Chap 003

Learning Objective 1Understand the basic approach in activity-based costing and how it differs from conventional costing.3-*

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.Assigning Overhead Costs to Products3-*

Plantwide Overhead RatePlantwide Overhead Rate A single overhead rate used throughout an entire factory. Direct labor has often been used as the allocation base for overhead because: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. 3-*

Today, direct labor may no longer be a satisfactory base for allocation of overhead.Most companies sell a large variety of products that consume differing amounts of overhead.As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of the new overhead costs may not be correlated with direct labor.Technology advancements have reduced the cost and complexity of gathering diverse sources of data. Plantwide Overhead RateA plantwide overhead allocation system may not be optimal for many companies in todays business environment.3-*

Departmental Overhead RatesMachining DepartmentShipping DepartmentAssembly DepartmentMany companies have a system in which each department has its own overhead rate.The allocation base depends on the nature of the work performed in each department. In the machining department, overhead may be based on machine-hours, but in the assembly department, overhead may be based on labor-hours.3-*

Departmental rates will not correctly assign overhead in situations where a company has a range of products and complex overhead costs.Departmental Overhead Rates3-*

A number of allocation bases are used for assigning costs to products.Activity-Based Costing (ABC)3-*

Activity-Based Costing (ABC)Cost Objects(e.g., products and customers)3-*

ActivityAn event that causes the consumption of overhead resourcesSetting up machinesExamples of ActivitiesAdmitting hospital patientsOpening a bank accountBilling customersActivity-Based Costing (ABC)3-*

Activity-Based Costing (ABC)3-*

Activity-Based Costing (ABC)For each activity in isolation, this system works exactly like the job-order costing system described in Chapter 2.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.3-*

Designing an Activity-BasedCosting SystemThe challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs.Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organizations resources.3-*

Related activities are frequently combined to reduce the amount of detail and record-keeping costs.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.Designing an Activity-BasedCosting System3-*

Hierarchy of Activities3-*

Sheet1

LevelActivitiesActivity Measure

Unit-levelProcessing units on machinesMachine-hours

Processing units by handDirect labor-hours

Consuming factory suppliesUnits produced

Batch-levelProcessing purchase ordersPurchase orders processed

Processing production ordersProduction orders processed

Setting up equipmentNumber of setups

Handling materialsPounds of material handled

Product-levelTesting new productsHours of testing time

Administering parts inventoriesNumber of part types

Designing productsHours of design time

Facility-levelGeneral factory administrationDirect labor-hours

Plant building and groundsDirect labor-hours

Sheet2

Sheet3

Graphic Example of Activity-Based CostingVarious Manufacturing Overhead Costs3-*

Graphic Example ofActivity-Based CostingVarious Manufacturing Overhead Costs3-*

Using Activity-Based CostingComtek Sound, Inc. Comtek Sound, Inc. makes two products: CD players and DVD players. The company has been losing bids to supply CD players, its main product, to lower priced competitors. The company has been winning all bids to supply DVD players, its secondary product. 3-*

Using Activity-Based CostingComtek Sound, Inc. For the current year, Comtek has budgeted sales of 50,000 DVD units and 200,000 CD units. Comteks traditional cost system applies manufacturing overhead to products based on direct labor hours. Both products require two direct labor-hours to complete, for a total of 500,000 direct labor hours.3-*

Sheet1

Hours

DVDs: 50,000 units @ 2 hours per unit =100,000

CDs: 200,00 units @ 2 hours per unit =400,000

Total direct labor-hours500,000

Sheet2

Sheet3

Using Activity-Based CostingComtek Sound, Inc. Unit costs for materials and labor are:3-*

Sheet1

DVDCD

UnitsUnits

Direct materials$90$50

Direct Labor$20$20

Sheet2

Sheet3

Total manufacturing overhead costs for the current year are estimated to be $10,000,000. The company develops the following overhead rate based upon labor-hours:Direct Labor-Hours as a Base3-*

