Accounting 211 Chapter 3 Notes

Limitations of ABC (p133)

1.) The cost of implementing and maintaining an activity-based costing system may outweigh the benefits. 2.) It would be naïve to assume that product costs provided even by an activity-based costing system are always relevant when making decisions.

Reason for Activity Based Costing (p118)

A plantwide predetermined overhead rate spreads overhead costs uniformly over products in proportion to whatever allocation base is used—most commonly, direct labor-hours. This procedure results in high overhead costs for products with a high direct labor-hour content and low overhead costs for products with a low direct labor-hour content. However, the real causes of overhead may have little to do with direct labor-hours and as a consequence, product costs may be distorted. Activity-based costing attempts to correct these distortions by more accurately assigning overhead costs to products.

Activity Based Management (p131)

Activity-based management involves focusing on activities to eliminate waste, decrease processing time, and reduce defects. The activity rates computed in activity-based costing can provide valuable clues concerning where there is waste and opportunity for improvement.

Activity Cost Pool (p121)

An activity cost pool is a "cost bucket" in which costs related to a particular activity measure are accumulated.

Activity Rate (p121)

An overhead rate in an activity-based costing system. Each activity has its own activity rate that is used to assign overhead costs to cost objects.

Modifying the ABC Model (134)

In order to make the ABC model more accurate some SG&A could be included. Also some facility level activity could be taken out.

Designing an ABC System (p121)

The challenge in designing an activity-based costing system is to identify a reasonably small number of activities that explain the bulk of the variation in overhead costs. This is usually done by interviewing a broad range of managers to find out what activities they think are important and that consume most of the resources. This list is refined and pruned in consultation with top managers where related activities are frequently combined to reduce the amount of detail and record-keeping cost. The end result of this stage of the design process is an ACTIVITY DICTIONARY that defines each of the activities that will be included in the activity-based costing system and how the activities will be measured.

Plantwide Overhead Rate (p119)

This is the simplest and yet least accurate method for allocating overhead costs. Direct labor and overhead costs have been moving in opposite directions for a long time. As a percentage of total cost, direct labor has been declining, whereas overhead has been increasing. Many tasks previously done by hand are now done with largely automated equipment—a component of overhead However, direct labor is an appropriate allocation base for overhead when overhead costs and direct labor are highly correlated.

Unit-Level Activities (p122)

Unit-level activities are performed each time a unit is produced. The costs of unit-level activities should be proportional to the number of units produced. For example, providing power to run processing equipment is a unit-level activity because power tends to be consumed in proportion to the number of units produced.

Accuracy of Product Costs through ABC (p131)

Activity-based costing improves the accuracy of product costs in three ways. 1.) ABC usually increases the number of cost pools used to accumulate overhead costs. 2.) The activity cost pools are more homogeneous than departmental cost pools. 3.) ABC uses a variety of activity measures to assign overhead costs to products, some of which are correlated with volume and some of which are not.

Benchmarking (p131)

A systematic approach to identifying the activities with the greatest room for improvement. It is based on comparing the performance in an organization with the performance of other, similar organizations known for their outstanding performance.

Activity Based Costing (p120)

Rather than a single allocation base such as direct labor-hours or machine-hours, in activity-based costing a company uses a number of allocation bases for assigning costs to products. Each allocation base in an activity-based costing system represents a major activity that causes overhead costs. An activity in activity-based costing is an event that causes the consumption of overhead resources. Taking each activity in isolation, this system works exactly like the job-order costing system described in the last chapter. An activity rate is computed for each activity and then these rates are used to assign costs to jobs and products based on the amount of activity consumed by the job or product.

Activity Measure (p121)

The activity measure expresses how much of the activity is carried out and it is used as the allocation base for assigning overhead costs to products and services.

Cost Hierarchy of ABC (p122, exhibit 3-2)

Activities are grouped into a four-level hierarchy: Unit-level activities Batch-level activities Product-level activities Facility-level activities. This cost hierarchy is useful in understanding the difference between activity-based costing and conventional approaches. It also serves as a guide when simplifying an activity-based costing system. In general, activities and costs should be combined in the activity-based costing system only if they fall within the same level in the cost hierarchy.

Benefits of ABC (p131)

Activity-based costing improves the accuracy of product costs, helps managers to understand the nature of overhead costs, and helps target areas for improvement through benchmarking and other techniques. Because conventional costing systems typically apply overhead costs to products using direct labor-hours, it may appear to managers that overhead costs are caused by direct labor-hours. Activity-based costing makes it clear that batch setups, engineering change orders, and other activities cause overhead costs rather than just direct labor. Managers thus have a better understanding of the causes of overhead costs, which should lead to better decisions and better cost control. ABC highlights the activities that could benefit most from process improvement initiatives. Thus, activity-based costing can be used as a part of programs to improve operations.

Increasing Returns to Scale (p133)

As activity increases, the average cost drops. As a practical matter, this means that product costs computed by a traditional or activity-based costing system will be overstated for the purposes of making decisions.

Batch-Level Activities (122)

Batch-level activities consist of tasks that are performed each time a batch is processed, such as processing purchase orders, setting up equipment, packing shipments to customers, and handling material. Costs at the batch level depend on the number of batches processed rather than on the number of units produced. For example, the cost of processing a purchase order is the same no matter how many units of an item are ordered.

Which Companies will Benefit from ABC (p133)

Companies that have some of the following characteristics are most likely to benefit from activity-based costing: 1. Products differ substantially in volume, batch size, and in the activities they require. 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 cost system and ignores cost data from the system when making decisions.

3 Methods of Assigning Overhead Costs (p118)

Companies use three common approaches to assign overhead costs to products. The simplest method is to use a plantwide overhead rate. A slightly more refined approach is to use departmental overhead rates. The most complex method is activity-based costing, which is the most accurate of the three approaches to overhead cost assignment.

Computing Activity Rates (p127)

Define each activity and allocate by product 1. Determine the amount of each Activity Cost Pool 2. Divide step 1 by the Total Expected Activity 3. This gives you the Activity Rate This is done for each activity to allocate the overhead by product.

Facility-Level Activities (p123)

Facility-level activities (also called organization-sustaining activities) are activities that are carried out regardless of which products are produced, how many batches are run, or how many units are made. Facility-level costs include items such as factory management salaries, insurance, property taxes, and building depreciation. These costs cannot be traced on a cause-and-effect basis to individual products. Therefore, companies that choose to implement an activity-based absorption costing system will be required to arbitrarily allocate facility-level cost to products.

Departmental Overhead Rate (p119)

In this method the nature of the work performed in a department will determine the department's allocation base. For example, overhead costs in a machining department may be allocated on the basis of machine-hours. In contrast, the overhead costs in an assembly department may be allocated on the basis of direct labor-hours. Unfortunately, even departmental overhead rates will not correctly assign overhead costs in situations where a company has a range of products and complex overhead costs. The reason is that the departmental approach usually relies on a single measure of activity as the base for allocating overhead cost to products.

Product-Level Activities (p123)

Product-level activities (sometimes called product-sustaining activities) relate to specific products and typically must be carried out regardless of how many batches or units of the product are manufactured. Product-level activities include maintaining inventories of parts for a product, issuing engineering change notices to modify a product to meet a customer's specifications, and developing special test routines when a product is first placed into production.