LECTURE OUTLINE
A.Traditional Costing Systems
1.A traditional costing system allocates overhead to products on the basis of predetermined plantwide or departmentwide volume of unit-based output rates such as direct labor or machine hours.
2.Historically, there was a high correlation between direct labor and the incurrence of overhead cost. In recent years, however, manufacturers have experienced tremendous changes that have altered the manufacturing environment drastically.
3. Companies that have complex processes need to use multiple allocation bases to compute accurate product costs. An overhead cost allocation method that uses multiple bases is activity-based costing.
B.Activity-Based Costing
1.Activity-based costing (ABC) allocates overhead to multiple activity cost pools and then assigns the activity cost pools to products and services by means of cost drivers.
2.In ABC, an activity is any event, action, transaction, or work sequence that incurs cost when producing a product or providing a service.
3.ABC allocates overhead in a two-stage process. The first stage allocates overhead costs to activity cost pools. The second stage assigns the overhead allocated to the activity cost pools to products, using cost drivers.
4.A cost driver is any factor or activity that has a direct cause-effect relationship with the resources consumed.
C.Unit Costs Under ABC.
1.Activity-based costing involves the following steps:
a.Identify and classify the activities involved in the manufacture of specific products, and assign manufacturing overhead costs to the appropriate cost pools.
b.Identify the cost driver that has a strong correlation to the costs
accumulated in each cost pool.
c.Compute the overhead rate for each cost pool.
d.Allocate overhead costs to products using the overhead rates determined for each cost pool.
2.A well designed activity-based costing system starts with an analysis of the activities performed to manufacture a product or provide a service.
3.It requires a detailed, step-by-step review of each operation, documenting every activity undertaken to accomplish a task. At this point, the company will identify activity cost pools such as inspecting, assembling, and supervising.
4.Next, the system assigns overhead costs directly to the appropriate activity cost pools identified in step #3.
D.Identify Cost Drivers, Compute Overhead Rates, and Assign Overhead Costs to Products.
1.After costs are allocated to the activity cost pools, the company must identify the cost drivers for each cost pool.
2.A high degree of correlation must exist between the cost driver and the actual consumption of the overhead costs in the cost pool to achieve
accurate costing.
3.The company computes an activity-based overhead rate per cost driver by dividing the estimated overhead per activity by the number of cost drivers expected to be used per activity.
4.In assigning overhead costs, it is necessary to know the expected use of cost drivers for each product.
5.The company multiplies activity-based overhead rates per cost driver by the number of cost drivers expected to be used per product to assign overhead costs to each product.
6.Under ABC, overhead costs are usually shifted from a high-volume product to a low-volume product. This shift results in more accurate costing because:
a.Low-volume products often require more special handling, (i.e.-more machine setups and inspections), than high-volume products.
b.Assigning overhead using ABC will usually increase the cost per unit for low-volume products (and decrease the cost per unit for high-volume products) as compared to traditional overhead allocation.
E.Benefits of ABC.
1.The primary benefit of ABC is more accurate product costing because
a.ABC leads to more cost pools being used to assign overhead costs to products; therefore, costs are assigned more directly based on cost drivers
b.ABC leads to enhanced control over overhead costs; companies can trace many overhead costs directly to activities under ABC.
c.ABC leads to better management decisions; more accurate product costing should contribute to desired product profitability levels.
F.Classification of Activity Levels.
1.A classification of ABC activities consisting of four levels are defined as
a.Unit-level activities: activities performed for each unit of production.
b.Batch-level activities: activities performed for each batch of products rather than each unit.
c.Product-level activities: activities performed in support of an entire product line.
d.Facility-level activities: activities required to support an entire production process.
2.Companies may achieve greater accuracy in overhead cost allocation by recognizing the different levels of activities and developing specific activity cost pools and their related cost drivers.
3.Nonrecognition of this classification of activities is one of the reasons that volume-based cost allocation causes distortions in product costing.
4.The resources consumed by batch-, product-, and facility-level supporting activities do not vary at the unit level, nor can managers control them at the unit level.
5.Companies can control batch-, product-, and facility-level costs only by modifying batch-, product-, and facility-level activities.
G.Value-Added Versus Non-Value-Added Activities.
1.In developing an ABC System, managers increase their awareness of the activities performed by the company in its production and supporting processes. This helps managers classify activities as value-added or non-value-added.
2.Value-added activities increase the worth of a product or service, for which the customer is willing to pay.
3.Value-added activities are the activities of actually manufacturing a product or performing a service (i.e., engineering design, assembly, packaging).
4.Non-value-added activities are production- or service-related activities that simply add cost to or increase the time spent on a product or service without increasing its market value (i.e. machine repair, building maintenance, inventory control).
5.Companies often use activity flowcharts to help identify the ABC activities.
6.Not all non-value-added activities are totally wasteful, nor can they be totally eliminated, but managers are motivated to minimize them as much as possible.
H.The Limitations and When to Use ABC.
