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Chapter 9
Activity-Based Costing
Learning Objectives
1. Understand the potential effects of using externally reported product costs for decision
making.
2. Explain how a two-stage product costing system works.
3. Compare and contrast plantwide and department allocation methods.
4. Explain how activity-based costing and a two-stage product system are related.
5. Compute product costs using activity-based costing.
6. Compare activity-based product costing to traditional department product costing methods.
7. Demonstrate the flow of costs through accounts using activity-based costing.
8. Apply activity-based costing to marketing and administrative services.
9. Explain how time-driven activity-based costing works.
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Chapter Overview
I. REPORTED PRODUCT COSTS AND DECISION MAKING
II. TWO-STAGE COST ALLOCATION
• Two-Stage Cost Allocation and the Choice of Cost Drivers
• Plantwide Versus Department-Specific Rates
• Choice of Cost Allocation Methods: A Cost-Benefit Decision
III. ACTIVITY-BASED COSTING
• Developing Activity-Based Costs
o Identifying Activities that Use Resources
IV. COST HIERARCHIES
V. ACTIVITY-BASED COSTING ILLUSTRATED
• Step 1: Identify the Activities
• Step 2: Identify the Cost Drivers
• Step 3: Compute the Cost Driver Rates
• Step 4: Assign Costs Using Activity-Based Costing
• Unit Costs Compared
VI. COST FLOW THROUGH ACCOUNTS
VII. CHOICE OF ACTIVITY BASES IN MODERN PRODUCTION SETTINGS
• Complexity as a Resource-Consuming Activity
VIII. ACTIVITY-BASED COSTING IN ADMINISTRATION
IX. WHO USES ABC?
X. TIME-DRIVEN ACTIVITY-BASED COSTING
• Developing Time-Driven Activity-Based Costs
o The Costs of Resources Supplied
o The Time Required for Each Activity
o Calculating the Costs of the Activities
• Extensions of TDABC
o Cost Drivers other than Time
o Time Equations
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Chapter Outline
LO 9-1 Understand the potential effects of using reported product costs for
decision making.
REPORTED PRODUCT COSTS AND DECISION MAKING
• Dropping a Product
o Managers may consider dropping a product if the reported costs of producing it have
risen more rapidly than the price charged for it, and the product line margins have fallen
to unacceptable levels.
▪ The decision will be based on the impact it has on reported product costs.
o Product costs are used primarily for developing inventory balances and cost of goods sold
amounts for financial reporting.
allocating manufacturing overhead costs to products.
o If managers rely on the cost accounting system to make the decision to keep or drop a
product, the cost system provides potentially inaccurate unit costs.
▪ Exhibit 9.1 shows the assignment of costs to two products using an allocation base of
direct labor hours; management is considering dropping the C-27s; the cost savings
appear to be $198,400.
▪ Exhibit 9.2 shows the assignment of costs assuming that the C-27 is dropped and only
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o Once a predetermined overhead rate is calculated, it is applied as if all overhead costs
were variable with respect to the allocation base, which is not true in most cases for two
reasons:
▪ Some of the overhead items could be fixed, and reducing the number of units
• The Death Spiral
o If managers attempt to recover the costs with a smaller number of units, they are likely to
meet resistance in the market, resulting in demand for even fewer units. With the smaller
production, the reported product costs increase even more.
o The death spiral is a process that begins by attempting to increase price to meet higher
reported product costs, losing market, reporting still higher costs, and so on, until the firm
is of business.
▪ Death spiral may occur when the demand for a product falls for some reason or a
major customer leaves.
• The decline in demand will lead to higher reported costs.
they too will reduce or eliminate their demand.
▪ The death spiral can occur even in firms with increasing demand.
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them idle because of reduced demand.
LO 9-2 Explain how a two-stage product costing system works.
TWO-STAGE COST ALLOCATION
• The basic approach in product costing is to allocate costs in the cost pools to the individual
cost objects, which are the products or services of interest.
o We assign (or allocate) these costs to the individual cost objects by using appropriate cost
allocation bases or cost drivers.
▪ Exhibit 9.4 illustrates a cost flow diagram for a two-stage cost allocation system.
• The first-stage cost objects are the overhead accounts, such as supplies,
depreciation, and so on.
• An alternative view of the two-stage cost allocation process is as follows:
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• Two-Stage Cost Allocation and the Choice of Cost Drivers
o Complexity and special handling required during production may distort the product
costs reported when the traditional costing method is used. The two-stage system, on the
other hand, allows the firm to develop product costing systems that more closely align the
allocation of costs with the use of resources.
