1. “Cost Driver” (the activity) Owning a car
More traditional approach: One “Cost Pool”
“Cost Driver” (the activity) Owning a car

2. 2) Owning a Car
1) Driving a Car
Two Cost Drivers (Activities with a cause-effect relationship to the cost pools)

6. Allocating Overhead
Chapter 16 … “Job Order Costing”: allocated overhead using Pred. Overhead Rate with Direct Labor as an allocation (activity) base.
Chapter 17 … “Process Costing”: allocated overhead using Predetermined Overhead Rate often with Machine Hours as the allocation (activity) base.
Chapter 18 … Activity-Based-Costing (ABC): allocates overhead using multiple rates (activity cost pools) and multiple activity bases (cost drivers).

7. Traditional Costing The Need for a New Approach
Huge change in manufacturing & service industries.
Decrease in amount of direct labor usage.
Significant increase in total overhead costs.
Single plant-wide overhead rates gives poor info when manufacturing is complex … less human labor.
Complex manufacturing processes may require multiple allocation bases called: Activity-Based Costing (ABC).

8. This “total” is one single “activity cost-pool”
In Ch16 & 17 we used “Mfg OverHead” to develop a single “predetermined overhead rate” of $1,300,000.
This “total” is one single “activity cost-pool”
Machine lube oil
10,000
Machine maint parts
80,000
Machine maint labor
160,000
Machine set-up
120,000
Machine calibration & Testing
40,000
Machine repair
320,000
Factory security guards
190,000
Factory managers salary
100,000
Factory Utilities
Factory Lease
300,000
Total Mfg Overhead Costs … $1,300,000

9. A-B-C Costing Approach
In Ch16 & 17 we used “Mfg OverHead” to develop a single “predetermined overhead rate” of $1,300,000.
A-B-C Costing Approach
Machine lube oil
10,000
Machine maint parts
80,000
Machine maint labor
160,000
Machine set-up
120,000
Machine calibration & Testing
40,000
Machine repair
320,000
Factory security guards
190,000
Factory managers salary
100,000
Factory Utilities
Factory Lease
300,000
Machine Maintenance Cost Pool …… $250,000
Machine Set-Up
Cost Pool .… $160,000
Machine Repair
Cost Pool … $320,000
Misc Factory
Cost Pool … $670,000
Total …….. $1,300,000
Total Mfg Overhead Costs … $1,300,000

10. Activity‐based costing (A-B-C) assumes that the steps or activities required to manufacture a product are what determine the overhead costs incurred.
Each overhead cost, whether variable or fixed, is assigned to a category of costs. These categories are called … activity cost pools.
Cost drivers are the actual activities that cause the total cost in an activity cost pool to increase.
When using ABC, the total cost of each activity pool is divided by the total number of units of the activity to determine the cost per unit.

11. Activity-Based Costing
Activity: event, action, transaction, or work sequence that causes a cost to be incurred. Ex: ordering materials, setting up a machine, packing a machine for shipping.
Activity Cost Pool: a collection of costs incurred when certain operations (activities) are performed within the organization. Ex: ordering materials; setting up machines; packing.
Cost Drivers: factors or activities that have a direct cause- effect relationship with the resources consumed Ex: direct labor; machine setups; engineering change orders; special inspections; handling and storage; machine hours.

12. Activity Cost Pools: Payroll taxes
A-B-C assumes that steps or activities needed to make a product determines the overhead costs incurred.
What manufacturing overhead “steps” or “activities are involved in making product
Payroll taxes
Fringe benefits
Electricity
Factory rent
Equipment maintenance
Factory maintenance

13. Cost Driver
Factor (activity) that controls the amount of costs incurred for each “step” or “activity”.
Payroll taxes
Fringe benefits
Electricity
Factory rent
Equip maint
Factory maint
... Direct Labor Hours
... Direct Labor Hours
... Machine Hours
... Square Feet
... Machine Hours
... Square Feet

14. Activity Cost Pool:
Expenses influenced by the same cost drivers can now be grouped into activity cost pools.
Direct Labor Hours:
Payroll taxes
Fringe benefits
Machine Hours:
Electricity
Equipment maintenance
Number of Square Feet:
Factory rent
Factory maintenance

15. Example Using Traditional “Predetermined Overhead Rate”

17. (a)
Estimated overhead
= Predetermined overhead rate
Direct labor costs
(a)
$270,000
= 180% of direct labor cost
$50,000 + $100,000

18. Continued (c) Traditional costing Standard Custom $50,000 X 180%
 Custom 
$50,000 X 180%
$90,000
$100,000 X 180%
             
$180,000
* Rate = 180% of direct labor cost

19. Same Example Using
“A-B-C Costing”

21. Machining Cost
Machine Hours

22. Machining Cost
Machine Hours
Set-Up Cost
Set-Up Hours

24. Calculation to Allocate A-B-C
Standard
Custom
Machining
1,000 x $85
$ 85,000
$ 85,000

25. Standard Custom Standard Custom
Calculation to Allocate A-B-C
Standard
Custom
Machining
1,000 x $85
$ 85,000
$ 85,000
Calculation to Allocate A-B-C
Standard
Custom
Machining
1,000 x $85
$ 85,000
$ 85,000
Set-Up
100 x $200
20,000
400 x $200
80,000
105,000
165,000

