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CHAPTER

Activity-Based Costing

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Objectives Objectives
1. Discuss the importance of unit costs. After studying this After studying this 2. Describe functional-based costing chapter, you should chapter, you should approaches. be able to: 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 continued

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Objectives 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.

Unit cost is the total cost Unit cost is the total cost associated with the units associated with the units produced divided by the produced divided by the number of units produced. 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 Product cost is often defined as the sum of direct materials, direct sum of direct materials, direct labor, and manufacturing overhead. labor, and manufacturing overhead. This definition is required for This definition is required for external financial reporting. external financial reporting.

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

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

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Measurement Systems 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 Measurement Systems

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

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Examples of Unit-Level Drivers 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 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 = Predetermined Overhead Rate = Predetermined Overhead Rate = Budgeted (estimated) cost Estimated activity usage $360,000 100,000 DLH $3.60 per DLH

The total overhead The total overhead assigned to actual assigned to actual production is called production is called applied overhead. 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 $3.60 x 90,000 Total manufacturing costs Units produced Unit cost 36,000 --$114,000 $ 11.40 --324,000 $1,062,000 $ 10.62 $ 78,000 Regular $ 738,000

10,000 100,000

Functional-Based Costing Department Rates 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 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 4,000 36,000 40,000 1,000 9,000 10,000 7,000 13,000 20,000 3,000 77,000 80,000 $252,000 $108,000

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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 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 Symptoms of an Outdated Functional Cost System 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 Continued

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Symptoms of an Outdated Symptoms of an Outdated Functional Cost System 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 Non-unit activity drivers are factors that measure the factors that measure the consumption of non-unit consumption of non-unit activities by products and activities by products and other cost objects. other cost objects.

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

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Belring, Inc.
Product-Costing Data Product-Costing Data
Cordless
Units produced per year Prime costs Direct labor hours Machine hours Production runs Number of moves 10,000 $78,000 10,000 5,000 20 60

Regular
100,000 $738,000 90,000 45,000 10 30

Total
110,000 $816,000 100,000 50,000 30 90

Activity Usage Activity Usage Measures Measures

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Belring, Inc.
Product-Costing Data Product-Costing Data
Activity Setups Material handling Machining Testing Total Activity Cost $120,000 60,000 100,000 80,000 $360,000

Overhead Activities

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

Setups Material handling Machining Testing

a

0.67 0.67 0.10 0.10

0.33 0.33 0.90 0.90

Production runs Number of moves Machine hours Direct labor hours

b c

b c d

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

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

Setups Material handling Machining Testing

b

0.67 0.67 0.10 0.10

0.33 0.33 0.90 0.90

Production runs Number of moves Machine hours Direct labor hours

b c

b c d

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

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

Setups Material handling Machining Testing

c

0.67 0.67 0.10 0.10

0.33 0.33 0.90 0.90

Production runs Number of moves Machine hours Direct labor hours

b c

b c d

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

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

Setups Material handling Machining Testing

d

0.67 0.67 0.10 0.10

0.33 0.33 0.90 0.90

Production runs Number of moves Machine hours Direct labor hours

b c

b c d

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

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

Material-handling rate: $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 Activity Rates
Prime costs Overhead costs: Setups Material handling Machining Testing Total manufacturing costs Units produced Unit cost (total costs/units) 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 10,000 $ 21.60 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 $ 960,000 100,000 $ 9.60

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Belring, Inc.
Comparison of Unit Costs Comparison of Unit Costs
Cordless Regular

Plantwide rate Departmental rate Activity rate

$11.40 10.73 21.60

$10.62 10.69 9.60

ABC: Two-Stage Assignment

Cost of Resources

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Driver Tracing

Assign Costs Activities

Driver Tracing

Driver Tracing

Assign Costs Products

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

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

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Classification of Activities 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 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 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 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.

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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

Example Example

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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 $202,000 $110,000

500,000 200 210 $3,000,000 $202,000 $110,000

Example 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 Example
Unit purchase price Units purchased Failed units Late shipments Murray Inc. Part A 1 Part B2 $20 $52 80,000 1,600 60 40,000 380 40

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Plata Associates Part A 1 Part B2 $24 $56 10,000 10 0 10,000 10 0

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

Example Example
Purchase cost Repairing products Expediting products Total costs Units Total unit cost Murray Inc. Part A 1 Part B2 $1,600,000 $2,080,000 640,000 120,000 152,000 80,000 $244,000 10,000 $ 24.40

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Plata Associates Part A 1 Part B2 $240,000 $560,000 4,000 4,000 $564,000 10,000 $ 56.40

$2,360,000 $2,312,000 80,000 40,000 $ 29.50 $ 57.80

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Chapter Four

The End The End

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