Chapter 4 - Activity- Based Costing (ABC)

ABC Benefits

-ABC leads to more cost pools and therefore more accurate product costing. -ABC leads to enhanced control over overhead costs. -ABC leads to better management decisions.

ABC Limitations

1. Expensive to use 2. Some arbitrary allocations remain

ACTIVITY

Any event, action, transaction, or work sequence that incurs costs when producing a product or performing a service.

Non-value-added activities

Non-value-added activities simply add cost to, or increase the time spent on, a product or service without increasing its perceived value. One example is inventory storage. If a company eliminated the need to store inventory, it would not reduce the value of its product, but it would decrease its product costs.

ACTIVITY COST POOL

The overhead cost attributed to a distinct activity (e.g., ordering materials or setting up machines).

Value-added activities

Value-added activities are those activities of a company's operations that increase the perceived value of a product or service to customers. Examples for the manufacture of Precor exercise equipment include engineering design, machining, assembly, and painting. Examples of value-added activities in a service company include performing surgery at a hospital, performing legal research at a law firm, or delivering packages by a freight company.

Activity-Based Costing Steps (4)

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

Factors for use of ABC

1. Product lines differ greatly in volume and manufacturing complexity. 2. Product lines are numerous and diverse, requiring various 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.

CLASSIFICATION OF ACTIVITY LEVELS

1. 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. 2. 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. 3. 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. 4. Facility-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.

Activity-based costing (ABC)

Activity-based costing (ABC) is an approach for allocating overhead costs. Specifically, ABC allocates overhead to multiple activity cost pools and then assigns the activity cost pools to products and services by means of cost drivers.

Activity-based management (ABM)

Activity-based management (ABM) extends the use of ABC from product costing to a comprehensive management tool that focuses on reducing costs and improving processes and decision-making.

Activity-based overhead rate

Activity-based overhead rate per cost driver by dividing the estimated overhead per activity by the number of cost drivers expected to be used per activity.

COST DRIVER

Any factor or activity that has a direct cause-effect relationship with the resources consumed.

ABC 2 Step Overhead Allocation Process

The first stage (Step 1) assigns 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 (Steps 2-4) allocates the overhead in the activity cost pools to products, using cost drivers. The cost drivers measure the number of individual activities undertaken to produce goods or perform services. Examples are number of purchase orders, number of setups, labor hours, and number of inspections.