1. 18-1

2. 18-2 Activity-Based Costing 18 Learning Objectives Discuss the difference between traditional costing and activity-based costing. Apply activity-based costing to a manufacturer. Explain the benefits and limitations of activity-based costing. 3 Apply activity-based costing to service industries. 2 1 4

3. 18-3  Allocates overhead using a predetermined rate. ► Job order costing: direct labor cost may be the relevant activity base. ► Process costing: machine hours may be the relevant activity base. Traditional Costing Systems LEARNING OBJECTIVE Discuss the difference between traditional costing and activity-based costing. 1 LO 1 Illustration 18-1 Traditional one-stage costing system

4. 18-4 Atlas Company produces two abdominal fitness products—the Ab Bench and the Ab Coaster. The direct materials cost per unit is $40 for the Ab Bench and $30 for the Ab Coaster. The direct labor cost is $12 per unit for each product. Both products require one direct labor hour per unit, both products are allocated overhead cost of $30 per unit. Illustration 18-3 Total unit costs— traditional costing Illustration of a Traditional Costing System LO 1

5. 18-5  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). The Need for a New Approach LO 1

6. 18-6 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. Activity-Based Costing LO 1

7. 18-7 2. Identify the cost driver that has a strong correlation to the costs accumulated in each cost pool. Activity-Based Costing (Four Steps) 1.Identify and classify the activities involved in the manufacture of specific products and assign overhead to cost pools. 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. LO 1

8. 18-8 ABC allocates overhead in a two-stage process:  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). The more complex a product’s manufacturing operation, the more activities and cost drivers are likely to be present. Activity-Based Costing LO 1

9. 18-9 Illustration 17-2 Activities and related cost drivers Illustration 18-5 Activities and related cost drivers LO 1

10. 18-10 Solution: 1. False. 2. True. 3. True. 4. False. 5. True. Indicate whether the following statements are true or false. 1.A traditional costing system allocates overhead by means of multiple overhead rates. 2.Activity-based costing allocates overhead costs in a two-stage process. 3.Direct material and direct labor costs are easier to trace to products than overhead. 4.As manufacturing processes have become more automated, more companies have chosen to allocate overhead on the basis of direct labor costs. 5.In activity-based costing, an activity is any event, action, transaction, or work sequence that incurs cost when producing a product. 1 Costing Systems LO 1

11. 18-11 Activity-Based Costing Involves the following four steps. 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. LEARNING OBJECTIVE Apply activity-based costing to a manufacturer. 2 LO 2

12. 18-12 Overhead costs are assigned directly to the appropriate activity cost pool. Identify and Classify Activities and Allocate Overhead to Cost Pools (Step 1) Illustration 18-6 Activity cost pools and estimated overhead LO 2

13. 18-13 Cost driver must accurately measure the actual consumption of the activity by the various products. Illustration 18-7: Cost drivers that Atlas Company identifies and their total expected use per activity cost pool. Illustration 18-7 Identify Cost Drivers (Step 2) LO 2

14. 18-14 Illustration 18-8 Illustration 18-9 Next, the company computes an activity-based overhead rate per cost driver. Compute Activity-Based Overhead Rates (Step 3) LO 2

15. 18-15 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. Illustration 17-8 Allocate Overhead Costs to Products (Step 4) Illustration 18-10 Expected use of cost drivers per product LO 2

16. 18-16 Illustration 18-11 Allocation of activity cost pools to products To allocate overhead costs, Atlas multiplies the activity-based overhead rates per cost driver (Ill. 18-9) by the number of cost drivers expected to be used per product (Ill. 18-10). LO 2 Allocate Overhead Costs to Products (Step 4)

17. 18-17 Illustration 18-11 LO 2 To allocate overhead costs, Atlas multiplies the activity-based overhead rates per cost driver (Ill. 18-9) by the number of cost drivers expected to be used per product (Ill. 18-10). Allocate Overhead Costs to Products (Step 4)

18. 18-18 Likely consequence of differences in assigning overhead.  Overpricing the Ab Bench and possibly losing market share to competitors.  Sacrificing profitability by underpricing the Ab Coaster. Illustration 17-10 Comparing Unit Costs Illustration 18-12 Comparison of unit product costs LO 2

