Ch 4 Activity Based Costing

Topics: Costs, Manufacturing Pages: 22 (1756 words) Published: August 14, 2015
Activity Based Costing
Accounting 2020
Professor Richard McDermot

Traditional Costing Systems
• Product Costs
– Direct labor
– Direct materials
– Factory Overhead

• Period Costs
– Administrative expense
– Sales expense

Appear on the income
statement when
goods are sold, prior
to that time they are
stored on the balance
sheet as inventory.
Appear on the income
statement in the
period incurred.

Traditional Costing Systems
• Product Costs
– Direct labor
– Direct materials
– Factory Overhead

• Period Costs
– Administrative expense
– Sales expense

Direct labor and direct
materials are easy to
trace to products.
The problem comes
with factory
overhead.

Traditional Costing Systems
• Typically used one rate to allocate overhead to
products.
• This rate was often based on direct labor
dollars or direct labor hours.
• This made sense, as direct labor was a major
cost driver in early manufacturing plants.

Problems with Traditional Costing
Systems
• Manufacturing processes and the products
they produce are now more complex.
• This results in over-costing or under-costing.
– Complex products are not allocated an adequate
amount of overhead costs.
– Simple products get too much.

Today’s Manufacturing Plants





Are more complex
Are often automated
Often make more than one product
Use proportionately smaller amount of direct
labor making direct labor a poor allocation
base for factory overhead.

When the manufacturing process is
more complex:
• Then multiple allocation bases should be
used to allocate overhead expense.
• In such situations, managers need to
consider using activity based costing
(ABC).

ABC Definitions
• Activity based costing is an approach for
allocating overhead costs.
• An activity is an event that incurs costs.
• A cost driver is any factor or activity that has a
direct cause and effect relationship with the
resources consumed.

ABC Steps
• Overhead cost drivers are determined.
• Activity cost pools are created.
– A activity cost pool is a pool of individual costs
that all have the same cost driver.

• All overhead costs are then allocated to one of
the activity cost pools.

ABC Steps:
• An overhead rate is then calculated for each
cost pool using the following formula:
– Costs in activity cost pool/base
– The base is, of course, the cost driver

• Overhead costs are then allocated to each
product according to how much of each base
the product uses.

Let’s work an example . . .
• Assume that a company makes widgets
• Management decides to install an ABC system

Overhead Cost Drivers are Determined:
• Management decides that all overhead costs
only have three cost drivers—sometimes
called activities (obviously a simplification of
the real world)
– Direct labor hours
– Machine hours
– Number of purchase orders

All overhead costs are then allocated to one of the
activity cost pools.
Direct Labor

General Ledger
Payroll taxes

$1,000

Machine maintenance

$500

Purchasing Dept. labor

$4,000

Fringe benefits

$2,000

Purchasing Dept. Supplies

$250

Equipment depreciation

$750

Electricity

$1,250

Unemployment insurance

$1,500

Which overhead costs do you
think are driven by direct labor
hours?

Machine Hours

# of Purchase Orders

All overhead costs are then allocated to one of the
activity cost pools.
Direct Labor

General Ledger
Payroll taxes

$1,000

Machine maintenance

$500

Purchasing Dept. labor

$4,000

Fringe benefits

$2,000

Purchasing Dept. Supplies

$250

Equipment depreciation

$750

Electricity

$1,250

Unemployment insurance

$1,500

Overhead driver by direct labor
hours

$1,000
2,000
1,500
$4,500

Machine Hours

# of Purchase Orders

All overhead costs are then allocated to one of the
activity cost pools.
Direct Labor

General Ledger
Payroll taxes

$1,000...
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