Managerial Accounting – Chapter 4

Calculating costs isn’t a “one size fits all” process!

Job order costing works for many companies

But not all…

Process costing works for some companies

But not all…

This chapter is all about another costing method – Activity based costing

Last Chapters – we assigned overhead cost to each job

Used a predetermined overhead rate

Direct labor cost for job order costing

Machine hours for process costing

But what’s happened in society?

Technological advances have caused more automated manufacturing

Less workers = less direct labor costs

So maybe that’s not a good measure for some industries… and could be misleading!

Machine hours isn’t always the answer either

Product design and engineering costs aren’t correlated with machine hours

These can be substantial costs and should be allocated

So how should we allocate these overhead costs?

Activity Based Costing (ABC)

Another way to allocate overhead costs

Direct Materials and Direct Labor are easy to calculate and allocate

It’s overhead that gives us headaches!

Activity Based Costing Allocates overhead to multiple activity cost pools then

assigns these activity cost pools to products and services by using cost drivers

It doesn’t replace Job Order Costing or Process Costing, it’s just another, possibly more accurate way, to calculate Overhead within the current Costing system.

Activity-Based Costing Comes with some unique vocab:

Activity: event, action, transaction, or work sequence that incurs costs when producing a product or performing a service

Activity Cost Pool: overhead cost attributed to a distinct activity

Cost Driver: any factor or activity that has a direct cause-effect relationship with the resources consumed

Four Steps Involved Identify and classify the activities involved in

manufacturing specific products and assign overhead to cost pools

Identify the cost driver that has a strong correlation to the costs accumulated in each cost pool

Compute the activity based overhead rate for each pool

Allocate overhead costs to products using overhead rates determined for each cost pool

What do cost drivers do? Measure number of individual activities

undertaken to produce goods or perform services

Has to be high correlation between the cost driver and actual consumption of overhead costs in the cost pool

Ex: how many purchase orders processed; how many machines are set up; how many inspections completed

Typical overhead cost pools Ordering materials (cost driver = # of

orders processed)

Setting up machines (cost driver = # of machines set up

Assembling products (cost driver = # products assembled)

Inspecting products (cost driver = # products inspected)

Let’s trace the process through all four steps

Using some pretty old-school exercise equipment!

ABC Costing DOES NOT Change Overhead allocated

Just allocates it in a different way than using direct labor hours or machine hours in Job Order or Process Costing

Why do lower-volume products usually have higher costs?

Often more customized

Require more special handling

Time means money!

ABC Cost Benefits

1: Increased product cost accuracy by using multiple cost pools

In stead of one plantwide pool or several departmental pools and a single cost driver, companies use multiple cost pools with more relevant cost drivers

ABC Cost Benefits

2: Enhanced control over overhead costs because costs can be traced directly to activities

Some costs previously considered to be indirect might be identified as direct

Managers increase awareness of activities performed in production and supporting processes

Can be better classified as value-added or non-value added

Side Note Value added activities increase the perceived value of a

product or service to customers (engineering design, paint color, etc)

Which one has more value added?

Side Note #2

Non-value activities, if eliminated, do not reduce perceived value of company’s product or service. They just add cost or time to product or service.

For example – inventory storage. Customers don’t care about it, no added value.

ABC Benefits

3: Better management decisions. Knowledge is power!

For example, if products require a lot of manufacturing set up time, produce more before tearing manufacturing equipment down to start producing another product

Use to establish performance standards for the company

Use to benchmark (compare performance to other companies)

ABC Limitations

EXPENSIVE! Identifying multiple activities, applying multiple cost drivers discourages companies from using ABC

More complicated than traditional systems

Is cost greater than benefit?

Still some arbitrary allocation (things like insurance)

How do we know when to use ABC? When product lines differ greatly in volume and

manufacturing complexity

When product lines are numerous and diverse, requiring various degrees of support services

Overhead costs constitute a significant portion of total costs

Manufacturing process or number of products has changed significantly (did we just automate factory?)

Production or marketing managers are ignoring data in existing system and using their own bootleg costing data when pricing or making other decisions