Chapter 3

System Design:
Activity Based Costing

PowerPoint Authors:
Jon A. Booker, Ph.D., CPA, CIA
Charles W. Caldwell, D.B.A., CMA
Susan Coomer Galbreath, Ph.D., CPA

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All

3-2

Learning Objective 1

Understand the basic

approach in activity-based
costing and how it differs
from conventional costing.
3-3

Assigning Overhead Costs to

Products
When
When cost
cost systems
systems were
were developed
developed in
in the
the 1800s,
1800s,
the
the emphasis
emphasis was
was on
on simplicity
simplicity because:
because:
1.
1. Cost
Cost and
and activity
activity data
data had
had to
to be
be collected
collected by
by
hand
hand and
and all
all calculations
calculations were
were done
done with
with paper
paper
and
and pencil.
pencil.
2.
2. Most
Most companies
companies produced
produced aa limited
limited variety
variety of
of
similar
similar products,
products, so
so there
there was
was little
little difference
difference
in
in the
the overhead
overhead costs
costs consumed
consumed by by each
each
product.
product.
3-4

Plantwide Overhead Rate

Plantwide Overhead Rate
A single overhead rate used
throughout an entire factory.
Direct
Direct labor
labor has
has often
often been
been used
used as
as the
the allocation
allocation
base
base for
for overhead
overhead because:
because:
1.
1. Direct
Direct labor
labor information
information was
was already
already being
being recorded.
recorded.
2.
2. Direct
Direct labor
labor was
was aa large
large component
component of of product
product costs.
costs.
3.
3. Managers
Managers believed
believed direct
direct labor
labor and
and overhead
overhead costs
costs
were
were highly
highly correlated.
correlated.
3-5

Plantwide Overhead Rate

Today, direct labor may no longer be a
satisfactory base for allocation of overhead.
1.
1. Most
Most companies
companies sell
sell aa large
large variety
variety of
of products
products that
that
consume
consume differing
differing amounts
amounts of of overhead.
overhead.
2.
2. As
As aa percentage
percentage of
of total
total costs,
costs, direct
direct labor
labor has
has been
been
shrinking
shrinking and
and overhead
overhead has
has been
been increasing.
increasing. Many
Many ofof the
the
new
new overhead
overhead costs
costs may
may not
not be
be correlated
correlated with
with direct
direct
labor.
labor.
3.
3. Technology
Technology advancements
advancements have have reduced
reduced the
the cost
cost and
and
complexity
complexity of of gathering
gathering diverse
diverse sources
sources ofof data.
data.
AA plantwide
plantwide overhead
overhead allocation
allocation system
system may
may not
not be
be optimal
optimal
for
for many
many companies
companies inin today’s
today’s business
business environment.
environment.
3-6

Departmental Overhead Rates

Many
Many companies
companies have
have aa system
system in
in which
which each
each
department
department has
has its
its own
own overhead
overhead rate.
rate.
The
The allocation
allocation base
base depends
depends
on
on the
the nature
nature of
of the
the work
work
Machining Department performed
performed in in each
each department.
department.
In
In the
the machining
machining department,
department,
Assembly Department overhead
overhead may may be
be based
based on on
machine-hours,
machine-hours, but but in
in the
the
Shipping Department assembly
assembly department,
department,
overhead
overhead may may be
be based
based on on
labor-hours.
labor-hours.
3-7

Departmental Overhead Rates

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

The
The departmental
departmental approach
approach relies
relies
exclusively
exclusively on
on volume-related
volume-related allocation
allocation bases
bases while
while
some
some overhead
overhead costs
costs may
may be
be caused
caused byby factors
factors
that
that are
are not
not related
related to
to the
the volume
volume of
of production.
production.

