156 P150.00 23,400
Insurance Revenue billed P260,000 P 0.06 15,600
Recruiting and training Direct Prof. Hours 3,800 P 7.00 26,600
P165,100
Activity-Based Costing in Service Industries: ABC
Costing Example
CHECK AND DOUBLECHECK, CPAs
Plano Molding Company Audit

Traditional Costing ABC

Revenues P260,000 P260,000
Expenses
Direct professional labor P 70,000 P 70,000
Applied overhead 140,000 165,100
Total expenses 210,000 235,100
Operating income P 50,000 P 24,900
Profit Margin 19% 10%