Just in Time

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M t y - B a s e d Costing
(ABC), Just-in-Time
(JIT), T otal Quality
M anagement (TQM),
a nd Quality Costs
b

I
.

.ITY-BASED COSTING

Many companies use a traditional cost system such as job-order costing or process costing, or some hybrid of t he two. Using the traditional methods of assigning overhead costs to products using a single predetermined overhead rate based on any single activity measure can produce distorted product costs. The growth in the automation of manufacturing (such as increased use of robotics, high-tech machinery, and other computer-driven processes) has changed the nature of manufacturing and the composition of total product cost. The significance of direct labor cost has diminished and that of overhead costs has increased. In this environment, overhead application rates based on direct labor or any other volume-based cost driver may not provide accurate overhead charges, since they no longer represent cause-and-effect relationships between output and overhead costs. Activity-based costing (ABC) attempts to get around this problem. An ABC system assigns costs to products based on the product’s use of activities, not product volume. An activity-based cost system ,t traces costs to activities and then to products Traditional product costing also 1

[es, but in the first stage costs are traced to departments, not to activities. In both I
traditional and activity-based costing, the second stage consists of tracing costs to products. T he principal difference between the two methods is the number of cost drivers used. Activitybased costing uses a much larger number of cost drivers than the one or two volume-based cost drivers typical in a conventional system. In fact, the approach separates overhead costs into overhead cost

335

336

[CHAP. 13

ACTIVITY-BASED COSTING

pools, where each cost pool is associated with a different cost driver. Then a predetermined overhead rate is computed for each cost pool and each cost driver. In consequence, this method has enhanced accuracy.

13.2 HOW DOES ABC WORK?
ABC is not an alternative costing system to job costing or process costing. It starts with the detailed activities required to produce a product or service and computes a product's cost using the following three steps:

1. Identify the activities or transactions that cause costs to be incurred. These activities are called cost drivers. Cost drivers are causes of costs incurred. Table 13-1 lists possible cost drivers. 2. Assign a cost to each cost driver.

3 . Sum the costs of the cost drivers that make up the product. Table 13-1 Cost Drivers
Manufacturing:
Number of setups
Weight of material
Number of units reworked
Number of orders placed
Number of orders received
Number of inspections
Number of material handling operations
Number of orders shipped
Design time

Square footage
Number of vendors
Asset value
Number of labor transactions
Number of units scrapped
Number of parts
Replacement cost
Machine hours
Direct labor hours

N onmanufacturing:
Number of hospital beds occupied
Number of take-offs and landings for an airline
Number of rooms occupied in a hotel

EXAMPLE 13.1 Global Metals, Inc., has established the following overhead cost pools and cost drivers for their product:

Overhead
c ost Pool
Machine setups
Material handling
Waste control
Inspection
O ther overhead costs

Budgeted
Overhead Cost
$100,000
100,000
50,000
75,000
~00~000
$525.000

Cost Driver
Number of setups
Weight of raw material
Weight of hazardous
chemical used
Number of inspections
Machine hours

Predicted Level
for Cost Driver
100
50,000 pounds
10,000 pounds
1,000
20,000

Predetermined
Overhead Rate
$1,000 p er setup
$2.00 p er pound

$5.00 per pound
$75 p er inspection
$10 p er machine hour

CHAP. 131

337

ACTIVITY-BASED COSTING

J ob No. 107 consists of 2,000 special-purpose machine tools with the following requirements:...
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