ACCT2121 Management Accounting

Chapter 5
Activity-Based Costing
And Activity-Based Management
 Review of Ch4
1. How do we allocate MOH? What is actual MOH? What is total manufacturing cost (manu cost)?

➢ Obtain allocated MOH in two steps:

• (step 1) Budgeted Budgeted Manufacturing Overhead Costs of All Jobs

Manufacturing Overhead
=
Budgeted Total Quantity of Cost-Allocation Base of All Jobs
Rate of All Jobs

• (step 2) Allocated MOH of a job = Budgeted MOH rate of all jobs X Actual ACB of a job

• Or combining the two steps: Allocated MOH of a job = (Budgeted MOH cost / Budgeted ACB)
X Actual ACB of a job

➢ Actual MOH = Actual IDM of a job + Actual IDL of a job + other MOH of a job

or Actual MOH = (Actual MOH cost of all jobs / Actual ACB of all jobs) X Actual ACB of a job

o How do we know the actual IDM of a job?

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 Review of Ch4
2. How do we journalize allocated MOH, actual MOH and manufacturing cost?
• We record manu cost (= DM + DL + MOH allocated) including allocated MOH under WIP control
Account Debit Credit
WIP Control 200,000
Material Control 81,000
Cash Control 39,000
MOH Allocated 80,000

• We record actual MOH (= IDM + IDL + other) under MOH control

Account Debit Credit

MOH Control 94,000
Material Control 4,000
Cash Control 72,000
Accumulated Depreciation Control 18,000

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 Review of Ch4
3. How do we deal with the difference between actual MOH and allocated MOH? Suppose the
difference is allocated MOH – actual MOH = D.
• Proration approach
• The key is to determine the percentage or ratio with respect to the three accounts (WIP, FG and
COGS)
• In HW 4, there are two scenarios. In the first case, the ending balances of the three accounts are
known as A, B and C and are used as the base to allocate D. We then follow two steps to allocate
D.
▪ Step #1, we obtain the ratios of the three accounts based on ending balance: A/(A+B+C), B/(A+B+C)
and C/(A+B+C)
▪ Step #2, we allocate D * A/(A+B+C) to WIP, D * B/(A+B+C) to FG, and D* C/(A+B+C) to COGS
▪ Adjust the three accounts according to whether D is over-allocated or under-allocated
• In the second case, D is allocated to the three accounts according to “overhead allocated in 2020
in the ending balance before proration”
▪ We first need to allocate MOH based on the allocation base which is labor cost. So the MOH
allocated to three accounts are Budgeted MOH rate * Actual ACB. In other words, MOH
allocated to WIP (or FG or COGS) = Budgeted MOH rate * Actual labor cost in WIP (or FG or
COGS). Then we repeat the two steps above based on these allocated amount instead of EI.
• Write-off to COGS approach
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Review of Ch4
Solution to the question on Slide 21 of Ch4
1. Allocated MOH = Budgeted rates X actual ACB = 40 X 2,000 = 80,000
Actual MOH = IDM + IDL + Other = 4,000 + 15,000 + (44,000 + 13,000 + 18,000) = 94,000
2. Manu cost = DM (used) + DL + MOH allocate = 81, 000 + 39,000 + 80,000 = 200,000
3. COGM = 188,800
COGM = manu cost + BI of WIP – EI of WIP → 188,800 = 200,000 + 0 – EI of WIP
→ EI of WIP = 11,200
4. COGS = 180,000
COGS = COGM + BI of FG – EI of FG → 180,000 = 188,800 + 0 – EI of FG
→ EI of FG = 8,800

Thus far, we have ending balances for the three accounts WIP, FG and COGS: 11,200, 8,800, and
180,000 → we can then use these EI to allocate the underallocated MOH of (14,000) to the three
accounts as on Slide 31 of Ch4.

