activity-based costing

Question 1

the traditional cost allocation relies on 4 basic steps, what are they?

Answer 1

• accumulate costs within a production or non-production (i.e. service) departments
• allocate non-production costs to production departments
• compute separate overhead rates for each production cost centre
• allocate production department costs to various products, services or customers (cost objectives)

Question 2

once, costs have been allocated to departments, what happens next?

Answer 2

they must be then charged out to cost objectives (e.g. units of production) - using a fair and logical basis
- total overhead costs are charged to all units produced in proportion to the amount of budgeted productive capacity used up in making each unit

Question 3

how are total overhead costs allocated to units based on their use of budgeted productive capacity

Answer 3

use a predetermined overhead rate (POHR)
- needed at the beginning of the accounting period
- requires estimating the total manufacturing overhead costs as well as the cost driver volume for the coming period

Question 4

what is the POHR?

Answer 4

used to apply overhead to units of output (products, etc.) and is determined before the period begins

Question 5

formula for POHR

Answer 5

POHR = estimated total manufacturing overhead cost for the coming period / estimated total units in the allocation base for the coming period

*ideally, the allocation base is a cost driver that causes overhead

Question 6

formula for overhead applied

Answer 6

= POHR x actual activity

Question 7

limitations to the traditional approach

Answer 7

traditional costing systems use volume-based (e.g. direct labour and machine hours) second stage drivers. so, …
- it UNDER allocates overheads to low-volume products
- it OVER allocates overheads to high-volume products
if volume bases are not the cause of indirect costs, reported costs will be misleading
- it UNDER allocates overheads to less complex products
- high-volume production absorbs OH costs but…
- low volume production causes OH costs

Question 8

when were traditional systems appropriate?

Answer 8

when..
- direct costs were the dominant costs
- indirect costs were relatively small
- information costs were high
- there was a lack of intense global competition
- a limited range of products were produced

but now…
- we have a rider range of products
- direct labour is not the dominant cost
- overheads (indirect costs) are now of considerable importance

Question 9

what are the reasons for ABC?

Answer 9

the importance of accurate overhead assignment methods has increased..
- to avoid financial reporting distortion (product costs not period costs)
- to adapt to the increase in complexity of manufacturing services
- competitive environment - accurate costs
- non-factory emphasis (e.g. service organisations, hospitals, etc)

Question 10

what are product costs?

Answer 10

costs that are directly related to the production of the product or service (such as the cost of raw materials, labour and production overheads)

Question 11

what are period costs?

Answer 11

all other indirect costs that are incurred in the production (such as overhead and sales and marketing expense)

Question 12

what kind of cost drivers does ABC use?

Answer 12

both volume-based and non-volume based drivers

Question 13

define volume-based drivers

Answer 13

are appropriate where the activities are performed each time a unit of product or service is produced (i.e. direct labour hours)

Question 14

define non-volume related activities

Answer 14

not performed each time a unit of a product or service is produced (e.g. setting-up machines)
- the more there are, the more distorted your product costs will be if you do not use ABC

Question 15

explain the two stage allocation process for ABC

Answer 15

• organisations consist of a series of inter-related activities
• resources are consumed by ACTIVITIES (not departments) -> activity cause costs
• products/services accrue costs through making demand on the activities
• ABC assigns costs to a product or service on its consumption of an activity

*instead of the second stage allocations to cost centres (traditional approach), ABC uses activity cost centres and drivers

Question 16

what are the stages in designing an ABC system?

Answer 16

1. identify major organisational activities
2. assign costs to activity cost pools/centres
3. select appropriate cost drivers for assigning the cost of objectives to cost objects
4. calculate activity rates
5. assign costs of activities to products according to the product’s demand of activities

Question 17

explain stage 1 of designing an ABC system

Answer 17

the activities chosen should be at a reasonable level of aggression based on cost/benefit criteria and can be grouped at different levels

Question 18

what are choice of activities influenced by?

Answer 18

• the total cost of the activity centre, and
• the ability of a single cost driver to provide a satisfactory determinant of the cost activity

Question 19

what are the different levels activity can be grouped by?

Answer 19

• unit level (including direct labour, material and energy costs): performed each time a unit of the product or service is produced; resources are consumed in proportion to the number of units produced or sold
• batch level (setting up a machine)
• product level (designing and advertising)
• customer level (sales calls and customer visits)
• organisation-sustaining (general admin)

Question 20

explain stage 2 of designing an ABC system

Answer 20

assign costs to activity cost pools/centres:
- after the activities have been identified, the cost of resources consumed over a specified period must be assigned to each activity
- in the first stage of allocation, OH costs are assigned to activity cost pools (not necessarily allocated on a departmental basis)

Question 21

what is a cost pool?

Answer 21

a cost pool groups together all costs associated with an activity

Question 22

what is an activity’s direct and indirect costs?

Answer 22

activity’s direct costs = resources that will be traceable to specific activity centres

activity’s indirect costs = e.g. lighting and heating costs, are assigned to its cost pool using RESOURCE cost drivers !

Question 23

explain stage 3 of designing an ABC system

Answer 23

select appropriate cost drivers for assigning the cost of activities to cost objectives - drivers at this stage are called activity drivers. they should:
- provide a good explanation of costs of each activity pool
- be easily measurable
- the data should be easy to obtain and identifiable with the product

the cost driver should be measurable so that it can be identified with individual products

Question 24

examples of activities and cost drivers

Answer 24

activity = cost driver
- purchasing = number of purchase orders
- materials handling = number of material requisitions
- set-ups = no. of production runs/number of set ups
- quality inspection = number of inspections / no. of production runs

Question 25

explain stage 4 of designing an ABC system

Answer 25

calculate activity rates -> these are used for assigning overhead costs to products
- finally assign costs of activities to products according to the product’s consumption of activities

Question 26

how are activity rates calculated?

Answer 26

calculated by dividing the overhead cost by the total activity for each activity cost pool
= gives a charge out rate for each activity