ch04

John Wiley & Sons, Inc.

Prepared byKarleen Nordquist..

The College of St. Benedict... and St. John’s University....

Managerial Accounting Weygandt, Kieso, & Kimmel

Chapter 4

Activity-Based Costing

After studying this chapter, you should be able to:

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 Identify the activity cost pools used in activity-based costing.

4 Identify and use the activity cost drivers in activity-based costing.

Chapter 4Activity-Based Costing

After studying this chapter, you should be able to:

5 Understand the benefits and limitations of activity-based costing.

6 Differentiate between value-added and nonvalue-added activities.

7 Understand the value of a hierarchy of activity levels to activity-based costing.

8 Explain just-in-time (JIT) processing.


Preview of Chapter 4

ABC vs. Traditional Costing• Traditional Costing Systems• Need for New Costing Systems• Activity-Based Costing

Illustration of Traditional Costing Versus ABC

• Unit Costs Under Traditional Costing

• Unit Costs Under ABC• Comparing Unit Costs

ACTIVITY-BASED

COSTING

Preview of Chapter 4

ABC: A Closer Look• Benefits• Limitations• When to Switch to ABC• Value-Added Versus Nonvalue-

Added Activities• Hierarchy of Activity Levels

Just-in-Time Processing• Objective• Elements• Benefits

ACTIVITY-BASED

COSTING

Recognize the difference between traditional costing and activity-

based costing.

Study Objective 1

Traditional Costing Systems

Often the most difficult part of computing accurate unit costs is determining the proper amount of overhead cost to assign to each product, service, or job.

Unlike direct materials and direct labor costs which can usually be easily traced to the product, overhead is an indirect or common cost that generally cannot be traced to a product.


In Chapters 2 and 3 a single predetermined overhead rate was used throughout the year to assign costs to products.

We assumed that direct labor cost and machine hours were the relevant activity bases for the assignment of all overhead in job order and process costing, respectively.


When overhead cost allocation systems were first developed, direct labor made up a large part of total manufacturing cost. It was widely accepted that there was a high correlation between direct labor and the incurrence of overhead cost. As a result, direct labor became the most popular basis for overhead allocation. A simplified (one-stage) traditional costing system relying on

direct labor to assign overhead is displayed below:

Overhead Costs

Direct Labor Hours

Products

Illustration 4-2


Even in today’s environment, direct labor is often the appropriate basis for assigning overhead cost to products.

It is appropriate when

–direct labor constitutes a significant part of total product cost, and

–a high correlation exists between direct labor and changes in the amount of overhead costs.

The Need for a New Costing System

Advances in computerized systems, technological innovation, international competition, and automation have changed the manufacturing environment drastically. The amount of direct labor used in many industries is now greatly reduced, and total overhead costs have significantly increased.

Companies that continue to use plantwide predetermined overhead rates based on direct labor, where the correlation between direct labor and overhead no longer exists, experience significant product cost distortions.

The Need for a New Costing System

Recognizing these distortions, many companies now use machine hours as the overhead allocation base in an automated manufacturing environment.

But even machine hours may not suffice as the sole plantwide basis for allocating all overhead.

If the manufacturing process is complex, then only multiple allocation bases can result in more accurate computations.

In such situations, managers need a new overhead cost allocation method: activity-based costing.


Activity-based costing (ABC) allocates overhead to multiple activity cost pools and assigns the activity cost pools to production by means of cost drivers.

In ABC, an activity is any event, action, transaction, or work sequence that causes the incurrence of cost in the production of a product or rendering of a service.

A cost driver is any factor or activity that has a direct cause/effect relationship with the resources consumed.


ABC first allocates costs to activities, and then to the products based on each product’s use of those activities.

The reasoning behind ABC cost allocation is simple: products consume activities; activities consume resources.


ABC allocates overhead in a two-stage process:

– Overhead is allocated to activity cost pools, each of which is a distinct type of activity,

– Overhead in the cost pools is assigned to products using cost drivers which represent and measure the number of individual activities undertaken or performed to produce products or render services.


Not all products or services share equally in activities. The more complex a product’s manufacturing

operation, the more activities and cost drivers it is likely to have.

If there is little or no correlation between changes in the cost driver and consumption of the overhead cost, inaccurate product costs are inevitable.

The next slide shows an illustration of an activity-based costing system with seven activity cost pools and correlated cost drivers.

