CHAPTER 4
ACTIVITY-BASED COSTING
Activity-based costing (ABC) can be used for computing traditional product costs, but at a greater cost.
The chapter examines factors impacting a company’s decision to implement ABC or continue to utilize
unit-based costing methods.
LEARNING OBJECTIVES
After studying Chapter 4, students should be able to:
2. Explain why plantwide and departmental overhead costing may not be accurate.
4. Explain how ABC can be simplified.
KEY TOPICS
The following major topics are covered in this chapter (related learning objectives are listed for each
topic):
1. Unit-Level Product Costing (LO 1)
3. Activity-Based Costing System (LO 3)
4. Reducing the Size and Complexity of an ABC System (LO 4)
I. UNIT-LEVEL PRODUCT COSTING
A. Overhead Assignment using Plantwide or Departmental Rates
Assigning direct materials or direct labor costs to products poses no particular challenge since they can be
assigned using direct tracing. Overhead costs, however, are more difficult to trace because of a weaker
input-output relationship. Assignment of overhead is often accomplished through driver tracing or
allocation.
Exhibit 4.1 (p. 141) illustrates the unit-based product costing system. Unit-level drivers are factors that
measure the demands placed on unit-level activities. Unit-level activities are activities performed each
and every time a unit of a product is produced.
Traditional methods of assigning overhead costs to products have used plantwide or departmental rates.
Plantwide rates assign all overhead costs to products from a single plantwide pool using a single unit-
level driver such as direct labor hours. Overhead costs are assigned to products by multiplying the
plantwide rate by the actual amount of direct labor hours used by each product. Assigning budgeted
overhead cost to the plantwide pool is known as the first-stage cost assignment. Assigning overhead cost
to individual products is known as the second stage assignment. Cornerstone 4.1 (p. 142) illustrates the
calculations and their rationale of how to apply overhead and unit overhead cost.
When using departmental rates, overhead costs are assigned to individual production departments,
creating departmental overhead cost pools. Overhead costs are then assigned to products from the
departmental pools using unit-based departmental rates. Cornerstone 4.3 (p. 146) displays calculations
and summarizes their rationale of how to use departmental overhead rates.
B. Under- and Overapplied Overhead
Because plantwide and departmental overhead rates are calculated using budgeted amounts, there is often
a difference between the amount of overhead applied to production and actual overhead occurred. This
difference is known as an overhead variance. Overhead variances occur because it is not possible to
perfectly estimate overhead costs and production activity. If the amount of overhead applied to
production exceeds the actual overhead incurred, then the variance is called overapplied overhead. If the
amount of overhead applied to production is less than the actual overhead cost incurred, then the variance
is called underapplied overhead.
At the end of the accounting period, a company must have a process in place to dispose of overhead
variances. Choice of a method depends on the materiality of the variance. If immaterial, assign the
overhead variance to cost of goods sold. If material, prorate among the ending balances in work-in–
process inventory, finished goods inventory, and cost of goods sold. Cornerstone 4.2 (p. 145) illustrates
the calculation and disposal of overhead variances.
Teaching hint: The example in the text (Juguette, Inc.) provides a good illustration of using plantwide and
departmental rates to assign overhead cost to products. In addition, determination and disposition of
overhead variances are illustrated.
II. LIMITATIONS OF PLANTWIDE AND DEPARTMENTAL RATES
Plantwide and departmental rates have been used by firms to allocate overhead costs for many years.
However, there are instances where such methods are not appropriate.
Unit-based plantwide and departmental rates generally do not assign costs accurately when:
1. The proportion of non-unit-related overhead costs to total overhead costs is large.
2. The degree of product diversity is great.
Teaching hint: The Boise plant of Juguette, Inc., example in the text provides a good illustration of how
the use of plantwide or departmental rates can distort cost. Point out that the regular cards received eight
times as much overhead cost as the scented cards. This is because the regular card line uses eight times as
many direct labor hours as the scented card line. Ask the students if they think that the plantwide rate
provides a fair and accurate assignment of costs. Most will indicate that the cost assignment is unfair
since regular cards will be receiving more than their fair share of cutting and printing costs. This
undercosts the scented cards and overcosts the regular ones. With this in mind, indicate that moving to
departmental rates has been suggested as a way to improve overhead costing accuracy. Ask why the
conventional approaches are failing. This should lead to a discussion of product diversity and the relative
significance of non-unit-related overhead costs. The products consume the overhead activities in different
proportions from those of the unit-based cost drivers. Also, the non-unit-based overhead costs represent a
significant proportion of total overhead costs. Finally, ask what approach should be taken for assigning
overhead costs. Generally, students will suggest an activity-based approach, allowing the transition to
activity-based costing.
III. ACTIVITY-BASED COSTING SYSTEM
A. Activity-Based Costing Model
Activity-based costing can help improve the accuracy of product costing when:
1. Multiple products are produced.
3. Non-unit-level overhead is a significant percentage of production cost.
The basic activity-based costing model is presented in the text in Exhibit 4.5 (p. 156).
