CHAPTER 5 Activity Based Costing LEARNING OUTCOMES After this chapter, the learner will be able to: * Differentiate valued-added activities from non-value-added activities © Compute product costs using Activity based costing system- | 174 Chapter 5 ~ A Based Costi ACTIVITY BASED COSTING VERSUS TRADITIONAL COSTING Activity Based Costing Activity based costing (ABC) allocates overhead to products based on the performance of activities, most often multi stage activity cost pools. In the first stage, activities are identified. These activities are work performed or undertaken to produce products such as number of set ups, number of scheduling, number of orders, number of parts, number of inspections, number of labor hours, number of designs and many more, These activities are used as the cost drivers in computing overhead rates. The total factory overhead is then allocated to activity cost pools. The cost per activity is divided by the activity driver's practical capacity to arrive at the overhead rate per activity. In the second stage, the overhead cost pool is traced to products using the pool rates computed in the first stage, Thus, the overhead assigned to the product is computed as follows: Applied overhead = Pool rate x actual activity usage ‘Traditional costing method Ina traditional cost system, the budgeted overhead cost is divided by the budgeted level of activity to arrive at the predetermined overhead rate. The traditional basis of application bases are direct labor hours, direct labor costs, machine hours, or units produced. Under this method, the larger the denominator, the smaller the predetermined overhead rate, therefore the lesser the amount of overhead applied to the job, Overhead cost is then applied to the products multiplying the overhead rate by the actual level of activity. Illustration: ABC & traditional method Dragon Furniture Company has identified activity centers to which overhead costs are assigned. The following data are available: Activity Centers Sika Utilities Costs Activity drivers 300,000 60,000 machine hours one i uling and setup 273,000 780 setups hediing 640,000 1,600,000 pounds of mat. The company’s products and other operating statistics follow:7: 175 Chapter 5 - Activity Based Costing Products A B c Prime costs 80,000 P80,000 90,000 Machine hours 30,000 10,000 20,000 Number of setups 130 380 270 Pounds of materials 500,000 300,000 800,000 Number of units produced 40,000 20,000 60,000 Direct labor hours 32,000 18,000 50,000 : Determine the production cost per unit using ABC and traditional method of costing. (1) ABC method 15° Step: Determine the pool rates 300000 Utilities P30,000/60,000 PS/mhr Scheduling & set up P273,000/780 P350/set up ‘Materials handling P640,000/1,600,000 P.40Ibs ‘2 step: Allocate the overhead using the poo! rates determined above ee Activity Prod.A __Prod.B Prod. C Total Utilities: 430,000 x5 P150,000 . B10,000x5 50,000 €20,000 x 5 100,000 ‘300,000 Scheduling & Setups: A130x350 —-P45,500 B380 x 350 P133,000 C270 x 350 1P273,000 120,000 320,000 640,000 Taso soe 5500 a3 —Bry 76 5 ~ Activity Based Costin: 3% Step ~ determine the total costs of the job The Manufacturing cost for each product is computed as: a Cost item A B c Prime costs ‘80,000 80,000 90,000 Overhead 995500 303,000 814,500. Tort a 26989, 0100 POA O0 (2) Traditional Method Under the traditional method of costing where factory overhead is allocated to products using direct labor hours, the unit cost of product A would be _ [Predetermined OH rate = P1,213,000/100,000 = P12-13/DLH, Product A: Prime cost 80,000 Overhead cost (32,000 x 12.13) 388,160 Total P468,160 Units produced 40,000 Manufacturing cost per unit PIL132 Chapter 4 - Accounting for Factory Overhead MANUFACTURING OVERHEAD ACCOUNT ‘overhead is i edetermined rat Normally, cost charged to jobs is estimated using @ pr . fe ‘because it is jepectial to ieee to specific jobs. It is called ined overhead rate because this is computed before the start of an period. To determine the predetermined overhead rate, the budgeted overhead is divided by the estimated activity level based on normal capacity. The selection of base is dependent to the functions of overhead cost that is applied to production. ‘The Manufacturing Overhead