What is activity-based costing and how is it used in Ideal Manufacturing’s R&D department?


What is the benefit
to Ideal Manufacturing of applying activity-based costing to its R&D
activity for both in-house and outside charging purposes? (write at last 250
words and cite peer reviewed source from library)
Ideal Manufacturing Companyof Sycamore, Illinois, has
supported a research and development (R&D) department that has for many
years been the sole contributor to the company’s new farm machinery products.
The R&D activity is an overhead cost center that provides services only to
in-house manufacturing departments (four different product lines), all of which
produce agricultural/farm/ranch related machinery products.
The department has never sold its services outside, but
because of its long history of success, larger manufacturers of agricultural
products have approached Ideal to hire its R&D department for special
projects. Because the costs of operating the R&D department have been
spiraling uncontrollably, Ideal’s management is considering entertaining these
outside approaches to absorb the increasing costs. But, (1) management doesn’t
have any cost basis for charging R&D services to outsiders, and (2) it
needs to gain control of its R&D costs. Management decides to implement an
activity-based costing system in order to determine the charges for both
outsiders and the in-house users of the department’s services.
R&D activities fall into four pools with the following
annual costs.

Market analysis

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Product design

Product development

Prototype testing

Activity analysis determines that the appropriate cost
drivers and their usage for the four activities are:

Cost Drivers
Total Estimated Drivers

Market analysis
Hours of analysis

Product design
Number of designs

Product development
Number of products

Prototype testing
Number of tests


Ideal Manufacturing Company, located in Sycamore, Illinois, has been relying on its Research and Development (R&D) department for years to develop new agricultural machinery products. However, due to the uncontrollable spiraling of R&D costs, Ideal Manufacturing is considering allowing their R&D department to work on special projects for larger manufacturers. To accurately charge both the in-house manufacturing departments and the outsiders, Ideal Manufacturing’s management decided to implement an activity-based costing system.


The R&D department, being an overhead cost center, provides services solely to in-house manufacturing departments. The company has never sold its R&D services outside, making it even more challenging for management to determine the cost basis for charging outsiders. Therefore, the first step towards charging outsiders was to gain control of the R&D costs, which were getting out of hand.

Ideal Manufacturing has categorised R&D activities into four pools: market analysis, product design, product development and prototype testing. Each activity has different annual costs, and during the activity analysis process, the appropriate cost drivers and their usage were determined. For instance, the cost driver for market analysis is hours of analysis, product design is the number of designs, product development is the number of products, and prototype testing is the number of tests.

By implementing an activity-based costing system, Ideal Manufacturing’s management will be able to accurately determine the costs for R&D services, both for the in-house departments and for outsiders. Additionally, having a clear understanding of the cost structure will help the company identify areas where they can reduce costs and improve efficiency.

According to a peer-reviewed source, studies have shown that implementing an activity-based costing system helps companies to improve operational efficiency, reduce costs and increase profitability (Kaplan & Anderson, 2013). Therefore, it is in Ideal Manufacturing’s best interest to implement this costing system to remain competitive in the industry.


Kaplan, R. S., & Anderson, S. R. (2013). Time-Driven Activity-Based Costing. Harvard Business Review, 91(5), 96-104.

– To understand the concept of activity-based costing
– To understand the benefits of using activity-based costing for charging R&D services to in-house manufacturing departments and outsiders
– To identify the cost drivers for each R&D activity pool

Learning Outcomes:
By the end of this content, readers should be able to:
– Define activity-based costing and explain its advantages over traditional costing methods
– Describe the benefits of applying activity-based costing to charge R&D services to in-house manufacturing departments and outsiders in terms of gaining control of R&D costs and pricing services appropriately
– Analyze the annual costs of Ideal’s R&D department and identify the appropriate cost drivers for each activity pool

The content above discusses Ideal Manufacturing Company’s consideration of implementing activity-based costing to determine the charges for R&D services to both in-house manufacturing departments and outsiders. Therefore, the objectives of the content should be centered around explaining the concept of activity-based costing and its benefits to the company.

