Cost Chapter 4

Resource drivers

factors that measure the consumption of resources by activities.

Non-unit-based drivers

factors, other than the number of units produced, that measure the demands that cost objects place on activities.

If the overhead variance is material

it should be allocated to the period's production. Conceptually, the overhead costs of a period belong to goods started but not completed (work-in-process inventory), goods finished but not sold (finished goods inventory), and goods finished and sold (cost of goods sold).

The use of either plantwide rates or departmental rates assumes that a product's consumption of overhead resources is related strictly to the units produced.

using only unit-level drivers to assign non-unit-related overhead costs can create distorted product costs. The severity of this distortion depends on what proportion of total overhead costs these non-unit-based costs represent - learly, as this percentage decreases, the acceptability of using unit-based drivers for assigning costs increases.

Plantwide or departmental predetermined overhead rates are used to assign or apply overhead costs to production as the actual production activity unfolds

The total overhead assigned to actual production at any point in time is called applied overhead.

The five most commonly used unit-level drivers are:

Units produced Direct labor hours Direct labor dollars Machine hours Direct material dollars

activity inventory

a listing of the activities performed within an organization.

underapplied overhead

actual overhead is greater than applied overhead

overapplied overhead

applied overhead is greater than actual overhead

Unit-level drivers

are factors that measure the demands placed on unit-level activities by products. Unit-level activities are activities performed each and every time a unit of a product is produced

Assuming, however, that the overhead costs are a significant percentage of total manufacturing costs, at least two major factors can impair the ability of the unit-based plantwide and departmental rates to assign overhead costs accurately

(1) the proportion of non-unit-related overhead costs to total overhead costs is large, and (2) the degree of product diversity is great.

To help identify activity drivers and enhance the management of activities, activities are often classified into one of the following four general activity categories:

(1) unit-level, (2) batch-level, (3) product-level, and (4) facility-level.

With the drivers defined, a bill of activities can be created

A bill of activities specifies the product, expected product quantity, activities, and amount of each activity expected to be consumed by each product.

the overhead variance is added to cost of goods sold if underapplied and subtracted from cost of goods sold if overapplied.

A journal entry is the mechanism for adding or subtracting the overhead variance. Assuming that both actual and applied overhead are accumulated in the overhead control account, Cost of Goods Sold would be debited (credited) if under- (over-) applied.

Attributes define and describe activities and, at the same time, become the basis for activity classification.

A primary activity is an activity that is consumed by a final cost object such as a product or customer. A secondary activity is one that is consumed by intermediate cost objects such as primary activities, materials, or other secondary activities. Recognizing the difference between the two types of activities facilitates product costing.

Costs reported on the financial statements must be actual—not estimated—amounts.

Accordingly, at the end of a reporting period, procedures must exist to dispose of any overhead variance. An overhead variance is disposed of in one of two ways: If immaterial, it is assigned to cost of goods sold. If material, it is allocated among work-in-process inventory, finished goods inventory, and cost of goods sold.

Once an inventory of activities exists, then activity attributes are used to define activities

Activity attributes are nonfinancial and financial information items that describe individual activities. An activity dictionary lists the activities in an organization along with desired attributes. The attributes selected depend on the purpose being served.

For plantwide rates, all budgeted overhead costs are assigned to a plantwide pool (first-stage cost assignment)

Next, a plantwide rate is computed using a single unit-level driver, which is usually direct labor hours. Finally, overhead costs are assigned to products by multiplying the rate by the actual total direct labor hours used by each product (second-stage assignment). - A plantwide rate is used under the assumption that all overhead costs are largely caused by a single, unit-level cost driver such as direct labor hours or machine hours.

assignment of overhead must rely on driver tracing and perhaps allocation. Unit-based costing first assigns overhead costs to a functional unit, creating either plant or departmental cost pools. Next, these pooled costs are assigned to products using predetermined overhead rates based on unit-level drivers.

Predetermined rates are used because overhead and production often are incurred nonuniformly throughout the year, and it is not possible to wait until the end of the year to calculate the actual overhead cost assignments (managers need unit product cost information throughout the year).

Batch-level activities are those that are performed each time a batch is produced. The costs of batch-level activities vary with the number of batches but are fixed (and, therefore, independent) with respect to the number of units in each batch. Setups, inspections (if done by sampling units from a batch), purchasing, and materials handling are examples of batch-level activities.

Product-level activities are those activities performed that enable the various products of a company to be produced. These activities and their costs tend to increase as the number of different products increases.

Facility-level activities are those that sustain a factory's general manufacturing processes. Providing facilities, maintaining grounds, and providing plant security are examples.

Unit-level activities are those that are performed each time a unit is produced. Grinding, polishing, and assembly are examples of unit-level activities.

activity-based costing (ABC) system

a cost accounting system that uses both unit- and non-unit-based cost drivers to assign costs to cost objects by first tracing costs to activities and then tracing costs from activities to products.

normal cost system

a cost measurement system in which the actual costs of direct materials and direct labor are assigned to production and a predetermined rate is used to assign overhead costs to production.