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Learning Objectives

1 Explain how broad averaging undercosts and overcosts products or services

2 Distinguish between simple and activity-based costing system

3 Cost products or services using activity-based costing

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Background – Broad Averaging
➢Cost assignment
➢ Direct costs including DM and DL are traced; they are actual costs
➢ Under normal costing approach, MOH are allocated during a year based on
Budgeted MOH rate
• Budgeted MOH rate is determined at the beginning of a year
• We allocate MOH to a specific job when that job is completed so that we know the actual
allocation base (ACB) usage of that job (Allocated MOH = Budgeted rate of all jobs * Actual
ACB of a job
• We only know the total MOH of all jobs until the end of the year
➢Recall that manufacturing overhead (indirect) is applied to production at a simple
manufacturing overhead rate –
• Plantwide or Company Overhead Rate (e.g., $60 per DLH = allocate $60 indirect costs to each
product for every direct labor hour worked)
• Department Overhead Rate
(e.g., Dept A, $40 per DLH and Dept B, $35 per MH or machine hour )
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 Background – Broad Averaging

❑This type of averaging (peanut-butter costing) often involve tradeoffs between simplicity
and realism
❑A single allocation rate → broad averaging → cross subsidization (one product is
overcosted and another is undercosted)
❑ Cross-subsidization is the results of overcosting one product and undercosting another
➢ Total cost is constant → overcosting one product means undercosting another
➢ Overcosting -- a product consumes a low level of resources but is allocated high
costs per unit
➢ Undercosting -- a product consumes a high level of resources but is allocated
low costs per unit

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Consequence of Cross-subsidization

❑ 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
❑ So, simple costing rely exclusively on volume may not be practical for every business
❑ Any solution ?

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 Activity-Based Costing
❑ In addition to volume, consider other cost factors
❑ Other than simple costing, consider activity-based costing
❑ Direct costs are traced; same as simple costing

❑ ABC refines allocation of indirect costs: from a single indirect cost pool to N activity cost pools
(with N cost allocation bases)
Activity 1: X1
Product A
Total Indirect cost: Activity 2: X2
(X1+X2+X3+…+Xn)
Like supervisor
salaries; Activity 3: X3 Product B
depreciation;
…
Maintenance etc
Activity n: Xn

First-stage allocation: Second-stage allocation:

Ch 14/15 Ch 5
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Cost Hierarchies under ABC

ABC (Activity–Based Costing) uses a four-level cost structure

to determine how far down the production cycle costs
should be pushed:
1. Output unit-level
2. Batch-level
3. Product- (or Service-) sustaining-level
4. Facility-sustaining-level

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Cost Hierarchies under ABC (1/4)

In general, there are four cost level classifications for

manufacturers under ABC.
How do we classify “heating, cleaning, or safe-guarding a factory,
or an executive office”?
A. Output unit-level.
B. Batch-level.
C. Product- (or Service-) sustaining-level.
D. Facility-sustaining-level.

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 Cost Hierarchies under ABC (2/4)

How do we classify “designing or advertising a product/service”?

A. Output unit-level.
B. Batch-level.
C. Product- (or Service-) sustaining-level.
D. Facility-sustaining-level.

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Cost Hierarchies under ABC (3/4)

How do we classify “setting up equipment” before

production begins?
A. Output unit-level.
B. Batch-level.
C. Product- (or Service-) sustaining-level.
D. Facility-sustaining-level.

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Cost Hierarchies under ABC (4/4)

How do we classify “providing power to run manufacturing

equipment for production”?
A. Output unit-level.
B. Batch-level.
C. Product- (or Service-) sustaining-level.
D. Facility-sustaining-level.

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Example: Plastim Corporation
• Plastim Corp manufactures lenses for rear taillights of
automobiles
• Plastim makes 2 types of lenses for a customer, Giovanni
Motors
S3 CL5 (per unit)
Selling price $63 $137
Total cost $58.75 $ 97
• A competitor, Bandix, makes S3 and offers to sell at $53
• What can Plastim do?
• Give up the S3 (simple lense) business?
• Or reduce the selling price of S3?