▪ The Port Arthur manufacturing facility of Joplin Industries makes two types of digital
cameras.
▪ Exhibit 9.6 shows the data on the operations of the Port Arthur manufacturing facility
for the third quarter by product line and in total.
▪ Exhibit 9.7 shows the unit product cost report.
• When the production managers they studied the cost report, they were surprised
that the J40X was only about twice as costly to produce as the J25P. That seemed
too low.
▪ Company policies called for initial price guidelines for products to include a 30
percent markup over full cost.
• The marketing managers complained that, although the J40X was selling very
well even with prices quoted above the guidelines, the J25P was meeting very
heavy price resistance and was being discounted well below the guidelines to sell.
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o Janis decided to experiment with a two-stage cost allocation system.
▪ In the first stage, the overhead costs would be allocated to the two buildings
(departments).
▪ See Exhibit 9.8 for the cost flow diagram that the cost accounting manager developed
for the cost system.
▪ Exhibit 9.9 shows the data on the operations of the Port Arthur manufacturing facility
for the third quarter by product line and in total using the new two-stage cost
allocation system.
LO 9-3 Compare and contrast plantwide and departmental allocation
methods.
• Plantwide Versus Department-Specific Rates
o The plantwide allocation method is an allocation method that uses one cost pool for the
entire plant; it uses one overhead allocation rate, or one set of rates, for all of a plant’s
departments.
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o Plantwide allocation is the single-stage approach first described in Chapter 6.
▪ Accounting for overhead is simple.
• All actual overhead costs are recorded in one cost pool in the Manufacturing
Overhead Control account for the plant without regard to the department or
activity that caused them.
▪ Companies using a single plantwide rate generally use an allocation base related to
the volume of output, such as direct labor-hours, machine-hours, units of output, or
materials costs.
• Example 1: A company estimated its annual overhead costs to be $240,000. The
company uses the plantwide allocation method to assign overhead costs to its two
products, AA and BB, using machine hours, budgeted to be 12,000 for the coming
year. Then the single plantwide rate would be $20 (= $240,000 ÷ 12,000 machine
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▪ Companies using a single plantwide rate generally use an allocation base related to
the volume of output, such as direct labor hours, machine hours, units of output, or
materials costs.
• Choice of Cost Allocation Methods: A Cost-Benefit Decision
o The choice of whether to use a plantwide rate or departmental rates depends on the
products and the production process.
LO 9-4 Explain how activity-based costing and a two-stage product system
are related.
ACTIVITY-BASED COSTING
• Activity-based costing (ABC) is a two-stage product costing method that first assigns costs
to activities and then allocates them to products based on the each product’s consumption of
activities.
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• Developing Activity-Based Costs
o Activity-based costing involves the following four steps:
▪ Identify the activities that consume resources and assign costs to them.
o Identifying Activities that Use Resources
▪ Often the most interesting and challenging part of the exercise is identifying activities
that use resources because doing so requires understanding all the activities required
to make a product.
o Choosing Cost Drivers
▪ Exhibit 9.10 provides several examples of the types of cost drivers that most
companies use.
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▪ Cost drivers are selected based on three criteria:
• Causal relation. Ideally, choose a cost driver that causes the cost. This is the best
cost drive available.
o Computing a Cost Rate per Cost Driver
▪ For any indirect cost, a predetermined rate can be computed as follows:
o Assigning Costs to Products
▪ The final step in the activity-based costing system is to assign the activity costs to
products.
• We do this just as we have done for the other product costing systems we have
considered. We multiply the cost driver rates by the number of units of the cost
driver in each product.
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COST HIERARCHIES
• A cost hierarchy classifies cost drivers by general dimensions or levels of activity
o A cost hierarchy represents a classification of cost drivers into general levels of activity,
volume, batch, product, etc.
▪ Four possible levels of cost hierarchy are:
o An activity-based costing system can have fewer than four levels in the hierarchy or it
can have more than four.
▪ The important factor is whether the cost drivers for the activities reflect the cost
LO 9-5 Compute product costs using activity-based costing.
ACTIVITY-BASED COSTING ILLUSTRATED
In this section, the reported product costs under activity-based costing are computed in a
comprehensive example.
• Step 1: Identify the Activities
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▪ The information is presented in Exhibit 9.13.
• Step 3: Compute the Cost Driver Rates
• Step 4: Assign Costs Using Activity-Based Costing
o Based on these interviews, the cost accountant develops a cost flow diagram, which
o 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.
