Activity-Based Costing

and
Activity-Based

Chapte
r5
Learning Objective 1

Explain
undercosting
and overcosting of

products and
Undercosting and
Overcosting Example

Jose, Roberta, and Nancy order

separate items for lunch.
Jose’s order amounts to $14
Roberta consumed 30
Nancy’s order is 16
Total $60
What is the average cost per lunch?
Undercosting and
Overcosting Example

$60 ÷ 3 = $20

Jose and Nancy Roberta is

are overcosted. undercosted.
Learning Objective 2

Present three
guidelines for
refining a costing
Existing Single Indirect-
Cost Pool System Example

Kole Corporation manufactures a normal lens

(NL) and a complex lens (CL).
Kole currently uses a single indirect-cost rate
job costing system.
Cost objects: 80,000 (NL) and 20,000 (CL).
Existing Single Indirect-
Cost Pool System Example

Normal Lenses (NL)

Direct materials $1,520,000
Direct mfg. labor 800,000
Total direct costs $2,320,000
Direct cost per unit: $2,320,000 ÷ 80,000 = $29
Existing Single Indirect-
Cost Pool System Example

Complex Lenses (CL)

Direct materials $ 920,000
Direct mfg. labor 260,000
Total direct costs $1,180,000
Direct cost per unit: $1,180,000 ÷ 20,000 = $59
Existing Single Indirect-
Cost Pool System Example

INDIRECT-COST All Indirect

POLL Costs
$2,900,000

INDIRECT 50,000 Direct

COST-ALLOCATION Manufacturing
BASE Labor-Hours

$58 per Direct

Manufacturing
Labor-Hour
Existing Single Indirect-
Cost Pool System Example

COST OBJECT: Indirect Costs

NL AND CL
LENSES Direct Costs

DIRECT
COSTS
Direct Direct
Manufacturing
Materials Labor
Existing Single Indirect-
Cost Pool System Example

Kole uses 36,000 direct manufacturing

labor-hours to make NL and 14,000 direct
manufacturing labor-hours to make CL.
How much indirect costs are allocated
to each product?
Existing Single Indirect-
Cost Pool System Example
NL: 36,000 × $58 = $2,088,000
CL: 14,000 × $58 = $812,000
What is the total cost of normal lenses?
Direct costs $2,320,000 +
Allocated costs $2,088,000 = $4,408,000
What is the cost per unit?
$4,408,000 ÷ 80,000 = $55.10
Existing Single Indirect-
Cost Pool System Example

What is the total cost of complex lenses?

Direct costs $1,180,000 + Allocated costs
$812,000 = $1,992,000
What is the cost per unit?
$1,992,000 ÷ 20,000 = $99.60
Existing Single Indirect-
Cost Pool System Example

Normal lenses sell for $60 each and

complex lenses for $142 each.
Normal Complex
Revenue $60.00 $142.00
Cost 55.10 99.60
Income $ 4.90 $ 42.40
Margin 8.2% 29.9%
Refining a Costing
System

Direct-cost tracing

Indirect-cost pools

Cost-allocation basis
Refining a Costing System

1. Design of Products and Process

The Design Department designs the molds
and defines processes needed (details of
the manufacturing operations).
Refining a Costing System

2. Manufacturing Operations
Lenses are molded, finished,
cleaned, and inspected.
3. Shipping and Distribution
Finished lenses are packed and
sent to the various customers.
Learning Objective 3

Distinguish between
the
traditional and the

activity-based

costing
approaches to
Activity-Based Costing
System

Fundamental Assignment to
Cost Objects Other
Cost Objects
Activities Cost of:
Product
Service
Costs of Activities Customer
Activity-Based Costing
System

A cross-functional team at Kole

Corporation identified key activities:
Design products and processes.
Set up molding machine.
Operate machines to manufacture lenses.
Maintain and clean the molds.
Activity-Based Costing
System

Set up batches of finished lenses for shipment.