Activity-base
Activity-base costing
costing is
is required
required to
to account
account for
for these
these
other
other factors.
factors.
3-8

Activity-Based Costing (ABC)

A number of allocation bases are

used for assigning costs to products.
3-9

Activity-Based Costing (ABC)

Cost
Cost Objects
Objects
(e.g.,
(e.g., products
products and
and customers)
customers)

Activities
Activities

Consumption
Consumption of
of Resources
Resources

Cost
Cost
3-10

Activity-Based Costing (ABC)

An event that causes
Activity the consumption of
overhead resources

Examples of Activities

Admitting
Setting up Billing Opening a
hospital
machines customers bank account
patients
3-11

Activity-Based Costing (ABC)

A “cost bucket” in which
Activity
costs related to a particular
Cost Pool activity are accumulated.

Expresses how much of the

Activity activity is carried out and is
Measure used as the allocation base
for applying overhead costs.

A predetermined overhead
Activity
rate for each activity
Rate cost pool.
3-12

Activity-Based Costing (ABC)

For each activity in
isolation, this system works exactly
like the job-order costing system
described in Chapter 2.

AA predetermined
predetermined overhead
overhead rate
rate is
is computed
computed for for
each
each activity
activity and
and then
then applied
applied toto jobs
jobs and
and
products
products based
based onon the
the amount
amount of of activity
activity
consumed
consumed by by the
the job
job or
or product.
product.
3-13

Designing an Activity-Based
Costing System

The
The challenge
challenge isis to
to select
select aa reasonably
reasonably
small
small number
number of of activities
activities that
that explain
explain the
the
bulk
bulk of
of the
the variation
variation inin overhead
overhead costs.
costs.

Activities
Activities are
are usually
usually chosen
chosen by
by interviewing
interviewing aa
broad
broad range
range of
of managers
managers to
to find
find out
out what
what
activities
activities they
they think
think consume
consume most
most of
of the
the
organization’s
organization’s resources.
resources.
3-14

Designing an Activity-Based
Costing System
Related activities are
frequently combined to reduce
the amount of detail and
record-keeping costs.
For example, several activities may
be involved in handling and moving
raw materials, but these may be
combined into a single activity
entitled material handling.
An
An activity
activity dictionary
dictionary defines
defines each
each of of the
the activities
activities
that
that will
will be
be included
included in
in the
the activity-based
activity-based costing
costing
system
system andand how
how the
the activities
activities will
will be
be measured.
measured.
3-15

Hierarchy of Activities
Level
Level Activities
Activities Activity
Activity Measure
Measure
Unit-level
Unit-level Processing
Processing units
unitson
on machines
machines Machine-hours
Machine-hours
Processing
Processing units
unitsby
byhand
hand Direct
Directlabor-hours
labor-hours
Consuming
Consuming factory
factorysupplies
supplies Units
Unitsproduced
produced
Batch-level
Batch-level Processing
Processing purchase
purchaseorders
orders Purchase
Purchaseorders
ordersprocessed
processed
Processing
Processing production
production orders
orders Production
Production orders
ordersprocessed
processed
Setting
Setting up
up equipment
equipment Number
Numberofofsetups
setups
Handling
Handling materials
materials Pounds
Poundsofofmaterial
materialhandled
handled
Product-level
Product-level Testing
Testing new
new products
products Hours
Hoursof
oftesting
testing time
time
Administering
Administering parts
partsinventories
inventories Number
Numberofofpart
parttypes
types
Designing
Designing products
products Hours
Hoursof
ofdesign
design time
time
Facility-level
Facility-level General
Generalfactory
factoryadministration
administration Direct
Directlabor-hours
labor-hours
Plant
Plantbuilding
building and
and grounds
grounds Direct
Directlabor-hours
labor-hours
3-16

Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs

First-Stage Cost Assignment

Labor Machine Setup Production Parts General

Related Pool Related Pool Pool Order Pool Admin. Pool Factory Pool
3-17

Graphic Example of
Activity-Based Costing
Various Manufacturing Overhead Costs

First-Stage Cost Assignment

Labor Machine Setup Production Parts General

Related Pool Related Pool Pool Order Pool Admin. Pool Factory Pool

Second-Stage Allocations

$/DLH $/MH $/Setup $/Order $/Part Type $/MH

Products
Unit-Level Batch-Level Product-Level Facility-Level
Activity Activity Activity Activity
3-18

