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Chapter 16 … “Job Order Costing”: allocated overhead using Pred. Overhead Rate with Direct Labor as an allocation (activity) base.
Chapter 17 … “Process Costing”: allocated overhead using Predetermined Overhead Rate often with Machine Hours as the allocation (activity) base.
Chapter 18 … “Activity-Based-Costing” (ABC): will allocate overhead using multiple rates and multiple activity bases.
Allocating OverheadAllocating Overhead
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The Need for a New Approach
Huge change in manufacturing & service industries.
Decrease in amount of direct labor usage.
Significant increase in total overhead costs.
A single plant-wide overhead rates gives poor info
when manufacturing is more complex and less
human labor is involved.
Complex manufacturing processes may require
multiple allocation bases; this approach is called
Activity-Based Costing (ABC).
Traditional CostingTraditional Costing
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Activity-Based Costing
Allocates overhead to multiple activity-based cost pools versus
the OLD methods that used single allocation base (labor hours,
machine hours etc.
Assigns the activity-based cost pools to products or services by
means of “cost drivers” … an activity that is the root cause of
why a cost occurs. In the past this was direct labor hours and
sometimes machine hours.
Activity-Based CostingActivity-Based Costing
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Activity-Based Costing
Activity: any event, action, transaction, or work sequence that
causes a cost to be incurred in producing a product or providing a
service.
Activity Cost Pool: a distinct type of activity. For example:
ordering materials or setting up machines.
Cost Drivers: any factors or activities that have a direct cause-
effect relationship with the resources consumed. In addition to
direct labor, today's drivers may include machine setups,
engineering change orders, special inspections, handling and
storage, components and machine hours.
Activity-Based CostingActivity-Based Costing
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ONE “Activity Driver” = Owning a Car
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Activity-Based Costing
ABC allocates overhead costs in two stages:
Stage 1: Overhead costs are allocated to activity cost pools.
Stage 2: Assigns overhead allocated to the activity cost
pools to products, using cost drivers.
The more complex a product’s manufacturing operation, the
more activities and cost drivers are likely to be present.
A-B-C … Activity-Based CostingA-B-C … Activity-Based Costing
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Activity-Based Costing Illustration 18-2Activities and related cost drivers
Traditional Costing and Activity-Based CostingTraditional Costing and Activity-Based Costing
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Activity-Based Costing Illustration 18-3ABC system design—Lift Jack Company
Traditional Costing and Activity-Based CostingTraditional Costing and Activity-Based Costing
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Activity-Based Costing
Involves the following four steps.
1. Identify and classify the activities involved in the manufacture
of specific products, and allocate overhead to cost pools.
2. Identify the cost driver that has a strong correlation to the costs
accumulated in the cost pool.
3. Compute the activity-based overhead rate for each cost driver.
4. Assign overhead costs to products, using the overhead rates
determined for each cost pool (cost per driver).
Example of ABC Versus Traditional CostingExample of ABC Versus Traditional Costing
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“Company” produces two products (abdominal trainers):
► Ab Bench: a high volume item with sales totaling 25,000 units annually.
► Ab Coaster: a low volume item with sales totaling 5,000 units annually.
Each product requires 1 hour of direct labor.
► Total annual direct labor hours (DLH) 30,000 (25,000 + 5,000)
► Direct labor cost $12 per unit for each product
Expected annual manufacturing overhead costs $900,000.
Direct materials cost:
► Ab Bench - $40 per unit
► Ab Coaster - $30 per unit
Illustration:
Required: Calculate unit costs under ABC.
Example of ABC Versus Traditional CostingExample of ABC Versus Traditional Costing
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* Overhead rate = $900,000/30,000 DLH = $30 per DLH
Overhead = ($30 X 1 hr. = $30)
Illustration:
Manufacturing costs Ab Bench Ab Coaster
Direct materials $40 $30
Direct labor 12 12
Overhead 30 30
Total unit cost $82 $72
Example of ABC Versus Traditional CostingExample of ABC Versus Traditional Costing
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Identify and Classify Activities and AllocateOverhead to Cost Pools (Step 1)
Illustration 18-4
Overhead costs are assigned directly to the appropriate activity
cost pool.
Example of ABC Versus Traditional CostingExample of ABC Versus Traditional Costing
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Identify Cost Drivers (Step 2)
Illustration 18-5
Cost driver must accurately measure the actual consumption of the
activity by the various products.
Example of ABC Versus Traditional CostingExample of ABC Versus Traditional Costing
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Compute Overhead Rates (Step 3)
Illustration 18-6
Illustration 18-7
Next, the company computes an activity-based overhead rate per
cost driver.
Example of ABC Versus Traditional CostingExample of ABC Versus Traditional Costing
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In assigning overhead, it is necessary to know the expected
use of cost drivers for each product. Because of its low volume,
Ab Coaster requires more set-ups and inspections than Ab Bench.
