Chapter 8 Notes Page 1

Activity-Based Costing
Cost Pools
As we mentioned in Chapter 3, in a manufacturing situation, there are three
components to cost:

 Direct Labor,
 Direct Materials, and
 Manufacturing Overhead.

As noted previously, it is relatively easy to allocate Direct Labor and Direct Materials to
the products produced, but it is difficult to allocate Manufacturing Overhead costs.
Because of this, we have Normal Costing and the allocation of Manufacturing Overhead
using Predetermined Overhead Rates.

In Chapter 3, we used a single, Predetermined Overhead Rate to allocate the

Manufacturing Overhead costs to the products being produced. If all of the products are
similar, this approach may produce a fairly accurate allocation of Manufacturing
Overhead.

On the other hand, if you have widely diversified product lines and production
operations, then a Plant-Wide Application Rate may not be very accurate. You may find
that some products are being under-costed and others are being over-costed. In this
case, you might obtain more accuracy in the allocation of Manufacturing Overhead to
the units that generated it by using more than one overhead cost pools. The number of
cost pools to use always involves a cost-benefit analysis, because of the additional
record keeping involved.

Why should you care whether your products being over-costed or under-costed?
Having more accurate cost information can lead to an improvement in your bidding
process. If you base your customer bid prices on your costs, you could charge the
wrong amounts. If you charge more than your competitors, then you will lose business.
If you charge less than your competitors, you will get more business, but your profits will
be less than you expected because you are not charging your customers enough.

Having more accurate cost information could improve a firm’s product mix. Even if your
prices are not based on your costs (e.g., set by the free market), you still may have
problems. For example, you may not actively go after certain business because you
don't think it is very profitable when that business actually is profitable. Similarly, you
may go after other business that you believe is very profitable, when it is not profitable
or less profitable than you believe.

Another way that over-costing or under-costing can affect a business is in the decision
whether to offer a product or discontinue a product. Having misinformation on the

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Chapter 8 Notes Page 2

profitability of a product may cause a product to be improperly discontinued (or retained

when it should be discontinued). For example, a firm may incorrectly outsource the
manufacture of a part or product because it wrongly believes that it is cheaper to
purchase the part or product rather than manufacture it.

Department Allocations of Overhead

A simple way to have multiple cost pools is to pool Manufacturing Overhead costs
separately by production department. This is especially true if the departments are very
different (e.g., one is labor intensive, and the other is automated).

You calculate a separate Predetermined Overhead Rate for each department’s

Manufacturing Overhead. When using Departmental Application Rates, it is possible to
use different Cost Drivers for different departments.

Departmental Application Rate Example

Ajax Inc. produces standard model trophies, as well as, custom
designed trophies. Ajax’s plant has two production departments: (i)
the Design Department and (ii) the Manufacturing Department. The
standard model trophies are made in the Manufacturing Department
without any Design Department services. Custom designed trophies
are designed in the Design Department and then manufactured in the
Manufacturing Department.

The Design Department uses 10,000 Direct Labor Hours, and the
Manufacturing Department uses 90,000 Direct Labor Hours. Ajax
currently allocates its Manufacturing Overhead using one Plant-Wide
Application Rate using Direct Labor Hours as the Cost Driver.

The Manufacturing Overhead for the plant is as follows:

Indirect Costs Design Manufacturing Total

Rent $20,000 $ 80,000 $100,000
Depreciation ---- 200,000 200,000
Supervisors 50,000 50,000 100,000
Maintenance 20,000 80,000 100,000
Total $90,000 $410,000 $500,000

Recently, Ajax bid on two different jobs. Job 1 involves a unique product design, and it
requires 20 Direct Labor Hours of Design services and 20 Direct Labor Hours of
Manufacturing services. Job 2 involves a standard model, and it involves no Design
services. Job 2 only requires 20 Direct Labor Hours of Manufacturing services. Both
jobs require $200 of Direct Materials, and the Direct Labor Cost is $5 per Direct Labor
Hour. Ajax prices its products using a cost plus 20% profit margin method.

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Chapter 8 Notes Page 3

Even though Ajax's costs are no different than its competitors, the customer, who
received the Job 2 bid, asked Ajax to lower its bid stating that Ajax’s competitors
charged lower prices for similar work. On the other hand, the customer, who received
the Job 1 bid, did not hesitate to accept that bid.

