CHAPTER 17
ACTIVITY-BASED COSTING AND ANALYSIS
Related Assignment Materials
Student Learning Objectives Discussion
Questions
Quick
Studies*
Exercises* Problems* Beyond the
Numbers
Conceptual objectives:
C1. Distinguish among the plant
wide overhead rate method, the
departmental overhead rate
method, and the activity-based
costing method.
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C2. Explain cost flows for activity-
based costing.
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14, 15, 16
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C3. Describe the four types of
activities that cause overhead
costs.
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Analytical objectives:
A1. Identify and assess advantages
and disadvantages of the
plantwide overhead and
department overhead rate
methods.
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11
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A2. Identify and assess advantages
and disadvantages of activity-
based costing.
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17-14, 17-16 17-1, 17-2,
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Procedural objectives:
P1. Allocate overhead costs to
products using the plantwide
overhead rate method.
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P2. Allocate overhead costs to
products using the
departmental overhead rate
method.
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P3. Allocate overhead costs to
products using activity-based
costing.
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17-9, 17-10,
17-11, 17-12,
17-13, 17-14,
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*See additional information on next page that pertains to these quick studies, exercises and
problems.
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Additional Information on Related Assignment Material
Connect (Available on the instructor’s course-specific website) repeats all numerical Quick
Studies, all Exercises and Problems Set A. Connect provides new numbers each time the Quick
Study, Exercise or Problem is worked. It allows instructors to monitor, promote, and assess
student learning. It can be used in practice, homework, or exam mode.
Synopsis of Chapter Revision
Suja Juice Company NEW opener.
Clarified departmental overhead rate method and ABC methods as four-step processes.
Re-graded heading levels to highlight plantwide and departmental overhead rate method topics.
Expanded discussion of examples used in the ABC application, to enhance clarity.
Revised Exhibit 17.16, separating Costs of Good Quality from Costs of Poor Quality, thus
highlighting the Cost of Quality Report.
4 new Quick Studies, and some old Quick Studies repurposed to Exercises.
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Chapter Outline
I. Assigning Overhead Costs
Knowing accurate costs for producing, delivering, and servicing
products helps managers set a price to cover product costs and yield a
profit. Product costs consist of direct labor, direct materials and
manufacturing overhead. Overhead costs cannot be traced to units of
product in the same way that direct labor and direct materials can.
Therefore, we must assign such overhead costs using an allocation
system.
A. Plantwide Overhead Rate Method
1. Cost Flows Under Plantwide Overhead Rate Method. This
method is also referred to as the single plantwide overhead
rate method or the plantwide overhead rate method.
a. Target of the cost object is the unit of product.
b. The rate is determined using volume-related measures
such as direct labor hours, direct labor cost dollars, or
machine hours.
c. For industries where overhead costs are closely related to
these volume-related measures, it is logical to use this
method to allocate indirect manufacturing costs to
products.
2. Applying the PlantWide Overhead Rate Method
a. Total budgeted overhead costs are combined into one
overhead cost pool.
b. This cost pool is then divided by the chosen allocation
base to arrive at a single plantwide overhead rate.
c. This rate is then applied to assign costs to all products
based on the allocation base such as direct labor hours
required to manufacture each product.
B. Departmental Overhead Rate Method – use of a single plantwide
overhead rate can produce cost assignments that fail to accurately
reflect the cost to manufacture a specific product.
1. Cost Flows Under Departmental Overhead Rate Method
a. Use of multiple overhead rates can result in better overhead
cost allocations and improve management decisions.
b. The departmental overhead rate method uses a different
overhead rate for each production department. This is
usually done through a two-stage assignment process where
departments are the cost objects in the first stage and
products are the cost objects in the second stage.
c. Overhead costs are first determined separately for each
production department. Then an overhead rate is computed
for each production department to allocate the overhead.
Notes
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Chapter Outline Notes
d. This method allows each department to have its own
overhead rate and its own allocation base.