1.The limitations of ABC are:
a.ABC can be expensive to use; identifying multiple activities and
applying numerous cost drivers results in increased costs.
b.Some arbitrary allocations continue; certain overhead costs still have to be allocated by means of some arbitrary volume-based cost driver (i.e.labor hours).
2.The presence of one or more of the following factors would point to ABC’s possible use.
a.Product lines differ greatly in volume and manufacturing complexity.
b.Product lines are numerous and diverse, and they require differing degrees of support services.
c.Overhead costs constitute a significant portion of total costs.
d.The manufacturing process or the number of products has changed significantly.
e.Production or marketing managers are ignoring data provided by the existing system and are instead using other alternative data when pricing or making product decisions.
I.Activity-Based Costing in Service Industries.
1.The overall objective of ABC in service firms is no different than it is for a manufacturing company: The objective is to identify the key activities that generate costs and to keep track of how many activities are performed for each service provided.
2.The general approach to identifying activities, activity cost pools, and cost drivers is the same for service companies and for manufacturers.
3.Often, a larger proportion of overhead costs are company-wide costs that cannot be directly traced to specific services provided by the company, which sometimes makes implementation of ABC difficult in serviceindustries.
*J.Just-in-Time Processing.
1.Traditionally, continuous process manufacturing has been based on a just-in-case philosophy: inventories of raw materials are maintained just in case some items are of poor quality or a key supplier is shut down by a strike. This philosophy results in a “push approach”, in which raw materials are pushed through each process and often results in the buildup of extensive manufacturing inventories.
2.Many U.S. firms have switched to just-in-time (JIT) processing. Under JIT processing, companies receive raw materials just in time for use in production, they complete subassembly parts just in time for use in finished goods, and they complete finished goods just in time to be sold.
3.JIT strives to eliminate inventories by using a pull approach in manufacturing. This approach begins with the customer placing an order with the company, which starts the process of pulling the product through the manufacturing process.
4.JIT processing consists of three important elements:
a.Suppliers must be dependable and willing to deliver on short notice exact quantities of materials, and to specified work stations. Online computer linkage between the company and its suppliers facilitates this arrangement.
b.Workers must be multiskilled in order to operate and maintain several different types of machines.
c.The company must establish total quality control throughout the manufacturing operations, which tolerates no defects. Continuous monitoringby both employees
5.The major benefits of JIT processing include:
a.Significant reduction or elimination of manufacturing inventories.
b.Enhanced product quality.
c.Reduction or elimination of rework costs and inventory storage costs.
d.Production cost savings from the improved flow of goods through the processes.
6.One of the major accounting benefits of JIT is the elimination of separate raw materials and work-in-process inventory accounts.
20 MINUTE QUIZ
Circle the correct answer.
True/False
1.Even in today’s automated environment, direct labor is sometimes the appropriate basis for assigning overhead cost to products.
TrueFalse
2.In the first stage of activity-based costing, overhead is assigned to products using cost drivers.
TrueFalse
3.The first step in activity-based costing is to identify and classify the major activities
involved in the manufacture of specific products, and allocate manufacturing overhead to the appropriate cost pools.
TrueFalse
4.Before costs are allocated to the cost pools, the cost drivers for each cost pool must be identified.
TrueFalse
5.Under ABC, overhead costs are shifted from the high-volume product to the low-volume product.
TrueFalse
6.Activity-based costing does not change the amount of overhead costs, but it does allocate those costs in a more accurate manner.
TrueFalse
7.Overhead costs are not allocated by means of arbitrary volume-based cost drivers under ABC.
TrueFalse
8.Value-added activities increase the worth of a product or service to customers and
involve resource usage that customers are willing to pay for.
TrueFalse
9.Product-level activities in ABC are required to support or sustain an entire production process.
TrueFalse
*10.Just-in-time processing strives to eliminate inventories by using a “pull approach” in manufacturing.
TrueFalse
Multiple Choice
1.The last step in activity-based costing is to
a.identify the major activities involved in the manufacture of specific products.
b.compute the overhead rate per cost driver.
c.identify the cost driver that has a strong correlation to the costs accumulated in the cost pool.
d.assign manufacturing overhead costs for each cost pool to products.
2.Machine hours would be an accurate cost driver for
a.assembly costs.
b.inspecting costs.
c.machining costs.
d.machine setup costs.
3.All of the following are benefits of ABC except it leads to
a.elimination of all arbitrary cost allocations.
b.more accurate cost data.
c.enhanced control over overhead costs.
d.better management decisions.
4.The level of ABC activities performed in support of an entire product line are classified as
a.batch-level activities.
b.facility-level activities.
c.product-level activities.
d.unit-level activities.
*5.Just-in-time processing strives to eliminate inventories by using a
a.just in case approach.
b.pull approach.
c.push approach.
d.process approach.
ANSWERS TO QUIZ
True/False
1. True 6.True
2. False 7.False
3. True 8.True
4. False 9.False
5. True *10.True
Multiple Choice
1. d.
2. c.
3. a.
4. c.
*5. b