Name two traditional costing systems.
What are examples for the activity base?
- Job order costing (direct labor cost)
2. Process costing (machine hours)
What does a costing system?
Allocates overhead using a predetermined rate.
Why is there a need to switch from the traditional costing system to activity-based costing (ABC)?
- Change in manufacturing and service industries
- Decrease in amount of direct labor usage
- Significant increase in total overhead costs
- Inappropriate to use plant-wide predetermined overhead rates when a lack of correlation exists
- Complex manufacturing processes may require multiple allocation bases
What is the ABC approach?
An approach for allocating overhead costs
- Allocates overhead to multiple activity cost pools
- Assigns the activity cost pools to products or services by means of cost drivers
ABC has a key concept:
Activity, Activity cost pool and cost driver
Explain each word.
Activity: Any event, action, transaction or work sequence that incurs costs when producing a product or performing a service
Activity cost pool: The overhead cost attributed to a distinct activity
Cost driver: Any factor or activity that has a direct cause-effect relationship with the resources consumed
What are the four steps of Activity-Based Costing?
- Identify and classify the activities involved in the manufacture of specific products and assign overhead to cost pools.
- Identify the cost driver that has a strong correlation to the costs accumulated in each cost pool.
- Compute the activity-based overhead rate for each cost pool.
- Allocate overhead costs to products using the overhead rates determined for each cost pool.
ABC allocates overhead in a two-stage process.
Name the Stages and the corresponding steps.
Stage 1: Overhead costs are assigned to activity cost pools (Step 1).
Stage 2: Allocates overhead assigned to the activity cost pools to products, using cost drivers (Steps 2-4).
Link between cost drivers and complex operations.
The more complex a product’s manufacturing operation…
….the more activities and cost drivers are likely to be present.
Cost driver must accurately measure…
….the actual consumption of the activity by the various products.
How to compute an activity-based overhead rate
per cost driver?
Estimated overhead per activity/Expected use of cost driver per activity
What are likely consequence of differences in assigning overhead(overstated, understated)?
Overpricing one product and possibly losing market
share to competitors.
Sacrificing profitability by underpricing the second product.
what are the three primary benefits of ABC?
- More cost pools, therefore more accurate product costing.
- Enhanced control over overhead costs.
- Better management decisions.
CLASSIFICATION OF ACTIVITY LEVELS
The Advantage of Multiple Cost Pools
- Unit-Level (Performed for each unit of production/ Example: Assembly of cell phones)
- Batch-Level ( Performed every time a company produces another batch of a product/ Example: Batch of ice cream)
- Product-Level ( Performed every time a company produces a new type of product/ Example: Time spent testing a new drug by a pharmaceutical company)
- Facility-Level ( Required to support or sustain an entire production process/Example: A hospital)
Describe and give examples for Value-Added Activities and Non-Value-Added Activities.
(These are the Advantage of Enhanced Cost Control)
- Increase the perceived value of a product or service to customers, such as:
Manufacturing Company
Engineering design, Machining services, Assembly, Painting
Service Company
Performing surgery, Legal research, Delivering packages - Adds cost to, or increases the time spent on, a product/service without increasing its perceived value, such as:
Manufacturing Company
Storage of inventory, Moving of inventory, Inspections, Fixing defective goods, Set up machines
Service Company
Taking appointments, Reception, Bookkeeping and billing, Traveling, Ordering supplies, Advertising
What is Activity-based management (ABM)?
Advantage of Better Management Decisions
a management tool that focuses on reducing costs and improving processes and decision-making.
Managers use ABC via ABM for what?
- for both strategic and operational decisions or perspectives
- to help managers evaluate employees, departments, and business units
- to establish performance standards, as well as benchmark against other companies
What are limitations of ABC?
- Expensive to use
2. Arbitrary allocations remain
Knowing When to use ABC
- Product lines differ in volume and manufacturing complexity
- Product lines are numerous and diverse
- Overhead costs constitute a significant portion of total costs
- Manufacturing process or the number of products has changed significantly
- Production or marketing managers are ignoring data
Explain just-in-time (JIT)
JIT manufacturing is dedicated to having the right amount of materials, parts, or products just as they are needed.
Objective of JIT Processing
To eliminate all manufacturing inventories.
Elements of JIT Processing
- Dependable suppliers
- Multi-skilled work force
- Total quality control system
Benefits of JIT Processing
- Significant reduction or elimination of manufacturing inventories
- Enhanced product quality
- Reduction or elimination of rework costs and inventory
storage costs - Production cost savings from the improved flow of goods through the processes
Apply activity-based costing to service industries
Identify key activities that generate costs and keep track of how many of those activities are completed for each service performed.
- General approach is to identify activities, cost pools, and cost drivers
- Labeling of activities as value-added or non-value-added
