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(3) product-related, and
(4) facility-related.
• Exhibit 9.12 provides example of costs and cost drivers associated with each of the four
levels.
• Not all activity-based costing systems need to have all four levels in the hierarchy, and
some can have more than four. The important factor is whether the cost drivers for the
activities reflect the cost incurred by the activity.
LO 9-5 Compute product costs using activity-based costing.
♦ In this section, the reported product costs under activity-based costing are computed in a
comprehensive example.
• Step 1: Identify the activities. A cost accountant interviewed the production manager to
determine the major activities used in the manufacturing process.
• Step 2: Identify the cost drivers. The cost accountant interviewed production
supervisors, who in turn discussed with line employees, to determine the cost
drivers and the expected volume of each driver. The information is presented in
Exhibit 9.13.
• Step 3: Compute the cost driver rates. Once the overhead costs incurred in the facility
were determined, the cost accountant calculated the cost driver rates by dividing
overhead cost by the estimated volume for each activity identified in Step 1.
Exhibit 9.14 shows the calculation.
• Step 4: Assign costs using activity-based costing. Exhibit 9.15 shows the cost flow
diagram that assigns overhead costs to activity pools in the first stage and
allocates activity costs to products in the second stage. For each product, the
direct costs (direct materials and direct labor) are the same regardless of the
costing methods used. The difference is in the assignment of overhead costs.
• There are two ways to calculate unit cost for each product.
(1) The total cost of production for each product is calculated first. Then the total cost is
divided by the number of units produced to arrive at the unit cost. This approach is
shown in Exhibit 9.16.
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(2) The cost driver rate per unit of product for each of the cost drivers can be calculated
first, which then is multiplied by the volume of activity consumption per unit of
product. The resulting sum across the cost drivers will also determine the unit cost.
======================
Demonstration Problem 3
(Continued from Demonstration Problems 1 and 2)
The cost accountant of ABC Manufacturing attended a workshop on activity-based costing and
was impressed by the results. After consulting with the production personnel, he prepared the
following information on cost drivers and the estimated volume for each driver.
Activity
Cost driver
Cost driver volume
Total
Machining
Ace
Best
Champ
Setup
Number of setups
125
75
50
250
Machining
Machine hours
2,500
1,500
2,000
6,000
Assembly
Assembly
Direct labor hours
25,000
15,000
5,000
45,000
Inspection
Number of inspections
50
25
25
100
The cost accountant also determined how much overhead costs were incurred in each of the four
activities as follows:
Activity
Machining
Setup
Machining
Total Machining department overhead
Assembly
Assembly
Inspection
Total Assembly department overhead
Total overhead costs
Required:
1. Determine the cost driver rate for each activity cost pool.
2. Use the activity-based costing method to determine the unit cost for each product.
3. Summarize and comment the results.
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Solution:
1.
Activity
Cost drive rate
Machining
Setup
$600 per setup (= $150,000 ÷ 250 setups)
Machining
$125 per machine hour (= $750,000 ÷ 6,000 machine hours)
Assembly
Assembly
$8 per direct labor hour (= $360,000 ÷ 45,000 direct labor hours)
Inspection
$900 per inspection (= $90,000 ÷ 100 inspections)
2. In the following table, the total costs are divided by the number of units to arrive at the
unit cost for each product.
Ace
Best
Champ
Direct materials
$1,000,000
$450,000
$275,000
Direct labor
375,000
225,000
75,000
Applied overhead
Setup ($600 per setup)
75,000
45,000
30,000
Machining ($125 per machine hour)
312,500
187,500
250,000
Assembly ($8 per direct labor hour)
200,000
120,000
40,000
Inspection ($900 per inspection)
45,000
22,500
22,500
Total overhead costs
$632,500
$375,000
$342,500
Total costs
$2,007,500
$1,050,000
$692,500
Number of units
25,000
15,000
5,000
Unit cost
$80.30
$70.00
$138.50
Alternatively, the following table shows direct calculation of unit cost for each product based
on consumption of the activities for each unit of the products.
Ace
Best
Champ
Units produced
25,000
15,000
5,000
Number of setups per unit
0.005
0.005
0.01
Machine hours per unit
0.1
0.1
0.4
Direct labor hours per unit
1
1
1
Number of inspections per unit
0.002
0.00167
0.005
Direct materials
$40.00
$30.00
$55.00
Direct labor
15.00
15.00
15.00
Applied overhead
Setup ($600 per setup)
3.00
3.00
6.00
Machining ($125 per machine hour)
12.50
12.50
50.00
Assembly ($8 per direct labor hour)
8.00
8.00
8.00
Inspection ($900 per inspection)
1.80
1.50
4.50
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Unit cost
$80.30
$70.00
$138.50
3. In summary, a comparison of the methods used to calculate unit cost for each product is
presented below.
