Ch. 17 Activity-Based Costing and Analysis

Plantwide Rate allocation method

-Overhead allocations based on -Overhead allocation rates based on

Departmental rate allocation method

-Overhead allocations based on two or more rates -Overhead allocation rates based on volume based measure such as direct labor hours or machine hours

Overhead allocated to each product unit =

Plantwide overhead rate x direct labor hours per unit

Backflush costing

Product costing system that flushes costs of unfinished products out of Cost of Goods Sold at the end of the period.

The plantwide and departmental overhead rate methods have three key advantages

(1) They are based on readily available information, like direct labor hours. (2) They are easy to implement. (3) They are consistent with GAAP and can be used for external reporting. -Both suffer from an important disadvantage, in that overhead costs are frequently too complex to be explained by only one factor like direct labor hours or machine hours.

The departmental overhead rate method assumes that

(1) different products are similar in volume, complexity, and batch size (2) departmental overhead costs are directly proportional to the department allocation base (such as direct labor hours and machine hours for KartCo).

usefulness of the single plantwide overhead rate depends on two assumptions

(1) overhead costs change with the allocation base (such as direct labor hours) (2) all products use overhead costs in the same proportions.

three methods of overhead allocation

(1) the single plantwide overhead rate method (2) the departmental overhead rate method (3) the activity-based costing method.

Activities causing overhead costs can be separated into four levels

(1) unit-level activities (2) batch-level activities (3) product-level activities (4) facility-level activities

Disadvantages of Activity-Based Costing

- Costs to Implement and Maintain ABC - Some Product Cost Distortion Remains - Uncertainty with Decisions Remains

Advantages of Activity-Based Costing

- More Effective Overhead Cost Control - Better Production and Pricing Decisions - Additional Uses

Activity based costing allocation method

-Overhead allocations based on at least two (but often many) rates -Overhead allocation rates based on activities that drive costs, such as number of batches of product produced -attempts to more accurately assign overhead costs by focusing on activities. Unlike the plantwide rate method, ABC uses more than a single rate. Unlike the departmental rate method, ABC focuses on activities rather than departments. We illustrate the activity-based costing method of assigning overhead costs.

4 steps of the departmental overhead rate method

1 Assign overhead costs to departmental cost pools. 2 Select an allocation base for each department. 3 Compute overhead allocation rates for each department. 4 Use departmental overhead rates to assign overhead costs to cost objects (products).

4 steps to Activity Based costing

1) Identify activities and the overhead costs they cause. 2) Trace overhead costs to activity cost pools. 3) Compute overhead allocation rates for each activity. 4) Use the activity overhead rates to assign overhead costs to cost objects (products).

Batch-level activities

Activities that are performed each time a batch of goods is handled or processed, regardless of how many units are in a batch; the amount of resources used depends on the number of batches run rather than on the number of units in the batch.

Unit-level activities

Activities that arise as a result of the total volume of goods and services that are produced, and that are performed each time a unit is produced.

Facility-level activities

Activities that relate to overall production and cannot be traced to specific products; costs associated with these activities pertain to a plant's general manufacturing process.

Product-level activities

Activities that relate to specific products that must be carried out regardless of how many units are produced and sold or batches run

value-added activities

Add value to products or services

Activity-based management (ABM)

Approach that uses the link between activities and costs for better management decisions.

Costs of quality

Costs resulting from manufacturing defective products or providing services that do not meet customer expectations.

Common features of lean manufacturing include

Just-in-time (JIT) inventory systems to reduce the costs of moving and storing inventory. With JIT, raw materials are put into production after a customer order, and the finished goods are delivered soon after completion. This reduces the costs of storing and moving inventory. Cellular manufacturing, where products are made by teams of employees in small workstations ("cells"). Producing an entire product in one cell allows manufacturers to reduce machine setup times, produce in smaller batches, and meet customer orders more quickly. Building quality into products by focusing on the costs of good quality. Lean manufacturers do not have time to rework defective products and usually are not able to meet customer orders from inventory.

Cost pool activity rate =

Overhead costs assigned to pool ÷ Expected activity level

Activity overhead (cost pool) rate

Overhead rate for a pool of costs driven by the same activity. - used to assign overhead costs to final cost objects such as products. Proper determination of activity rates depends on (1) proper identification of the factor that drives the cost in each activity cost pool and (2) proper measures of activities.

Cost of quality report

Report that summarizes the costs of quality, classified by prevention, appraisal, internal failure, and external failure costs.

Lean accounting

System designed to eliminate waste in the accounting process and better reflect the benefits of lean manufacturing techniques. -Lean thinking to eliminate waste in the accounting process. -Alternative performance measures, like the percentage of products made without defects and the percentage of on-time deliveries. -Simplified product costing. With JIT, most of the product costs during a period will be included in cost of goods sold rather than in inventory. Instead of transferring costs across inventory accounts during a period, a backflush costing system measures the costs of inventory only at the end of the period. Costs of unfinished products are "flushed out" of Cost of Goods Sold and transferred to inventory accounts.

Activity cost pool

Temporary account that accumulates costs a company incurs to support an activity.

Departmental overhead rate =

Total budgeted departmental overhead cost -------------------------------------------------- Total amount of departmental allocation base

Plantwide overhead rate =

Total budgeted overhead cost / Total budgeted direct labor hours

Activity cost driver

Variable that causes an activity's cost to go up or down; a causal factor.