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Simple Costing at Plastim Corp.
➢ Simple costing when a job is the cost object: Job costing in Ch4
➢ Example (below) of a product as a cost object using simple costing (one cost pool (direct
cost pool) → one cost allocation base (labor hour) → one indirect cost allocation rate)

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 Simple Costing at Plastim Corp.

Budgeted Indirect Costs

➢ Budgeted indirect cost rate =
Budgeted ACB
▪ Budgeted labor hours (lh) to make S3 are 30,000 hr; Budgeted lh to make CL5 are 9,750hr
▪ Budgeted rate = $2,385,000 / 39,750 hr = $ 60 / hr (step 5)

➢ Allocated indirect cost= Budgeted indirect cost rate X Actual ACB of the product
▪ Allocated indirect cost to the S3 = $ 60/hr X 30,000 hr = $ 1,800,000 (step 6)
▪ Allocated indirect cost to the CL5 = $ 60/hr X 9,750 hr = $ 585,000 (step 6)

➢ Total cost = Total direct cost + Total indirect cost allocated (step 7)
➢ Cost per unit for S3 and CL5? (next slide)
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 Simple Costing at Plastim Corp.
S3 CL5 (per unit)
Selling price $63 $137
Total cost $58.75 $97
• A competitor, Bandix, makes S3 and offers to sell at $53
• Should Plastim reduce the selling price of S3, given that it does not give S3 up?
• Need more accurate cost information of S3 using better costing system

➢ More broadly, we need a more refined costing system as apposed to simple

costing in the case of:
➢ Increase in product diversity
➢ Increase in indirect costs with different cost drivers
➢ Competition in product market

➢ The use of a more refined costing system ABC system

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 Plastim’s ABC System in Seven Steps
1. Identify the Cost Object (e.g. S3 and CL5)
2. Identify the Direct Costs of the Products
3. Select the Activities and Cost Allocation base (ACB) to use for allocating Indirect Costs to the Products
4. Identify the Indirect Costs associated with their respective Cost-Allocation base(s) → e.g. 6 activity pools
and 6 allocation bases

5. Calculate the allocation rate for each activity pool (6 allocation rates):

Budgeted Indirect Costs of Each Activity

➢ Budgeted Activity-Cost Rate =
Budgeted ACB of Each Activity

6. Allocate indirect costs to each product:

Allocated indirect costs = Budgeted activity-cost Rate of Activity 1 ✕ Actual ACB of Activity 1 + Budgeted activity-
cost Rate of Activity 2 ✕ Actual ACB of Activity 2 + … + Budgeted activity-cost Rate of Activity n ✕ Actual ACB of
Activity n
7. Compute total product costs by adding all direct and indirect costs together
Total cost = DC + allocated IDC

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 Plastim’s ABC System
• 6 cost pools → 6 ACB → 6 budgeted allocation rates

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 Budgeted Indirect Costs of Each Activity
➢ Budgeted Activity-Cost Rate =
Budgeted ACB of Each Activity

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A simplified version – Budgeted rates for different cost pools
Budgeted Indirect Costs of Each Activity
➢ Budgeted Activity-Cost Rate =
Budgeted ACB of Each Activity

Total Indirect Cost of Each Budgeted Rate of Each

Activity Cost Pool ACB of Each Pool
Pool Activity

Design $450,000 100 parts square-feet $4,500 per parts square-feet

Set-up molding machines $300,000 2,000 set-up hours $150 per set-up hour

Machines operations $637,500 12,750 molding mh $50 per molding mh

Shipment set-up $81,000 200 shipments $405 per shipment

Distribution $391,500 67,500 cubic feet delivered $5.8 per cubic foot delivered

Administration $255,000 39,750 labor hour $6.42 per labor hour

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• Allocate indirect costs to each product:
Allocated indirect costs = Budgeted activity-cost Rate of Activity 1 ✕ Actual ACB of Activity 1 + Budgeted activity-cost
Rate of Activity 2 ✕ Actual ACB of Activity 2 + … + Budgeted activity-cost Rate of Activity n ✕ Actual ACB of Activity n

