Chapter 4 Managerial Accounting

Activity based costing (ABC)

assigns overhead cost by focusing on activities

Both the plantwide and departmental overhead rate methods have three strengths:

1) They use readily available information like direct labor hours or machine hours 2) They are easy to implement 3) They comply with GAAP and can be used for external reporting

The department overhead rate method assumes that:

1) different products that are similar in volume, complexity, and batch size 2) departmental overhead costs are proportional to the department allocation base

Activities causing overhead can be separated into four levels:

1) unit level activities 2) batch level activities 3) product level activities 4) facility level activities

Departmental overhead Steps

1. Assign a budgeted overhead cost to department cost pools 2. Select an allocation base and compute an overhead allocation rate for each department 3. Allocate overhead costs to cost objects

Activity based costing follows three steps:

1. Identify activities and assign budgeted cost to activity cost pools 2. Compute an overhead activity rate for each activity cost pool 3. Allocate overhead costs to cost objects

Weaknesses of Plantwide and Departmental Overhead Rate methods:

Overhead cost is often too complex to be explained by factors like direct labors or machine hours

Activity-based management (ABM)

an outgrowth of ABC that uses the link between activities and costs for better management

Batch level activities

are performed on each batch of units -Batch level costs do not vary with the number of units, but instead vary with the number of batches

Product level activities

are performed on each product line and are not affected by either numbers of units or batches -Product level costs do not vary with the number of units or batches produced

activity cost pool

group of costs that are related to the same activity

Unit level activities

performed on each unit -unit level costs tend to change with the number of units produced

Examples of activities

production setups, machine usage, fabrication, design, assembly, and inspections

Under the plantwide overhead rate method, total budgeted overhead costs are divided by the allocation base, such as total budgeted direct labor hours, to get a plantwide overhead rate. This rate is used to allocate overhead costs to products based on the actual amount of allocation base used.

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Unlike plantwide rate method, ABC uses more than a single rate. ABC focuses on activities rather than departments.

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When overhead cost bears little relation to the allocation base, allocating overhead cost using a single plantwide overhead rate can distort product cost and lead to poor managerial decisions

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With the plantwide and departmental methods, low volume complex products are often undercosted, and high-volume simpler products are often overcoasted

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plantwide overhead rate uses one overhead rate to allocate overhead costs

true

cost object

unit of production (the rate is determined using a volume-related measure such as direct labor hours or machine hours)

Disadvantages of Activity Based Costing

1. Costly to Implement and Maintain -ABC systems are costly. ABC requires a through analysis of cost activities and cost drivers, which can be expensive. 2. Product Cost Distortion -Two sources of cost distortion are 1) when costs cannot be readily classified into activity cost pools 2) when cost drivers do not have a strong cause-effect relation with costs 3. Not compliant with GAAP Activity-based costing cannot be used for external financial reporting purposes under GAAP

Advantages of Activity Based Costing

1. More effective overhead cost -ABC can be used to identify activities that can benefit from process improvement by focusing on activities 2. Better Production and Pricing Decisions -ABC can provide more accurate overhead cost allocation. More accurate costs allow managers to focus production activities on more profitable products and to more accurately set selling prices

The usefulness of the single plantwide overhead rate depends on two assumptions

1. overhead costs change with allocation base and 2. all products use overhead cost in the same proportions

Customer support activity rate

Budgeted customer support cost/ budgeted technician miles

activity cost driver

factor that causes the cost of an activity to go up or down

Facility level activities

sustain facility as a whole and are not caused by any specific product -rent and factory maintenance costs are incurred no matter what is being produced

Activity-based management can help distinguish value-added activities which add value to a product from non-value-added activities, which do not.

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Analyzing activities leads many companies to supply chain management, which involves coordination and control of goods, services, and information as they move from suppliers to consumers

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Because departmental overhead rate method allocates overhead cost based on measures closely related to production volume, it fails to accurately assign many overhead costs

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Each department has its own overhead rate and its own allocation base.

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Laboratories performing medical tests, accounting and law offices, and advertising agencies are other examples of service firms that benefit from ABC

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The basic principle underlying activity-based costing is that an activity, which is a task operation, or procedure, is what causes overhead cost to be incurred.

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The departmental overhead rate method uses a different overhead rate for each department.

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The plantwide and departmental methods do not capture the products' different use of activities, and can distort overhead cost allocations

true