Plant-Wide Application Rate

Ajax’s current Plant-Wide Application Rate is calculated as follows:

$500,000 / 100,000 = $5 per Direct Labor Hour

Using this application rate resulted in the following Manufacturing Overhead cost
calculation for Jobs 1 and 2:

Job 1: 40 hours x $5 per DLH = $200.

Job 2: 20 hours x $5 per DLH = $100.

Using these costs, Ajax bid the two jobs as follows:

Job 1 Job 2
Direct Materials $200 $200
Direct Labor $200 $100
Manufacturing Overhead $200 $100
Total Cost $600 $400
Profit $120 $80
Price Bid $720 $480

Departmental Application Rates

If Ajax were to use separate Departmental Application Rates, the following rates would
be used:

Design Department: $90,000/10,000 = $9.00 per DLH

Manufacturing Department: $410,000/90,000 = $4.55 per DLH

If Ajax had used Departmental Application Rates to calculate the Manufacturing

Overhead costs of Jobs 1 and 2 the following costs would have resulted:

Job 1 Job 2
Design Department 20 hours x $9 = $180
Manufacturing Department 20 hours x $4.55 = $91 20 hours x $4.55 = $91
Total Overhead $271 $91

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Chapter 8 Notes Page 4

If Ajax had used these Manufacturing Overhead costs, the two jobs would have been
priced as follows:

Job 1 Job 2
Direct Materials $200.00 $200.00
Direct Labor $200.00 $100.00
Manufacturing Overhead $271.00 $91.00
Total Cost $671.00 $391.00
Profit $134.20 $78.20
Price Bid $805.20 $469.20

Comparison

As you can see, when compared to Departmental Application Rates, the use of a Plant-
Wide Application Rate produces a lower bid for Job 1 and a higher bid for Job 2:

Job 1 Job 2
Plant-Wide Rate $720.00 $480.00
Departmental Rates $805.20 $469.20
Difference -$85.20 $10.80

Assuming that Ajax’s competitor uses Departmental Application Rates, you can see why
the competitor was able to offer a cheaper bid for Job 2.

The reason why these differences exist can be seen by comparing the Plant-Wide
Application Rate with the Departmental Application Rates:

Plant-Wide Rate $5.00

Design Department Rate $9.00
Manufacturing Department Rate $4.55

The Design services use a great deal of Manufacturing Overhead. When you use a
Plant-Wide Application Rate, the Design overhead costs are spread over all of the units
being produced. When Departmental Application Rates are used, then the
Manufacturing Overhead associated with the Design services are borne by only those
units that require Design services. This treatment results in the units accurately
reflecting the Manufacturing Overhead costs incurred to produce them.

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Chapter 8 Notes Page 5

Activity-Based Costing
With Activity-Based Costing (ABC), you divide
your Manufacturing Overhead into different cost
pools based upon the different activities within
the plant. These activities are not sub-divisions of
a department. Activities can span more than one
department. For example, CSULB’s College of
Business is divided into five departments,
Accounting, Finance, Marketing, Management
and Information Systems, but the College could
be divided into activities of such as lecturing,
computer lab usage, copying, word processing,
counseling, and office hours. These activities
transcend multiple departments.

In a manufacturing operation, you might have the following activities:

 Perform Engineering Work;

 Plan Production;
 Purchase Materials;
 Receive and Handle Materials;
 Manage Production;
 Setup Machinery;
 Store Final Product; and
 Ship Final Product.

With ABC, you will calculate a Predetermined Application Rate for each activity, and
apply it to your products, activity by activity, using appropriate Cost Drivers.

A major disadvantage of ABC is that it requires more work to implement, maintain and
use. The initial analysis of a firm’s activities and the costs associated with those
activities is extensive, and this analysis must be updated in order to maintain the
accuracy of the ABC system. Moreover, the record keeping necessary to use an ABC
system is greater than other systems because of the increase in the number of Cost
Drivers employed.

