18-1
18-2
Activity-Based Costing18
Learning Objectives
Discuss the difference between traditional costing and activity-based costing.
Apply activity-based costing to a manufacturer.
Explain the benefits and limitations of activity-based costing.
3
Apply activity-based costing to service industries.
2
1
4
18-3
Allocates overhead using a
predetermined rate.
► Job order costing: direct labor
cost may be the relevant activity
base.
► Process costing: machine hours
may be the relevant activity base.
Traditional Costing Systems
LEARNINGOBJECTIVE
Discuss the difference between traditional costing and activity-based costing.
1
LO 1
Illustration 18-1Traditional one-stage costing system
18-4
Atlas Company produces two abdominal fitness products—the Ab
Bench and the Ab Coaster. The direct materials cost per unit is $40 for
the Ab Bench and $30 for the Ab Coaster. The direct labor cost is $12
per unit for each product. Both products require one direct labor hour
per unit, both products are allocated overhead cost of $30 per unit.
Illustration 18-3Total unit costs—traditional costing
Illustration of a Traditional Costing System
LO 1
18-5
Tremendous change in manufacturing and service
industries.
Decrease in amount of direct labor usage.
Significant increase in total overhead costs.
Inappropriate to use plantwide predetermined overhead
rates when a lack of correlation exists.
Complex manufacturing processes may require
multiple allocation bases; this approach is called
activity-based costing (ABC).
The Need for a New Approach
LO 1
18-6
An approach for allocating overhead costs.
Allocates overhead to multiple activity cost pools.
Assigns the activity cost pools to products or services by
means of cost drivers.
Activity-Based Costing
LO 1
18-7
2. Identify the cost driver that has a strong correlation to the costs accumulated in each cost pool.
Activity-Based Costing (Four Steps)
1. Identify and classify the activities involved in the manufacture of specific products and assign overhead to cost pools.
3. Compute the activity-based overhead rate for each cost pool.
4. Allocate overhead costs to products using the overhead rates determined for each cost pool.
LO 1
18-8
ABC allocates overhead in a two-stage process:
Stage 1: Overhead costs are assigned to activity cost
pools (Step 1).
Stage 2: Allocates overhead assigned to the activity cost
pools to products, using cost drivers (Steps 2-4).
The more complex a product’s manufacturing operation, the
more activities and cost drivers are likely to be present.
Activity-Based Costing
LO 1
18-9
Illustration 17-2Activities and related cost drivers
Illustration 18-5Activities and related cost drivers LO 1
18-10
Solution: 1. False. 2. True. 3. True. 4. False. 5. True.
Indicate whether the following statements are true or false.
1. A traditional costing system allocates overhead by means of multiple overhead rates.
2. Activity-based costing allocates overhead costs in a two-stage process.
3. Direct material and direct labor costs are easier to trace to products than overhead.
4. As manufacturing processes have become more automated, more companies have chosen to allocate overhead on the basis of direct labor costs.
5. In activity-based costing, an activity is any event, action, transaction, or work sequence that incurs cost when producing a product.
1 Costing Systems
LO 1
18-11
Activity-Based Costing
Involves the following four steps.
1. Identify and classify the activities involved in the manufacture
of specific products and assign overhead to cost pools.
2. Identify the cost driver that has a strong correlation to the
costs accumulated in each cost pool.
3. Compute the activity-based overhead rate for each cost pool.
4. Allocate overhead costs to products, using the overhead
rates determined for each cost pool.
LEARNINGOBJECTIVE
Apply activity-based costing to a manufacturer.
2
LO 2
18-12
Overhead costs are assigned directly to the appropriate activity
cost pool.
Identify and Classify Activities and Allocate Overhead to Cost Pools (Step 1)
Illustration 18-6Activity cost pools and estimated overhead
LO 2
18-13
Cost driver must accurately measure the actual consumption
of the activity by the various products.
Illustration 18-7: Cost drivers that Atlas Company identifies
and their total expected use per activity cost pool.Illustration 18-7
Identify Cost Drivers (Step 2)
LO 2
18-14
Illustration 18-8
Illustration 18-9
Next, the company computes an activity-based overhead rate
per cost driver.
