2. 17-2
Apply activity-based costing to a manufacturer.
CHAPTER OUTLINE
Discuss the difference between traditional costing and
activity-based costing.1
2
LEARNING OBJECTIVES
Explain the benefits and limitations of activity-based
costing.3
Apply activity-based costing to service industries.4
3. 17-3
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
LO 1
LEARNING
OBJECTIVE
Discuss the difference between traditional
costing and activity-based costing.1
ILLUSTRATION 17-1
Traditional one-stage
costing system
4. 17-4
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 17-3
Total unit costs—
traditional costing
ILLUSTRATION OF A TRADITIONAL
COSTING SYSTEM
LO 1
5. 17-5
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. 17-6
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. 17-7
2. Identify the cost driver that has a strong correlation to the costs
accumulated in each cost pool.
ACTIVITY-BASED COSTING
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
ILLUSTRATION 17-4
The four steps of activity-
based costing
8. 17-8
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
10. 17-10
Activity-based costing (ABC):
a. can be used only in a process cost system.
b. focuses on units of production.
c. focuses on activities needed to produce a good or
perform a service.
d. uses only a single basis of allocation.
Question
ACTIVITY-BASED COSTING
LO 1
11. 17-11
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.
LO 2
LEARNING
OBJECTIVE
Apply activity-based costing to a
manufacturer.2
12. 17-12 LO 2
Overhead costs are assigned directly to the appropriate activity
cost pool.
IDENTIFY AND CLASSIFY ACTIVITIES AND
ALLOCATE OVERHEAD TO COST POOLS
(STEP 1)
ILLUSTRATION 17-6
Activity cost pools and
estimated overhead
13. 17-13
Cost driver must accurately measure the actual consumption of
the activity by the various products.
Illustration 17-6: Cost drivers that Atlas Company identifies and
their total expected use per activity cost pool.
IDENTIFY COST DRIVERS (STEP 2)
LO 2
ILLUSTRATION 17-7
Cost drivers and their expected use
14. 17-14
Which of the following would be the best cost driver for the
assembling cost pool?
a. Number of product lines.
b. Number of parts.
c. Number of orders.
d. Amount of square footage.
Question
LO 2
IDENTIFY COST DRIVERS (STEP 2)
16. 17-16
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.
ALLOCATE OVERHEAD COSTS TO
PRODUCTS (STEP 4)
ILLUSTRATION 17-10
Expected use of cost
drivers per product
LO 2
17. 17-17
ILLUSTRATION 17-11
Allocation of activity
cost pools to products
To allocate overhead costs, Atlas multiplies the activity-based
overhead rates per cost driver (Ill. 17-9) by the number of cost
drivers expected to be used per product (Ill. 17-10).
LO 2
ALLOCATE OVERHEAD COSTS (STEP 4)
18. 17-18
ILLUSTRATION 17-11
LO 2
ALLOCATE OVERHEAD COSTS (STEP 4)
To allocate overhead costs, Atlas multiplies the activity-based
overhead rates per cost driver (Ill. 17-9) by the number of cost
drivers expected to be used per product (Ill. 17-10).
19. 17-19
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 17-12
Comparison of unit
product costs
LO 2
20. 17-20
MANAGEMENT INSIGHT
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.
ABC Evaluated
LO 2
21. 17-21
ABC has three primary benefits:
1. More cost pools, therefore more accurate product costing.
2. Enhanced control over overhead costs.
3. Better management decisions.
LO 3
LEARNING
OBJECTIVE
Explain the benefits and limitations of
activity-based costing.3
22. 17-22
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.
ADVANTAGE OF MULTIPLE COST POOLS
LO 3
24. 17-24
Batch-
level
Facility-
level
Performed for each unit of production.
► Example: Assembly of cell phones
Unit-level
Product-
level
ADVANTAGE OF MULTIPLE COST POOLS
Classification of Activity Levels
LO 3
25. 17-25
Batch-
level
Facility-
level
Performed every time a company produces another
batch of a product.
► Example: Batch of ice cream
Unit-level
Product-
level
ADVANTAGE OF MULTIPLE COST POOLS
LO 3
Classification of Activity Levels
26. 17-26
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
ADVANTAGE OF MULTIPLE COST POOLS
LO 3
Classification of Activity Levels
27. 17-27
Batch-
level
Facility-
level
Required to support or sustain an entire production
process.
