Chapter 4: Activity- Based Costing

ABC - what is it and how is it different from traditional costing?

ABC allocates overhead in a two stage process. 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 each individual product using the overhead rates determined for each cost pool. Then list all manufacturing costs: DM DL OH ______ Total Direct cost per unit

Value-added vs Non-Value-added activities

Activity based costing classifies all activities as either value-added or non-value added. Value-assed activities increase the worth of a product or service to the customer while non value-added activities do not increase the worth of a product or service to the customer. Value-added and non-value added lets the company know which products increase the perceived value of a product or service to customers and which activities can be eliminated. The advantage is enhanced cost control.

Advantages and disadvantages of using ABC

The book states many benefits and limitations of activity based costing. For example, the benefits of activity based costing include the increased number of cost pools that can be used to assign overhead, the better control over costs associated with overhead, and better management decisions. On the contrary, there are also limitations that come with activity based costing. The limitations include the higher measurement and analysis costs that come with multiple activity centers and cost drivers, and activity based costing is not completely accurate since some overhead costs still need to be assigned using "arbitrary cost drivers".

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 products, not with the number of units produced. examples: -equipment setups, -purchase ordering, -inspection, -materials handling

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. examples: -machine related: drilling, cutting, milling, trimming, pressing -labor related: assembling, painting, sanding, sewing, polishing

Facilities 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. examples: -plant management salaries -plant depreciation -property taxes -utilites -interviews of prospective employees -health and safety

Activity classification - Unit-level, Batch-level, Product-level, Facility-level

-First shift supervisor's salary= facility level -Powdered raw plastic= unit-level -Dies for casting plastic components= product-level -Depreciation on injection molding machines= unit-level -Changing dies on machines= batch level -Moving components to assembly department= batch-level -Engineering design= product-level -Employee health and medical insurance coverage= facility-level

ABC for service companys

Activity based costing is the same to service industries as it is to manufacturing companies since the objective is the exact same. The overall objective when using activity based costing with both service industries and manufacturing companies is to improve costing of services perfume and the approach to do so is the same as well. The book gives us the four steps of activity based costing which is listed as: identify and classify the activities and assign overhead to cost pools, identify the cost driver, compute the activity based overhead rate, and lastly, allocate overhead costs to products. The same steps apply for a service industry.

ABC Overhead Rate - know how to calculate and how to use

Estimated overhead per activity/ expected use of cost drivers per activity

Applied overhead - be able to apply overhead to products using an ABC system

To allocate overhead costs to each product, a company multiplies the activity-based overhead rates per cost driver by the number of cost drivers expected to be used per product. For both products: Expected use of cost drivers per product X Activity based overhead rates= cost allocated (a) total costs allocated (b) units produced Overhead cost per unit a/b

ABC vs Traditional Costing - know how to compare the two methods of overhead application

Traditional Costing system: uses a single predetermined overhead rate based on direct labor hours. Each product will be allocated the same amount of overhead because both products will use the same amount of the cost drive (direct labor hours for example). ABC Costing: allocates overhead to products based on multiple cost drivers. Note that ABC does not change the amount of overhead costs. Under both traditional and ABC, a company spends the same amount of overhead. However, ABC allocates overhead costs in a more accurate manner.

Product level activites

are performed every time a company produces a new type of product. For example, before a pharmaceutical company can product 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. examples: - product design -engineering changes -engineering design -toy design