Chapter 5: Activity-Based Costing Flashcards
Plantwide Overhead Rate
- Simplest method
- Uses a single allocation base and rate
- Cost accounting information captures only total overhead costs (accumulated in a single pool) and then volume of the allocation base (such as total direct labour-hours)
The use of plantwide rate assumes the following:
1) All overhead costs in the organization are driven (or caused) by the single allocation base used
2) Cost objects (eg products) consume overhear resources in the same proportion in which they consume the allocation base
Both assumptions are weak, meaning a single plantwide overhead rate has serious limitations
Departmental Overhead ate
- Using multiple cost pools
- Using multiple overhead rates along departmental lines
- Each cost pool captures the overhead costs incurred by a specific department
Ex: 3 departments in a manufacturing plant: Machining, assembly, and maintenance = 3 overhead cost pools (one for each)
Not as great as other systems, can still lead to distortions
In departmental Overhead Rate the rates are usually tied to an aspect of the job
Machining could use machine-hours used
Assembly could use labour-hours
Maintenance could use maintenance-hours
A serious limitation in the case of both plantwide and departmental overhead allocation is the failure by both methods to recognize two facts:
1) The total overhead cost pool in an organization is an accumulation of the costs of numerous resources that are consumer by the organization its serve its customer
2) The individual overhead costs may be driven by different factors
Lastly, they fail to recognize that different cost objects (i.e products, services, and customers0 may consume the different overhead resources in varying proportion
Conventional costing systems that use plantwide or departmental overhead rates suffer from an important limitation:
They tend to assign too much overhead to high-volume products and too little overhead to low-volume products
Activity-based Costing (ABC)
A two-stage costing method in which overhead costs are assigned to products on the basis of the activities they consume.
Far better than using a plantwide or department wide manufacturing overhead
Super simple way to look at ABC
A customer order for a product or service triggers a number of activities; a number of different types of resources are required to carry out these activities; and resources cost money
Cost drivers
Activities that drive costs, that is, cause costs to go up or down.
Each allocation base in an ABC system represents a major _________ that causes overhead costs
Activity
Activity
A task (or a series of tasks) carried out to fulfill the organization’s purpose.
Examples of activities:
1) customer service cost pool
- Receiving customer orders
- Handling customer complaints
- Billing Customers
2) Manufacturing Costs
- Machining
- Assembly
- Production scheduling
- Product testing
3) Accounting cost pool
- Processing payroll
- Processing a credit application
- Repairing performance reports
- Processing accounts payable or accounts receivable
Each major activity has its own _________ (aka activity cost pool), its own ____________, and its own predetermined ________________( also known as activity rate)
Overhead cost pool
Activity Measure
Overhead rate
Activity cost pool
A “bucket” in which costs that relate to a single activity in the activity-based costing system are accumulated.
Activity Measure
An allocation base in an activity-based costing system; ideally, a measure of whatever causes the costs in an activity cost pool.
Activity rate
A predetermined overhead rate in activity-based costing. Each activity cost pool has its own activity rate that is used to apply overhead to products and services.
Predetermined activity rate =
(equation)
POHR
Estimated activity costs / Estimated activity volume
Estimated $50,000 for sewing and there is estimated 200 hours worth of sewing, activity rate = $250 / hour
Designing an Activity-based costing system includes at least the following 7 steps:
Steps 3-6 = 1st part / first stage of ABC
Step 7 = second stage / 2nd part of ABC
1) Identify activities and create an activity dictionary
2) Create activity cost pools
3) Identify the resources consumed by individual activity cost pools
4) Identify the activity measure for each activity cost pool
5) Estimate the total activity volume for each measure
6) Compute a predetermined activity rate for each activity cost pool
7) Allocate activity costs to desired cost objects
Step 1) Identify activities and create an activity dictionary
- Hundred or even thousands of activities cause overhead costs (Such as taking phone call orders, filling out an invoice, training new employees)
- To figure out most important activities to consider, they interview a broad range of managers to identify the activities they think are important and consume the most resources
- List is then refined and goes past top management
- Results in a activity dictionary that defines the activities to be included in the system and specifies how each will be measured
Step 2) Create activity cost pools
In a manufacturing firm, not every organization has to perform every activity listed in the activity dictionary each time an additional unit is manufactured
Generally a manufacturing organization can classify its activities into four types
Generally a manufacturing organization can classify its activities into four types:
1) Unit level
2) Batch level
3) Product level
4) Facility level
1) Unit level activities
Activities that arise as a result of the total volume of goods and services produced, and that are performed every time a unit is produced.
Example: The assembly of a Runner Dog Watch would be a unit level activity since every unit has to be assembled
2) Batch level activities
Activities performed every time a batch of goods is handled or processed, regardless of how many units are in a batch. The amount of resources consumed depends on the number of batches run, rather than on the number of units in the batch.
They depend on the number of batches processed (the number of schedules, number of setups, number of material receipts)
Examples of processing objectives include:
Scheduling production orders, setting up equipment (ie getting equipment ready for producing the next batch of products)
3) Product level activities (product-sustaining activities)
Activities that relate to specific products and that must be carried out regardless of how many units are produced and sold or batches run.
Example: Maintaining information regrading the parts for a product (known as product administration), issuing engineering change notices to modify a product to meet a customer’s specifications, and developing special test routines when a product is first placed into production
4) Facility level activities (organization-sustaining activities)
Activities that relate to overall production and therefore cannot be traced to specific products. Costs associated with these activities pertain to a plant’s general manufacturing process.
