1. University of Louisiana at Lafayette
Prepared by
Dan R. Ward
Suzanne P. Ward
University of Louisiana at Lafayette
Chapter 17-1

2. Activity-Based Costing Accounting, Third Edition
Chapter 17-2
Accounting, Third Edition

3. Study Objectives
1. Recognize the difference between traditional costing and activity based costing.
2. Identify the steps in the development of an activity-based costing system.
3. Know how companies identify the activity cost pools used in activity-based costing.
Chapter 17-3

4. Study Objectives
4. Know how companies identify and use cost drivers in activity-based costing.
5. Understand the benefits and limitations of activity-based costing.
6. Differentiate between value-added and
non-value-added activities.
Chapter 17-4

5. Study Objectives
7. Understand the value of using activity levels in activity-based costing.
8. Apply activity-based costing to service industries.
Chapter 17-5

6. Chapter 17-6

7. CHAPTER PREVIEW Traditional costing systems
Traditional Costing and Activity-Based Costing
Traditional costing systems
The need for a new approach
Activity-based costing
Illustration of Traditional Costing versus ABC
Unit costs under traditional costing
Unit costs under ABC
Comparing unit costs
Chapter 17-7

8. CHAPTER PREVIEW Benefits/Limitations of ABC
Activity-Based Costing: A Closer Look
Benefits/Limitations of ABC
When to use ABC
Value-added vs. Non-value-added activities
Classification of activity levels
Activity-Based Costing in Service Industries
Traditional costing example
Activity-based costing example
Appendix: Just-in-time Processing
Objective – Elements - Benefits
Chapter 17-8

9. ACTIVITY-BASED COSTING VERSUS TRADITIONAL COSTING
Traditional Costing Systems
Allocates overhead using a single predetermined rate.
Job order costing: direct labor cost is assumed to be the relevant activity base.
Process costing: machine hours is the relevant activity base.
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.
Chapter 17-9
SO 1 Recognize the difference between traditional costing and activity based costing.

10. 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
Chapter 17-10
SO 1 Recognize the difference between traditional costing and activity based costing.

11. Tremendous change in manufacturing and service industries.
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).
Chapter 17-11
SO 1 Recognize the difference between traditional costing and activity based costing.

12. 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.
Chapter 17-12
SO 1 Recognize the difference between traditional costing and activity based costing.
SO 1 Recognize the difference between traditional costing and activity based costing.

13. 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.
Chapter 17-13
SO 1 Recognize the difference between traditional costing and activity based costing.

14. Products consume activities, activities consume resources.
The Logic Behind ABC
Products consume activities,
and
activities consume resources.
Chapter 17-14
SO 1 Recognize the difference between traditional costing and activity based costing.

15. Activity-Based Costing (ABC)
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.
Chapter 17-15
SO 1 Recognize the difference between traditional costing and activity based costing.

16. Activities and Related Cost Drivers
Illustration 17-2
Chapter 17-16
SO 1 Recognize the difference between traditional costing and activity based costing.

17. ABC System Design – Lift Jack Company
Illustration 17-3
Chapter 17-17
SO 1 Recognize the difference between traditional costing and activity based costing.

18. 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.
Chapter 17-18
SO 1 Recognize the difference between traditional costing and activity based costing.

19. 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, )
Direct labor cost $12 per unit for each product
Expected annual manufacturing overhead costs $900,000
Direct materials cost:
The Boot - $40 per unit
The Club - $30 per unit
Chapter 17-19
SO 1 Recognize the difference between traditional costing and activity based costing.

20. Unit Costs Under Traditional Costing
Products
Manufacturing Costs The Boot The Club
Direct Materials $40 $30
Direct Labor
Overhead * *
Total unit cost $ $72
* Predetermined overhead rate: $900,000/30,000 DLH = $30 per DLH
Overhead = predetermined overhead rate times direct labor hours
($30 X 1 hr. = $30)
Chapter 17-20
SO 1 Recognize the difference between traditional costing and activity based costing.

21. STEPS IN ACTIVITY-BASED COSTING SYSTEM
Identify and classify the major activities and allocate manufacturing overhead costs to the appropriate cost pools.
Identify the cost driver that has a strong correlation to the costs in the cost pool.
Compute the overhead rate for each pool.
Assign overhead costs for each costs to products using the overhead rates.
SO 2 Identify the steps in the development of an activity-based costing system.

22. Activity Cost Pools Estimated Overhead Setting up machines $300,000
Unit Costs Under ABC: Step 1: Identify and Classify Activities and Allocate Overhead to Cost Pools
Activity Cost Pools Estimated Overhead
Setting up machines $300,000
Machining ,000
Inspecting ,000
Total $900,000
Chapter 17-22
SO 3 Know how companies identify the activity cost pools used in activity-based costing.

23. 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 ,500
Machining Machine hours ,000
Inspecting Number of
Inspections ,000
Chapter 17-23
SO 4 Know how companies identify and use cost drivers in activity-based costing.

