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CHAPTER

Activity-Based Costing

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Objectives
1. Discuss the importance of unit costs. After studying this 2. Describe functional-based costing chapter, you should approaches. be able to: 3. Explain why functional-based costing approaches may produce distorted costs. 4. Explain how an activity-based costing system works for product costing.
continued

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Objectives
5. Provide a detailed description of how activities can be grouped into homogeneous sets to reduce the number of activity rates. 6. Describe activity-based customer and supplier costing.

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Unit cost is the total cost associated with the units produced divided by the number of units produced. Unit cost is used for-Inventory valuation Income determination Providing input to a variety of decisions such as pricing, make or buy, and accept or reject special orders

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Product cost is often defined as the sum of direct materials, direct labor, and manufacturing overhead. This definition is required for external financial reporting.

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Cost measurement consists of determining the dollar amounts of direct materials, direct labor, and overhead used in production.

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The process of associating the costs, once measured, with the units produced is called cost assignment.

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Measurement Systems
Two possible measurement systems are actual costing and normal costing.
Actual costing assigns the actual costs of direct materials, direct labor, and overhead to products.

Normal costing assigns the actual costs of direct materials and direct labor to products; however, overhead cots are assigned to products using predetermined rates.

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Measurement Systems
A predetermined overhead rate is a rate based on estimated data. Budgeted (estimated) cost Estimated activity usage

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Examples of Unit-Level Drivers

Units produced
Direct labor hours

Direct labor dollars

Machine-hours

Direct material dollars

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Units (of driver)

Theoretical
Practical
Expected actual

Normal

Time

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Functional-Based Costing: Plantwide Rate

Overhead Costs Assign Costs Plantwide Pool Assign Costs Products
Direct Tracing Stage One: Pool Formation Unit-Level Driver Stage Two: Costs Assigned

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Belring, Inc.
Belring, Inc. produces two telephones: a cordless and a regular model. The company has the following actual and budgeted data:

Budgeted overhead Expected activity (DLH) Actual activity (DLH) Actual overhead

$360,000 100,000 100,000 $380,000

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Belring, Inc.
Predetermined Overhead Rate = Budgeted (estimated) cost Estimated activity usage

Predetermined Overhead Rate =

Predetermined Overhead Rate =

$360,000
100,000 DLH $3.60 per DLH

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The total overhead assigned to actual production is called applied overhead.

Overhead rate Applied x = overhead Actual activity output

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Belring, Inc.
Applied = Overhead rate x Actual activity output overhead = $3.60 x 100,000 DLH = $360,000

Per-Unit Cost

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Belring, Inc.
Cordless Prime costs Overhead costs: $3.60 x 10,000 36,000 --$ 78,000 Regular $ 738,000

$3.60 x 90,000
Total manufacturing costs Units produced Unit cost

--$114,000 10,000 $ 11.40

324,000
$1,062,000 100,000 $ 10.62

Functional-Based Costing Department Rates

Overhead Costs
Allocation Direct Tracing

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Assign Costs

Driver Tracing

Department A Pool Assign Costs Products

Stage One: Pool Formation

Unit-Level Drivers Stage Two: Costs Assigned

Department B Pool Assign Costs Products

Departmental Data

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Belring, Inc.
Fabrication Assembly

Budgeted overhead
Expected and actual usage (dlh): Cordless Regular Expected and actual usage (mh.): Cordless Regular

$252,000
7,000 13,000 20,000 4,000 36,000 40,000

$108,000
3,000 77,000 80,000 1,000 9,000 10,000

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Belring, Inc.
Applied = ($6.30 x actual mh) + ($1.35 x actual dlh) overhead = ($6.30 x 40,000) + ($1.35 x 80,000) = $252,000 + $108,000

= $360,000

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Belring, Inc.
Per-Unit Cost: Departmental Rates Cordless
Prime costs Overhead costs: ($6.30 x 4,000) + ($1.35 x 3,000) ($6.30 x 36,000) + (1.35 x 77,000) Total manufacturing costs Units produced Unit cost $ 78,000 29,250 --$107,250 10,000 $ 10.73

