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1. © The McGraw-Hill Companies, Inc., 2007
McGraw-Hill/Irwin
Chapter 4
Activity-Based Costing and Analysis

2. © The McGraw-Hill Companies, Inc., 2007
McGraw-Hill/Irwin
Conceptual Learning Objectives
C1: Distinguish between the plantwide
overhead rate method, the departmental
overhead rate method, and activity-based
costing method.
C2: Explain cost flows for the plant wide
overhead rate method.
C3: Explain cost flows for the departmental
overhead rate method.
C4: Explain cost flows for activity-based
costing.

3. © The McGraw-Hill Companies, Inc., 2007
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A1: Identify and assess advantages and
disadvantages of the plantwide overhead
rate method.
A2: Identify and assess advantages and
disadvantages of the departmental
overhead rate method.
A3: Identify and assess advantages and
disadvantages of activity-based costing.
Analytical Learning Objectives

4. © The McGraw-Hill Companies, Inc., 2007
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P1: Allocate overhead costs to products
using the plantwide overhead rate
method.
P2: Allocate overhead costs to products
using departmental overhead rate
method.
P3: Allocate overhead costs to products
using activity-based costing.
Procedural Learning Objectives

5. © The McGraw-Hill Companies, Inc., 2007
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Assigning Overhead Costs
C1
Goods in
Process
Cost of
Goods
Sold
Labor
Materials
Indirect
Indirect
Finished
Goods
Factory
Overhead
Direct
Direct
Allocate

6. © The McGraw-Hill Companies, Inc., 2007
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Assigning Overhead Costs
C1
Overhead can be assigned to production in
one of three ways:
Single plant-
wide rate
Departmental
overhead
rates
Activity-based
costing

7. © The McGraw-Hill Companies, Inc., 2007
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Plant Wide Overhead Rate Method
Overhead Cost
Indirect
Costs
Cost
Allocation
Base
Single Plant-Wide
Overhead Rate
Cost
Objects Product 1 Product 2 Product 3
C2

8. © The McGraw-Hill Companies, Inc., 2007
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Plant Wide Overhead Rate Method Illustration
P1
KartCo.
Manufactures two
models of go-karts,
standard and
custom. They use a
plantwide rate and
use direct labor
hours as the
allocation base

9. © The McGraw-Hill Companies, Inc., 2007
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Plant Wide Overhead Rate
Method Illustration
P1
Let’s look at their
direct labor hour
and factory
overhead
information

10. © The McGraw-Hill Companies, Inc., 2007
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Plant Wide Overhead Rate Method
Illustration
Exhibit 17.2 KartCo's Budgeted Direct Hours
Direct Total
Number Labor Direct Labor
of units Hours Hours
Standard go-kart 5,000 X 15 =
Custom go-kart 1,000 X 25 =
Total
Kartco's Budgeted Overhead Costs
100,000
75,000
25,000
$4,800,000
Indirect Labor costs……………………………………………………………
Factory Utilities…………………………………………………………………
Total Overhead Costs…………………………………………………………
$4,000,000
800,000
P1

11. © The McGraw-Hill Companies, Inc., 2007
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Plant Wide Overhead Rate
Method Illustration
P1
Plantwide
overhead
rate
=
Total budgeted overhead costs
Total budgeted DLH

12. © The McGraw-Hill Companies, Inc., 2007
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Plant Wide Overhead Rate
Method Illustration
P1
Plantwide
overhead
rate
=
$4,800,000
100,000 DLH
= $48/DLH

13. © The McGraw-Hill Companies, Inc., 2007
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Plant Wide Overhead Rate
Method Illustration
P1
Allocation of overhead cost to products
Overhead Allocated
Rate Per Per
DLH DLH Unit
Standard go-kart $48 X 15 = 720
$
Custom go-kart $48 X 25 = 1,200
$
Total product cost per unit
Total
Direct Direct Factory Cost
Materials Labor Overhead Per Unit
Standard go-kart 400
$ 350
$ 720
$ 1,470
$
Custom go-kart 600 500 1,200 2,300

14. © The McGraw-Hill Companies, Inc., 2007
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Plant Wide Overhead Rate Method
Advantages and Disadvantages
P1
Advantages
 Information is
readily available
 Easy to implement
 Often sufficient to
meet external
financial reporting
needs
Disadvantages
 Overhead costs
may not bear any
relationship with
direct labor hours
 All products may
not use overhead
costs in the same
proportion

15. © The McGraw-Hill Companies, Inc., 2007
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Departmental Overhead Rate
Method
Overhead Cost
First
Stage
Second
Stage
Department
A
Indirect
Costs
Cost
Objects
Allocation
Base
Cost
Objects
Department A
Overhead Rate
Department
B
Department B
Overhead Rate
Product 1 Product 2 Product 3
C3