Carried out regardless of which products are produced, how many batches are run, or how many units are made
Not caused by particular products
Facility level costs
Include such items as factory management salaries, insurance, property taxes, and building depreciation
Usually combined into a single cost pool and allocated to products using an arbitrary basis such as direct labour-hours
Facility-level costs must be allocated to meet
external reporting requirements as well as to hold managers accountable for the costs of resources which, unless allocated, would be considered by them to be free
Step 3) Identify the resources consumed by individual activity cost pools
As an example: Product Testing
-Include tome supplied by testers, depreciation of testing equipment, and the testing supplies that can be directly traced to the cost pool
Such resources must be assigned to the individual cost pools and the cost determined
Step 4) Identify the activity measure for each activity cost pool
For example: When the amount of the cost assigned to the product testing activity cost pool is known, the next step is to identify an activity measure that will be used to assign the cost of this activity cost pool to final cost objects
Ideally the activity measure should be the cost driver for this activity cost pool
It may not always be possible to identify the cost driver
Step 5) Estimate the total activity volume for each measure
Remaining step are about the mechanics of allocating the pool cost to the cost objects
Since product testing is a batch-level activity, the volume of the activity measure will depend on the estimated number of batches to be produced as well the testing policy
Step 6) Compute a predetermined activity rate for each activity cost pool
Next you compute the activity rate using the formula Estimated activity costs / Estimated activity volume
Step 7) Allocate activity costs to desired cost objects
Second stage of the cost allocation process
in this stage, costs from the different pools are allocated to the desired cost objects using the activity rate and the volume of activity measure consumed by that cost object
Usually you take the number from step 6 and multiply it by how many tests / objects will be conducted
Activity-based costing in nonmanufacturing function and organizations
- Can be used to assign selling and admin expenses
- Allows manager in organizations to enhance their understanding of costs as well as asses the performance of the cost objects
Can be found in marketing and administrative sections, also used in banks, hospitals, cities, and data service companies
Using activity-based costing in service companies
Can be used to prepare a channel profitability report
Benefits of Activity-based Costing
1) Accurate costing
2) Cost estimation
3) Activity-based management
1) Accurate costing
- Improve the accuracy of costs assigned to cost objects
- Improves product costs by accumulating overhead costs into multiple activity cost pools that represent the major activities, instead of just one or two pools
- The activity cost pools are more homogeneous than departmental cost pools
- ABC does not rely on volume-based allocation bases (such as direct labour-hours or machine-hours), instead managers use a combination of volume-based and non-volume based activity measures to assign overhead costs to cost objects
Non-volume based activity measures
Include batch-level and product-level activity measures
2) Cost estimation
Increased accuracy means better estimation of costs
-can help estimate costs related to quality
3) Activity-based management
Allows manager to identify activities that could be improved, resulting in greater efficiency and lower cost
Activity-based management (ABM)
A management approach that focuses on managing activities as a way of eliminating waste and reducing delays and defects.
ABM is a tool that can supplement management practices such as total quality management and process reengineering
Benchmarking
A study of organizations that are among the best in the world at performing a particular task.
Comparing yourself against the best
Limitations of activity-based costing
1) The cost of implementing and maintaining an ABC system may outweigh the benefits
2) It would be naïve to assume that all the costs comprising the product cost-even when provided by an activity-based costing system-are all relevant when making decisions
1) The cost of implementing and maintaining an ABC system may outweigh the benefits
- Involves a great deal of effort
- must be designed by a cross-functional team
- data must be collected and verified
When are the benefits of activity-based costing most likely to be worth the cost?
1) Products differ substantially in volume, in lot size, and the activities they require
2) Conditions have changed substantially since the existing cost system was established
3) Overhead costs are high and increasing, and no one knows why
4) Management does not trust the existing cost system and ignores data from the system when making decisions
Limitations of the ABC model
-Relies on a number of critical assumptions such as the cost in each activity pool is strictly proportional to its activity measure
Downfalls to having a single allocation base in assinging overhead costs to prodcts
In this situation, the allocation is driven by the relative volume of production - the high volume consumes more of the allocation base and is burdened with more of the overhead cost
ABC differs from traditional costing in two ways
1) ABS uses multiple allocation bases that each represent an activity cost pool
2) The activity cost pools are diverse, and both volume-based and non volume based activity measures are used to assign the overhead costs
When overhead is applied to a product, Work in Process is debited, and Manufacturing Overhead is credited.
True
The journal entry to record actual manufacturing overhead costs involves:
a debit to manufacturing overhead
Prevention costs are:
costs associated with activities aimed at preventing future defects/errors
Appraisal costs are:
costs associated with quality inspection activities
Ordinarily, the unit product costs of high-volume products increase and the unit product costs of low-volume products decrease when activity-based costing replaces a traditional overhead costing system based on direct labour-hours.
False
Low-volume product
When a company implements activity-based costing, allocation of MOH often shifts from high-volume to low-volume products with a higher unit product cost resulting for the low-volume products.
Appendix 5A
Everything below this until stated elsewise
Four Categories of Quality Costs:
1) Prevention Costs:
2) Appraisal costs
3) Internal failure costs
4) External failure costs
1) Prevention Costs:
Costs associated with activities aimed at preventing future defects/errors
2) Appraisal costs
Costs associated with quality inspection activities
3) Internal failure costs
Costs associated with activities carried out when the defect is discovered before the product is delivered to the customer
4) External failure costs
Costs associated with activities undertaken after the defect/error is discovered by the customer.
Cost of Quality Report:
shows the details of quality costs under the four categories mentioned above.
