Ch. 17 - ACTIVITY-BASED COSTING

Activity-Based Costing (ABC)

-Allocates overhead to multiple activity cost pools and -Assigns the activity cost pools to products or services by means of cost drivers. *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.

Traditional Costing Systems

Allocates overhead using a single predetermined rate. ►Job order costing: direct labor cost may be the relevant activity base. ►Process costing: machine hours may be the relevant activity base. Assumption was satisfactory when direct labor was a major portion of total manufacturing costs. ►Wide acceptance of a high correlation between direct labor and overhead costs.

Value-Added Versus *Non-Value-Added Activities*

An activity that *adds cost* to, or *increases the time spent* on, a product/service without increasing its market value such as: Manufacturing Company ►Repair of machines ►Storage of inventory ►Moving of inventory ►Building maintenance ►Inspections ►Inventory Control Service Company ►Taking appointments ►Reception ►Bookkeeping and billing ►Traveling ►Ordering supplies ►Advertising

*Value-Added* Versus Non-Value-Added Activities

An activity that *increases the perceived worth* of a product or service such as: Manufacturing Company ►Engineering design ►Machining services ►Assembly ►Painting Service Company ►Performing surgery ►Legal research ►Delivering packages

Elements of JIT Processing

Dependable suppliers. Multiskilled work force. Total quality control system.

Compute Overhead Rates

Estimated Overhead Per Activity / Expected Use of Cost Drivers per Activity = Activity Based Overhead

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.

Indicate whether the following statements are true or false. 1. A traditional costing system allocates overhead by means of multiple overhead rates.

False

Indicate whether the following statements are true or false. 4 .As manufacturing processes have become more automated, more companies have chosen to allocate overhead on the basis of direct labor costs.

False

Benefits of ABC

More accurate product costing through: ►Use of more cost pools to assign overhead costs. ►Enhanced control over overhead costs. ►Better management decisions.

Activity-Based Costing in Service Industries

Overall 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.

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.

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.

Objective of JIT Processing

To eliminate all manufacturing inventories

The Need for a New Approach

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).

6. In activity-based costing, an activity is any event, action, transaction, or work sequence that incurs cost when producing a product.

True

Indicate whether the following statements are true or false. 2.Activity-based costing allocates overhead costs in a two-stage process.

True

Indicate whether the following statements are true or false. 3. Direct material and direct labor costs are easier to trace to products than overhead.

True

Limitations of ABC

►Can be expensive to use. ►Some arbitrary allocations continue.

Classify each of the following activities within a water-ski manufacturer as value-added (VA) or non-value-added (NVA). 1. Inspecting completed skis. 2. Storing raw materials. 3. Machine setups. 4. Installing bindings on skis. 5. Packaging skis for shipment. 6. Reworking defective skis.

1. NVA 2. NVA 3. NVA 4. VA 5. VA 6. NVA

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).

Comparing Unit Costs

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.*