In designing an ABC system, there are six essential steps:
1. Identify, define, and classify activities and key attributes.
3. Assign the cost of secondary activities to primary activities (see discussion below).
5. Calculate primary activity rates.
6. Assign activity costs to cost objects.
The focus of activity-based costing is activities. Activities represent actions taken or work performed by
equipment or people for other people. Activities consume resources. For costing purposes, activities
must first be identified, and then classified as primary and secondary. A primary activity is an activity
that is consumed by a final cost object such as a product or customer. A secondary activity is one that is
consumed by intermediate cost objects such as primary activities, materials, or other secondary activities.
Information necessary for implementation of an ABC system can be gathered through interviews,
questionnaires, surveys, and observation. Interviews may be the most common approach for gathering
needed information. Sometimes an activity dictionary is prepared. An activity dictionary names
activities, describes the tasks that make up the activities, classifies the activities as primary or secondary,
lists the users (cost objects), and identifies a measure of activity output (activity driver).
Teaching hint: Exercise 4.16 is a good example to work in class as an introduction to ABC.
B. Classifying Activities
Activity identification is critical for activity costing. There are four activity categories:
2. Batch-level
4. Facility-level
Unit-level activities are those that are performed each time a unit is produced. Examples of unit-level
activities include power and machine hours (both of these are used each time a unit is produced). Direct
materials and direct labor activities are also unit-level activities, even though they are not overhead costs.
Batch-level activities are those that are performed each time a batch of products is produced. Examples of
batch-level activities include setups, inspections, purchasing, and materials-handling costs.
Product-level activities are those activities performed that enable the various products of a company to be
produced. These activities and their costs tend to increase as the number of different products increases.
Examples of product-level activities include engineering changes, developing product-testing procedures,
introducing new products, and expediting goods.
Facility-level activities are those that sustain a factory’s general manufacturing processes. Examples of
facility-level activities include plant management, landscaping, maintenance, security, property taxes, and
plant depreciation.
After classifying activities into one of the four categories, the costs associated with the unit-level, batch-
level, and product-level categories are assigned to products using cost drivers that reflect the cause-and-
effect relationship between activity consumption and cost. Facility-level costs are viewed as fixed costs
and are not traceable to individual products. In practice, most firms allocate these costs to products even
though no cost driver is available. Because they are usually a small percentage of total costs, this
allocation probably will not have an appreciable effect on the accuracy of individual product costs. The
product cost categories should be reported separately so managers can focus on activities by category and
choose those categories for cost reduction that have the greatest potential impact.
Teaching hint: Exercise 4.19 is a good example for a class discussion in classifying activities and in
preparing an activity dictionary.
C. Reducing the Size and Complexity of an ABC System
In principle, ABC requires an activity rate for each activity. An organization may have hundreds of
different activities and potentially hundreds of activity rates as well. Although information technology is
capable of handling this volume, there is merit to reducing the number of application rates as long as
accuracy is not compromised. Fewer rates may produce more readable and manageable product cost
reports, reducing the perceived complexity of an activity-based costing system and increasing its
likelihood of acceptance. Efforts to simplify ABC have been proposed that involve either before-the-fact
simplification or after-the-fact simplification. Some ABC systems are introduced as a solution for
companies wishing to implement ABC without having to create complex data collection systems.
D. Before-the-Fact Simplification: TDABC
Time-Driven Activity-Based Costing (TDABC) is a before-the-fact simplification method that simplifies
Stage 1 by eliminating the need for detailed interviewing and surveying to determine resource drivers.
First, it calculates the total operating cost of a department or process for supplying resource capacity.
Second, it calculates a capacity cost rate by dividing the total resource cost by the practical capacity.
Third, it estimates the time to perform one unit of activity. Cornerstone 4.7 (p. 166) illustrates the basic
concepts of TDABC.
An approximately relevant ABC system may be useful for those firms where a few activities account for
most of the overhead costs. To implement, a company would analyze the activity accounting system and
then use only the most expensive activities for ABC assignment. The costs of all other activities can be
added to the cost pools of the expensive activities. The costs of the most expensive activities are still
assigned using appropriate cause-and-effect drivers, while the added costs are assigned somewhat
arbitrarily. The advantages of the approach are that it is simple, easy to understand, and easy to
implement. It also often provides a good approximation of ABC costs. Cornerstone 4.8 (p. 170)
illustrates the approximately relevant ABC concept.
An equally accurate reduced ABC system uses consumption ratios to reduce the number of drivers. This
method is useful whenever the number of activities is greater than the number of products. The
consumption ratio refers to the proportion of an activity used by each product. The steps that should be
followed to achieve the desired simplification are:
1. Calculate the expected global consumption ratio (ABC product cost/Total overhead cost).
3. Form equations by multiplying the consumption ratios of each product by the allocation weights
and set this equal to the product’s consumption ratio.
5. Use the weights to form the cost pools that will duplicate the larger ABC system cost
assignments.
Cornerstone 4.9 (p. 172) illustrates the equally accurate reduced ABC concept.
Teaching hint: Exercises 4.21 and 4.22 might be useful to work in class. Exercise 4.21 addresses an
approximately relevant ABC system, while Exercise 4.22 uses the data derived in Exercise 4.21 to create
an equally accurate reduced ABC system.