2. Applying the Departmental Overhead Rate Method – 4 step
process.
a. Step 1: Assign overhead costs to departmental cost pools.
b. Step 2: Select an allocation base for each department. If
overhead costs are common to several departments,
companies must allocate overhead to departments applying
reasonable allocation bases. Each department determines an
allocation base for its operations.
c. Step 3: Compute overhead allocation rates for each
department.
d. Step 4: Apply overhead costs to each product based on
departmental overhead rates.
e. This method usually results in more accurate overhead
allocations as compared to the plantwide rate method.
When analysts are able to logically trace costs to cost
objects, costing accuracy is improved.
C. Assessing the Plantwide and Departmental Overhead Rate
Methods
1. Advantages:
a. Based on readily available information.
b. Easy to implement.
c. Consistent with GAAP and can be used for external
reporting needs.
2. Disadvantage – overhead costs are too complex to be
explained by one factor like direct labor or machine hours.
3. Usefulness based on the single plantwide overhead rate
depends on two critical assumptions:
a. Overhead costs change with the allocation base.
b. All products use overhead costs in the same proportions.
4. Reasonableness of these assumptions varies.
a. For companies that manufacture few products or are labor–
intensive, the single plantwide method can yield
reasonably useful information.
b. For companies with many different products or ones that
use overhead costs in very different ways, the assumptions
of the single plantwide rate are not reasonable.
5. The departmental overhead rate method is more refined but
also has limitations.
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Chapter Outline Notes
b. When products differ in batch size and complexity, they
usually consume different amounts of overhead costs.
D. Activity-Based Costing Rates and Method
1. Cost Flows Under Activity-Based Costing Method. Activity-
based costing (ABC) attempts to more accurately assign
overhead costs to the users of overhead by focusing on
activities.
a. Basic principle is that activities, which are tasks,
operations, or procedures, cause costs to be incurred.
b. All activities of an organization can be linked to use of
resources.
c. Activity cost pool is a collection of costs that are related to
the same or similar activity.
d. Pooling costs to determine an activity overhead (pool) rate
for all costs incurred by the same activity reduces the
number of cost assignments required.
e. The first stage of ABC is to identify activities (cost objects)
involved in manufacturing products and match those
activities with the costs they cause (drive).
f. To reduce the number of activities, the homogenous
activities (those caused by the same factor) are grouped
into activity cost pools.
g. The second stage is to compute an activity rate for each cost
pool and then use this rate to allocate overhead costs to
products.
h. ABC is similar to the departmental method in that it uses
more than one overhead rate. It differs from the
departmental method in that it focuses on activities rather
than departments.
II. Applying Activity-Based Costing – Activity-based costing
accumulates overhead costs into activity cost pools and then allocates
those costs to products using activity rates. This involves four steps:
(1) identify activities and the costs they cause, (2) group similar
activities into activity cost pools, (3) determine an activity rate for
each activity cost pool, and (4) allocate overhead costs to products
using those activity rates.
A. Step 1: Identify Activities and the Costs They Cause
1. Commonly done through discussions with employees in
production departments and through review of production
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Chapter Outline Notes
B. Step 2: Trace Overhead Costs to Cost Pools
1. Step 2 involves assigning activities and their overhead costs to
cost pools. These costs are commonly accumulated by each
department in a traditional accounting system. Some costs are
traced directly to a specific activity cost pool.
2. Activity-based costing provides more detail about the activities
and the costs they cause than is provided from traditional
costing methods.
3. To form cost pools, companies look for costs that are caused by
the same or similar activities within each activity level.
Pooled costs include only those costs related to the same
driver.
C. Step 3: Determine Activity Rates
1. Step 3 is to compute activity rates used to assign overhead
costs to final cost objects such as products.
2. Proper determination depends on (1) proper identification of
the factor that drives the cost in each activity cost pool, and (2)
proper measures of activities.
3. The cost driver is that activity causing costs in the pool to be
incurred.
4. Next, an activity driver, a measure of activity level, is
determined for use as the allocation base.
5. Examples of activity drivers include: number of products
devised or modified, number of square feet occupied, and the
number of batches.
6. To compute the activity rate, total cost in an activity cost pool
is divided by the measure of the activity.
D. Step 4: Assign Overhead Costs to Cost Objects
1. Step 4 is to assign overhead costs in each activity cost pool to
final cost objects using activity rates.
