ACCT 2020 Ch 5 Lecture

Limitations of Unit-Based Cost Accounting Systems

In many settings, this unit-based approach to costing acts as an averaging technique, which can lead to distorted or inaccurate costs

Implications of Cost Distortion

Product and service cost distortions can be particularly damaging for firms operating in challenging environments characterized by: intense or increasing competitive pressures, small profit margins, continuous improvement mandates, total quality management initiatives, total customer satisfaction demands, and sophisticated technology requirements

Need for accuracy

The need for more accurate product and service costs is particularly pressing for companies primarily providing services, prompting many to reassess their costing procedures

Major Factors Affecting Overhead Cost Assignment

Large Proportion of Non-Unit Based Overhead Costs (this significantly affects the total overhead structure); degree of product or service diversity (a high level of diversity complicates accurate costing, making conventional unit-based approaches less effective)

Activity Rates

A proposed solution to cost distortion involves using activity rates rather than a single plantwide rate; it is the rate at which activity costs are assigned to products and is calculated by dividing the activity cost by the activity driver; choice of activity driver is fundamental, as it establishes the causal connection between activities and the costs incurred

Choosing Activity Drivers

To enhance the accuracy of overhead cost assignments, causal factors known as activity drivers are selected; they measure the amount of activity consumed by a product and the formula is: Activity Cost Assigned= Activity Rate × Activity Driver

Total Overhead Cost

The total overhead consumed by a product is calculated by summing all assigned activity costs; Total Overhead= Overhead Costs + Prime Costs, which divided by the units produced yields the unit cost

Plantwide Rate Based on Direct Labor Hours

This traditional calculation can lead to inaccuracies in cost assignments, particularly evident when analyzing activity based product costs

Accuracy with Activity-Based Cost Assignment

Activity based costing reflects the actual pattern of overhead consumption and is deemed more accurate compared to unit-based costing, which often undercosts low-volume, deluxe models and overcosts high volume, regular models

Assigning Overhead Costs to Units (Activity Based Costing)

This involves assigning overhead costs first to an organizational unit (plant or department) and then to cost objects (products, services)

Activity

an action or work performed by equipment or people for others

Activity Identification Process

Identifying activities is typically achieved through interviewing managers or representatives from functional work areas

Key Questions for Identifying Activities

How many employees are in your department? Describe their labor consumption; What services do staff provide? Do customers outside your department utilize equipment? If so, how? What resources are utilized by each activity (i.e., equipment, materials, energy)?

Output Measurement

Information on the time workers spend on each activity is important for assigning labor and equipment costs accurately

Activity Dictionary

lists activities relevant to an organization alongside critical attributes that describe these activities

Attributes in Activity Dictionary include:

Types of resources consumed, amount of time spent on an activity by workers, cost objects that consume the activity outputs, and measure of the activity output

Assigning Costs to Activities

A critical step is determining the cost of performing each activity; costs associated with activities include labor, energy, materials, and capital; however, the general ledger may not reveal how much is spent on an activity directly

Driver Tracing

for shared resources, driver tracing is utilized, which employs resource drivers to measure how much resources are consumed by each activity

Assigning Costs to Products

Costs are assigned to products by multiplying a predetermined activity rate by the measure of activity consumed by each product

Determining Practical Capacity

To assign costs effectively, practical capacity- the maximum output of an activity when operating efficiently- must be identified

Activity Based Costing Origin

Initially popular for improving product costing accuracy, activity based costing (ABC) has expanded into various sections of the value chain including:

Upstream (research, development, prototyping)

Downstream (marketing, distribution, customer service)

Customer Costing Insights

ABC allows firms to more accurately identify the upstream costs of suppliers and the downstream costs associated with customers

Importance of Knowledge

Understanding supplier and customer costs yields vital insights for improving profitability

Cumulative Customer Profitability Example

An eighteen producer of semiconductors implemented ABC customer costing:

Discovered 10% of its customers were responsible for approximately 90% of its profits; found it was losing money on the remaining customers, prompting a strategic overhaul where unprofitable customers were encouraged to seek business elsewhere

Result: Sales decreased but profits tripled, illustrating the effectiveness of accurately measuring customer profitability

Activity Based Supplier Costing

ABC also assists in recognizing the true costs associated with suppliers beyond mere component purchase prices

Supplier Activities

Purchasing, receiving, inspection of incoming components, reworking products, expediting products, warranty work; cost assignment- resources consumed by these activities are assigned to individual suppliers using activity drivers; these costs are then aggregated with direct purchase costs to provide a comprehensive view of supplier costs