Direct Labor-Hours as a BaseSince each product requires two hours of direct labor, $40 of overhead is assigned to each product. 3-*

Sheet1

DVD UnitCD Unit

Direct materials$90$50

Direct labor2020

Manufacturing overhead4040

(2 DLHs x $20 per DLH)

Unit product cost$150$110

Sheet2

Sheet3

Learning Objective 2Compute activity rates for an activity-based costing system.3-*

The ABC project team at Comtek has developed the following basic information.Computing Activity Rates3-*

Sheet1

Activity and Activity MeasuresEstimated Overhead CostExpected Activity

TotalDVDCD

Labor related (DLH)$800,000500,000100,000400,000

Machine related (MH)2,100,0001,000,000300,000700,000

Machine setups (setups)1,600,0004,0003,0001,000

Production orders (orders)3,150,0001,200800400

Parts administration (part types)350,000700400300

General factory (MH)2,000,0001,000,000300,000700,000

$10,000,000

Sheet2

Sheet3

We can calculate the following activity rates:Using the new activity rates, lets assign overhead to the two products based upon expected activity.Computing Activity Rates3-*

Sheet1

Activity and Activity MeasuresEstimated Overhead CostTotal Expected ActivityActivity Rate

Labor related (DLHs)$800,000500,000=$1.60per DLH

Machine related (MHs)2,100,0001,000,000=2.10per MH

Machine setups (setups)1,600,0004,000=400.00per setup

Production orders (orders)3,150,0001,200=2,625.00per order

Parts administration (part types)350,000700=500.00per part type

General factory (MHs)2,000,0001,000,000=2.00per MH

$10,000,000

Sheet2

Sheet3

Learning Objective 3Compute product costs using activity-based costing.3-*

Computing Overhead Cost per UnitDVD Units3-*

Sheet1

Activity and Activity MeasuresExpected ActivityActivity RateAmount

Labor related (DLHs)100,000$1.60=$160,000

Machine related (MHs)300,0002.10=630,000

Machine setups (setups)3,000400.00=1,200,000

Production orders (orders)8002,625.00=2,100,000

Parts administration (part types)400500.00=200,000

General factory (MHs)300,0002.00=600,000

Total overhead cost assigned$4,890,000

Number of units produced50,000

Overhead cost per unit$97.80

Sheet2

Sheet3

Computing Overhead Cost per UnitCD Units3-*

Sheet1

Activity and Activity MeasuresExpected ActivityActivity RateAmount

Labor related (DLHs)400,000$1.60=$640,000

Machine related (MHs)700,0002.10=1,470,000

Machine setups (setups)1,000400.00=400,000

Production orders (orders)4002,625.00=1,050,000

Parts administration (part types)300500.00=150,000

General factory (MHs)700,0002.00=1,400,000

Total overhead cost assigned$5,110,000

Number of units produced200,000

Overhead cost per unit$25.55

Sheet2

Sheet3

Note that the unit product cost of a CD unit decreased from $110 to $95.55 . . . .. . . . while the unit cost of a DVD unit increased from $150 to $207.80.Comparing the Two Approaches3-*

Sheet1

Activity-Based CostingDirect-Labor Costing

DVD UnitCD UnitDVD UnitCD Unit

Direct material$90.00$50.00$90.00$50.00

Direct labor20.0020.0020.0020.00

Manufacturing overhead97.8025.5540.0040.00

Unit product cost$207.80$95.55$150.00$110.00

Sheet2

Sheet3

Learning Objective 4Contrast the product costs computed under activity-based costing and conventional costing methods.3-*

Comparing the Two ApproachesThe ABC system assigns $14.45 less overhead than the traditional system to each CD player.3-*

Sheet1



Direct material$90.00$50.00$90.00$50.00

Direct labor20.0020.0020.0020.00



Sheet2

Sheet3

Comparing the Two ApproachesThe ABC system assigns $57.80 more overhead than the traditional system to each DVD player.3-*