Compute Activity-Based Overhead Rates (Step 3)
LO 2
18-15
In allocating overhead costs, it is necessary to know the
expected use of cost drivers for each product. Because of its
low volume and higher number of components, the Ab Coaster
requires more setups and purchase orders than the Ab Bench.
Illustration 17-8
Allocate Overhead Costs to Products (Step 4)
Illustration 18-10Expected use of cost drivers per product
LO 2
18-16
Illustration 18-11Allocation of activity cost poolsto products
To allocate overhead costs, Atlas multiplies the activity-based
overhead rates per cost driver (Ill. 18-9) by the number of cost
drivers expected to be used per product (Ill. 18-10).
LO 2
Allocate Overhead Costs to Products (Step 4)
18-17
Illustration 18-11
LO 2
To allocate overhead costs, Atlas multiplies the activity-based
overhead rates per cost driver (Ill. 18-9) by the number of cost
drivers expected to be used per product (Ill. 18-10).
Allocate Overhead Costs to Products (Step 4)
18-18
Likely consequence of differences in assigning overhead.
Overpricing the Ab Bench and possibly losing market
share to competitors.
Sacrificing profitability by underpricing the Ab Coaster.
Illustration 17-10
Comparing Unit Costs
Illustration 18-12Comparison of unit product costs
LO 2
18-19
ABC Evaluated
Surveys of companies often show ABC usage of approximately 50%. Yet, in recent years, articles about ABC have expressed mixed opinions regarding its usefulness. To evaluate ABC practices and user satisfaction with ABC, a survey was conducted of 348 companies worldwide. Some of the interesting findings included the following: ABC methods are widely used across the entire value chain, rather than being primarily used to allocate production-specific costs; only 25% of non-ABC companies think they are accurately tracing the costs of activities, while 70% of ABC companies think their company does this well; and respondents felt that ABC provides greater support for financial, operational, and strategic decisions. More than 87% of respondents said that their ideal costing system would include some form of ABC. Since this significantly exceeds the 50% of the respondents actually using it, ABC usage may well increase in the future.
Source: William Stratton, Denis Desroches, Raef Lawson, and Toby Hatch, “Activity-Based Costing: Is It Still Relevant?” Management Accounting Quarterly (Spring, 2009), pp. 31–39.
Management Insight
LO 2
18-20
2 Apply ABC to Manufacturer
Casey Company has five activity cost pools and two products. It expects to
produce 200,000 units of its automobile scissors jack and 80,000 units of
its truck hydraulic jack. Having identified its activity cost pools and the cost
drivers for each cost pool, Casey Company accumulated the following data
relative to those activity cost pools and cost drivers.
LO 2
18-21
Casey Company has five activity cost pools and two products. It expects to
produce 200,000 units of its automobile scissors jack and 80,000 units of
its truck hydraulic jack. Having identified its activity cost pools and the cost
drivers for each cost pool, Casey Company accumulated the following data
relative to those activity cost pools and cost drivers.
Using the data provided,
a. Prepare a schedule showing the computations of the activity-based
overhead rates per cost driver.
b. Prepare a schedule assigning each activity’s overhead cost to the
two products.
c. Compute the overhead cost per unit for each product.
d. Comment on the comparative overhead cost per unit.
2 Apply ABC to Manufacturer
LO 2
18-22
a. Prepare a schedule showing the computations of the activity-based overhead rates per cost driver.
2 Apply ABC to Manufacturer
LO 2
18-23
2 b. Prepare a schedule assigning each activity’s overhead cost to the two products.
LO 2
18-24
c. Compute the overhead cost per unit for each product.
These data show that the total overhead assigned to 80,000 hydraulic jacks exceeds the overhead assigned to 200,000 scissors jacks. The overhead cost per hydraulic jack is $34.25. It is only $12.80 per scissors jack.
d. Comment on the comparative overhead cost per unit.
2 Apply ABC to Manufacturer
LO 2
18-25
ABC has three primary benefits:
1. More cost pools, therefore more accurate product costing.
2. Enhanced control over overhead costs.
3. Better management decisions.
LEARNINGOBJECTIVE
Explain the benefits and limitations of activity-based costing.
