The Key Question: Does the amount of the activity cost pool increase with the number of units produced?
There is a no link between the cause of
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support activity costs and the basis for assigning these costs to products Why? 1. Allocations are based on unit or volume related measures. 2. Different products consume different amounts of support activities.
Departmental Overhead Rates
Indirect Labor Indirect Materials Other Overhead
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Stage One: Costs assigned to pools Cost pools
Department 1
Department 2
Department 3
4
Departmental Overhead Rates
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Finishing Department Painting Department
Shipping Department
A two stage process is necessary because costs are allocated to departments and then to products.
Solution: Activity Based Costing
ACTIVITIES CONSUME RESOURCES PRODUCTS CONSUME ACTIVITIES
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Activities are used to link resource costs
to products
Activity Based Costing (ABC)
The objective of activity-based costing is to understand the causes of overhead costs and to identify the real profitability of products and customers.
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Identifying and Defining Activities 21
Unit-Level Activities Batch-Level Activities
An ACTIVITY is a part of the production process for which management wants a separate reporting of costs. Product-sustaining Activities Facility-sustaining Activities
Department 1
Direct Labour Hours
Department 2
Machine Hours
Department 3
Raw Materials Cost
Products
Departmental Allocation Bases
Cost Distortions caused by 2-stage allocations
Plantwide Overhead Rates
Companies have tended to use direct labour as the overhead application base.
However direct labour is now a relatively minor part of total manufacturing cost. Many tasks that used to be done by hand are now done by automated equipment.
Questionable profit margins
To compete in the marketplace, some
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companies have had to cut the prices of high volume popular items. But They have been able to achieve high mark-ups on low volume specialty products.
ABC is a good supplement to our traditional cost system
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I agree!
Activity Based Costing (ABC)
Activity-Based Costing
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There are a number Both manufacturing of cost pools, each of and nonmanufacturing which is allocated costs may be using a unique assigned to measure of activity. products. Some manufacturing costs may be excluded from product costs.
Erosion of company profits
Price cuts produce increased sales in
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units but decreased total revenue High mark-ups on specialty products didn’t offset the fall in profit margins of highvity Based Costing
ABC uses cost drivers that directly link
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activities performed to products made. cost drivers are selected which measure the average demand placed on each activity by each product. activity cost pools are assigned to products in proportion to the way that they consume each activity.
Designing an ABC System
Cost Objects (e.g., products and customers)
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Activities
Consumption of Resources
Cost
Designing an ABC System
Steps for Implementing ABC
Allocation bases often differ from traditional costing systems. Overhead rates may be based on activity at capacity.
How Costs are Treated Under Activity-Based Costing
Departmental Overhead Rates
Indirect Labor
Indirect Materials
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Stage One: Costs assigned to pools Cost pools Stage Two: Costs applied to products
Other Overhead
1
Activity-Based Costing
Evolution of ABC
Conventional costing systems use a two-
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stage allocation process: 1. service department costs are allocated to production departments. 2. production department overhead costs are allocated to products using a volume-based predetermined overhead rate.
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cost objects and the performance of activities can help solve problems such as distorted product costs poor cost control the form of ABC adopted depends on the problems that need to be addressed
1. Identify and define activities and activity pools. 2. Where possible, directly trace costs to activities and cost objects. 3. Assign costs to activity cost pools. 4. Calculate activity rates. 5. Assign costs to cost objects. 6. Prepare management reports.
Department 1
Department 2
Department 3
Products
Departmental Overhead Rates