Product costs don’t make sense
Problem: There may be no relationship between the overhead application base and the way that different products cause overhead costs
Causes of problems
Increased product diversity changing cost structures use of volume-based cost drivers Have resulted in:
Departmental Overhead Rates
Finishing Department Painting Department
Shipping Department
A two stage process is necessary because costs are allocated to departments
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.
MAA 703 Management Accounting
Topic 6 Activity-Based Costing
Evolution of ABC
Conventional costing systems use a twostage 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.
The result: ❖High-volume simple products are overcosted and over-priced ❖Low-volume complex products are under-costed and under-priced
Plantwide Overhead Rates
Department 3
Departmental Overhead Rates
Indirect
Stage One:
Labor
Costs assigned
to pools
Cost pools
Department 1
Stage Two: Costs applied to products
Indirect Materials
Department 2
Products
Other Overhead
Department 3
Departmental Overhead Rates
Indirect
Stage One:
Labor
Costs assigned
to pools
Cost pools
Department 1
Indirect Materials
To compete in the marketplace, some companies have had to cut the prices of high volume popular items high mark-ups on low volume specialty products.
Cost Distortions caused by 2-stage allocations
There is a no link between the cause of support activity costs and the basis for assigning these costs to products
Department 2
Other Overhead
Department 3
Stage Two: Costs applied to products
Direct Labour Hours
Machine Hours
Raw Materials
Cost
Products
Departmental Allocation Bases
Erosion of company profits
Price cuts produce increased sales in units but decreased total revenue
High mark-ups on specialty products didn’t offset the fall in profit margins of high volume products
and then to products.
Departmental Overhead Rates
Indirect
Stage One:
Labor
Costs assigned
to pools
Cost pools
Department 1
Indirect Materials
Department 2
Other Overhead
Why?
1. Allocations are based on unit or volume related measures.
2. Different products consume different amounts of support activities.
Questionable profit margins