Using Activity-Based Costing

Comtek 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.
3-19

Using Activity-Based Costing

Comtek Sound, Inc.
 For the current year, Comtek has budgeted sales
of 50,000 DVD units and 200,000 CD units.
 Comtek’s 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.
Hours
Hours
DVDs:
DVDs: 50,000
50,000 units
units@
@ 22 hours
hoursper
per unit
unit == 100,000
100,000
CDs:
CDs: 200,00
200,00 units
units@
@ 22 hours
hoursper
per unit
unit == 400,000
400,000
Total
Total direct
direct labor-hours
labor-hours 500,000
500,000
3-20

Using Activity-Based Costing

Comtek Sound, Inc.
 Unit costs for materials and labor are:

DVD
DVD CD
CD
Units
Units Units
Units
Direct
Direct materials
materials $$ 90
90 $$ 50
50
Direct
Direct Labor
Labor $$ 20
20 $$ 20
20
3-21

Direct Labor-Hours as a Base

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:

Predetermined $10,000,000
= = $20 per DLH
overhead rate 500,000 DLHs
3-22

Direct Labor-Hours as a Base

Since
Since each
each product
product requires
requires two
two hours
hours of
of
direct
direct labor,
labor, $40
$40 of
of overhead
overhead isis assigned
assigned to
to
each
each product.
product.
DVD
DVD Unit
Unit CD
CD Unit
Unit
Direct
Directmaterials
materials $$ 90
90 $$ 50
50
Direct
Directlabor
labor 20
20 20
20
Manufacturing
Manufacturing overhead
overhead 40
40 40
40
(2
(2DLHs
DLHsxx$20
$20per
perDLH)
DLH)
Unit
Unitproduct
productcost
cost $$ 150
150 $$ 110
110
3-23

Learning Objective 2

Compute activity rates for an

activity-based costing
system.
3-24

Computing Activity Rates

The ABC project team at Comtek has
developed the following basic information.
Estimated
Estimated
Overhead
Overhead
Activity
Activityand
andActivity
ActivityMeasures
Measures Cost
Cost Expected
ExpectedActivity
Activity
Total
Total DVD
DVD CD
CD
Labor
Laborrelated
related(DLH)
(DLH) $$ 800,000
800,000 500,000
500,000 100,000
100,000 400,000
400,000
Machine
Machinerelated
related(MH)
(MH) 2,100,000
2,100,000 1,000,000
1,000,000 300,000
300,000 700,000
700,000
Machine
Machinesetups
setups(setups)
(setups) 1,600,000
1,600,000 4,000
4,000 3,000
3,000 1,000
1,000
Production
Productionorders
orders(orders)
(orders) 3,150,000
3,150,000 1,200
1,200 800
800 400
400
Parts
Partsadministration
administration(part
(parttypes)
types) 350,000
350,000 700
700 400
400 300
300
General
Generalfactory
factory(MH)
(MH) 2,000,000
2,000,000 1,000,000
1,000,000 300,000
300,000 700,000
700,000
$$10,000,000
10,000,000
3-25

Computing Activity Rates

We can calculate the following activity rates:
Estimated Total
Overhead Expected
Activity and Activity Measures Cost Activity Activity Rate
Labor related (DLHs) $ 800,000 ÷ 500,000 = $ 1.60 per DLH
Machine related (MHs) 2,100,000 ÷ 1,000,000 = 2.10 per MH
Machine setups (setups) 1,600,000 ÷ 4,000 = 400.00 per setup
Production orders (orders) 3,150,000 ÷ 1,200 = 2,625.00 per order
Parts administration (part types) 350,000 ÷ 700 = 500.00 per part type
General factory (MHs) 2,000,000 ÷ 1,000,000 = 2.00 per MH
$ 10,000,000