16. © The McGraw-Hill Companies, Inc., 2007
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Departmental Overhead Rates
P2
Let’s return to
KartCo and
calculate their
departmental
overhead
rates

17. © The McGraw-Hill Companies, Inc., 2007
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Departmental Overhead Rate
Method: First Stage
Overhead Cost
$4,800,000
First
Stage
Machining Dept.
$4,200,000
Assembly Dept.
$600,000
P2

18. © The McGraw-Hill Companies, Inc., 2007
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Departmental Overhead Rate
Method: Second Stage
Second
Stage
Department A
Overhead Rate
Department B
Overhead Rate
Product 1 Product 2 Product 3
P2

19. © The McGraw-Hill Companies, Inc., 2007
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Departmental Overhead Rate
Method: Second Stage
Number
of
Units
Hoursper
Unit
Total
Hours
Hoursper
Unit TotalHours
Standardgo-kart 5,000 10MH 50,000MH 5DLH 25,000DLH
Customgo-kart 1,000 20MH 20,000MH 5DLH 5,000DLH
Totals 70,000MH 30,000DLH
Exhibit17.5AllocationInformationforMachineryandAssemblyDepartments
MachiningDepartment AssemblyDepartment
P2

20. © The McGraw-Hill Companies, Inc., 2007
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Departmental Overhead Rate
Method: Second Stage
P2
Departmental
Overhead
Rate
=
Total departmental overhead costs
Total unit number in departmental
allocation base

21. © The McGraw-Hill Companies, Inc., 2007
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Departmental Overhead Rate
Method: Second Stage
P2
Machining
Department
Overhead
Rate
=
$4,200,000
70,000 MH
= $60/MH
Assembly
Department
Overhead
Rate
=
$600,000
30,000 DLH
= $20/DLH

22. © The McGraw-Hill Companies, Inc., 2007
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Departmental Overhead Rate
Method: Second Stage
Standard go-kart:
 Requires 10 MH from machining dept.
and 5 DLH from assembly dept.
 Thus, overhead cost allocated to each
standard go-kart is as follows:
Machining Dept: 10 MH x 60/MH = $600
Assembly Dept. 5 DLH x $20/DLH = $100
P2

23. © The McGraw-Hill Companies, Inc., 2007
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Departmental Overhead Rate
Method: Second Stage
Departmental
Overhead Rate
Hours per
Unit
Overhead
Allocated
Hours per
Unit
Overhead
Allocated
Machining Dept. $60 per MH 10 MH per unit $600 20 MH per Unit 1,200.00
$
Assembly Dept. $20 per DLH 5 DLH per unit 100 5 DLH per unit 100.00
$
Totals $700 1,300.00
$
Total cost per unit
Direct Direct Factory Total
Materials Labor Overhead Cost
Standard Go-Kart 400
$ 350
$ 700
$ 1,450
$
Custom Go-Kart 600 500 1,300 2,400
Exhibit 17.6 Overhead Allocation Using Departmental Overhead Rates
Standard go-kart Custom go-kart
P2

24. © The McGraw-Hill Companies, Inc., 2007
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Departmental Overhead Rate
Method: Second Stage
Departmental
Overhead Rate
Hours per
Unit
Overhead
Allocated
Hours per
Unit
Overhead
Allocated
Machining Dept. $60 per MH 10 MH per unit $600 20 MH per Unit 1,200.00
$
Assembly Dept. $20 per DLH 5 DLH per unit 100 5 DLH per unit 100.00
$
Totals $700 1,300.00
$
Total cost per unit
Direct Direct Factory Total
Materials Labor Overhead Cost
Standard Go-Kart 400
$ 350
$ 700
$ 1,450
$
Custom Go-Kart 600 500 1,300 2,400
Exhibit 17.6 Overhead Allocation Using Departmental Overhead Rates
Standard go-kart Custom go-kart
P2
Note that the total unit
cost for each model of
go-kart is different than
the cost determined
using the plantwide rate
Cost per unit using plantwide rate: Standard: $1,470
Custom: $2,300

25. © The McGraw-Hill Companies, Inc., 2007
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Advantages and Disadvantages of
Departmental Overhead Rate Method
A2
Advantages
•More accurate overhead
allocations
•More refined than the
plantwide overhead rate
method
Disadvantages
•Can distort product
costs
•Assumes that products
are similar in volume,
complexity, batch size
•Assumes that
departmental overhead
costs are proportional to
the allocation base

26. © The McGraw-Hill Companies, Inc., 2007
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Activity-Based Costing Rates and
Method: Cost Flows Under Activity-
Based Costing Method
C4
Activity-based costing
(ABC) attempts to more
accurately assign
overhead costs to the
proper users of overhead
by focusing on activities.

