1. Activity Based Costing: A Tool to Aid Decision Making
Chapter4
Activity Based Costing: A Tool to Aid Decision Making

2. Allocates Costs Company-wide at One Rate
TRADITIONAL COSTING
Allocates Costs Company-wide at One Rate
Allocates overhead using a single predetermined overhead rate.
Historically based on gross profit or relative sales. Now often on direct labor or machine hours.
Process costing: Usuallybased on machine hours.
Allocation accurately shows profitability of the company as a whole.
Problem: Profitability of individual products may not accurately reflect the effort and costs incurred.

3. ACTIVITY BASED COSTING (ABC)
Both manufacturing
and nonmanufacturing
overhead costs are
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. Overhead rates based on Activities
Activity 1
Activity 3
Activity 2
A two stage process is
necessary because costs are allocated to activities and then to products.

5. Activities and Related Cost Drivers
Activity Cost Pool is a “bucket” in which costs are accumulated that relate to a single activity in the ABC system. $ $ $ $ $ $

6. Designing an ABC System
Steps for Implementing ABC
Identify and define activities, activity cost pools, and cost drivers.
Trace identifiable costs to activities.
Allocate overhead costs to activity cost pools.
Calculate activity rates based on expected total use of cost drivers.
Assign costs to products.

7. Designing an ABC System
Identifiable
(Indirect) Costs
Activities
(Cost Pools)
Amount of
Activity Used
Overhead Costs
Costs Applied

8. ABC Overhead Rates Stage One: Costs assigned to activity pools
Indirect
Labor
Indirect
Materials
Other
Overhead
Activity 1
Activity 2
Activity 3
Cost pools

9. ABC Overhead Rates Machine Hours Inspections Setups Stage One:
Costs assigned
to activity pools
Indirect
Labor
Indirect
Materials
Other
Overhead
Activity 1
Activity 2
Activity 3
Cost pools
Based on cost drivers
Setups
Machine Hours
Inspections

10. ABC Overhead Rates Machine Hours Inspections Setups Stage One:
Costs assigned
to activity pools
Indirect
Labor
Indirect
Materials
Other
Overhead
Activity 1
Activity 2
Activity 3
Cost pools
Based on cost drivers
Setups
Machine Hours
Inspections
Stage Two:
Costs applied
to products
Products

11. Traditional Costing vs ABC
ABC does segregate overhead into various cost pools to provide more accurate cost information.
ABC supplements – it does not replace – the existing traditional job order/process cost system.
Why? Variances (over/under applied) would become very complex and not very meaningful.

12. Activities and Related Cost Drivers

13. The Mechanics of ABC
One overhead cost - shipping - can be traced directly to customer orders.

15. Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
Traced
$/DLH
Traced
Products or Customers

16. Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Customer
Orders
(# of Orders)
Product
Design
Order
Size
(Mach Hrs)
Customer
Relations
(# of Customers)
Other
Products or Customers

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

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

19. 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

20. 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

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

22. 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.

23. 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: ÷ ÷ ÷ ÷

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 custom 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. Example Traditional Using Machine Hours
Total Production Dept O/H $1,000,000
Total Machine Hours 20,000
Overhead Allocation/Machine Hour $50/hr.

35. Predetermined manufacturing
Product Margins
Traditional Cost Accounting System
Predetermined manufacturing
overhead rate
$1,000,000
20,000 MH
= $50/MH =
400 units x 0.5 MH/unit x $50/MH = $10,000

36. Comparison of Unit Costs Traditional vs ABC
Standard Compass
Stanchion Housing
Traditional Traditional
Costing ABC Costing ABC
Sales $ 13, $ 13, $ $ 650
Manufacturing Costs
Direct Materials , ,
Direct Labor , ,
Overhead ,000 4, ,701
Total Cost per Product 13, , ,764
Overstated Understated
$5, $1,438

37. Comparison of Unit Costs Traditional vs ABC
Standard Compass
Stanchion Housing
Traditional Traditional
Costing ABC Costing ABC
Sales $ 13, $ 13, $ $ 650
Manufacturing Costs
Direct Materials , ,
Direct Labor , ,
Overhead ,000 4, ,701
Total Cost per Product 13, , ,764
Product Margin (360) 5, (1,114)

38. 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.

39. 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.

40. 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.

42. Simplified Approach to ABC
2 $315 per order

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

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

45. Activity-Based Costing
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

46. 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

47. Value-Added vs. 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

48. End of Chapter 4
I call this
quality
time!