ACCT 201 - Chapter 5 Notes

Activity-based costing (ABC)

A costing method based on activities that provides managers with cost information for strategic and other decisions potentially affecting capacity and therefore fixed as well as variable costs.

Traditional absorption costing limitations when used for internal management purposes

It only assigns manufacturing costs to products—ignoring any nonmanufacturing costs that may be consumed by products. Second, it assigns all manufacturing costs to products even if those products do not consume those costs. Third, it relies on a limited number of overhead cost pools that always use allocation bases correlated with the volume of output. This ignores any non-volume-related cosot drivers that exist in organizations, thereby allocating too much overhead cost to high-volume products and too little overhead to low-volume products.

Activity-based costing overcomes the limitations of traditional cost systems in three ways

Nonmanufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis. Some manufacturing costs may be excluded from product costs. Numerous overhead cost polls are used, each of which is allocated to products and other cost objects using its own unique measure of activity.

Manufacturing and nonmanufacturing costs

Activity-based costing includes ____ when measuring product profitability.

Nonmanufacturing costs that can be directly traced to individual products

Commissions paid to salesperson, shipping costs, and warranty repair costs.

Activity

An event causing the consumption of overhead resources.

Activity cost pool

A “bucket” that accumulates costs related to a single activity measure in an activity-based costing system.

Activity measure

An allocation base in an activity-based costing system; ideally, a measure of the amount of activity that drives the costs in an activity cost pool.

Two most common types of activity measures

Transaction drivers and duration drivers.

Transaction driver

A count of the number of times an activity occurs.

Duration driver

A measure of the time required to perform an activity.

Traditional cost systems recognize only one level of activity

Volume of production.

Activity-based costing defines five levels of activity

Unit-level, batch-level, product-level, customer-level, and organization-sustaining.

Unit-level activities

Activities performed each time a unit is produced.

Unit-level activity example

Providing power to run processing equipment and do rough milling work on products

Batch-level activities

Activities performed each time a batch of goods is handled or processed, regardless of how many units are in the batch. The amount of resources consumed depends on the number of batches run rather than the number of units in the batch.

Batch-level activities examples

Placing purchase orders, setting up equipment, receiving raw materials from suppliers, and arranging for shipments to customers.

Product-level activities

Activities related to specific products that must be performed regardless of how many units are produced and sold or batches run.

Product-level activities examples

Designing a product, advertising a product, managing parts inventories, and maintaining a product manager and staff.

Customer-level activities

Activities carried out to support customers that are unrelated to specific products.

Customer-level activities examples

Sales calls, catalog mailings, customer meetings, and general technical support.

Organization-sustaining activities

Activities that are carried out regardless of which customers are served, which products are produced, how many batches are run, or how many units are made.

Organization-sustaining activities examples

Heating the factory, interview and process new employees, cleaning executive offices, providing a computer network, arranging for loans, and preparing annual reports to shareholders.

Activity-based costing implementation in five steps

Define activities, activity cost pools, and activity measures. Assign overhead costs to activity cost pools. Calculate activity rates. Assign overhead costs to cost objects. Prepare management reports.

Activity-based costing implementation step one

Define activities, activity cost pools, and activity measures.

Activity-based costing implementation step two

Assign overhead costs to activity cost pools.

First-stage allocation

The process of assigning overhead costs to activity cost pools in an activity-based costing system.

Activity-based costing implementation step three

Calculate activity rates.

Activity-based costing implementation step four

Assign overhead costs to cost objects.

Second-stage allocation

Using activity rates to apply costs to products and customers in activity-based costing.

Activity-based costing implementation step five

Prepare management reports.

Most common management reports prepared with activity-based costing data

Product and customer profitability reports.

Plantwide overhead rate equals

Total estimated manufacturing overhead divided by total estimated machine hours.

Activity-based management

A management approach focusing on managing activities as a way of eliminating waste and reducing delays and defects.

Benchmarking

A systematic approach to identifying the activities with the greatest potential for improvement.

Activity-based costing is ordinarily used as

Supplement to, rather than as a replacement for, the company’s usual costing system.

Activity-based costing nonmanufacturing and manufacturing costs

May be assigned to products, but only on a cause-and-effect basis.

Activity-based costing systems can assign

Sales commissions, shipping costs, and warranty repair costs to specific products.

Excluded

In activity-based costing, some manufacturing costs may be ___ from product costs.

Activity-based costing excludes

Organization-sustaining costs and idle capacity costs from product cost.

Unique measure of activity; direct labor hours and/or machine hours

Each ABC cost pool has its own ___, while traditional cost systems usually rely on ____ to allocate all overhead costs to products.

Characteristics of a successful ABC implementation

Strong top management support, linked to how people are evaluated and rewarded, and cross-functional teams should be created.

Customer orders

Assigned all costs of resources that are consumed by taking and processing customer orders.

Product design

Assigned all costs of resources used to design new products.

Order size

Assigned all costs of resources consumed as a consequence of the number of units produced.

Customer relations

Assigned all costs associated with maintaining relations with customers.

Other

Assigned all overhead costs that are not associated with customer orders, product design, the size of the orders, or customer relations.

Limitations of activity-based costing

Substantial resources required to implement and maintain, resistance to unfamiliar numbers and reports, desire to fully allocate all costs to products, potential misinterpretation of unfamiliar numbers, and doesn’t replace existing cost system that supports external reporting. Two costing systems may be needed.

Plantwide overhead rate equals

Estimated total manufacturing overhead divided by estimated total allocation-base units.

Activity rate equals

Total cost in activity pool divided by total activity measure.

Overhead assigned to a cost object

Activity rate X amount of activity used.

Transaction driver examples

Number of purchase orders, number of setups.

Duration driver examples

Machine setup hours and inspection hours.

Product profitability

Helps managers identify which products generate the most profit after accounting for the resources they consume.

Customer profitability

Helps managers identify which customers are profitable after accounting for the costs of serving them.

Activity-based management

Uses activity-related information to improve operations, reduce waste, and eliminate delays and defects.