Assign Overhead Cost to Products (Step 4)
Illustration 18-8
Example of ABC Versus Traditional CostingExample of ABC Versus Traditional Costing
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Assign Overhead Cost to Products (Step 4)
To assign overhead, “Company” multiplies the ABC overhead
rates per cost driver by the number of cost drivers expected to be
used per product.
Example of ABC Versus Traditional CostingExample of ABC Versus Traditional Costing
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Assign Overhead Cost to Products (Step 4)
To assign overhead costs, “Company” multiplies the activity-
based overhead rates per cost driver (Ill. 18-7) by the number of
cost drivers expected to be used per product (Ill. 18-8).
Example of ABC Versus Traditional CostingExample of ABC Versus Traditional Costing
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A likely consequence of the differences in assigning overhead is
that Atlas has been overpricing the Ab Bench and possibly losing
market share to competitors. It also has been sacrificing profitability
by underpricing the Ab Coaster.
Illustration 18-10 Comparing Unit Costs
Example of ABC Versus Traditional CostingExample of ABC Versus Traditional Costing
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Illustration 18-11
Comparing Unit Costs
Example of ABC Versus Traditional CostingExample of ABC Versus Traditional Costing
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More accurate product costing through:
Use of more cost pools to assign overhead costs.
Enhanced control over overhead costs.
Better management decisions.
Benefits of ABC
Can be expensive to use.
Some arbitrary allocations continue.
Limitations of ABC
Activity-Based Costing: A Closer LookActivity-Based Costing: A Closer Look
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When to Use ABC
Factors to consider:
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. The manufacturing process or the number of products has
changed significantly.
5. Production or marketing managers are ignoring data provided by
the existing system.
Activity-Based Costing: A Closer LookActivity-Based Costing: A Closer Look
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Value-Added Versus Non–Value-Added Activities
Activity Based Management (ABM):
An extension of ABC from a product costing system to a
management function that focuses on reducing costs and
improving processes and decision making.
► Value-added activities
► Non–value-added activities
Activity-Based Costing: A Closer LookActivity-Based Costing: A Closer Look
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An activity that increases the perceived worth of a product or service such as:
Value-Added Activities
Manufacturing Company
Engineering design
Machining services
Assembly
Painting
Service Company
Performing surgery
Legal research
Delivering packages
Activity-Based Costing: A Closer LookActivity-Based Costing: A Closer Look
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An activity that adds cost to, or increases the time spent on, a product/service without increasing market value such as:
Non–Value-Added Activities
Manufacturing Company
Repair of machines
Storage of inventory
Building maintenance
Inspection
Service Company
Taking appointments
Reception
Bookkeeping and billing
Advertising
Activity-Based Costing: A Closer LookActivity-Based Costing: A Closer Look
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Objective: Identify key cost-generation activities and keep track
of quantity of activities performed for each service provided.
General approach is to identify activities, cost pools, and
cost drivers.
Labeling of activities as value-added or non-value-added.
A larger proportion of overhead costs are company-wide
costs that cannot be directly traced to specific services
provided by the company.
Activity-Based Costing in Service IndustriesActivity-Based Costing in Service Industries
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Traditional Costing Example
The public accounting firm of Check and Doublecheck prepares
the following condensed annual budget.
Illustration 18-14
Activity-Based Costing in Service IndustriesActivity-Based Costing in Service Industries
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Traditional Costing Example
Illustration 18-15
Under traditional costing Check and Doublecheck would
compute applied overhead and operating income as:
Activity-Based Costing in Service IndustriesActivity-Based Costing in Service Industries
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Activity-Based Costing Example
Check and Doublecheck distributes its estimated annual
overhead costs of $1,200,000 to several activity cost pools.
Illustration 18-16
Activity-Based Costing in Service IndustriesActivity-Based Costing in Service Industries
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Activity-Based Costing Example
Assigning overhead in a service industryIllustration 18-17
Activity-Based Costing in Service IndustriesActivity-Based Costing in Service Industries
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Activity-Based Costing Example
Illustration 18-18
Comparison of traditional costing with ABC in a service
company.
Activity-Based Costing in Service IndustriesActivity-Based Costing in Service Industries
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JIT manufacturing is dedicated to having the right amount of materials, parts, or products just as they are needed.
.
Illustration 18A-1
APPENDIX 18A JUST-IN-TIME PROCESSING
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Objective of JIT Processing
To eliminate all manufacturing inventories.
Elements of JIT Processing
Dependable suppliers.
Multiskilled work force.
Total quality control system.
APPENDIX 18A JUST-IN-TIME PROCESSING
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APPENDIX 18A JUST-IN-TIME 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.
