21 terms

Activity Based Costing Ch. 17

Traditional Costing Systems
Allocates overhead using a single predetermined rate.
Job order costing: direct labor cost may be the relevant activity base.
Process costing: machine hours may be the relevant activity base.
Assumption was satisfactory when direct labor was a major portion of total manufacturing costs.
Wide acceptance of a high correlation between direct labor and overhead costs.
The Need for a New Approach
Tremendous change in manufacturing and service industries.
Decrease in amount of direct labor usage.
Significant increase in total overhead costs.
Inappropriate to use plant-wide predetermined overhead rates when a lack of correlation exists.
Complex manufacturing processes may require multiple allocation bases; this approach is called Activity-Based Costing (ABC).
Activity-Based Costing
Allocates overhead to multiple activity cost pools and
Assigns the activity cost pools to products or services by means of cost drivers.
any event, action, transaction, or work sequence that causes a cost to be incurred in producing a product or providing a service
Activity Cost Pool
a distinct type of activity. For example: ordering materials or setting up machines.
Cost Drivers:
any factors or activities that have a direct cause-effect relationship with the resources consumed.
ABC allocates overhead costs in two stages
Stage 1: Overhead costs are allocated to activity cost pools.
Stage 2: Assigns overhead allocated to the activity cost pools to products, using cost drivers
*The more complex a product's manufacturing operation, the more activities and cost drivers are likely to be present.
ABC :Involves the following four steps
1. Identify and classify the activities involved in the manufacture of specific products, and allocate overhead to cost pools.
2. Identify the cost driver that has a strong correlation to the costs accumulated in the cost pool.
3. Compute the activity-based overhead rate for each cost driver.
4. Assign overhead costs to products, using the overhead rates determined for each cost pool (cost per driver).
Identify and Classify Activities and Allocate
Overhead to Cost Pools (Step 1)
Overhead costs are assigned directly to the appropriate activity cost pool.
Identify Cost Drivers (Step 2)
Cost driver must accurately measure the actual consumption of the activity by the various products.
Compute Overhead Rates (Step 3)
Next, the company computes an activity-based overhead rate per cost driver.
Assign Overhead Cost to Products (Step 4)
In assigning overhead costs, it is necessary to know the expected use of cost drivers for each product
Benefits of ABC
More accurate product costing through:
Use of more cost pools to assign overhead costs.
Enhanced control over overhead costs.
Better management decisions.
Limitations of ABC
Can be expensive to use.
Some arbitrary allocations continue.
Activity Based Management (ABM
An extension of ABC from a product costing system to a management function that focuses on reducing costs and improving processes and decision making
Value-Added Activities
An activity that increases the perceived worth of a product or service such as:

Manufacturing Company
Engineering design
Machining services
Service Company
Performing surgery
Legal research
Delivering packages
Non-Value-Added Activities
An activity that adds cost to, or increases the time spent on, a product/service without increasing its market value such as:
Manufacturing Company
Repair of machines
Storage of inventory
Moving of inventory
Building maintenance
Inventory Control
Service Company
Taking appointments
Bookkeeping and billing
Ordering supplies
Unit-level activities
Performed each time a unit is produced and are generally considered variable costs
Examples: Machine hours and Direct labor hors
Batch-level activities
Performed each time a batch or production run of goods are produced
Examples: Number of setups, orders, inspections
Product- level activities
Performed to support a particular product line
Examples: Number of product designs, number of changes
Facility-level activities
Performed to support a facility's general manufacturing process and are generally fixed costs
Examples: Number of employees managed, square footage