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Unit 5
ACTIVITY-BASED COSTING
Study Objectives
Recognize the difference between traditional costing and activity based costing.
Identify the steps in the development of an activity-based costing system.
Classify resource consuming activities.
Study Objectives: Continued
Distinguish cost drivers in activity based costing systems.
Explain the benefits and limitations of ABC.
ACTIVITY-BASED COSTING VERSUS TRADITIONAL COSTING
Study Objective 1
Traditional Costing Systems
Allocates overhead using a single predetermined rate.
Job order costing: direct labor cost is assumed to be the relevant activity base.Process costing: machine hours is 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.
Traditional Costing Systems:Continued
Direct labor is still often the appropriate basis for assigning overhead costs when:
Direct labor constitutes a significant part of total product cost
and
High correlation exists between direct labor and changes in overhead costs.
Overhead Direct Labor Products
Costs Hours/Dollars
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.
May be inappropriate to use plant-wide predetermined overhead rates based on direct labor or machine hours 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 (ABC)
An overhead cost allocation system that allocates overhead to multiple activity cost pools
and Assigns the activity cost pools to products or
services by means of cost drivers that represent the activities used.
Activity-Based Costing (ABC)Terms
Activity: 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.
The Logic Behind ABC
Products consume activities,
and activities consume resources.
Activity-Based Costing (ABC) – Continued
ABC allocates overhead costs in two stages:
Stage 1: Overhead costs are allocated to activity cost pools.
Stage 2: The overhead costs allocated to the cost pools is assigned to products using cost drivers.
The more complex a product’s manufacturing operation, the more activities and cost drivers likely to be present.
Activities and Related Cost Drivers
ABC System Design – Lift Jack Company
Traditional Costing vs ABC
ABC does not replace an existing job order/process cost system.
ABC does segregate overhead into various cost pools to provide more accurate cost information.
ABC, thus, supplements – it does not replace – the traditional cost system.
Traditional Costing vs ABCAn IllustrationStudy Objectives 2, 3, & 4
Atlas Company produces two automotive antitheft devices: The Boot: a high volume item with sales totaling 25,000 per year The Club: a low volume item with sales totaling 5,000 per
year
Each product requires 1 hour of direct labor Total annual direct labor hours (DLH) 30,000 (25,000 + 5000) Direct labor cost $12 per unit for each product
Expected annual manufacturing overhead costs $900,000
Direct materials cost: The Boot - $40 per unit The Club - $30 per unit
Unit Costs Under Traditional Costing
Products
Manufacturing Costs The Boot The ClubDirect Materials $40 $30Direct Labor 12 12Overhead 30* 30*Total unit cost $82 $72
* Predetermined overhead rate: $900,000/30,000 DLH = $30 per DLH Overhead = predetermined overhead rate times direct labor hours
($30 X 1 hr. = $30)
Unit Costs Under ABC:Step 1: Identify and Classify Activities and
Allocate Overhead to Cost PoolsStudy Objective 3
Activity Cost Pools Estimated OverheadSetting up machines $300,000Machining 500,000 Inspecting 100,000 Total $900,000
Unit Costs Under ABC:Step 2: Identify Cost Drivers
Study Objective 4
Expected Use of Cost Drivers
Activity Cost Pools Cost Drivers Per ActivitySetting up machines Number of setups 1,500 Machining Machine hours 50,000
Inspecting Number of Inspections 2,000
Unit Costs Under ABC:Step 3: Compute Overhead Rates
Formula for Computing Activity-Based Overhead Rate:
Estimated Overhead Per Activity Activity-Based
Expected Use of Cost Drivers Per Activity Overhead Rate
Expected Use Estimated of Cost Drivers Activity-Based
Activity Cost Pools Overhead Per Activity Overhead RatesSetting up machines $300,000 1,500 setups $200 per setup Machining 500,000 50,000 machine hrs. $ 10 per mach. hour Inspecting 100,000 2,000 inspections $ 50 per inspectionTotal $900,000
Unit Costs Under ABC:Step 4: Assign Overhead Costs to ProductsPart 1: Expected Use of Cost Driver Per Product
Expected Use of Cost Drivers per Product
Expected UseActivity Cost of Cost Drivers Pools Cost Driver Per Activity The Boot The
