Cma CH 3 - Abc March 2019-1

Chapter Three
Activity-
Activity-Based Costing
(ABC)
Study objectives
1. Recognize the difference between traditional costing and
activity-based costing.
2. Identify the steps in the development of an activity-based
costing system.
3. Know how companies identify the activity cost pools used in
activity-based costing.
4. Know how companies identify and use cost drivers in activity-
based costing.
5. Understand the benefits and limitations of activity-based
costing.
6. Differentiate between value-added and non–value-added
activities.
7. Understand the value of using activity levels in activity-based
costing.
8. Apply activity-based costing to service industries.
Preview of chapter 3
Managerial Accounting Basics
Managerial accounting, also called management

accounting, is a field of accounting that provides
economic and financial information for managers and
other internal users.
Managerial accounting applies to all types of

businesses.
 Corporations
 Proprietorships
 Partnerships
 Not-for-profit
Traditional Costing and Activity-
Traditional Costing Systems

Allocates overhead using a single predetermined rate.
 Job order costing: direct labor cost is assumed to be the
relevant activity base.
 Process costing: machine hours is the relevant activity

base.
Assumption was satisfactory when direct labor was a

major portion of total manufacturing costs.
 Wide acceptance of a high correlation between direct
labor and overhead costs.
The Need for a New Approach
Tremendous change in manufacturing and service

industries.
Decrease in amount of direct labor usage.
Significant increase in total overhead costs.
Inappropriate to use plant-wide predetermined
overhead rates when a lack of correlation exists.
Complex manufacturing processes may require
multiple allocation bases; this approach is called
Activity-Based Costing (ABC). Illustration 3-1
Traditional one-stage
costing system
Allocates overhead to multiple activity cost
pools, and
Assigns the activity cost pools to products

or services by means of cost drivers.
Activity: any event, action, transaction, or work
sequence that incurs cost when producing a product
or providing a service.
Activity Cost Pool: the overhead cost attributed

to a distinct type of activity For example: ordering
materials or setting up machines
Cost Drivers: any factor or activity that have a

direct cause-effect relationship with the resources
consumed.
ABC allocates overhead costs in two stages:
Stage 1: Overhead costs are allocated to activity cost
pools.
Stage 2: The overhead costs allocated to the cost pools

is assigned to products using cost drivers.
The more complex a product’s manufacturing

operation, the more activities and cost
drivers likely to be present.
Illustration 3-2
Activity-Based Costing Activities and related cost drivers
Activity-Based Costing Illustration 3-3

ABC system design—Lift Jack Company
Indicate whether the following statements

CLASS WORK
are true or false.
1. A traditional costing system allocates overhead by

False
means of multiple overhead rates.
True 2. Activity-based costing allocates overhead costs in a

two-stage process.
3. Direct material and direct labor costs are easier to

True
trace to products than overhead.
Solution on
notes page
Indicate whether the following statements

CLASS WORK
are true or false.
4. As manufacturing processes have become more

False
automated, more companies have chosen to allocate
overhead on the basis of direct labor costs.
5. In activity-based costing, an activity is any event,

True
action, transaction, or work sequence that incurs cost
when producing a product.
Solution on
notes page
Example of ABC Versus Traditional Costing
ABC allocates overhead costs in two stages:
Stage 1: Overhead costs are allocated to activity

cost pools.
Stage 2: The overhead costs allocated to the cost

pools is assigned to products using cost drivers.
The more complex a product’s manufacturing

operation, the more activities and cost drivers likely
to be present.
Illustration:
Atlas Company produces two automobile antitheft devices:
 The Boot: a high volume item with sales totaling 25,000 per year
 The Club: a low volume item with sales totaling 5,000 per year
Each product requires 1 hour of direct labor

 Total annual direct labor hours (DLH) 30,000 (25,000 + 5000)
 Direct labor cost $12 per unit for each product
Expected annual manufacturing overhead costs $900,000
Direct materials cost: Required: Calculate unit

 The Boot - $40 per unit costs under TCA and
 The Club - $30 per unit ABC.
Illustration:
Products
Manufacturing costs The Boot The Club
Direct materials $40 $30
Direct labor 12 12
Overhead 30* 30*
Total unit cost $82 $72
* Overhead rate = $900,000/30,000 DLH = $30 per DLH