Another problem that is commonly reported when implementing ABC is institutional

resistance. While managers are familiar with applying Manufacturing Overhead based
upon common drivers (e.g., Direct Labor Hours or Cost) because of its widespread use;
these managers have no experience with ABC. Internal personnel may have trouble
understanding or adapting to ABC. Similar problems may be experienced with outside
personnel, who use your reported costs (e.g., regulatory bodies that approve rate hikes,
or government bodies that are purchasing products at prices based on costs). Firms

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Chapter 8 Notes Page 6

may find that it is easier to use a more traditional technique for applying Manufacturing
Overhead rather than educating these managers as to the need for ABC.

An advantage of ABC is that it that the detailed cost calculations and analysis provide
businesses with important information regarding how costs are incurred. This
information provides insight into how costs can be controlled. For example, an analysis
of activities might identify the fact that your firm spends a great deal of money on
Material Handling, which uses the number of parts as its Cost Driver. With this
information, you may discover that you can reduce your Material Handling Costs by
reengineering your product to have less parts. Making management decisions based
upon ABC data is called Activity-Based Management (also called Activity Based Cost
Management).

Direct Labor Costs may also be incorporated into the ABC system by including
production activities (e.g., assembly and finishing) within the list of activities. When
Direct Labor and Manufacturing Overhead Costs are combined they are referred to as
Conversion Costs. The thought is that these costs “convert” Direct Materials into the
finished product.

ABC can also be used to determine the allocation of non-manufacturing costs (e.g.,
selling, general and administrative expenses). This is not GAAP, however, and such
financial information is for internal use only.

ABC Example
Lutz, Inc. produces three products: Quality, Superior, and Superb. The Lutz cost
accounting system applied Conversion Costs using a Plant-Wide Application Rate using
Direct Labor Hours as the Cost Driver. Lutz is thinking of employing an ABC system for
Conversion Costs.

Lutz concluded that its plant had six activities with the following Cost Drivers and costs
budgeted for the upcoming year:

Activity Area Budgeted Costs Cost Driver

Material Handling $ 258,400 Number of parts
Production Scheduling 114,000 Number of prod. orders
Setups 160,000 Number of prod. setups
Machinery Cost & Maintenance 3,510,000 Machine hours
Finishing 1,092,000 Direct Labor Hours
Packaging & Shipping 190,000 Number of orders shipped
Total $5,324,400

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Chapter 8 Notes Page 7

The following information summarizes Lutz’ projections of the Cost Drivers listed above
down by product type.

Cost Driver Quality Superior Superb

Units to be produced 10,000 5,000 800
Number of parts per unit 30 50 120
Production orders 300 70 200
Production setups 100 50 50
Machine hours per unit 7 7 15
Direct Labor Hours per unit 2 5 12
Orders shipped 1,000 2,000 800

It is estimated that there will be 54,600 Direct Labor Hours in the upcoming year.

Calculation of Application Rates

Using this information, you can calculate the Predetermined Application Rates for each
activity:

Activity Calculation Application Rate

Material Handling $258,400 / [(30 x10,000)+(50 x 5,000)+(120 x 800)] 40¢ / part
Prod. Scheduling $114,000 / [300 + 70 + 200] $200 / prod order
Setups $160,000 / [100 + 50 + 50] $800 / prod setup
Machinery $3,510,000 / [(7 x 10,000) + (7 x 5,000) + 15(800)] $30 / mach hour
Finishing $1,092,000 / [(2 x 10,000)+(5 x 5,000) + (12 x 800)] $20 / DLH
Packng & Shipng $190,000 / [1,000+2,000+800] $50 per order shpd

The more traditional, Plant-Wide Application Rate for Conversion Costs using Direct
Labor Hours as the Cost Driver would be calculated as follows:

Estimated Overhead $5,324,400

= = $97.52 (rounded)
Estimated DLHs 54,600

Application of Conversion Costs

Let us calculate the budgeted Conversion Cost for the budgeted production described
above. Because activities can represent batch costs (costs incurred in the production
of products in groups) and product costs (cost incurred at the product line level) as
opposed to unit-level costs, it is best to calculate the total Conversion Cost for the entire
product line and then divide that total by the budgeted production level in order to get a
Conversion Cost per unit.

