The document provides an overview of activity-based costing (ABC). It begins by explaining the limitations of traditional costing methods and why ABC was developed. ABC assigns overhead costs to products based on their consumption of activities, rather than a single allocation base like direct labor hours. The document then demonstrates how to design and implement an ABC system using an example company. It shows how ABC can assign costs differently than traditional methods and help identify areas for process improvement.

1. Chapter 3
© The McGraw-Hill Companies, Inc., 2007McGraw-Hill /Irwin
Systems Design: Activity-
Based Costing

2. 3-2
Learning Objective
To understand the basic
approach in activity-
based costing and how
it differs from
conventional costing.
LO1

3. 3-3
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 Products

4. 3-4
Assigning Overhead Costs to Products
Plantwide 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.

5. 3-5
Today, direct labor may no longer be a
satisfactory base for allocation of overhead.
1. Most companies sell a large variety of products that
consume differing amounts of overhead.
2. 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.
3. Technology advancements have reduced the cost and
complexity of gathering diverse sources of data.
Plantwide Overhead Rate
A plantwide overhead allocation system may not be optimal
for many companies in today’s business environment.

6. 3-6
Departmental Overhead Rates
Finishing Department
Shipping Department
Painting Department
Many companies have a system in which
each department has its own overhead rate.
The allocation bases depend 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.

7. 3-7
A more sophisticated approach, such as activity-based
costing, is required to account for these other factors.
Departmental Overhead Rates
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.
Unfortunately, even departmental rates will not correctly
assign overhead in situations where a company has a
range of products and complex overhead costs.

8. 3-8
Activity-Based Costing (ABC)
A number of
allocation bases are
used for assigning
costs to products.

9. 3-9
Cost
A number of
allocation bases
are used for
assigning costs
to products.
Activity-Based Costing (ABC)
Consumption of Resources
Activities
Cost Objects
(e.g., products and customers)

10. 3-10
Activity
An event that causes the
consumption of overhead
resources
Activity-Based Costing (ABC)
Setting up
machines
Examples of Activities
Admitting
hospital
patients
Opening a
bank account
Billing
customers

11. 3-11
Activity
An event that causes the
consumption of overhead
resources
Activity
Cost Pool
A “cost bucket” in which
costs related to a particular
activity measure are
accumulated
Activity
Measure
Expresses how much of the
activity is carried out and is
used as the allocation base
for applying overhead costs
Activity-Based Costing (ABC)

12. 3-12
Activity
An event that causes the
consumption of overhead
resources
Activity
Cost Pool
A “cost bucket” in which
costs related to a particular
activity measure are
accumulated
Activity
Measure
Expresses how much of the
activity is carried out and is
used as the allocation base
for applying overhead costs
Activity
Rate
A predetermined overhead
rate for each activity cost
pool.
Activity-Based Costing (ABC)

13. 3-13
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.

14. 3-14
Designing an Activity-Based
Costing System
In 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.
Activities are usually chosen by interviewing
a broad range of managers to find out what
activities they think consume most of the
organization’s resources.

15. 3-15
Designing an Activity-Based
Costing System
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.
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.

16. 3-16
Hierarchy of Activities
Level Activities Activity Measure
Unit-level Processing units on machines Machine-hours
Processing units by hand Direct labor-hours
Consuming factory supplies Units produced
Batch-level Processing purchase orders Purchase orders processed
Processing production orders Production orders processed
Setting up equipment Number of setups
Handling materials Pounds of material handled
Product-level Testing new products Hours of testing time
Administering parts inventories Number of part types
Designing products Hours of design time
Facility-level General factory administration Direct labor-hours
Plant building and grounds Direct labor-hours

17. 3-17
Graphic Example of
Activity-Based Costing
Labor
Related Pool
Machine
Related Pool
Setup
Pool
Production
Order Pool
General
Factory Pool
Parts
Admin. Pool
First-Stage Cost Assignment
Various Manufacturing Overhead Costs