Activity-Based Costing System

Overhead Costs

Products

Assem-bling

Cost Pool

Number of

Parts

Inspecting and

Testing Cost Pool

Number of

Tests

Painting Cost Pool

Number of

Parts

Super-vising

Cost Pool

Direct Labor Hours

Ordering and

Receiving Materials Cost Pool

Number of POs

Setting Up

Machines Cost Pool

Number of

Setups

Machining Cost Pool

Machine Hours

Illustration 4-4

Illustration of Traditional Costing versus ABC

A simple case example will now be presented to compare traditional costing and activity-based costing. It illustrates the distortion that can occur in traditional overhead cost allocation.

Atlas Company products two automobile anti-theft devices, The Boot and The Club. The Boot is a high-volume item, totaling 25,000 units annually, while The Club is a low-volume item totaling only 5,000 units a year. Both products require one hour of direct labor. Therefore, annual direct labor hours are 30,000. Expected annual manufacturing overhead costs are $900,000. Thus, the predetermined overhead rate is $30 ($900,000 30,000) per direct labor hour.

Unit Costs Under Traditional Costing

The direct materials cost per unit is $40 for The Boot and $30 for The Club. The direct labor cost is $12 for each product.

The computation of the unit cost for The Boot and The Club under traditional costing is shown below:

Atlas Company

Manufacturing CostsDirect materialDirect laborOverhead Total unit cost

The Boot$40 12 30*$82

The Club$30 12 30*$72

Products

*Predetermined overhead rate times direct labor hours ($30 x 1 hr. = $30)Illustration 4-5

Identify the steps in the development of an activity-based costing system.

Study Objective 2

Unit Costs under ABC

Activity-based costing involves the following steps:

1 Identify the major activities that pertain to the manufacture of specific products and allocate manufacturing overhead costs to activity cost pools.

2 Identify the cost drivers that accurately measure each activity’s contributions to the finished product and compute the activity-based overhead rate.

3 Assign manufacturing overhead costs for each activity cost pool to products using the activity-based overhead rates (cost per driver).

Identify the activity cost pools used in activity-based costing.

Study Objective 3

Identifying Activities

A well designed activity-based costing system starts with an analysis of the activities performed to manufacture a product. This analysis should identify all resource-consuming activities.

Atlas Company identified three activity cost pools: setting up machines, machining, and inspecting.

Allocating Overhead to Cost Pools

After the activity cost pools are identified, overhead costs are assigned directly to activity cost pools.

Atlas Company’s activity cost pools, along with with estimated overhead allocated to each activity cost pool are shown below:

Atlas Company

Activity Cost Pools Setting up machinesMachiningInspecting

Total

EstimatedOverhead$300,000

500,000 100,000

$900,000

Illustration 4-6

Identify and use the activity cost drivers in activity-based costing.

Study Objective 4

Identifying Cost Drivers

After costs are allocated to the activity cost pools, the cost drivers for each activity cost pool must be identified. To achieve accurate costing, a high degree of correlation must exist between the activity cost driver and the actual consumption of the activity cost pool.

The cost drivers identified by Atlas and their total expected use per activity cost pool are shown below:

Activity Cost PoolsSetting up machinesMachiningInspecting

Cost Drivers Number of setupsMachine hoursNumber of inspections

Expected Use ofCost Driversper Activity

1,500 setups50,000 machine hours

2,000 inspections

Atlas Company

Illustration 4-7

Computing Overhead Rates

Availability and ease of obtaining data relating to the activity cost driver is an important factor that must be considered in its selection.

The activity-based overhead rate is computed as shown below:

Estimated Overhead per

Activity

Expected Use of Cost Drivers per

Activity

Activity-based Overhead Rate =

Computing Overhead Rates

Atlas Company’s computations of its activity-based overhead rates are below:

Illustration 4-9



2,000 inspections

Atlas Company


Total

EstimatedOverhead$300,000

500,000 100,000

$900,000

=Activity-Based

Overhead Rates$200 per setup

$10 per machine hour$50 per inspection

Assigning Overhead Costs to Products under ABC

In assigning overhead costs, it is necessary to know the expected use of cost drivers for each product.

