Akbi Chapt 5

Cost Accounting
Sixteenth Edition, Global Edition
Chapter 5
Activity-Based Costing
And Activity-Based
Management
Copyright © 2018, 2016, 2015 Pearson Education, Ltd. All Rights Reserved.
Learning Objectives (1 of 2)
5.1 Explain how broad averaging undercosts and
overcosts products or services
5.2 Present three guidelines for refining a costing
system
5.3 Distinguish between simple and activity-based
costing systems
5.4 Describe a four-part cost hierarchy
5.5 Cost products or services using activity-based
costing
Learning Objectives (2 of 2)
5.6 Evaluate the benefits and costs of
implementing activity-based costing systems
5.7 Explain how managers use activity-based
costing systems in activity-based management
5.8 Compare activity-based costing systems and
department costing systems
Background
Recall that plant overhead is applied to production
in a rational systematic manner, using some type of
averaging. There are a variety of methods to
accomplish this goal.
These methods often involve trade-offs between
simplicity and realism.
Simple Methods ↔ Complex Methods

Can be Inaccurate Usually more accurate
EQT Support
910 BAIT x Sam
Ultraboost Uncaged
Smith
ADIDAS produces
more than 1.302 types
of shoes
HOW WOULD YOU

ASSIGN OVERHEAD Nice kicks x RMD
COST TO EACH N1
Solebox x Ultraboost PRODUCT? LO1
Plantwide & Department Overhead
Calculations
Plantwide Overhead Rate:
Total Estimated Overhead ** / Total Estimated Base ***
** Obtain total of all overhead costs to be allocated.
*** Determine the best “base” – direct labor hours,
machine hours, etc.
This rate is used to allocate overhead costs to all products
Department Overhead Rate:
Similar concept except overhead cost pools and selected
base are obtained by department rather than plantwide.
Example Of Plantwide & Department
Overhead Calculations (1 of 2)
For our example, let’s say we have two
departments, A and B with overhead costs of
$300,000 and $450,000, respectively.
The best base (the most likely cost driver) in
Department A is Direct Labor Hours and Machine
Hours in Department B.
Example of Plantwide & Department
Overhead Calculations (2 of 2)
- Dept A Dept B Plantwide
Overhead $300,000 $450,000 $750,000
Direct Labor Hrs 8,000 7,000 15,000
Machine Hours 750 1,200 1,950
Allocation Rate-DLH $37.50 n/a $50.00
Allocation Rate-MH n/a $375.00 $384.62
Broad Averaging
• Historically, firms produced a limited variety of goods and at
the same time, their indirect costs were relatively small.
• Allocating overhead costs was simple: use broad averages
to allocate costs uniformly regardless of how they are
actually incurred.
– Generally known as “Peanut-butter costing” (because it
is spread evenly)
– Fails in accommodating the behavior consumption of
OH cost per product.
• The end-result:
– Products using fewer resources are overcosted and
products using more resources are undercosted.
Why ABC and ABM?
• There is a problem with the traditional costing system
 the current business operations are complex and no longer produce
limited number of products.
• In the current business operation, traditional costing

system not accurate in calculating product costs.
 This is due to the increasing number of overhead items involved in
the modern business operation.
• In traditional costing system, overhead cost per unit is

calculated as a cost-averaged. This means:
 OH costs per unit = Total plant-wide OH costs/Total number of
outputs
LO1
Problems with Traditional Costing
System – Non-unit level cost
Illustration:
• Krusty Krab’s is a very traditional burger place with Spongebob and
Squidward as its only employee. Spongebob was and still is the
place’s chef also cleaner. Squidward was and still is the place’s
cashier and supervisor.
• The burger place only has two products, i.e. a single variant of
krabby patty and coke.
LO1
System – Non-unit level cost
Traditional Costing System ABC
100 units sold 100 units sold

4 kwh per unit
100 units sold

100 units sold
1 kwh per unit
electricity costs electricity costs
$1000 $1000
If the company wants to allocate its electricity
If the company wants to allocate its electricity costs then it will calculate:
costs then it will calculate: $1000/[(100 burger x 4 kwh)+ (100 coke
$1000/(100 burger+100 coke) x 1 kwh)]
$5 per unit product $2 per kwh
LO1
System - Broad Averaging
Types of Emma James Jessica Matthew Total Average