Using the new activity rates, let’s assign overhead

to the two products based upon expected activity.
3-26

Learning Objective 3

Compute product costs using

activity-based costing.
3-27

Computing Overhead Cost per

Unit
DVD Units
Expected
Expected Activity
Activity
Activity
Activity and
and Activity
Activity Measures
Measures Activity
Activity Rate
Rate Amount
Amount
Labor
Labor related
related (DLHs)
(DLHs) 100,000
100,000 ×× $$ 1.60
1.60 == $$ 160,000
160,000
Machine
Machine related
related (MHs)
(MHs) 300,000
300,000 ×× 2.10
2.10 == 630,000
630,000
Machine
Machine setups
setups (setups)
(setups) 3,000
3,000 ×× 400.00
400.00 == 1,200,000
1,200,000
Production
Production orders
orders (orders)
(orders) 800
800 ×× 2,625.00
2,625.00 == 2,100,000
2,100,000
Parts
Parts administration
administration (part
(parttypes)
types) 400
400 ×× 500.00
500.00 == 200,000
200,000
General
Generalfactory
factory (MHs)
(MHs) 300,000
300,000 ×× 2.00
2.00 == 600,000
600,000
Total
Totaloverhead
overhead cost
costassigned
assigned $$4,890,000
4,890,000
Number
Number of ofunits
units produced
produced 50,000
50,000
Overhead
Overhead costcostper
per unit
unit $$ 97.80
97.80
3-28

Computing Overhead Cost per

Unit
CD Units
Expected
Expected Activity
Activity
Activity
Activity and
and Activity
Activity Measures
Measures Activity
Activity Rate
Rate Amount
Amount
Labor
Labor related
related (DLHs)
(DLHs) 400,000
400,000 ×× $$ 1.60
1.60 == $$ 640,000
640,000
Machine
Machine related
related (MHs)
(MHs) 700,000
700,000 ×× 2.10
2.10 == 1,470,000
1,470,000
Machine
Machine setups
setups (setups)
(setups) 1,000
1,000 ×× 400.00
400.00 == 400,000
400,000
Production
Production orders
orders (orders)
(orders) 400
400 ×× 2,625.00
2,625.00 == 1,050,000
1,050,000
Parts
Parts administration
administration (part
(parttypes)
types) 300
300 ×× 500.00
500.00 == 150,000
150,000
General
Generalfactory
factory (MHs)
(MHs) 700,000
700,000 ×× 2.00
2.00 == 1,400,000
1,400,000
Total
Totaloverhead
overhead cost
costassigned
assigned $$5,110,000
5,110,000
Number
Number of ofunits
units produced
produced 200,000
200,000
Overhead
Overhead costcostper
per unit
unit $$ 25.55
25.55
3-29

Comparing the Two

Approaches
Activity-Based
Activity-Based Costing
Costing Direct-Labor
Direct-Labor Costing
Costing
DVD
DVD Unit
Unit CD
CD Unit
Unit DVD
DVD Unit
Unit CD
CD Unit
Unit
Direct
Direct material
material $$ 90.00
90.00 $$ 50.00
50.00 $$ 90.00
90.00 $$ 50.00
50.00
Direct
Direct labor
labor 20.00
20.00 20.00
20.00 20.00
20.00 20.00
20.00
Manufacturing
Manufacturing overhead
overhead 97.80
97.80 25.55
25.55 40.00
40.00 40.00
40.00
Unit
Unit product
product cost
cost $$ 207.80
207.80 $$ 95.5595.55 $$ 150.00
150.00 $$ 110.00
110.00

