Chapter_03

Title: Activity-Based CostingCopyright: © 2016 by McGraw-Hill Education. All rights reserved.

Historical Context of Cost Systems

Cost systems established in the 1800s focused on simplicity due to:

• Manual data collection and calculations using paper and pencil.

• Companies produced limited varieties of similar products leading to minimal differences in overhead costs among products.Importance: Understanding the context highlights why traditional methods are less effective today.

Plantwide Overhead Rate

Definition:A single overhead rate used throughout an entire factory.Common Allocation Base: Direct labor due to the following reasons:

• Pre-established recording of direct labor information.

• Direct labor constituting a significant portion of overall product costs.

• Assumed correlation between direct labor and overhead costs.

Limitations of Direct Labor as Allocation Base

Current trends show that direct labor may no longer be effective for overhead allocation due to:

• Diverse product offerings resulting in varying overhead consumption.

• Shrinking percentage of direct labor in relation to total costs; rising overhead costs.

• Technological advancements simplifying the collection of diverse data.Conclusion: Plantwide overhead allocation may not provide optimal results in contemporary business settings.

Departmental Overhead Rates

Concept: Each department may utilize its own overhead rate based on work performed.Examples of Allocation Bases:

• Machining Department: Based on machine-hours.

• Assembly Department: Based on direct labor-hours.

Activity-Based Costing (ABC)

ABC addresses limitations of the departmental overhead rate which relies solely on volume-related allocation bases.Key Point: Some overhead costs arise from factors unrelated to volume, which can lead to inadequate overhead cost assignment for companies with diverse products and complex overhead structures.

Summary of Activity-Based Costing (ABC)

Key Feature: Utilizes multiple allocation bases for assigning costs to products, enhancing accuracy in cost management and pricing strategies.

End of Chapter 3

Chapter Summary: A brief recap of ABC and its implications for modern cost accounting.