Activity based costing Flashcards
State the different treatments of fixed overheads
- Direct costing
- Traditional absorption costing
- Activity based costing
Explain direct costing
Fixed Costs (including manufacturing overheads) are treated as a period cost.
Only assign direct costs to cost object
Explain traditional absorption costing
- Absorbed in cost of products
- Arbitrary using machine hours/labour hours/units (no clear logic)
Explain activity based costing
- Allocation based on activity level of both manufacturing and nonmanufacturing indirect costs (cause and effect)
Define activity based costing
- An approach to the costing and monitoring of activities that involves tracing resource consumption and costing final outputs.
- Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs.
When is it appropriate to use activity based costing?
- Fixed overheads are a material amount.
- Product diversity (various overhead activities and varying proportions) Δ product size:
➢product complexity
➢size of production runs
➢set-up times/procedures - Clear cause-and-effect relationship
Disclose the advantages of activity based costing
- More accurate than traditional costing
- Provides a better understanding of what causes (drives) overhead costs
- Fairer allocation of costs
- Leads to better cost control
- Recognises complexity of modern manufacturing
- Helps eliminate non-value-adding activities
- Reapportionment of service department costs is avoided
State the limitations of activity based costing
- Cost allocations can still be arbitrary
- Need to identify appropriate cost drivers and activities (may be difficult to do)
- A single cost driver may not explain the cost behavior of all items in the associated pool
- Complex to operate
- Expensive to introduce and to operate
Explain why a cost accumulation system is required for generating relevant cost information for decision making
There are three main reasons why a cost accumulation system is required for generating relevant cost information.
1. Many indirect costs are relevant for decision making and costing system is therefore required that provides an estimate of resources consumed by cost objects using cause and effect allocations to allocate indirect costs.
2. An attention directing information system is required that periodically identifies those potentially unprofitable products that require more detailed investigation.
3. Many product decisions are not independent and to capture product interdependencies those joint resources that fluctuate in the longer term according to the demand for them should be assigned to products.
Describe the difference between activity based and traditional costing system
The major differences relate to the 2-stages allocation process.
1. In the first stage, traditional systems allocate indirect costs to cost centres (normally departments), whereas activity based system allocates indirect costs centers based on activities rather than departments. Since there are many more activities than departments, a distinguishing feature is that activity-based systems will have greater number of cost centers in the first stage of the allocation process.
2. In the second stage, traditional systems use a limited number of different types of second stage volume-based allocation bases (cost drivers) whereas activity based systems use many different types of volume based and non-volume based cause and effect second stage drivers.
Explain why traditional costing systems may provide misleading information for decision making
Traditional systems tend to rely on arbitrary allocations of indirect costs. In particular, they rely extensively on volume based allocations. Many indirect costs are non-volume based but, if volume based allocation bases are used, high volume products are likely to be assigned with a greater proportion of indirect costs than they have consumed, whereas low volume products will be assigned a lower proportion. In these circumstances, traditional systems will over-cost high volume products and under-cost low volume products.
In contrast, ABC systems recognize that many indirect costs vary in proportion to changes other than production volume. By identifying the cost drivers that cause the costs to change and assigning costs to costs objects on the basis of cost driver usage, costs can be more accurately traced. It is claimed that this cause and effect relationship provides a superior way to determining relevant costs
Identify and explain each of the 4 stages involved in designing ABC system
The design of ABC systems involves the following 4 stages:
1. identify the major activities that take place in the organization
2. Create a cost center/cost pool for each activity
3. Determine the cost driver for each major activity
4. Trace the cost of activities to the product according to a product’s demand (using cost drivers as a measure of demand) for activities
Describe the ABC cost hierarchy
ABC system classify activities along a cost hierarchy consisting of unit-level, batch level, product-sustaining level and facility-sustaining activities.
Unit level activities are performed each time a unit of the product or service is produced.
Batch level activities are performed each time a batch is produced.
Product-sustaining activities are performed to enable the production and sale of individual products.
Facility sustaining activities are performed to support the facility’s general manufacturing process.
Describe the ABC profitability analysis hierarchy
The ABC profitability analysis hierarchy categories costs according to their variability at different hierarchal levels to report different hierarchical contribution levels. At the final level, facility or business sustaining costs are deducted from the sum of the product contributions to derive a profit at the business unit level. Meaning, facility/business sustaining costs are not allocated to individual products. The aim of hierarchical profitability analysis is to assign all organizational expenses to particular hierarchical or organizational level where cause and effect cost assignment can be established so that arbitrary apportionments are non-existent
Describe the ABC resource consumption model
ABC systems are models of resource consumption. They measure the cost of using resources and not the cost of supplying resources. The difference between the cost resources supplied and the cost of resources used represents the cost of unused capacity, The cost of unused capacity for each activity is the reporting mechanism for identifying the need to adjust the supply of resources to match the usage of resources. However, to translate the benefits of reduced activity demands into cash flow savings, management action is required to remove the unused capacity by reducing the spending on the supply of resources
