Financial and managerial accounting 2nd kimel kieso willey chapter 18

 Allocates overhead to multiple activity cost pools.. Identify and classify the activities involved in the manufacture of specific products and assign overhead to cost pools.. ABC allo

Activity-Based Costing 18

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.

 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

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.

Tremendous change in manufacturing and service

industries

rates when a lack of correlation exists

activity-based costing (ABC)

The Need for a New Approach

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

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

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

Illustration 17-2

Activities and related cost drivers

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

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.

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)

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

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 18-10

Expected use of cost

drivers per product

Illustration 18-11

Allocation of activity cost pools

to 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)

Illustration 18-11

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)

Likely consequence of differences in assigning overhead.

 Overpricing the Ab Bench and possibly losing market

LO 2

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

Management Insight

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

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

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

2 Apply ABC to Manufacturer

LO 2

2 b.Prepare a schedule assigning each activity’s

overhead cost to the two products.

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

ABC has three primary benefits:

1 More cost pools, therefore more accurate product costing

2 Enhanced control over overhead costs

3 Better management decisions

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

The Advantage of Multiple Cost Pools

► Example: Assembly of cell phones

level Product- level

Unit-The Advantage of Multiple Cost Pools

CLASSIFICATION OF ACTIVITY LEVELS

LO 3

level Facility- level

batch of a product

► Example: Batch of ice cream

The Advantage of Multiple Cost Pools

CLASSIFICATION OF ACTIVITY LEVELS

of product

► Example: Time spent testing a new drug by a

pharmaceutical company

The Advantage of Multiple Cost Pools

CLASSIFICATION OF ACTIVITY LEVELS

LO 3

process

► Example: A hospital

The Advantage of Multiple Cost Pools

CLASSIFICATION OF ACTIVITY LEVELS

Increase the perceived value of a product or service to

customers, such as:

Value-Added Activities

Manufacturing Company

Engineering designMachining services

AssemblyPainting

Service Company

Performing surgeryLegal researchDelivering packages

The Advantage of Enhanced Cost Control

Adds cost to, or increases the time spent on, a

product/service without increasing its perceived value, such as:

Manufacturing Company

Storage of inventoryMoving of inventory

InspectionsFixing defective goodsSet up machines

Service Company

Taking appointments

ReceptionBookkeeping and billing

TravelingOrdering suppliesAdvertising

Non-Value-Added Activities

The Advantage of Enhanced Cost Control

LO 3

General Mills Management Insight

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

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

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

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-level

LO 3

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

The public accounting firm of Check and Doublecheck prepares

the following condensed annual budget

Illustration 18-16

Condensed annual budget of a service firm under traditional costing

Traditional Costing Example

LO 4

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

Check and Doublecheck distributes its estimated annual

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

Activity-Based Costing Example

Illustration 18-18

Condensed annual budget of

a service firm under

activity-based costing

LO 4

Assigning overhead in a service industry.

Activity-Based Costing Example

Illustration 18-19

Assigning overhead in

a service company

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 18-20

Comparison of traditional costing

with ABC in a service company

LO 4

American Airlines Service Company Insight

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.

4 Apply ABC to Service Company

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

LO 4

4 Apply ABC to Service Company

(b) Determine the overhead allocated to Job A1027 which has 150 pieces, requires

200 miles of driving, and 0.75 hours of logistics.

(150 x $0.70) + (200 x $0.50) + (0.75 x $30) = $227.50

JIT manufacturing is dedicated to having the right amount of materials,

parts, or products just as they are needed.

Objective of JIT Processing

To eliminate all manufacturing inventories

Elements of JIT Processing

Dependable suppliers

Multiskilled work force

Total quality control system

Just-In-Time Inventory Processing

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