• 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.
LO 9-6 Compare activity-based product costing to traditional department
product costing methods.
• Unit Costs Compared
o As summarized in Exhibit 9.17, both the plantwide rate and the department rate systems
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o Important points about activity-based costing:
LO 9-7 Demonstrate the flow of costs through accounts using activity-based
costing.
COST FLOW THROUGH ACCOUNTS
• 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.
CHOICE OF ACTIVITY BASES IN MODERN PRODUCTION SETTINGS
• 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.
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o 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.
LO 9-8 Apply activity-based costing to marketing and administrative
services.
ACTIVITY-BASED COSTING IN ADMINISTRATION
• Activity-based costing can be applied to administrative activities. The principles and methods
are the same as those discussed earlier.
o Activity-based costing in administration involves these steps:
▪ Identify the activities that consume resources.
o 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.
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WHO USES ABC?
• Exhibit 9.20 lists some of the organizations that have been cited as using ABC for at least
some of their operations.
• There are three problems with identifying users of ABC:
TIME-DRIVEN ACTIVITY-BASED COSTING
• A modified version of ABC that addresses the costs of maintaining an ABC system has been
developed.
o This modified approach to ABC is called time-driven activity-based costing (TDABC).
• Developing Time-Driven Activity-Based Costs
o With TDABC, the manager only needs to determine:
o The Costs of Resources Supplied
▪ The number of people in the department are identified as are the activities that they
perform.
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o The Time Required for Each Activity
o Calculating the Costs of the Activities
▪ We start by calculating a cost driver rate.
• The difference between the actual departmental cost and the total cost of activity
for the department is due to idle time and represents the excess capacity in the
department.
▪ How can these calculations help the cost accountant and other managers?
• Extensions of TDABC
o TDABC is all based on a single measure for each activity: time. We can modify this
somewhat without adding all of the complications of a regular ABC system.
o Cost Drivers other than Time
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o Time Equations
▪ The TDABC system that we have developed so far assumes all orders that go through
any one of the activities take the same amount of time. We can extend the TDABC
system to allow for differences among orders by using what are called time equations.
▪ TDABC provides an alternative to an unmodified ABC system that might be too
costly to maintain given the benefits the ABC system provides.
Matching
A.
Activity-based costing(ABC)
E.
Department allocation method
B.
Cost driver
F.
Plantwide allocation method
C.
Cost hierarchy
G.
Time equations
D.
Death spiral
_____ 1. Classification of cost drivers into general levels of activity, volume, batch, product,
and so on.
_____ 2. Process that begins by attempting to increase price to meet reported product costs,
losing market, reporting still higher costs, and so on, until the firm is out of business.
_____ 3. Allocation method using one cost pool for the entire plant. It uses one overhead
allocation rate, or one set of rates, for all of a plant’s departments.
_____ 4. Allocation method that has a separate cost pool for each department, which has its
own overhead allocation rate or set of rates.
_____ 5. Costing method that first assigns costs to activities and then assigns them to products
based on the products’ consumption of activities.
_____ 6. Factor that causes, or “drives,” costs.
_____ 7. Allow managers to adjust the times for orders with different characteristics.
Matching Answers
1. C
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Multiple Choice
1. A death spiral:
a. Happens when managers try to set higher prices to recover increasing reported costs.
b. Occurs when capacity is reduced.
c. May happen when the market share is gaining.
d. Has to do with costs other than overhead.
2. In a two-stage cost allocation system:
a. The first stage involves assigning overhead costs to cost pools.
b. The cost pools may be departments.
c. Each cost pool requires an allocation rate.
d. All of the above.
3. One of the cost pools at Toylands Store is the Personnel department that provides recruiting
and training for Sales and Administrative departments and has an estimated overhead of
$45,000. Sales department has 12 employees and Administrative department has 3. How
much of the overhead cost of the Personnel department should be allocated to the Sales
department?
a. $9,000
b. $22,000
c. $36,000
d. $38,000
Use the following information to answer questions 4 through 7:
The accountant of Toylands Manufacturing collected the following information:
Activity
Overhead costs
Cost driver
Product X1
Product X2
Machining Dept.
Setup
$200,000
Number of setups
200
50
Machining
700,000
Machine hours
20,000
15,000
Packaging Dept.