Because of its low volume, The Club requires more setups and inspection than The Boot. The expected use of cost drivers per product is shown below:

Illustration 4-10



2,000 inspections

Atlas Company


Cost DriversNumber of setups

Machine hoursNumber of inspections

Expected Useof Cost Drivers per Product

The Boot500

30,000500

The Club1,00

20,0001,500


To assign overhead costs to each product, the activity-based overhead rates are multiplied by the number of cost drivers expected to be used per product. The assignment of Atlas Company’s estimated annual

overhead cost to The Boot is shown below. Estimated overhead assigned to The Club is shown on the next slide.

Atlas Company: The Boot

Activity Cost Pools Setting up machinesMachiningInspectingTotal assigned costs (a)

Units produced (b)

Overhead cost per unit (a) (b)


50030,000

500

Activity-BasedOverhead

Rates $200$ 10$ 50

Cost Assigned

$100,000300,000

25,000$425,000

25,000

$17

x =

Illustration 4-11a

Atlas Company: The Club

Activity Cost Pools Setting up machinesMachiningInspectingTotal assigned costs (a)

Units produced (b)

Overhead cost per unit (a) (b)


1,00020,000

1,500

Activity-BasedOverhead

Rates $200$ 10$ 50

Cost Assigned

$200,000200,000

75,000$475,000

5,000

$95

x =


These data show that under ABC, overhead costs are shifted from the high volume product (The Boot) to the low-volume product (The Club).

Illustration 4-11b

This shift of overhead from high to low volume products results in more accurate costing for two reasons:

– Low-volume products often require more special handling, such as setups. Thus, the low-volume product is responsible for more overhead costs per unit than a high-volume product.

– The overhead costs incurred by the low-volume product often are disproportionate to a traditional allocation base such as direct labor hours.


Atlas Company

Comparing Unit Costs

The comparison shows that unit costs under traditional costing are significantly distorted. The cost of producing The Boot is overstated $13 per unit and the cost of producing The Club is understated $65 per unit.

Manufacturing CostsDirect materialsDirect laborOverhead

Total cost per unit

Traditional Costing

$40 12 30

$82

ABC$40 12 17

$69

The Boot Traditional

Costing$30 12 30

$72

ABC$ 30 12 95

$137

The Club

Comparing Unit Costs

The differences in cost per unit are attributable entirely to how manufacturing overhead is assigned.

A likely consequence of the differences is that Atlas Company has been overpricing The Boot and possibly losing market share to competitors. In addition, it has been sacrificing profitability by underpricing The Club.

Understand the benefits and limitations of activity-based costing.

Study Objective 5

Benefits of ABC

The primary benefit of ABC is more accurate product costing because:

ABC leads to more cost pools used to assign overhead costs to products. Instead of one pool and one driver, numerous activity cost pools with more relevant cost drivers are utilized.

ABC leads to enhanced control over overhead costs. Many overhead costs can be traced directly to activities. Thus, managers become more aware of their responsibility to control the activities that generate costs.

Benefits of ABC

ABC leads to better management decisions. More accurate product costing helps in setting selling prices and in deciding to whether make or buy components.

Activity-based costing does not, in and of itself, change the amount of overhead costs, but it does in certain circumstances allocate those costs in a more accurate manner. And, if the score-keeping is more realistic, more accurate, and better understood, managers should be able to better understand cost behavior and overall profitability.

Limitations of ABC

Although ABC systems often provide better product cost data than traditional volume-based systems, there are limitations.

ABC can be expensive to use. ABC systems are more complex than traditional costing systems. There is a cost to identifying multiple activities and applying numerous cost drivers.

Some arbitrary allocations continue. Even though more overhead costs can be assigned directly to products, certain overhead costs remain to be allocated by means of some arbitrary volume-based cost driver.

When to Switch to ABC

The presence of one or more of the following factors indicates ABC as the superior costing system:

Product lines differ greatly in volume and manufacturing complexity.

Product lines are numerous, diverse, and require differing degrees of support services.

The manufacturing process or the number of products has changed significantly.

Production or marketing managers are ignoring data provided by the existing system, and are instead using alternative data in making decisions.

When to Switch to ABC

The redesign and installation of a new product-costing system is a significant decision that requires considerable cost and a major effort to accomplish. Therefore, financial managers need to be very cautious and deliberative when initiating changes in costing systems.

Differentiate between value-added and nonvalue-added activities.

Study Objective 6

Activity-Based Management

Activity-based management (ABM) is 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 activity-based costing used in ABM is the classification of activities as either value-added or nonvalue-added.

