Chapter 4 - Activity-Based Costing

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90 Terms

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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

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What allocation base is most commonly used?

direct labor-hours

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What does using a plantwide POHR result in? High overhead costs for products with…

a high direct labor-hours content

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What does using a plantwide POHR result in? Low overhead costs for products with…

a low direct-labor hours content.

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However, the real causes of overhead may have little to do with direct labor-hours and, as a consequence…

product costs may be distorted

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What does activity-based costing attempt to do?

it attempts to correct these distortions by more accurately assigning overhead costs to products

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Companies use three common approaches to assign overhead costs to products. What are they?

  • plantwide overhead rate

  • departmental overhead rates

  • activity-based costing

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Which is the simplest approach?

plantwide overhead rate

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Which is a slightly more refined approach?

departmental overhead rates

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Which is the most complex approach?

activity-based costing

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Of the three, which approach is the most accurate to overhead cost assignment?

activity-based costing

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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

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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

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Activity-based costing systems usually reveal that low-volume products…

cost more than reported by conventional cost systems

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Activity-based costing systems usually reveal that high-volume products…

cost less than reported by conventional cost systems

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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.

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ABC is a technique that attempts to…

assign overhead costs more accurately to products than the simpler methods

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A customer order triggers a number of activities. These activities…

consume resources

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In activity-based costing, an attempt is made to…

trace these costs directly to the products that cause them

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Activity-Based Costing Model

  1. Cost Objects

  2. customer orders require activities

  3. activities consume resources

  4. consumption of resources incur

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Rather than a single allocation base, in ABC a company…

uses a number of allocation bases for assigning costs to products

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Each allocation base in an ABC system represents…

a major activity that causes overhead costs

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activity

an event that causes the consumption of overhead resources

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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

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Each major activity has its own…

overhead cost pool, activity measure, and overhead rate

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what is the overhead cost pool also known as?

activity cost pool

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what is the overhead rate also known as?

activity rate

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activity cost pool

A “cost bucket” in which costs related to a particular/single activity measure are accumulated

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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

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example of activity measure

number of patients admitted is used for the activity admitting patients to the hospital

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activity rate

An overhead rate in activity-based costing.

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Each activity cost pool has its own…

activity rate to assign overhead costs to cost objects

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Products are ordinarily processed in…

batches

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how to calculate activity rate

total cost in activity pool / total expected activity

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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

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Taking each activity in isolation, this system works exactly like…

the job-order costing system

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An activity rate is computed for…

each activity

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Then, these rates are used to…

assign costs to jobs and products based on the amount of activity consumed by the job or product

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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.

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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

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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

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the end result of the design process of an ABC system is…

an activity dictionary

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activity dictionary

defines each of the activities that will be included in the ABC system and how the activities will be measured

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activities are grouped into a four-level hierarchy:

  • unit-level

  • batch-level

  • product-level

  • facility-level

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This cost hierarchy is useful in understanding…

the difference between activity-based costing and conventional approaches

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In general, activities and costs should be combined in the ABC system only if…

they fall within the same level in the cost hierarchy

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processing units on machines

unit-level activities

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machine-hours

unit-level activity measures

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processing units by hand

unit-level activities

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direct-labor hours

unit-level activity measures

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consuming factory supplies

unit-level activities

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units produced

unit-level activity measures

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processing purchase orders

batch-level activity

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purchase orders processed

batch-level activity measures

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processing production orders

batch-level activity

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production orders processed

batch-level activity measures

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setting up equipment

batch-level activity

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number of setups/setup hours

batch-level activity measures

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handling material

batch-level activity

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pounds of material handled/number of times material moved

batch-level activity measures

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testing new products

product-level activities

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hours of testing time

product-level activity measures

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administering parts inventories

product-level activities

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number of part types

product-level activity measures

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designing products

product-level activities

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hours of design time

product-level activity measures

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general factory administration

facility-level activities

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plant building and grounds

facility-level activities

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direct labor hours

facility level activity measures

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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.

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the costs of unit-level activities should be…

proportional to the number of units produced

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example of unit-level activity

providing power to run processing equipment

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why?

because power tends to be consumed in proportion to the number of units produced

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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.

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The amount of resources consumed depends on…

the number of batches run rather than on the number of units in the batch.

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example of batch-level activities

  • processing purchase orders

  • setting up equipment

  • packing shipments

  • handling material

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costs at the batch level depend on…

the number of batches processed

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for example, the cost of processing a purchase order is the same no matter how many units of an item are ordered.

true

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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.

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what are product-level activities sometimes called?

product-sustaining activities

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