Managerial Accounting - Traditional Costing & ABC

List three factors that are important when selecting cost drivers for ABC costing.

(a) Degree of correlation between consumption of an activity and consumption of the cost driver. (b) Cost of measurement of the cost driver. (c) Behavioral effects, that is, how the cost driver selected will affect the behavior of the individuals involved in the activity related to the cost driver.

Breifly explain two factors which result in product cost distortion under traditional volume based product costing.

(a) Non-unit level overhead costs: Many overhead costs vary with cost drivers that are not unit-level activities. Use of a unit-level cost driver to assign such costs tends to result in cost distortion. (b) Product diversity: When a manufacturer produces a diverse set of products, which exhibit different consumption ratios for overhead activities, use of a single cost driver to assign costs results in cost distortion.

overhead rate

(total manufacturing - overhead costs ) /(budgeted direct - labour cost)

How can ABC be used?

-ABC assigns both manufacturing and non-manufacturing costs to products -Allocation bases used usually differ from traditional costing systems, ABC is more likely to have more than one cost pool and more than one cost driver to allocate overhead costs -can be used in internal decisions making, e.g if a company needs to deciede whether to withdraw a product from the market or not -inventory evaluation

Costing Systems and firm profitability

-Traditional and ABC result in different cost figures this will have an impact on: -Pricing Decisions -Product discontinuation decisions -overall, measuring product costs accurately enables a company to evaluate product profitability -estimating costs of new product

Background

-both manufacturing and service industries have experienced remarkable changes -International competition, technological advancements, service economy, growth of internet, trend towards outsourcing -Management accounting plays a central role in helping firms address the new challenges and compete effectively

Cost drivers

-make sure the cost driver is highly correlated to manufacturing, processing, sale -if it shifts the cost driver might not be representive any more -for example if the firms shifts from labour manufacturing to machine manufacturing labour hours might not be the best representitive anymore

Selection of drivers

-the degree of correlation, between cost pool and cost driver -the cost of measurement of cost drivers -behavioural effects, that the cost driver has on managerial behaviour

Traditional Costing (absportion costing)

-were created when manufacturing proceses were labour intensive -a signle company-wide overhead rate based on direct labour hours may be used to allocate overhead to products in these labour intensive processes to what extent is this still appropriate?

ABC stages

1) the costs of an organisations significant activites are first isolated into COST POOLS the cost pools (and related costs) fall into the following broad categories, which collectively are known as cost hierarchy: unit level batch level product line distribution channel customer level facility sustaining 2)the step involves identification of a COST DRIVER for each pool The system then assigns overhead costs by using the cost drivers and assesing the relative porportion of the activity consumed by a product This process results in the calculation of a pool rate, a cost for each "product line" and eventual cost per unit

What are cost drivers? what are their role in activity based costing?

A cost driver is a characteristic of an event or activity that results in the incurrence of costs by that event or activity. In activity-based costing systems, the most significant cost drivers are identified. Then a database is created that shows how these cost drivers are distributed across products. This database is used to assign costs to the various products depending on the extent to which they use each cost driver In activity-based costing, an activity cost driver drives the costs of labor, maintenance or other variable expenses.

ABC & decision making

ABC improves pricing decisions because product costs are more accurate estimates of oppurtunity cost -low volume high complexity products should get higher prices or be dropped -ABC focuses attention on reducing use of activites that are more associated with costs

ABC & Traditional costing

All high for ABC, all low for Traditional Level of complexity cost of implemntation level of benefits

Explain how an activity based costing system operates.

An activity-based costing system is a two-stage process of assigning costs to products. In stage one, activity-cost pools are established. In stage two a cost driver is identified for each activity-cost pool. Then the costs in each pool are assigned to each product line in proportion to the amount of the cost driver consumed by each product line.

Breifly explain how a traditional volume based product costing system operates.

In a traditional, volume-based product-costing system, only a single predetermined overhead rate is used. All manufacturing-overhead costs are combined into one cost pool, and they are applied to products on the basis of a single cost driver that is closely related to production volume. The most frequently used cost drivers in traditional product-costing systems are direct-labor hours, direct-labor dollars, machine hours, and units of production.

Different Cost Drivers

Lot Size, Direct labour hours, Design time, Machine hours, Proccess setup, Customer contact

Difference

Main difference is that instead of putting all the overhead costs in one basket you have different activity centres or cost pools

why do product costing systems based on a single based cost driver often overvalue high volume products? What is the effect of this?

Product-costing systems based on a single, volume-based cost driver tend to overcost high-volume products, because all overhead costs are combined into one pool and distributed across all products on the basis of only one cost driver. This simple averaging process fails to recognize the fact that a disproportionate amount of costs often is associated with low-volume or complex products. The result is that low-volume products are assigned less than their share of manufacturing costs, and high-volume products are assigned more than their share of the costs.

ABC

Resource Costs (directly traced or allocated) I Cost Pools: Activites or Activity Centres (cost driver rate for each activity) I Cost objective

Traditional Costing

Resource Costs (directly traded or allocated) I Cost Pools: Plant or Department (predetermined overhead rate) I Cost obejctives

Absorption cost vs ABC

Similarities: direct and unit-level costs are allocated the same Differences: ABC allocates more indirect costs to products with smaller production volume and more complex set-up

List and describe the activities involved in the first stage of activity based costing.

The four broad categories of activities identified in an activity-based costing system are as follows: (a) Unit-level activities: Must be done for each unit of production. (b) Batch-level activities: Must be performed for each batch of products. (c) Product-sustaining activities: Needed to support an entire product line. (d) Facility-level (or general-operations-level) activities: Required for the entireproduction process to occur.

ABC

costing is improved when ABC is used; as the system identifies products that were overcosted or undercosted by traditional methods ABC uses multiple drivers because more than one item drives the costs of an organisation. Not all activites are unit-level in nature, and ABC allows a user to recognise batch product-sustaning and facility level activities

when to use ABC

more than one product produce in complexity if sales are increasing and profits are declining if profit margins are difficult to explain if costs are not defined in an accurate way

Disadvantages of Traditional costing

systems overcost high volume products lines and undercost complex, relatively low-volume lines. The high volume esstentially subsidise the low volume lines. In ABC, activites become the vital link between resources and cost objects.

Costing system

the main objective of a costing system is to allocate overhead costs. The main concern is the overhead costs, the cost that cannot directly be assignd to a product or service direct material cost, direct labour cost can be allocated directly.

Cost pools

the more activity cost pools there are in an activity based system, the greater will the accuracy of the cost assignment be. However more cost pools also means more cost dirvers, which results in greater costs of implementing and maintaining the system

ABC in Service Industry

Even though ABC has its orgins in manufacturing firms, many service firms are obtaining great benefits from this approach as well in practice it is applicable to both the manufacturing and service industries