Join Jim Stice for an in-depth discussion in this video Introduction to activity-based costing, part of Accounting Foundations: Managerial Accounting.
- Product costing has always been a primary purpose of management accounting because the companies that best understand their costs have an advantage over their competitors. However, the manufacturing processes of today don't look at all like the manufacturing processes of the late 1800s when the traditional product costing model was developed. One major development in product costing is activity-based costing or ABC. With an ABC system, a company identifies business activities that create overhead costs such as worker turnover or design changes.
And then, assigns overhead to products or divisions based on the level of those activities. For many types of manufacturing and service companies, ABC is a more accurate product-costing system than the traditional product-costing systems introduced previously. However, ABC requires more time and expense to administer than do traditional costing systems. To review what we know about product costing and to introduce activity-based costing, we're going to make ice cream. We'll use a hypothetical ice cream manufacturer, Lily Ice Cream Company.
Now, Lily has traditionally produced and sold just plain vanilla ice cream. Lily has been in business for years and has always reported solid profits. However, with the increase demand for gourmet ice cream flavors, Lily has seen company sales and profits slide. So this year, Lily decided to start making and selling her own flavors of gourmet ice cream. Lily now makes the following ice cream flavors: Vanilla, Marhmallow Caramel Delight, Gingerbread Cheesecake Supreme, Strawberry Banana Surprise, Double Dutch Chocolate Brownie, and our favorite, Peanut Butter Swirl.
By expanding beyond the production of plain vanilla ice cream, Lily has seen manufacturing overhead cost increased. Some of the new overhead costs are as follows. It turns out Lily had to hire a flavor chemist. With all of these new flavors, Lily has had to hire a highly qualified flavor chemist to research, develop, and monitor the chemical interactions among the new array of flavor ingredients. She needed more quality control inspections. Because Lily is now constantly switching the production process among the different flavors, the production supervisor is required to test flavor quality at the start and at the end of every batch.
She also needs more machine operators. The ice cream machinery has to be reconfigured for the production of each different flavor. As a result, Lily has hired additional workers to set up the machines for each flavor batch. And she needs more machine maintenance personnel. With the broad range of flavor ingredients that now flow through the machinery, the machines need to be cleaned more frequently to remove flavor residue. So that the vanilla ice cream doesn't get tainted with gingerbread flavoring for example. Accordingly, more machine maintenance personnel have been hired.
And finally, she needs more accounting staff. When Lily made just vanilla ice cream, the company's accounting needs were simple. Now, there is a much broader set of suppliers and customers requiring a more sophisticated billing and collection system. Now, note that these new costs are not related to the cost of direct materials or to the number of hours worked by skilled technicians who actually operate the ice cream machinery. These new costs are all overhead costs. Now traditionally, Lily has had a very simple method of overhead allocation.
Total expected overhead cost for a year divided by the number of gallons of ice cream expected to be produced in a year. And then, each gallon of ice cream was allocated the same amount of overhead. Now in the past, this overhead allocation system worked just fine because all of the ice cream was one flavor. However, Lily is concerned that this simple overhead allocation method may no longer work in the more complex manufacturing setting. Lily's concern are prompted by two problems in the company's most recent financial reports.
First, Lily's overall profitability has slipped since the introduction of these new flavors. And second, using the old overhead allocation method, it appears now that vanilla ice cream is being sold at a loss. Lily is considering whether to stop selling vanilla ice cream altogether. But first wants to do a more detailed overhead cost analysis using the ABC approach. The objective of this overhead cost analysis is to be able to answer one fundamental question for each of Lily's ice cream flavors.
How much does it cost to produce ice cream?
Want to hear more from Jim and Kay? Learn about all three types of accounting—financial, managerial, and income tax—in their Accounting Fundamentals course.
- Planning, controlling, and evaluating costs
- Controlling product flow costs
- Performing CVP analysis
- Understanding cost flows in different industries
- Understanding standard product costing and variances
- Understanding activity-based costing
- Capital budgeting