Prelims 3

Activity based costing

A management accounting method that assigns indirect costs to products, services, customers, or other cost objects based on the activities required to produce them.

Activities

Refers to a specific task, process, or operation that consumes organizational resources and is performed to produce goods or deliver services.

Resources

Are the economic inputs consumed in performing organizational activities.

They represent the expenditures incurred by the organization to carry out its operations and serves as the starting point for cost assignment.

Activity centers

Are segments of the organization where related activities are performed and managed.

It helps organizations identify which dept. consume the most resources snd where efficiency improvements may be achieved.

Cost objects

Are anything for which cost information is desired.

It is the final destination of allocated costs.

Activity driver rate

Represents the cost assigned to each unit of a cost driver.

This rate is then used to allocate activity costs to cost objects based on their actual consumption of the activity.

Unit-level activities

These activities are performed each time a single unit is produced.

Batch-level activities

These activities are performed once for every batch of products.

Product-level activities

These activities support s specific product line and are incurred regardless of the number of batches or units produced.

Customer-level activities

These activities are performed to serve specific customers.

Organization-sustaining activities

These activities support the overall operation of the organization.

Service allocation

Process of assigning costs incurred by service dept to production dept, operating dept, products, services, or other cost objects based on the benefits received or the resources consumed.

Direct method

Allocates service dept costs only to production departments.

Step method (Sequential method)

Allocates service dept costs sequentially, recognizing that one service dept may provide services to another service dept.

More accurate than the direct method.

Provides greater accuracy than the direct method while remaining relatively easy to implement

Advantage of step method

It does not fully recognize the reciprocal services exchanged among all service dept.

Limitation of step method

Reciprocal method

Fully recognizes the mutual services exchanged among service dept before allocating costs to production dept.

Uses simultaneous equations or matrix algebra to determine the total service dept costs.

Most accurate method

Recognizes all interdepartmental services

Commonly used in organizations with extensive service department interactions

Characteristics of reciprocal method

Provides the highest degree of cost allocation accuracy by fully reflecting the actual consumption of resources among service departments.

Advantage of reciprocal method

It is more computationally complex and requires more detailed information to implement effectively.

Limitations of reciprocal method

Step 1: Identify major activities and create activity cost pools.

Identify the significant activities involved in operations and group related overhead costs into separate activity cost pools.

Step 2: Identify appropriate cost drivers

Determine the cost driver for each activity costs pool.

Step 3: Compute activity rates

Calculate the activity rate for each cost pool by dividing the total activity cost by the total quantity of its corresponding cost driver.

Step 4: Allocate overhead costs to cost objects

Assign overhead costs to products, services, customers, or other cost objects based on their actual consumption of each activity.