Managerial Accounting

Weygandt, Kieso, & Kimmel

Prepared by
Karleen Nordquist..
The College of St. Benedict...
and St. Johns University....

John Wiley & Sons, Inc.

Chapter 4

Activity-Based Costing

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 activitybased costing system.
3 Identify the activity cost pools used in activity-based
costing.
4 Identify and use the activity cost drivers in activitybased costing.

Chapter 4
Activity-Based Costing
After studying this chapter, you should be able to:
5 Understand the benefits and limitations of activitybased costing.
6 Differentiate between value-added and nonvalueadded 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

ACTIVITYBASED
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

Preview of Chapter 4
ABC: A Closer Look

ACTIVITYBASED
COSTING

Benefits
Limitations
When to Switch to ABC
Value-Added Versus NonvalueAdded Activities
Hierarchy of Activity Levels

Just-in-Time Processing
Objective
Elements
Benefits

Study Objective 1

Recognize the difference between

traditional costing and activity-based
costing.

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.

Traditional Costing
Systems
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.

Traditional Costing
Systems
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

Traditional Costing
Systems
Even in todays 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
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.

Activity-Based Costing
ABC first allocates costs to activities, and
then to the products based on each products
use of those activities.
The reasoning behind ABC cost allocation is
simple: products consume activities;
activities consume resources.

Activity-Based Costing
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.

Activity-Based Costing
Not all products or services share equally in activities.
The more complex a products 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
Ordering
and
Receiving
Materials
Cost Pool

Setting
Up
Machines
Cost Pool

Numbe
r of
POs

Numbe
r of
Setups

Machining
Cost Pool

Assembling
Cost Pool

Inspecting
and
Testing
Cost Pool

Painting
Cost Pool

Supervising
Cost Pool

Machin
e Hours

Numbe
r of
Parts

Numbe
r of
Tests

Numbe
r of
Parts

Direct
Labor
Hours

Products

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
Products
Manufacturing Costs
Direct material
Direct labor
Overhead
Total unit cost

The Boot
$40
12
30*
$82

The Club
$30
12
30*
$72

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

Illustration 4-5

Study Objective 2

Identify the steps in the development

of an activity-based costing system.

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
activitys 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).

Study Objective 3

Identify the activity cost pools used

in activity-based costing.

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

Activity Cost Pools

Setting up machines
Machining
Inspecting
Total

Estimated
Overhead
$300,000
500,000
100,000
$900,000
Illustration 4-6

Study Objective 4

Identify and use the activity cost

drivers in activity-based costing.

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:
Atlas Company

Activity Cost Pools

Setting up machines
Machining
Inspecting

Cost Drivers
Number of setups
Machine hours
Number of inspections

Expected Use of
Cost Drivers
per Activity
1,500 setups
50,000 machine hours
2,000 inspections
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 Companys computations of its activitybased overhead rates are below:
Atlas Company

Activity Cost Pools

Setting up machines
Machining
Inspecting
Total

Estimated
Overhead
$300,000
500,000
100,000

Expected Use of
Cost Drivers
per Activity
1,500 setups
50,000 machine hours
2,000 inspections

Activity-Based
Overhead Rates
$200 per setup
$10 per machine hour
$50 per inspection

$900,000

Illustration 4-9

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:
Atlas Company
Expected Use
of Cost Drivers
per Product

Activity Cost Pools

Cost Drivers
Setting up machines
Number of setups
Machining
Machine hours
Inspecting
Number of inspections

Expected Use of
Cost Drivers
per Activity
The Boot
1,500 setups
500
50,000 machine hours
30,000
2,000 inspections
500

The Club
1,00
20,000
1,500
Illustration 4-10

Assigning Overhead Costs

to Products under ABC
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 Companys 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
Expected Use
of Cost Drivers
per Product
Activity Cost Pools
Setting up machines
500
Machining
30,000
Inspecting
500
Total assigned costs (a)
Units produced (b)
Overhead cost per unit (a) (b)

Activity-Based
Overhead
Rates
$200
$ 10
$ 50

Cost
Assigned
$100,000
300,000
25,000
$425,000
25,000
$17

Illustration 4-11a

Assigning Overhead Costs

to Products under ABC
Atlas Company: The Club
Expected Use
of Cost Drivers
per Product
Activity Cost Pools
Setting up machines
1,000
Machining
20,000
Inspecting
1,500
Total assigned costs (a)
Units produced (b)
Overhead cost per unit (a) (b)

Activity-Based
Overhead
Rates
$200
$ 10
$ 50

Cost
Assigned
$200,000
200,000
75,000
$475,000
5,000
$95

Illustration 4-11b

These data show that under ABC, overhead

costs are shifted from the high volume product
(The Boot) to the low-volume product (The
Club).

Assigning Overhead Costs

to Products under ABC
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.

Comparing Unit Costs

Atlas Company

Manufacturing Costs
Direct materials
Direct labor
Overhead
Total cost per unit

The Boot
Traditional
ABC
Costing
$40
$40
12
12
17
30
$82

$69

The Club
Traditional
ABC
Costing
$ 30
$30
12
12
95
30
$72

$137

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.

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.

Study Objective 5

Understand the benefits and

limitations of activity-based costing.

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 productcosting 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.

Study Objective 6

Differentiate between value-added

and nonvalue-added activities.

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.

Value-Added versus
Nonvalue-Added Activities
Nonvalue-added activities are production- or servicerelated 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.

Value-Added versus
Nonvalue-Added Activities
Not all activities labeled nonvalue-added are
totally wasteful, nor can they be totally
eliminated.
For example, although inspection is a nonvalueadded activity from a customers 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.

Value-Added versus
Nonvalue-Added Activities
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.

Study Objective 7

Understand the value of a hierarchy

of activity levels to activity-based
costing.

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 unitlevel. Dividing these types of costs by the number
of units produced gives the mistaken impression
that these costs vary with the number of units.

Study Objective 8

Explain just-in-time (JIT)

processing.

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

Appendix 4A
Study Objective 9
Apply activity-based costing to
service industries.

Appendix 4A

Activity-Based Costing in Service

Industries
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.

Appendix 4A

Activity-Based Costing in Service

Industries
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

Activity-Based Costing in Service

Industries
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.

Copyright
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Chapter 4
Activity-Based Costing