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.
3-30

Learning Objective 4

Contrast the product costs

computed under activity-
based costing and
conventional costing
methods.
3-31

Comparing the Two

Approaches
Activity-Based
Activity-Based Costing
Costing Direct-Labor
Direct-Labor Costing
Costing
DVD
DVD Unit
Unit CD
CD Unit
Unit DVD
DVD Unit
Unit CD
CD Unit
Unit
Direct
Direct material
material $$ 90.00
90.00 $$ 50.00
50.00 $$ 90.00
90.00 $$ 50.00
50.00
Direct
Direct labor
labor 20.00
20.00 20.00
20.00 20.00
20.00 20.00
20.00
Manufacturing
Manufacturing overhead
overhead 97.80
97.80 25.55
25.55 40.00
40.00 40.00
40.00
Unit
Unit product
product cost
cost $$ 207.80
207.80 $$ 95.5595.55 $$ 150.00
150.00 $$ 110.00
110.00

The
The ABC
ABC system
system assigns
assigns $14.45
$14.45
less
less overhead
overhead than
than the
the traditional
traditional
system
system to
to each
each CD
CD player.
player.
3-32

Comparing the Two

Approaches
Activity-Based
Activity-Based Costing
Costing Direct-Labor
Direct-Labor Costing
Costing
DVD
DVD Unit
Unit CD
CD Unit
Unit DVD
DVD Unit
Unit CD
CD Unit
Unit
Direct
Direct material
material $$ 90.00
90.00 $$ 50.00
50.00 $$ 90.00
90.00 $$ 50.00
50.00
Direct
Direct labor
labor 20.00
20.00 20.00
20.00 20.00
20.00 20.00
20.00
Manufacturing
Manufacturing overhead
overhead 97.80
97.80 25.55
25.55 40.00
40.00 40.00
40.00
Unit
Unit product
product cost
cost $$ 207.80
207.80 $$ 95.5595.55 $$ 150.00
150.00 $$ 110.00
110.00

The
The ABC
ABC system
system assigns
assigns $57.80
$57.80
more
more overhead
overhead than
than the
the traditional
traditional
system
system toto each
each DVD
DVD player.
player.
3-33

Shifting of Overhead Cost

Activity-Based
Activity-Based Costing
Costing Direct-Labor
Direct-Labor Costing
Costing
DVD
DVD Unit
Unit CD
CD Unit
Unit DVD
DVD Unit
Unit CD
CD Unit
Unit
Direct
Direct material
material $$ 90.00
90.00 $$ 50.00
50.00 $$ 90.00
90.00 $$ 50.00
50.00
Direct
Direct labor
labor 20.00
20.00 20.00
20.00 20.00
20.00 20.00
20.00
Manufacturing
Manufacturing overhead
overhead 97.80
97.80 25.55
25.55 40.00
40.00 40.00
40.00
Unit
Unit product
product cost
cost $$ 207.80
207.80 $$ 95.5595.55 $$ 150.00
150.00 $$ 110.00
110.00

Low-volume product
When
When aa company
company implements
implements activity-based
activity-based costing,
costing,
overhead
overhead cost
cost often
often shifts
shifts from
from high-volume
high-volume toto low-
low-
volume
volume products
products with
with aa higher
higher unit
unit product
product cost
cost
resulting
resulting for
for the
the low-volume
low-volume products.
products.
3-34

Shifting of Overhead Cost

Activity-Based
Activity-Based Costing
Costing Direct-Labor
Direct-Labor Costing
Costing
DVD
DVD Unit
Unit CD
CD Unit
Unit DVD
DVD Unit
Unit CD
CD Unit
Unit
Direct
Direct material
material $$ 90.00
90.00 $$ 50.00
50.00 $$ 90.00
90.00 $$ 50.00
50.00
Direct
Direct labor
labor 20.00
20.00 20.00
20.00 20.00
20.00 20.00
20.00
Manufacturing
Manufacturing overhead
overhead 97.80
97.80 25.55
25.55 40.00
40.00 40.00
40.00
Unit
Unit product
product cost
cost $$ 207.80
207.80 $$ 95.5595.55 $$ 150.00
150.00 $$ 110.00
110.00

High-volume product

The
The traditional
traditional system
system assigns
assigns the
the same
same amount
amount of
of
all
all overhead
overhead costs
costs to
to each
each CD
CD oror DVD
DVD player
player
($40
($40 per
per unit).
unit).
3-35

Shifting of Overhead Cost

Production
Production Orders
Orders Activity
Activity Cost
Cost Pool
Pool
(a
(a batch-level
batch-level cost
cost pool)
pool)
The
The ABC
ABC system
system assigns
assigns different
different amounts
amounts of of
Production
Production Order-related
Order-related overhead
overhead costscosts to
to each
each product.
product.
This
This fact
fact can
can be
be illustrated
illustrated in
in aa two-step
two-step process.
process.