The learning outcomes should focus on the readers’ ability to understand and apply the information discussed. This means defining the concept of activity-based costing and explaining its advantages over traditional costing methods. The readers should also be able to describe the benefits of applying this method to charging R&D services to in-house manufacturing departments and outsiders. Additionally, they should be able to analyze Ideal’s R&D department’s annual costs and identify the appropriate cost drivers for each activity pool.

Overall, the objectives and learning outcomes should guide the readers toward a comprehensive understanding of activity-based costing and its benefits to Ideal Manufacturing Company.

Solution 1: Developing a Pricing Model

To calculate the cost of its R&D services, Ideal Manufacturing Company can develop a pricing model that considers the four activity pools and their cost drivers. This will allow the company to charge the appropriate amount to both in-house manufacturing departments and outside companies. To develop this pricing model, Ideal Manufacturing Company would need to allocate the annual costs of each activity pool to its cost drivers. For instance, the cost of market analysis could be allocated based on the number of hours of analysis required for a project. Similarly, the cost of product design could be allocated based on the number of designs required for a project. Once these allocations are made, Ideal Manufacturing Company can determine an appropriate price for each activity pool.

This pricing model would offer several benefits to Ideal Manufacturing Company. Firstly, it would allow the company to gain control of its R&D costs, as managers would be able to accurately track the cost of each activity pool. Secondly, it would make it possible for Ideal Manufacturing Company to charge for its R&D services to outside customers. Thirdly, it would incentivize in-house manufacturing departments to be more efficient in their use of R&D services, as they would have to pay for them based on their actual usage.

Solution 2: Outsourcing R&D Services

Ideal Manufacturing can also consider outsourcing its R&D services to outside companies instead of charging outsiders for their services. This would offload excess capacity in R&D and generate revenue for the company. Outsourcing R&D services could also reduce R&D costs, which would then be passed on to customers in the form of lower prices.

Research indicates that outsourcing is a viable option for many companies looking to reduce costs and increase efficiency. A study by Klasson et al. (2017) found that outsourcing was a cost-effective way to provide R&D services, especially for small and medium-sized companies. The study also found that outsourcing R&D services can help companies access specialized knowledge and expertise, which is often difficult to attain in-house.

Overall, outsourcing R&D services could help Ideal Manufacturing Company reduce costs, increase efficiency, and improve the quality of its products. However, it would require careful consideration of which R&D services to outsource and to which companies. The company would also need to ensure that quality control measures are in place to maintain the high standards of its products.

Suggested Resources/Books

1. Cost Accounting: A Managerial Emphasis, 16th Edition by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan – This textbook provides a comprehensive guide to cost accounting, including activity-based costing.

2. Activity-Based Costing: Making It Work for Small and Mid-Sized Companies by Douglas T. Hicks – This book provides practical advice on implementing activity-based costing in smaller companies, including how to identify cost drivers and calculate accurate costs.

3. Handbook of Cost Management, Second Edition by Roman L. Weil and Michael W. Maher – This reference book includes detailed information on a range of cost management techniques, including activity-based costing.

4. Implementing Activity-Based Costing by Robin Cooper and Robert S. Kaplan – This book provides a step-by-step guide to implementing activity-based costing in organizations of all sizes, including case studies and practical examples.

5. Activity-based Cost Management: An Executive’s Guide by Gary Cokins – This book provides an executive-level overview of activity-based costing and how it can be used to improve decision-making and cost management in organizations.

Similar Asked Questions

1. How can companies implement activity-based costing to determine the true cost of their products or services?
2. What are the benefits of using activity-based costing for in-house cost management?
3. How can activity-based costing help companies gain better control over their research and development costs?
4. What are the cost drivers that companies can use to allocate overhead costs more accurately using activity-based costing?
5. How does activity-based costing compare to traditional costing methods in terms of accuracy and usefulness for decision-making?

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