27. © The McGraw-Hill Companies, Inc., 2007
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Cost Flows Under Activity-Based
Costing Method
C4
Let’s look at
the two stages
of activity-
based costing

28. © The McGraw-Hill Companies, Inc., 2007
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Cost Flows Under Activity-Based
Costing Method
Overhead Cost
Activity
Cost
Pool X
Activity
Cost
Pool Y
Activity
Cost
Pool Z
First
Stage
Second
Stage Activity Overhead
rate
Activity Overhead
rate
Activity Overhead
rate
Product 1 Product 2 Product 3
C4
Indirect Costs
Cost Objects
Cost Objects
Cost Allocation
Base

29. © The McGraw-Hill Companies, Inc., 2007
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Differences Between ABC and
Multiple Departmental Rates
 ABC differs from using multiple
departmental rates in how overhead
cost pools are identified and in how
overhead cost in each pool is
allocated.
C4

30. © The McGraw-Hill Companies, Inc., 2007
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Applying Activity-Based
Costing
4 steps:
1. Identify activities and the costs they cause.
2. Group similar activities into activity pools.
3. Determine an activity rate for each activity
cost pool.
4. Allocate overhead costs to products using
those activity rates.
P3

31. © The McGraw-Hill Companies, Inc., 2007
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Step One: Identify Activities
 Talk with employees in production
departments
 Review production activities
The aim of this first step is to understand
actions performed in the organization
that drive costs.
P3

32. © The McGraw-Hill Companies, Inc., 2007
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Levels of types of activities
P3
Unit level
Batch level
Product level
Facility level

33. © The McGraw-Hill Companies, Inc., 2007
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Levels of activities
Unit level activities are performed
on each product unit; for
example, providing electricity to
power machinery in the
machining department is needed
to produce each unit of product.
P3
Unit level

34. © The McGraw-Hill Companies, Inc., 2007
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Levels of Activities
Batch level activities are performed
only on each batch or group of
units.
P3
Batch level

35. © The McGraw-Hill Companies, Inc., 2007
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Levels of Activities
Product level activities are
performed on each product line
and are not affected by either
numbers of units or batches.
P3
Product level

36. © The McGraw-Hill Companies, Inc., 2007
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Facility Level Activities
Facility level activities are
performed to sustain facility
capacity as a whole and are not
caused by any specific product.
P3
Facility level

37. © The McGraw-Hill Companies, Inc., 2007
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Step Two: Trace Overhead
Costs to Cost Pools
P3
Overhead Cost
Activity
Cost
Pool X
Activity
Cost
Pool Y
Activity
Cost
Pool Z

38. © The McGraw-Hill Companies, Inc., 2007
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Step Two: Trace Overhead
Costs to Cost Pools
P3
Let’s go back to
the KartCo data
and see what cost
pools they have

39. © The McGraw-Hill Companies, Inc., 2007
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Step Two: Trace Overhead Costs
to Cost Pools
Activity
Indirect
Labor
Factory
Utilities
Total
Overhead
Replacing Tools $700,000 $700,000
Machine Repair 1,300,000
$ 1,300,000
Factory Maintenance 800,000
$ 800,000
Engineer Salaries 1,200,000
$ 1,200,000
Assembly Line Power $600,000 600,000
Heating and Lighting 200,000 200,000
Totals $4,000,000 $800,000 $4,800,000
Exhibit 17.9 Kartco Overhead Cost Details
P3

40. © The McGraw-Hill Companies, Inc., 2007
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Step Two: Assigning Overhead to
Activity Cost Pools
Activity Pools Activity Cost Pooled Cost Activity Driver
Craftsmanship 30,000 direct labor hours
Assembly line power $600,000 $600,000
Set-up 200 batches
Replacing tools 700,000
Machine repair 1,300,000 2,000,000
Design modification 10 designs
Engineer salaries 1,200,000 1,200,000
Plant services
Factory maintenance 800,000 20,000 square feet
Heating and lighting 200,000 1,000,000
Total overhead cost $4,800,000
Exhibit 17.10 Assigning Overhead Costs to Activity Pools
P3

41. © The McGraw-Hill Companies, Inc., 2007
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Step Three: Determine
Activity Rate
Step 3 is to compute the activity rates
used to assign overhead costs to final
cost objects such as products.
P3
Activity
Cost
Pool X
Activity
Cost
Pool Y
Activity
Cost
Pool Z
Activity Overhead
rate
Activity Overhead
rate
Activity Overhead
rate

42. © The McGraw-Hill Companies, Inc., 2007
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Step Three: Determine
Activity Rate
P3
Proper
identification
of the factor
that drives
the cost
Proper
measures of
activities
Proper determination of activity
rates depends on:
and

