Ch. 4 ACC

Chapter 4 by Creighton Heider, UNIVERSITY College of Business
Aim: - Discuss the differences between traditional costing and activity-based costing (ABC). - Apply ABC in manufacturing and service industries. - Explain Just-In-Time (JIT) processing.

Traditional costing involves applying overhead as learned in Chapter 2. - Process costing: Commonly uses machine hours as the relevant activity base. - Job order costing: Typically uses direct labor as the relevant basis for allocation.
Overhead is allocated using a single predetermined overhead rate. The original assumption was satisfactory when direct costs constituted a large portion of total manufacturing costs.

Significant shifts have occurred in manufacturing and service sectors: - Decrease in direct labor usage. - Significant rise in total overhead costs.
It is inappropriate to use a plantwide predetermined overhead rate when there is a lack of correlation with the actual costs incurred.
Complex manufacturing processes necessitate multiple allocation bases, leading to the development of Activity-Based Costing (ABC).

Activity-Based Costing (ABC): - Allocates overhead to multiple activity cost pools. - Assigns costs from activity cost pools to products/services using individual cost drivers.
Key Definitions: - Activity: Any event, action, transaction, or work sequence that incurs costs in producing a product or service. - Activity Cost Pool: Overhead costs assigned to a specific activity. - Cost Driver: Any factor or activity that has a direct cause-effect relationship with the resources consumed.

Stage 1: Assign overhead costs to activity cost pools.
Stage 2: Allocate the overhead assigned to activity cost pools to products using cost drivers. - More complex manufacturing operations have more activities and cost drivers.

Identify Activity Cost Pools and allocate costs to these pools.
Identify Cost Drivers and estimate total usage.
Compute Activity-Based Overhead Rate: - This may involve determining estimated overhead per activity based on expected usage.
Assign Overhead Costs to Products based on the utilization of cost drivers.

Producing two products: - Ab Bench: High-volume item (25,000 units annual sales). - Ab Coaster: Low-volume item (5,000 units annual sales). - Pricing: - Ab Bench: $40 per unit. - Ab Coaster: $30 per unit.
Direct Materials Cost: - Total annual direct labor hours amounts to 30,000 hours (25,000 + 5,000). - Direct labor cost: $12 per unit for each product. - Each product requires 1 hour of direct labor.
Predetermined Overhead Rate under Traditional Costing: - Expected annual manufacturing overhead costs: $900,000.

The activity-based overhead rate computations are based on the anticipated usage of cost drivers per activity, which corresponds to the expected overhead costs for each activity pool.

Overhead costs are assigned to products based on the usage of identified cost drivers.

Comparison of Manufacturing Costs for Ab Bench and Ab Coaster: - Direct materials: - Ab Bench: $40.00 - Ab Coaster: $30.00 - Direct labor: - Both: $12.00 - Overhead Costs under Traditional vs. ABC: - Ab Bench: Traditional = $30.00, ABC = $18.40 - Ab Coaster: Traditional = $30.00, ABC = $12.00 - Total direct cost per unit: - Ab Bench: Traditional = $82.00, ABC = $70.40 - Ab Coaster: Traditional = $72.00, ABC = $130.00
Notable Differences: - Likely consequences between traditional and ABC allocation: - Overpricing the Ab Bench may result in a loss of market share. - Underpricing the Ab Coaster leads to reduced profitability.
Important Context: While total overhead costs remain the same under both methods, the allocation to products varies, influencing individual cost assessments.

Benefits of ABC: - More cost pools resulting in more precise product costing. - Improved control over overhead costs. - Facilitates better management decision-making.
Limitations of ABC: - Can be costly to implement. - More intricately complex compared to traditional methods. - Some arbitrary allocations still persist.

ABC is advisable in situations where: - Product lines differ by volume and complexity. - There is a diverse range of product lines. - Overhead costs account for a sizable portion of total costs. - There is a substantial shift in production processes or product variability. - Production or marketing managers are not utilizing underlying data effectively.

Unit-level Activities: - Machine-related (e.g., drilling, cutting). - Labor-related (e.g., assembling, painting). - Examples of Cost Drivers: - Machine hours - Direct labor hours or cost
Batch-level Activities: - Activities performed with each new batch of products (e.g., setups, ordering).
Product-level Activities: - Activities tied to the production of a new product type (e.g., material handling, product design).
Facility-level Activities: - Activities that support the entire production process (e.g., plant management, utilities).

Value-Added Activities: - These activities enhance the perceived value of a product or service.
Non-Value-Added Activities: - Activities that incur costs or extend time without adding perceived value.

ABC can also apply in service industries similarly to manufacturing: - Focus on identifying key activities generating costs. - Distinction between value-adding and non-value-adding activities is critical for effective cost management.
Overall, total overhead remains unchanged, yet allocation strategies vary significantly based on the methodology applied.