3
LO 3
18-26
Multiple cost pools
Used instead of one plantwide pool and a single cost driver.
Numerous activity cost pools with more relevant cost drivers.
► Costs allocated on basis of cost drivers used to produce
each product.
The Advantage of Multiple Cost Pools
LO 3
18-27
Illustration 18-13A more detailed view of Atlas’s machining activities
The Advantage of Multiple Cost Pools
LO 3
18-28
Batch-level
Facility-level
Performed for each unit of production.
► Example: Assembly of cell phones
Unit-level
Product-level
The Advantage of Multiple Cost Pools
CLASSIFICATION OF ACTIVITY LEVELS
LO 3
18-29
Batch-level
Facility-level
Performed every time a company produces another
batch of a product.
► Example: Batch of ice cream
Unit-level
Product-level
The Advantage of Multiple Cost Pools
CLASSIFICATION OF ACTIVITY LEVELS
LO 3
18-30
Batch-level
Facility-level
Performed every time a company produces a new type
of product.
► Example: Time spent testing a new drug by a
pharmaceutical company
Unit-level
Product-level
The Advantage of Multiple Cost Pools
CLASSIFICATION OF ACTIVITY LEVELS
LO 3
18-31
Batch-level
Facility-level
Required to support or sustain an entire production
process.
► Example: A hospital
Unit-level
Product-level
The Advantage of Multiple Cost Pools
CLASSIFICATION OF ACTIVITY LEVELS
LO 3
18-32
Illustration 18-14Hierarchy of activity levels
LO 3
18-33
Increase the perceived value of a product or service to customers, such as:
Value-Added Activities
Manufacturing Company
Engineering design
Machining services
Assembly
Painting
Service Company
Performing surgery
Legal research
Delivering packages
The Advantage of Enhanced Cost Control
LO 3
18-34
Adds cost to, or increases the time spent on, a product/service without increasing its perceived value, such as:
Manufacturing Company
Storage of inventory
Moving of inventory
Inspections
Fixing defective goods
Set up machines
Service Company
Taking appointments
Reception
Bookkeeping and billing
Traveling
Ordering supplies
Advertising
Non-Value-Added Activities
The Advantage of Enhanced Cost Control
LO 3
18-35
General MillsManagement Insight
LO 3
What Does NASCAR Have to Do with Breakfast Cereal?
Often the best way to improve a process is to learn from observing a different process. Production-line technicians from food producer General Mills were flown to North Carolina to observe firsthand how race-car pit crews operate. In a NASCAR race, the value-added activity is driving toward the finish line; any time spent in the pit is non–value-added. Every split second saved in the pit increases the chances of winning. From what the General Mills’ technicians learned at the car race, as well as other efforts, they were able to reduce setup time from 5 hours to just 20 minutes.
18-36
Activity-based management (ABM), a management tool that
focuses on reducing costs and improving processes and
decision-making.
Managers use ABC via ABM
for both strategic and operational decisions or perspectives.
to help managers evaluate employees, departments, and
business units.
to establish performance standards, as well as benchmark
against other companies.
Advantage of Better Management Decisions
LO 3
18-37
Limitations and Knowing When to use ABC
Limitations
Expensive to use.
Arbitrary allocations remain.
When to Use
1. Product lines differ in volume and manufacturing complexity.
2. Product lines are numerous and diverse.
3. Overhead costs constitute a significant portion of total costs.
4. Manufacturing process or the number of products has
changed significantly.
5. Production or marketing managers are ignoring data.
LO 3
18-38
a. Engineering design
b. Machine setup
c. Toy design
d. Interviews of prospective employees
e. Inspections after each setup
f. Polishing parts
g. Assembling parts
h. Health and safety
Morgan Toy Company manufactures six primary product lines in its
Morganville plant. As a result of an activity analysis, the accounting
department has identified eight activity cost pools. Each of the toy
products is produced in large batches, with the whole plant devoted to one
product at a time. Classify each of the following activities as either unit-
level, batch-level, product-level, or facility-level:
3 Classify Activity Levels
a. Product-level
b. Batch-level
c. Product-level
d. Facility-level
e. Batch-level
f. Unit-level
g. Unit-level
h. Facility-levelLO 3
18-39
LEARNINGOBJECTIVE
Apply activity-based costing to service industries.
