Defining Activities

Learning Outcomes

  • Identify activities and estimate total indirect costs for each

Activities are events, units of work, or tasks that have a specific goal.

In a factory, ABC identifies activities within the manufacturing process that occur repeatedly, such as purchasing, production scheduling, setups, moves, inspections, testing, clean-ups, and invoicing. Each activity has its own activity base to measure usage. The following list matches common activities of a manufacturing company with their respective activity bases.

Common Activities Activity Bases
Accounting
Accounts Payable
Payroll
Purchasing
Number of accounting reports
Number of invoices processed
Number of payroll checks processed
Number of purchase orders processed
Customer Service Number of customer returns
Human resources Number of employees
Production setup Number of setups
Quality control Number of inspections
Shipping Number of sales orders processed

Two flowcharts are shown side by side. On the left is the Traditional System flowchart, which starts with Manufacturing Overhead. Below that is Direct Labor Costs, which is labeled as the Allocation Base. Below Direct Labor Costs are two arrows pointing to the Standard Model and Premium Model, which are both labeled as Cost Objects. On the right is the Activity-Based Costing System flowchart. It also starts with Manufacturing Overhead at the top, which then flows into three Activities--Setup, Production, and Testing. The Setup activity leads to the allocation base "Number of Batches" which then points to both the Standard Model and Premium Model cost objects. The Production activity leads to the allocation base "Direct Labor Hours", which then points to both the Standard Model and Premium Model cost objects. The activity Testing leads to the allocation base "Number of Tests" which then points to both the Standard Model and Premium Model cost objects.

Remember that activities are different than departments. A department, such as production, may have many activities, such as setup, assembly, finishing, packaging, and quality testing. It is also possible that an activity could cross traditional departmental lines. For instance, there could be a safety department, a maintenance department, and a production department, where the activity of assembling an item may involve personnel and equipment from each of those.

Let’s assume for purposes of this lesson that the production function of Yore Company is divided into two departments: assembly and finishing. The assembly department is mostly automated and the finishing department is labor-intensive with humans doing most of the work by hand. However, without regard to departments, managerial accountants using ABC would identify significant activities, such as setup, production, and quality assurance. Each of these activities has a unique cost driver. For instance, production could be assigned a cost driver of labor hours, setup could be assigned a cost driver of batches, and quality assurance could be assigned a cost driver of # of inspections.

Here is a bit more detail from the accounting department to add in more information about indirect costs for each:

Description Total
Subcategory, Assembly Department Budget
Supervisory $             13,200
Depreciation                 67,800
Building costs                 60,000
    Assembly Single Line$           141,000
Single Line
Finishing Department Budget
Inspection staff $             12,000
Supervisory salaries                 11,400
Building costs                 23,600
    Finishing Single Line$             47,000
Single Line
Total overhead Single Line$           188,000Double line

 

There are probably some intermediate allocations going on here. For instance, building costs may be allocated to each department based on square footage, and supervisory salaries may be allocated to each department based on hours worked or number of employees.

Now, using Activity Based Costing, we will be asking the accounting department to accumulate costs slightly differently. Most accounting systems should be able to do both–report costs on a departmental basis AND on an activity level, but those costs will have to be coded correctly as they are entered. Let’s say that, working with the financial accounting staff, you are able to determine the following:

Description Cost Setup Assembly Quality Assurance
Subcategory, Assembly Department Budget
Supervisory $             13,200 $              10,000 $                3,200 $                      –
Depreciation                 67,800                 18,200                 49,600                         –
Building costs                 60,000                         –                 60,000                         –
    Assembly Single Line$           141,000 Single Line$              28,200 Single Line$            112,800 Single Line$                      –
Single Line Single Line Single Line Single Line
Subcategory, Finishing Department Budget
Inspection staff $             12,000 $                      – $                      – $              12,000
Supervisory salaries                 11,400                         –                   8,200                   3,200
Building costs                 23,600                         –                 20,000                   3,600
    Finishing Single Line$             47,000 Single Line$                      – Single Line$              28,200 Single Line$              18,800
Single Line Single Line Single Line Single Line
Total overhead Single Line$           188,000Double line Single Line$              28,200Double line Single Line$            141,000Double line Single Line$              18,800Double line

 

The assembly department costs are the same under both systems, but that is just a coincidence. That would never happen in reality. The finishing department includes the final stages of assembly and the inspections stage. Under activity based costing, we would break that out (in this case into our new “activity” of assembling and an activity called Quality Assurance. Also, some of the assembly department costs are now classified as an activity called Setup.

Again, in an actual business, there would be more departments and more activities and more product lines, but we are keeping this example as simple as possible.

Before we examine how to apply these different methods to determine the cost of our product, let’s review the definition of an activity and how that is different from a department.

Practice Question