Assembly
300,000
Direct labor hours
40,000
60,000
Inspection
180,000
Number of inspections
120
60
4. If Toylands Manufacturing uses a plantwide rate based on direct labor hours to allocate
overhead costs, how much is product X1’s share of overhead?
a. $324,000
b. $416,000
c. $638,000
d. $552,000
5. If the department allocation method is used, what is the overhead rate for the Machining
department with machine hours as the allocation base?
a. $39.43 per machine hour
b. $13.71 per machine hour
c. $20 per machine hour
d. $25.71 per machine hour
6. When activity-based costing is used, what is product X2’s share of the Packaging department
overhead costs?
a. $270,000
b. $240,000
c. $580,000
d. $380,000
7. When activity-based costing is used, how much of the overhead cost is allocated to product
X1?
a. $580,000
b. $800,000
c. $950,000
d. $670,000
8. Which of the following is true of activity-based costing relative to traditional costing?
a. It requires less detailed cost measures.
b. Accounting department alone can handle all the work.
c. It needs more cost pools.
d. It is less costly to implement.
9. Activity-based costing can be beneficial to:
a. Banks.
b. Nonprofit organizations.
c. Law firms
d. All of the above.
10. Low-volume products, relative to high-volume ones:
a. Entail less complexity during production.
b. Often require more machine setups.
c. Will not disrupt the production flow of high-volume items.
d. Are usually overcosted.
11. What are the steps required for activity-based costing in administration?
a. Identify activities that consume resources.
b. Identify cost drivers associated with activities.
c. Compute activity rate per cost driver.
d. All of the above.
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12. Which of the following statements is incorrect?
a. Nowadays, labor is still a major product cost in many companies, especially service
organizations.
b. When the labor component drops, it is prudent to allocate overhead based on direct labor.
c. When the labor component drops, the overhead rate based on direct labor tends to
increase substantially.
d. When all resources are used proportionally, allocation of overhead based on machine
hours is acceptable.
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Multiple Choice Answers
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Demonstration Problem 1
ABC Manufacturing, Inc. produces three gadgets (Ace, Best, and Champ) in two departments,
Machining and Assembly. Each product requires one hour of direct labor for completion. The
following table provides production and cost data for the year.
Ace
Champ
Number of units
25,000
5,000
Machine hours
2,500
2,000
Direct materials
$1,000,000
$275,000
Direct labor
375,000
75,000
Overhead
Machining
Assembly
Total overhead
Tot costs
Required:
Use the plantwide allocation method to determine the unit cost for each product using each of the
following allocation bases:
1. Machine hours
2. Direct labor costs
Demonstration Problem 1 – Solution
Part 1
The overhead allocation rate when machine hours were used as the allocation base was $225 per
machine hour (= $1,350,000 ÷ 6,000 machine hours). The unit cost report would show the
following:
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Demonstration Problem 2
(Continued from Demonstration Problem 1)
Considering the nature of the production processes, the cost accountant of ABC Manufacturing
decided to experiment with the department-specific allocation approach and determined that the
Machining Department can use machine hours as the allocation base for overhead assignment
while the Assembly Department can use direct labor costs instead.
Required:
Use the department allocation method to determine the unit cost for each product.
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Demonstration Problem 2 – Solution
For the Machining Department, the overhead allocation rate would be $150 per machine hour (=
$900,000 ÷ 6,000 machine hours).
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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.
Cost Driver Volume
Activity
Cost Driver
Ace
Best
Champ
Total
Machining:
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
Overhead Costs
Machining:
Setup
$ 150,000
Machining
750,000
Total Machining department overhead
900,000
Assembly:
Assembly
360,000
Inspection
90,000
Total Assembly department overhead
450,000
Total overhead costs
$1,350,000
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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Demonstration Problem 3 – Solution
Part 1
Activity
Cost drive rate
Machining:
Part 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
Applied overhead
Setup ($600 per setup)
Machining ($125 per machine hour)
Assembly ($8 per direct labor hour)
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
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)
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Demonstration Problem 3 – Solution, continued
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
Ace
Best
Champ
Plantwide rate based on machine hours
$77.50
$67.50
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
Part 3
In summary, a comparison of the methods used to calculate unit cost for each product is
presented below.
Number of setups per unit
0.005
0.005
Machine hours per unit
Direct labor hours per unit
Number of inspections per unit
0.002
0.005
Direct materials
$40.00
$30.00
$55.00
Direct labor
15.00
15.00
15.00
Applied overhead
Setup ($600 per setup)
Machining ($125 per machine hour)
12.50
12.50
50.00
Assembly ($8 per direct labor hour)
Inspection ($900 per inspection)
Unit cost
$80.30
$70.00