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What does a plantwide predetermined overhead rate do?
spreads overhead costs uniformly over products in proportion to whatever allocation base is used
What allocation base is most commonly used?
direct labor-hours
What does using a plantwide POHR result in? High overhead costs for products with…
a high direct labor-hours content
What does using a plantwide POHR result in? Low overhead costs for products with…
a low direct-labor hours content.
However, the real causes of overhead may have little to do with direct labor-hours and, as a consequence…
product costs may be distorted
What does activity-based costing attempt to do?
it attempts to correct these distortions by more accurately assigning overhead costs to products
Companies use three common approaches to assign overhead costs to products. What are they?
plantwide overhead rate
departmental overhead rates
activity-based costing
Which is the simplest approach?
plantwide overhead rate
Which is a slightly more refined approach?
departmental overhead rates
Which is the most complex approach?
activity-based costing
Of the three, which approach is the most accurate to overhead cost assignment?
activity-based costing
Conventional cost systems that use plantwide predetermined overhead rates suffer from an important limitation. What is that?
they tend to inaccurately assign too much overhead to high-volume products and too little overhead to low-volume products
Why does this distortion occur?
because conventional cost systems rely exclusively on allocation bases, such as direct labor hours and machine hours, that are highly correlated with (or move in tandem with) the volume of production
Activity-based costing systems usually reveal that low-volume products…
cost more than reported by conventional cost systems
Activity-based costing systems usually reveal that high-volume products…
cost less than reported by conventional cost systems
Activity-based costing (ABC)
A two-stage costing method in which overhead costs are assigned to products on the basis of the activities they require.
ABC is a technique that attempts to…
assign overhead costs more accurately to products than the simpler methods
A customer order triggers a number of activities. These activities…
consume resources
In activity-based costing, an attempt is made to…
trace these costs directly to the products that cause them
Activity-Based Costing Model
Cost Objects
customer orders require activities
activities consume resources
consumption of resources incur
Rather than a single allocation base, in ABC a company…
uses a number of allocation bases for assigning costs to products
Each allocation base in an ABC system represents…
a major activity that causes overhead costs
activity
an event that causes the consumption of overhead resources
examples of activities (verbs)
setting up machines
admitting patients to a hospital
scheduling production
performing blood tests
billing customers
maintaining equipment
ordering materials
stocking shelves
meeting with clients
preparing shipments
inspecting materials
opening a ban account
Each major activity has its own…
overhead cost pool, activity measure, and overhead rate
what is the overhead cost pool also known as?
activity cost pool
what is the overhead rate also known as?
activity rate
activity cost pool
A “cost bucket” in which costs related to a particular/single activity measure are accumulated
activity measure
expresses how much of the activity is carried out and is used as the allocation base for assigning overhead costs to products and services
example of activity measure
number of patients admitted is used for the activity admitting patients to the hospital
activity rate
An overhead rate in activity-based costing.
Each activity cost pool has its own…
activity rate to assign overhead costs to cost objects
Products are ordinarily processed in…
batches
how to calculate activity rate
total cost in activity pool / total expected activity
This rate does NOT depend on how many units are produced after the activity is done.
A small batch requiring this activity would be charged the same as a large batch like a fixed cost
Taking each activity in isolation, this system works exactly like…
the job-order costing system
An activity rate is computed for…
each activity
Then, these rates are used to…
assign costs to jobs and products based on the amount of activity consumed by the job or product
The most important decisions in designing an activity-based costing system concern…
what activities will be included in the system and how the activities will be measured.
the challenge in designing an activity-based costing system is to…
identify a reasonably small number of activities that explain the bulk of the variation in overhead costs
how is this done?
by interviewing a broad range of managers in the organization to find out what activities they think are important and that consume most of the resources they manage
the end result of the design process of an ABC system is…
an activity dictionary
activity dictionary
defines each of the activities that will be included in the ABC system and how the activities will be measured
activities are grouped into a four-level hierarchy:
unit-level
batch-level
product-level
facility-level
This cost hierarchy is useful in understanding…
the difference between activity-based costing and conventional approaches
In general, activities and costs should be combined in the ABC system only if…
they fall within the same level in the cost hierarchy
processing units on machines
unit-level activities
machine-hours
unit-level activity measures
processing units by hand
unit-level activities
direct-labor hours
unit-level activity measures
consuming factory supplies
unit-level activities
units produced
unit-level activity measures
processing purchase orders
batch-level activity
purchase orders processed
batch-level activity measures
processing production orders
batch-level activity
production orders processed
batch-level activity measures
setting up equipment
batch-level activity
number of setups/setup hours
batch-level activity measures
handling material
batch-level activity
pounds of material handled/number of times material moved
batch-level activity measures
testing new products
product-level activities
hours of testing time
product-level activity measures
administering parts inventories
product-level activities
number of part types
product-level activity measures
designing products
product-level activities
hours of design time
product-level activity measures
general factory administration
facility-level activities
plant building and grounds
facility-level activities
direct labor hours
facility level activity measures
unit-level activities
Activities that arise as a result of the total volume of goods and services that are produced, and that are performed each time a unit is produced.
the costs of unit-level activities should be…
proportional to the number of units produced
example of unit-level activity
providing power to run processing equipment
why?
because power tends to be consumed in proportion to the number of units produced
batch-level activities
Activities that are performed each time a batch of goods is handled or processed, regardless of how many units are in a batch.
The amount of resources consumed depends on…
the number of batches run rather than on the number of units in the batch.
example of batch-level activities
processing purchase orders
setting up equipment
packing shipments
handling material
costs at the batch level depend on…
the number of batches processed
for example, the cost of processing a purchase order is the same no matter how many units of an item are ordered.
true
product-level activities
Activities that relate to specific products that must be carried out regardless of how many units are produced and sold or batches run.
what are product-level activities sometimes called?
product-sustaining activities