Order
Entree 11 20 15 14 60 15
Dessert 0 8 4 4 16 4
Drink 4 14 8 6 32 8
Total 15 42 27 24 108 27
What do you think of this bill summary?
LO1
Illustration
• Consider a company manufacturing refrigerators with different features and complexities
(such as different types of internal compartments, cooling systems, and vents).
• Suppose the complex refrigerator is undercosted and the simple refrigerator is

overcosted.
• In this case, the complex refrigerator will appear to be more profitable than it actually is
while the simple refrigerator will appear to be less profitable than it actually is.
• Managers may strategically promote the complex undercosted refrigerators thinking they
are highly profitable, when in fact these refrigerators consume large amounts of
resources and are far less profitable than they appear.
• They may underinvest in the simple overcosted refrigerator, which shows low profits
when in fact the profits from this refrigerator may be considerably better.
• Alternatively, they may focus on trying to reduce the cost of the simple refrigerator to
make it more profitable when, in fact, this refrigerator is reasonably profitable and the
opportunities to reduce its costs may be quite limited.
Over And Undercosting - Defined
• OVERCOSTING occurs when a product consumes a low level
of resources but is allocated high costs per unit.
• Overcosted product will lead to overpricing and causing those
product to lose market share to competitors producing similar
product
• UNDERCOSTING occurs when a product consumes a high

level of resources but is allocated low costs per unit.
• Undercosted product will be underpriced and may lead to
sales that actually result in losses because it bring less
revenue than the cost of resources they use.
Product Cost
Cross-Subsidization (1 of 4)
• If a company undercosts one of its products, it will
overcost at least one of its other products.
• If all diners pay $27, Emma is paying $12 more than
her actual cost of $15. She is cross-subsidizing
James who is paying $15 less than his actual cost of
$42.
• The overcosted product absorbs too much cost,
making it seem less profitable than it really is.
• The undercosted product is left with too little cost,
making it seem more profitable than it really is.
Product Cost
Cross-Subsidization (2 of 4)
CONSIDER THIS:
• If you were using cost to determine price,
what effect would this have?
• Managers use product costs everyday to
make decisions. If the cost is wrong, so will
be the decision.
• Cost information will be used to guide
pricing decision
An Example: Plastim
This chart depicts the process involved in simple costing for our sample company
EXHIBIT 5.1 Plastim which is currently using that costing system. Let’s go through the steps.
1. Identify the cost objects (our cost objects are products)
Quantity 60,000 S3 lenses and Quantity 15,000 CL5 lenses
2. Identify the direct costs depicted by the bottom two triangles identified as direct
materials and direct manufacturing labor.
3. Select the Cost-Allocation Base to Use for Allocating the Indirect (Overhead)
Costs to the cost objects
Plastim has elected to use Direct Manufacturing Labor Hours as the base and
estimates 39,750 such hours
4. Identify the Indirect Costs Associated with each allocation base
• If you have only one base, you’ll need only one cost pool for all the costs to
be allocated.
• If you are using multiple bases, you’ll separate the costs to be allocated into
a separate pool for each base.
Plastim uses only one allocation base. The estimate of their indirect costs is
$2,385,000.
5. Compute the Rate per Unit of Each Cost-Allocation Base
Budgeted Total Costs in Indirect Cost Pool / Budgeted Total Quantity of the Cost
Allocation Base. $2,385,000 / 39,750 = $60.00 per Direct Mfg Labor Hour
6. Compute the Indirect Cost Allocated to the Products
Our managers have indicated that the DLH budget for the 60,000 S3 lenses is
30,000 hours and 9,750 hours for the 15,000 CL5 lenses. That will allocate
overhead as follows:
S3 = 30,000 * $60 = $1,800,000
CL5 = 9,750 * $60 = $585,000
7. Compute the total cost of the products by adding all Direct and Indirect Costs
Assigned to the Product
Plastim And Simple Costing
EXHIBIT 5.2 Plastim’s Product Costs Using the Simple Costing System
Activity Based Costing-Cost of
Overhead
1. Identifying
Activities
2. Assigning
Cost to
Activities
3. Assigning
Activity
Costs to
Product
Reasons For Refining A Costing
System
Three principal reasons have accelerated the demand for
refinements to the costing system.
1. Increase in product diversity Growing demand for
customized product
2. Increase in indirect costs with different cost drivers the
use of product and process technology such as
computer-integrated manufacturing (CIM)- and flexible
manufacturing systems (FMS) has led to an increase in
indirect costs and a decrease in direct costs.
3. Competition in product markets making correct
decisions about pricing and product mix is critical in
competitive markets
The Shifting Costing Model
Traditional Costing Activity-Based Costing
• Plant-wide/departmental rates using • Reflects the pattern of overhead
DM/DL - assumes that a product’s consumption and is the most accurate
consumption of overhead resources is because considers non-unit level
related strictly to the units produced. activities
• Weakness: • Reveals that functional-based costing
may under-costs the low volume
• Distorted product costing products or over-costs the high
because the proportion of non volume products.
unit-related OH to total OH costs
is large.
• The degree of product diversity is
great with differing level of OH
consumption
LO1
Traditional Product Costing
Traditional Costing Activity-Based Costing
• Two major stages:

1. Overhead costs are assigned to an
organizational unit (plant or
department)
2. Overhead costs are then assigned
to cost objects
LO-2
Guidelines For Refining A Costing
System
There are three main guidelines for refining a costing system:
1. Direct-cost tracing  Identify as many direct costs as is economically feasible. This

guideline aims to reduce the amount of costs classified as indirect, thereby
minimizing the extent to which costs have to be allocated rather than traced.
2. Indirect-cost pools  Expand the number of indirect-cost pools until each pool is
more homogeneous.
For example, a single indirect-cost pool containing both indirect machining costs and
indirect distribution costs that are allocated to products using machine-hours is not
homogeneous because machine-hours are a cost driver of machining costs but not of
distribution costs, which has a different cost driver, cubic feet of product delivered.
Instead, machining costs and distribution costs are separated into two indirect-cost
pools, with machine-hours as the cost-allocation base for the machining cost pool and
cubic feet of product delivered as the cost-allocation base for the distribution cost
pool, each indirect-cost pool would become homogeneous.
3. Cost-allocation bases  whenever possible, managers should use the cost driver
(the cause of indirect costs) as the cost-allocation base for each homogeneous
indirect-cost pool (the effect).
Cost Hierarchies (1 of 2)
A cost hierarchy categorizes various activity cost

pools on the basis of the different types of cost
drivers, cost-allocation bases, or different degrees
of difficulty in determining cause-and-effect
relationships.
ABC systems commonly use a cost hierarchy with
four levels to identify cost-allocation bases that are
cost drivers of the activity cost pools.
Cost Hierarchies (2 of 2)
The four levels in the cost hierarchy are:
• Output unit-level costs measure the consumption of unit-
level activities (related to the individual units of a product
or service)
• Batch-level costs (related to a group of units)  Set Up
Cost
• Product (or service)-sustaining costs (related to support a
particular product or service without regard to the number
of units or batches)  Design Cost
• Facility-sustaining costs (related to costs of activities that
cannot be traced to individual products or services)
Support organization as a whole
Categorizing Cost with ABC
Plastim and ABC Illustrated
EXHIBT 5.3 Overview of Plastim’s Activity-Based Costing System
Plastim And ABC Rate Calculation
EXHIBIT 5.4 Activity-Cost Rates for Indirect-Cost Pools
Plastim and ABC Product Costs
EXHIBIT 5.5 Plastim’s Product Costs Using Activity-Based Costing System
Plastim: Simple and ABC Compared
EXHIBIT 5.6 Comparing Alternative Costing Systems
Exercise
• Producing 10,000 units of a cell phone requires
prime cost of $300,000 and activities:
ACTIVITY DRIVER ACTIVITY RATES
machine hours 2,000 $40/machine
hour
setup hours 1,200 $100/setup hour
• What is the unit cost of a cell phone?