Distribute lenses to customers.
Administer and manage all processes.
 Activity-Based Costing
System
Activity
Indirect Cost Design Setup Shipping
Pool

Cost Parts- No. of

Allocatio Square Setup No. of
n feet Hours Shipments
Base

Product Lenses Lenses Lenses

Cost
Objects NL CL Other
Activity-Based Costing
System

NL CL
Quantity produced 80,000 20,000
No. produced/batch 250 50
Number of batches 320 400
Setup time per batch 2 hours 5 hours
Total setup-hours 640 2,000
Total setup costs are $409,200.
Activity-Based Costing
System

What is the setup cost per setup-

hour?
$409,200 ÷ 2,640 hours = $155
What is the setup cost per
direct manufacturing labor-hour?
$409,200 ÷ 50,000 = $8.184
Activity-Based Costing
System
Allocation using direct labor-hours:
NL: $8.184 × 36,000 = $294,624
CL: $8.184 × 14,000 = $114,576
Total $409,200
Allocation using setup-hours:
NL: $155 × 640 = $ 99,200
CL: $155 × 2,000 = $310,000
Total $409,200
Learning Objective 4

 Describe a four-
part
cost hierarchy.
Cost Hierarchies

A cost hierarchy is a categorization

of costs into different cost pools.
Cost drivers bases (cost-allocation bases)
Degrees of difficulty in determining
cause-and-effect relationships
Cost Hierarchies

ABC systems commonly use a

four-part cost hierarchy to
identify cost-allocation bases:
1. Output unit-level costs
2. Batch-level costs
3. Product-sustaining costs
4. Facility-sustaining costs
Output Unit-Level Costs

These are resources sacrificed

on activities performed on each
individual unit of product or service.
Energy
Machine depreciation
Repairs
Batch-Level Costs

These are resources sacrificed on

activities that are related to a group
of units of product(s) or service(s)
rather than to each individual unit
of product or service.
Setup-hours
Procurement costs
Product-Sustaining Costs

These are often called service-sustaining

costs and are resources sacrificed on
activities undertaken to support
individual products or services.
Design costs
Engineering costs
Facility-Sustaining Costs

These are resources sacrificed on

activities that cannot be traced to
individual products or services but
support the organization as a whole.
General administration
– rent – building security
Learning Objective 5

Cost products or
services using
activity-based costing.
Implementing
Activity-Based Costing

Step 1 Step 2
Identify cost objects. Identify the direct
costs
of the products.
NL Direct material
CL Direct labor
Mold cleaning and
maintenance
Implementing
Activity-Based Costing

Cleaning and maintenance costs of

$360,000 are direct batch-level costs.
Why?
Because these costs consist of workers’
wages for cleaning molds after each
batch of lenses is run.
Implementing
Activity-Based Costing

 Normal Lenses (NL)

 Cost Hierarchy
 Description Category
Direct materials Unit-level $1,520,000
Direct mfg. labor Unit-level 800,000
Cleaning and maint. Batch-level

160,000
Total direct costs $2,480,000
Implementing
Activity-Based Costing

 Complex Lenses (CL)

 Cost Hierarchy
 Description Category
Direct materials Unit-level $ 920,000
Direct mfg. labor Unit-level 260,000
Cleaning and maint. Batch-level

200,000
Total direct costs $1,380,000
Implementing
Activity-Based Costing
Step 3
Select the cost-allocation bases to use
for
allocating indirect
(1) (2) costs to the
(3)
Activity Cost Hierarchy
Total Costs
Design Product-sustaining
$450,000
Implementing
Activity-Based Costing

Step 4
Identify the indirect costs
associated
with each cost-allocation
Overhead costs incurredbase
are .
assigned
to activities, to the extent
possible, on
Implementing
Activity-Based Costing

Step 5
Compute the rate per unit.
(1) (5)
NL CL Total
Setup-hours: 640 2,000 2,640
$409,200 ÷ 2,640 = $155
Implementing
Activity-Based Costing

Step 6
Compute the indirect costs
allocated
NL: $155to×the640
products.
= $
99,200
CL: $155 × 2,000 =
310,000
Implementing
Activity-Based Costing

Step 7
Compute the costs of the
NL and CLproducts.
would show three
direct cost categories.
1. Direct materials
2. Direct manufacturing
labor
3. Cleaning and maintenance
Implementing
Activity-Based Costing
NL and CL would show six indirect cost
1. Design pools.
2. Molding machine setups
3. Manufacturing operations
4. Shipment setup
5. Distribution
6. Administration
 End of
Chapter 5