accounts used to record the actual overhead incurred and the amount of overhead applied to the job. This account is debited when overhead is incurred. Examples of _-~—- manufacturing overhead charged to the account are: indirect labor, indirect materials like factory supplies and other materials that are auxiliary to the processing operations, expired factory insurance, cost of repairs and maintenance, electricity and water coasumption and depreciation of property, plant and equipment. ‘The amount of overhead applied to the job is calculated using the predetermined ‘overhead rate multiplied by the actual level of activity. The amount computed is credited to Manufacturing Overhead account. a a At the end of an accounting period, it is unlikel i t ly that the total debits and total Cae pepo et account will have identical balances. If the i r total credits, overhead is under applied whereas, if total credits are greater than total debits, overhead is over appt: ee PREDETERMINED OVERHEAD RATE The common . ly used activi Physical a Phos ce hours , Materials Machine hour, Jagat x penose | :133 iccounting for Factory Overhead Formula in computing pre-determined overhead rate is: Predetermined Budgeted ing overhead Overhead rate = Budgeted production activity Mlustration. Determining overhead rate Let us assume that the budgeted annual overhead is composed of; Fixed cost, 1,000,000 and variable cost is P40 per direct labor hours. The budgeted annual direct labor hours are 125,000. The predetermined OH rate is computed as: Predetermined 1,000,000 + (125,000 x 40) ‘overhead rate = 125,000DLH = PAS per DLH Overhead applied = — OH ratex actual DLH utilized The predetermined overhead rate is multiplied by the number of direct labor ‘hours actually utilized in production to arrive at the amount of overhead applied to thejob. INCURRENCE OF OVERHEAD ‘As mentioned in Chapter 1, factory overhead includes the following: a) Factory supplies ‘b) Wages peninaction, factory maintenance personnel, raw materials handlers/stockman, factory security men ©) Factory overtime, shift and night premium d) Employers share of SSS, Philhealth, and Pag-ibig ®) Factory Power, light & water f)_ Insurance of factory plant and workers 'g) Depreciation of factory plant and equipment ‘Telephone and mailing costs ? Costs of Seeikiony compliance such as meeting factory safety requirements and disposal of waste materials i) Idle time by factory workers due to machine breakdowns or new set ups which are unavoidable in production process. During their idle time, the workers are not productive therefore the cost is spread over the entire Production not to a specific product.at: Chapter 4 - Accounting for Factory Overhead, ced To record incurrence of factory overhead, the following entry is made: Factory Overhead (total) 000 Cash or Accounts Payable 000 Accumulated Depreciation 000 ‘Raw Materials (for factory supplies used) 000 Factory (for indirect labor) 00 SSS, Philhealth, Pag ibig Payable 000 To record factory overhead applied to the job under actual costing: Work in Process 00 Factory overhead (actual OH incurred) 000 Factory Overhead hae Tncurred overhead 000 | 000, ‘Applied Overhead Under actual costing method, the factory overhead account has no variance ‘because actual overhead incurred is charged to work in process account. To record factory overhead applied to the job under normal costing: Work in Process 000 Factory overhead (actual OH incurred) 000 Factory Overhead | Incurred overhead 000/00 Applied Overhead } Under normal costing, itis possible that the amount of overhead actually incurred is greater than what is charged to the job in process, therefore resulting # ¢ cee enol applied i the ; ipplied to the job is lesser than Fi Overhead Incurred overhead 00] 000 Applied Overhead If it is the other way its hte way ound he nth ove Taco the faci meh135 chapter 4 - Accounting for Factory Overhead DISPOSITION OF OVER OR UNDER APPLIED OVERHEAD Under normal costing system, actual overhead rarely equal the amount of overhead applied to the jobs in process. At the end of accounting period, actual and applied overhead are compared to evaluate the appropriateness of the mined overhead rate. If actual overhead is greater than the applied