ClubSetting up Number of machines setups 1,500 setups 500 1,000Machining Machine hours 50,000 hours 30,000 20,000Inspecting Number of
inspections 2,000 inspections 500 1,500
Unit Costs Under ABC:Step 4: Assign Overhead Costs to Products
Part 2: Assign Cost Pools to Products
The Boot
Expected Use of Activity-BasedActivity Cost Drivers X Overhead = Cost Cost Pools per Product Rates AssignedSetting up machines 500 $200 $100,000Machining 30,000 10 300,000Inspecting 500 50 25,000Total costs assigned $425,000Units produced 25,000Overhead cost per unit $17
Unit Costs Under ABC:Step 2: Assign Overhead Costs to Products
Part 2: Assign Cost Pools to Products
The Club
Expected Use of Activity-BasedActivity Cost Drivers X Overhead = Cost Cost Pools per Product Rates AssignedSetting up machines 1,000 $200 $200,000Machining 20,000 10 200,000Inspecting 1,500 50 75,000Total costs assigned $475,000Units produced 5,000Overhead cost per unit $95
Comparison of Unit CostsTraditional vs ABC
The Boot The ClubTraditional Traditional
Manufacturing Costs Costing ABC Costing ABCDirect Materials $40 $40 $30 $30Direct Labor 12 12 12 12Overhead 30 17 30 95
Total Cost per Unit $82 $69 $72 $137
Overstated Understated $13 $65
Activity-Based Costing:A Closer Look
Study Objective 5
More accurate product costing through: Use of more cost pools to assign overhead costsEnhanced control over overhead costsBetter management decisions
Activity-Based Costing: A Closer Look
Limitations of ABC
Can be expensive to use Some arbitrary allocations continue
Activity-Based Costing:A Closer Look
Use ABC When One or More of the Following Exist:
Products differ greatly in volume/manufacturing complexity
Products lines are Numerous Diverse Require different degrees of support services
Overhead costs are a significant portion of total costs
Significant change in manufacturing process or number of products
Managers ignore data from existing system and instead use “bootleg” costing data
Let’s ReviewLet’s Review
Activity-based costing (ABC):
a. Can be used only in a process cost system
b. Focuses on units of production
c. Focuses on activities performed to produce a product
d. Uses only a single basis of allocation
Let’s ReviewLet’s Review
Activity-based costing (ABC):
a. Can be used only in a process cost system
b. Focuses on units of production
c. Focuses on activities performed to produce a product
d. Uses only a single basis of allocation
Summary of Study Objectives
Recognize the difference between traditional and activity-based costing.
Traditional system allocates overhead to products using predetermined unit-based output rate.ABC allocates overhead to activity cost pools and assigns cost to products using cost drivers.
Identify the steps in the development of an activity-based costing system.
Step 1: Identify the major activities and allocate the overhead costs to cost pools.
Step 2: Identify the cost driver highly correlated to the cost pool.Step 3: Compute the overhead rate per cost driver.Step 4: Assign cost pools to products or services using the
overhead rates.
Summary of Study Objectives Know how companies identify cost pools used in ABC.
Analyze each operation or process, document and time every task, action, or transaction.
Know how companies identify and use cost drivers in ABC.Cost drivers identified for assigning activity cost pools must: Accurately measure the consumption of the activity Have related data easily available.
Understand the benefits and limitations of ABCBenefits: Enhanced control over overhead costs Better management decisions
Limitations: Higher costs accompany multiple activity centers and cost
drivers Some costs must still be allocated arbitrarily
Summary of Study Objectives
Differentiate between value-added and non-value-added activities.
Value-added activities increase the worth of a product or service.
Non-value-added activities add cost to, or increase the time spent on, a product or service without increasing its market
value.
Understand the value of using activity levels in ABCActivities may be classified as:
Unit-level Batch-level Product-level Facility-level
Failure to recognize this classification can resultin distorted product costing.
Summary of Study Objectives
Apply ABC to service industries.Same objective – improved costing of
services provided.
The general approach to costing is also the same: analyze operations identify activities accumulate overhead costs by activity
cost pools identify and use cost drivers to assign
cost to services