2. Overhead costs in each activity cost pool are allocated to
product lines based on the actual level of activity used,
multiplied by a predetermined activity rate for each cost pool.
3. The unit overhead cost is computed by dividing total overhead
cost allocated to the product lines by the number of product
units.
4. When ABC is used, overhead costs commonly shift from
standardized, high-volume products to low-volume,
customized specialty products that consume more resources.
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Chapter Outline Notes
E. Differences between ABC and Multiple Departmental Rates.
1. ABC recognizes that overhead costs are complex and
emphasizes activities and costs of these activities.
2. ABC better reflects the complex nature of overhead costs and
how these costs are used in making products.
III. Assessing Activity-Based Costing
A. Advantages of Activity-Based Costing
1. More Accurate Overhead Cost Allocation – because (1) there
are more cost pools, (2) costs in each pool are more similar,
and (3) allocation is based on activities that cause overhead
costs.
2. More Effective Overhead Cost Control – can be used to
identify activities that can benefit from process improvement.
Also helps managers effectively control overhead cost by
focusing on processes or activities instead of only direct labor.
3. Focus on Relevant Factors – provides better customer
profitability information by including all resources consumed
to serve a customer. Allows managers to make better pricing
decisions on custom orders and to better manage customers by
focusing on those that are most profitable.
4. Better Management of Activities – helps managers identify the
causes, or activities that drive costs. Activity-based
management is an out-growth of ABC that draws on the link
between activities and cost incurrence for better management.
Activity-based management can be useful in distinguishing
value-added activities which add value to a product from non-
value-added activities, which do not.
5. Costs of quality–costs resulting from manufacturing
defective products or providing services that do not meet
customer expectations. Costs of quality include prevention,
appraisal, internal failure and external failure costs. Can be
summarized in a cost of quality report.
B. Disadvantages of Activity-Based Costing
1. Costs to Implement and Maintain ABC. Collecting and
analyzing cost data are expensive and so is maintaining an
ABC system.
2. Uncertainty with Decisions Remains. Managers must
interpret ABC data with caution in making managerial
decisions. Managers must examine carefully the
controllability of costs before making decisions.
C. ABC for Service Providers – ABC also applies to service
providers. The only requirements are the existence of costs and
demand for reliable cost information.
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Chapter Outline
D. Types of Activities:
1. Unit level activities – performed on each product unit. Costs
tend to change with the number of units produced
2. Batch level activities – performed only on each batch or group
of units. Costs do not vary with the number of units, but with
the number of batches.
Notes
3. Product level activities – performed on each product line and
are not affected by either the number of units or batches. Costs
do not vary with the number of units or batches.
4. Facility level activities– performed to sustain facility capacity as
a whole and are not caused by any specific product. Costs do
not vary with what is manufactured, number of batches, or the
output quantity.
IV. Global View: Many lean manufacturers embrace lean accounting, which
has two key components:
A. First, the company applies lean thinking to eliminate waste in its
accounting process.
B. Instead of focusing on cost allocation methods, such as activity-based
costing, the company develops alternative performance measures that
better reflect the benefits of manufacturing process changes.
V. Decision Analysis: Customer Profitability. Companies cause the ABC
method to analyze their customer profitability. ABC encourages
management to consider all resources consumed to serve a customer, not
just manufacturing costs that are the focus of traditional costing methods.
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Chapter 17 Alternate Demonstration Problem #1
Windy River Float Trips uses activity-based costing to compute the cost of
the river raft trips. Each raft holds six customers and a guide. The costs
for these float trips are as follows:
Activities (cost driver) Costs
Trailer rent fee (trip) $127 per trip
Advertising (trips) 215 per trip
Insurance (trips) 50 per trip
Depreciation (trips, people) 40 per trip plus $8 per person
Wages (trips, guides) 400 per trip per guide
Shore lunch (people) 60 per person
Compute the cost of a raft trip with 4 rafts, 24 customers and 4 guides.
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Solution: Chapter 17 Alternate Demonstration Problem #1
Activities River Float Trips
Trailer Rent Fee $ 127
Advertising 215
Insurance 50
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