Chapter 17

• Classification of Activity Levels

o Unit Level o Batch-Level o Product-Level o Facility-level

• Multiple Cost Pools

o Used instead of one plantwide pool and a single cost driver. o Numerous activity cost pools with more relevant cost drivers. o Costs allocated on basis of cost drivers used to produce each product.

Step 2: Identify Cost Drivers

• Cost driver must accurately measure the actual consumption of the activity by the various products.

Explain just-in-time (JIT) processing

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

o Product-Level

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

o Batch-Level

Performed every time a company produces another batch of a product. Example: Batch of ice cream

o Unit Level

Performed for each unit of production. Example: Assembly of cell phones

o Facility-level

Required to support or sustain an entire production process. Example: A hospital

Apply activity-based costing to a manufacturer

Step 1: Identifying and Classify Activities and Allocate Overhead to Cost Pools Step 2: Identify Cost Drivers Step 3: Compute Activity-Based Overhead Rates Step 4: Allocate Overhead Costs to Products

Classify Activity Levels

a) Engineering design - Product level b) Machine setup - Batch Level c) Toy design - Product level d) Interviews of prospective employees - Facility level e) Inspections after each setup - Batch level f) Polishing parts - Unit level g) Assembling parts - Unit level h) Health and safety - Facility level

DO IT: • Indicate whether the following statements are true or false.

• A traditional costing system allocates overhead by means of multiple overhead rates. o false • Activity-based costing allocates overhead costs in a two-stage process. o true • Direct material and direct labor costs are easier to trace to products than overhead. o true • As manufacturing processes have become more automated, more companies have chosen to allocate overhead on the basis of direct labor costs. o False • In activity-based costing, an activity is any event, action, transaction, or work sequence that incurs cost when producing a product. o True

Question The first step in the development of an activity-based costing system for a service company is:

• A: identify and classify activities and allocate overhead to cost pools. • assign overhead costs to products. • identify cost drivers. • compute overhead rates.

Non-Value Added Activities

• Adds cost to, or increases the time spent on, a product/service without increasing its perceived value, such as: • Manufacturing Company o Storage of inventory o Moving of inventory o Inspections o Fixing defective goods o Set up machines • Service Company o Taking appointments o Reception o Bookkeeping and billing o Traveling o Ordering supplies o Advertising

Traditional Costing System

• Allocates overhead using a predetermined rate. o Job order costing: direct labor cost may be the relevant activity base. o Process costing: machine hours may be the relevant activity base. • Traditional one-stage costing system o Overhead costs > DL (hours or $) > Products

Activity-Based Costing

• 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. • Focuses on activities needed to produce a good or perform a service

Activity

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

Cost Driver

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

Step 4: Allocate Overhead Costs to Products

• 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. • Likely consequence of differences in assigning overhead. o Overpricing the Ab Bench and possibly losing market share to competitors. o Sacrificing profitability by underpricing the Ab Coaster.

Value-Added Activities

• Increase the perceived value of a product or service to customers, such as: • Manufacturing Company o Engineering design o Machining services o Assembly o Painting • Service Company o Performing surgery o Legal research o Delivering packages

Some limitations and Knowing when to use ABC

• Limitations o Expensive to use. o Arbitrary allocations remain. • When to Use o Product lines differ in volume and manufacturing complexity. o Product lines are numerous and diverse. o Overhead costs constitute a significant portion of total costs. o Manufacturing process or the number of products has changed significantly. o Production or marketing managers are ignoring data.

Step 3: Compute Activity-Based Overhead Rates

• Next, the company computes an activity-based overhead rate per cost driver. • Estimated Overhead per activity / Expected use of cost Drivers per Activity = Activity-Based Overhead rate

Just-In-Time (JIT) Processing

• Objective of JIT Processing o To eliminate all manufacturing inventories • Elements of JIT Processing o Dependable suppliers. o Multiskilled work force. o Total quality control system . • Benefits o Significant reduction or elimination of manufacturing inventories. o Enhanced product quality. o Reduction or elimination of rework costs and inventory storage costs. o Production cost savings from the improved flow of goods through the processes.

Apply activity-based costing to service industries.

• Overall objective: Identify key activities that generate costs and keep track of how many of those activities are completed for each service performed. o General approach is to identify activities, cost pools, and cost drivers. o Labeling of activities as value-added or non-value added. o Sometimes, a larger proportion of overhead costs are company-wide costs that cannot be directly traced to specific services provided by the company.

Step 1: Identifying and Classify Activities and Allocate Overhead to Cost Pools

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

ABC allocates OH in a 2-stage process

• Stage 1: o Overhead costs are assigned to activity cost pools (Step 1). • Stage 2: o 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.

Question: The Following activity is value-added:

• Storage of raw materials. • Moving parts from machine to machine. • A: Shaping a piece of metal on a lathe. • All of the above.

Activity Cost Pool

• The overhead cost attributed to a distinct activity • Ex: ordering materials or setting up machines

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. • activity-based costing (ABC): o Complex manufacturing processes may require multiple allocation bases

ABM (Activity-Based Management

• a management tool that focuses on reducing costs and improving processes and decision-making. • Managers use ABC via ABM o for both strategic and operational decisions or perspectives. o to help managers evaluate employees, departments, and business units. o to establish performance standards, as well as benchmark against other companies.

Question: The Primary Objective of JIT Processing is to?

• accumulate overhead in activity cost pools. • A: eliminate or reduce all manufacturing inventories. • identify relevant activity cost drivers. • identify value-added activities.

Four Steps of Activity-Based Costing

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.

ABC has 3 main Benefits

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