overhead, the variance is unfavorable termed as underapplied or underabsorbed overhead, whereas, if the applied overhead is greater than actual overhead, the variance is favorable and it is termed as overapplied or overabsorbed overhead. Illustration. OH variance is insignificant If the amount of variance is insignificant, that is, the variance is so small that the difference is not expected to affect management's decision: the variance is closed to Cost of Goods Sold. The T-account below shows that the overhead applied to the jobis understated, thus, the cost of sales is also understated. The entry to close the variance is: Cost of Sales 0 Factory overhead o Factory Overhead Incurred overhead ‘000 00 ‘Applied Overhead If the amount of overhead applied is greater than the overhead actually incurred, as shown in the T-aecount, the cost of sales is overstated, thus, the entry to dispose the variance is: 0 Cost of sales Factory Overhead. . Weried pveriend 00[ 000 Applied Overhead Te verterce i significant in amnotant the variance is cloned 10 ell accomnts with overhead elements, like Work in process, Finished Goods and Cost of Sales ‘The te oF tiation jo the overhead comparent of each inventory account. available, Trot, based on the belances of the accounts atthe time of disposal Baas 4 a+ eS ~~ 135 tC ‘on. OH variance is significant ‘Assume the following dat forthe period just ended: : period: Finished goods inventory, end of Per 174,000 ‘Direct materials 261000 ees! 208,800 643,800 Cost of sales for the year: Direct materials 696,000 Direct labor 1,479,000 Factory overhead 183,200 3,358,200 Work in process, end of year: Direct Materials 87,000 Direct labor 130,500 Factory overhead 104,400 321,900 Applied factory overhead 1,496,400 Actual overhead 1,400,000 ‘Overhead variance - over applied 96,400 ‘The over-applied overhead is. Process Overhead Allocation; FG = 208,800/1496 , cog 8 1496.400'96 400 1183,200/1 Ww 200/496 400°96 499 closed to Finished Goods, Cost of Sales and Work in ‘accounts based on the overhead component in each account. FG COs WIP Total 208,800 1,183,200 104,400 1,496,400 13451 i |Chapter 4 - Accounting for Factory Overhead aia eh The entry to close the variance is: overhead Cost of sales 96,400 Finished goods 76,223 Work in process eh ry Overhead Actual OH 000 | 1,496,400 ~“AppliedOH Variance 96,400 1,496,400 | 1,496,400 If the overhead variance is closed to cost of sales, the balance of the cost of sales account after closing the variance is: Cost of sales COSforthe period 1,183,200] 9400 adjustment __|_ 1,086,800 Adjusted balance 1,183,200 | 1.183,200 Factory overhead Cost of sales MULTIPLE OVERHEAD RATES If normal costing is used, the company may use different cost drivers in determining overhead rate. Illustration: Job Costing using different cost drivers an order from TJ Ramos for 2,500 units 76,223 Manufacturing Company accepted ; othichen gadget cat is ee jin three departments. The following data Telated to the job are as follows: ee i Cost Driver Production Cees ue oe Process 1 : P45 per hour 100% of direct material cost Process 2 PAO perhour — 120%% of direct labor costs 5 per machine hour Process 3 P35 per hour4 = Accounting for Overhead — Direct Materials: Process 1 620,000 Process 2 250,000 Process 3 100,000 Direct Labor Hours: Pisces 5,200 Process 2 an Process 3 ah Machine Hours: Process 1 in Process 2 coe Process 3 27400 The order was completed as scheduled. (1) Determine the total costs of the job. Q) If Tiger Manufacturing Company's policy of billing is production cost plus 50%, howe much is the total billing price of the job? Solutions: ‘otal costs job: Total costs of the job: Cost Element Process 1 Process2___Process3___Total Direct Materials 620,000 250,000 100,000 970,000 Direct Labor 234,000 300,000 87,500 621,500 Overhead 620,000 360,000 135,000 _1,115,000 Total costs 2,706,500 Applied overhead is computed as: Process 1 (100% of DM costs = 620,000 x 100%) 620,000 Process 2 (120% of DL. costs = 120% x 300,000) 360,000 ements P5 x 27,000) 135,000 overhead applied to t —Pr115,000_ plied to the job P1,115,000 (2) Billed Price = 2,706,500 x 150% = P4,059,750.00Chapter 4 — Accounting for Factory Overhead ers ‘TMENT, DEPAR: ‘AL RATE AND PLANTWIDE RATE