chapter 4 activity base costing

Computing Activity Rates

We can calculate an activity rate by dividing the estimated overheard for an activity by the total expected activity

Targeting Process Improvements Activity-Based Management

An ABC system can help identify areas where the company can benefit from improving its current processes

Activity

An event that causes the consumption of overhead resources ex: setting up machines Admitting hospital patients Billing customers Opening a bank account

Targeting Process Improvements - Step 1 Activity Rates + Benchmarking

1st Step : in any improvement program is deciding what to improve AR: can be used to target areas where costs seem excessively high B: can be used to compare activity cost information with world-class standards of performance achieved by other organizations

Costs of implementing an ABC system may outweigh the benefits. However, the benefits are more likely to be worth the costs when

1. Products differ substantially in volume, batch size, and in activities required. 2. Conditions have changed substantially since the existing cost system was established. 3. Overhead costs are high and increasing and no one seems to understand why. 4. Management does not trust the existing cost system and it ignores data from it when making decisions

Activity Cost Pool: Activity Measure: Activity Rate:

A "cost bucket" in which costs related to a particular activity are accumulated Expresses how much of the activity is carried out and is used as the allocation base for applying overhead cost A predetermined overhead rate for each activity cost pool

Plantwide Overhead Rate

A single overhead rate that is used throughout an entire factory

Departmental Overhead Rates - Disadvantages

Departmental rates will not correctly assign overhead in situations where a company has a range of products and complex overhead costs The departmental approach relies on a single measure of activity as allocation base while some overhead costs may be caused by factors that are not directly proportional to the volume of production

Shifting of Overhead Cost Volume Products

When a company implements activity-based costing, overhead cost shifts from high-volume to low-volume products with a higher unit product cost resulting for the low-volume products

Direct labor has often been used as the allocation base for overhead because

1. Direct labor information was already being recorded. 2. Direct labor was a large component of product costs. 3. Managers believed direct labor and overhead costs were highly correlated

Activity-Based Costing (ABC)

1. A technique that attempts to assign overhead costs more accurately to products 2. It uses multiple allocation bases for assigning costs to products. 3. Each base represents a major activity. 4. Activity is an event that causes consumption of overhead resources.

When cost systems were developed in the 1800s, the emphasis was on simplicity because

1. Cost and activity data had to be collected by hand and all calculations were done with paper and pencil. 2. Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product.

ABC improves the accuracy of product costing by

1. Increasing the number of cost pools used to accumulate overhead costs 2. Using activity cost pools that are more homogeneous than departmental cost pools 3. Assigning overhead costs using activity measures that cause those costs, rather than relying solely on direct labor-hours 4. Activity-based costing also highlights activities that could benefit most from process improvement efforts

Today, direct labor may no longer be a satisfactory base for allocation of overhead

1. Most companies sell a large variety of products that consume differing amounts of overhead. 2. As a percentage of total costs, direct labor has been declining and overhead has been increasing. Many of these growing overhead costs may not be correlated with direct labor. 3. Technology advancements have reduced the cost and complexity of gathering diverse sources of data

The illustrations in the chapter assume that ABC is being used for external reporting purposes. If the system is used for internal decision-making purposes, two important modifications should be made

1. Selling and administrative costs should be assigned to products, where appropriate. 2. Facility-level costs should be removed from product costs

Activity-Based Costing (ABC) Process

Cost Objects ex. products and customers v Activities v Consumption of Resources v Consumption of Resources Incur Cost

Activity-Based Management

Focuses on managing activities to eliminate waste and reduce processing time and defects

Activity-Based Costing (ABC) Similarities to Job-Order Costing

For each activity in isolation, this system works exactly like the job-order costing system described in earlier chapter A predetermined overhead rate is computed for each activity and then applied to jobs and products based on the amount of activity consumed by the job or product

Departmental Overhead Rates

Many companies have a system in which each department has its own overhead rate allocation base depends on the nature of the work performed in each department

Comparing Activity base costing w Direct labor costing

Note that the unit product cost of a GPS unit decreased from $110 to $95.55 while the unit cost of a phone unit increased from $150 to $207.80

Shifting of Overhead Cost - Production-Order Cost per Unit

Notice, the costs are being shifted from the high-volume GPS systems to the low-volume Phone systems

Designing an Activity-Based Costing System - Combining Activities

Related activities are frequently combined to reduce the amount of detail and record-keeping costs

Shifting of Overhead Cost - Production-Orders Cost Pool

The ABC system assigns different amounts of Production-Order-related overhead costs to each product. This fact can be illustrated in a two-step process 1. Compute the number of units processed per production order for each product 2. Compute production-order cost per unit for each product

Designing an Activity-Based Costing System - Challenges

The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization's resources

Limitations of the ABC Model

The cost in each activity pool is strictly proportional to its activity measure. When this assumption is violated, the accuracy of ABC data can be called into question managers should be particularly alert to product costs that contain allocated facility-level costs

Shifting of Overhead Cost - ABC vs. Traditional System

The traditional system assigns the same amount of all overhead costs to each Phone or GPS unit