Exercise
• Answer:
– Prime Cost $300,000

– OH Cost
 Machining ($40 x 2,000 hr) $80,000
 Setup ($100 x 1,200 hr) $120,000
$200,000
Total Cost $500,000
Unit cost: $500,000/10,000 = $50
Exercise
• Honeydew Comp. produces 2 products: (1) Bunsen High-end Laptops;
and (2) Beaker Regular Computers. The two products use two OH
activities, with following costs:
setting up equipment $2,000
machining $12,000
• Collected expected activity for each product:
Bunsen Beaker
Direct Labor $20,000 $5,000
Direct Materials 15,000 4,000
Expected Production in Units 2,000 2,000
Machine hours 750 1,500
Setup hours 50 50
• Calculate unit cost for each Bunsen and Beaker, using OH rates based
on machine hours and setup hours!
Exercise
• Activity Rate:
– Setting up: $2,000/100 hrs = $20/setup hr
– Machining: $12,000/2,250 hrs = $5.33/machine hr
• Assigning Cost:
– Bunsen: Prime cost + OH cost
= ($20,000 + $15,000) + [($20x50) + ($5.33x750)
= $35,000 + $4,997.5
= $39,997.5  Unit cost = $19.99
– Beaker: Prime cost + OH cost
= ($5,000 + $4,000) + [($20x50) + ($5.33x1,500)
= $9,000 + $8,995
= $17,995  Unit Cost = $8.99
ABC Vs. Simple Costing (1 of 2)
• ABC is generally perceived to produce superior
costing figures due to the use of multiple drivers
across multiple levels.
• ABC is only as good as the drivers selected, and their
actual relationship to costs. Poorly chosen drivers will
produce inaccurate costs, even with ABC.
• Using ABC does not guarantee more accurate costs!
• As we’ve seen, implementing a refined cost system is not an easy task and
it requires considerable resources of the company. Badly done, it is
possible to have exhausted those resources without an improvement in the
company’s costing.
ABC Vs. Simple Costing (2 of 2)
• ABC is an alternate way to allocate costs.
• It is generally considered to be more accurate and more costly
to implement.
• A company should consider refining their cost system when
evidence begins to suggest that their existing system is flawed.
• Because a number of critical decisions, such as pricing,
whether or not one product should be “pushed” over another,
whether or not a product should be dropped, etc. will be made
using cost information, best efforts should be used to arrive at a
cost that is fair and reasonable for each product. The goal isn’t
to attain a cost that serves the current purposes.
• This is an imprecise science and differences of opinion are
likely to occur.
Signals that suggest that ABC
Implementation could help a Firm: (1 of 2)
1. Significant amounts of indirect costs are

allocated using only one or two cost pools.
2. All or most indirect costs are identified as output
unit-level costs.
3. Products make diverse demands on resources
because of volume, process steps, batch size or
complexity.
Signals that suggest that ABC
Implementation could help a Firm: (2 of 2)
4. Products that a company is well-suited to make

show small profits whereas products that a
company is less suited to make show large
profits.
5. Operations staff has substantial disagreement
with the reported costs of manufacturing and
marketing products or services
Behavioral Issues in Implementing ABC
• Gain the support of top management and create a
sense of urgency.
• Create a guiding coalition of managers throughout the
value chain for the ABC effort.
• Educate and train employees in ABC as a basis for
employee empowerment
• Seek small short-run success as proof that the ABC
implementation is yielding results.
• Recognize that ABC is not perfect. (better costs but
complex system)
Activity-based Management
A method of management decision-making
that uses ABC information to improve
customer satisfaction and profitability.
We define ABM broadly to include decisions
about pricing and product mix, cost reduction,
process improvement and product and
process design.
ABC and Service/Merchandising Firms
ABC implementation is widespread in a variety of
applications outside manufacturing, including:
• Health Care
• Banking
• Telecommunications
• Retailing
• Transportation
ABC are used to identify profitable product mies,
improve efficiency, and satisfy customers

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Cost Accounting

Sixteenth Edition, Global Edition

Simple Methods ↔ Complex Methods

HOW WOULD YOU

• In the current business operation, traditional costing

• In traditional costing system, overhead cost per unit is

100 units sold 100 units sold

100 units sold

Types of Emma James Jessica Matthew Total Average

What do you think of this bill summary?

• Suppose the complex refrigerator is undercosted and the simple refrigerator is

• UNDERCOSTING occurs when a product consumes a high

• Two major stages:

1. Direct-cost tracing  Identify as many direct costs as is economically feasible. This

A cost hierarchy categorizes various activity cost

• What is the unit cost of a cell phone?

– Prime Cost $300,000

Unit cost: $500,000/10,000 = $50

1. Significant amounts of indirect costs are

4. Products that a company is well-suited to make

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