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Chapter 17
Develop activity-based costs (ABC)



Refines the way indirect costs are allocated to
production
Focuses on costs incurred by each production
activity
Each activity has its own cost driver
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Activities:
Material purchasing
Material handling
Production scheduling
Quality inspections
Photocopying
Cost Drivers:
# of purchase orders
# of parts
# of batches
# of inspections
# of pages copied
Warranty service
# of service calls
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Identify each
activity and
estimate its
total indirect
cost
Identify the
cost driver for
each activity
and estimate
the quantity of
each driver
Compute the
cost allocation
rate for each
activity
Allocate
indirect costs
to the cost
object
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Cost
allocation
rate
Estimated total indirect cost
Estimated total quantity of the
allocation base
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Allocated activity cost
Cost
allocation
rate
Actual
quantity of
allocation
base
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Activity
Budgeted
Cost
Allocation
base
Estimated
base
activity
Cost
allocation
rate
Materials
handling
$6,000 Number of
parts
3,000
$2 per part
Machine
setup
3,300 Number of
setups
20
$165 per
setup
Insertion of
parts
54,000 Number of
parts
3,000
$18 per
part
Finishing
80,000 Finishing
direct labor
hours
2,000
$40 per
direct labor
hour
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Activity
Cost
allocation
rate
Activity per
1,000
bumpers
Materials
handling
$2 per part
3,000 parts
Machine setup $165 per setup 20 setups
Indirect cost
allocated
$6,000
$3,300
Insertion of
parts
$18 per part
3,000 parts
$54,000
Finishing
$40 per hour
2,000 hours
$80,000
Total indirect costs allocated to 1,000 bumpers
Indirect cost for one bumper
$143,300
$143.30
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Use activity-based management (ABM) to achieve
target costs


Uses ABC to make decisions that increase profits
while meeting customer needs
Types of decisions:
◦ Pricing and product mix
 ABC provides a more accurate cost of products
 Helps companies determine how profitable products are
◦ Cost cutting
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

Reevaluating activities to reduce costs
Requires cross-functional teams
◦ Marketers
◦ Engineers
◦ Accountants

Setting sales prices based on target prices
◦ What customers are willing to pay
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Target Pricing
Traditional
Cost-based Pricing
Target sales price
Full product cost
minus
plus
Desired profit
equals
Target cost
Desired profit
equals
Sales price
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Describe a just-in-time (JIT) production system,
and record its transactions




Materials purchased and goods completed “just in
time” for delivery
Production completed in work cells
Employees work in a team without supervision
Goods completed in small batches that are
inspected for quality
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Demandpull
system
Receive order from customer
Schedule production
Defect-free materials are delivered by
suppliers just in time for production
Finished product is delivered to customer
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shaping
smoothing
cutting
grinding
Finished Goods
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


Lost sales can occur if materials do not arrive on
time or if the materials are of poor-quality
Strong relations with quality materials’ vendors are
essential
Some JIT companies have small inventories of
critical materials
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
Also called “Backflush costing”
◦ Starts with completed products and then assigns
manufacturing costs to units sold and inventory
Traditional
Just-in-time
Recording
production activity
Build costs as products
move through three
inventory accounts
Record costs when
units are complete
Inventory accounts
Materials inventory
Work in process
Finished goods
Raw and in-process
inventory
Finished goods
Manufacturing costs
Direct materials
Direct labor
Manufacturing overhead
Direct materials
Conversion costs
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(a) Products produced in large batches
Traditional
(b) Large stocks of finished goods protect against lost sales
Traditional
(c) Suppliers make frequent deliveries of small quantities of
materials
JIT
(d) Long setup times
Traditional
(e) Employees do a variety of jobs
JIT
(f) Machines are grouped into self-contained in production cells
JIT
(g) Machines are grouped according to function
Traditional
(h) Suppliers can access the company’s intranet
JIT
(i) The final operation in the production sequence “pulls” parts
from the preceding operation
Traditional
(k) Management works with suppliers to ensure defect-free
materials
JIT
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Use the four types of quality costs
to make decisions
Goals
 To provide customers with superior products and
services
 Continuous improvement
◦ Improve quality
◦ Eliminate defects and waste
◦ Invest in research & development
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Prevention
Appraisal
• Avoid poor-quality
goods
• Detect poorquality goods
Internal failure
External failure
• Avoid poor-quality
before delivery
• Poor-quality
goods delivered
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Examples of Quality Costs
Prevention
Appraisal costs
Training personnel
Inspection during production
Improved materials
Inspection of final product
Preventative maintenance
Product testing
Internal failure
External failure
Production loss caused by downtime Lost profits from unhappy customers
Rework
Warranty costs
Rejected units
Service costs at customer sites
Sales returns
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