Identifying activities is a logical first step in designing an activity-based costing system.

Activities represent actions taken or work performed by equipment or people for other people.

when ABC may be useful for a firm.

First, multiple products are needed. ABC offers no increase in product-costing accuracy for a single-product setting. Second, there must be product diversity. If products consume non-unit-level activities in the same proportion as unit-level activities, then ABC assignments will be the same as unit-based assignments. Third, non-unit-level overhead must be a significant percentage of production cost.

In designing an ABC system, there are six essential steps,

Identify, define, and classify activities and key attributes. Assign the cost of resources to activities. Assign the cost of secondary activities to primary activities. Identify cost objects and specify the amount of each activity consumed by specific cost objects. Calculate primary activity rates. Assign activity costs to cost objects.

Based on the answers to the interview, an activity dictionary can now be prepared

The activity dictionary names the activity (typically by using an action verb and an object that receives the action), describes the tasks that make up the activity, classifies the activity as primary or secondary, lists the users (cost objects), and identifies a measure of activity output (activity driver).

After identifying and describing activities, the next task is determining how much it costs to perform each activity.

The cost of an activity is simply the cost of the resources consumed by each activity. Activities consume resources such as labor, materials, energy, and capital. The cost of these resources is found in the general ledger, but how much is spent on each activity is not revealed. Resource costs must be assigned to activities using direct and driver tracing

Plantwide and departmental rates have been used for decades and continue to be used successfully by many organizations. In some settings, however, they do not work well and may actually cause severe product cost distortions.

Of course, to cause a significant cost distortion, overhead costs must be a significant percentage of total manufacturing costs

Primary activity rates are computed by dividing the budgeted activity costs by practical activity capacity, where activity capacity is the amount of activity output (as measured by the activity driver).

Practical capacity is the activity output that can be produced if the activity is performed efficiently.

It is possible (and likely) that the applied amount in a period differs from the actual overhead incurred for the period.

Since the predetermined overhead rate is based on estimated data, applied overhead will rarely equal actual overhead.

Consumption ratios are simply the proportion of each activity consumed by a product.

The assumed consumption ratios can also be calculated for the plantwide and overhead rates. - departmental rates are likely making a correction in the right direction (more overhead is being assigned to the robots and less to the race cars), but whether the correction is about right, too little, or too much can be assessed by calculating activity-based costs.

Budgeted overhead is simply the firm's best estimate of the amount of overhead (utilities, indirect labor, depreciation, etc.) to be incurred in the coming year.

The estimate is often based on last year's figures, adjusted for anticipated changes in the coming year. The second input requires that the predicted level for an activity driver be specified. Assignment of overhead costs should follow, as nearly as possible, a cause-and-effect relationship. Drivers are simply causal factors that measure the consumption of overhead by products. In unit-based costing, only unit-level drivers are used to calculate overhead rates.

Consumption ratios reflect the proportion of an activity consumed by the individual products.

They are especially useful to assign costs of a shared resource. For example, two individuals sharing the cost of a pizza would logically do so in proportion to the amount of the pizza consumed. In a multiple-product firm, there are many shared resources, and it is reasonable to assign the costs of shared resources in proportion to the resource consumed. Activity drivers are a measure of activity output and thus can be used as measures of activity consumption.

Products passing through the departments are assumed to consume overhead resources in proportion to the departments' unit-based drivers (machine hours or direct labor hours used).

Thus, in the second stage, overhead is assigned to products by multiplying the departmental rates by the amount of the driver used in the respective departments. The total overhead assigned to products is simply the sum of the amounts received in each department. Increased accuracy is the usual justification offered for the use of departmental rates.

Activity Rates: A Better Approach

Thus, instead of pooling the overhead costs in plant or departmental pools, rates are calculated for each individual overhead activity. The rates are based on causal factors that measure consumption (unit- and non-unit-level activity drivers). Costs are assigned to each product by multiplying the activity rates by the amount consumed by each activity (as measured by the activity driver).

For departmental rates,

overhead costs are assigned to individual production departments, creating departmental overhead cost pools. In the first stage, producing departments are cost objects, and budgeted overhead costs are assigned using direct tracing, driver tracing, and allocation. Once costs are assigned to individual production departments, then unit-level drivers such as direct labor hours (for labor-intensive departments) and machine hours (for machine-intensive departments) are used to compute predetermined overhead rates for each department

overhead variance

the difference between the actual overhead and the applied overhead.

consumption ratio

the proportion of an overhead activity consumed by a product.

Product diversity

the situation present when products consume overhead in different proportions. - Product diversity is caused by such things as differences in product size, product complexity, setup time, and size of batches.

Most ABC system designs choose between one of two types of activity drivers:

transaction drivers and duration drivers. Transaction drivers measure the number of times an activity is performed, such as the number of treatments and the number of requests. Duration drivers measure the demands in terms of the time it takes to perform an activity, such as hours of hygienic care and monitoring hours.