Managerial accounting garrison norren 11th ed chap008

11th Edition
Chapter 8

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Activity-Based Costing: A
Tool to Aid Decision Making
Chapter Eight

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Activity Based Costing (ABC)

ABC is designed to
provide managers with
cost information for
strategic and other
decisions that
potentially affect
capacity and therefore
affect fixed as well as
variable costs.

McGraw-Hill/Irwin

ABC is a
good supplement
to our traditional
cost system

I agree!

Copyright © 2006, The McGraw-Hill Companies, Inc.


How Costs are Treated Under
Activity–Based Costing
“Best
“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
Manufacturing
costs

Nonmanufacturing
costs

Traditional

product costing

ABC
product costing

 ABC assigns both types of costs to products.
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


How Costs are Treated Under
Activity–Based Costing
“Best
“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

Traditional
product costing

Nonmanufacturing
costs

Mo
st, b
ut
not
all

Some

All

Manufacturing
costs

ABC
product costing

 ABC does not assign all manufacturing costs to products.
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


How Costs are Treated Under
Activity–Based Costing

Level of complexity

“Best
“Best practice”
practice” ABC

ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
Activity–Based
Activity–Based
Costing
Costing
Departmental
Departmental
Overhead
Overhead
Rates
Rates
Plantwide
Plantwide
Overhead
Overhead
Rate
Rate

Number of cost pools
 ABC uses more cost pools.
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.

How Costs are Treated Under
Activity–Based Costing

Number of
Allocation Bases

“Best
“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
Volume
measures
plus other
bases.

Bases usually
rely solely on
volume
measures.

Traditional Costing

ABC
 ABC uses more allocation bases.
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


How Costs are Treated Under
Activity–Based Costing
“Best
“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
The
The most
most commonly
commonly used
used allocation
allocation base
base
in
in traditional
traditional costing

costing is
is direct
direct labor
labor hours.
hours.
Direct labor hours work
well when overhead
increases as direct
labor hours increase.

 ABC uses more allocation bases.
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


How Costs are Treated Under
Activity–Based Costing
“Best
“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.
The

The most
most commonly
commonly used
used allocation
allocation base
base
in
in traditional
traditional costing
costing is
is direct
direct labor
labor hours.
hours.
Problems:
 In many processes, overhead is increasing
while direct labor is decreasing.
 Variety and complexity of products is increasing.

 ABC uses more allocation bases.
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


How Costs are Treated Under
Activity–Based Costing
“Best
“Best practice”
practice” ABC

ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

All overhead
costs are not related
to volume measures like
direct labor
hours.

ABC uses
volume as well as
other allocation bases not
related to the volume
of production.

 ABC uses more allocation bases.
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


How Costs are Treated Under
Activity–Based Costing
“Best

“Best practice”
practice” ABC
ABC differs
differs from
from traditional
traditional costing
costing in
in five
five ways.
ways.

Traditional Costing

ABC

The predetermined
overhead rate is based
on budgeted activity.
This results in applying
all overhead costs
including unused, or
idle capacity costs to
products.

Products are charged
for the costs of
capacity they use – not
for the costs of
capacity they don’t
use. Unused capacity

costs are treated as
period expenses.

 ABC bases level of activity on capacity.
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Characteristics of Successful
ABC Implementations

Strong
Strong top
top
management
management support
support

Link
Link to
to evaluations
evaluations
and
and rewards
rewards

Cross-functional
Cross-functional
involvement

involvement
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Designing an ABC System

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

Activities

Consumption
of Resources

Cost
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


Designing an ABC System
Steps for Implementing ABC
 Identify and define activities and activity cost
pools.
 Trace costs to activities and cost objects.
 Assign costs to activity cost pools.
 Calculate activity rates.

 Assign costs to cost objects.
 Prepare management reports.

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


 Identify and Define Activities
and Activity Cost Pools
Unit-Level
Activity

Batch-Level
Activity

Manufacturing
companies typically combine
their activities into five
classifications.

Product-Level
Activity
McGraw-Hill/Irwin

Organizationsustaining
Activity

Customer-Level
Activity

Copyright © 2006, The McGraw-Hill Companies, Inc.


 Identify and Define Activities
and Activity Cost Pools
Activities
should only be
combined within a level
if they are highly
correlated.
When combining
activities, they should be
grouped together only at
the appropriate
level.

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


 Identify and Define Activities
and Activity Cost Pools

An Activity Cost
Pool is a “bucket” in
which costs are
accumulated that
relate to a single
activity measure in

the ABC system.

McGraw-Hill/Irwin

$$
$
$ $
$

Copyright © 2006, The McGraw-Hill Companies, Inc.


 Identify and Define Activities
and Activity Cost Pools
Two types of activity measures:
Transaction
driver

Duration
driver

Simple count
of the number of
times an activity
occurs.

A measure
of the amount
of time needed
for an activity.

McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


 Identify and Define Activities
and Activity Cost Pools
At Classic Brass, the ABC team, selected the following
activity cost pools and activity measures:

Activity Cost Pools at Classic Brass
Activity Cost Pool
Customer orders
Product design
Order size
Customer relations
Other

McGraw-Hill/Irwin

Activity Measure
Number of customer orders
Number of product designs
Machine-hours
Number of active customers
Not applicable

Copyright © 2006, The McGraw-Hill Companies, Inc.

 Identify and Define Activities
and Activity Cost Pools
•• Customer
Customer Orders
Orders -- assigned
assigned all
all costs
costs of
of resources
resources
that
that are
are consumed
consumed by
by taking
taking and
and processing
processing
customer
customer orders.
orders.
•• Product
Product Designs
Designs -- assigned
assigned all
all costs
costs of
of resources
resources

consumed
consumed by
by designing
designing products.
products.
•• Order
Order Size
Size -- assigned
assigned all
all costs
costs of
of resources
resources
consumed
consumed as
as aa consequence
consequence of
of the
the number
number of
of units
units
produced.
produced.
•• Customer
Customer Relations
Relations –– assigned
assigned all
all costs
costs associated

associated
with
with maintaining
maintaining relations
relations with
with customers.
customers.
•• Other
Other –– assigned
assigned all
all overhead
overhead costs
costs that
that are
are not
not
associated
associated with
with the
the other
other cost
cost pools.
pools.
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.


 When Possible, Directly Trace Overhead
Costs to Activities and Cost Objects

Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)
Production Department
Indirect factory wages
$
Factory equipment depreciation
Factory utilities
Factory building lease
Shipping costs traced to customer orders
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total overhead costs
McGraw-Hill/Irwin

500,000
300,000
120,000
80,000 $

400,000
50,000
60,000

1,000,000
40,000

510,000

250,000
50,000
$

300,000
1,850,000

Copyright © 2006, The McGraw-Hill Companies, Inc.


 Assign Costs to Activity Cost Pools
At Classic Brass the following distribution of resource
consumption across activity cost pools is determined.
Activity Cost Pools
Customer Product
Order
Orders
Design
Size
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
Shipping costs **
General Administrative Department
Administrative wages and salaries

Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses

Customer
Relations

Other

Total

25%
20%
0%
0%

40%
0%
10%
0%

20%
60%
50%
0%

10%
0%

0%
0%

5%
20%
40%
100%

100%
100%
100%
100%

15%
30%
0%

5%
0%
0%

10%
0%
0%

30%
25%
0%

40%

45%
100%

100%
100%
100%

20%
10%

10%
0%

0%
0%

60%
70%

10%
20%

100%
100%

**Not included because they are directly traced to customer orders.
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.

 Assign Costs to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Activity
Customer
Orders
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

$ 125,000

Production Department
$
CostIndirect
Poolsfactory wages
Factory equipment depreciation
Product

Order
Customer
Factory utilities
Design
Sizelease Relations
Factory building
Shipping costs traced to customer orders
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total overhead costs

500,000
300,000
120,000
Other
80,000 $

Total
1,000,000
40,000

400,000
50,000
60,000

510,000

250,000
50,000
$

300,000
1,850,000

Indirect
$500,000
Indirect factory
factory wages
wages
$500,000
Percent
25%
Percent consumed
consumed by
by customer
customer orders
orders
25%
$125,000
$125,000
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.

 Assign Costs to Activity Cost Pools
Overhead Costs at Classic Brass
(Manufacturing and NonManufacturing)

Activity
Customer
Orders
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

$ 125,000
60,000

Production Department
$
CostIndirect
Poolsfactory wages
Factory equipment depreciation
Product

Order
Customer
Factory utilities
Design
Sizelease Relations
Factory building
Shipping costs traced to customer orders
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total overhead costs

500,000
300,000
120,000
Other
80,000 $

Total
1,000,000
40,000

400,000
50,000
60,000

510,000

250,000
50,000
$

300,000
1,850,000

Factory
$300,000
Factory equipment
equipment depreciation
depreciation
$300,000
Percent
20%
Percent consumed
consumed by
by customer
customer orders
orders
20%
$$ 60,000
60,000
McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.

 Assign Costs to Activity Cost Pools

Activity Cost Pools
Customer
Product
Orders
Design
Production Department
Indirect factory wages
Factory equipment depreciation
Factory utilities
Factory building lease
General Administrative Department
Administrative wages and salaries
Office equipment depreciation
Administrative building lease
Marketing Department
Marketing wages and salaries
Selling expenses
Total

McGraw-Hill/Irwin

Order
Size

Customer
Relations

$ 125,000 $ 200,000 $ 100,000 $

60,000
180,000
12,000
60,000
60,000
15,000
-

20,000
-

40,000
-

50,000 $
120,000
12,500
-

Other
25,000 $
60,000
48,000
80,000
160,000
22,500
60,000

Total
500,000

300,000
120,000
80,000
400,000
50,000
60,000

50,000
25,000
150,000
25,000
250,000
5,000
35,000
10,000
50,000
$ 315,000 $ 257,000 $ 380,000 $ 367,500 $ 490,500 $ 1,810,000

Copyright © 2006, The McGraw-Hill Companies, Inc.