Week 4 Everything Flashcards
Industry used to be:
direct-labour intensive and production paced around labour.
direct costs were the dominant costs and indirect costs (overheads) were low relative to direct costs.
operating in less competitive markets.
involved with a limited range of products.
information costs were high.
Few decades ago overheads represented
a small element of total cost, it was acceptable to deal with overhead costs in a fairly arbitrary manner.
Traditional Cost Systems
Uses actual departments or cost centers for accumulating and redistributing costs. Asks how much of an allocation basis (usually based on volume) is used by the production department. Service department expenses are allocated to a production department based on the ratio of the allocation basis used by the production department
Contemporary costing context
However, in contemporary business context, overheads are much more significant.
Industry context now:
Capital intensive and production paced around machines
Overheads are higher relative to direct costs
Highly competitive markets
Service industries dominate
Need for a comprehensive cost accumulation system (1)
As a result of increase in the proportion of overhead costs in total production cost it is more important to accurately absorb overhead costs. A small inaccuracy in absorption rate may lead to big variances in total unit costs
Need for a comprehensive cost accumulation system (2)
In this competitive business environment there are 3 main reasons why a comprehensive cost accumulation system is required to generate accurate cost information:
In this competitive business environment there are 3 main reasons why a comprehensive cost accumulation system is required to generate accurate cost information:
Decision-making relevance of indirect costs,
Product profitability analysis,
Interdependence of product-related decisions.
Activity-Based Costing
Uses activities for accumulating costs and redistributing costs.
ABC: Key questions
Why is the organization spending money on indirect and support resources?
How much is the organization spending on each of its activities
Why is the organization performing activities?
How much of each activity is required for the organization’s products, services, and customers?
Activities drive costs
Companies have now recognised that activities drive costs . “Products consume activities, while activities consume resources (costs)” . Therefore, costs of these activities should be allocated to those cost units.
Activity based costing (ABC)
ABC is a method of allocating overhead costs to products and services. ABC asks the question: ‘What activities drive overhead costs?’ ABC analyses those activities and assigns relevant costs to these activities. ABC allocates costs of the activities to products based on the consumption of activities by each product.
ABC involves the following four main steps:
(1) Identify the major activities of the business.
(2) Assign costs to activity cost centres (or cost pools).
(3) Identify an appropriate cost driver for each activity and compute a cost driver rate
(4) Assign the costs of activities to products based on their demand for each activity.
(1) Identify the major activities of the business.
To identify major activities. Overhead costs should be analysed in detail. Each element of overhead should be associated with the activity from which it arises.
Examples of major activities:
Holding products in storage
Processing an order
Machine set up activity
(2) Assign costs to activity cost centres (or cost pools)
Cost centres (or cost pools) are locations to which overhead costs are initially assigned. In the second step, ABC assigns costs of activities to relevant cost centres/pools:
In the second step, ABC assigns costs of activities to relevant cost centres/pools:
Costs assigned to activity cost pools will include direct and indirect costs. Resource cost drivers used to assign indirect costs. Reliability of cost information will be reduced if arbitrary allocations are used to assign a significant proportion of costs to activities.
Cost centres
A cost centre (pool) for an activity brings together those costs arising from that activity. In other words, a cost centre for an activity includes all of the costs caused by that activity:
In other words, a cost centre for an activity includes all of the costs caused by that activity:
Total storage cost
Total cost of processing orders
Total machining cost
(3) Identify cost driver and compute cost driver rate
Cost driver rate is calculated as cost pool divided by the number of times that the activity occurs.
Cost driver rate is calculated as cost pool divided by the number of times that the activity occurs.
For example:
Total storage cost divided by the number of holding days in storage.
.
Total cost of processing orders divided by the number of orders processed.
Total machining cost divided by number of machine runs.
Two stage allocation under ABC
Similar to traditional costing method, ABC allocates costs to products using a two stage process. At first stage allocates overhead costs to activity cost centres using Resource cost drivers. At the second stage allocates activity cost centre overheads to products using Activity cost drivers
Cost drivers
The basis that is used to allocate costs to cost object is called cost drivers. A cost driver of an activity gives rise to (causes changes in) overhead costs related to this activity. A cost driver should be a significant determinant of the cost of activities.
Examples of cost drivers
Number of holding days materials in storage
Number of orders or number of production runs.
