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Chapter 3
Lecture Notes
Chapter theme: Overhead costs cannot be easily traced to
products. Using a plantwide predetermined overhead rate
as described in Chapter 2 is simple but may inaccurately
assign costs to products. Activity-based costing is an
alternative that attempts to accurately assign overhead
costs to products for financial reporting and other
purposes.
Learning Objective 1: Understand the basic approach
in activity-based costing and how it differs from
conventional costing.
I. Assigning overhead costs to products
A. Plantwide overhead rate
i. When cost systems were developed in the 1800s
the emphasis was on simplicity because:
1. Cost and activity data had to be collected by
hand and all calculations were done with
paper and pencil.
2. Most companies produced a limited variety
of similar products, so there was little
difference in the overhead costs consumed
by each product.
ii. In the interest of simplicity, companies often
established a single overhead pool for an entire
factory that used direct labor as the allocation
base. Direct labor was the obvious choice because:
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1. Direct labor information was already being
recorded.
2. Direct labor was a large component of
product costs.
3. Managers believed direct labor and
overhead costs were highly correlated.
iii. Conditions have changed in three ways.
1. Most companies sell a large variety of
products that consume differing amounts of
overhead.
2. As a percentage of total costs, direct labor
has been shrinking and overhead has been
increasing.
a. Many of these growing overhead
costs may not be correlated with
direct labor.
3. Technology advancements have reduced
the cost and complexity of gathering
diverse sources of data.
iv. These changes suggest that plantwide overhead
allocation systems may not be optimal for many
companies in today’s business environment.
B. Departmental overhead rates
i. Many companies use departmental overhead rates
instead of a plantwide overhead rate. The nature of
the work performed in a department will
determine the department’s allocation base. For
example:
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1. Overhead costs in a machining department
may be allocated using machine-hours.
2. Overhead costs in an assembly department
may be allocated using direct labor-hours.
ii. Departmental overhead rates will not correctly
assign overhead costs in situations where a
company has a range of products and complex
overhead costs.
1. This is because the departmental approach
relies exclusively on volume-related
allocation bases.
2. Some overhead costs may be caused by
factors that are not related to the volume of
production.
a. A more sophisticated approach such
as activity-based costing is required
to account for these other factors.
C. Activity-Based Costing (ABC)
i. Activity-based costing is a technique that uses
numerous allocation bases in an attempt to assign
overhead costs more accurately to products than the
plantwide and departmental approaches discussed
thus far. The basic idea of ABC is:
1. A customer order triggers a number of
activities.
2. Performing the activities consumes
resources.
3. The consumption of resources incurs
costs.
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ii. Key terminology
1. An activity in activity-based costing is an
event that causes the consumption of
overhead resources. Examples of activities
include:
a. Setting up machines
b. Admitting patients to a hospital
c. Billing customers
d. Opening an account at a bank
2. An activity cost pool is a “cost bucket” in
which costs related to a particular activity
are accumulated.
3. An activity measure expresses how much
of an activity is carried out and it is used as
the allocation base for applying overhead to
products and services.
a. Activity measures can be related to
volume or not related to volume.
4. An activity rate is a predetermined
overhead rate in an activity-based costing
system. Each activity has its own activity
rate.
iii. Taking each activity in isolation, this system
works exactly like the job-order costing system
described in the Chapter 2.
1. A predetermined overhead rate is computed
for each activity and then applied to jobs and
products based on the amount of activity
consumed by the job or product.
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II. Designing an activity-based costing system
A. Design decisions
i. In most companies, hundreds or even thousands of
different activities cause overhead costs. The
challenge is to select a reasonably small number
of activities that explain the bulk of the variation
in overhead costs.
ii. Activities are usually chosen by interviewing a
broad range of managers to find out what
activities they think consume most of the
organization’s resources.
iii. Related activities are frequently combined to
reduce the amount of detail and record-keeping
costs. For example:
1. Several actions may be involved in handling
and moving raw materials, but these may be
combined into a single activity titled
material handling.
iv. An activity dictionary defines each of the
activities that will be included in the activity-based
costing system and how the activities will be
measured.
B. Hierarchy of activities − a common framework for
combining activities in manufacturing companies is as
follows:
i. Unit-level activities are performed each time a unit
is produced. For example:
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1. Providing power to run processing
equipment would be a unit-level activity.
ii. Batch-level activities are performed each time a
batch is handled or processed, regardless of how
many units are in the batch. For example:
1. Setting up equipment and shipping customer
orders are batch-level activities.
iii. Product-level activities relate to specific products
and must be carried out regardless of how many
batches are run or units produced and sold. For
example:
1. Designing or advertising a product would be
a product-level activity.
iv. Facility-level activities are carried out regardless
of which customers are served, which products are
produced, how many batches are run, or how many
units are made. For example:
1. Heating a factory and cleaning executive
offices are facility-level activities.
III. An example of an activity-based costing system design
A. Two-stage cost allocation process
i. In the first stage, overhead costs are assigned to
the six activity cost pools shown on the slide. For
example:
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1. The production-order cost pool could
include the salaries of engineers who modify
products for individual orders and the costs
of scheduling and monitoring orders.
2. In the examples and assignments in this
book, the first-stage cost assignments have
already been completed.
ii. In the second stage, the costs in the activity cost
pools are allocated to products using activity rates
and activity measures. For example:
1. If the total cost in the production-order cost
pool was $450,000 and the company
expected to process 1,200 orders, the
activity rate would be $375 per order.
2. Each order would be charged $375 for
production-order costs.
iii. Notice, the example shown on the slide includes
two unit-level activities, two batch-level activities,
one product-level activity, and one facility-level
activity.
