Activity Based Costing Study Guide

1 January 2017

Hours of design time| Facility-level| General factory administration Plant building and grounds| Direct labor-hours* Direct labor-hours*| *Facility-level costs cannot be traced on a cause-and-effect basis to individual products. Nevertheless, these costs are usually allocated to products for external reports using some arbitrary allocation basis such as direct labor-hours -Unit-level activities- are performed each time a unit is produced. The costs of unit-level activities should be proportional to the number of units produced. -Ex.

Providing power to run processing equipment is a unit-level activity because power tends to be consumed in proportion to the number of units produced. -Batch-level activities- consist of tasks that are performed each time a batch is processed, such as processing purchase orders, setting up equipment, packing shipments to customers, and handling material. Costs at the batch level depend on the number of batches processed rather than on the number of units produced. -Ex. The cost of processing a purchase order is the same no matter how many units of an item are ordered. Product-level activities- relate to specific products and typically must be carried out regardless of how many batches or units of the product are manufactured. Product-level activities include maintaining inventories of parts for a product, issuing engineering change notices to modify a product to meet a customer’s specifications, and developing special test routines when a product is first placed into production. -Facility-level activities- are activities that are carried out regardless of which products are produced, how many batches are run, or how many units are made.

Include items such as factory management salaries, insurance, property taxes, and building depreciation. An Example of an ABC System Design -Under ABC, the manufacturing overhead costs at the top are allocated to products via a two-stage process. -In the first stage, overhead costs are assigned to the activity cost pools. In the second stage, the costs in the activity cost pools are allocated products using activity rates and activity measures. -Ex. In the first stage cost assignment, various manufacturing overhead costs are assigned to the production order activity cost pool.

These costs could include the salaries of engineers who modify products for individual orders, the cost of scheduling and monitoring orders, and other costs that are incurred as a consequence of the number of different orders received and processed by the company. -Once the amount of cost in production-order activity is known, procedures from Job-Order Costing are followed. Example of Activity Based Costing Comtek Sound, Inc. , makes two products, a radio with a built-in CD player (called a CD unit) and a radio with a built-in DVD player (called a DVD unit).

Both of these products are sold to automobile manufacturers for installation in new vehicles. Recently, the company has been losing bids to supply CD players because competitors have been bidding less than Comtek Sound has been willing to bid. At the same time, Comtek has been winning every bid it has submitted for its DVD player, which management regards as a secondary product. The marketing manager has been complaining that at the prices Comtek is willing to bid, competitors are taking the company’s high-volume CD business and leaving Comtek with just the low-volume DVD business.

However, the prices competitors quote on the CD players are below Comtek’s manufacturing costs for these units–at least according to Comtek’s conventional accounting system that applies manufacturing overhead to products based on direct-labor hours. Production managers suspected that the conventional costing system might be distorting the relative costs of the CD player and the DVD player–the DVD player takes more overhead resources to make than the CD player and yet their manufacturing overhead costs are identical under the conventional costing system.

The company may have even been suffering a loss on the DVD units without knowing it because the cost of these units has been so vastly understated. Conversely, it seems Comtek has been overcharging for the CD units all along since their costs were overstated. -When a company implements activity-based costing, overhead cost often shifts from high-volume products to low-volume products, with a higher unit product cost resulting for the low-volume products. -This happened in the Comtek example, where the cost of the low-volume DVD units increased from $150 to $207. 0 per unit. This increase in cost resulted from batch-level and product-level costs, which shifted from the high-volume product to the low-volume product. Fewer DVD units are processed per production order than CD units. Evaluation of Activity Based Costing Benefits -improves the accuracy of product costs in three ways: -it usually increases the number of cost pools used to accumulate overhead costs, which in turn accumulates costs for each major activity -the activity cost pools are more homogenous than departmental cost pools.

In principle, all of the costs in an activity cost pool pertain to a single activity. In contrast, departmental cost pools contain the costs of many different activities carried out in the department. -Activity-based costing uses a variety of activity measures to assign overhead costs to products, some of which are correlated with volume and some which are not. -makes it clear that batch setups, engineering change orders, and other activities cause overhead costs rather than just direct labor.

Managers thus have a better understanding of the causes of overhead costs, which should lead to better decisions and better cost control. -can be used as a part of programs to improve operations Limitations -The Cost of implementing ABC -the cost system must be designed, which involves a cross-functional team. It requires taking valued employees away from other tasks for a major project. -The data used in ABC must be collected and verified. In some cases, this requires collecting data that has never been collected before. Because of these costs, some managers might decide that the costs outweigh the expected benefits ABC costing would bring about. *When is ABC most likely worth the effort? When companies have: -products that differ substantially in volume, batch size, and in the activities they require -conditions have substantially changed since the existing cost system was established -overhead costs are high and increasing and no one seems to understand why -management does not trust the existing cost system and ignores data from the system when making decisions -Limitations of ABC Model relies on a number of critical assumptions: -the cost in each activity pool is strictly proportional to its activity measure. We have little evidence on this, suggesting that overhead costs are less than proportional to activity. Also known as increasing returns to scale–as activity increases, the average cost drops. -This means that product costs computed by traditional or activity-based costing will be overstated for the purposes of making decisions

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