Chapter 19

Object 1 HOW DO COMPANIES ASSIGN AND ALLOCATE COSTS?

3 types of systems companies use to manage their businesses

 Activity-based management systems (ABM)

 Just-in-time management systems (JIT)
 Quality management systems (QMS)

predetermined overhead allocation rate  Estimated overhead cost per unit of the allocation base, calculated at
the beginning of the accounting period. Total estimated overhead costs / Total estimated quantity of the overhead
allocation base.

Total Cost To

determine the unit cost of the manufacturing

overhead, we divide the total cost by the number of
units. We can then add the manufacturing overhead
unit cost to the direct materials and direct labor unit
costs to determine the total unit cost

(https://www.youtube.com/watch?v=gm41Dp0788Q)
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Object 2 HOW IS AN ACTIVITY-BASED COSTING SYSTEM DEVELOPED?
Activity-Based Management  focuses on the primary activities the business performs, determines the costs of the
activities, and then uses the cost information to make decisions that will lead to improved customer satisfaction and
greater profits.

Activity  A task, operation, or procedure

Activity-based costing (ABC)  The process of first determining the costs of the activities to then determine the cost
of products and services is called activity-based costing (ABC).

1. Step. Identify activities and estimate their Total Indirect costs

The first step in developing an activity-based costing system is to identify the activities that will be used to
allocate the manufacturing overhead. Analyzing all the activities required for a product or service forces
managers to think about how each activity might be improved— or whether it is necessary at all.
2. Step. Identify the Allocation Base for each activity and Estimate the Total Quantity of each Allocation Base
Because there are multiple activities that require different resources, Smart Touch Learning will use a
different allocation base for each activity. In ABC systems, ideally, the allocation base is the primary cost
driver, the factor that causes the cost to increase or decrease.

Every activity has a different base allocation.

Like, the Setup has the number of Batches.
And the production has Direct Labor Hours.
And Testing has The number of tests.

3. Step. Compute the predetermined overhead allocation rate for each activity.
The formula to compute the predetermined overhead allocation rate for each activity is the same as the
formula used for the other methods. The process is repeated for each activity. The predetermined overhead
allocation rates for Smart Touch Learning are:

4. Step. Allocate Indirect Costs of the Cost Object

The fundamental cost pools of an activity-based costing system are the activities. Now that we have
determined the cost of each activity and computed a predetermined overhead allocation rate for each
activity, we can use the rates to allocate overhead costs from the cost pools to the units
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The following table shows the allocation of overhead costs and the calculation of overhead cost per unit for
each model:
The total production cost of each model,
including direct materials, direct labor, and
manufacturing overhead costs, is shown
below:

The most accurate calculation.

With each refinement of the costing system, from a single plantwide allocation rate to multiple department
allocation rates to activity-based allocation rates, the cost per unit of the standard model increased while the cost
per unit of the premium model decreased. Activity-based costs are more accurate because ABC considers the
resources (activities) each product actually uses. Allocating overhead based on labor costs distorted the cost of the
premium units. This happened because the laborers working on premium units are paid more due to their advanced
skills, which increased the cost of direct labor on the premium models. However, the higher direct labor cost does
not have a direct cause-and-effect relationship on the overhead costs. Other factors, such as the number of batches
and the number of tests, do have an effect.

Object 3 HOW CAN COMPANIES USE ACTIVITY-BASED MANAGEMENT TO MAKE DECISIONS?

Activity-based management (ABM) uses activity-based costs to make decisions that increase profits while meeting
customer needs. In this section, we show how Smart Touch Learning can use ABM in making two kinds of decisions:

 Pricing and Product mix

 Cost management

Pricing and Product Mix Decisions

Smart Touch Learning now knows the ABC manufacturing overhead cost per tablet. To determine which products are
the most profitable, the company controller recomputes each product’s total manufacturing cost and gross profit.

Compared with last year’s

production, Smart Touch Learning
has predicted costs will decrease by
$26.80 per unit this year using a
traditional allocation method (from
$300.00 to $273.20). The refinement
of the costing system with ABC shows
actual costs to be slightly higher than calculated with the traditional allocation method, but the company has still
increased the gross profit margin by $23.25 per unit ($223.25 as compared with $200.00). If the company sells 2,000
units as expected, gross profits will increase by $46,500 (2,000 units * $23.25 per unit). With the decrease in costs,
Smart Touch Learning could consider lowering the sales price. With costs of $276.75, to maintain a 40.00% gross
profit percentage (which means COGS is 60%), the sales price could drop to $461.25 ($276.75 / 60%). The decrease
in sales price could lead to an increase in sales volume
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Cost management decisions
Most companies adopt ABC to get more accurate product costs for pricing and product mix decisions.
However, they often benefit more by cutting costs. ABC and value engineering can work together. Value
engineering means reevaluating activities to reduce costs while still meeting customer needs. It requires
cross-functional teams that include the
 Marketers to identify customer needs
 Engineers to design products that can be produced more efficiently
 Production personnel to help improve manufacturing processes
 Accountants to estimate costs

Target Price  The amount customers are willing to pay for a product or service.