Regular
$ 738,000 --330,750 $1,068,750 100,000 $ 10.69

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Symptoms of an Outdated Functional Cost System

1. The outcome of bids is difficult to explain. 2. Competitors prices appear unrealistically low. 3. Products that are difficult to produce show high profits. 4. Operational managers want to drop products that appear profitable. 5. Profit margins are difficult to explain. Continued

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Symptoms of an Outdated Functional Cost System

6. The company has a highly profitable niche all to itself. 7. Customers do not complain about price increases.

8. The accounting department spends a lot of time supplying cost data for special projects.
9. Some departments are using their own accounting system. 10. Product costs change because of changes in financial reporting regulations.

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Non-unit activity drivers are factors that measure the consumption of non-unit activities by products and other cost objects.

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Product diversity means that the products consume overhead activities in systematically different proportions.

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Belring, Inc.
Product-Costing Data
Cordless
Units produced per year Prime costs Direct labor hours 10,000 $78,000 10,000

Regular
100,000 $738,000 90,000

Total
110,000 $816,000 100,000

Machine hours
Production runs Number of moves

5,000
20 60

45,000
10 30

50,000
30 90

Activity Usage Measures

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Belring, Inc.
Product-Costing Data
Activity
Setups Material handling

Activity Cost
$120,000 60,000

Machining
Testing Total

100,000
80,000 $360,000

Overhead Activities

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Belring, Inc.
Product Diversity: Consumption Ratios
Overhead Activity Cordless Phone Regular Phone Activity Driver

Setups Material

0.67

0.33

Production runs

handling
Machining Testing

0.67

b c

0.33
0.90 0.90

b c

Number of moves
Machine hours Direct labor hours

0.10 0.10

a 20/30 (cordless) and 10/30 (regular)

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Belring, Inc.
Product Diversity: Consumption Ratios
Overhead Activity Cordless Phone Regular Phone Activity Driver

Setups Material

0.67

0.33

Production runs

handling
Machining Testing

0.67

b c

0.33
0.90 0.90

b c

Number of moves
Machine hours Direct labor hours

0.10 0.10

b 60/90 (cordless) and 30/90 (regular)

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Belring, Inc.
Product Diversity: Consumption Ratios
Overhead Activity Cordless Phone Regular Phone Activity Driver

Setups Material

0.67

0.33

Production runs

handling
Machining Testing

0.67

b c

0.33
0.90 0.90

b c

Number of moves
Machine hours Direct labor hours

0.10 0.10

c 5,000/50,000 (cordless) and 45,000/50,000 (regular)

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Belring, Inc.
Product Diversity: Consumption Ratios
Overhead Activity Cordless Phone Regular Phone Activity Driver

Setups Material

0.67

0.33

Production runs

handling
Machining Testing

0.67

b c

0.33
0.90 0.90

b c

Number of moves
Machine hours Direct labor hours

0.10 0.10

d 10,000/100,000 (cordless) and 90,000/100,000 (regular)

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Belring, Inc.
Activity Rates Setup rate: Material-handling rate: $120,000/30 =$4,000 per run

$60,000/90 = $666.67 per move

Machining rate: Testing rate: $100,000/50,000 = $2 per MH $80,000/100,000 = $0.80 per DLH

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Belring, Inc.
Activity Rates
Prime costs
Overhead costs: Setups Material handling Machining Testing Total manufacturing costs Cordless $4,000 $ 78,000 x $667 20 x $2 60 x 80,000 $0.80 5,000 x 40,000 10,000 10,000 8,000 $216,000 Regular $4,000 $ 738,000 x $667 10 x $2 30 x 40,000 $0.80 45,000 x 20,000 90,000 90,000 72,000 $ 960,000

Units produced
Unit cost (total costs/units)

10,000
$ 21.60

100,000
$ 9.60

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Belring, Inc.
Comparison of Unit Costs
Cordless Regular

Plantwide rate

$11.40

$10.62

Departmental rate
Activity rate

10.73
21.60

10.69
9.60

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ABC: Two-Stage Assignment

Cost of Resources

Driver Tracing

Assign Costs Activities

Driver Tracing

Driver Tracing

Assign Costs Products

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A secondary activity is A primary activity is one one that is consumed by that is consumed by a other primary and product or customer. secondary activities.

