Chapter 2 described how manufacturing companies use traditional absorption costing systems to calculate unit product costs. In this appendix, we contrast traditional absorption costing with an alternative approach called activity-based absorption costing.
Activity-based absorption costing assigns all manufacturing overhead costs to products based on the activities performed to make those products. An activity is an event that causes the consumption of manufacturing overhead resources. Rather than relying on plantwide or departmental cost pools, the activity-based approach accumulates each activity’s overhead costs in activity cost pools. An activity cost pool is a “bucket” in which costs are accumulated that relate to a single activity. Each activity cost pool has one activity measure. An activity measure is an allocation base that is used as the denominator for an activity cost pool. The costs accumulated in the numerator of an activity cost pool divided by the quantity of the activity measure in its denominator equals what is called an activity rate. An activity rate is used to assign costs from an activity cost pool to products.
Activity-based absorption costing differs from traditional absorption costing in two ways. First, the activity-based approach uses more cost pools than a traditional approach.
Second, the activity-based approach includes some activities and activity measures that do not relate to the volume of units produced, whereas the traditional approach relies exclusively on allocation bases that are driven by the volume of production. For example, the activity-based approach may include batch-level activities. A batch-level activity is performed each time a batch is handled or processed, regardless of how many units are in the batch. Batch-level activities include tasks such as placing purchase orders, set- ting up equipment, and transporting batches of component parts. Costs at the batch level depend on the number of batches processed rather than the number of units produced.
The activity-based approach may also include product-level activities. A product-level activity relates to specific products and typically must be carried out regardless of how many batches are run or units of product are produced and sold. Product-level activities include tasks such as designing a product and making engineering design changes to a product. Costs at the product-level depend on the number of products supported rather than the number of batches run or the number of units of product produced and sold.
To illustrate the differences between traditional and activity-based absorption costing, we’ll use an example focused on Maxtar Industries, a manufacturer of high-quality smoker/
LO2–5
Use activity-based absorption costing to compute unit product costs.
Basic Data
Total estimated manufacturing overhead cost . . . $1,520,000 Total estimated direct labor-hours . . . 400,000 DLHs
Premium Standard
Direct materials per unit . . . $40.00 $30.00 Direct labor per unit . . . $24.00 $18.00 Direct labor-hours per unit . . . 2.0 DLHs 1.5 DLHs Units produced . . . 50,000
units 200,000 units
Computation of the Plantwide Predetermined Overhead Rate Predetermined overhead rate = Total estimated manufacturing overhead
Total estimated amount of the allocation base
= $1,520,000
400,000 DLHs= $3.80 per DLH Traditional Unit Product Costs
Premium Standard Direct materials . . . $40.00 $30.00 Direct labor . . . 24.00 18.00 Manufacturing overhead (2.0 DLHs × $3.80
per DLH; 1.5 DLHs × $3.80 per DLH) . . . 7.60 5.70 Unit product cost . . . $71.60 $53.70
E X H I B I T 2 A – 1 Maxtar Industries’ Traditional Costing System
barbecue units. The company has two product lines—Premium and Standard. The company has traditionally applied manufacturing overhead costs to these products using a plantwide predetermined overhead rate based on direct labor-hours. Exhibit 2A–1 details how the unit product costs of the two product lines are computed using the company’s traditional costing system. The unit product cost of the Premium product line is $71.60 and the unit product cost of the Standard product line is $53.70 according to this traditional costing system.
Maxtar Industries has recently experimented with an activity-based absorption costing system that has three activity cost pools: (1) supporting direct labor; (2) setting up machines;
and (3) parts administration. The top of Exhibit 2A–2 displays basic data concerning these activity cost pools. Note that the total estimated overhead cost in these three costs pools,
$1,520,000, agrees with the total estimated overhead cost in the company’s traditional cost- ing system. The company’s activity-based approach simply provides an alternative way to allocate the company’s manufacturing overhead across the two products.
The activity rates for the three activity cost pools are computed in the second table in Exhibit 2A–2. For example, the total cost in the “setting up machines” activity cost pool,
$480,000, is divided by the total activity associated with that cost pool, 800 setups, to determine the activity rate of $600 per setup.
The activity rates are used to allocate overhead costs to the two products in the third table in Exhibit 2A–2. For example, the activity rate for the “setting up machines”
activity cost pool, $600 per setup, is multiplied by the Premium product line’s 600 setups to determine the $360,000 machine setup cost allocated to the Premium product line.
The table at the bottom of Exhibit 2A–2 displays the overhead costs per unit and the activity-based unit product costs. The overhead cost per unit is determined by divid- ing the total overhead cost by the number of units produced. For example, the Premium product line’s total overhead cost of $728,000 is divided by 50,000 units to determine the $14.56 overhead cost per unit. Note that the unit product costs differ from those
Basic Data
Activity Cost Pools and Activity Measures
Estimated Overhead
Cost Premium Standard Total
Supporting direct labor (DLHs). . . $ 800,000 100,000 300,000 400,000 Setting up machines (setups) . . . 480,000 600 200 800 Parts administration (part types) . . . 240,000 140 60 200 Total manufacturing overhead cost . . . $1,520,000
Computation of Activity Rates
Activity Cost Pools
(a) Estimated Overhead
Cost
(b) Total Expected
Activity
(a) ÷ (b) Activity
Rate Supporting direct labor . . . $800,000 400,000 DLHs $2 per DLH Setting up machines . . . $480,000 800 setups $600 per setup Parts administration . . . $240,000 200 part types $1,200 per part type Assigning Overhead Costs to Products
The Premium Product
Activity Cost Pools (a)
Activity Rate (b)
Activity (a) × (b) ABC Cost Supporting direct labor . . . $2 per DLH 100,000 DLHs $200,000 Setting up machines . . . $600 per setup 600 setups 360,000 Parts administration . . . $1,200 per part type 140 part types 168,000
Total . . . $728,000
The Standard Product
Activity Cost Pools (a)
Activity Rate (b)
Activity (a) × (b) ABC Cost
Supporting direct labor. . . $2 per DLH 300,000 DLHs $600,000
Setting up machines . . . . $600 per setup 200 setups 120,000 Parts administration . . . $1,200 per part type 60 part types 72,000
Total . . . $792,000
Activity-Based Absorption Costing Product Costs
Premium Standard
Direct materials . . . $40.00 $30.00 Direct labor . . . 24.00 18.00 Manufacturing overhead ($728,000 ÷ 50,000 units;
$792,000 ÷ 200,000 units) . . . 14.56 3.96 Unit product cost . . . $78.56 $51.96
Expected Activity E X H I B I T 2 A – 2
Maxtar Industries’ Activity-Based Absorption Costing System
computed using the company’s traditional costing system in Exhibit 2A–1. Because the activity-based approach contains both a batch-level (setting up machines) and a product- level (parts administration) activity cost pool, the unit product costs under the activity- based approach follow the usual pattern in which overhead costs are shifted from the
high-volume to the low-volume product. The unit product cost of the Standard product line, the high-volume product, has gone down from $53.70 under the traditional cost- ing system to $51.96 under activity-based costing. In contrast, the unit product cost of the Premium product line, the low-volume product, has increased from $71.60 under the traditional costing system to $78.56 under activity-based costing. Instead of using direct labor-hours (which moves in tandem with the volume of the production) to assign all manufacturing overhead costs to products, the activity-based approach uses a batch- level activity measure and a product-level activity measure to assign the batch-level and product-level activity cost pools to the two products.