IV. Using activity-based costing
A. Comtek, Inc. – the direct labor approach
i. Comtek makes two products – GPS systems and
Phone systems. Recently:
1. The company has been losing bids to supply
GPS systems to lower-priced competitors.
2. The company has been winning all of its
bids to supply Phone systems.
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ii. Comtek’s traditional cost system applies
manufacturing overhead to products based on
direct labor-hours. As shown, the Phone systems
and GPS systems consume 100,000 and 400,000
direct labor hours, respectively.
iii. The direct material and direct labor cost for one
unit of each product is as shown.
iv. The company’s estimated manufacturing
overhead cost for the year is $10,000,000.
Therefore, the predetermined overhead rate of $20
per direct labor-hour is computed as shown.
v. Using the information provided thus far, the unit
product cost of each product ($150 for Phones
systems and $110 for GPS systems) would be
computed as shown.
Learning Objective 2: Compute activity rates for an
activity-based costing system.
B. Comtek, Inc. – the ABC approach
i. Assume that Comtek assigned its $10,000,000 of
manufacturing overhead into six activity cost pools
as shown.
1. The activity measure for each activity is
stated in parentheses.
2. The quantity of the activity measure
consumed is shown by product line.
ii. The activity rate for each activity cost pool would
be computed as shown.
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Learning Objective 3: Compute product costs using
activity-based costing.
iii. The overhead cost per unit ($97.80) for the Phone
systems is computed as shown. For example:
1. The expected activity in the machine setups
pool is 3,000 setups. This activity level is
multiplied by the activity rate of $400 per
setup to yield the total setup cost assigned to
Phone systems of $1,200,000.
iv. The overhead cost per unit ($25.55) for the GPS
systems is computed as shown. For example:
1. The expected activity in the machine setups
pool is 1,000 setups. This activity level is
multiplied by the activity rate of $400 per
setup to yield the total setup cost assigned to
GPS systems of $400,000.
C. Comparing the two approaches
i. Under ABC, the unit product cost of Phones and
GPS systems are $207.80 and $95.55, respectively.
ii. Under the traditional approach, we had computed
unit product costs for Phones and GPS systems of
$150 and $110, respectively.
iii. Notice, the direct material and direct labor costs
under the two approaches are the same. The
differences in unit product costs result from the
two different approaches to assigning overhead
costs.
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Learning Objective 4: Contrast the product costs
computed under activity-based costing and
conventional costing methods.
1. The ABC system assigns $14.45 less in
overhead to each GPS system than the
traditional system ($40.00 – $25.55).
2. The ABC system assigns $57.80 more in
overhead to each Phone system than the
traditional system. ($97.80 – $40.00).
D. Shifting of overhead
i. Activity-based costing shifts costs from high–
volume products to low-volume products. This
results from the existence of batch and product-
level costs. For example, consider the Production-
Orders activity cost pool (a batch-level cost pool):
1. The traditional system assigns the same
amount of all overhead costs (including the
costs related to Production Orders) to each
GPS or Phone system ($40 per unit).
2. However, the ABC system assigns different
amounts of Production-Order-related
overhead costs to each product. This fact
can be illustrated in a two-step process.
a. First, compute the number of units
processed per production order for
each product (62.5 units for Phones
and 500 units for GPS systems).
b. Second, compute the production–
order cost per unit for each product
($42 for Phones and $5.25 for GPS
systems).
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3. Notice, the costs are being shifted from the
high-volume product (GPS systems) to
the low-volume product (Phone systems).
V. Targeting process improvements
Activity-based management
i. Activity-based management focuses on managing
activities as a way of eliminating waste and
reducing delays and defects.
1. It is used in organizations as diverse as
manufacturing companies, hospitals, and the
U.S. Marine Corps.
ii. The first step in any improvement program is to
decide what to improve.
1. Activity-based management can help in
this regard.
a. Activity-rates can be used to target
areas where costs seem excessively
high.
b. Benchmarking can also be used to
compare activity cost information
with world-class standards of
performance achieved by other
organizations.
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VI. Evaluation of activity-based costing
A. The benefits of activity-based costing
i. It improves the accuracy of product costs in three
ways:
1. It increases the number of cost pools used
to accumulate overhead costs.
2. It uses activity cost pools that are more
homogeneous than departmental cost pools.
3. It assigns overhead costs using activity
measures that cause those costs rather than
relying solely on direct labor-hours.
a. Some activity measures may be unit–
level in nature, but importantly,
others will be batch-level, product–
level, or facility-level in nature.
4. It highlights the activities that could
benefit most from process improvement
efforts, such as Six Sigma.
B. Limitations of activity-based costing
i. The cost of implementing an ABC system may
outweigh the benefits. However, the benefits are
more likely to be worth the cost when:
1. Products differ substantially in volume,
batch size, and in the activities they require.
2. Conditions have changed substantially
since the existing cost system was
established.
3. Overhead costs are high and increasing
and nobody seems to understand why.
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4. Management does not trust the existing
cost system and it ignores data from it when
making decisions.
ii. Critical assumption
1. The cost in each activity pool is strictly
proportional to its activity measure. When
this assumption is violated, the accuracy of
ABC data can be called into question. For
example:
a. Managers should be particularly alert
to product costs that contain
allocated facility-level costs.
iii. Modifying the ABC model
1. This chapter illustrates the usage of activity–
based absorption costing. For internal
decision-making purposes, companies
should make two important modifications
to the type of ABC system illustrated in this
chapter:
a. Selling and administrative costs
should be assigned to products
where appropriate.
b. Facility-level costs should be
removed from product costs.
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