Ch. 4 - Activity-Based Costing - ACCT 2302

Cost shifting from High to Low 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

activity rate

a predetermined overhead rate for each activity cost pool

Activity-based costing (ABC) similarities to job-order costing

- for each activity in isolation, this system works exactly like the job-order costing system - a POHR is computed for each activity and the applied to jobs and products based on the amount of activity consumed by the job or product

Designing an Activity-based costing (ABC) - combining activities

- related activities are frequently combined to reduce the amount of detail and record-keeping costs - for example, several actions may be involved in moving and handling raw materials, but these may be combined into a single activity titled material handling

activity cost pool

A "cost bucket" in which costs related to a single activity measure are accumulated.

Platwide overhead rate

A single overhead rate that is used throughout an entire factory

1. Comtek Inc. makes two products: GPS systems and Phone systems. 2. The company has been losing bids to supply GPS systems to lower-priced competitors. 3. The company has been winning all bids to supply Phone systems. 4. For the current year, Comtek has budgeted sales of 50,000 Phone units and 200,000 GPS units. 5. Contek's traditional costing system applies manufacturing overhead to products based on direct labor-hours. 6. Both products require 2 direct labor-hours to complete.

PHONES: 50,000 units * 2 DLH = 100,000 hours GPS: 200,000 units * 2 DLH = 400,000 hours TOTAL DIRECT LABOR-HOURS: 500,000 UNIT COSTS (given) Direct Material: 90 (P), 50 (G) Direct Labor: 20 (P), 20 (G)

...continued Total manufacturing overhead costs for the current year are estimated to be $10,000,000. The company develops the following overhead rate based upon direct labor-hours:

POHR = 10,000,000 / 500,000 POHR = $20 per DLH

Hierarchy of Activities

1. unit level 2. batch level 3. product level 4. facility level

If the system is used fro internal decision-making purposes, two important modifications should be made:

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

Departmental Overhead Rates - Definition

- System in which each department has its own overhead rate - Examples (Machining, assembly, shipping) - Allocation base depends on nature of work (direct labor hours, machine hours, etc)

Activity-based costing (ABC)

- a technique to assign product costs based on links between activities that drive costs and the production of specific products - uses multiple allocation bases for assigning costs to products - each base represents a major activity - activity is an even that causes major consumption of overhead resources

Designing an Activity-based costing (ABC) - challenges

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

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 - relies on a single measure of activity as an allocation base while some overhead costs may be caused by factors that are not directly proportional to the volume of production - ABC is used to account for these other factors and more accurately assigns overhead costs to products

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

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 production costs 3. Managers believed direct labor and overhead costs were highly correlated

Computing overhead cost per unit - Phones & GPS

1. Expected Activity * Activity Rate + 2. Expected Activity * Activity Rate + 3. Expected Activity * Activity Rate + 4. Expected Activity * Activity Rate + 5. Expected Activity * Activity Rate + 6. Expected Activity * Activity Rate ---------------------------------------- = Total Overhead Cost Assigned / Number of Units Produced ---------------------------------------- = Overhead Cost Per Unit

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. many companies in today's business environment.

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. highlights activities that could benefit most from process improvement efforts

costs of implementing an ABC 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 costs system and it ignores data from it when making decisions 5. 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

examples of activities

1. setting up machines 2. admitting hospital patients 3. billing customers 4. opening a bank account

Computing activity rates

Calculate each activity rate: Estimated Overhead Cost ----------------------------- Total Expected Activity

...continued Since each product requires 2 hours of direct labor, $40 of overhead is assigned to each product

DIRECT MATERIALS = 90 (P), 50 (G) DIRECT LABOR = 20 (P), 20 (G) MAN. OVERHEAD = 40 (P), 40 (G) UNIT PRODUCT COST = 150 (P), 110 (G)

activity based management

Focuses on managing activities to eliminate waste and reduce delays and defects

Overhead cost per unit

Total Cost assigned / Total units produced

ABC vs Traditional

Traditional assigns same amount of all overhead costs to each Phone and GPS unit ($40 per unit)

activity dictionary

defines each of the activities that will be included in the activity-based costing system and how the activities will be measured

activity measure

expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs