1. Activity Based Costing: A Tool to Aid Decision Making
Chapter8
Activity Based Costing: A Tool to Aid Decision Making

2. Activity Based Costing (ABC)
The objective of activity-based costing is to understand overhead and the profitability of products and customers.
ABC is a
good supplement to our traditional cost system
I agree!

3. Activity Based Costing (ABC)
Both manufacturing
and nonmanufacturing
costs may be
assigned to
products.
There are a number
of cost pools each of which is allocated
using a unique
measure of activity.
Some manufacturing
costs may be excluded
from product
costs.
Allocation bases often
differ from
traditional costing
systems.
Overhead rates may
be based on activity
at capacity.

4. How Costs are Treated Under Activity-Based Costing
Departmental
Overhead
Rates
Level of Complexity
Plantwide
Overhead
Rate
Overhead Allocation

5. Plantwide Overhead Rate
Companies tend to use direct labor
as the overhead allocation base.

6. Departmental Overhead Rates
Finishing Department
Shipping Department
Painting Department
A two stage process is
necessary because costs are allocated to departments and then to products.

7. Departmental Overhead Rates
Indirect
Labor
Indirect
Materials
Other
Overhead
Stage One:
Costs assigned
to pools
Department 1
Department 2
Department 3
Cost pools

8. Departmental Overhead Rates
Indirect
Labor
Indirect
Materials
Other
Overhead
Stage One:
Costs assigned
to pools
Department 1
Department 2
Department 3
Cost pools
Stage Two:
Costs applied
to products
Products

9. Departmental Overhead Rates
Indirect
Labor
Indirect
Materials
Other
Overhead
Stage One:
Costs assigned
to pools
Department 1
Department 2
Department 3
Cost pools
Direct
Labor
Hours
Machine
Hours
Raw
Materials
Cost
Stage Two:
Costs applied
to products
Products
Departmental Allocation Bases

10. Designing an ABC System
Cost Objects
(e.g., products
and customers)
Consumption
of Resources
Activities
Cost

11. Designing an ABC System
Steps for Implementing ABC
Identify and define activities and activity pools.
Where possible, trace costs to activities and cost objects.
Assign costs to activity cost pools.
Calculate activity rates.
Assign costs to cost objects.
Prepare management reports.

12. Identifying Activity to Include
Unit-Level
Activity
Batch-Level
Activity
A part of the production
process for which management
wants a separate reporting of the
costs of the activity involved.
Product-Level
Activity
Customer-Level
Activity
Organization- sustaining
Activity

13. Identifying Activity to Include
Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity in the ABC system. $ $ $ $ $ $

14. At Classic Brass, the ultimate cost objects are:
The Mechanics of ABC
At Classic Brass, the ultimate cost objects are:
Products,
Customer orders, and
Customers.
One overhead cost - shipping - can be traced directly to customer orders.
The company’s overhead costs are shown on the next slide.

16. Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
Traced
$/DLH
Traced
Cost Objects:
Products, Customer Orders, Customers

17. Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Other
Cost Objects:
Products, Customer Orders, Customers

18. Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Other
Second-Stage Allocations
$/MH
$/Order
$/Design
$/Customer
Cost Objects:
Products, Customer Orders, Customers
Unallocated

19. Assigning Costs to Activity Cost Pools
Management at Classic Brass believes overhead should be distributed as follows:

20. Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.
Indirect factory wages $500,000
Percent consumed by customer orders %
$125,000

21. Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.
Factory equipment depreciation $300,000
Percent consumed by customer orders %
$ 60,000

22. Assigning Costs to Activity Cost Pools
Using the total costs and percentage consumption of overhead, costs are assigned to activity pools.

23. Computation of Activity Rates
The ABC team has determined that Classic Brass has the following total activities for each activity cost pool . . .
1,000 customer orders,
200 new designs,
20,000 machine-hours
100 customers.
Now the team can compute the individual activity rates.

24. Computation of Activity Rates

25. Computation of Activity Rates

26. Assigning Costs to Cost Objects
Let’s take a look at how our system works for just one customer - Windward Yachts.
Windward ordered two products - Stanchions and customer compass housings. Here are the details:
Standard Stanchions (no design required)
units ordered with 2 separate orders.
2. Each stanchion required 0.5 machine-hours .
3. Selling price is $34 each.
4. Direct materials total $2,110.
5. Direct labor totals $1,850.
6. Shipping costs total $180.

27. Assigning Costs to Cost Objects
Let’s take a look at how our system works for just one customer - Windward Yachts.
Windward ordered two products - Stanchions and customer compass housings. Here are the details:
Custom Compass Housing (requires new design)
1. One order during the year.
2. Each housing required 4 machine-hours .
3. Selling price is $650 each.
4. Direct materials total $13.
5. Direct labor totals $50.
6. Shipping costs total $25.

28. Assigning Costs to Cost Objects
Overhead cost of two orders for standard stanchions.
$125 per order × 2 orders = $250

29. Assigning Costs to Cost Objects
Overhead cost of two orders for standard stanchions.

30. Assigning Costs to Cost Objects
Overhead cost of one order for custom compass housing.
$125 per order × 1 order = $125

31. Assigning Costs to Cost Objects
Overhead cost of one order for custom compass housing.

32. Product Margins

33. Product Margins

34. Predetermined manufacturing
Product Margins
Traditional Cost Accounting System
Predetermined manufacturing
overhead rate
$1,000,000
20,000 MH
= $50/MH =

35. 400 units x 0.5 MH/unit x $50/MH = $10,000
Product Margins
Traditional Cost Accounting System
400 units x 0.5 MH/unit x $50/MH = $10,000

36. Difference Between ABC and Traditional Product Costs
ABC will ordinarily shift batch-level and product-level overhead costs from high-volume products produced in large batches to low-volume products produced in small batches.

37. Difference Between ABC and Traditional Product Costs
Under ABC both manufacturing and nonmanufacturing costs may be assigned to products. Organization-sustaining costs and the costs of idle capacity are not assigned to products.

38. Ease of Adjustment
Costs that adjust automatically to changes in activity:
Direct materials.
Shipping.
Costs that could be adjusted to changes in activity:
Direct labor.
Factory utilities.
Administrative wages and salaries.
Office equipment depreciation.
Marketing wages and salaries.
Selling expenses.
Costs that are difficult to adjust to changes in activity:
Factory equipment depreciation.
Factory building lease.
Administrative building lease.

40. Simplified Approach to ABC
After the first-stage allocation is complete, computation of activity rates for each activity cost pool can be simplified as follows: ÷ ÷ ÷ ÷

41. Simplified Approach to ABC
2 $315 per order

42. Simplified Approach to ABC
1 $1,285 per design

43. Simplified Approach to ABC
Customer margin for Windward Yachts is shown below:

44. End of Chapter 8
I call this
quality
time!