abc - from managerial accounting weygandt, kimmel et kieso

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  • Feature Story

    The NavigatorLearning ObjectivesAfter studying this chapter, you should be able to:

    1 Recognize the difference between traditional costing and activity-based costing.

    2 Identify the steps in the development of an activity-based costing system.

    3 Know how companies identify the activity cost pools used in activity-based costing.

    4 Know how companies identify and use cost drivers in activity-based costing.

    5 Understand the benefi ts and limitations of activity-based costing.

    6 Differentiate between value-added and nonvalue-added activities.

    7 Understand the value of using activity levels in activity-based costing.

    8 Apply activity-based costing to service industries.

    The Navigator

    Chapter 4

    Activity-Based Costing

    Precor Is on Your SideDo you feel like the whole world is

    conspiring against your efforts to get

    in shape? Is it humanly possible to

    resist the constant barrage of adver-

    tisements and fast-food servers who

    pleasantly encourage us to supersize

    it? Lest we think that we have no allies

    in our battle against the bulge,

    consider Precor.

    Ever since it made the fi rst ergonomi-

    cally sound rowing machine in 1980,

    Precors sole mission has been to

    provide exercise equipment. It makes

    elliptical trainers, exercise bikes,

    rowing machines, treadmills, multi-

    station strength systems, and many

    other forms of equipment designed

    to erase the cumulative effects of a

    fast-food nation. Its equipment is

    widely used in Hilton hotels, Golds

    Gym franchises, and even in Madonnas

    Hard Candy fi tness center in Moscow.

    Building high-quality fi tness equipment

    requires sizable investments by Precor

    in buildings and machinery. For

    example, Precor recently moved its

    facilities from Valencia, California, to

    Greensboro, North Carolina. In order

    to reduce costs and minimize environ-

    mental impact, the company installed

    low-fl ow water fi xtures, high-effi ciency

    heating and cooling systems, and

    state-of-the-art lighting in its $26

    million, 230,000-square-foot facility.

    As a result of these efforts, Precors

    new facility received a Leadership in

    Energy and Effi cient Design (LEED) CI

    Gold Certifi cation.

    144

    Scan Learning Objectives

    Read Feature Story

    Read Preview

    Read Text and answer p. 149 p. 153 p. 158 p. 161

    Work Using the Decision Toolkit p. 164

    Review Summary of Learning Objectives

    Work Comprehensive p. 169

    Answer Self-Test Questions

    Complete Assignments

    Go to WileyPLUS for practice and tutorials

    DO IT!

    DO IT!

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  • Because of its huge investments in property, plant, and

    equipment, overhead costs represent a large percentage of

    the cost of Precors exercise equipment. The

    combination of high overhead costs and a

    wide variety of products means that it is

    important that Precor allocates its overhead

    accurately to its various products. Without

    accurate cost information, Precor would not

    know whether its elliptical trainers and

    recumbent bicycles are making money,

    whether its AMT 100i adaptive motion

    trainer is priced high enough to cover its

    costs, or if its 240i Stretchtrainer is losing

    money. To increase the accuracy of its costs,

    Precor uses a method of overhead allocation

    that focuses on identifying the types of activities that cause

    the company to incur costs. It then assigns more overhead

    to those products that rely most heavily

    on cost-incurring activities. By doing this,

    the allocation of overhead is less arbitrary

    than traditional overhead allocation methods.

    In short, before it can help us burn off the

    pounds, Precor needs to understand what

    drives its overhead costs.

    Watch the Precor video in WileyPLUS to

    learn more about activity-based costing

    in the real world.

    Source: www.precor.com.

    The Navigator

    As indicated in the Feature Story about Precor, the traditional costing systems described in earlier chapters are not the best answer for every company. Because Precor suspected that the traditional system was masking signifi cant differences in its real cost structure, it sought a new method of assigning costs. Similar searches by other companies for ways to improve operations and gather more accurate data for decision-making have resulted in the development of powerful new management tools, including activity-based costing (ABC). The primary objective of this chapter is to explain and illustrate this concept.

    The content and organization of this chapter are as follows.

    Preview of Chapter 4

    ACTIVITY-BASED COSTING

    Traditional costing Need for a new

    approach Activity-based costing

    Traditional Costing and ABC

    Identify activities and allocate to cost pools

    Identify cost drivers Compute overhead

    rates Assign overhead costs

    to products Compare unit costs

    Example of ABC versus Traditional Costing

    Benefi ts Limitations When to use ABC Value-added versus

    nonvalue-added activities

    Classifi cation of activity levels

    ABC: A Closer Look Traditional costing

    example ABC example

    ABC in Service Industries

    The Navigator

    145

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  • 146 4 Activity-Based Costing

    Traditional Costing Systems

    It is probably impossible to determine the exact cost of a product or service. However, in order to achieve improved management decisions, companies strive to provide decision-makers with the most accurate cost estimates they can. The most accurate estimate of product cost occurs when the costs are traceable di-rectly to the product produced or the service provided. Direct material and direct labor costs are the easiest to trace directly to the product through the use of mate-rial requisition forms and payroll time sheets. Overhead costs, on the other hand, are an indirect or common cost that generally cannot be easily or directly traced to individual products or services. Instead, companies use estimates to assign overhead costs to products and services.

    Often the most diffi cult part of computing accurate unit costs is determining the proper amount of overhead cost to assign to each product, service, or job. In our coverage of job order costing in Chapter 2 and of process costing in Chapter 3, we used a single or plantwide overhead rate throughout the year for the entire factory operation. That rate was called the predetermined overhead rate. For job order costing, we assumed that direct labor cost was the relevant activity base for assigning all overhead costs to jobs. For process costing, we assumed that machine hours was the relevant activity base for assigning all overhead to the process or department.

    The use of direct labor as the activity base made sense when overhead cost allocation systems were fi rst developed. At that time, direct labor made up a large portion of total manufacturing cost. Therefore, it was widely accepted that there was a high correlation between direct labor and the incurrence of overhead cost. As a result, direct labor became the most popular basis for allocating overhead.

    Even in todays increasingly automated environment, direct labor is some-times the appropriate basis for assigning overhead cost to products. It is appro-priate to use direct labor when (a) direct labor constitutes a signifi cant part of total product cost, and (b) a high correlation exists between direct labor and changes in the amount of overhead costs. Illustration 4-1 displays a simplifi ed (one-stage) traditional costing system relying on direct labor to assign overhead.

    The Need for a New Approach

    In recent years, manufacturers and service providers have experienced tremen-dous change. Advances in computerized systems, technological innovation, global competition, and automation have changed the manufacturing environment dras-tically. As a result, the amount of direct labor used in many industries has greatly decreased, and total overhead costs resulting from depreciation on expensive equipment and machinery, utilities, repairs, and maintenance have signifi cantly increased. When there is not a correlation between direct labor and overhead, it is inappropriate to use plantwide predetermined overhead rates based on direct labor. Companies that use overhead rates based on direct labor when this correla-tion does not exist experience signifi cant product-cost distortions.

    To avoid such distortions, many companies now use machine hours as the basis on which to allocate overhead in an automated manufacturing environ-ment. But even machine hours may not suffi ce as the only plantwide basis for allocating all overhead. If the manufacturing process is complex, then only mul-tiple allocation bases can result in more accurate product-cost computations. In such situations, managers need to consider an overhead cost allocation method that uses multiple bases. That method is activity-based costing.

    Traditional Costing and Activity-Based Costing

    Illustration 4-1Traditional one-stage costing system

    Product

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