Ch 3

The Activity Based Costing Approach

-Two-stage cost allocation process -Stage 1: overhead costs are assigned to each activity cost pool -Stage 2: the costs in the activity cost pools are allocated to products using activity rates and activity measures

Activity Based Costing

-a technique that uses numerous allocation bases -assigns costs to the activities that are the cause of the overhead -The overhead costs are then assigned only to the products or services that are demanding the activities

Benchmarking

-alternative to activity-based management -systematic approach to identifying processes

Activity

-an event that causes the consumption of overhead resources. -Examples: material purchase orders, machine set up, maintenance and cleaning

activity-based costing benefits

-can improve accuracy of product costs by allocating overhead to multiple activity pools -helps managers understand the causes of overhead costs

Facility-Level Activities

-carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made -ex: Heating a factory, the plant security officer's work, and cleaning manager's offices

Activity Measure

-measures the amount that the activity is carried out. -For example: the number of purchase orders would drive the costs of the purchase order cost pool, the number of machine set ups would drive the cost of the machine set up pool, and the number of batches run would drive the cost of the maintenance and cleaning. -The activity measure is the allocation base for applying overhead to products and services.

departmental overhead rate

-more useful -a different predetermined rate is used by each production department -the nature by the work performed by the department will for the department's allocation base -may not sign overhead costs based on what causes those costs in situations where the department has a wide range of products and complex overhead costs -requires activity-based costing to account for the diverse factors

Batch-Level Activities

-performed each time a batch is handled or processed, regardless of how many units are in the batch -ex: 1. Setting up equipment, maintenance and cleaning of machines and shipping customer orders

Unit-Level Activities

-performed each time a unit is produced -ex: assembling a bike, painting a lamp

Product-Level Activities

-relate to specific products and must be carried out regardless of how many batches are run or units produced and sold -ex: Design, testing a proto-type or advertising a product

activity-based costing limitations

-requires substantial resources -relies on assumptions

Weaknesses of plantwide overhead rate

-result in allocation of higher overhead costs to products with a higher allocation base and lower overhead costs to products with a lower allocation base -allocation base related to volume, but the actual overhead cost may have little to do with volume or the allocation base used. this disconnect leads to distorted costs and prices.

Plantwide overhead rate

-used to assign overhead costs to product -spreads overhead costs uniformly over products in proportion to the allocation base used -popular for simplicity

designing activity-based costing system

1. identify the activities 2. activity measures 3. related activities are combined to reduce the cost of record keeping 4. activity dictionary is complied --> defining each activity included and their activity measures 5. 4 level hierarchy of activities which help show differences between an activity based costing system and a traditional costing system

the predetermined overhead rate and assignment of overhead works exactly like the job-order costing system

A predetermined overhead rate is computed for each activity. Remember that it is applied to jobs and products based on the amount of actual activity consumed by the job or product.

Design Decisions in an activity-based costing system

Often times hundreds or even thousands of different activities cause overhead costs. A reasonably small number of activities that cause the bulk of the variation in overhead costs should be chosen. Managers help identify the activities that cause most of the overhead. Related activities are often times combined to reduce the amount of detail.

Activity Cost Pool

a "cost bucket" in which costs related to a particular activity are accumulated

Hierarchy of activities

a common framework for combining activities in manufacturing companies is as follows: 1) unit-level activities 2) batch-level activities 3) product-level activities 4) facility-level activities, "organization-sustaining activities"

activity measure

allocation base for assigning overhead costs

activity based management

focuses on improving activities to eliminate waste, decrease processing time, and reduce defects

Activity-based costing causes the unit product cost of _____-volume products to decrease and causes the unit cost of ____-volume costs to increase due to batch and product-level costs being more accurately assigned under activity-based costing

high, low

Overhead shifts from ________-volume to ____-volume products

high, low

Activity Rate

is a predetermined overhead rate in an activity-based costing system. Each activity has its own activity rate

Traditional cost system applies manufacturing overhead to products based on _____________ hours

machine hours.

activity-based costing approach

technique that attempts to assign overhead costs to products by identifying the activities that cause overhead costs

traditional costing systems cause distortions because

they ignore the fact that different products place different demands on resources

activity-based costing system is used to

used to identify activities that can benefit from process improvements