Cornerstones of Cost Management, 3E: Activity-Based Costing

CORNERSTONES OF COST
MANAGEMENT, 3E
HANSEN/MOWEN
ACTIVITY-BASED COSTING
CHAPTER 4
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CHAPTER 4 OBJECTIVES
1. Describe the basics of plantwide and
departmental overhead costing
2. Explain why plantwide and departmental
overhead costing may not be accurate
3. Provide a detailed description of activitybased product costing
4. Explain how ABC can be simplified
EXHIBIT 4.1UNIT-BASED PRODUCT

COSTING MODEL
LO-1
UNIT-LEVEL PRODUCT COSTING

Overhead costs are assigned to products
using predetermined overhead rates
Predetermine
d overhead
rate
Budgeted annual overhead

Budgeted annual driver
level
Applied overhead = Overhead rate Actual driver

usage
LO-1

Unit level drivers: factors that measure the
demands placed on unit-level activities by products
Unit level activities: activities performed each
and every time a unit of a product is produced
Five most commonly used unit level drivers
Units produced
Direct labor hours
Direct labor dollars
Machine hours
Direct material dollars
LO-1

Overhead
Overhead Variances
Variances
The difference between actual overhead

and applied overhead
If actual overhead > applied overhead:
underapplied overhead
If actual overhead < applied overhead:
overapplied overhead
LO-1

Overhead
Overhead Variances
Variances
Disposal of Variance
If immaterial, assign to cost of goods sold
If material, allocate among work-in-process
inventory, finished goods inventory, and cost of
goods sold
LO-1

Overhead Application: Departmental Rates
Costs assigned to individual production
department, creating departmental overhead cost
pools
Unit level drivers are used to compute
predetermined overhead rates for each department
Overhead is assigned to products by multiplying
the departmental rates by the amount of the driver
used in the respective departments
LO-1
LIMITATIONS OF PLANTWIDE AND

DEPARTMENTAL RATES
Non-Unit-Related Overhead Costs
Plantwide and department rates assume that a products
consumption of overhead is directly related to units
produced
Some costs, however, such as setups cost a certain
amount no matter how many products are produced
Other costs, such as engineering hours, may depend on
something entirely different, such as work orders, not
units
Non-unit-based drivers are factors, other than the
number of units produced, that measure the demands
that cost objects place on activities
LO-2

DEPARTMENTAL RATES
Product Diversity
Even if there are significant non-unit
driven overhead costs, it will not cause
distorted costing if the products all
consume overhead in the same proportion
as unit-level driven overhead costs
LO-2

DEPARTMENTAL RATES
Product Diversity
Products consume overhead activities in
different proportions
Caused by differences in product size, complexity,
setup time, batch size, etc.
The proportion of each activity consumed by a
product is called the consumption ratio
LO-2

DEPARTMENTAL RATES
Two producing departments: molding and
Assembly
Two products: race cars and robots
Five times more race cars than robots are
produced making race cars a high-volume product
and robots a low-volume product
The molds for robots are larger and more varied
than those for race cars
Four types of overhead activities are performed:
setups, machining, inspection, and moving
batches
LO-2
EXHIBIT 4.2PRODUCT-COSTING DATA
LO-2
EXHIBIT 4.2PRODUCT-COSTING DATA

(CONTINUED)
LO-2
EXHIBIT 4.3UNIT PRODUCT COST:

PLANTWIDE AND DEPARTMENTAL RATES
LO-2

DEPARTMENTAL RATES
Problems with Costing Accuracy
The main problem with using either plantwide or
departmental rates is the assumption that machine
hours and/or direct labor hours drive or cause all
overhead costs
Race cars, the high-volume product, use four times
the direct labor hours used by robots, the lowvolume product
If a plantwide rate is used, the race cars will receive
four times more overhead cost than will the robots
This might not be reasonable
LO2

DEPARTMENTAL RATES
The data in Exhibit 4.2 suggest that a
significant portion of overhead costs is not
driven or caused by the units produced
The high-volume product, race cars, uses three
times the number of setups of robots, about
2.33 times as many inspection hours, and only
one and one-half times as many moves
Use of direct labor hours, a unit-based activity
driver, and a plantwide rate assigns four times
more overhead costs to the race cars than to
the robots
LO-2

DEPARTMENTAL RATES
Activity Rates: A Better Approach
Instead of using a single pool or department pools
based on units, expand the number of pools and
rates and base them on activities
The rates are based on causal factors that
measure consumption both unit and non-unit
level activity drivers
Costs are assigned to each product by multiplying
the activity rates by the amount consumed by each
activity
LO-2
EXHIBIT 4.4COMPARISON OF UNIT

COSTS
LO-2

DEPARTMENTAL RATES
The activity-based cost assignment follows
a cause-and-effect pattern of overhead
consumption and is therefore the most
accurate of the three costs
In the presence of significant non-unit
overhead costs and product diversity,
using only unit-based activity drivers can
lead to one product subsidizing another
LO-2
EXHIBIT 4.5ACTIVITY BASED

