CHAPTER 4
LEARNING OBJECTIVES
1. DISCUSS THE DIFFERENCE BETWEEN TRADITIONAL
COSTING AND ACTIVITY-BASED COSTING.
2. APPLY ACTIVITY-BASED COSTING TO A
MANUFACTURER.
3. EXPLAIN THE BENEFITS AND LIMITATIONS OF
ACTIVITY-BASED COSTING.
4. APPLY ACTIVITY-BASED COSTING TO SERVICE
INDUSTRIES.
*5. EXPLAIN JUST-IN-TIME (JIT) PROCESSING.
CHAPTER REVIEW
Traditional Costing And Activity-Based Costing
1. (L.O. 1) Often the most difficult part of computing accurate unit costs is determining the proper
amount of overhead cost to assign each product, service or job. For job order costing we
assumed the direct labor cost was the relevant activity base for assigning overhead costs to a job
and for process costing we assumed that machine hours was the relevant activity base.
2. Activity-based costing (ABC) allocates overhead to multiple activity cost pools and assigns the
activity cost pools to products and services by means of cost drivers. In ABC, an activity is any
event, action, transaction, or work sequence that incurs costs when producing a product or
performing a service. A cost driver is any factor or activity that has a direct cause-effect
relationship with the resources consumed.
Unit Costs Under ABC
5. (L.O. 2) A well designed activity-based costing system starts with an analysis of the activities
performed to manufacture a product or provide a service. This analysis should identify all
resource-consuming activities. It requires a detailed, step-by-step walk through of each operation,
documenting every activity undertaken to accomplish a task.
6. After costs are allocated to the activity cost pools, the cost drivers for each cost pool must be
identified. The cost driver must accurately measure the actual consumption of the activity by the
various products. To achieve accurate costing, a high degree of correlation must exist between
the cost driver and the actual consumption of the overhead costs in the cost pool.
7. An activity-based overhead rate per cost driver is computed by dividing the total estimated
overhead per activity by the number of cost drivers expected to be used per activity. The formula
for this computation is as follows:
8. In assigning overhead costs, it is necessary to know the expected use of cost drivers for each
product. To assign overhead costs to each product, the activity-based overhead rates are
multiplied by the number of cost drivers expected to be used per product.
Benefits of ABC
9. (L.O. 3) The primary benefit of ABC is more accurate product costing because:
a. ABC leads to more cost pools.
Classification of Activity Levels
10. The recognition that some activity costs are not driven by unit-based cost drivers has led to the
development of a classification of ABC activities consisting of four levels. The four levels are
classified and defined as follows:
a. Unit-level activities. Activities performed for each unit of production.
Value-Added Versus Non-Value-Added Activities
11. In developing an ABC system, managers increase their awareness of the activities performed by
the company in its production and supporting processes. This helps managers classify activities
as value-added or non-value-added.
a. Value-added activities increase the worth of a product or service to customers. Examples
include engineering design, machining, assembly, painting, and packaging.
12. Activity-based management (ABM) extends the use of ABC from product costing to a
comprehensive management tool that focuses on reducing costs and improving processes and
decision making. The purpose of ABM is to reduce or eliminate the time and cost devoted to non–
value-added activities.
Limitations of ABC and When to Use ABC
13. Although ABC systems often provide better product cost data than traditional volume-based
systems, there are the following limitations:
a. ABC can be expensive to use.
b. Some arbitrary allocations continue.
14. The presence of one or more of the following factors would point to possibly using ABC:
a. Product lines differ greatly in volume and manufacturing complexity.
b. Product lines are numerous, diverse, and require differing degrees of support services.
Activity-Based Costing in Service Industries
15. (L.O. 4) The general approach to identifying activities, activity cost pools, and cost drivers is the
same for service companies and for manufacturers. Also, the labeling of activities as value-added
and non-value-added, and the attempt to reduce or eliminate non-value-added activities as much
as possible is just as valid in service industries as in manufacturing operations.