Overhead = ($30 X 1 hr. = $30)
Activity-based costing involves the following four

steps.
1. Identify and classify the major activities and
allocate manufacturing overhead costs to the
appropriate cost pools.
2. Identify the cost driver that has a strong

correlation to the costs in the cost pool.
3. Compute the overhead rate for each pool.
4. Assign overhead costs for each costs to products

using the overhead rates.
Identify and Classify Activities and Allocate

Overhead to Cost Pools (Step 1)
Overhead costs are assigned directly to the appropriate
activity cost pool.
Illustration 3-4
Identify Cost Drivers (Step 2)
The cost driver must accurately measure the actual

consumption of the activity by the various products.
Illustration 3-5
Compute Overhead Rates (Step 3)

Next, the company computes an activity-based overhead
rate per cost driver.
Illustration 3-6
Illustration 3-7
Assign Overhead Cost to Products (Step 4)

In assigning overhead costs, it is necessary to know the
expected use of cost drivers for each product. Because of
its low volume, The Club requires more set-ups and
inspections than The Boot.
Illustration 3-8

To assign overhead costs, Atlas multiplies the activity-based
overhead rates per cost driver (Ill. 3-7) by the number of cost
drivers expected to be used per product (Ill. 3-8).
Illustration 3-9

To assign overhead costs, Atlas multiplies the activity-based
overhead rates per cost driver (Ill. 3-7) by the number of cost
drivers expected to be used per product (Ill. 3-8).
Illustration 3-9
Comparing Unit Costs

Illustration 3-10
A likely consequence of the differences in assigning overhead is that

Atlas has been overpricing The Boot and possibly losing market
share to competitors. It also has been sacrificing profitability by
underpricing The Club.
Comparing Unit Costs

Under ABC, overhead costs are shifted from the high
volume product (The Boot) to the low volume product (The
Club) because:
Low volume products often require more special

handling.
Assigning overhead using ABC will usually increase the

cost per unit of low volume products.
Class work: Lift Jack Company has seven activity cost pools and
two products. It expects to produce 200,000 units of its automobile
scissors jack and 80,000 units of its truck hydraulic jack. Having
identified its activity cost pools and the cost drivers for each cost
pool, Lift Jack Company accumulated the following data relative to
those activity cost pools and cost drivers.
Required:
Using the previous data, do the following:
a. Prepare a schedule showing the computations of the
activity-based overhead rates per cost driver.
b. Prepare a schedule assigning each activity’s overhead
cost to the two products.
c. Compute the overhead cost per unit for each product.
d. Comment on the comparative overhead cost per unit.
Given:
a. Prepare a schedule showing the computations of the activity-based overhead rates per cost driver.
Solution on notes page

b. Prepare a
schedule assigning
each activity’s
overhead cost to
the two products.

b. Prepare a
schedule assigning
each activity’s
overhead cost to
the two products.

c. Compute the overhead cost per unit for each product.
d. Comment on the comparative overhead cost per unit.
These data show that the total overhead assigned to 80,000

hydraulic jacks is nearly as great as the overhead assigned
to 200,000 scissors jacks. However, the overhead cost per
hydraulic jack is $41. It is only $17.60 per scissors jack.
Activity-
Activity-Based Costing: A Closer Look
Benefits of ABC
More accurate product costing through:

Use of more cost pools to assign overhead costs
Enhanced control over overhead costs
Better management decisions

Activity-
Limitations of ABC
Can be expensive to use
Some arbitrary allocations continue

Activity-
When to Use ABC

Factors to consider:
1. Product lines differ in volume and manufacturing
complexity.
2. Product lines are numerous and diverse.
3. Overhead costs constitute a significant portion of
total costs.
4. The manufacturing process or the number of
products has changed significantly.
5. Production or marketing managers are ignoring data
provided by the existing system.
Activity-
Value-Added Versus Non–Value-Added Activities
Activity-Based Management (ABM):

An extension of ABC from a product costing system to a
management function that focuses on reducing costs and
improving processes and decision making.
 Value-added activities
 Non–value-added activities
Activity-
An activity that increases the worth of a

product or service such as:
Manufacturing Company Service Company
Engineering design Performing surgery
Machining services Legal research
Assembly Delivering packages
Painting
Packaging
Activity-
An activity that adds cost to, or increases the time

spent on, a product/service without increasing its market
value such as:
Manufacturing Company Service Company

