Handout 3

Activity based costing

The McGraw-Hill Companies, 2011

How Costs are Treated Under

Activity-Based Costing
Activity Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate

Overhead Allocation
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Plantwide Overhead Rate

Companies tend to use direct labour

as the overhead allocation base.
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Designing an ABC System

Cost Objects
(e.g. products
and customers)

Activities

Consumption
of Resources

Cost

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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.
The McGraw-Hill Companies, 2011

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

Organisationsustaining
Activity

Customer-Level
Activity
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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.

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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 companys overhead costs are shown on
the next slide.
The McGraw-Hill Companies, 2011

Overhead Costs at Classic Brass

(Manufacturing and NonManufacturing)
Production Department
Indirect factory wages

Factory equipment depreciation

Factory utilities
Factory building lease
Shipping costs traced to customer orders
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total overhead costs

500,000
300,000
120,000
80,000

400,000
50,000
60,000

1,000,000
40,000

510,000

250,000
50,000

300,000
1,850,000

The McGraw-Hill Companies, 2011

Activity-Based Costing at Classic Brass

Direct
Materials

Direct
labour

Shipping
Costs

Traced

/DLH

Traced

Overhead Costs

Cost Objects:
Products, Customer Orders, Customers
The McGraw-Hill Companies, 2011

Activity-Based Costing at Classic Brass

Direct
Materials

Direct
labour

Shipping
Costs

Overhead Costs

First-Stage Allocation
Order
Size

Customer
Orders

Product
Design

Customer
Relations

Other

Cost Objects:
Products, Customer Orders, Customers
The McGraw-Hill Companies, 2011

Activity-Based Costing at Classic Brass

Direct
Materials

Direct
labour

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
The McGraw-Hill Companies, 2011

Assigning Costs to Activity Cost Pools

Management at Classic Brass believes
overhead should be distributed as follows:
Activity Cost Pools
Customer Product
Orders
Design
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
Shipping costs traced to customer order
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses

Order
Size

Customer
Relations

Other

Total

25%
20%
0%
0%

40%
0%
10%
0%

20%
60%
50%
0%
N/A

10%
0%
0%
0%

5%
20%
40%
100%

100%
100%
100%
100%

15%
30%
0%

5%
0%
0%

10%
0%
0%

30%
25%
0%

40%
45%
100%

100%
100%
100%

20%
10%

10%
0%

0%
0%

60%
70%

10%
20%

100%
100%

The McGraw-Hill Companies, 2011

Assigning Costs to Activity Cost Pools

Using the total costs and percentage consumption
of overhead, costs are assigned to activity pools.
Activity Cost Pools
Customer
Product
Orders
Design

Order
Size

Customer
Relations

Other

Total

Production Department
Indirect factory wages
125,000
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Indirect factory
Total

wages
500,000
Percent consumed by customer orders
25%
125,000
The McGraw-Hill Companies, 2011

Assigning Costs to Activity Cost Pools

Using the total costs and percentage consumption
of overhead, costs are assigned to activity pools.
Activity Cost Pools
Customer
Product
Orders
Design
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Factory
Total

Order
Size

Customer
Relations

Other

Total

125,000
60,000

equipment depreciation
300,000
Percent consumed by customer orders
20%
60,000
The McGraw-Hill Companies, 2011

Assigning Costs to Activity Cost Pools

Using the total costs and percentage consumption
of overhead, costs are assigned to activity pools.
Activity Cost Pools
Customer Product
Order
Orders
Design
Size
Production Department
Indirect factory wages
125,000 200,000
Factory equipment depreciation
60,000
Factory utilities
12,000
Factory building lease
General Administrative Department
60,000
20,000
Administrative wages and salaries
Office equipment depreciation
15,000
Administrative building lease
Marketing Department
Marketing wages and salaries
50,000
25,000
Selling expenses
5,000
Total
315,000 257,000

Customer
Relations

Other

100,000 50,000 25,000

180,000
60,000
60,000
48,000
80,000
40,000
-

120,000
12,500
-

150,000
35,000
380,000 367,500

160,000
22,500
60,000

Total
500,000
300,000
120,000
80,000
400,000
50,000
60,000

25,000
250,000
10,000
50,000
####### 1,810,000

The McGraw-Hill Companies, 2011

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.