Just–In-Time Processing
*17. (L.O. 5) Just-in-time (JIT) manufacturing is dedicated to having the right amount of materials,
products, or parts at the time they are needed. Under JIT processing, raw materials are received
just in time for use in production, subassembly parts are completed just in time for use in finished
goods, and finished goods are completed just in time to be sold.
*18. A primary objective of JIT is to eliminate all manufacturing inventories. Inventories are considered
to have an adverse effect on net income because they tie up funds and storage space that could
be made available for more productive purposes.
*19. There are three important elements in JIT processing:
a. A company must have dependable suppliers who are willing to deliver on short notice exact
*20. The major benefits of implementing JIT processing are:
a. Manufacturing inventories are significantly reduced or eliminated.
LECTURE OUTLINE
A. Traditional Costing Systems
1. A traditional costing system allocates overhead to products on the basis
of predetermined plantwide or departmentwide volume of unit-based
output rates such as direct labor or machine hours.
2. Historically, there was a high correlation between direct labor and the
incurrence of overhead cost. In recent years, however, manufacturers
B. Activity-Based Costing
1. Activity-based costing (ABC) allocates overhead to multiple activity cost
pools and then assigns the activity cost pools to products and services
by means of cost drivers.
2. In ABC, an activity is any event, action, transaction, or work sequence
that incurs cost when producing a product or providing a service.
C. Unit Costs Under ABC.
1. Activity-based costing involves the following steps:
a. Identify and classify the activities involved in the manufacture of
specific products, and assign manufacturing overhead costs to the
appropriate cost pools.
2. A well designed activity-based costing system starts with an analysis of
the activities performed to manufacture a product or provide a service.
3. It requires a detailed, step–by–step review of each operation, documenting
every activity undertaken to accomplish a task. At this point, the
D. Identify Cost Drivers, Compute Overhead Rates, and Assign Overhead
Costs to Products.
1. After costs are allocated to the activity cost pools, the company must
identify the cost drivers for each cost pool.
3. The company computes an activity-based overhead rate per cost driver
by dividing the estimated overhead per activity by the number of cost
drivers expected to be used per activity.
4. In assigning overhead costs, it is necessary to know the expected use of
cost drivers for each product.
SERVICE COMPANY INSIGHT
Have you flown since airline baggage fees have been implemented? Baggage
handling is extremely labor intensive. The tagging, sorting, loading on carts,
loading in planes, unloading, etc., adds up to about $9/bag. Then there’s equip–
ment costs and storage facilities ($4/bag) and $2 fuel cost.
Why do airlines charge even higher rates for heavier bags, bags that are odd
shapes, and bags with hazardous materials in them?
Answer: Each of these factors increases the costs to the airlines. Heavier
baggage is more difficult to handle, thus increasing labor costs. It also
E. Benefits of ABC.
1. The primary benefit of ABC is more accurate product costing because
a. ABC leads to more cost pools being used to assign overhead costs
to products; therefore, costs are assigned more directly based on
cost drivers
F. Classification of Activity Levels.
1. A classification of ABC activities consisting of four levels are defined as
a. Unit-level activities: activities performed for each unit of production.
b. Batch-level activities: activities performed for each batch of products
rather than each unit.
2. Companies may achieve greater accuracy in overhead cost allocation by
recognizing the different levels of activities and developing specific
activity cost pools and their related cost drivers.
MANAGEMENT INSIGHT
Production line technicians from General Mills flew to North Carolina to observe
first-hand how race-car pit crews operate. In a NASCAR race the value-added
activity is driving toward the finish-line. General Mills technicians were able to
reduce setup time from 5 hours to just 20 minutes from what they learned at the
car race.
What are the benefits of reducing setup time?
Answer: Setup time is a non-value-added activity. Customers are not willing to
pay extra for more setup time. By reducing the time spent on setups,
G. Value-Added Versus Non-Value-Added Activities.
1. In developing an ABC System, managers increase their awareness of
the activities performed by the company in its production and supporting
processes. This helps managers classify activities as value-added or
non-value-added.
2. Value-added activities increase the worth of a product or service, for
which the customer is willing to pay.