Full Product Cost  The cost to develop,

produce, and deliver the product or
service.

Target Cost  The maximum cost to

develop, produce, and deliver the product
or service and earn the desired net profit.
Target sales price minus desired net profit

Cost-based pricing (left column) starts with the full product cost, the cost to develop, produce, and deliver the
product or service. The full product cost is added to the desired net profit to determine the sales price. Target pricing
(right column) does just the opposite. Target pricing starts with the sales price that customers are willing to pay and
then subtracts the company’s desired net profit to determine the target cost.

Note: Notice that we used net profit here, not gross profit. Gross profit is net sales minus cost of goods sold. Net
profit is gross profit less than the period costs. Remember that period costs are also called selling and administrative
expenses.
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Object 4 HOW CAN ACTIVITY-BASED MANAGEMENT BE USED IN SERVICE COMPANIES?

Activity-based management is not just for manufacturing companies. Many service companies also use ABM. For
example, a hospital may use activity-based costing to determine the cost of treating each patient. Activities could
include admitting the patient, conducting procedures such as X-rays and MRIs, and providing care for patients in
their hospital rooms. The hospital would follow the same four steps as the manufacturing company

Step 1. Identify activities and estimate their total indirect costs.

Step 2. Identify the allocation base for each activity and estimate the total quantity of each allocation base

Step 3. Compute the predetermined overhead allocation rate for each activity.

Step 4. Allocate indirect costs to the cost object

 Assume Get Well Hospital wishes to allocate overhead costs to Henry Whitestone, a patient at the hospital.
Get Well Hospital decides to use ABM and decides to allocate overhead on the basis of three activities
(admission, procedures, and care). The hospital has computed the predetermined overhead allocation rates
as follows:

 At the end of each patient’s

stay, the hospital would have an
accurate cost of providing
health care to the patient. The
hospital could then use the
costing information to make
decisions about prices to charge
the patient and also evaluate its
activities and look for ways to
cut costs.

 Activity-based management
is also useful in other types of
service companies, such as
accounting firms wanting to
know the cost of completing
various tax returns, attorneys
wanting to know the cost to
represent various clients, and
cleaning services wanting to
know the cost to clean different
residential and commercial
buildings.
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Object 5 HOW DO JUST-IN-TIME MANAGEMENT SYSTEMS WORK?

Just-in-Time (JIT) Management  A cost management system in which a company produces products just in time to
satisfy needs. Suppliers deliver materials just in time to begin production, and finished units are completed just in
time for delivery to the customer

Just-in-time costing,  A costing system that starts with output completed and then assigns manufacturing costs to
units sold and to inventories.

 JIT costing does not track the cost of products from Raw Materials Inventory to Workin-Process Inventory to
Finished Goods Inventory. Instead, JIT costing waits until the units are completed to record the cost of
production
 JIT costing combines Raw Materials Inventory and Work-in-Process Inventory accounts into a single account
called Raw and In-Process Inventory  A combined account for Raw Materials Inventory and Workin-Process
Inventory used in JIT management systems
 Under the JIT philosophy, workers perform many tasks. Most companies using JIT combine direct labor and
manufacturing overhead costs into a single account called Conversion Costs. The Conversion Costs
account is a temporary account that works just like the Manufacturing Overhead account. Actual conversion
costs accumulate as debits in the Conversion Costs account, and allocated conversion costs are credited to
the account as units are completed. Accountants adjust any underallocated or overallocated conversion
costs to Cost of Goods Sold at the end of the period, just as they do for underallocated or overallocated
manufacturing overhead.

As noted previously, JIT does not use a separate Work-in-Process Inventory account. Instead, it uses only two
inventory accounts:

 Raw and In-Process Inventory, which combines raw materials with work in process
 Finished Goods Inventory
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 Object 6 Quality management systems
Quality management systems (QMS)  system that helps managers improve a business’s performance by
providing quality products and services

The four types of quality-related costs

1. Prevention costs  costs incurred to avoid poor-quality goods or services
2. Appraisal costs  costs incurred to detect poor-quality materials, goods, or services
3. Internal failure costs  costs incurred when the company corrects poor-quality goods or services before
delivery to customers.
4. External failure costs  costs incurred after the company delivers poor-quality goods or services to
customers and then has to make things right with the customer.