26. Calculation to Allocate A-B-C
Traditional costing
Standard
 Custom 
$50,000 X 180%
$90,000
$100,000 X 180%
             
$180,000
270,000
Calculation to Allocate A-B-C
Standard
Custom
Machining
1,000 x $85
$ 85,000
$ 85,000
Set-Up
100 x $200
20,000
400 x $200
80,000
105,000
165,000
270,000

28. E18-2
Ayala Inc. has conducted the following analysis related to its product lines, using a traditional costing system (volume-based) and an activity-based costing system.
Both the traditional and the activity-based costing systems include direct materials and direct labor costs.
For each product line, compute operating income using the traditional costing system.
(b) For each product line, compute operating income using the activity-based costing system.
Products
Sales Revenue
Traditional
A-B-C
Product 540X
180,000
55,000
50,000
Product 137Y
160,000
35,000
Product 249S
70,000
15,000

29. E18-2
Ayala Inc. has conducted the following analysis related to its product lines, using a traditional costing system (volume-based) and an activity-based costing system.
Both the traditional and the activity-based costing systems include direct materials and direct labor costs.
Products
Sales Revenue
Traditional
A-B-C
Product 540X
180,000
55,000
50,000
Product 137Y
160,000
35,000
Product 249S
70,000
15,000
(a)
Traditional costing system
Product 540X
Product 137Y
Product 249S
Sales
$180,000
$160,000
$70,000
Costs
55,000
50,000
15,000
Operating income
$125,000
$110,000
$55,000

30. E18-2
Ayala Inc. has conducted the following analysis related to its product lines, using a traditional costing system (volume-based) and an activity-based costing system.
Both the traditional and the activity-based costing systems include direct materials and direct labor costs.
Products
Sales Revenue
Traditional
A-B-C
Product 540X
180,000
55,000
50,000
Product 137Y
160,000
35,000
Product 249S
70,000
15,000
(b)
Activity-based costing system
Product 540X
Product 137Y
Product 249S
Sales
$180,000
$160,000
$70,000
Costs
50,000
35,000
Operating income
$130,000
$125,000
$35,000

31. 410, , ,000
(b)
Activity-based costing system
Product 540X
Product 137Y
Product 249S
Sales
$180,000
$160,000
$70,000
Costs
50,000
35,000
Operating income
$130,000
$125,000
$35,000
410,000
120,000
290,000

32. (a)
Traditional costing system
Product 540X
Product 137Y
Product 249S
Sales
$180,000
$160,000
$70,000
Costs
55,000
50,000
15,000
Operating income
$125,000
$110,000
$55,000
410,000
120,000
290,000
(b)
Activity-based costing system
Product 540X
Product 137Y
Product 249S
Sales
$180,000
$160,000
$70,000
Costs
50,000
35,000
Operating income
$130,000
$125,000
$35,000
410,000
120,000
290,000
(c)
Product 540X:
($130,000 – $125,000) ÷ $125,000 = 4.00%
Product 137Y
($125,000 – $110,000) ÷ $110,000 = 13.64%
Product 249S
($35,000 – $55,000) ÷ $55,000 = (36.36%)

33. (a)
Traditional costing system
Product 540X
Product 137Y
Product 249S
Sales
$180,000
$160,000
$70,000
Costs
55,000
50,000
15,000
Operating income
$125,000
$110,000
$55,000
410,000
120,000
290,000
(b)
Activity-based costing system
Product 540X
Product 137Y
Product 249S
Sales
$180,000
$160,000
$70,000
Costs
50,000
35,000
Operating income
$130,000
$125,000
$35,000
410,000
120,000
290,000
(c)
Product 540X:
($130,000 – $125,000) ÷ $125,000 = 4.00%
Product 137Y
($125,000 – $110,000) ÷ $110,000 = 13.64%
Product 249S
($35,000 – $55,000) ÷ $55,000 = (36.36%)

34. (a)
Traditional costing system
Product 540X
Product 137Y
Product 249S
Sales
$180,000
$160,000
$70,000
Costs
55,000
50,000
15,000
Operating income
$125,000
$110,000
$55,000
410,000
120,000
290,000
(b)
Activity-based costing system
Product 540X
Product 137Y
Product 249S
Sales
$180,000
$160,000
$70,000
Costs
50,000
35,000
Operating income
$130,000
$125,000
$35,000
410,000
120,000
290,000
(c)
Product 540X:
($130,000 – $125,000) ÷ $125,000 = 4.00%
Product 137Y
($125,000 – $110,000) ÷ $110,000 = 13.64%
Product 249S
($35,000 – $55,000) ÷ $55,000 = (36.36%)

