Cost Hierarchy

The first step in activity-based costing involves identifying activities and classifying them
according to the cost hierarchy. Cost hierarchy is a framework that classifies activities based the
ease at which they are traceable to a product. The levels are (a) unit level, (b) batch level, (c)
product level, and (d) facility level.

Unit level activities are activities that are performed on each unit of product. Batch level
activities are activities that are performed whenever a batch of the product is produced. Product
level activities are activities that are carried out separately for each product. Facility level
activities are activities that are carried out at the plant level. The unit-level activities are most
easily traceable to products while facility-level activities are least traceable.

Example
Alex Erwin started Interwood, a niche furniture brand, 10 years ago. He ran the business as a
sole proprietorship. While he has 50 skilled carpenters and 5 salesmen on his payroll, he has
been taking care of the accounting by himself. Now, he intends to offer 40% of the ownership to
public in next couple years, and is willing to make changes and has hired you as the management
accountant to organize and improve the accounting systems.

Interwood's total budgeted manufacturing overheads cost for the current year is $5,404,639 and
budgeted total labor hours are 20,000. Alex applied traditional costing method during all of the
10 years period, and based the pre-determined overhead rate on total labor hours.

Interwood's sofa range includes the 2-set, 3-set and 6-set options. Platinum Interiors recently
placed an order for 150 units of the 6-set type. The order is expected to be delivered in 1 month
time. Since it is a customized order, Platinum will be billed at cost plus 25%.

You are not a fan of traditional product costing system. You believe that the benefits of activity-
based costing system exceeds its costs, so you sat down with Aaron Mason, the chief engineer, to
identify the activities which the firm undertakes in its sofa division. Next, you calculated the
total cost that goes into each activity, identified the cost driver that is most relevant to each
activity and calculated the activity rate. The results are summarized below:

Activity A (in $) Relevant Cost Driver B C=A/B (in $)

Production of components 2,313,132 Machine hours 25,000 93
Assembly of components 1,231,312 Number of labor hours 20,000 62
Packaging 213,123 Units 5,000 43
Shipping 231,230 Units 5,000 46
Setup costs 34,243 Number of setups 240 143
Designing 123,132 Designer hours 1,000 123
Product testing 24,234 Testing hours 500 48
Rent 1,234,233 Labor cost $1,645,644 75%

Once the order was ready for packaging, Aaron gave you a summary of total cost incurred and a
statement of activities performed (also called the bill of activities) as shown below:

Order No: 15X2013

Customer: Platinum Interiors
Units: 150
Type: 6 unit
Amounts in $

Cost of direct materials 25,000

Cost of purchased components 35,000
Labor cost 15,600

Activity Relevant Cost Driver Activity Usage

Production of components Machine hours 320
Assembly of components Number of labor hours 250
Packaging Units 150
Shipping Units 150
Setup costs Number of setups 15
Designing Designer hours 70
Testing Testing hours 22
Rent Labor cost 4500

Part A

Calculate the total cost of the order and the invoice value of the order based on traditional
costing system.

Solution

In the traditional costing system, cost equals materials cost plus labor cost plus manufacturing
overheads charged at the pre-determined overhead rate.

The pre-determined overhead rate based on direct labor hours = $5,404,639/20,000 = $270 per
labor hour

The actual number of labor hours spent on the order is 250. Once we have this data, we can
estimate the manufacturing overheads and the total cost as follows:

Direct materials 25,000

Purchased components 35,000
Labor cost 15,600
Manufacturing overheads ($270 × 250) 67,500
Total cost under traditional product costing system 143,100

Platinum is billed at cost plus 25%, so the amount of sales to be booked would amount to
$178,875 (= $143,100 × 1.25).

Part B

You know activity-based costing is a more refined approach. Now, since you have all the data
needed, calculate the order cost using activity based costing.

Solution

In activity-based costing, direct materials cost, cost of purchased components and labor cost
remains the same as in traditional product costing. However, the value of manufacturing
overheads assigned is more accurately estimated. The following worksheet estimates the
manufacturing overheads that should be assigned to the order of Platinum Interiors:

(A) (B) (A × B)
Activity Activity Rate Activity Usage Activity Cost Assigned
Production of components 93 320 29,760
Assembly of components 62 250 15,500
Packaging 43 150 6,450
Shipping 46 150 6,900
Setup costs 143 15 2,145
Designing 123 70 8,610
Product testing 48 22 1,056
Rent 75% 15,600 11,700
82,121

Total cost of the order is hence:

US$
Direct materials 25,000
Purchased components 35,000
Labor cost 15,600
Manufacturing overheads 82,121
Total cost under activity-based costing 157,721
Based on the more accurate estimation of the order cost, the invoice should be raised at $197,150
(=$157,721 × 1.25) instead of $178,875 calculated under traditional product costing system.