Sheet1



Direct material$90.00$50.00$90.00$50.00

Direct labor20.0020.0020.0020.00



Sheet2

Sheet3

When a company implements activity-based costing, overhead cost often shifts from high-volume to low-volume products with a higher unit product cost resulting for the low-volume products.Low-volume productShifting of Overhead Cost3-*

Sheet1



Direct material$90.00$50.00$90.00$50.00

Direct labor20.0020.0020.0020.00



Sheet2

Sheet3

High-volume productShifting of Overhead CostThe traditional system assigns the same amount of all overhead costs to each CD or DVD player ($40 per unit).3-*

Sheet1



Direct material$90.00$50.00$90.00$50.00

Direct labor20.0020.0020.0020.00



Sheet2

Sheet3

Shifting of Overhead Cost1. Compute the number of units processed per production order for each product.3-*

Sheet1

DVD UnitsCD Units

Number of units produced per year50,000200,000

Number of production orders issued per year800400

Number of units processed per production order62.5500

Sheet2

Sheet3

Shifting of Overhead Cost2. Compute production order cost per unit for each product.Notice, the costs are being shifted from the high volume CD players to the low volume DVD players.3-*

Sheet1

DVD UnitsCD Units

Cost to issue a production order$2,625$2,625

Average number of units processed per

production order62.5500

Production order cost per unit$42.00$5.25

Sheet2

Sheet3

Activity-Based Management Focuses on managing activities to eliminate waste and reduce delays and defects.Targeting Process ImprovementsAn ABC system can help identify areas where the company can benefit from improving its current processes.3-*

The first step in any improvement program is deciding what to improve.Targeting Process Improvements3-*

Benefits of Activity-Based Costing ABC improves the accuracy of product costing by:Increasing the number of cost pools used to accumulate overhead costs.Using activity cost pools that are more homogeneous than departmental cost pools.Assigning overhead costs using activity measures that cause those costs, rather than relying solely on direct labor hours.Activity-based costing also highlights activities that could benefit most from process improvement efforts, such as Six Sigma.3-*

Costs of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when:Products differ substantially in volume, batch size, and in activities required.Conditions have changed substantially since the existing cost system was established.Overhead costs are high and increasing and no one seems to understand why.Management does not trust the existing cost system and it ignores data from it when making decisions. Limitations of Activity-Based Costing 3-*

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. Activity-Based CostingCritical AssumptionFor example, managers should be particularly alert to product costs that contain allocated facility-level costs.3-*

Modifying the ABC Model The illustrations in the chapter assume that ABC is being used for external reporting purposes. If the system is used for internal decision-making purposes, two important modifications should be made: 1. Selling and administrative costs should be assigned to products, where appropriate. 2. Facility-level costs should be removed from product costs. 3-*

Learning Objective 5Record the flow of costs in an activity-based costing system.3-*

Sarvik Company uses activity-based costing. The company has five cost pools shown below.Cost Flows in an ABC System3-*

Sheet1

Activity Cost PoolActivity MeasureEstimated Overhead CostExpected Activity

Machine relatedMachine hours$175,0005,000MHs

Purchase ordersNumber of orders63,000700orders

Machine setupsNumber of setups92,000460setups

Product testingNumber of tests160,000200tests

General factoryDirect labor hours300,00025,000DLHs

$790,000

Sheet2

Sheet3

Activity rates are determined as follows:Cost Flows in an ABC System3-*

Sheet1

Activity Cost PoolEstimated Overhead CostTotal Expected ActivityActivity Rate

Machine related$175,0005,000 MHs=$35per MH

Purchase orders63,000700 orders=$90per order

Machine setups92,000460 setups=$200per setup

Product testing160,000200 tests=$800per test

General factory300,00025,000 DLH=$12per DLH

$790,000

Sheet2

Sheet3

Overhead is applied on the basis of actual activities during the year.Cost Flows in an ABC System3-*