Value-Added versus Nonvalue-Added Activities

Value-added activities increase the worth of a product or service to customers.

They involve resource usage and related costs that customers are willing to pay for.

Value-added activities are the functions of actually manufacturing a product or service.

Examples include engineering design, machining, assembly, painting, and packaging.


Nonvalue-added activities are production- or service-related activities that simply add cost to, or increase the time spent on, a product or service without increasing its market value.

Examples include the repair of machines, storage of inventory, moving of materials, maintenance, and inspections.

Identifying and labeling activities as value-added or nonvalue-added is part of the analysis of operations, the first step, in an ABC system.


Not all activities labeled nonvalue-added are totally wasteful, nor can they be totally eliminated.

For example, although inspection is a nonvalue-added activity from a customer’s perspective, few companies would eliminate their quality control functions. Similarly, moving and waiting time is nonvalue-added, but it would be impossible to completely eliminate.


Nevertheless, because mangers recognize the nonvalue-added characteristic of these activities, they are motivated to minimize them as much as possible.

Attention to such matters is part of the growing practice of activity-based management which helps managers concentrate on continuous improvement of operations and activities.

Understand the value of a hierarchy of activity levels to activity-based

costing.

Study Objective 7

Hierarchy of Activity Levels

The recognition that not all activity costs are driven by output units has led to the development of a hierarchy of ABC activities:

– Unit-level activities are performed for each unit of production. (Ex.: materials)

– Batch-level activities are performed for each batch of products. (Ex.: setups)

– Product-level activities are performed in support of an entire product line. (Ex.: design)

– Facility-level activities are required to support or sustain an entire production facility. (Ex.: security)

Hierarchy of Activity Levels

Failure to recognize this hierarchy of activities is one of the reasons that volume-based cost allocation causes distortions in product costing.

The resources consumed by batch-, product-, and facility-level supporting activities do not vary at the unit-level, and cannot be controlled at the unit-level. Dividing these types of costs by the number of units produced gives the mistaken impression that these costs vary with the number of units.

Explain just-in-time (JIT) processing.

Study Objective 8

Just-in-Time Processing

Many U.S firms have switched from a traditional “just in case” approach to production to just-in-time (JIT) processing.

JIT minimizes inventory storage and waiting time, which are nonvalue-added activities.

Under JIT processing, raw materials are received just in time for use in production, sub-assembly parts are completed just in time for use in finished goods, and finished goods are completed just in time to be sold.

Objective of JIT Processing

A primary objective of JIT is to eliminate all manufacturing inventories.

JIT strives to do this by using a pull approach to production, instead of the traditional “push approach” which often results in the buildup of extensive inventories.

Elements of JIT Processing

The three important elements in JIT processing are: Dependable suppliers willing to deliver exact

quantities of materials that meet precise quality specifications on short notice.

A multi-skilled work force. A total quality control system (which means no

defects) throughout all manufacturing operations.

Benefits of JIT Processing

The major benefits of JIT processing are: Manufacturing inventories are significantly

reduced or eliminated. Product quality is enhanced. Rework costs and inventory storage costs are

reduced or eliminated. Production cost savings are realized from the

improved flow of goods through the process.

Appendix 4A

Activity-Based Costing in Service Industries

Apply activity-based costing to service industries.

Appendix 4AStudy Objective 9

Appendix 4A


Although initially developed and implemented by manufacturing companies that produce products, ABC has been widely adopted in service industries.

The overall objective of ABC in service firms is no different than it is in manufacturing company: to identify the activities that generate costs and to keep track of how many of those activities are performed for each service that is rendered.

The general approach to identifying activities, activity cost pools, and cost drivers is the same for service and manufacturing companies.

Labeling activities as value-added and nonvalue-added, and trying to reduce or eliminate nonvalue-added activities is just as valid in service industries.

Appendix 4A


Classifying activities as unit-level, batch-level, product-level, and facility-level also applies to service industries.

What sometimes makes implementation of ABC difficult in service industries is that a larger proportion of overhead costs are facility-level costs that cannot be directly traced to specific services rendered by the company.

Appendix 4A


Copyright © 1999 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that named in Section 117 of the 1976 United States Copyright Act without the express written permission 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.

Copyright © 1999 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that named in Section 117 of the 1976 United States Copyright Act without the express written permission 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.

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