COSTING MODEL
LO-3
EXHIBIT 4.6DESIGN STEPS FOR AN

ABC SYSTEM
LO3
ACTIVITY-BASED COSTING SYSTEM

1. Identify, define, and classify activities and key
attributes
Activity inventory: a simple list of activities identified
Activity attributes: nonfinancial and financial
information items that describe individual activities
Activity dictionary: lists the activities in an organization
along with desired attributes
Primary activity: consumed by the final cost object
Secondary activity: consumed by intermediate cost
objects
Interviews, questionnaires, surveys, and observation

are means of gathering data for an ABC system
LO-3
EXHIBIT 4.7SAMPLE ACTIVITY

INVENTORY
LO-3

2. Assign the cost of resources to
activities
The cost of an activity is the resources
consumed by that activity
If a resource is exclusive to an activity, assign
100% of the cost to the activity
If the resource is split between more than one
activity, determine a resource driver
Resource drivers are factors that measure the
consumption of resources by activities
LO-3

3. Assign the cost of secondary
activities to primary activities
Treat the secondary activity like a resource from
the previous step
LO-3

4. Identify cost objects and specify the
amount of each activity consumed by
them
Assign costs consumed by more than one
activity in proportion to their usage of the
activity as measured by the activity driver
Transaction drivers measure the number of times
an activity is performed
Duration drivers measure the demands in terms of
the amount of time it takes to perform an activity
LO-3

A bill of activities specifies the product,
expected product quantity, activities, and
amount of each activity expected to be
consumed by each product
LO-3

5. Calculate primary activity rates
Primary activity rates are computed by dividing
budgeted activity costs by practical activity
capacity
Practical activity capacity is the activity output
that can be produced when the activity is
performed efficiently
LO-3

6. Assign activity costs to cost objects
Multiply the activity rate by the actual number
of activity drivers consumed.
LO-3

Classifying activities into categories aids in
product costing because the cost behavior
differs by level
Unit-level
Batch-level
Product-level
Facility-level
LO-3
EXHIBIT 4.8ACTIVITY DICTIONARY:

CARDIOLOGY UNIT
LO-3
EXHIBIT 4.9UNBUNDLING OF
GENERAL LEDGER COSTS
LO3
EXHIBIT 4.10BILL OF ACTIVITIES:

CARDIOLOGY UNIT
LO3
EXHIBIT 4.11ASSIGNING COSTS:

FINAL COST OBJECTS
LO3
REDUCING THE SIZE AND COMPLEXITY

OF AN ABC SYSTEM
Before-the-Fact
Before-the-Fact Simplification:
Simplification: TDABC
TDABC
A before-the-fact simplification method,
eliminates the need to identify resource
drivers, eliminating the need for much of the
detailed implementation interviews
LO4

OF AN ABC SYSTEM
Before-the-Fact
Before-the-Fact Simplification:
TDABC
First, it calculates total operating cost of a
department or process
Second, it calculates a capacity cost rate by
dividing the total resource cost by the practical
capacity of resources supplied
Third, it estimates the time to perform one unit of
activity
Activity cost = Capacity cost rate Time to
perform one unit of activity Total
activity output
= Activity rate Total activity output
LO-4

OF AN ABC SYSTEM
After-the-Fact
After-the-Fact Simplification:
TDABC
Approximately Relevant ABC Systems
Calculate the cost of your activities
Combine the less expensive activity costs into the more
expensive activity costs making fewer categories
Equally Accurate Reduced ABC Systems

Use expected consumption ratios to reduce the number of
drivers
LO-4
EXHIBIT 4.12DATA FOR PATTERSON

COMPANY
END OF CHAPTER 4
LO-4

Cornerstones of Cost Management, 3E: Activity-Based Costing

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CORNERSTONES OF COST

EXHIBIT 4.1UNIT-BASED PRODUCT

UNIT-LEVEL PRODUCT COSTING

Budgeted annual overhead

Applied overhead = Overhead rate Actual driver

UNIT-LEVEL PRODUCT COSTING

UNIT-LEVEL PRODUCT COSTING

The difference between actual overhead

UNIT-LEVEL PRODUCT COSTING

UNIT-LEVEL PRODUCT COSTING

LIMITATIONS OF PLANTWIDE AND

LIMITATIONS OF PLANTWIDE AND

LIMITATIONS OF PLANTWIDE AND

LIMITATIONS OF PLANTWIDE AND

EXHIBIT 4.2PRODUCT-COSTING DATA

EXHIBIT 4.2PRODUCT-COSTING DATA

EXHIBIT 4.3UNIT PRODUCT COST:

LIMITATIONS OF PLANTWIDE AND

LIMITATIONS OF PLANTWIDE AND

LIMITATIONS OF PLANTWIDE AND

EXHIBIT 4.4COMPARISON OF UNIT

LIMITATIONS OF PLANTWIDE AND

EXHIBIT 4.5ACTIVITY BASED

EXHIBIT 4.6DESIGN STEPS FOR AN

ACTIVITY-BASED COSTING SYSTEM

Interviews, questionnaires, surveys, and observation

EXHIBIT 4.7SAMPLE ACTIVITY

ACTIVITY-BASED COSTING SYSTEM

ACTIVITY-BASED COSTING SYSTEM

ACTIVITY-BASED COSTING SYSTEM

ACTIVITY-BASED COSTING SYSTEM

ACTIVITY-BASED COSTING SYSTEM

ACTIVITY-BASED COSTING SYSTEM

ACTIVITY-BASED COSTING SYSTEM

EXHIBIT 4.8ACTIVITY DICTIONARY:

EXHIBIT 4.10BILL OF ACTIVITIES:

EXHIBIT 4.11ASSIGNING COSTS:

REDUCING THE SIZE AND COMPLEXITY

REDUCING THE SIZE AND COMPLEXITY

REDUCING THE SIZE AND COMPLEXITY

Equally Accurate Reduced ABC Systems

EXHIBIT 4.12DATA FOR PATTERSON

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