18. 3-18
Unit-Level
Activity
Batch-Level
Activity
Facility-Level
Activity
Product-Level
Activity
Graphic Example of
Activity-Based Costing
Labor
Related Pool
Machine
Related Pool
Setup
Pool
Production
Order Pool
General
Factory Pool
Parts
Admin. Pool
First-Stage Cost Assignment
Various Manufacturing Overhead Costs
Products
$/DLH $/MH $/Setup $/Order $/MH$/Part Type
Second-Stage Allocations

19. 3-19
Using Activity-Based Costing
Comtek Sound, Inc.
 Comtek Sound, Inc. makes two products that are sold to
automobile manufacturers, a radio with a built-in CD
player and a radio with a built-in DVD player.
 The company has been losing bids to supply CD players,
its main product, to lower price competitors.
 The company has been winning all bids to supply DVD
players, its secondary product.

20. 3-20
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
DVDs: 50,000 units @ 2 hours per unit = 100,000
CDs: 200,00 units @ 2 hours per unit = 400,000
Total direct labor-hours 500,000

21. 3-21
Using Activity-Based Costing
Comtek Sound, Inc.
 Unit costs for materials and labor are:
DVD CD
Units Units
Direct materials 90$ 50$
Direct Labor 20$ 20$

22. 3-22
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
overhead rate
= $20 per DLH=
$10,000,000
500,000 DLHs
Direct Labor-Hours as a Base

23. 3-23
DVD Unit CD Unit
Direct materials 90$ 50$
Direct labor 20 20
Manufacturing overhead 40 40
(2 DLHs x $20 per DLH)
Unit product cost 150$ 110$
Direct Labor-Hours as a Base
Since each product requires two hours of direct
labor, $40 of overhead is assigned to each product.

24. 3-24
Learning Objective
To compute activity
rates for an activity-
based costing system.
LO2

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

26. 3-26
We can calculate the following activity rates:
Activity and Activity Measures
Estimated
Overhead
Cost
Total
Expected
Activity
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$
Activity Rate
Using the new activity rates, let’s assign overhead
to the two products based upon expected activity.
Computing Activity Rates

27. 3-27
Learning Objective
To compute product
costs using activity-
based costing.
LO3

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

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

30. 3-30
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 $207.80.
Comparing the Two Approaches
DVD Unit CD Unit DVD Unit CD Unit
Direct material 90.00$ 50.00$ 90.00$ 50.00$
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost 207.80$ 95.55$ 150.00$ 110.00$
Activity-Based Costing Direct-Labor Costing

31. 3-31
Learning Objective
To contrast the product
costs computed under
activity-based costing
and conventional
costing methods.
LO4

32. 3-32
DVD Unit CD Unit DVD Unit CD Unit
Direct material 90.00$ 50.00$ 90.00$ 50.00$
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost 207.80$ 95.55$ 150.00$ 110.00$
Activity-Based Costing Direct-Labor Costing
Comparing the Two Approaches
The ABC system assigns $14.45
less overhead than the traditional
system to each CD player.

33. 3-33
Comparing the Two Approaches
DVD Unit CD Unit DVD Unit CD Unit
Direct material 90.00$ 50.00$ 90.00$ 50.00$
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost 207.80$ 95.55$ 150.00$ 110.00$
Activity-Based Costing Direct-Labor Costing
The ABC system assigns $57.80
more overhead than the traditional
system to each DVD player.

34. 3-34
DVD Unit CD Unit DVD Unit CD Unit
Direct material 90.00$ 50.00$ 90.00$ 50.00$
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost 207.80$ 95.55$ 150.00$ 110.00$
Activity-Based Costing Direct-Labor Costing
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 product
Shifting of Overhead Cost

35. 3-35
DVD Unit CD Unit DVD Unit CD Unit
Direct material 90.00$ 50.00$ 90.00$ 50.00$
Direct labor 20.00 20.00 20.00 20.00
Manufacturing overhead 97.80 25.55 40.00 40.00
Unit product cost 207.80$ 95.55$ 150.00$ 110.00$
Activity-Based Costing Direct-Labor Costing
High-volume product
Shifting of Overhead Cost
The traditional system assigns the same amount of all
overhead costs to each CD or DVD player ($40 per unit).

