4-1 Activity-Based Costing 4 Learning Objectives Discuss the difference between traditional costing...

4-1

Activity-Based Costing4Learning 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

4-2

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

4-3

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 4-3Total unit costs—traditional costing

Illustration of a Traditional Costing System

LO 1

4-4

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

4-5

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

4-6

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

4-7

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.


LO 1

4-8

Illustration 17-2Activities and related cost drivers

Illustration 4-5Activities and related cost drivers LO 1

4-9

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

4-10


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

4-11

Overhead costs are assigned directly to the appropriate activity

cost pool.

Identify and Classify Activities and Allocate Overhead to Cost Pools (Step 1)

Illustration 4-6Activity cost pools andestimated overhead

LO 2

4-12

Cost driver must accurately measure the actual consumption

of the activity by the various products.

Illustration 4-6: Cost drivers that Atlas Company identifies and

their total expected use per activity cost pool.Illustration 4-7

Identify Cost Drivers (Step 2)

LO 2

4-13

Illustration 4-8

Illustration 4-9

Next, the company computes an activity-based overhead rate

per cost driver.

Compute Activity-Based Overhead Rates (Step 3)

LO 2

4-14

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 4-10Expected use of cost drivers per product

LO 2

4-15

Illustration 4-11Allocation of activity cost poolsto products

To allocate overhead costs, Atlas multiplies the activity-based

overhead rates per cost driver (Ill. 4-9) by the number of cost

drivers expected to be used per product (Ill. 4-10).

LO 2


4-16

Illustration 4-11

LO 2

To allocate overhead costs, Atlas multiplies the activity-based

overhead rates per cost driver (Ill. 4-9) by the number of cost

drivers expected to be used per product (Ill. 4-10).


4-17

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 4-12Comparison of unit product costs

LO 2

4-18

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

4-19

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.


LO 2

4-20

a. Prepare a schedule showing the computations of the activity-based overhead rates per cost driver.


LO 2

4-21

2 b. Prepare a schedule assigning each activity’s overhead cost to the two products.

LO 2

4-22

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.


LO 2

4-23

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

4-24

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

4-25

Illustration 4-13A more detailed view of Atlas’s machining activities


LO 3

4-26

Batch-level

Facility-level

Performed for each unit of production.

► Example: Assembly of cell phones

Unit-level

Product-level


CLASSIFICATION OF ACTIVITY LEVELS

LO 3

4-27

Batch-level

Facility-level

Performed every time a company produces another

batch of a product.

► Example: Batch of ice cream

Unit-level

Product-level



LO 3

4-28

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



LO 3

4-29

Batch-level

Facility-level

Required to support or sustain an entire production

process.

► Example: A hospital

Unit-level

Product-level



LO 3

4-30

Illustration 4-14Hierarchy of activity levels

LO 3

4-31

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

4-32

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

4-33

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

4-34

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

4-35

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

4-36

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

4-37

The public accounting firm of Check and Doublecheck prepares

the following condensed annual budget.

Illustration 4-16Condensed annual budget of a service firm under traditionalcosting

Traditional Costing Example

LO 4

4-38

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 4-16.

Traditional Costing Example

Illustration 4-17

LO 4

4-39

Check and Doublecheck distributes its estimated annual

overhead costs of $600,000 to three activity cost pools.

Activity-Based Costing Example

Illustration 4-18Condensed annual budget of a service firm under activity-based costing

LO 4

4-40

Assigning overhead in a service industry.


Illustration 4-19Assigning overhead in a service company

LO 4

4-41

Under activity-based costing, Check and Doublecheck assigns

overhead costs of $57,200 as compared to $70,000 under

traditional costing.


Illustration 4-20Comparison of traditional costing with ABC in a service company

LO 4

4-42

4 Apply ABC to Service Company

(a) Compute the activity-based overhead rates for each pool.

LO 4

4-43

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

4-44

JIT manufacturing is dedicated to having the right amount of materials, parts, or products just as they are needed.

.

Illustration 4A-1

LEARNINGOBJECTIVE 5 APPENDIX 4A: Explain just-in-time (JIT)

processing.

LO 5

4-45

Objective of JIT Processing

To eliminate all manufacturing inventories.

Elements of JIT Processing

Dependable suppliers.

Multiskilled work force.

Total quality control system.

LEARNINGOBJECTIVE 5 APPENDIX 4A: Explain just-in-time (JIT)

processing.

LO 5

4-46

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.

LEARNINGOBJECTIVE

APPENDIX 4A: Explain just-in-time (JIT) processing.

5

LO 5

4-47

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