Chapter 18(4) Activity-Based Costing 468
2. When identifying the activities needed to manufacture their product, many companies find
product’s cost.
4. Many companies developed ABC systems independently of their cost accounting systems. In such
cases, ABC is used only for decision making. It is not used for inventory valuation or decision
making.
LECTURE AID—The Need for Activity Based Costing
The following real-world example illustrates how traditional cost systems can understate the cost of
complex products.
A manufacturer of surgical gloves traditionally made gloves in one color: white. The company received a
request from one of its customers to make each size glove a different color. The customer wanted small
gloves to be pink, medium to be yellow, and large to be green.
Every time the manufacturer would start to produce a colored glove, the machines would have to be shut
down while colored dye was pumped into them. At the end of the production run, workers had to clean
the machines to remove the remaining dye. The special setup and cleaning caused the company to spend
more on labor to make the colored gloves.
No matter how thoroughly the machines were cleaned after producing a colored glove, they still contained
residue from the dye. To remove the residue, materials had to be run through the machine. So a batch of
gloves was made and scrapped just to prepare the machine to make white (or another color) gloves.
The company allocated overhead based on machine hours. Since the white and colored gloves used
exactly the same machine time while they were being made, they were assigned the same amount of
overhead. As a result, the colored gloves were “undercosted” because they were clearly more expensive
to produce.
Another example (used by Cooper and Kaplan) is two pen factories—one that sells only blue pens and
one that sells pens of all colors. Both sell 100,000 pens per month. Assume you walk into the multicolor
pen factory, but you’re colorblind. How would you know you are in the factory that makes a variety of
pen colors? Answer: There would be more activities than in the blue pen factory, such as color cleanouts,
additional materials requisitions and purchasing, more quality checks and rework, etc.
DEMONSTRATION PROBLEM—Activity-Based Costing
Allocating overhead to products under an ABC system can be explained as a four-step process.
Step 1: Identify activities. ABC costing allocates overhead to the activities that consume overhead costs.
This forces a company to identify the activities necessary to make its product.
Chapter 18(4) Activity-Based Costing 469
For example, assume that a manufacturing company identifies the following activities as necessary to
make a product:
1. Order materials.
2. Receive and inspect materials.
3. Schedule production.
4. Set up machines to make the product.
5. Make the product.
6. Inspect the finished product.
7. Pack and ship the product to the customer.
Step 2: Trace overhead costs to activity cost pools. The company would start this step by determining the
overhead costs it incurs to order materials (the first activity). Assume that these costs total $80,000 and
include such items as the salaries of the purchasing agent(s) and staff, supplies used by the purchasing
department, and depreciation on office equipment used by the purchasing department.
Step 3: Select an activity base. A means to allocate the cost of each activity to the product must be
chosen. This is known as selecting an activity base (also called an activity driver). The activity base for
any activity should be the event that causes costs to be incurred. For example, placing an order causes
purchasing costs to be incurred.
Step 4: Calculate an activity rate and allocate costs to products. Assume that the purchasing department
places 10,000 orders per year. The cost to place an order is calculated as follows:
Activity Cost Pool
Activity Rate Activity Base
Activity Rate: $80,000
Cost to place an order = 10,000 orders = $8 per order
If manufacturing a product causes the purchasing agent to place two orders for materials, the overhead
cost allocated to that product as the result of ordering materials is $16.
Once this process is complete for the purchasing activity, the same steps must be taken for the remaining
activities. As a result, ABC is usually implemented only with the use of a computer programmed to do the
many calculations required.
Problem 18(4)-3A or 18(4)-4A can be used to demonstrate ABC further if desired.
Chapter 18(4) Activity-Based Costing 470
OBJECTIVE 5
Use activity-based costing to allocate selling and administrative expenses to products.
SYNOPSIS
Learning Objective 5 presents an overview of how activity-based costing can be applied to selling and
administrative (S&A) expenses. For reporting purposes, S&A costs are simply expensed in full in the
period incurred. However, for managerial decision making, S&A costs are often allocated to products,
customers, or to some other cost object of interest. But what base should be used to make the allocation?
For example, if sales volumes are used, then more S&A costs will be allocated to high-volume customers
than low-volume customers. However, as Exhibit 13 implies, using sales volumes as the cost driver can
be misleading. Wouldn’t it be more accurate to allocate S&A costs based on how each customer
consumes selling and administrative activities?
Relevant Check Up Corner and Exhibits
Exhibit 13—Selling and Administrative Activity Product Differences
SUGGESTED APPROACH
concrete.
GROUP LEARNING ACTIVITY—ABC Applied to Selling and Administrative
Costs
Exhibit 13 in the text lists the selling and administrative activities for two products, Ipso and Facto. These
products consume dramatically different amounts of selling and administrative attention. TM 18(4)-5
Divide your class into small groups and ask each group to discuss possible activity bases that could be
used to allocate each cost. You may want to help your students start this project by suggesting possible
activity bases for the first and/or second activity.