35. Difference between the 2 methods
(a)
Traditional costing system
Product 540X
Product 137Y
Product 249S
Sales
$180,000
$160,000
$70,000
Costs
55,000
50,000
15,000
Operating income
$125,000
$110,000
$55,000
410,000
120,000
290,000
(b)
Activity-based costing system
Product 540X
Product 137Y
Product 249S
Sales
$180,000
$160,000
$70,000
Costs
50,000
35,000
Operating income
$130,000
$125,000
$35,000
410,000
120,000
290,000
(c)
Product 540X:
($130,000 – $125,000) ÷ $125,000 = 4.00%
Product 137Y
($125,000 – $110,000) ÷ $110,000 = 13.64%
Product 249S
($35,000 – $55,000) ÷ $55,000 = (36.36%)
Difference between the 2 methods

37. Engineering,

38. Machinery,

39. Machine Set-Up,

40. Quality Control,

41. Factory utilities,

42. Maintenance,

43. Budgeted Costs
Activity Cost Pool
Cost Driver
Engineering design
Engineering prototypes
Engineering
Engineering hours
Depreciation, machinery
Electricity, machinery
Machinery
Machine hours
Machine setup, indirect labor
Machine setup, indirect materials
Machine setup
Number of setups
Inspections
Tests
Quality control
Number of tests or
inspections
Depreciation, plant; Insurance, plant; Property taxes; Oil, heating; Electricity, plant lighting
Factory utilities
Square feet or
Machine maintenance wages
Maintenance
Number of machines
or Machine hours

45. Activity Based Costing
Four steps:
Identify / classify activities involved in making specific products, … and allocate overhead to cost pools.
Identify the cost driver with a strong correlation to the costs accumulated in the cost pool (above).

46. Expected annual manufacturing overhead costs $900,000.
“Company” produces two products (abdominal trainers):
Ab Bench: a high volume sales = 25,000 units.
Ab Coaster: a low volume sales = 5,000 units.
Expected annual manufacturing overhead costs $900,000.

47. Example of ABC Versus Traditional Costing
Illustration:
Manufacturing costs
Ab Bench
Ab Coaster
Direct materials
$40
$30
Direct labor
1 12
Overhead 30 30
Total unit cost
$82
$72
* Overhead rate = $900,000/30,000 DLH = $30 per DLH
Overhead = ($30 X 1 hr. = $30)

48. Identify and Classify Activities and Allocate
Expected annual manufacturing overhead costs $900,000.
Identify and Classify Activities and Allocate
Overhead to Cost Pools (Step 1)
Overhead costs are assigned directly to the appropriate activity cost pool.

49. Identify Cost Drivers (Step 2)
From (Step 1)
Identify Cost Drivers (Step 2)
Cost driver should accurately measure the actual consumption of the activity by the various products.

50. Calcuulate Overhead Rates (Step 3)
Calculate an activity-based overhead rate per cost driver.
From Step 2
Step 3 Results
From Step 1

51. Assign Overhead Cost to Products (Step 4)
In assigning overhead, it is necessary to know the expected use of cost drivers for each product.
Ab Coaster requires more set-ups and inspections than Ab Bench due to its low volume.
,000
30, ,000
,500

52. Assign Overhead Cost to Products (Step 4)
To assign overhead, multiply the ABC rates per cost driver by the number of cost drivers expected to be used per product.

53. Assign Overhead Cost to Products (Step 4)
To assign overhead, multiply the ABC rates per cost driver by the number of cost drivers expected to be used per product.

54. Example of ABC Versus Traditional Costing
Remember - Traditional Costing Was:

55. Example of ABC Versus Traditional Costing
Comparing Unit Costs
Using traditional costing may have caused company to over-price the Ab Bench … (losing sales & market share).
Also most likely caused company to under-price the Ab Coaster … (probably resulting in decreased profitability).

56. Activity-Based Costing: A Closer Look
Benefits of ABC
More accurate product costing through:
Use of more cost pools to assign overhead costs.
Enhanced control over overhead costs.
Better management decisions.
Limitations of ABC
Can be expensive to use.
Some arbitrary allocations continue.

57. Activity-Based Costing: A Closer Look
When to Use ABC
Factors to consider:
Product lines differ in volume and manufacturing complexity.
Product lines are numerous and diverse.
Overhead costs constitute a significant portion of total costs.
The manufacturing process or the number of products has changed significantly.
Production or marketing managers are ignoring data provided by the existing system.

58. Activity-Based Costing: A Closer Look
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.
Value-added activities
Non–value-added activities

59. Manufacturing Company
Activity-Based Costing: A Closer Look
Value-Added Activities
An activity that increases the perceived worth of a product or service such as:
Manufacturing Company
Engineering design
Machining services
Assembly
Painting
Service Company
Performing surgery
Legal research
Delivering packages

60. Manufacturing Company
Activity-Based Costing: A Closer Look
Non–Value-Added Activities
An activity that adds cost to, or increases the time spent on, a product/service without increasing market value such as:
Manufacturing Company
Repair of machines
Storage of inventory
Building maintenance
Inspection
Service Company
Taking appointments
Reception
Bookkeeping and billing
Advertising