36. 3-36
Shifting of Overhead Cost
DVD Units CD Units
Number of units produced per year 50,000 200,000
Number of production orders issued per year 800 400
Number of units processed per production order 62.5 500
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.
1. Compute the number of units processed
per production order for each product

37. 3-37
Shifting of Overhead Cost
2. Compute production order cost per unit for each product.
DVD Units CD Units
Cost to issue a production order 2,625$ 2,625$
Average number of units processed per
production order 62.5 500
Production order cost per unit 42.00$ 5.25$
Notice, the costs are being shifted from the high
volume CD players to the low volume DVD players.

38. 3-38
Activity-Based Management
involves focusing on activities to eliminate waste,
decrease processing time, and reduce defects.
Targeting Process Improvements
One of the great benefits derived from using
an ABC system is that it can help identify
areas where the company can benefit
from improving its current processes.

39. 3-39
The first step in any improvement
program is deciding what to improve.
Targeting Process Improvements
The Theory of Constraints
approach targets the
highest impact
improvement opportunities.
Activity rates can be
used to target areas
where costs seem
excessively high.
Benchmarking can be used to compare activity cost
information with world-class standards of performance
achieved by other organizations.

40. 3-40
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.

41. 3-41
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.
Limitations Activity-Based Costing

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

43. 3-43
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.

44. 3-44
Learning Objective
To record the flow of
costs in an activity-
based costing system.
LO5

45. 3-45
Sarvik Company uses activity-based costing.
The company has five cost pools shown below.
Activity Cost Pool Activity Measure
Estimated
Overhead
Cost
Machine related Machine hours 175,000$ 5,000 MHs
Purchase orders Number of orders 63,000 700 orders
Machine setups Number of setups 92,000 460 setups
Product testing Number of tests 160,000 200 tests
General factory Direct labor hours 300,000 25,000 DLHs
790,000$
Expected Activity
Cost Flows in an ABC System

46. 3-46
Activity rates are determined as follows:
Activity Cost Pool
Estimated
Overhead
Cost
Total
Expected
Activity
Machine related 175,000$ ÷ 5,000 MHs = 35$ per MH
Purchase orders 63,000 ÷ 700 orders = 90$ per order
Machine setups 92,000 ÷ 460 setups = 200$ per setup
Product testing 160,000 ÷ 200 tests = 800$ per test
General factory 300,000 ÷ 25,000 DLH = 12$ per DLH
790,000$
Activity Rate
Cost Flows in an ABC System

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

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

49. 3-49
The following journal entries would be used
to record transactions (a) and (b).
Cost Flows in an ABC System
Description Debit Credit
a. Raw Materials 915,000
Accounts Payable 915,000
b. Work in Process 810,000
Manufacturing Overhead 90,000
Raw materials 900,000

50. 3-50
The following journal entries would be used
to record transactions (c) and (d).
Cost Flows in an ABC System
Description Debit Credit
c. Work in Process 95,000
Manufacturing Overhead 275,000
Wages payable 370,000
d. Manufacturing Overhead 180,000
Accumulated Depreciation 180,000

51. 3-51
Description Debit Credit
e. Manufacturing Overhead 230,000
Accounts Payable 230,000
The following journal entry would be used to
record transaction (e).
Cost Flows in an ABC System

52. 3-52
Description Debit Credit
f. Work in Process 761,000
Manufacturing Overhead 761,000
The following journal entry would be used to
record transaction (f).
Cost Flows in an ABC System

53. 3-53
Description Debit Credit
g. Finished Goods 1,650,000
Work in Process 1,650,000
The following journal entry would be used to
record transaction (g).
Cost Flows in an ABC System

54. 3-54
Bal. 14,000
Manufacturing Overhead
(b) 90,000
(c) 275,000
(d) 180,000
(e) 230,000
(g) 761,000
Underapplied
Overhead Costs
Cost Flows in an ABC System

55. 3-55
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.

56. 3-56
End of Chapter 3