Sheet1

Activity Cost PoolActivity RateActual ActivityApplied Overhead Cost

Machine related$35/MH4,600 MHs=$161,000

Purchase orders$90/order800 orders=72,000

Machine setups$200/setup500 setups=100,000

Product testing$800/test190 tests=152,000

General factory$12/DLH23,000 DLHs=276,000

Total Overhead Applied$761,000

Sheet2

Sheet3

Selected transactions recorded by the company:Raw materials purchased on account, $915,000.Raw materials used in production, $900,000 ($810,000 direct and $90,000 indirect).Factory labor costs, $370,000 ($95,000 direct and $275,000 indirect).Depreciation of factory assets, $180,000.Miscellaneous manufacturing overhead costs incurred on account, $230,000.Manufacturing overhead applied, $761,000.Goods costing $1,650,000 were manufactured.Cost Flows in an ABC System3-*

The following journal entries would be used to record transactions (a) and (b).Cost Flows in an ABC System3-*

Sheet1

DescriptionDebitCredit

a.Raw Materials915,000

Accounts Payable915,000

b.Work in Process810,000

Manufacturing Overhead90,000

Raw Materials900,000

Sheet2

Sheet3

The following journal entries would be used to record transactions (c) and (d).Cost Flows in an ABC System3-*

Sheet1


c.Work in Process95,000


Salaries and Wages Payable370,000

d.Manufacturing Overhead180,000

Accumulated Depreciation180,000

Sheet2

Sheet3

The following journal entry would be used to record transaction (e).Cost Flows in an ABC System3-*

Sheet1


e.Manufacturing Overhead230,000

Cash/Accounts Payable230,000

Sheet2

Sheet3

The following journal entry would be used to record transaction (f).Cost Flows in an ABC System3-*

Sheet1


f.Work in Process761,000


Sheet2

Sheet3

The following journal entry would be used to record transaction (g).Cost Flows in an ABC System3-*

Sheet1


g.Finished Goods1,650,000

Work in Process1,650,000

Sheet2

Sheet3

Underapplied Overhead CostsCost Flows in an ABC System3-*

Cost Flows in an ABC SystemThe flow of costs through Raw Materials, Work in Process, and other accounts is the same under activity based costing.The only difference in activity based costing is that more than one predetermined overhead rate is used to apply costs to products.3-*

End of Chapter 33-*

Chapter 3: System Design: Activity Based Costing.

Overhead costs cannot be easily traced to products. Using a plantwide predetermined overhead rate as described in chapter 2 is simple, but using such a rate 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.3-*Learning objective number 1 is to understand the basic approach in activity-based costing and how it differs from conventional costing.

3-*When cost systems were developed in the 1800s, the emphasis was on simplicity because:Cost and activity data had to be collected by hand and all calculations were done with paper and pencil.Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product.

3-*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:Direct labor information was already being recorded.Direct labor was a large component of product costs.Managers believed direct labor and overhead costs were highly correlated. 3-*Conditions have changed in three ways.Most companies sell a large variety of products that consume differing amounts of overhead.As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of these growing overhead costs may not be correlated with direct labor.Technology advancements have reduced the cost and complexity of gathering diverse sources of data.These changes suggest that a plantwide overhead allocation system may not be optimal for many companies in todays business environment.

3-*Many companies use departmental overhead rates, instead of a plantwide overhead rate. The nature of the work performed in a department will determine the departments allocation base. For example:Overhead costs in a machining department may be allocated using machine hours.Overhead costs in an assembly department may be allocated using direct labor hours.3-*Part IDepartmental overhead rates will not correctly assign overhead costs in situations where a company has a range of products and complex overhead costs. Part IIThis is because the departmental approach relies exclusively on volume-related allocation bases. Some overhead costs may be caused by factors that are not related to the volume of production.

Part IIIA more sophisticated approach, such as activity-based costing, is required to account for these other factors.

3-*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 or departmental approaches discussed thus far.3-*The basic idea of ABC is as follows. A customer order triggers a number of activities. Performing the activities consumes resources. The consumption of resources incurs costs.