Activity Possible Activity Base
Post-Sale Technical Support Hours Spent Training Customers
Number of Training Sessions Provided to Customers
Support Hotline
Order Writing Hours Spent Writing Up Customer Orders
Number of Technical Drawings Accompanying Orders
Number of Pages in the Customer Orders
Chapter 18(4) Activity-Based Costing 471
Encourage your students to come up with more than one possible activity base for each activity. After the
groups have formulated their responses, ask them to share their ideas with the class.
Next, tell your students that Abacus Company (the retailer for Ipso and Facto) has selected the activity
presented on TM 18(4)-7.
OBJECTIVE 6
Use activity-based costing in a service business.
SYNOPSIS
Learning Objective 6 points out that service businesses can benefit from ABC just like manufacturing
for decisions on pricing and services offered.
Relevant Check Up Corner and Exhibits
Exhibit 14—Activity-Based Costing Method—Hopewell Hospital
Exhibit 15—Hopewell Hospital Overhead Costs Allocated to Mia Wilson
Exhibit 16—Customer Profitability Report—Hopewell Hospital
SUGGESTED APPROACH
The steps necessary to implement activity-based costing explained under Objective 4 can be applied to
either a manufacturing or a service business. The following writing exercise will help your students apply
these concepts to a service company.
WRITING EXERCISE—ABC in a Service Business
or she uses.
Chapter 18(4) Activity-Based Costing 472
Ask your students to select another type of service business and list the activities that that business would
Solutions will vary based on type of business the student chooses to write about.
ADM OBJECTIVE
Describe and illustrate the use of activity-based costing information in decision making.
SYNOPSIS
improvement opportunities.
Relevant Check Up Corner and Exhibits
Make a Decision – Using ABC Product Cost Information to Reduce Cost
Type Item Description Video Excel CLGL LO(s) Difficulty Time Est BUSPROG AICPA
ACBSP – Primary Bloom’s ADM Service Real World
Writing
Ethics
MC 1 1 Easy 5 min. Analytic FN – Measurement Managerial Accounting Features/Costs Remembering
MC 2 2 Easy 5 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
MC 3 2 Easy 5 min. Analytic FN – Measurement Managerial Accounting Features/Costs Remembering
MC 4 3 Easy 5 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
MC 5 4 Easy 5 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
LREX 1 Single plantwide factory overhead rate x 2 Easy 10 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
LREX 2 Multiple production department factory overhead rates x 3 Easy 10 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
LREX 3 Activity-based costing: factory overhead costs x 4 Easy 15 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
LREX 4 Activity-based costing: selling and administrative expenses x 5 Easy 15 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
LREX 5 Activity-based costing for a service business x 6 Easy 10 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
PP Problem n/a Challenging 1 hour Analytic FN – Measurement Managerial Accounting Features/Costs Applying
DQ 1 n/a Easy 5 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
DQ 2 n/a Easy 5 min. Analytic FN – Measurement Managerial Accounting Features/Costs Synthesizing
DQ 9 n/a Easy 5 min. Analytic FN – Measurement Managerial Accounting Features/Costs Synthesizing
DQ 10 n/a Easy 5 min. Analytic FN – Measurement Managerial Accounting Features/Costs Remembering x
BE 1 Single plantwide factory overhead rate x 2 Easy 10 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
BE 2 Multiple production department factory overhead rates x 3 Easy 10 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
EX 4
Product costs and product profitability reports, using a single plantw
x x 2 Moderate 25 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying x
EX 5 Multiple production department factory overhead rate method x x 3 Moderate 25 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
EX 6
Single plantwide and multiple production department factory over
2,3 Moderate 25 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying x
EX 7
Single plantwide and multiple production department factory over
2,3 Easy 25 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying x
Activity cost pools, activity rates, and product costs using activity–b
EX 14 Multiple production department factory overhead rate method x 3 Moderate 25 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
EX 15 Activity-based costing and product cost distortion x 4 Moderate 25 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
EX 17 Evaluating selling and administrative cost allocations 5 Moderate 30 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying x
EX 18
Construct and interpret a product profitability report, allocating se
x 5 Moderate 40 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying x
EX 19 Activity-based costing and customer profitability x 5 Moderate 40 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying x
PR 1A Single plantwide factory overhead rate 2 Moderate 35 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
PR 2A Multiple production department factory overhead rates 3 Moderate 35 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
PR 3A
Activity-based and department rate product costing and product
x 3,4 Challenging 45 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying x
Allocating selling and administrative expenses using activity-based
PR 1B Single plantwide factory overhead rate 2 Moderate 35 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
PR 2B Multiple production department factory overhead rates 3 Moderate 35 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying
PR 3B
Activity-based and department rate product costing and product
x 3,4 Challenging 45 min. Analytic FN – Measurement Managerial Accounting Features/Costs Applying x
Allocating selling and administrative expenses using activity-based
ADM 1 Activity-based product cost improvement ADM Moderate 20 min. Analytic FN – Measurement Managerial Accounting Features/Costs Analyzing x
ADM 2 Labor classification trade-off ADM Moderate 20 min. Analytic FN – Measurement Managerial Accounting Features/Costs Analyzing x x
TIF 3 Communication n/a Moderate 40 min. Analytic FN – Measurement Managerial Accounting Features/Costs Analyzing x
Focus
Tagging