Chapter 4 Managerial Accounting
Activity based costing (ABC)
assigns overhead cost by focusing on activities
Both the plantwide and departmental overhead rate methods have three strengths:
1) They use readily available information like direct labor hours or machine hours 2) They are easy to implement 3) They comply with GAAP and can be used for external reporting
The department overhead rate method assumes that:
1) different products that are similar in volume, complexity, and batch size 2) departmental overhead costs are proportional to the department allocation base
Activities causing overhead can be separated into four levels:
1) unit level activities 2) batch level activities 3) product level activities 4) facility level activities
Departmental overhead Steps
1. Assign a budgeted overhead cost to department cost pools 2. Select an allocation base and compute an overhead allocation rate for each department 3. Allocate overhead costs to cost objects
Activity based costing follows three steps:
1. Identify activities and assign budgeted cost to activity cost pools 2. Compute an overhead activity rate for each activity cost pool 3. Allocate overhead costs to cost objects
Weaknesses of Plantwide and Departmental Overhead Rate methods:
Overhead cost is often too complex to be explained by factors like direct labors or machine hours
Activity-based management (ABM)
an outgrowth of ABC that uses the link between activities and costs for better management
Batch level activities
are performed on each batch of units -Batch level costs do not vary with the number of units, but instead vary with the number of batches
Product level activities
are performed on each product line and are not affected by either numbers of units or batches -Product level costs do not vary with the number of units or batches produced
activity cost pool
group of costs that are related to the same activity
Unit level activities
performed on each unit -unit level costs tend to change with the number of units produced
Examples of activities
production setups, machine usage, fabrication, design, assembly, and inspections
Under the plantwide overhead rate method, total budgeted overhead costs are divided by the allocation base, such as total budgeted direct labor hours, to get a plantwide overhead rate. This rate is used to allocate overhead costs to products based on the actual amount of allocation base used.
true
Unlike plantwide rate method, ABC uses more than a single rate. ABC focuses on activities rather than departments.
true
When overhead cost bears little relation to the allocation base, allocating overhead cost using a single plantwide overhead rate can distort product cost and lead to poor managerial decisions
true
With the plantwide and departmental methods, low volume complex products are often undercosted, and high-volume simpler products are often overcoasted
true
plantwide overhead rate uses one overhead rate to allocate overhead costs
true
cost object
unit of production (the rate is determined using a volume-related measure such as direct labor hours or machine hours)
Disadvantages of Activity Based Costing
1. Costly to Implement and Maintain -ABC systems are costly. ABC requires a through analysis of cost activities and cost drivers, which can be expensive. 2. Product Cost Distortion -Two sources of cost distortion are 1) when costs cannot be readily classified into activity cost pools 2) when cost drivers do not have a strong cause-effect relation with costs 3. Not compliant with GAAP Activity-based costing cannot be used for external financial reporting purposes under GAAP
Advantages of Activity Based Costing
1. More effective overhead cost -ABC can be used to identify activities that can benefit from process improvement by focusing on activities 2. Better Production and Pricing Decisions -ABC can provide more accurate overhead cost allocation. More accurate costs allow managers to focus production activities on more profitable products and to more accurately set selling prices
The usefulness of the single plantwide overhead rate depends on two assumptions
1. overhead costs change with allocation base and 2. all products use overhead cost in the same proportions
Customer support activity rate
Budgeted customer support cost/ budgeted technician miles
activity cost driver
factor that causes the cost of an activity to go up or down
Facility level activities
sustain facility as a whole and are not caused by any specific product -rent and factory maintenance costs are incurred no matter what is being produced
Activity-based management can help distinguish value-added activities which add value to a product from non-value-added activities, which do not.
true
Analyzing activities leads many companies to supply chain management, which involves coordination and control of goods, services, and information as they move from suppliers to consumers
true
Because departmental overhead rate method allocates overhead cost based on measures closely related to production volume, it fails to accurately assign many overhead costs
true
Each department has its own overhead rate and its own allocation base.
true
Laboratories performing medical tests, accounting and law offices, and advertising agencies are other examples of service firms that benefit from ABC
true
The basic principle underlying activity-based costing is that an activity, which is a task operation, or procedure, is what causes overhead cost to be incurred.
true
The departmental overhead rate method uses a different overhead rate for each department.
true
The plantwide and departmental methods do not capture the products' different use of activities, and can distort overhead cost allocations
true