3-*Part IAn activity in activity-based costing is an event that causes the consumption of overhead resources.

Part IIExamples of activities include: a. Setting up machinesb. Admitting patients to a hospitalc. Billing customersd. Opening an account at a bank

3-*Part IAn activity cost pool can be thought of as a cost bucket in which costs related to a particular activity are accumulated.

Part IIAn activity measure expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs to products and services. Activity measures may or may not be related to volume.

Part IIIAn activity rate is a predetermined overhead rate in an activity-based costing system. Each activity cost pool has its own activity rate that is used to apply overhead costs to cost objects.

3-*Part ITaking each activity in isolation, this system works exactly like the job-order costing system described in Chapter 2.

Part IIA 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.

3-*Part IIn 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.

Part IIActivities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organizations resources.

3-*Part IRelated activities are frequently combined to reduce the amount of detail and record-keeping costs. Part IIFor example, several activities may be involved in handling and moving raw materials, but these may be combined into a single activity entitled material handling.Part IIIAn activity dictionary defines each of the activities that will be included in the activity-based costing system and how the activities will be measured.

3-*A common framework for combining activities in manufacturing companies is as follows: Unit-level activities are performed each time a unit is produced. For example, providing power to run processing equipment is a unit-level activity.Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, setting up equipment and shipping customer orders are batch-level activities.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, designing or advertising a product are product-level activities. Facility-level activities are carried out regardless of which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices are facility level activities.

3-*Using activity based costing, the manufacturing overhead costs are allocated to products using a two-stage process. In the first stage, overhead costs are assigned to the six activity cost pools shown on the slide. For example, the production order cost pool may include the salaries of engineers who modify products for individual orders and the costs of scheduling and monitoring orders. In the examples and assignments in this book, the first-stage cost assignments have already been completed.

3-*In the second stage, the costs in the activity cost pools are allocated to products, using activity rates and activity measures. For example, 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. Each order would be charged $375 for production order costs. 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.

3-*Comtek Sound, Inc. makes two products: CD players and DVD players. Recently, the company has been losing bids to supply CD players, its main product, to lower priced competitors. The company has been winning all bids to supply DVD players, its secondary product. 3-*For the current year, Comtek has budgeted sales of 50,000 DVD units and 200,000 CD units. Comteks traditional cost system applies manufacturing overhead to products based on direct labor hours. Both products require two direct labor-hours to complete. The DVD players and CD players consume 100,000 and 400,000 direct labor hours, respectively, for a total of 500,000 direct labor hours.

3-*Materials cost $90 per unit for the DVD player and $50 per unit for the CD player. Labor costs $20 per unit for both the DVD player and the CD player. First, lets look at how Comtek currently applies overhead using its existing costing system based on direct labor hours.3-*Total manufacturing overhead costs for the current year are estimated to be $10,000,000. Using a traditional predetermined overhead rate based on direct labor hours, we divide $10,000,000 of estimated overhead by 500,000 direct labor hours to yield an overhead rate of $20 per direct labor hour.3-*Since each product requires two hours of direct labor, $40 of overhead is assigned to each product. Using the information provided thus far, the unit product cost of each product ($150 for DVD players and $110 for CD players) would be computed as shown.

Now lets see how we assign overhead with an ABC system.3-*Learning objective number 2 is to compute activity rates for an activity-based costing system.

3-*The ABC project team at Comtek has identified six activity cost pools and activity measures: A labor related cost pool based on the activity measure of direct labor hours; A machine related cost pool based on the activity measure of machine hours; A machine setups cost pool based on the activity measure of number of setups; A production orders cost pool based on the activity measure of number of orders; A parts administration cost pool based on the activity measure of part types; and A general factory cost pool based on the activity measure of machine hours.