6. Not all non-value-added activities are totally wasteful, nor can they be
totally eliminated, but managers are motivated to minimize them as
much as possible.
H. The Limitations and When to Use ABC.
1. The limitations of ABC are:
a. ABC can be expensive to use; identifying multiple activities and
applying numerous cost drivers results in increased costs.
2. The presence of one or more of the following factors would point to
ABC’s possible use.
a. Product lines differ greatly in volume and manufacturing complexity.
b. Product lines are numerous and diverse, and they require differing
degrees of support services.
I. Activity-Based Costing in Service Industries.
1. The overall objective of ABC in service firms is no different than it is for a
manufacturing company: The objective is to identify the key activities
that generate costs and to keep track of how many activities are
performed for each service provided.
SERVICE COMPANY INSIGHT
Surveys show that approximately 50% of companies actually use ABC. At the
same time, a world-wide survey of almost 350 companies showed that 87% of
respondents said that their ideal costing system would include some form of
ABC. What are some of the reasons that explain why so many companies say
that ideally they would use ABC, but haven’t yet adopted it?
Answer: Implementation of an ABC system can be very expensive. It may be
difficult to justify expenditure for a system that allocates overhead
*J. Just-in-Time Processing.
1. Traditionally, continuous process manufacturing has been based on a
just-in-case philosophy: inventories of raw materials are maintained just
in case some items are of poor quality or a key supplier is shut down by
a strike. This philosophy results in a “push approach”, in which raw
materials are pushed through each process and often results in the
buildup of extensive manufacturing inventories.
4. JIT processing consists of three important elements:
a. Suppliers must be dependable and willing to deliver on short notice
exact quantities of materials, and to specified work stations. Online
computer linkage between the company and its suppliers facilitates
this arrangement.
5. The major benefits of JIT processing include:
a. Significant reduction or elimination of manufacturing inventories.
b. Enhanced product quality.
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. Even in today’s automated environment, direct labor is sometimes the appropriate basis
for assigning overhead cost to products.
True False
2. In the first stage of activity-based costing, overhead is assigned to products using cost
drivers.
True False
3. The first step in activity-based costing is to identify and classify the major activities
involved in the manufacture of specific products, and allocate manufacturing overhead to
the appropriate cost pools.
True False
4. Before costs are allocated to the cost pools, the cost drivers for each cost pool must be
identified.
True False
5. Under ABC, overhead costs are shifted from the high-volume product to the low-volume
product.
True False
6. Activity-based costing does not change the amount of overhead costs, but it does
allocate those costs in a more accurate manner.
True False
7. Overhead costs are not allocated by means of arbitrary volume-based cost drivers under
ABC.
True False
8. Value-added activities increase the worth of a product or service to customers and
involve resource usage that customers are willing to pay for.
True False
9. Product-level activities in ABC are required to support or sustain an entire production
process.
True False
*10. Just-in–time processing strives to eliminate inventories by using a “pull approach” in
manufacturing.
True False
Multiple Choice
1. The last step in activity-based costing is to
a. identify the major activities involved in the manufacture of specific products.
b. compute the overhead rate per cost driver.
c. identify the cost driver that has a strong correlation to the costs accumulated in the
cost pool.
d. assign manufacturing overhead costs for each cost pool to products.
2. Machine hours would be an accurate cost driver for
a. assembly costs.
b. inspecting costs.
c. machining costs.
d. machine setup costs.
3. All of the following are benefits of ABC except it leads to
a. elimination of all arbitrary cost allocations.
b. more accurate cost data.
c. enhanced control over overhead costs.
d. better management decisions.
4. The level of ABC activities performed in support of an entire product line are classified as
a. batch-level activities.
b. facility-level activities.
c. product-level activities.
d. unit-level activities.
*5. Just-in-time processing strives to eliminate inventories by using a
a. just in case approach.
b. pull approach.
c. push approach.
d. process approach.
ANSWERS TO QUIZ
True/False
1. True 6. True
Multiple Choice
1. d.