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Chapter 8 Notes Page 8

Activity Quality Superior Superb

Mat Hand ((30 x 10,000) x .40) $120,000 (50 x 5,000) x $.40) $100,000 ((120 x 800) x $.40) $38,400

Prod Sch (300 x $200) 60,000 (70 x $200) 14,000 (200 x $200) 40,000

Setups (100 x $800) 80,000 (50 x $800) 40,000 (50 x $800) 40,000

Machinery ((7 x 10,000) x $30) 2,100,000 ((7 x 5,000) x $30) 1,050,000 ((15 x 800) x $30) 360,000

Finishing ((2 x 10,000) x $20) 400,000 ((5 x 5,000) x $20) 500,000 ((12 x 800) x $20) 192,000

Pck & Shp (1,000 x $50) 50,000 (2,000 x $50) 100,000 (800 x $50) 40,000

Ttl Conv. $2,810,000 $1,804,000 $710,400

Conv./Unit ($2,810,000/ 10,000) $281.00 ($1,804,000/ 5,000) $360.80 ($710,400/ 800) $888.00

If you compare Conversion Cost applied to each unit using ABC versus the Plant-Wide
Application Rate, you can see the results are different:

Quality Superior Superb

Plant-Wide (2 x $97.52) $195.04 (5 x $97.52) $487.60 (12 x $97.52) $1,170.24
ABC $281.00 $360.80 $888.00
Difference -$85.96 $126.80 $282.24

Assuming that ABC presents a more accurate Conversion Cost for each product, under
the traditional, Plant-Wide Application Rate, the Quality units are under-costed and the
Superior and Superb units are over-costed.

Real Life ABC Examples

Laporte Industries, Ltd.

Laporte Industries, Ltd., a British specialty chemicals and materials producer,

implemented ABC in one of its Divisions in the 1990’s. The Division produced cleaning
chemicals for use in businesses where hygiene is important. The Division’s sales force
tended to focus on big-name customers, such as large food and drink producers, at the
expense of smaller ones, such as farmers. The prices charged to the larger customers
were higher than the prices charged to the smaller ones. The overhead allocation
system previously employed made the sales to the larger customers appear more
profitable than the sales to the smaller ones. After implementing ABC, the Division
realized that it was focusing on the wrong customers.

When overhead was accurately allocated using ABC, it turned out that the Operating
Profit margins on the smaller customer sales were actually higher than those on sales to
larger customers.

Smaller customers did not generate many overhead costs. These smaller customers
placed orders by telephone and required with little contact with the sales force. In

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Chapter 8 Notes Page 9

contrast, big-name customers required: (i) constant contact with the sales force, (ii) 24-
hour technical support, (iii) loans of equipment at no charge, and (iv) other concessions.

After implementing ABC, the awareness of actual costs led to a change in sales mixes
and prices bid. The Division’s Operating Profits increased as a result of these changes.

Mobil Oil

Mobil’s implementation of ABC at its US Lubricants Division in the early 1990’s,

highlighted thousands of unprofitable product lines and an inefficient relationship with its
suppliers. As a result of this analysis, the Division reduced the number of its products
from around 12,000 to 5,000 within eight years of adopting ABC, and cut the number of
its suppliers from over 2,000 to around 500 in that same period. The Division’s after-tax
profit increased from zero to $150 million within that same eight-year period.

The Boeing Company

Although Boeing does not use ABC as part of its accounting system, it has
experimented with Activity Based Management (ABM). As noted above, ABM involves
the use of ABC data in management decisions. In 2000, Boeing tested ABM in two
operations at its Wichita plant.

One of the operations studied was Boeing’s Phase I preassembly chemical bath
operation. It found that:

 Boeing incorrectly calculated the in-house cost of that operation at $7 per part.
As a result, Boeing outsourced that operation at a cost of $4 per part.
 Boeing found that it could actually conduct some of those outsourced operations
in house at a cost of $3.50 per part.
 Boeing identified additional costs that were associated with the outsourced
operation.

Boeing’s analysis of the activities that made up its Phase II structural bonding operation
highlighted the fact that rework orders were an important Cost Driver for Manufacturing
Overhead costs. An examination of the rework orders revealed that parts were being
unnecessarily reworked. By introducing standardized quality criteria, Boeing was able
to reduce the number of rework orders and thereby reduced its rework cost by 20%.

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