► Example: A hospital
Unit-level
Product-
level
ADVANTAGE OF MULTIPLE COST POOLS
LO 3
Classification of Activity Levels
29. 17-29
MANAGEMENT INSIGHT
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.
ABC Evaluated
LO 3
30. 17-30
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
31. 17-31
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
LO 3
THE ADVANTAGE OF ENHANCED COST
CONTROL
32. 17-32
The following activity is value-added:
a. Storage of raw materials.
b. Moving parts from machine to machine.
c. Shaping a piece of metal on a lathe.
d. All of the above.
Question
LO 3
THE ADVANTAGE OF ENHANCED COST
CONTROL
33. 17-33
MANAGEMENT INSIGHT
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.
General Mills
LO 3
34. 17-34
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.
LO 3
THE ADVANTAGE OF BETTER
MANAGEMENT DECISIONS
35. 17-35
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
SOME LIMITATIONS AND KNOWING
WHEN TO USE ABC
36. 17-36
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
LEARNING
OBJECTIVE
Apply activity-based costing to service
industries.4
37. 17-37
The public accounting firm of Check and Doublecheck prepares
the following condensed annual budget.
ILLUSTRATION 17-16
Condensed annual
budget of a service
firm under traditional
costing
TRADITIONAL COSTING EXAMPLE
LO 4
38. 17-38
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 17-17.
TRADITIONAL COSTING EXAMPLE
LO 4
ILLUSTRATION 17-17
Overhead applied under traditional costing system
39. 17-39
Check and Doublecheck distributes its estimated annual
overhead costs of $600,000 to three activity cost pools.
ACTIVITY-BASED COSTING EXAMPLE
ILLUSTRATION 17-18
Condensed annual budget of a service firm under activity-based costing
LO 4
40. 17-40
Assigning overhead in a service industry.
ACTIVITY-BASED COSTING EXAMPLE
ILLUSTRATION 17-19
Assigning overhead in a service company
LO 4
41. 17-41
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 17-20
Comparison of traditional costing with ABC in a service company
LO 4
42. 17-42
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.
b. assign overhead costs to products.
c. identify cost drivers.
d. compute overhead rates.
Question
LO 4
ACTIVITY-BASED COSTING
43. 17-43
SERVICE COMPANY INSIGHT
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.
Sources: Scott McCartney, “What It Costs an Airline to Fly Your Luggage,” Wall Street
Journal Online (November 25, 2008).
American Airlines
LO 4
44. 17-44
JIT manufacturing is dedicated to having the right amount of materials,
parts, or products just as they are needed. ILLUSTRATION 17A-1
LO 5
LEARNING
OBJECTIVE
APPENDIX 17A: Explain just-in-time
(JIT) processing.5
45. 17-45
OBJECTIVE OF JIT PROCESSING
To eliminate all manufacturing inventories.
ELEMENTS OF JIT PROCESSING
1. Dependable suppliers.
2. Multiskilled work force.
3. Total quality control system.
LO 5
Just-In-Time (JIT) Processing
46. 17-46
BENEFITS OF JIT PROCESSING
1. Significant reduction or elimination of manufacturing
inventories.
2. Enhanced product quality.
3. Reduction or elimination of rework costs and inventory
storage costs.
4. Production cost savings from the improved flow of goods
through the processes.
LO 5
Just-In-Time (JIT) Processing
47. 17-47
The primary objective of just-in-time processing is to:
a. accumulate overhead in activity cost pools.
b. eliminate or reduce all manufacturing inventories.
c. identify relevant activity cost drivers.
d. identify value-added activities.
Question
LO 5
Just-In-Time (JIT) Processing
Editor's Notes
The flow of accounting data is as follows: a transaction occurs and then is analyzed to see its effect on the company’s account. Next, a journal entry is made to record the transaction. Periodically, amounts from the journal are posted to the ledger to determine the account balances.
Under the FIFO method, the first costs into inventory are the first costs assigned to cost of goods sold—hence the name first-in, first-out.
Under the FIFO method, the first costs into inventory are the first costs assigned to cost of goods sold—hence the name first-in, first-out.
Under the FIFO method, the first costs into inventory are the first costs assigned to cost of goods sold—hence the name first-in, first-out.
Under the FIFO method, the first costs into inventory are the first costs assigned to cost of goods sold—hence the name first-in, first-out.