1.
1. Compute
Compute the
the number
number of of units
units processed
processed
per
per production
production order
order for
for each
each product.
product.

DVD
DVD Units
Units CD
CD Units
Units
Number
Number of
of units
unitsproduced
produced per
per year
year 50,000
50,000 200,000
200,000
Number
Number of
of production
production orders
ordersissued
issued per
per year
year 800
800 400
400
Number
Number of
of units
unitsprocessed
processed per
per production
production order
order 62.5
62.5 500
500
3-36

Shifting of Overhead Cost

2.
2. Compute
Compute production
production order
order cost
cost per
per unit
unit for
for each
each product.
product.

DVD
DVDUnits
Units CDCDUnits
Units
Cost
Costtoto issue
issue aa production
production order
order $$ 2,625
2,625 $$ 2,625
2,625
Average
Average number
number of ofunits
unitsprocessed
processed per
per
production
production order
order 62.5
62.5 500
500
Production
Production order
order cost
costper
per unit
unit $$ 42.00
42.00 $$ 5.25
5.25

Notice,
Notice, the
the costs
costs are
are being
being shifted
shifted from
from the
the high
high
volume
volume CDCD players
players to
to the
the low
low volume
volume DVDDVD players.
players.
3-37

Targeting Process
Improvements
An ABC system can help identify
areas where the company can benefit
from improving its current processes.

Activity-Based
Activity-Based Management
Management
Focuses
Focuses on
on managing
managing activities
activities to
to eliminate
eliminate
waste
waste and
and reduce
reduce delays
delays and
and defects.
defects.
3-38

Targeting Process
Improvements
The
The first
first step
step in
in any
any improvement
improvement
program
program isis deciding
deciding what
what to
to improve.
improve.

The
The Theory
Theory of
of Constraints
Constraints Activity
Activity rates
rates can
can be
be
approach
approach targets
targets the
the used
used toto target
target areas
areas
highest
highest impact
impact where
where costs
costs seem
seem
improvement
improvement opportunities.
opportunities. excessively
excessively high.
high.

Benchmarking
Benchmarking can
can be
be used
used to
to compare
compare activity
activity cost
cost
information
information with
with world-class
world-class standards
standards of
of performance
performance
achieved
achieved by
by other
other organizations.
organizations.
3-39

Benefits of Activity-Based
Costing
ABC
ABC improves
improves the
the accuracy
accuracy of
of product
product costing
costing by:
by:
•• Increasing
Increasing the
the number
number ofof cost
cost pools
pools used
used toto accumulate
accumulate
overhead
overhead costs.
costs.
•• Using
Using activity
activity cost
cost pools
pools that
that are
are more
more homogeneous
homogeneous thanthan
departmental
departmental cost
cost pools.
pools.
•• Assigning
Assigning overhead
overhead costs
costs using
using activity
activity measures
measures that
that
cause
cause those
those costs,
costs, rather
rather than
than relying
relying solely
solely on
on direct
direct
labor
labor hours.
hours.

Activity-based
Activity-based costing
costing also
also highlights
highlights activities
activities
that
that could
could benefit
benefit most
most from
from process
process
improvement
improvement efforts,
efforts, such
such asas Six
Six Sigma.
Sigma.
3-40

Limitations of Activity-Based
Costing
Costs of implementing an ABC system may outweigh
the benefits. However, the benefits are more likely to be
worth the costs when:
1. Products differ substantially in volume, batch size, and in
activities required.
2. 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.
3-41

Activity-Based Costing
Critical Assumption
The
The cost
cost in
in each
each activity
activity pool
pool is
is strictly
strictly
proportional
proportional to
to its
its activity
activity measure
measure.. When
When this
this
assumption
assumption isis violated,
violated, the
the accuracy
accuracy ofof ABC
ABC
data
data can
can be be called
called into
into question.
question.