The ABC team also has estimated the amount of overhead for each activity cost pool, the total number of activities for each cost pool, and the number of activities for each product as shown. Notice that the total overhead is still $10,000,000.3-*We calculate an activity rate for each of the six activities by dividing the estimated overhead for an activity by the total expected activity. For example, the activity rate for production orders is $3,150,000 of overhead divided by 1,200 orders, resulting in an activity rate of $2,625 per order.3-*Learning objective number 3 is to compute product costs using activity-based costing.

3-*We assign overhead to each product by multiplying individual activity rates by the expected number of activities. For example, we multiply the activity rate of $400 per machine setup by 3,000 machine setups, resulting in $1,200,000 of overhead assigned to DVD units based on the machine setup activity.

We complete the same overhead assignment for the other five activities. We then add the overhead for the six activities to determine the total overhead of $4,890,000, which will be assigned to DVD units.

Next, we calculate the overhead cost per DVD unit by dividing $4,890,000 of overhead by 50,000 DVD units. The result is $97.80 of overhead cost per DVD unit.3-*We follow the same procedure for CD units. For example, we multiply the activity rate of $400 per machine setup by 1,000 machine setups, resulting in $400,000 of overhead assigned to CD units based on the machine setup activity.

We use the same overhead assignment for the other five activities and then add the amounts to find that we have assigned a total of $5,110,000 of overhead to CD units.

Next, we calculate the overhead cost per CD unit by dividing $5,110,000 of overhead by 200,000 CD units. The result is $25.55 of overhead cost per CD unit.

3-*Note that assigning overhead using activity-based costing results in a decrease in the unit product cost of a CD unit from $110.00 to $95.55 and an increase in the unit cost of a DVD unit from $150.00 to $207.80.

Note that direct material and direct labor costs under the two approaches are the same. The differences in the total unit product cost are a result of the two different approaches to assigning overhead costs. 3-*Learning objective number 4 is to contrast the product costs computed under activity-based costing and conventional costing methods.

3-*The ABC system assigns $14.45 less overhead than the traditional system to each CD player ($40.00 - $25.55 = $14.45).

3-*The ABC system assigns $57.80 more overhead than the traditional system to each DVD player ($97.80 - $40.00 = $57.80).3-*Activity-based costing shifts costs from high-volume products produced in large batches to low-volume products produced in small batches. This occurs because of the existence of batch-level and product-level costs. 3-*The traditional system assigns the same amount of all overhead costs (including the costs related to Production Orders) to each CD or DVD player ($40 per unit).

3-*Consider the Production Orders activity cost pool (a batch-level cost pool): 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. First, compute the number of units processed per production order for each product (62.5 units for DVDs and 500 units for CDs)

3-*Second, compute the production order cost per unit for each product ($42 for DVDs and $5.25 for CDs).

Notice, the costs are being shifted from the high volume product (CD players) to the low volume product (DVD players).

3-*One of the great benefits derived from an ABC system is that it can help identify areas where the company can benefit from improving its current processes.

Activity-based management focuses on managing activities to eliminate waste, and reduce delays and defects. Activity-based management is used in organizations as diverse as manufacturing companies, hospitals, and the U.S. Marine Corps.

3-*The first step in any improvement program is to decide what to improve.

The Theory of Constraints approach discussed in the Prologue is one tool for targeting the highest impact improvement opportunities.

Activity-based management provides another approach. Activity-rates can be used to target areas where costs seem excessively high.

Benchmarking can also be used to compare activity cost information with world-class standards of performance achieved by other organizations.

3-*Activity-based costing improves the accuracy of product costs in three ways:It increases the number of cost pools used to accumulate overhead costs. It uses activity cost pools that are more homogeneous than departmental cost pools.It assigns overhead costs using activity measures that cause those costs, rather than relying solely on direct labor hours. Some activity measures may be unit-level in nature, while others may be batch-level, product-level, or facility-level in nature.

In addition, activity-based costing highlights the activities that could benefit most from process improvement efforts, such as Six Sigma.3-*The cost of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when:Products differ substantially in volume, batch size, and in the activities they require.Conditions have changed substantially since the existing cost system was established.3.Overhead costs are high and increasing and no one seems to understand why.4.Management does not trust the existing cost system and it ignores data from it when making decisions.

