Activity-Based Costing

Let’s look at an
example comparing
traditional costing
with ABC.
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Traditional Costing vs.
ABC
Example
Pear Company manufactures a product in regular and
deluxe models. Overhead is assigned on the basis of
direct labor hours. Budgeted overhead for the current
year is $2,000,000. Other information:

Deluxe Regular
Model Model
Direct Material $ 150 $ 112
Direct Labor Cost 16 8
Direct Labor Time 1.6 hours 0.8 hours
Expected Volume (units) 5,000 40,000

First, determine the unit cost of each model using traditional costing
methods.
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Traditional Costing
Direct
Labor Hours
Deluxe Model 5,000 units @ 1.6 hours 8,000
Regular Model 40,000 units @ 0.8 hours 32,000
Total Direct Labor Hours (DLH) 40,000

Overhead Estimated overhead costs

=
Rate Estimated activity

Overhead $2,000,000
= = $50 per DLH
Rate 40,000 DLH
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Traditional Costing

ABC will have different

overhead per unit. Deluxe Regular
Model Model
Direct Material $ 150 $ 112
Direct Labor 16 8
Manufacturing Overhead
$50 per hour × 1.6 hours 80
$50 per hour × 0.8 hours 40
Total Unit Cost $ 246 $ 160
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Activity-Based Costing
Pear Company plans to adopt activity-based costing.
Using the following activity center data, determine
the unit cost of the two products using activity-
based costing.
Overhead
Activity Cost Cost for Units of Activity
Center Driver Activity Deluxe Regular
Purchasing Orders $ 84,000 400 800
Scrap Rework Orders 216,000 300 600
Testing Tests 450,000 4,000 11,000
Machine Related Hours 1,250,000 20,000 30,000
Total Overhead $ 2,000,000
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Activity-Based Costing

Overhead Units
Activity Cost Cost for of
Center Driver Activity Activity Rate
Purchasing Orders $ 84,000 1,200
Scrap Rework Orders 216,000 900
Testing Tests 450,000 15,000
Machine Related Hours 1,250,000 50,000
Total Overhead $ 2,000,000

400 deluxe + 800 regular = 1,200 total

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Activity-Based Costing

Overhead Units
Activity Cost Cost for of
Center Driver Activity Activity Rate
Purchasing Orders $ 84,000 1,200 $ 70 per order
Scrap Rework Orders 216,000 900 $240 per order
Testing Tests 450,000 15,000 $ 30 per test
Machine Related Hours 1,250,000 50,000 $ 25 per hour
Total Overhead $ 2,000,000

Rate = Overhead Cost for Activity ÷ Units of Activity

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Activity-Based Costing

Deluxe Model Regular Model

Actual Cost Actual Cost
Units of Allocated Units of Allocated
Activity Rate Activity to Product Activity to Product
Purchasing $ 70/order 400 ? 800 ?
Scrap Rework $240/order 300 ? 600 ?
Testing $ 30/test 4,000 ? 11,000 ?
Machine Related $ 25/hour 20,000 ? 30,000 ?
Total overhead ? ?
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Activity-Based Costing

Deluxe Model Regular Model

Actual Cost Actual Cost
Units of Allocated Units of Allocated
Activity Rate Activity to Product Activity to Product
Purchasing $ 70/order 400 $ 28,000 800 $ 56,000
Scrap Rework $240/order 300 ? 600 ?
Testing $ 30/test 4,000 ? 11,000 ?
Machine Related $ 25/hour 20,000 ? 30,000 ?
Total overhead ? ?

Cost Allocated to Product = Actual Units of Activity × Rate

Let’s complete
the table.
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Activity-Based Costing

Deluxe Model Regular Model

Actual Cost Actual Cost
Units of Allocated Units of Allocated
Activity Rate Activity to Product Activity to Product
Purchasing $ 70/order 400 $ 28,000 800 $ 56,000
Scrap Rework $240/order 300 72,000 600 144,000
Testing $ 30/test 4,000 120,000 11,000 330,000
Machine Related $ 25/hour 20,000 500,000 30,000 750,000
Total overhead $ 720,000 $ 1,280,000

Cost Allocated to Product = Actual Units of Activity × Rate

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Activity-Based Costing

Deluxe Model Regular Model

Actual + $1,280,000
Total overhead = $720,000 Cost = $2,000,000
Actual Cost
Units
Recall that $2,000,000 was the of amount
original Allocated Units ofassigned
of overhead Allocated
to
Activity the products
Rate using Activity to Product
traditional Activity
overhead costing. to Product
Purchasing $ 70/order 400 $ 28,000 800 $ 56,000
Scrap Rework $240/order 300 72,000 600 144,000
Testing $ 30/test 4,000 120,000 11,000 330,000
Machine Related $ 25/hour 20,000 500,000 30,000 750,000
Total overhead $ 720,000 $ 1,280,000

Cost Allocated to Product = Actual Units of Activity × Rate

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Activity-Based Costing

Overhead Costs Assigned to Products:

Deluxe Model $720,000 ÷ 5,000 units = $144 per unit
Regular Model $1,280,000 ÷ 40,000 units = $32 per unit

Deluxe Regular
Model Model
Direct Materials $ 150 $ 112
Direct Labor 16 8
Manufacturing Overhead 144 32
Total Unit Cost $ 310 $ 152
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Traditional Costing vs. ABC

Traditional Costing ABC
Deluxe Regular Deluxe Regular
Model Model Model Model
Direct labor $ 150 $ 112 $ 150 $ 112
Direct material 16 8 16 8
Overhead 80 40 144 32
Total cost $ 246 $ 160 $ 310 $ 152

This result is not uncommon when activity-based costing is used. Many

companies have found that low-volume, specialized products have greater
overhead costs than previously realized.