24. 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 $300, ,500 setups $200 per setup
Machining , ,000 machine hrs. $ 10 per mach. hour
Inspecting , ,000 inspections $ 50 per inspection
Total $900,000
Chapter 17-24
SO 4 Know how companies identify and use cost drivers in activity-based costing.

25. 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
Activity Cost of Cost Drivers
Pools Cost Driver Per Activity The Boot The Club
Setting up Number of
machines setups ,500 setups ,000
Machining Machine hours ,000 hours , ,000
Inspecting Number of
inspections ,000 inspections ,500
Chapter 17-25
SO 4 Know how companies identify and use cost drivers in activity-based costing.

26. 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 $200 $100,000
Machining , ,000
Inspecting ,000
Total costs assigned $425,000
Units produced ,000
Overhead cost per unit $17
Chapter 17-26
SO 4 Know how companies identify and use cost drivers in activity-based costing.

27. 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 ,000 $200 $200,000
Machining , ,000
Inspecting , ,000
Total costs assigned $475,000
Units produced ,000
Overhead cost per unit $95
Chapter 17-27
SO 4 Know how companies identify and use cost drivers in activity-based costing.

28. Comparison of Unit Costs Traditional vs. ABC
The Boot The Club
Traditional Traditional
Manufacturing Costs Costing ABC Costing ABC
Direct Materials $40 $ $ $30
Direct Labor
Overhead
Total Cost per Unit $82 $ $72 $137
Overstated Understated
$ $65
Chapter 17-28
SO 4 Know how companies identify and use cost drivers in activity-based costing.

29. Comparison of Unit Costs Traditional vs. ABC
Note that under ABC, overhead costs are shifted from the high volume product (The Boot) to the low volume product (The Club) because:
Low volume products often require more special handling.
Assigning overhead using ABC will usually increase the cost per unit of low volume products.
Chapter 17-29
SO 4 Know how companies identify and use cost drivers in activity-based costing.

30. 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
Chapter 17-30
SO 5 Understand the benefits and limitations of activity-based costing.

31. Activity-Based Costing: A Closer Look Limitations of ABC
Can be expensive to use
Some arbitrary allocations continue
COST-BENEFIT
Chapter 17-31
SO 5 Understand the benefits and limitations of activity-based costing.

32. 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
Chapter 17-32
SO 5 Understand the benefits and limitations of activity-based costing.

33. Let’s Review Activity-based costing (ABC):
Can be used only in a process cost system
Focuses on units of production
Focuses on activities performed to produce a product
Uses only a single basis of allocation
Chapter 17-33
SO 5 Understand the benefits and limitations of activity-based costing.

34. Let’s Review Activity-based costing (ABC):
Can be used only in a process cost system
Focuses on units of production
Focuses on activities performed to produce a product
Uses only a single basis of allocation
Chapter 17-34
SO 5 Understand the benefits and limitations of activity-based costing.

35. 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.
Chapter 17-35
SO 6 Differentiate between value-added and non–value-added activities.

36. 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
Chapter 17-36
SO 6 Differentiate between value-added and non–value-added activities.

37. 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
Chapter 17-37
SO 6 Differentiate between value-added and non–value-added activities.

38. 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
Chapter 17-38
SO 7 Understand the value of using activity levels in activity-based costing. .

39. 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 Activities Equipment 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 Number of employees salaries managed
Plant depreciation Square footage
Property taxes Square footage
Utilities Square footage
Chapter 17-39

40. 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
Chapter 17-40
SO 8 Apply activity-based costing to service industries.

41. HEARTLAND MANUFACTURING COMPANY Activity Flowchart
Activities
NVA VA
Remove
Move and
Move Materials
Move
Inspect
Store
Package
and Inspect
to Production
Set-Up
Machining
and
Assembly to
Finished
Materials
and Wait
Machines
Drill
Lathe
Wait
Test
Storage
Goods
Ship
Current
Days 1 12
2.5
1.5 2
0.2 6
0.3
0.5 14
<
Total Current Average Time = 44 days
>
Proposed 4 10
Total Proposed Average Time = 27 days
>
Chapter 17-41

42. 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.
Chapter 17-42
SO 8 Apply activity-based costing to service industries.

43. CHECK AND DOUBLECHECK, CPAs
Activity-Based Costing in Service Industries: Traditional Costing Example
CHECK AND DOUBLECHECK, CPAs
Annual Budget
Revenue $2,000,000
Direct labor $ 600,000
Overhead (expected) 1,200,000
Total Costs ,800,000
Operating income $ 200,000
Estimated overhead
= Predetermined overhead rate
Direct labor cost
$1,200,000
= %
$600,000
Chapter 17-43

44. CHECK AND DOUBLECHECK, CPAs Plano Molding Company Audit
Activity-Based Costing in Service Industries: Traditional Costing Example
CHECK AND DOUBLECHECK, CPAs
Plano Molding Company Audit
Revenue $260,000
Less: Direct professional labor $ 70,000
Applied Overhead (200% x $70,000) , ,000
Operating Income $ 50,000
Chapter 17-44
SO 8 Apply activity-based costing to service industries.