Repair of machines Taking appointments
Storage of inventory Reception
Moving of inventory Bookkeeping and billing
Building maintenance Traveling
Inspections Ordering supplies
Inventory control Advertising
Activity-
Class Classify each of the following activities within a

dental practice as value-added (VA) or non–value-
Work added (NVA).
NVA 1. Ordering supplies.
NVA 2. Taking appointments.
VA 3. Completing continuing education requirements.
VA 4. Explaining dental-hygiene techniques to patients.
NVA 5. Completing insurance documents.
VA 6. Examining patients.
Solution on
notes page
Activity-
Classification of Activity Levels
ABC activities levels:
1. Unit-level activities
2. Batch-level activities
3. Product-level activities
4. Facility-level activities
Activity-
Classification
of Activity
Levels
Illustration 3-13
SO7
Activity-
Class Work Morgan Toy Company manufactures six primary
product lines in its Morganville plant. As a result of
an activity analysis, the accounting department has identified eight
activity cost pools. Each of the toy products is produced in large
batches, with the whole plant devoted to one product at a time.
Classify each of the following activities as either unit-level, batch-
level, product-level, or facility-level:
Product-level a. Engineering design,
Batch-level b. Machine setup,
Product-level c. Inventory management,
Facility-level d. Plant cafeteria,
Solution on
notes page
Activity-
Morgan Toy Company manufactures six primary product lines in its

Morganville plant. As a result of an activity analysis, the accounting
department has identified eight activity cost pools. Each of the toy
products is produced in large batches, with the whole plant devoted to
one product at a time. Classify each of the following activities as
either unit-level, batch-level, product-level, or facility-level:
Batch-level e. Inspections after each setup,
Unit-level f. Polishing parts,
Unit-level g. Assembling parts,
Batch-level h. Health and safety.
Solution on
notes page
End of Chapter 3: ABC
Next Chapter 4: Cost Analysis

and Pricing Decisions

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Chapter Three

Managerial accounting, also called management

Managerial accounting applies to all types of

Traditional Costing Systems

 Process costing: machine hours is the relevant activity

Assumption was satisfactory when direct labor was a

The Need for a New Approach

Tremendous change in manufacturing and service

Assigns the activity cost pools to products

Activity Cost Pool: the overhead cost attributed

Cost Drivers: any factor or activity that have a

Stage 2: The overhead costs allocated to the cost pools

The more complex a product’s manufacturing

Activity-Based Costing Illustration 3-3

Indicate whether the following statements

1. A traditional costing system allocates overhead by

True 2. Activity-based costing allocates overhead costs in a

3. Direct material and direct labor costs are easier to

Indicate whether the following statements

4. As manufacturing processes have become more

5. In activity-based costing, an activity is any event,

ABC allocates overhead costs in two stages:

Stage 1: Overhead costs are allocated to activity

Stage 2: The overhead costs allocated to the cost

The more complex a product’s manufacturing

Each product requires 1 hour of direct labor

Expected annual manufacturing overhead costs $900,000

Direct materials cost: Required: Calculate unit

* Overhead rate = $900,000/30,000 DLH = $30 per DLH

Activity-based costing involves the following four

2. Identify the cost driver that has a strong

3. Compute the overhead rate for each pool.

4. Assign overhead costs for each costs to products

Identify and Classify Activities and Allocate

Identify Cost Drivers (Step 2)

The cost driver must accurately measure the actual

Compute Overhead Rates (Step 3)

Assign Overhead Cost to Products (Step 4)

Assign Overhead Cost to Products (Step 4)

Assign Overhead Cost to Products (Step 4)

Comparing Unit Costs

A likely consequence of the differences in assigning overhead is that

Comparing Unit Costs

Low volume products often require more special

Assigning overhead using ABC will usually increase the

Solution on notes page

Solution on notes page

Solution on notes page

c. Compute the overhead cost per unit for each product.

d. Comment on the comparative overhead cost per unit.

These data show that the total overhead assigned to 80,000

More accurate product costing through:

Enhanced control over overhead costs

Better management decisions

Can be expensive to use

Some arbitrary allocations continue

When to Use ABC

Value-Added Versus Non–Value-Added Activities