lecture 2 - activity based costing
TRANSCRIPT
TOPIC 2
ACTIVITY-BASED COSTING (ABC)
PREVIEW OF PREVIOUS TOPIC
Traditional Costing and Activity-Based Costing
Traditional costing systems
The need for a new approach
Activity-based costing
Illustration of Traditional Costing versus ABC
Unit costs under traditional costing
Unit costs under ABC
Comparing unit costs
ACTIVITY-BASED COSTING VERSUS TRADITIONAL COSTING
Traditional Costing Systems
Allocates overhead using a single predetermined rate.
Job order costing: direct labor cost is assumed to be the relevant activity base.Process costing: machine hours is 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.
Traditional Costing Systems:Continued
Direct labor is still often the appropriate basis for assigning overhead costs when:
Direct labor constitutes a significant part of total product cost
and
High correlation exists between direct labor and changes in overhead costs.
Overhead Direct Labor Products
Costs Hours/Dollars
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.
May be inappropriate to use plant-wide predetermined overhead rates based on direct labor or machine hours when a lack of correlation exists.
Complex manufacturing processes may require multiple allocation bases; this approach is called Activity-Based Costing (ABC).
Activity-Based Costing (ABC)
An overhead cost allocation system that allocates overhead to multiple activity cost pools
and Assigns the activity cost pools to products or
services by means of cost drivers that represent the activities used.
Activity-Based Costing (ABC)Terms
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.
The Logic Behind ABC
Products consume activities,
and activities consume resources.
Activity-Based Costing (ABC) – Continued
ABC allocates overhead costs in two stages:
Stage 1: Overhead costs are allocated to activity cost pools.
Stage 2: The overhead costs allocated to the cost pools is assigned to products using cost drivers.
The more complex a product’s manufacturing operation, the more activities and cost drivers likely to be present.
Activities and Related Cost Drivers
ABC System Design – Lift Jack Company
Traditional Costing vs ABC
ABC does not replace an existing job order/process cost system.
ABC does segregate overhead into various cost pools to provide more accurate cost information.
ABC, thus, supplements – it does not replace – the traditional cost system.
Traditional Costing vs ABCAn Illustration
Atlas Company produces two automotive antitheft devices: The Boot: a high volume item with sales totaling 25,000 per year The Club: a low volume item with sales totaling 5,000 per
year
Each product requires 1 hour of direct labor Total annual direct labor hours (DLH) 30,000 (25,000 + 5000) Direct labor cost $12 per unit for each product
Expected annual manufacturing overhead costs $900,000
Direct materials cost: The Boot - $40 per unit The Club - $30 per unit
Activity-Based Costing:A Closer Look
More accurate product costing through: Use of more cost pools to assign overhead costsEnhanced control over overhead costsBetter management decisions
Activity-Based Costing: A Closer Look
Limitations of ABC
Can be expensive to use Some arbitrary allocations continue
Activity-Based Costing:A Closer Look
Use ABC When One or More of the Following Exist:
Products differ greatly in volume/manufacturing complexity
Products lines are Numerous Diverse Require different degrees of support services
Overhead costs are a significant portion of total costs
Significant change in manufacturing process or number of products
Managers ignore data from existing system and instead use “bootleg” costing data
Value-Added vs.Non-Value-Added Activities
Study Objective 6
Activity Based Management (ABM):
An extension of ABC from a product costing system to a management function
that focuses on reducing costs and improving processes and decision making
A refinement of ABC used in ABM classifies activities as either value-added or non-value-added.
Value-Added vs.Non-Value-Added Activities
Value-Added Activity
An activity that increases the worth
of a product or service such as:
Manufacturing Company Service Company
engineering design performing surgery
machining legal research services
assembly delivering packages
painting
packaging
Value-Added vs.Non-Value-Added Activities
Non-Value-Added ActivitiesAn activity that adds cost to, or increases the time
spent on, a product/service without increasing its
market value such as:
Manufacturing Company Service Company
Repair of machines Taking appointments
Storage of inventory Reception
Moving of raw materials, Bookkeeping/billing
assemblies, and finished goods Traveling
Building maintenance Ordering supplies
Inspections
Inventory Control
CLASSIFICATION OF ACTIVITY LEVELS
Unit-level activities:Performed for each unit of production
Batch-level activities:Performed for each batch of product
Product-level activities:Performed in support of an entire product
line, but not always performed every time a new unit or batch is produced
Facility-level activities:Required to support or sustain an entire
production process
Hierarchy of Activity LevelsFour Levels Types of Activities Cost DriversUnit-Level Activities Machine-related: Machine Hours
Drilling, cutting, milling
Labor-related Direct labor hours/cost Assembling, painting
Batch-Level Activities Equipment setups Number of setups/setup time
Purchase ordering Number of purchase orders
Inspection Number of inspections or
inspection time
Material handling Number of material moves
Product-Level Activities Product design Number of product designs
Engineering changes Number of changes
Facility-Level Activities Plant management Number of employees salaries managed
Plant depreciation Square footage
Property taxes Square footage
Utilities Square footage
Activity-Based Costing in Service Industries
Similarities with Manufacturing Firms
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
Reduction of non-value-added activities
Activity-Based Costing in Service Industries
Major difficulty to implementing ABC:
A larger proportion of overhead
costs are company-wide costs
that cannot be directly traced to
specific services.
Summary of Study Objectives
Recognize the difference between traditional and activity-based costing.
Traditional system allocates overhead to products using predetermined unit-based output rate.ABC allocates overhead to activity cost pools and assigns cost to products using cost drivers.
Identify the steps in the development of an activity-based costing system.
Step 1: Identify the major activities and allocate the overhead costs to cost pools.
Step 2: Identify the cost driver highly correlated to the cost pool.Step 3: Compute the overhead rate per cost driver.Step 4: Assign cost pools to products or services using the
overhead rates.
Summary of Study Objectives Know how companies identify cost pools used in ABC.
Analyze each operation or process, document and time every task, action, or transaction.
Know how companies identify and use cost drivers in ABC.Cost drivers identified for assigning activity cost pools must: Accurately measure the consumption of the activity Have related data easily available.
Understand the benefits and limitations of ABCBenefits: Enhanced control over overhead costs Better management decisions
Limitations: Higher costs accompany multiple activity centers and cost
drivers Some costs must still be allocated arbitrarily
Summary of Study Objectives
Differentiate between value-added and non-value-added activities.
Value-added activities increase the worth of a product or service.
Non-value-added activities add cost to, or increase the time spent on, a product or service without increasing its market
value.
Understand the value of using activity levels in ABCActivities may be classified as:
Unit-level Batch-level Product-level Facility-level
Failure to recognize this classification can resultin distorted product costing.
Summary of Study Objectives
Apply ABC to service industries.Same objective – improved costing of
services provided.
The general approach to costing is also the same: analyze operations identify activities accumulate overhead costs by activity
cost pools identify and use cost drivers to assign
cost to services
AppendixJust-In-Time Processing (JIT)
A processing system dedicated to having the
right amount of materials, products, or parts
arrive as they are needed, thereby reducing
the amount of inventory.
Just-In-Time Processing
Goods Manufactured Goods Shipped to Customer
Susan’s
SoccerSneakers
Sales Order Received
100 pairs of sneakers...
got it!
Send rubber and shoe laces directly
to the factory.
JIT Processing
Objective of JIT: Eliminate all manufacturing inventories
Elements of JIT: Dependable suppliers Multi-skilled work force Total quality control system
Benefits of JIT: Reduced inventory Enhanced product quality Reduced rework and storage costs Savings from improved flow of goods