Chp 4 - Activity Based Costing

examples of non-value added activities

-inventory storage -moving materials, work in process, or finished goods from one location to another -inspecting goods -fixing defective goods under warranty -machine setup -in-process inspections -FDA certification

In allocating overhead costs, it is necessary to know the expected use of cost drivers for each product. 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).

Allocate Overhead Costs to Products (Step 4)

activity

Any event, action, transaction, or work sequence that incurs costs when producing a product or performing a service.

1. More cost pools, therefore more accurate product costing. 2. Enhanced control over overhead costs. 3. Better management decisions.

BENEFITS OF ABC

Performed every time a company produces another batch of a product. Example: Batch of ice cream equitment setup purchase ordering inspection

Batch level

-significant reduction or elimination of manufacturing inventories -enhanced product quality -reduction or elimination of rework costs and inventory storage -production cost savings from the improved flow of goods through the processes -elimination of separate raw materials and WIP inventory accounts

Benefits of JIT processing

-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.

Components of applying ABC to service industries

Next, the company computes an activity-based overhead rate per cost driver.

Compute Activity-Based Overhead Rates (Step 3)

dependable suppliers multiskilled workforce total quality control system (no defects)

Elements of JIT Processing

Required to support or sustain an entire production process. Example: A hospital these costs do not vary as a function of the number of units, batches, or products. plant manager salaries plant depreciation property taxes utilities

Facility Level

Allocates overhead using a predetermined rate

How do traditional costing systems allocate overhead?

Cost driver must accurately measure the actual consumption of the activity by the various products. a high degree of correlation must exist between the cost driver and the actual consumption of the overhead costs in the cost pool.

Identify Cost Drivers (Step 2)

Overhead costs are assigned directly to the appropriate activity cost pool.

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

direct labor as the relevant activity base

Job order costing uses

expensive to use arbitrary allocations remain

Limitations

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.

Managers use ABC via ABM for/to

Identify key activities that generate costs and keep track of how many of those activities are completed for each service performed

Overall objective in applying ABC to service industries

Performed every time a company produces a new type of product. Example: Time spent testing a new drug by a pharmaceutical company product design engineering changes

Product level

Identify and classify the activities involved in the manufacture of specific products and assign overhead to cost pools

STEP 1

Identify the cost driver that has a strong correlation to the costs accumulated in each cost pool

STEP 2

Compute the activity based overhead rate for each cost pool

STEP 3

Allocate overhead costs to products using the overhead rates determined for each cost pool

STEP 4

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

the more activities and cost drivers are likely to be present

The more complex a product's manufacturing operation...

overpricing and losing market share to competitors underpricing and sacrificing profitability

Traditional costing system could lead to over pricing which causes.... and underpricing which causes...

performed for each unit of production -assembly of cell phones machine related labor related

Unit level

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.

When to use

1. Tremendous change in manufacturing and service industries 2. Decrease in amount of direct labor usage 3. Significant increase in total overhead costs 4. Inappropriate to use plantwide predetermined overhead rates when a lack of correlation exists 5. Complex manufacturing processes may require multiple allocation bases

Why do we need a new approach?

activity-based management

a management tool that focuses on reducing costs and improving process and decision-making

value-added activities

increase the perceived value of a product or service to customers

to eliminate all manufacturing inventories JIT strives to eliminate inventories by using a "pull approach" in manufacturing.

objective of JIT processing

machine hours may be the relevant activity base

process costing uses:

activity cost pool

the overhead cost attributed to a distinct activity (e.g. ordering materials or setting up machines)

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)

ABC allocates overhead in a two-stage process:

OH into various cost pools in an effort to provide more accurate cost info -it supplements other cost systems

ABC does not replace an existing job order or process cost system. ABC instead segregates

Examples of value added activities

engineering design machining assembly painting performing surgery performing legal research delivering packages

non value added activities

adds costs to, or increases the time spent on, a product/service without increasing its perceived value

cost driver

any factor or activity that has a direct cause-effect relationship with the resources consumed

Activity-based costing

approach for allocating overhead costs. allocates overhead to multiple activity cost pools and then assigns the activity cost pools to products and services by means of cost drivers

Just-in-time manufacturing

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