4
Overall objective: Identify key activities that generate costs
and keep track of how many of those activities are completed
for each service performed.
General approach is to identify activities, cost pools, and
cost drivers.
Labeling of activities as value-added or non-value-added.
Sometimes, a larger proportion of overhead costs are
company-wide costs that cannot be directly traced to
specific services provided by the company.
LO 4
18-40
The public accounting firm of Check and Doublecheck prepares
the following condensed annual budget.
Illustration 18-16Condensed annual budget of a service firm under traditionalcosting
Traditional Costing Example
LO 4
18-41
Assume that Check and Doublecheck records $140,000 of actual
direct professional labor cost during its audit of Plano Molding
Company, which was billed an audit fee of $260,000. Under
traditional costing, using 50% as the rate for applying overhead to
the job, Check and Doublecheck would compute applied
overhead and operating income as shown in Illustration 18-17.
Traditional Costing Example
Illustration 18-17
LO 4
18-42
Check and Doublecheck distributes its estimated annual
overhead costs of $600,000 to three activity cost pools.
Activity-Based Costing Example
Illustration 18-18Condensed annual budget of a service firm under activity-based costing
LO 4
18-43
Assigning overhead in a service industry.
Activity-Based Costing Example
Illustration 18-19Assigning overhead in a service company
LO 4
18-44
Under activity-based costing, Check and Doublecheck assigns
overhead costs of $57,200 as compared to $70,000 under
traditional costing.
Activity-Based Costing Example
Illustration 18-20Comparison of traditional costing with ABC in a service company
LO 4
18-45
American AirlinesService Company Insight
LO 3
Traveling Light
Have you flown on American Airlines since baggage fees have been implemented? Did the fee make you so mad that you swore that the next time you flew, you would pack fewer clothes so you could use a carry-on bag instead? That is exactly how American Airlines (and the other airlines that charge baggage fees) hoped that you would react. Baggage handling is extremely labor intensive. All that tagging, sorting, loading on carts, loading in planes, unloading, and sorting again add up to about $9 per bag. Baggage handling also involves equipment costs: sorters, carts, conveyors, tractors, and storage facilities. That’s about another $4 of equipment-related overhead per bag. Finally, there is additional fuel cost of a 40-pound item—about $2 in fuel for a 3-hour flight. These costs add up to $15 ($9+$4+$2). Since airlines have implemented their baggage fees, fewer customers are checking bags. Not only does this save the airlines money, it also increases the amount of space available for hauling cargo. An airline can charge at least $80 for hauling a small parcel for same-day delivery service.
Source: Scott McCartney, “What It Costs an Airline to Fly Your Luggage,” Wall Street Journal Online (November 25, 2008).
18-46
4 Apply ABC to Service Company
(a) Compute the activity-based overhead rates for each pool.
LO 4
18-47
4 Apply ABC to Service Company
(b) Determine the overhead allocated to Job A1027 which has 150 pieces, requires200 miles of driving, and 0.75 hours of logistics.
(150 x $0.70) + (200 x $0.50) + (0.75 x $30) = $227.50
LO 4
18-48
JIT manufacturing is dedicated to having the right amount of materials, parts, or products just as they are needed.
.
Illustration 18A-1
LEARNINGOBJECTIVE 5 APPENDIX 18A: Explain just-in-time (JIT)
processing.
LO 5
18-49
Objective of JIT Processing
To eliminate all manufacturing inventories.
Elements of JIT Processing
Dependable suppliers.
Multiskilled work force.
Total quality control system.
LO 5
Just-In-Time Inventory Processing
18-50
Benefits of JIT Processing
Significant reduction or elimination of manufacturing
inventories.
Enhanced product quality.
Reduction or elimination of rework costs and inventory
storage costs.
Production cost savings from the improved flow of goods
through the processes.
LO 5
Just-In-Time Inventory Processing
18-51
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