19. 18-19 ABC Evaluated Surveys of companies often show ABC usage of approximately 50%. Yet, in recent years, articles about ABC have expressed mixed opinions regarding its usefulness. To evaluate ABC practices and user satisfaction with ABC, a survey was conducted of 348 companies worldwide. Some of the interesting findings included the following: ABC methods are widely used across the entire value chain, rather than being primarily used to allocate production-specific costs; only 25% of non-ABC companies think they are accurately tracing the costs of activities, while 70% of ABC companies think their company does this well; and respondents felt that ABC provides greater support for financial, operational, and strategic decisions. More than 87% of respondents said that their ideal costing system would include some form of ABC. Since this significantly exceeds the 50% of the respondents actually using it, ABC usage may well increase in the future. Source: William Stratton, Denis Desroches, Raef Lawson, and Toby Hatch, “Activity- Based Costing: Is It Still Relevant?” Management Accounting Quarterly (Spring, 2009), pp. 31–39. Management Insight LO 2

20. 18-20 2 Apply ABC to Manufacturer Casey Company has five activity cost pools and two products. It expects to produce 200,000 units of its automobile scissors jack and 80,000 units of its truck hydraulic jack. Having identified its activity cost pools and the cost drivers for each cost pool, Casey Company accumulated the following data relative to those activity cost pools and cost drivers. LO 2

21. 18-21 Casey Company has five activity cost pools and two products. It expects to produce 200,000 units of its automobile scissors jack and 80,000 units of its truck hydraulic jack. Having identified its activity cost pools and the cost drivers for each cost pool, Casey Company accumulated the following data relative to those activity cost pools and cost drivers. Using the data provided, a.Prepare a schedule showing the computations of the activity-based overhead rates per cost driver. b.Prepare a schedule assigning each activity’s overhead cost to the two products. c.Compute the overhead cost per unit for each product. d.Comment on the comparative overhead cost per unit. 2 Apply ABC to Manufacturer LO 2

22. 18-22 a.Prepare a schedule showing the computations of the activity-based overhead rates per cost driver. 2 Apply ABC to Manufacturer LO 2

23. 18-23 2 b.Prepare a schedule assigning each activity’s overhead cost to the two products. LO 2

24. 18-24 c. Compute the overhead cost per unit for each product. These data show that the total overhead assigned to 80,000 hydraulic jacks exceeds the overhead assigned to 200,000 scissors jacks. The overhead cost per hydraulic jack is $34.25. It is only $12.80 per scissors jack. d. Comment on the comparative overhead cost per unit. 2 Apply ABC to Manufacturer LO 2

25. 18-25 ABC has three primary benefits: 1.More cost pools, therefore more accurate product costing. 2.Enhanced control over overhead costs. 3.Better management decisions. LEARNING OBJECTIVE Explain the benefits and limitations of activity-based costing. 3 LO 3

26. 18-26 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 LO 3

27. 18-27 Illustration 18-13 A more detailed view of Atlas’s machining activities The Advantage of Multiple Cost Pools LO 3

28. 18-28 Batch- level Facility- level  Performed for each unit of production. ► Example: Assembly of cell phones Unit- level Product- level The Advantage of Multiple Cost Pools CLASSIFICATION OF ACTIVITY LEVELS LO 3

29. 18-29 Batch- level Facility- level  Performed every time a company produces another batch of a product. ► Example: Batch of ice cream Unit- level Product- level The Advantage of Multiple Cost Pools CLASSIFICATION OF ACTIVITY LEVELS LO 3

30. 18-30 Batch- level Facility- level  Performed every time a company produces a new type of product. ► Example: Time spent testing a new drug by a pharmaceutical company Unit- level Product- level The Advantage of Multiple Cost Pools CLASSIFICATION OF ACTIVITY LEVELS LO 3

31. 18-31 Batch- level Facility- level  Required to support or sustain an entire production process. ► Example: A hospital Unit- level Product- level The Advantage of Multiple Cost Pools CLASSIFICATION OF ACTIVITY LEVELS LO 3

32. 18-32 Illustration 18-14 Hierarchy of activity levels LO 3

33. 18-33 Increase the perceived value of a product or service to customers, such as: Value-Added Activities Manufacturing Company Engineering design Machining services Assembly Painting Service Company Performing surgery Legal research Delivering packages The Advantage of Enhanced Cost Control LO 3

34. 18-34 Adds cost to, or increases the time spent on, a product/service without increasing its perceived value, such as: Manufacturing Company Storage of inventory Moving of inventory Inspections Fixing defective goods Set up machines Service Company Taking appointments Reception Bookkeeping and billing Traveling Ordering supplies Advertising Non-Value-Added Activities The Advantage of Enhanced Cost Control LO 3

35. 18-35 General Mills Management Insight LO 3 What Does NASCAR Have to Do with Breakfast Cereal? Often the best way to improve a process is to learn from observing a different process. Production-line technicians from food producer General Mills were flown to North Carolina to observe firsthand how race-car pit crews operate. In a NASCAR race, the value-added activity is driving toward the finish line; any time spent in the pit is non–value-added. Every split second saved in the pit increases the chances of winning. From what the General Mills’ technicians learned at the car race, as well as other efforts, they were able to reduce setup time from 5 hours to just 20 minutes.

36. 18-36 Activity-based management (ABM), a management tool that focuses on reducing costs and improving processes and decision-making. Managers use ABC via ABM  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. Advantage of Better Management Decisions LO 3

37. 18-37 Limitations and Knowing When to use ABC Limitations  Expensive to use.  Arbitrary allocations remain. When to Use 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. LO 3

38. 18-38 a.Engineering design b.Machine setup c.Toy design d.Interviews of prospective employees e.Inspections after each setup f.Polishing parts g.Assembling parts h.Health and safety Morgan Toy Company manufactures six primary product lines in its Morganville plant. As a result of an activity analysis, the accounting department has identified eight activity cost pools. Each of the toy products is produced in large batches, with the whole plant devoted to one product at a time. Classify each of the following activities as either unit- level, batch-level, product-level, or facility-level: 3 Classify Activity Levels a.Product-level b.Batch-level c.Product-level d.Facility-level e.Batch-level f.Unit-level g.Unit-level h.Facility-level LO 3

39. 18-39 LEARNING OBJECTIVE Apply activity-based costing to service industries. 4 Overall objective: Identify key activities that generate costs and keep track of how many of those activities are completed for each service performed.  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. LO 4

40. 18-40 The public accounting firm of Check and Doublecheck prepares the following condensed annual budget. Illustration 18-16 Condensed annual budget of a service firm under traditional costing Traditional Costing Example LO 4

41. 18-41 Assume that Check and Doublecheck records $140,000 of actual direct professional labor cost during its audit of Plano Molding Company, which was billed an audit fee of $260,000. Under traditional costing, using 50% as the rate for applying overhead to the job, Check and Doublecheck would compute applied overhead and operating income as shown in Illustration 18-17. Traditional Costing Example Illustration 18-17 LO 4

42. 18-42 Check and Doublecheck distributes its estimated annual overhead costs of $600,000 to three activity cost pools. Activity-Based Costing Example Illustration 18-18 Condensed annual budget of a service firm under activity- based costing LO 4

43. 18-43 Assigning overhead in a service industry. Activity-Based Costing Example Illustration 18-19 Assigning overhead in a service company LO 4

44. 18-44 Under activity-based costing, Check and Doublecheck assigns overhead costs of $57,200 as compared to $70,000 under traditional costing. Activity-Based Costing Example Illustration 18-20 Comparison of traditional costing with ABC in a service company LO 4

45. 18-45 American Airlines Service Company Insight LO 3 Traveling Light Have you flown on American Airlines since baggage fees have been implemented? Did the fee make you so mad that you swore that the next time you flew, you would pack fewer clothes so you could use a carry-on bag instead? That is exactly how American Airlines (and the other airlines that charge baggage fees) hoped that you would react. Baggage handling is extremely labor intensive. All that tagging, sorting, loading on carts, loading in planes, unloading, and sorting again add up to about $9 per bag. Baggage handling also involves equipment costs: sorters, carts, conveyors, tractors, and storage facilities. That’s about another $4 of equipment-related overhead per bag. Finally, there is additional fuel cost of a 40-pound item—about $2 in fuel for a 3-hour flight. These costs add up to $15 ($9+$4+$2). Since airlines have implemented their baggage fees, fewer customers are checking bags. Not only does this save the airlines money, it also increases the amount of space available for hauling cargo. An airline can charge at least $80 for hauling a small parcel for same-day delivery service. Source: Scott McCartney, “What It Costs an Airline to Fly Your Luggage,” Wall Street Journal Online (November 25, 2008).

46. 18-46 4 Apply ABC to Service Company (a) Compute the activity-based overhead rates for each pool. LO 4

47. 18-47 4 Apply ABC to Service Company (b) Determine the overhead allocated to Job A1027 which has 150 pieces, requires 200 miles of driving, and 0.75 hours of logistics. (150 x $0.70) + (200 x $0.50) + (0.75 x $30) = $227.50 LO 4

48. 18-48 JIT manufacturing is dedicated to having the right amount of materials, parts, or products just as they are needed.. Illustration 18A-1 LEARNING OBJECTIVE 5 APPENDIX 18A: Explain just-in-time (JIT) processing. LO 5

49. 18-49 Objective of JIT Processing  To eliminate all manufacturing inventories. Elements of JIT Processing  Dependable suppliers.  Multiskilled work force.  Total quality control system. LO 5 Just-In-Time Inventory Processing

50. 18-50 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. LO 5 Just-In-Time Inventory Processing

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