3-*Part IThe 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.

Part IIFor example, managers should be particularly alert to product costs that contain allocated facility-level costs.

3-*The illustrations in the chapter assume that ABC is being used for external reporting purposes. If the system is used for internal decision-making purposes, two important modifications should be made: Selling and administrative costs should be assigned to products, where appropriate. Facility-level costs should be removed from product costs.

3-*Learning objective number 5 is to record the flow of costs in an activity-based costing system.

3-*The ABC project team at Sarvik Company has identified five activity cost pools and activity measures: A machine related cost pool based on the activity measure of machine hours; A purchase orders cost pool based on the activity measure of number of orders; A machine setups cost pool based on the activity measure of number of setups; A product testing cost pool based on the activity measure of number of tests; and A general factory cost pool based on the activity measure of direct labor hours.

The ABC team has also estimated the amount of overhead for each activity cost pool, the total number of activities for each cost pool, and the number of activities for each product.

3-*We calculate an activity rate for each of the five activities by dividing the estimated overhead for an activity by the total expected activity. For example, the activity rate for purchase orders is $63,000 of overhead divided by 700 orders, resulting in an activity rate of $90 per order.

3-*Assume the company incurred actual activity levels for the year as shown. We assign overhead by multiplying individual activity rates by the actual activities. For example, we multiply the activity rate of $90 per purchase order by 800 actual purchase orders, resulting in $72,000 of applied overhead due to the production order activity.

We use the same overhead assignment for the other four activities and then add the amounts to find that we have assigned a total of $761,000 of overhead.

Now that we have assigned the overhead, lets look at the entries necessary to record all of the cost flows in an ABC system.3-*We will record the transactions that you see on your screen. Why dont you jot down the entries, and then check your work, as we examine each transaction on the following screens.

Remember, on the previous slide, we determined the amount of manufacturing overhead to apply using activity-based costing.3-*The following journal entries would be used to record transactions (a) and (b):

(a) Raw material purchases of $915,000. Debit Raw Materials for $915,000 Credit Accounts Payable for $915,000

(b) Raw material requisitions of $900,000. Debit Work in Process for $810,000 Debit Manufacturing Overhead for $90,000 Credit Raw Materials for $900,000

3-*The following journal entries would be used to record transactions (c) and (d):

(c) Labor costs of $370,000 incurred. Debit Work in Process for $95,000 Debit Manufacturing Overhead for $275,000 Credit Salaries and Wages Payable for $370,000

(d)Depreciation of $180,000 recorded.Debit Manufacturing Overhead for $180,000 Credit Accumulated Depreciation for $180,000 3-*The following journal entry would be used to record transaction (e).

(e) Miscellaneous manufacturing overhead costs of $230,000 incurred.Debit Manufacturing Overhead for $230,000 Credit Cash/Accounts Payable for $230,0003-*The following journal entry would be used to record transaction (f).

(f) Manufacturing overhead costs of $761,000 applied to production. First, compute $761,000 using ABC data as shown. Then:Debit Work in Process for $761,000 Credit Manufacturing Overhead for $761,000

3-*The following journal entry would be used to record transaction (g).

(g) Goods costing $1,650,000 completed during the year.Debit Finished Goods for $1,650,000 Credit Work in Process for $1,650,000

3-*Notice that overhead is underapplied by $14,000. This amount is calculated by computing the total actual manufacturing overhead incurred of $775,000 ($90,000 + $275,000 + $180,000 + $230,000) and deducting the manufacturing overhead applied of $761,000.

3-*Note that the flow of costs through Raw Materials, Work in Process, and other accounts is the same under activity-based costing as it was in Chapter 2 when using a job-order costing. The only difference is that ABC uses more than one predetermined overhead rate to apply costs to products. 3-*End of Chapter 3.3-*

Chap 003

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