ABC promises greater costing accuracy, improved decision making, enhanced strategic planning, and
improved insight concerning activity management. These benefits are not obtained without costs,
however. Firms have operated for decades with the simpler, traditional, unit-based costing systems.
Therefore, when to adopt an ABC system becomes an important issue.
IV. INFORMATION ABOUT EXERCISES, PROBLEMS, AND CASES
Exercises and problems are described on the following two pages according to coverage of content,
learning objective(s), and level of difficulty. The time required to solve the problems is roughly
proportional to the level of difficulty.
In general, basic exercises/problems are fairly simple and straightforward. The text material is relatively
brief; only one or two concepts are covered. Basic exercises and problems should take about 15 to 20
minutes each.
Moderate exercises/problems may take longer and involve more concepts. These problems may have a
“twist” and require more thought. Moderate exercises and problems may take 20 to 40 minutes each.
Challenging problems are more comprehensive and may cover more concepts. The text material is
relatively longer and may include some ambiguity. Challenging problems may take 60 to 90 minutes
each.
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Topic
Learning
Objective
Degree of
Difficulty
CS 4.1
Applied Overhead and Unit Overhead Cost: Plantwide
Rates
LO 1
Basic
CS 4.2
Overhead Variances and Their Disposal
LO 1
Basic
CS 4.3
Departmental Overhead Rates
LO 1
Basic
CS 4.4
Consumption Ratios
LO 2
Basic
CS 4.5
Activity-Based Product Costing
LO 2
Basic
CS 4.6
Assigning Cost of Resources to Activities, Unbundling
the General Ledger
LO 3
Basic
CS 4.7
Simplifying the ABC System: TDABC
LO 4
Basic
CS 4.8
Simplifying the ABC System: Approximately Relevant
ABC Systems
LO 4
Basic
CS 4.9
Simplifying the ABC System: Equally Accurate
Reduced ABC Systems
LO 4
Basic
4.10
Predetermined Overhead Rate, Applied Overhead, Unit
Cost
LO 1
Basic
4.11
Predetermined Overhead Rate, Application of
Overhead
LO 1
Basic
4.12
Predetermined Overhead Rate, Overhead Variances,
Journal Entries
LO 1
Basic
4.13
Departmental Overhead Rates
LO 1
Basic
4.14
Drivers and Product Costing Accuracy
LO 2
Basic
4.15
Multiple versus Single Overhead Rates, Activity
Drivers
LO 3, 4
Basic
4.16
Activity-Based Costing, Activity Identification,
Activity Dictionary
LO 3
Basic
4.17
Assigning Resource Costs to Activities, Resource
Drivers, Primary and Secondary Activities
LO 3
Basic
4.18
Assigning Resource Costs to Activities, Resource
Drivers, Primary and Secondary Activities
LO 3
Moderate
4.19
Process Identification and Activity Classification
LO 3
Moderate
4.20
TDABC
LO 4
Moderate
4.21
Approximately Relevant ABC
LO 4
Moderate
4.22
Equally Accurate Reduced ABC System
LO 4
Moderate
4.23
CPA-Type Exercise
LO1
Basic
4.24
CPA-Type Exercise
LO3
Basic
4.25
CPA-Type Exercise
LO3
Basic
4.26
CPA-Type Exercise
LO3
Basic
4.27
CPA-Type Exercise
LO3
Basic
4.28
Predetermined Overhead Rates, Overhead Variances,
Unit Costs
LO 1
Moderate
4.29
Unit-Based versus Activity-Based Costing
LO 2
Moderate
4.30
ABC, Resource Drivers, Service Industry
LO 2, 3
Moderate
4.31
Activity-Based Costing, Service Firm
LO 2, 3
Moderate
4.32
Product Costing Accuracy, Corporate Strategy, ABC
LO 2, 3
Challenging
4.33
Time-Driven Activity-Based Costing Compared to
ABC, Stage 1
LO 4
Challenging
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Topic
Learning
Objective
Degree of
Difficulty
4.34
Activity-Based Costing, Reducing the Number of
Drivers and Equal Accuracy
LO 2, 4
Challenging
4.35
Approximately Relevant ABC
LO 2
Challenging
4.36
Product Costing Accuracy, Plantwide and
Departmental Rates, ABC
LO 1, 2, 4
Challenging
4.37
Cyber Research Case
LO 4
Challenging
LIST OF ILLUSTRATIONS
Illustration
Topic
Exhibit 4.1
Unit-Based Product Costing Model
Exhibit 4.2
Product Costing Data
Exhibit 4.3
Unit Product Cost: Plantwide and Departmental Rates
Exhibit 4.4
Comparison of Unit Costs
Exhibit 4.5
Activity-Based Costing Model
Exhibit 4.6
Design Steps for an ABC System
Exhibit 4.7
Sample Activity Inventory
Exhibit 4.8
Activity Dictionary: Cardiology Unit
Exhibit 4.9
Unbundling of General Ledger Costs
Exhibit 4.10
Bill of Activities: Cardiology Unit
Exhibit 4.11
Assigning Costs: Final Cost Objects
Exhibit 4.12
Data for Patterson Company