For
For example,
example, managers
managers should
should be
be particularly
particularly
alert
alert to
to product
product costs
costs that
that contain
contain allocated
allocated
facility-level
facility-level costs
costs..
3-42

Modifying the ABC Model

The
The illustrations
illustrations inin the
the chapter
chapter assume
assume
that
that ABC
ABC is is being
being used
used for
for external
external reporting
reporting
purposes.
purposes. IfIf the
the system
system is is used
used for
for internal
internal
decision-making
decision-making purposes,
purposes, two two important
important
modifications
modifications should
should bebe made:
made:
1.
1. Selling
Selling and
and administrative
administrative costs
costs should
should be
be
assigned
assigned to to products,
products, where
where appropriate.
appropriate.
2.
2. Facility-level
Facility-level costs
costs should
should bebe removed
removed
from
from product
product costs.
costs.
3-43

Learning Objective 5

Record the flow of costs in an

activity-based costing
system.
3-44

Cost Flows in an ABC System

Sarvik
Sarvik Company
Company uses
uses activity-based
activity-based costing.
costing.
The
The company
company has
has five
five cost
cost pools
pools shown
shown below.
below.

Estimated
Estimated
Overhead
Overhead
Activity
Activity Cost
Cost Pool
Pool Activity
Activity Measure
Measure Cost
Cost Expected
Expected Activity
Activity
Machine
Machine related
related Machine
Machine hours
hours $$ 175,000
175,000 5,000
5,000 MHs
MHs
Purchase
Purchase orders
orders Number
Number of of orders
orders 63,000
63,000 700
700 orders
orders
Machine
Machine setups
setups Number
Number of of setups
setups 92,000
92,000 460
460 setups
setups
Product
Product testing
testing Number
Number of of tests
tests 160,000
160,000 200
200 tests
tests
General
General factory
factory Direct
Direct labor
labor hours
hours 300,000
300,000 25,000
25,000 DLHs
DLHs
$$ 790,000
790,000
3-45

Cost Flows in an ABC System

Activity rates are determined as follows:

Estimated
Estimated Total
Total
Overhead
Overhead Expected
Expected
Activity
ActivityCost
CostPool
Pool Cost
Cost Activity
Activity Activity
ActivityRate
Rate
Machine
Machinerelated
related $$ 175,000
175,000 ÷÷ 5,000
5,000MHs
MHs == $$ 35
35 perperMH
MH
Purchase
Purchaseorders
orders 63,000
63,000 ÷÷ 700
700orders
orders == $$ 90
90 perperorder
order
Machine
Machinesetups
setups 92,000
92,000 ÷÷ 460
460setups
setups == $$ 200
200 perpersetup
setup
Product
Producttesting
testing 160,000
160,000 ÷÷ 200
200tests
tests == $$ 800
800 perpertest
test
General
Generalfactory
factory 300,000
300,000 ÷÷ 25,000
25,000DLH
DLH == $$ 12
12 perperDLH
DLH
$$ 790,000
790,000
3-46

Cost Flows in an ABC System

Overhead is applied on the basis of
actual activities during the year.
Applied
Applied
Activity
Activity Actual
Actual Overhead
Overhead
Activity
ActivityCost
CostPool
Pool Rate
Rate Activity
Activity Cost
Cost
Machine
Machinerelated
related $35/MH
$35/MH ×× 4,600
4,600MHs
MHs == $$ 161,000
161,000
Purchase
Purchaseorders
orders $90/order
$90/order ×× 800
800orders
orders == 72,000
72,000
Machine
Machinesetups
setups $200/setup
$200/setup ×× 500
500setups
setups == 100,000
100,000
Product
Producttesting
testing $800/test
$800/test ×× 190
190tests
tests == 152,000
152,000
General
Generalfactory
factory $12/DLH
$12/DLH ×× 23,000
23,000DLHs
DLHs == 276,000
276,000
Total
TotalOverhead
OverheadApplied
Applied $$ 761,000
761,000
3-47