43. © The McGraw-Hill Companies, Inc., 2007
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Step Three: Determine
Activity Rate
 Cost Driver: is that activity causing
costs in the pool to be incurred.
 Activity Driver: a measure of activity
level that is determined for use as the
allocation base.
P3

44. © The McGraw-Hill Companies, Inc., 2007
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Step Three: Determine
Activity Rate
For example:
Set-up cost pool activity rate = $2,000,000 / 200 batches
= $10,000 per batch
Craftsmanship cost pool activity rate = $600,000/30,000 DLH
= $20 per DLH
P3
Activity
rate
=
Total cost in activity pool
Measure of the activity

45. © The McGraw-Hill Companies, Inc., 2007
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Step Three: Determine
Activity Rate
Activity Cost
Pools
Overhead Costs
Assigned to
Pool
Activity
Measure
Chosen
Number of
Activities
Activity Rate
Craftsmanship $600,000 DLH 30,000 DLH $20 per DLH
Set-up 2,000,000 Batches 200 batches $10,000 per batch
Design
modification
1,200,000
Number of
design
modifications
10 designs $120,000 per design
Plant services 1,000,000 Square feet 20,000 sq. ft. $50 per sq. ft.
Exhibit 17.11 Activity Ratesfor KartCo.
P3

46. © The McGraw-Hill Companies, Inc., 2007
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Step Four: Assign Overhead
Costs to Cost Objects
Step 4 is to assign overhead costs in
each activity cost pool to final cost
objects using activity rates.
P3
Activity Overhead
rate
Activity Overhead
rate
Activity Overhead
rate
Product 1 Product 2 Product 3

47. © The McGraw-Hill Companies, Inc., 2007
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Step Four: Assign Overhead
Costs to Cost Objects
 To illustrate, the overhead costs in
the craftsmanship pool are
allocated to standard go-karts as
follows:
Overhead allocated to standard go-kart =
Activities consumed X Activity rate =
25,000 DLH x $20 / DLH = $500,000
P3

48. © The McGraw-Hill Companies, Inc., 2007
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Step Four: Assign Overhead
Costs to Cost Objects
Standard go-karts Custom go-karts
Activities
Consumed
Activity
Rate
Activity Cost
Allocated
Activities
Consumed
Activity
Rate
Activity Cost
Allocated
Craftsmanship 25,000 DLH $20 per DLH $500,000 5,000 DLH $20 per DLH $100,000
Set-up 40 batches
$10,000 per
batch 400,000 160 batches $10,000 per batch 1,600,000
Design
modification 0 designs
$120,000 per
design 0 10 designs $120,000 per design 1,200,000
Plant services 12,000 sq. ft. $50 per sq. ft. 600,000 8,000 sq. ft. $50 per sq. ft 400,000
Total cost $1,500,000 $3,300,000
Exhibit 17.12 Overhead Allocated to Go-Kartsfor KartCo.
P3

49. © The McGraw-Hill Companies, Inc., 2007
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Step Four: Assign Overhead
Costs to Cost Objects
(A)
Total Overhead
cost allocated
(B)
Budgeted
unitsof
production
(A/B)
Overhead cost
per Unit
Standard go-kart $1,500,000 5,000 units $300 per unit
Custom go-kart 3,300,000 1,000 units $3,300 per unit
Exhibit 17.13 Overhead per Unit for go-karts Using ABC
P3

50. © The McGraw-Hill Companies, Inc., 2007
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Step Four: Assign Overhead
Costs to Cost Objects
Directmaterial Directlabor Overhead Totalcostperunit
Standardgo-kart $400 $350 $300 $1,050
Customgo-kart $600 $500 $3,300 $4,400
P3

51. © The McGraw-Hill Companies, Inc., 2007
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Comparison of Overhead
Allocations by Method
Does the method of
overhead allocation really
make a difference?
P3

52. © The McGraw-Hill Companies, Inc., 2007
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Comparison of Overhead
Allocations by Method
C1
Comparison of Overhead Allocation by Method
Allocation method Standard Custom
Plantwide overhead rate 720
$ 1,200
Departmental overhead rate 700 1,300
ABC overhead rate 300 3,300

53. © The McGraw-Hill Companies, Inc., 2007
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Advantages and Disadvantages of
Activity-Based Costing
A3
Advantages:
•More accurate
overhead cost allocation
•More effective overhead
cost control
•Focus on relevant
factors
•Better management of
activities
Disadvantages:
•Costs to implement and
maintain
•Uncertainty with
decisions still remains

54. © The McGraw-Hill Companies, Inc., 2007
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End of Chapter 4