Ace
Best
Champ
Plantwide rate based on machine hours
$77.50
$67.50
$160.00
Plantwide rate based on direct labor costs
85.00
75.00
100.00
Department rates
80.00
70.00
140.00
Activity-based costing
80.30
70.00
138.50
In this series of demonstration problems, both of the plantwide allocation methods distort
product costs. Since Champ uses four times as much machine hours as the other two products,
it inevitably receives more cost assignment from the plantwide method based on machine
hours; the opposite is the case when direct labor costs are used as the allocation base.
The department allocation method and activity-based costing produce comparable numbers
that portray consumption of resources closer to reality. Since it is less costly to implement the
department allocation method than the activity-based costing method, the managers of ABC
Manufacturing should probably use the department allocation method to handle overhead
costs in the future.
======================
LO 9-6 Compare activity-based product costing to traditional department
product costing methods.
♦ As summarized in Exhibit 9.17, both the plantwide rate and the department rate systems
assumed that overhead was incurred proportionally with the volume of output. The activity-
based costing system recognized that overhead was related to activity usage, not necessarily to
the volume of output.
• Different cost allocation methods result in different estimates of how much it costs to
make a product.
• Activity-based costing provides more detailed measures of costs than do plantwide or
department allocation methods.
• Production also benefits because activity-based costing provides better information
about how much each activity costs. It helps identify cost drivers that previously were
unknown.
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• Activity-based costing provides more information about product costs but requires more
record keeping.
• Installing activity-based costing requires teamwork between accounting, production,
marketing, management, and other non-accounting personnel.
LO 9-7 Demonstrate the flow of costs through accounts using activity-
based costing.
♦ Exhibit 9.18 shows the flow of costs through accounts using activity-based costing. The
overhead accounts (both incurred and applied) are grouped by activities.
♦ Early industries were labor intensive, and much of the overhead cost was related to the support
of labor. At that time, it made sense to allocate overhead to products based on the amount of
labor component in the products.
• Nowadays, labor is still a major product cost in many companies, especially service
organizations such as consulting, law, and public accounting firms. In those cases,
overhead is often allocated to products (jobs) on the basis of the amount of labor in the
product.
• When the labor component drops in the products and overhead cost increases,
companies that continue to allocate overhead to products based on direct labor are
experiencing substantial overhead rate increases. Even small errors in cost allocation can
be magnified many times. It also sends the wrong signal that direct labor is more
expensive than it really is and drives managers to reduce the already slim labor content of
products.
• The magnitude of the overhead rate based on direct labor is of less concern when all
resources are used proportionally.
• In modern manufacturing settings, proportionality between machine hours and direct
labor hours is much less so.
♦ Costs are a function of both volume and complexity.
• Low-volume products often require more machine setups for a given level of production
output because they are produced in smaller batches.
• Low-volume product adds complexity to the operation by disrupting the production
flow of the high-volume items.
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• Volume-based allocation methods allocate a high proportion of overhead costs to high-
volume products, which “subsidize” low-volume products and hide the cost effects of
keeping a large number of low-volume products. The result is that high-volume products
tend to be overcosted while low-volume products undercosted.
LO 9-8 Apply activity-based costing to marketing and administrative
services.
♦ Activity-based costing can be applied to administrative activities. The principles and methods
are the same as those discussed earlier.
• Activity-based costing in administration involves these steps:
(1) Identify the activities that consume resources.
(2) Identify the cost driver associated with each activity.
(3) Compute a cost rate per cost driver for each unit or transaction.
(4) Assign costs to the marketing or administration activity by multiplying the cost driver
rate by the volume of cost driver units consumed for that activity.
• Instead of computing the cost of a product, accountants compute the cost of performing
an administrative service.
• Time-related factors (and therefore cost drivers) are common for an administrative
function or a service business. Exhibit 9.19 shows other common cost drivers in a typical
purchasing department for various activities performed.
♦ There are three problems with identifying users of ABC.
(1) ABC means different things to different observers.
(2) ABC can be applied in parts of an organization but not everywhere.
(3) While firms may publicly announce the adoption of ABC, they are less likely to announce its
discontinuance.
• The adopters of ABC include a wide range of organizations with various sizes, from
manufacturing firms to government agencies, and from a small, regional financial service
firm to a multinational manufacturing firm. See Exhibit 9.20 for examples.
• All organizations are interested in getting better cost information for decision making,
and ABC implementation serves the purpose well.