Case: Costs and Chicago Plant

Glaser Health Products manufactures medical items for the health care industry. Production involves machining, assembly and painting. Finished units are then packed and shipped. The financial controller is interested to introduce an activity-based costing (ABC) system to allocate (or distribute) indirect costs to products. Indirect costs, as distinct from direct costs, cannot be unambiguously linked to specific products. The controller would like to calculate product costs based on ABC for planning and control, not inventory valuation.

Activity-based costing (ABC) methodology is an instrument designed to provide accountants and managers with valuable costing information that will allow them to make sound strategic decisions. It is used as a secondary methodology rather than a replacement for the company’s primarily costing system. The ABC methodology identifies activities in an organization and for each activity it assigns a cost. The cost reflects the actual resource consumption by each activity that has been identified.

In Activity based costing there are many activities we could consider for the jelly belly factory. One of the activities we could consider is inspection. We can consider this cost because every jelly bean must be inspected before they are packaged to make sure they meet company standards. If they do not meet the company standard they are package with the other unsatisfactory jelly beans and sold in the candy store inside the factory. Another activity we could consider is customer orders. We can look at how many customer orders and use this as our activity

The Springfield plant is simply doing one thing and that is producing cradles, there is no need for a different costing system there.

In activity-based costing (ABC), nonmanufacturing as well as manufacturing costs may be assigned to products (on a cause-and-effect basis). Further, some manufacturing costs may be excluded from product costs. An ABC system uses a number of overhead cost pools, each of which is allocated to products and other defined cost objects using its own unique measure of activity. In contrast to traditional absorption costing which is used mostly for external financial reporting, activity-based costing is particularly useful for internal and strategic decision-making.

The inability to compete in commodities was creating a finished goods inventory that continued to grow. At the same time, producing low-volume specialty orders added complexity to the manufacturing process that was not revealed in the standard cost system. At one time GEI had two sets of cost data, Product Unit Cost (PUC) that used time as a cost driver and direct labor dollar, where managers could choose the data that made their departments look best. The problem was that managers spent a great deal of time conflicted about which costs were actually correct instead of dealing with the true problems at hand. This led the company to discard of the PUC system and an executive as well as a steering committee was developed to create a solution where ABC was adopted.

To develop a strategy for WMC’s Detroit plant that is no longer viable because of underinvestment, labor issues and product-process mismatch. This has lead to negative return on assets, high burden rate (6.00) and low sales figures. The report investigates the issues causing the situation. A recommendation to address the Detroit plant will be made based on the findings.

The new costing method (Louise’s suggestions) calculates the cost driver rates which are derived from dividing activity expenses by budgeted activity level for the cost driver. For example, to calculate the purchasing cost driver rate simply divide $80,000 by 909 to get an outcome of $88.01. Similarly, to calculate the material handling cost driver rate divide $95,000 by 1,846 to get a result of $51.46. Continuing the same method of calculation for the rest of the activities will determine the rest of the cost driver rates. Adding all of the budgeting costs together results in the total manufacturing overhead costs which is, in this particular instance, is $600,000.

profit. However, by using the ABC method to analyze and allocate "other operating costs" to each of the market segments the

1. The current costing system is a simple costing system. This type of system is functional in terms of its simplicity, but often relies on allocations that may not be accurate. The choice of allocation drivers is usually based on convenience rather than the specific activity. In this case, the machine hours allocation seems to be arbitrary, at 2-to-1 brass to chrome. Yet, direct manufacturing labour is not allocated in accordance with the same ratio. If a unit of chrome takes 3.5 hours compared with 1.5 hours of brass, then allocating overhead costs on the basis of 2-to-1 distorts the true costs of that overhead. Thus, the way that Scotty is implementing its simple costing system is not delivering accurate cost information. Further, the addition of the new product (chrome) serves the purposes of reducing the overhead allocation for brass, making brass look more profitable than it would have looked without chrome in the lineup.

When it comes to any business, company, or firm there will always need to be some way or system that they use to see and calculate how they are doing cost wise. Some companies think that production is going because of the system that is being used. But in reality a company can either be undercosting or overcosting their total cost that they should be using for a job that they produce. If a company doesn’t break down everything they will never really know if the system is hurting or benefiting the company. So when it comes to companies that are in a competitive market, Activity-based costing system (ABC system) would be best for the company to use. The ABC system is a costing method that helps identify the activities and then assigns the cost of each activity with resources to all products and services according to the actual consumption. This means that ABC system will give you a more accurate amount of costs that are being used for each activity. This summary report will outline functions when ABC is implemented, pros, cons, and comparing the ABC system other methods to give you a better understanding of how it works and how it can benefit a company.

Activity-based costing refers to a costing system that initially identifies activities and assigns costs incurred in a single manufacturing task (Gunasekaran A, Marri, H. B, Yusuf, Y.Y, 1999). This, therefore, allocates costs and overheads to items that

Blocher et al (2013), says that the ABC system is relatively new to cost accounting; however, some industries within the government and non-profit agencies use the system for improving cost determination. Additionally, the ABC system is utilized to maximum profitability, while ensuring adequate resources is available to meet demand (Kirche et al, 2005). However, in order for firms to adopt a costing system, managers must understand how beneficial the system can effectively improve the firm’s profits. An ABC system identifies gaps in the old-style accounting systems and recognize the relationship between products and customer. Furthermore, the system identifies high impact areas for process improvements (Kirche et al, 2005). At the same time, based on traditional reasoning, changes in production technology, competition and other related factors underlie giving up on costing (Rof, 2012). In order to develop a costing system tailored for a specific firm, managers and management accountants, must be aware of the relationship between the firm’s resources, activities, and products or services (Blocher et al, 2013).

Activity-based costing (ABC) is a costing methodology that identifies activities in an organization and assigns the cost of each activity with resources to all products and services according to the actual consumption by each. This model assigns more indirect costs(overhead) into direct costs compared to conventional costing.

Nowadays, the development of technology allow the company reduce the cost from direct labour and material cost, but the indirect or overhead cost become significant high. Therefore, price decisions on each product become essential. ABC costing system is a form of splitting overhead costs into different overhead activities. The costs are then allocated to products or projects proportionally by their cost driver activity levels. In another words, this system result the manager to look at the more accurate overhead cost from each products which they producing, then find out the intrinsic value of the product to make a fair price decision.