The McGraw-Hill Companies, 2011

Computation of Activity Rates

Activity Cost Pools
1,000
Orders
Production Department
Indirect factory wages

Factory equipment depreciation

Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

200
Designs

20,000
machine100
hours
Customers

Other

125

Custom er
Orders

Indirect factory wages

125,000
Number of orders

1,000
Indirect factory wages/order

125

The McGraw-Hill Companies, 2011

Computation of Activity Rates

Activity Cost Pools
1,000
Orders
Production Department
Indirect factory wages

Factory equipment depreciation

Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

200
Designs

125
60
60
15
50
5
315

20,000
machine100
hours
Customers

1,000
60
100
125
1,285

5
9
3
2

500
-

1,200
125
-

19

1,500
350
3,675

Other
N/A

The McGraw-Hill Companies, 2011

Assigning Costs to Cost Objects

Lets 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)
1. 400 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 labour totals 1,850.
6. Shipping costs total 180.
The McGraw-Hill Companies, 2011

Assigning Costs to Cost Objects

Lets 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 labour totals 50.
6. Shipping costs total 25.

The McGraw-Hill Companies, 2011

Assigning Costs to Cost Objects

Overhead cost of two orders for standard stanchions.
Activity Cost Pools

2 Orders
Production Department
Indirect factory wages

Factory equipment depreciation

Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

No new
design

200
machine
hours

N/A

Total

250

125 per order 2 orders = 250

The McGraw-Hill Companies, 2011

Assigning Costs to Cost Objects

Overhead cost of two orders for standard stanchions.
Activity Cost Pools

2 Orders
Production Department
Indirect factory wages

Factory equipment depreciation

Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salarie
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

No new
design

250
120
-

120
30
-

100
10
630

200
machine
hours
-

1,000
1,800
600
400
-

3,800

N/A

Total
-

1,250
1,920
600

520
30

100
10
4,430

The McGraw-Hill Companies, 2011

Assigning Costs to Cost Objects

Overhead cost of one order for custom compass housing.
Activity Cost Pools

1 Order
Production Department
Indirect factory wages

Factory equipment depreciation

Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

1 new
design

4
machine
hours

N/A

Total

125

125 per order 1 order =

125

The McGraw-Hill Companies, 2011

Assigning Costs to Cost Objects

Overhead cost of one order for custom compass housing.
Activity Cost Pools

1 Order
Production Department
Indirect factory wages

Factory equipment depreciation

Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

125
60
60
15
50
5
315

1 new
design

4
machine
hours

1,000
60
100
125
1,285

20
36
12
8
76

N/A

Total
-

1,145
96
72

168
15

175
5
1,676

The McGraw-Hill Companies, 2011

Product Margins
Standard Stanchions
Sales
Cost:
Direct materials
Direct labour
Shipping costs
Customer orders
Product design
Order size
Product margin

13,600

8,570
5,030

2,110
1,850
180
630
3,800

Custom Compass Housing

Sales
Cost:
Direct materials
Direct labour
Shipping costs
Customer orders
Product design
Order size
Product margin

13
50
25
315
1,285
76

650

1,764
1,114

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Product Margins/Customer Profitability

Standard Stanchions
Sales
Cost:
Direct materials
Direct labour
Shipping costs
Customer orders
Product design
Order size
Product margin

13,600

8,570
5,030

2,110
1,850
180
630
3,800

Custom Compass Housing

Sales
Cost:
Windward Yachts
Direct materials
Product margins:
Direct labour
Standard stanchion Shippingcosts
5,030
Customer (1,114)
orders
Custom compass housing
Total product margin Product design
3,916
Order size
Less: Customer relations
Product margin 3,675

Customer margin

241

13
50
25
315
1,285
76

650

1,764
1,114

The McGraw-Hill Companies, 2011

Product Margins
Traditional Cost Accounting System
Sales
Costs
Direct materials
Direct labour
Manufacturing overhead
Product margin
Predetermined manufacturing
=
overhead rate

Standard
Stanchions

13,600
(2,110)
(1,850)
(10,000)
360
1,000,000
20,000 MH

Compass
Housing

650

(13)
(50)
(200)
387

= 50/MH

The McGraw-Hill Companies, 2011

Product Margins
Traditional Cost Accounting System
Sales
Costs
Direct materials
Direct labour
Manufacturing overhead
Product margin

Standard
Stanchions

13,600
(2,110)
(1,850)
(10,000)
360

Compass
Housing

650

(13)
(50)
(200)
387

400 units x 0.5 MH/unit x 50/MH = 10,000

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Difference Between ABC and

Traditional Product Costs
Under the old cost system the costs of
designing products were spread across
all products without regard to whether
they actually required design work.
The Customer Orders costs, which are
batch-level costs, were applied on the
basis of machine-hours, a unit-level
base, under the old cost system.
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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.
The McGraw-Hill Companies, 2011