Manufacturing companies nor oduct sa aw lh a pt luction technology may differ in each depart : Epiphany Senet a oe Spe mostly manpower. Because ofthis, the use of departmental raies (one overhead rate per department) is recommended to allow each department to select the most appropriate measure of activity relative to its operation. ‘This method provides more accurate product costing considering that manufacturing overhead incurred includes various overhead costs that vary greatly in their relationship to the production process. If only one overhead rate is chosen by a company for the allocation of manufacturing overhead to different jobs, that overhead rate is called plant wide rate. Ilustration: Job Costing using Plant wide rate and Departmental Rate. Sunflower Manufacturing Company has two producing departments, Assembly and Finishing Department. Assembly Department has significant amount of labor related overhead and it uses direct labor hours as the cost driver while Finishing Department has significant amount of machine-related overhead and it uses machine hours as the cost driver ‘The following data are available for Sunflower Manufacturing Company for the yearjustended: —.) fy ce bey “aia Budgeted Data = Assenibly Finishing Manufacturing overhead 1,890,000 1,260,000 Direct labor hours 52,000 20,000 Machine hours 15,000 80,000 Actual data: DM it P120 P50 Taka sos per unit Thrs@ P37.50/hr —-7hr@ P37.50/h Machine time used per unit 30 min. 3 hrs. Actual production, 25,000 units i 000 units assuming (a) plant wide Required: Determine the total cost of producing the 25; Tate based on direct labor hours and (b) department rates.Finishing P1,250,000.00 703,125.00 820,312.50 n divide it by the budgeted level of activity iii 72,000 DLHs Applied: fin Assembly 25,000x2x43.75 = HinFinishing 25,000x.75x 43.75 = while Finishing dept. uses MH 2 overhead rate by surnming up the budgeted overhead for the whole ¥ -(b) Production costs using departmental rates: Assembly Dept. uses DLH 'P4,250,000.00 2,578,125.00 3,007,812.50 P9,835,937.50 1,890,000 + P1,260,000 = P43.75/DLH P2,187,500.00 P820,312.50 Cost Elements Assenibly Finishing Total P1,250,000.00 P4,250,000.00 'P3,000,000.00 1,875,000.00 703,125.00 1,817,500.00 1,181,250,00 P6,692,500.00___P3,134,375.00 DM costs DL costs Overhead* Total costs 2,578,125.00 2,998,750.00 P9,826,875.00 Overhead rates Assembly Finishing P1,890,000 /52,000 DLH P36.35/DLH 1,260,000 / 80,000 MH P15.75/MH Overhead applied Finish 25,000 x 2DLhrs x 36.35 rs7s00 4 25,000 x 3 MH x 15.75 1,181,250141 ter 4 - Accounting for Factory Overhead eet ALLOCATION OF SERVICE DEPARTMENT Costs Service or support department isa unit in an organization tributes ina very indirect way to the conversion of raw materials into a ‘nei product. Inshort, they are involved directly in producing the goods or services. However, a service department does provide a service that enables the organization's production process to take place. These units are the purchasing, personnel, warehousing and maintenance department. Since these departments support the production department, the costs incurred must be allocated to production departments to determine the full costs of a product. Below are possible bases of allocating service costs: “Type of Cost 4 ‘Allocation Base a) Personnel costs ‘Number of employees, direct labor costs or Number of new hires 'b) Maintenance costs Number of machine hours ) Administration costs Peso value of assets employed d) Research & development | Assets employed, new products costs developed or estimated time or usage e) Cafeteria costs Number of employees f) Public Relations Amount of Sales &corporate function g) Legal costs Assets employed 1h) Warehousing costs Area occupied i) Materials & Storeroom | Number of materials move costs i) Power costs Kilowatt hours used ) Engineering costs Number of hours utilized p Shipping al Number of orders shipped m) Purchasing costs Number of purchase orders or Peso value of purchase order Methods of Allocating Service Costs The above costs can be allocated to production departments using Direct, Step or Algebraic method. 4 fice costs directly to production department only ee ined by oe avon department to another. This isthe most widely used method.