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Resource drivers are factors that measure the consumption of resources by activities.

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Classification of Activities
Unit-level activities are those that are performed each time a unit is produced.

Examples: Power and machine hours are used each time a unit is produced. Direct materials and direct labor activities are also unit-level activities, even though they are not overhead costs.

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Classification of Activities
Batch-level activities are those that are performed each time a batch of products is produced.

Examples: Setups, inspections, production scheduling, and material handling.

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Classification of Activities
Product-level (sustaining) activities are those that are performed as needed to support the various products produced by a company. These activities consume inputs that develop products or allow products to be produced and sold. Examples: Engineering changes, process engineering, and expediting.

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Classification of Activities
Facility-level activities are those that sustain a factory's general manufacturing processes.

Examples: Plant management, landscaping, maintenance, security, property taxes, and plant depreciation.

Case
Light Industries produces two types of flashlights: Regular and Deluxe. Three activities have been identified in the production process: setups, machining and packing. Resource drivers have been used to assign costs to each activity. The overhead rates, their costs and other related data follows: ProductMachine hoursSet-upsPacking ordersRegular2,000100600Deluxe3,0004002,400Cost$50,000$4,000$8,0 00

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a) Classify the overhead activities as unit-level, batch-level, product-level, or facility-level.

b) Identify the most appropriate activity driver for each pool and compute the pool rate. c) Assign the overhead costs to each product using the pool rates computed in requirement b.

Ans
a) Unit-level activities: machining, batch-level activities: set-ups and packing. b) Unit level: Machine hours. Pool rate = $50,000/5,000 machine hours = $10 per machine hour Batch level: Pool rate = $12,000/500 set-ups = $24 per set up or $12,000/3,000 packing order = $4 per packing order. Because the consumption ratio is the same, either set-ups or packing orders may be used to assign cost. c) Regular: ($10 x 2,000) = $20,000; ($24 x 100) = $2,400; Total $22,400 Alternate: $20,000 + ($4 x 600) = $22,400 Deluxe: ($10 x 3,000) = $30,000; ($24 x 400) = $9,600; Total $39,600 Alternate: $30,000 + ($4 x 2,400) = $39,600

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A1

A2

A3
Activit y Level Filter

A4

A5

Unit Level Driver Filter

Set 1 Set 2

Batch Level Driver Filter

Set 3 Set 4

Product Level Driver Filter

Set 5 Set 6

Facility Level

Set 7

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Customer Costing versus Product Costing

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Example
Large Customer Ten Smaller Customers (50% of sales) (50% of sales)

Units purchased Orders placed Number of sales calls Manufacturing cost Order-filling costs allocated Sales-force costs allocated

500,000 2 10 $3,000,000

500,000 200 210 $3,000,000

$202,000
$110,000

$202,000
$110,000

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Example
The purchasing manager uses two suppliers, Murray Inc. and Plata Associates, as the source of two machine parts: Part A1 and Part B2.
Activity Repairing products
Expending products

Costs $800,000
200,000

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Example
Murray Inc. Part A 1 Part B2 $20 $52 80,000 40,000 1,600 380 Plata Associates Part A 1 Part B2 $24 $56 10,000 10,000 10 10

Unit purchase price Units purchased Failed units

Late shipments

60

40

Repair rate = $800,000 2,000 = $400 per failed part Expediting rate = $200,000 100 = $2,000 per late (1,600 + 380 + 10 + 10) delivery
60 + 40

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Example
Murray Inc. Part A 1 Part B2 Purchase cost $1,600,000 $2,080,000 Repairing products 640,000 152,000 Expediting products 120,000 80,000 Plata Associates Part A 1 Part B2 $240,000 $560,000 4,000 4,000

Total costs Units

Total unit cost

$2,360,000 $2,312,000 80,000 40,000

$ 29.50 $ 57.80

$244,000 10,000
$ 24.40

$564,000 10,000
$ 56.40

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Chapter Four

The End