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A simplified version – Allocate indirect costs in cost pools to each product and
estimate the total cost and unit cost of each product
• Allocate indirect costs to each product:
Allocated indirect costs = Budgeted activity-cost Rate of Activity 1 ✕ Actual ACB of Activity 1 + Budgeted activity-cost
Rate of Activity 2 ✕ Actual ACB of Activity 2 + … + Budgeted activity-cost Rate of Activity n ✕ Actual ACB of Activity n

Product Total DC Total IDC Total Cost Unit Cost

4500*30 + 150*500 +
50*9000 + 405*100 + 1,845,000 + 1,153,953 2,998,953/60,000 =
S3 (60,000 units) 1,845,000
5.8*45000 +6.42*30000 = = 2,998,953 49.98
1,153,953
4500*70 + 150*1500 +
50*3750 + 405*100 + 1,020,000 + 961,047 = 1,981,047/15,000 =
CL5 (15,000 units) 1,020,000
5.8*22500 + 6.42*9750 = 1,981,047 132.07
961,047

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 Plastim Corp. → Simple vs. ABC
• Which product is overcosted? Which one is undercosted?

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Examples of Activity Cost Pool and Activity Cost Driver

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Signals Suggesting ABC System Likely Helpful to a Firm:
❑ significant overhead costs allocated using just one or two
cost pools
❑ most or all overhead is just considered unit-level

❑ products consume different amounts of resources

❑ products that should be successfully made and sold

consistently show small profits
❑ operational staff disagree with accounting over
manufacturing and marketing costs

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ABC System is used…
➢ABC implementation is widespread in a variety of applications
outside manufacturing, including: Health Care; Banking;
Telecommunications; Retailing; Transportation, etc.
➢Use of cost information generated from ABC to make
decisions (Activity-based Management):
➢ Pricing and product-mix Decisions
➢ Cost reduction and process improvement decisions
➢ Design decisions
➢ Planning and managing activities

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In-class Exercise #1

#1 Conroe Company is reviewing the data provided by its management

accounting system. Which of the following statements is/are correct?
I. A cost driver is a causal factor that increases the total cost of a cost
object.
II. Cost drivers may be volume based or activity based.
III. Cost drivers are normally the largest cost in the manufacturing
process.
1. I, II, and III are correct.
2. I and II only are correct.
3. I only is correct.
4. II and III only are correct.

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 In-class Exercise #2
The job costing system at Sheri’s Custom Framing has five indirect-cost pools (purchasing, material handling, machine
maintenance, product inspection, and packaging). The company is in the process of bidding on two jobs: Job 215, an order of
15 intricate personalized frames, and Job 325, an order of 6 standard personalized frames. The controller wants you to
compare overhead allocated under the current simple job-costing system and a newly designed activity-based job-costing
system. Total budgeted costs in each indirect-cost pool and the budgeted quantity of activity driver are as follows:
Budgeted Overhead Activity Driver Budgeted Quantity of
Activity Driver
Purchasing $35,000 Purchase orders processed 2,000
Material handling 43,750 Material moves 5,000
Machine maintenance 118,650 Machine-hours 10,500
Product inspection 9,450 Inspections 1,200
Packaging 19,950 Units produced 3,800
$226,800

Information related to Job 215 and Job 325 follows. Job 215 incurs more batch-level costs because it uses more types
of materials that need to be purchased, moved, and inspected relative to Job 325.

Job 215 Job 325

Number of purchase orders 25 8
Number of material moves 10 4
Machine-hours 40 60
Number of inspections 9 3
Units produced 15 6

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• In-class Exercise #2
Required:
1. Compute the total overhead allocated to each job under a simple costing system, where overhead is allocated based on machine-
hours.
2. Compute the total overhead allocated to each job under an activity-based costing system using the appropriate activity drivers.

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 Homework: 5-43
Deadline: 8 March 2023 Wed, by 23 pm

Mid-term Exam
Ch1-Ch5 & Ch10, closed-book (no cheat sheet)
3 March 2023, Friday, 18:30 – 20:30 (Hong Kong Time)

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