Accounting II Activity Based Costing

Direct labor is an appropriate activity base when

(a) direct labor constitutes a significant part of total product cost, and (b) a high correlation exists between direct labor and changes in the amount of overhead costs.

Step 3 of ABC

Compute the activity based overhead rate per cost driver by dividing to get an activity based overhead rate for each pool. estimated overhead per activity / expected use of cost drivers per activity.

Step 4 of ABC

Determine expected use of cost drivers for each product. Multiply the activity based overhead rates per cost driver by the number of cost drivers expected to be used per product.

Step 1 of ABC

Identify activity cost pools and assign estimated overhead costs to each.

Step 2 of ABC

Identify the cost driver(activity base) for each pool that has the highest degree of correlation to the actual consumption used.

Benefits of ABC

It leads to more accurate product costing since it contains cost pools, leads to more control over overhead costs, and leads to better management decisions.

traditional costing overhead

Predetermined overhead rate x direct labor hours = overhead cost per unit.

Two stage process for ABC

The first stage allocates overhead costs to activity cost pools. (Traditional costing systems, in contrast, allocate these costs to departments or to jobs.) Examples of overhead cost pools are ordering materials, setting up machines, assembling products, and inspecting products. The second stage assigns the overhead allocated to the activity cost pools to products, using cost drivers. The cost drivers measure the number of individual activities undertaken or performed to produce products or provide services. Examples are number of purchase orders, number of setups, labor hours, and number of inspections.

no different

The overall objective of ABC in service firms is ___________ than it is in a manufacturing company. That objective is to identify the key activities that generate costs and to keep track of how many of those activities are performed for each service provided (by job, service, contract, or customer).

Negatives of ABC

This method can be expensive to use and some arbitrary allocations continue.

service company

a larger proportion of overhead costs are company-wide costs that cannot be directly traced to specific services provided by the company.

Activity based management

a method of management decision making that uses activity based costing info to improve customer satisfaction and profitability. It focuses on reducing costs and improving processes and decision making.

cost driver

is any factor or activity that has a direct cause-effect relationship with the resources consumed. The reasoning behind ABC cost allocation is simple: Products consume activities, and activities consume resources.

activity cost pool

is the overhead cost attributed to a distinct type of activity (e.g., ordering materials or setting up machines).

4 steps for ABC

1. Identify and classify the activities involved in the manufacture of specific products, and allocate overhead to cost pools. 2. Identify the cost driver that has a strong correlation to the costs accumulated in the cost pool. 3. Compute the activity-based overhead rate for each cost driver. 4. Assign overhead costs to products, using the overhead rates determined for each cost pool (cost per driver).

When to use ABC

1. Product lines differ greatly in volume and manufacturing complexity. 2. Product lines are numerous and diverse, and they require differing degrees of support services. 3. Overhead costs constitute a significant portion of total costs. 4. The manufacturing process or the number of products has changed significantly—for example, from labor-intensive to capital-intensive due to automation. 5. Production or marketing managers are ignoring data provided by the existing system and are instead using "bootleg" costing data or other alternative data when pricing or making other product decisions.

Value based activities

activities of a company's operations that increase the perceived worth of a product or service to customers. Ex. design, machining, assembly, painting.

Non value based activities

activities that, if eliminated, would not hinder the company's operations or reduce the perceived worth of its product or service. These activities simply add cost to, or increase the time spent on, a product or service without increasing its perceived value. Ex. inventory storage, moving materials, work in process, or finished goods from one location to another in the plant during the production process

activity based costing

allocates overhead to multiple activity cost pools, and it then assigns the activity cost pools to products and services by means of cost drivers.

product level activities

are performed every time a company produces a new type of product. For example, before a pharmaceutical company can produce and sell a new type of medicine, it must undergo very substantial product tests to ensure the product is effective and safe. The amount of time spent on testing activities increases with the number of products the company produces.

batch level activities

are performed every time a company produces another batch of a product. For example, suppose that to start processing a new batch of ice cream, an ice cream producer needs to set up its machines. The amount of time spent setting up machines increases with the number of batches produced, not with the number of units produced.

Unit level activities

are performed for each unit of production. For example, the assembly of cell phones is a unit-level activity because the amount of assembly the company performs increases with each additional cell phone assembled.

factory level activities

are required to support or sustain an entire production process. Consider, for example, a hospital. The hospital building must be insured and heated, and the property taxes must be paid, no matter how many patients the hospital treats. These costs do not vary as a function of the number of units, batches, or products.