Cost Flows in an ABC System

Selected
Selected transactions
transactions recorded
recorded by
by the
the company:
company:
a.
a. Raw
Raw materials
materials purchased
purchased on
on account,
account, $915,000.
$915,000.
b.
b. Raw
Raw materials
materials used
used in
in production,
production, $900,000
$900,000 ($810,000
($810,000
direct
direct and
and $90,000
$90,000 indirect).
indirect).
c.
c. Factory
Factory labor
labor costs,
costs, $370,000
$370,000 ($95,000
($95,000 direct
direct and
and
$275,000
$275,000 indirect).
indirect).
d.
d. Depreciation
Depreciation of
of factory
factory assets,
assets, $180,000.
$180,000.
e.
e. Miscellaneous
Miscellaneous manufacturing
manufacturing overhead
overhead costs
costs
incurred
incurred on
on account,
account, $230,000.
$230,000.
f.f. Manufacturing
Manufacturing overhead
overhead applied,
applied, $761,000.
$761,000.
g.
g. Goods
Goods costing
costing $1,650,000
$1,650,000 were
were manufactured.
manufactured.
3-48

Cost Flows in an ABC System

The
The following
following journal
journal entries
entries would
would be
be used
used
to
to record
record transactions
transactions (a)
(a) and
and (b).
(b).

Description
Description Debit
Debit Credit
Credit
a.
a. Raw
Raw Materials
Materials 915,000
915,000
Accounts
Accounts Payable
Payable 915,000
915,000
b.
b. Work
Work in
in Process
Process 810,000
810,000
Manufacturing
Manufacturing Overhead
Overhead 90,000
90,000
Raw
Raw Materials
Materials 900,000
900,000
3-49

Cost Flows in an ABC System

The
The following
following journal
journal entries
entries would
would be
be used
used
to
to record
record transactions
transactions (c)
(c) and
and (d).
(d).

Description
Description Debit
Debit Credit
Credit
c.
c. Work
Work in
in Process
Process 95,000
95,000
Manufacturing
Manufacturing Overhead
Overhead 275,000
275,000
Salaries
Salaries and
and Wages
Wages Payable
Payable 370,000
370,000
d.
d. Manufacturing
Manufacturing Overhead
Overhead 180,000
180,000
Accumulated
Accumulated Depreciation
Depreciation 180,000
180,000
3-50

Cost Flows in an ABC System

The
The following
following journal
journal entry
entry would
would be
be used
used to
to
record
record transaction
transaction (e).
(e).

Description
Description Debit
Debit Credit
Credit
e.
e. Manufacturing
Manufacturing Overhead
Overhead 230,000
230,000
Cash/Accounts
Cash/Accounts Payable
Payable 230,000
230,000
3-51

Cost Flows in an ABC System

The
The following
following journal
journal entry
entry would
would bebe used
used to
to
record
record transaction
transaction (f).
(f).

Description
Description Debit
Debit Credit
Credit
f.f. Work
Work in
in Process
Process 761,000
761,000
Manufacturing
Manufacturing Overhead
Overhead 761,000
761,000
3-52

Cost Flows in an ABC System

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

Description
Description Debit
Debit Credit
Credit
g.
g. Finished
Finished Goods
Goods 1,650,000
1,650,000
Work
Work in
in Process
Process 1,650,000
1,650,000
3-53

Cost Flows in an ABC System

Manufacturing Overhead
(b) 90,000 (g) 761,000
(c) 275,000
(d) 180,000
(e) 230,000

Bal. 14,000

Underapplied
Overhead Costs
3-54

Cost Flows in an ABC System

The 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.
3-55

End of Chapter 3