Managerial Accounting – Chapter 4: Activity-Based Costing – Flashcards
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Traditional Costing Systems
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Allocated overhead using a single predetermined rate; Assumption was satisfactory when DL was a major portion of total manufacturing costs; Wide acceptance of a high correlation between DL & overhead costs; 1 bucket approach - Job Order Costing - Process Costing
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Job Order Costing
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Direct Labor Cost may be the relevant activity base
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Process Costing
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Machine hours may be the relevant activity base
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Demand for a New Approach
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Tremendous change in manufacturing & service industries: advances in computerized systems, technological innovation, global competition, & automation; Decrease in amount of DL usage; Significant increase in total overhead costs; Inappropriate to use plant-wide (single rate to assign all overhead costs) predetermined overhead rates when a lack of correlation exists; Complex manufacturing processes may require multiple allocation (activity) bases
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Activity-Based Costing (ABC)
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A new approach; Allocates overhead to multiple activity cost pools & assigns the activity cost pools to products or services by means of cost drivers; Products consume activities, & activities consume resources; Multiple buckets approach; The more complex a product's manufacturing operation, the more activities & cost drivers that are likely to be present; Allocates overhead costs in 2 stages; Involves 4 steps
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Activity
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Any event, action, transaction, or work sequence that incurs cost when producing a product or providing a service
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Activity Cost Pool
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The overhead costs attributed to a distinct type of activity; Example: ordering materials or setting up machines
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Cost Drivers
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Any factors or activities that have a direct cause-effect relationship with the resources consumed
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Stage 1 of ABC
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Overhead costs are allocated to activity cost pools
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Stage 2 of ABC
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Assigns the overhead allocated to the activity cost pools to products, using cost drivers
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Step 1 of ABC
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Identify & Classify Activities & Allocate Overhead to Cost Pools; Overhead costs are assigned directly to the appropriate activity cost pool
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Step 2 of ABC
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Identify Cost Drivers; Cost driver must accurately measure the actual consumption of the activity by the various products
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Step 3 of ABC
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Compute Overhead Rates; Compute an activity-based overhead rate per cost driver
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Step 4 of ABC
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Assign Overhead Cost to Products; In assigning overhead costs, it is necessary to know the expected use of cost drivers for each product; A low volume product (produces fewer units of product) requires more set-ups & inspections than a high volume product
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Overstating Total Cost per Unit
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When total cost per unit is higher with Traditional Costing than with ABC; The company is overpricing the product & possibly losing market share to competitors
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Understating Total Cost per Unit
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When total cost per unit is lower with Traditional Costing than with ABC; The company is sacrificing profitability by underpricing the product
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Pros of ABC
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More accurate product costing through: - Use of more cost pools to assign overhead costs - Enhanced control over overhead costs - Better management decisions
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Cons of ABC
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- Can be expensive to use - More arbitrary allocations continue
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Factors to Consider with ABC
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1) Product lines differ in volume & manufacturing complexity 2) Product lines are numerous & diverse 3) Overhead costs constitute a significant portion of total costs 4) The manufacturing process or the # of products has changed significantly 5) Production or marketing managers are ignoring data provided by the existing system
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Activity Based Management (ABM)
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An extension of ABC from a product costing system to a management function that focuses on reducing costs & improving processes & decision making; - Value-Added Activities - Non-Value-Added Activities
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Value-Added Activities
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An activity that increases the perceived worth of a product or service; - Examples for Manufacturing Company - Examples for Service Company
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Value-Added Activities for a Manufacturing Company
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- Engineering design - Machining services - Assembly - Painting
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Value-Added Activities for a Service Company
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- Performing surgery - Legal research - Delivering packages
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Non-Value-Added Activities
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An activity that adds cost to, or increases the time spent on, a product/service without increasing its market value; Something that won't cause customers to pay extra for - Examples for Manufacturing Company - Examples for Service Company
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Non-Value-Added Activities for a Manufacturing Company
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- Repair of machines - Storage of inventory - Moving of inventory - Building maintenance - Inspections - Inventory control
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Non-Value-Added Activities for a Service Company
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- Taking appointments - Reception - Bookkeeping & billing - Traveling - Ordering supplies - Advertising
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ABC in Services Industries
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Overall objective: Identify key cost-generation activities & keep track of quantity of activities performed for each service provided; General approach is to identify activities, cost pools, & cost drivers; Labeling of activities as value-added or non-value-added; A larger proportion of overhead costs are company-wide costs that cannot be directly traced to specific services provided by the company