45. 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 $ 210, , $7 per hour
Direct labor Fringe benefits Direct labor cost , $ 600, $0.40 per $1 labor
Printing and photocopying Working paper pages , , $1 per page
Computer support CPU minutes , , $4 per minute
Telephone and postage None (traced directly) , N/A Based on usage
Legal support Hours used , $150 per hour
Insurance Revenue billed , $2,000, $0.06 per $1 rev.
Recruiting and training Direct Prof. Hours __210, , $7 per hour $1,200,000
Chapter 17-45

46. 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 , $ $ 26,600
Direct labor Fringe benefits Direct labor cost $ 70, $ ,000
Printing and photocopying Working paper pages , $ ,800
Computer support CPU minutes , $ ,400
Telephone and postage None (traced directly) ,700
Legal support Hours used $ ,400
Insurance Revenue billed $260, $ ,600
Recruiting and training Direct Prof. Hours , $ , $165,100
Chapter 17-46

47. Activity-Based Costing in Service Industries: ABC Costing Example
CHECK AND DOUBLECHECK, CPAs
Plano Molding Company Audit
Traditional Costing ABC
Revenues $260, $260,000
Expenses
Direct professional labor $ 70, $ 70,000
Applied overhead 140, ,100
Total expenses , ,100
Operating income $ 50, $ 24,900
Profit Margin % %
Chapter 17-47
SO 8 Apply activity-based costing to service industries.

48. Summary of Study Objectives
Recognize the difference between traditional and activity-based costing.
Traditional system allocates overhead to products using predetermined unit-based output rate.
ABC allocates overhead to activity cost pools and assigns cost
to products using cost drivers.
Identify the steps in the development of an activity-based costing system.
Step 1: Identify the major activities and allocate the overhead costs to cost pools.
Step 2: Identify the cost driver highly correlated to the cost pool.
Step 3: Compute the overhead rate per cost driver.
Step 4: Assign cost pools to products or services using the overhead rates.
Chapter 17-48

49. Summary of Study Objectives
Know how companies identify cost pools used in ABC.
Analyze each operation or process, document and time every task, action, or transaction.
Know how companies identify and use cost drivers in ABC.
Cost drivers identified for assigning activity cost pools must:
Accurately measure the consumption of the activity
Have related data easily available.
Understand the benefits and limitations of ABC
Benefits:
Enhanced control over overhead costs
Better management decisions
Limitations:
Higher costs accompany multiple activity centers and cost drivers
Some costs must still be allocated arbitrarily
Chapter 17-49

50. Summary of Study Objectives
Differentiate between value-added and non-value-added activities.
Value-added activities increase the worth of a product or service.
Non-value-added activities add cost to, or increase the time spent on, a product or service without increasing its market value.
Understand the value of using activity levels in ABC
Activities may be classified as:
Unit-level
Batch-level
Product-level
Facility-level
Failure to recognize this classification can result
in distorted product costing.
Chapter 17-50

51. Summary of Study Objectives
Apply ABC to service industries.
Same objective – improved costing of services provided.
The general approach to costing is also the same:
analyze operations
identify activities
accumulate overhead costs by activity cost pools
identify and use cost drivers to assign cost to services
Chapter 17-51

52. Appendix Just-In-Time Processing (JIT)
A processing system dedicated to having the
right amount of materials, products, or parts
arrive as they are needed, thereby reducing
the amount of inventory.
Chapter 17-52
SO 9 Explain just-in-time (JIT) processing.

53. JUST IN TIME PROCESSING.
Sales Order Received
100 pairs of sneakers... got it!
Send rubber and shoe laces directly to the factory.
Goods Shipped to Customer
Susan’s
Soccer
Sneakers
Chapter 17-53
Goods Manufactured

54. Eliminate all manufacturing inventories
JIT Processing
Objective of JIT:
Eliminate all manufacturing inventories
Elements of JIT:
Dependable suppliers
Multi-skilled work force
Total quality control system
Benefits of JIT:
Reduced inventory
Enhanced product quality
Reduced rework and storage costs
Savings from improved flow of goods
JIT
Chapter 17-54
SO 9 Explain just-in-time (JIT) processing.

55. Let’s Review
An activity that adds costs to the product but does not increase market value is a
a. Value-added activity
b. Cost driver
c. Cost-benefit activity
d. Nonvalue-added activity
Chapter 17-55
SO 9 Explain just-in-time (JIT) processing.

56. Let’s Review
An activity that adds costs to the product but does not increase market value is a
a. Value-added activity
b. Cost driver
c. Cost-benefit activity
d. Nonvalue-added activity
Chapter 17-56
SO 9 Explain just-in-time (JIT) processing.

57. COPYRIGHT
Copyright © 2009 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
Chapter 17-57